10-K 1 form10k.htm FINANCIAL REPORT AND FOOTNOTES  
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

_______________

FORM 10-K
_______________
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014
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 000-12896
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OLD POINT FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
_______________

Virginia
 
54-1265373
(State or other jurisdiction of incorporation or organization)
 
(IRS Employer Identification No.)

1 West Mellen Street, Hampton, Virginia 23663
(Address of principal executive offices) (Zip Code)

(757) 728-1200
(Registrant's telephone number, including area code)

_______________
Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $5 par value
 
The NASDAQ Stock Market LLC
(Title of each class)
 
(Name of each exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act:
None
_______________

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Act.
Yes [ ]                                No [X]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes [ ]                                No [X]

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 [ ]

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
[ ]

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.

Large accelerated filer [ ]
 
Accelerated filer [ ]
 
 
 
Non-accelerated filer [ ] (Do not check if a smaller reporting company)
 
Smaller reporting company [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes [ ]                                No [X]

The aggregate market value of voting and non-voting stock held by non-affiliates of the registrant as of June 30, 2014 was $49,311,653 based on the closing sales price on the NASDAQ Capital Market of $15.39.

There were 4,959,009 shares of common stock outstanding as of March 17, 2015.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Company's Annual Meeting of Stockholders to be held on May 26, 2015, are incorporated by reference in Part III of this report.


OLD POINT FINANCIAL CORPORATION

FORM 10-K

INDEX

PART I
 
Page
 
 
 
1
7
14
14
14
14
 
 
 
PART II
 
 
 
 
 
15
16
17
35
35
80
80
80
 
 
 
PART III
 
 
 
 
 
80
81
81
81
81
 
 
 
PART IV
 
 
 
 
 
81
 
Index to Consolidated Financial Statements
81
 
Index to Exhibits
82
 
Signatures
83


Part I
Item 1. Business

GENERAL

Old Point Financial Corporation (the Company) was incorporated under the laws of Virginia on February 16, 1984, for the purpose of acquiring all the outstanding common stock of The Old Point National Bank of Phoebus (the Bank), in connection with the reorganization of the Bank into a one-bank holding company structure. At the annual meeting of the stockholders on March 27, 1984, the proposed reorganization was approved by the requisite stockholder vote. At the effective date of the reorganization on October 1, 1984, the Bank merged into a newly formed national bank as a wholly-owned subsidiary of the Company, with each outstanding share of common stock of the Bank being converted into five shares of common stock of the Company.

The Company completed a spin-off of its trust department as of April 1, 1999. The organization is chartered as Old Point Trust & Financial Services, N.A. (Trust). Trust is a nationally chartered trust company. The purpose of the spin-off was to have a corporate structure more ready to compete in the field of wealth management. Trust is a wholly-owned subsidiary of the Company.

The Bank is a national banking association that was founded in 1922. As of the end of 2014, the Bank had 18 branch offices serving the Hampton Roads localities of Hampton, Newport News, Norfolk, Virginia Beach, Chesapeake, Williamsburg/James City County, York County and Isle of Wight County. The Bank offers a complete line of consumer, mortgage and business banking services, including loan, deposit, and cash management services to individual and business customers.

The Company's primary activity is as a holding company for the common stock of the Bank and Trust. The principal business of the Company is conducted through its subsidiaries, which continue to conduct business in substantially the same manner as before the reorganization and spin-off.

As of December 31, 2014, the Company had assets of $876.3 million, loans of $536.0 million, deposits of $716.7 million, and stockholders' equity of $88.5 million. At year-end, the Company and its subsidiaries had a total of 301 employees, 18 of whom were part-time.

MARKET AREA AND COMPETITION

The Company's market area is located in Hampton Roads, situated in the southeastern corner of Virginia and boasting the world's largest natural deepwater harbor. The Hampton Roads Metropolitan Statistical Area (MSA) is the 37th most populous MSA in the United States according to the U.S. Census Bureau's 2010 census and the third largest deposit market in Virginia, after Richmond and the Washington Metropolitan area, according to the Federal Deposit Insurance Corporation (FDIC). Hampton Roads includes the cities of Chesapeake, Hampton, Newport News, Norfolk, Poquoson, Portsmouth, Suffolk, Virginia Beach and Williamsburg, and the counties of Isle of Wight, Gloucester, James City, Mathews, York and Surry. The market area is serviced by 73 banks, savings institutions and credit unions and, in addition, branches of virtually every major brokerage house serve the Company's market area.

The banking business in Virginia, and in the Company's primary service areas in the Hampton Roads MSA, is highly competitive and dominated by a relatively small number of large banks with many offices operating over a wide geographic area. Among the advantages such large banks have over the Company is their ability to finance wide-ranging advertising campaigns, and by virtue of their greater total capitalization, to have substantially higher lending limits than the Company. Factors such as interest rates offered, the number and location of branches and the types of products offered, as well as the reputation of the institution affect competition for deposits and loans. The Company competes by emphasizing customer service and technology, establishing long-term customer relationships and building customer loyalty, and providing products and services to address the specific needs of the Company's customers. The Company targets individual and small-to-medium size business customers.

Concurrently, the Company continues to build a stronger presence in the business banking market, where greater opportunities for fee-based revenues and cross-selling exist. In 2009, the Company expanded its treasury services offerings by adding a Corporate Banking group and expanding its product offerings to match those offered by larger institutions. This expansion continued throughout 2013 and 2014 with an aim towards growth and relationship development. Through these business banking capabilities, the Company is able to service a highly lucrative market that offers the opportunities to identify new revenue streams and cross sell additional products.
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Personal assets held by non-banks are difficult to track at a local level, so research relies on deposits reported by governmental agencies to measure market share. In 2014, the Company held tenth place with 2.60% market share of all Hampton Roads deposits, as compared to 2.51% market share in 2013. Overall deposit growth remains consistent including most of the geographically smaller markets as well. The Company retains first place in Hampton with 31.63% market share and deposit growth from 2013 of over $5.4 million. Market share also increased as deposits grew from 2013 in Newport News by over $12.4 million and in Isle of Wight County by over $1.1 million. While deposits declined in York County from 2013 by just over $1.9 million, deposits in James City County increased by $768 thousand.

The Company saw significant growth in the Chesapeake market with deposits increasing just over $15.0 million and moving up in rank from thirteenth to eleventh. However, in the Norfolk and Virginia Beach markets deposits decreased by just over $4.2 million and $3.4 million, respectively. Combined with heightened marketing efforts, the staff in the Company's newer locations continues to work diligently to increase the Company's name recognition in their respective regions of the Hampton Roads MSA.

The Company also faces competitive pressure from credit unions. The three largest credit unions headquartered in the Hampton Roads MSA are Chartway Federal Credit Union, Langley Federal Credit Union, and Bayport Credit Union (also known as Newport News Shipbuilding Employees' Credit Union) with deposits totaling approximately $1.7 billion, $1.5 billion and $1.1 billion, respectively. Both Langley Federal Credit Union and Newport News Shipbuilding Employees' Credit Union posted a positive growth rate from 2013.

AVAILABLE INFORMATION

The Company maintains a website on the Internet at www.oldpoint.com. The Company makes available free of charge, on or through its website, its proxy statements, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission (SEC). This reference to the Company's Internet address shall not, under any circumstances, be deemed to incorporate the information available at such Internet address into this Form 10-K or other SEC filings. The information available at the Company's Internet address is not part of this Form 10-K or any other report filed by the Company with the SEC. The public may read and copy any documents the Company files at the SEC's Public Reference Room at 100 F Street, N.E. Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company's SEC filings can also be obtained on the SEC's website on the Internet at www.sec.gov.

REGULATION AND SUPERVISION

Set forth below is a brief description of some of the material laws and regulations that affect the Company. The description of these statutes and regulations is only a summary and is not a complete discussion or analysis. This discussion is qualified in its entirety by reference to the statutes and regulations summarized below. No assurance can be given that these statutes or regulations will not change in the future.

General. The financial crisis of 2008, including the downturn of global economic, financial and money markets and the threat of collapse of numerous financial institutions, and other events led to the adoption of numerous laws and regulations that apply to financial institutions. The most significant of these laws is the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), adopted on July 21, 2010, to implement significant structural reforms to the financial services industry. The Dodd-Frank Act is discussed in more detail below.

As a result of the Dodd-Frank Act and other regulatory reforms, the Company continues to experience a period of rapidly changing regulatory requirements. These regulatory changes have had and will continue to have a significant impact on how the Company conducts its business. The full extent of the Dodd-Frank Act and other proposed regulatory reforms cannot yet be fully determined and will depend to a large extent on regulations that will be adopted in the coming months and years.

As a public company, the Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the Exchange Act), which include, but are not limited to, the filing of annual, quarterly and other reports with the SEC. The Company is also required to comply with other laws and regulations of the SEC applicable to public companies.

The Company is also a bank holding company within the meaning of the Bank Holding Company Act of 1956 (the BHCA) and is registered as such with, and subject to the supervision of, the Board of Governors of the Federal Reserve System (the FRB). Generally, a bank holding company is required to obtain the approval of the FRB before acquiring direct or indirect ownership or control of more than five percent of the voting shares of a bank or engaging in an activity considered to be a non-banking activity, either directly or through a subsidiary. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.
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As a national bank, the Bank is subject to regulation, supervision and regular examination by the Office of the Comptroller of the Currency (the Comptroller). The prior approval of the Comptroller or other appropriate bank regulatory authority is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant's performance record under the Community Reinvestment Act (the CRA) and fair housing initiatives, and the effectiveness of the subject organizations in combating money laundering activities. Each depositor's account with the Bank is insured by the FDIC to the maximum amount permitted by law. The Bank is also subject to certain regulations promulgated by the FRB and applicable provisions of Virginia law, insofar as they do not conflict with or are not preempted by federal banking law.

As a non-depository national banking association, Trust is subject to regulation, supervision and regular examination by the Comptroller. Trust's exercise of fiduciary powers must comply with Regulation 9 promulgated by the Comptroller and with Virginia law.

The regulations of the FRB, the Comptroller and the FDIC govern most aspects of the Company's business, including deposit reserve requirements, investments, loans, certain check clearing activities, issuance of securities, payment of dividends, branching, and numerous other matters. As a consequence of the extensive regulation of commercial banking activities in the United States, the Company's business is particularly susceptible to changes in state and federal legislation and regulations, which may have the effect of increasing the cost of doing business, limiting permissible activities or increasing competition.

The Bank Holding Company Act. As a bank holding company, the Company is subject to the BHCA and regulation and supervision by the FRB. A bank holding company is required to obtain the approval of the FRB before making certain acquisitions or engaging in certain activities. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.

A bank holding company is required to obtain the approval of the FRB before it may acquire all or substantially all of the assets of any bank, and before it may acquire ownership or control of the voting shares of any bank if, after giving effect to the acquisition, the bank holding company would own or control more than 5 percent of the voting shares of such bank. The approval of the FRB is also required for the merger or consolidation of bank holding companies.

Pursuant to the BHCA, the FRB has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the FRB has reasonable grounds to believe that continuation of such activity or ownership constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.

The Company is required to file periodic reports with the FRB and provide any additional information the FRB may require. The FRB also has the authority to examine the Company and its subsidiaries, as well as any arrangements between the Company and its subsidiaries, with the cost of any such examinations to be borne by the Company. Banking subsidiaries of bank holding companies are also subject to certain restrictions imposed by federal law in dealings with their holding companies and other affiliates.

The Dodd-Frank Act. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including changes that will affect all bank holding companies and banks, including the Company and the Bank. Among other provisions, the Dodd-Frank Act:

·
changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital. The Dodd-Frank Act also made permanent the $250,000 limit for federal deposit insurance and increased the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000;

·
repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

·
created and centralized significant aspects of consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (CFPB), which is discussed in more detail below;

·
imposed limits for debit card interchange fees for issuers that have assets greater than $10 billion, which also could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets;
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·
restricted the preemption of state law by federal law and disallowed subsidiaries and affiliates of national banks from availing themselves of such preemption;

·
imposed comprehensive regulation of the over-the-counter derivatives market subject to significant rulemaking processes, to include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself;

·
required loan originators to retain 5 percent of any loan sold or securitized, unless it is a "qualified residential mortgage", subject to certain restrictions;

·
prohibited banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (the Volcker Rule); and

·
implemented corporate governance revisions that apply to all public companies, not just financial institutions.

Many aspects of the Dodd-Frank Act remain subject to future rulemaking, making it difficult to anticipate the overall financial impact on the Company, Bank and Trust or their customers, or on the financial industry more generally. Dodd-Frank Act provisions that require revisions to the capital requirements of the Company, the Bank and Trust could impact their ability to raise capital in the future. Although the Company has not issued trust preferred securities, Dodd-Frank Act provisions that revoke the Tier 1 capital treatment of trust preferred securities could cause the Company, the Bank and Trust to seek other sources of capital in the future. Some of the rules that have been adopted or proposed to comply with Dodd-Frank Act mandates are discussed in more detail below.

Capital Requirements and Prompt Corrective Action. The FRB, the Comptroller and the FDIC have adopted risk-based capital adequacy guidelines for bank holding companies and banks pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) and the Basel III Capital Accords. See "Management's Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources" in Item 7 of this report on Form 10-K.

The federal banking agencies have broad powers to take prompt corrective action to resolve problems of insured depository institutions. Under the FDICIA, there are five capital categories applicable to bank holding companies and insured institutions, each with specific regulatory consequences. The extent of the agencies' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." These terms are defined under uniform regulations issued by each of the federal banking agencies. If the appropriate federal banking agency determines that an insured institution is in an unsafe or unsound condition, it may reclassify the institution to a lower capital category (other than critically undercapitalized) and require the submission of a plan to correct the unsafe or unsound condition.

Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject the Company and its subsidiaries to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits, and other restrictions on its business. In addition, an institution may not make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if the making of such dividend would cause the Bank to become undercapitalized, it could not pay a dividend to the Company.

Basel III Capital Framework. In July 2013, the federal bank regulatory agencies adopted rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision and standards for calculating risk-weighted assets and risk-based capital measurements (collectively, the Basel III Final Rules). For purposes of these capital rules, (i) common equity Tier 1 capital (CET1) consists principally of common stock (including surplus) and retained earnings; (ii) Tier 1 capital consists principally of CET1 plus non-cumulative preferred stock and related surplus, and certain grandfathered cumulative preferred stock and trust preferred securities; and (iii) Tier 2 capital consists principally of Tier 1 capital plus qualifying subordinated debt and preferred stock, and limited amounts of the allowance for loan losses. Each regulatory capital classification is subject to certain adjustments and limitations, as implemented by the Basel III Final Rules. The Basel III Final Rules also establish risk weightings that are applied to many classes of assets held by community banks, including, importantly, applying higher risk weightings to certain commercial real estate loans.

The Basel III Final Rules were effective on January 1, 2015, and the Basel III Final Rules' capital conservation buffer (as described below) will be phased in through 2019.  When fully phased in, the Basel III Final Rules require banks to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).
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The Basel III Final Rules provide deductions from and adjustments to regulatory capital measures, and primarily to CET1, including deductions and adjustments that were not applied to reduce CET1 under historical regulatory capital rules. For example, mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities must be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. These deductions from and adjustments to regulatory capital will generally be phased in beginning in 2015 through 2018.

The Basel III Final Rules also implement a "countercyclical capital buffer," generally designed to absorb losses during periods of economic stress and to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk. This buffer is a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).

Insurance of Accounts, Assessments and Regulation by the FDIC. The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC. The basic limit on FDIC deposit insurance coverage is $250,000 per depositor.

Under the Federal Deposit Insurance Act (FDIA), the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC, subject to administrative and potential judicial hearing and review processes.

The DIF is funded by assessments on banks and other depository institutions calculated based on average consolidated total assets minus average tangible equity (defined as Tier 1 capital). As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment scheme, set a target "designated reserve ratio" (described in more detail below) of 2 percent for the DIF, and established a lower assessment rate schedule when the reserve ratio reaches 1.15 percent and, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2 percent and 2.5 percent.

An institution's assessment rate depends upon the institution's assigned risk category, which is based on supervisory evaluations, regulatory capital levels and certain other factors. Initial base assessment rates range from 2.5 to 45 basis points. The FDIC may make the following further adjustments to an institution's initial base assessment rates: decreases for long-term unsecured debt including most senior unsecured debt and subordinated debt; increases for holding long-term unsecured debt or subordinated debt issued by other insured depository institutions; and increases for brokered deposits in excess of 10 percent of domestic deposits for institutions not well rated and well capitalized.

The Dodd-Frank Act transferred to the FDIC increased discretion with regard to managing the required amount of reserves for the DIF, or the "designated reserve ratio." Among other changes, the Dodd-Frank Act (i) raised the minimum designated reserve ratio to 1.35 percent and removed the upper limit on the designated reserve ratio, (ii) requires that the designated reserve ratio reach 1.35 percent by September 2020, and (iii) requires the FDIC to offset the effect on institutions with total consolidated assets of less than $10 billion of raising the designated reserve ratio from 1.15 percent to 1.35 percent – which requirement will be met through rules the FDIC intends to propose when the reserve ratio is closer to 1.15 percent. The FDIA requires that the FDIC consider the appropriate level for the designated reserve ratio on at least an annual basis. The FDIC has adopted a DIF restoration plan to ensure that the fund reserve ratio reaches 1.35 percent by September 30, 2020, as required by the Dodd-Frank Act.

The Sarbanes-Oxley Act. The Sarbanes-Oxley Act (SOX) enacted major reforms of the federal securities laws intended to protect investors by improving the accuracy and reliability of corporate disclosures. It impacts all companies with securities registered under the Exchange Act, including the Company. SOX creates increased responsibility for chief executive officers and chief financial officers with respect to the content of filings with the SEC. Section 404 of SOX and related SEC rules focused increased scrutiny by internal and external auditors on the Company's systems of internal controls over financial reporting, to insure that those internal controls are effective in both design and operation. SOX sets out enhanced requirements for audit committees, including independence and expertise, and it includes stronger requirements for auditor independence and limits the types of non-audit services that auditors can provide. Finally, SOX contains additional and increased civil and criminal penalties for violations of securities laws.

Incentive Compensation Guidance. The FRB, the Comptroller and the FDIC have issued regulatory guidance (the Incentive Compensation Guidance) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not "large, complex banking organizations." The findings will be included in reports of examination, and deficiencies will be incorporated into the organization's supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
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As required by the Dodd-Frank Act, in March 2011 the SEC and the federal bank regulatory agencies proposed regulations that would require financial institutions with assets of at least $1 billion to disclose the structure of their incentive compensation practices and prohibit such institutions from maintaining executive compensation arrangements that encourage inappropriate risk taking by providing excessive compensation or that could lead to material financial loss. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which a company whose total consolidated assets reach or exceed $1 billion may structure compensation for its executives and will require such company to submit annual reports to the Federal Reserve regarding the company's incentive compensation. These proposed regulations incorporate the principles discussed in the Incentive Compensation Guidance. A final rule has not yet been published. Although the final rule is not expected to apply to institutions with less than $1 billion in total consolidated assets, the federal banking agencies, including the Comptroller, emphasize that all banking organizations, regardless of size, must carefully design and oversee incentive compensation policies to ensure such policies do not undermine the safety and soundness of such organizations.

Community Reinvestment Act. The Company is subject to the requirements of the CRA, which imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution's efforts in meeting community credit needs are currently assessed based on specified factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility.

Confidentiality and Required Disclosures of Consumer Information. The Company is subject to various laws and regulations that address the privacy of nonpublic personal financial information of consumers. The Gramm-Leach-Bliley Act and certain regulations issued thereunder protect against the transfer and use by financial institutions of consumer nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. These privacy provisions generally prohibit a financial institution from providing a customer's personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

The Company is also subject to various laws and regulations that attempt to combat money laundering and terrorist financing. The Bank Secrecy Act requires all financial institutions to, among other things, create a system of controls designed to prevent money laundering and the financing of terrorism, and imposes recordkeeping and reporting requirements. The USA Patriot Act facilitates information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering, and requires financial institutions to establish anti-money laundering programs. The Federal Bureau of Investigation (FBI) sends banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities, and requests banks to search their records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report with the U.S. Department of the Treasury (the Treasury) and contact the FBI. The Office of Foreign Assets Control (OFAC), which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with "enemies" of the United States, as defined by various Executive Orders and Acts of Congress. If the Bank finds a name of an "enemy" of the United States on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account or place transferred funds into a blocked account, file a suspicious activity report with the Treasury and notify the FBI.

Consumer Laws and Regulations. The Company is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions transact business with customers. The Company must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing customer relations.

The CFPB is the federal regulatory agency responsible for implementing, examining and enforcing compliance with federal consumer financial laws for institutions with more than $10 billion of assets and, to a lesser extent, smaller institutions. The CFPB supervises and regulates providers of consumer financial products and services and has rulemaking authority in connection with numerous federal consumer financial protection laws (for example, but not limited to, the Truth in Lending Act and the Real Estate Settlement Procedures Act).  As a smaller institution (i.e., with assets of $10 billion or less), most consumer protection aspects of the Dodd-Frank Act will continue to be applied to the Company by the FRB and to the Bank by the Comptroller. However, the CFPB may include its own examiners in regulatory examinations by a smaller institution's prudential regulators and may require smaller institutions to comply with certain CFPB reporting requirements. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the FRB and Comptroller apply consumer protection laws and regulations to financial institutions that are not directly supervised by the CFPB. The precise effect of the CFPB's consumer protection activities on the Company cannot be forecast.
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Mortgage Banking Regulation. In connection with making mortgage loans, the Bank is subject to rules and regulations that, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers, in some cases, restrict certain loan features and fix maximum interest rates and fees, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level. The Bank's mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth in Lending Act, Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, and Home Ownership Equity Protection Act, and the regulations promulgated under these acts, among other additional state and federal laws, regulations and rules.

The Bank's mortgage origination activities are also subject to Regulation Z, which implements the Truth in Lending Act. Certain provisions of Regulation Z require mortgage lenders to make a reasonable and good faith determination, based on verified and documented information, that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Alternatively, a mortgage lender can originate "qualified mortgages", which are generally defined as mortgage loans without negative amortization, interest-only payments, balloon payments, terms exceeding 30 years, and points and fees paid by a consumer equal to or less than 3% of the total loan amount. Higher-priced qualified mortgages (e.g., subprime loans) receive a rebuttable presumption of compliance with ability-to-repay rules, and other qualified mortgages (e.g., prime loans) are deemed to comply with the ability-to-repay rules.

Volcker Rule. The Dodd-Frank Act prohibits bank holding companies and their subsidiary banks from engaging in proprietary trading except in limited circumstances, and places limits on ownership of equity investments in private equity and hedge funds (the Volcker Rule). On December 10, 2013, the U.S. financial regulatory agencies (including the FRB, the FDIC, the Comptroller and the SEC) adopted final rules to implement the Volcker Rule.  In relevant part, these final rules would have prohibited banking entities from owning collateralized debt obligations (CDOs) backed by trust preferred securities (TruPS), effective July 21, 2015. However, subsequent to these final rules the U.S. financial regulatory agencies issued an interim rule effective April 1, 2014 to exempt CDOs backed by TruPS from the final rule implementing the Volcker Rule, provided that (a) the CDO was established prior to May 19, 2010, (b) the banking entity reasonably believes that the CDO's offering proceeds were used to invest primarily in TruPS issued by banks with less than $15 billion in assets, and (c) the banking entity acquired the CDO investment on or before December 10, 2013. The Company currently does not have any CDO investments, and the Company believes that its financial condition will not be significantly impacted by the Volcker Rule, the final rules or the interim rule.  Smaller banks, with total consolidated assets of $10 billion or less, engaged in modest proprietary trading activities for their own accounts are subject to a simplified compliance program under the final rules.  Several portions of the Volcker Rule remain subject to regulatory rulemaking and legislative activity, including to further delay effectiveness of some provisions of the Volcker Rule.  The Company does not expect that any delays in the effectiveness of a portion of the Volcker Rule will significantly impact its financial condition.

Item 1A. Risk Factors

U.S. and international economic conditions and credit markets pose challenges for the Company and could adversely affect the results of operations, liquidity and financial condition. The Company is currently operating in a challenging and uncertain economic environment, both in the local markets it serves and in the broader national and international economies. In addition, uncertainty regarding oil prices, ongoing federal budget negotiations, the implementation of the employer mandate under the Patient Protection and Affordable Care Act, and the level of U.S. debt may present challenges to businesses and have a destabilizing effect on financial markets.  If the economic recovery continues to be relatively weak or there is further deterioration of national or international economic conditions, the financial condition and operating performance of financial institutions, including the Company, could be adversely affected. Such adverse effects could include a decline in the value of the Company's securities portfolio, and could increase the regulatory scrutiny of financial institutions. Another deterioration of local economic conditions could again lead to declines in real estate values and home sales and increases in the financial stress on borrowers and unemployment rates, all of which could lead to increases in loan delinquencies, problem assets and foreclosures and reductions in loan collateral value. Such a deterioration of local economic conditions could cause the level of loan losses to exceed the level the Company has provided in its allowance for loan losses which, in turn, would reduce the Company's earnings.

Global credit market conditions could return to being disrupted and volatile. Although the Company remains well capitalized and has not suffered any liquidity issues, the cost and availability of funds may be adversely affected by illiquid credit markets. Any future turbulence in the U.S. and international markets and economy may adversely affect the Company's liquidity, financial condition and profitability.
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The Company is subject to interest rate risk and variations in interest rates may negatively affect its financial performance. The Company's profitability depends in substantial part on its net interest margin, which is the difference between the rates received on loans and investments and the rates paid for deposits and other sources of funds. The net interest margin depends on many factors that are partly or completely outside of the Company's control, including competition; federal economic, monetary and fiscal policies; and economic conditions. Changes in interest rates affect operating performance and financial condition. The Company tries to minimize its exposure to interest rate risk, but it is unable to completely eliminate this risk. Because of the differences in the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect the Company's net interest margin and, in turn, its profitability. In addition, the FRB's Federal Open Market Committee has stated that it will keep the federal funds target rate at 0%-0.25% until economic and labor conditions (as indicated by the unemployment rate) improve, which which may be later in 2015. Even though such a continuance of accommodative monetary policy could allow the Company to continue to reprice fixed-rate deposits at lower rates, continued low interest rates could put further pressure on the yields generated by the Company's loan portfolio and on the Company's net interest margin. At December 31, 2014, based on scheduled maturities only, the Company's balance sheet was liability sensitive at the one-year time frame and, as a result, its net interest margin will tend to decrease in a rising interest rate environment and increase in a declining interest rate environment. However, when using decay rates to simulate maturities for non-maturing deposits, the Company's balance sheet as of December 31, 2014 is asset sensitive at the one-year time frame. When the Company is asset sensitive, the net interest margin should rise if rates rise and should fall if rates fall.  For additional details, See "Management's Discussion and Analysis of Financial Condition and Results of Operations – Interest Sensitivity" in Item 7 of this report on Form 10-K.

In addition, any substantial and prolonged increase in market interest rates could reduce the Company's customers' desire to borrow money or adversely affect their ability to repay their outstanding loans by increasing their credit costs. Interest rate changes could also affect the fair value of the Company's financial assets and liabilities. Accordingly, changes in levels of market interest rates could materially and adversely affect the Company's net interest margin, asset quality, loan origination volume, business, financial condition, results of operations and cash flows.

The Company's accounting estimates and risk management processes rely on analytical and forecasting models. Processes that management uses to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on the Company's earnings performance and liquidity, depend upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are accurate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation.

If the models that management uses for interest rate risk and asset-liability management are inadequate, the Company may incur increased or unexpected losses upon changes in market interest rates or other market measures and may be unable to maintain sufficient liquidity. If the models that management uses to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what the Company could realize upon sale or settlement of such financial instruments. Any such failure in management's analytical or forecasting models could have a material adverse effect on the Company's business, financial condition and results of operations.

Weaknesses in the commercial real estate markets could negatively affect the Company's financial performance.  At December 31, 2014, the Company had $296.6 million, or 55.34%, of total loans concentrated in commercial real estate, which includes, for purposes of this concentration, all construction loans, loans secured by multifamily residential properties, loans secured by farmland and loans secured by nonfarm, nonresidential properties. Commercial real estate loans carry risks associated with the successful operation of a business if the properties are owner occupied. If the properties are non-owner occupied, the repayment of these loans may be dependent upon the profitability and cash flow from rent receipts. Weak economic conditions may impair a borrower's business operations, slow the execution of new leases and lead to turnover in existing leases. The combination of these factors could result in deterioration in value of some of the Company's loans. The deterioration of one or more of the Company's significant commercial real estate loans could cause a significant increase in nonaccrual loans. An increase in nonaccrual loans could result in a loss of interest income from those loans, an increase in the provision for loan losses, and an increase in loan charge-offs, all of which could have a material adverse effect on the Company's financial performance.

The Company is subject to losses resulting from fraudulent and negligent acts on the part of loan applicants, correspondents or other third parties. The Company relies heavily upon information supplied by third parties, including the information contained in credit applications, employment and income documentation, property appraisals, title information, and equipment pricing and valuation, in deciding which loans to originate, as well as in establishing the terms of those loans. If any of the information upon which the Company relies during the loan approval process is misrepresented, either fraudulently or inadvertently, and the misrepresentation is not detected prior to asset funding, the value of the asset may be significantly lower than expected, the Company may fund a loan that it would not have otherwise funded or the Company may fund a loan on terms that it would not have otherwise extended. Whether a misrepresentation is made by the applicant or by another third party, the Company generally bears the risk of loss associated with the misrepresentation. In addition, a loan subject to a material misrepresentation is typically unsellable or subject to repurchase if it is sold prior to detection of the misrepresentation. The sources of the misrepresentation are often difficult to locate, and it may be difficult to recover any monetary loss the Company may suffer.
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The Company's profitability depends significantly on local economic conditions and changes in the federal government's military or defense spending may negatively affect the local economy. The Company's success depends primarily on the general economic conditions of the markets in which the Company operates. Unlike larger financial institutions that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Hampton Roads MSA. The local economic conditions in this area have a significant impact on the demand for loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic calamities, unemployment or other factors beyond the Company's control could impact these local economic conditions.

In addition, Hampton Roads is home to one of the largest military installations in the world and one of the largest concentrations of Department of Defense personnel in the United States. Some of the Company's customers may be particularly sensitive to the level of federal government spending on the military or on defense-related products. Federal spending is affected by numerous factors, including macroeconomic conditions, presidential administration priorities, and the ability of the federal government to enact relevant appropriations bills and other legislation. Any of these factors could result in future cuts to military or defense spending or increased uncertainty about federal spending, which could have a severe negative impact on individuals and businesses in the Company's primary service area. Any related increase in unemployment rates or reduction in business development activities in the Company's primary service area could lead to increases in loan delinquencies, problem assets and foreclosures and reductions in loan collateral value, which could have a material adverse effect on the Company's operating results and financial condition.

The downgrade of the U.S. credit rating could have a material adverse effect on the Company's business, financial condition and liquidity. Standard & Poor's lowered its long term sovereign credit rating on the United States of America from AAA to AA+ in 2011. A further downgrade or a downgrade by other rating agencies could have a material adverse impact on financial markets and economic conditions in the United States and worldwide, which may lead to among other things, increased volatility and illiquidity in the capital markets, declines in consumer confidence, increased unemployment levels, and declines in the value of U.S. Treasury securities and securities guaranteed by the U.S. government, any of which could have a material adverse effect on the Company's liquidity, financial condition and results of operations.

Declines in loans outstanding could have a material adverse impact on the Company's operating results and financial condition. If quality loan demand does not continue to increase and the Company's loan portfolio begins to decline, the Company expects that excess liquidity will be invested in marketable securities. Because loans typically yield higher returns than the Company's securities portfolio, a shift towards investments in the Company's asset mix would likely result in an overall reduction in net interest income and the net interest margin. The principal source of earnings for the Company is net interest income, and as discussed above, the Company's net interest margin is a major determinant of the Company's profitability. The effects of a reduction in net interest income and the net interest margin may be exacerbated by the intense competition for quality loans in the Company's primary service area and by rate reductions on loans currently held in the portfolio. As a result, a reduction in loans could have a material adverse effect on the Company's operating results and financial condition.

The Company's substantial dependence on dividends from its subsidiaries may prevent it from paying dividends to its stockholders and adversely affect its business, results of operations or financial condition. The Company is a separate legal entity from its subsidiaries and does not have significant operations or revenues of its own. The Company substantially depends on dividends from its subsidiaries to pay dividends to stockholders and to pay its operating expenses. The availability of dividends from the subsidiaries is limited by various statutes and regulations. It is possible, depending upon the financial condition of the Company and other factors, that the Comptroller could assert that payment of dividends by the subsidiaries is an unsafe or unsound practice. In the event the subsidiaries are unable to pay dividends to the Company, the Company may not be able to pay dividends on the Company's common stock, service debt or pay operating expenses. Consequently, the inability to receive dividends from the subsidiaries could adversely affect the Company's financial condition, results of operations, cash flows and limit stockholders' return, if any, to capital appreciation.

The small-to-medium size businesses the Company targets may have fewer financial resources to weather a downturn in the economy, which could materially harm operating results.  The Company targets individual and small-to-medium size business customers.  Small-to-medium-size businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand and compete and may experience significant volatility in operating results. Any one or more of these factors may impair a borrower's ability to repay a loan.  In addition, the success of a small-to-medium size business often depends on the management talents and efforts of one or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact businesses in the Company's primary service area could cause the Company to incur substantial credit losses that could negatively affect its results of operations and financial condition.
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A decline in real estate values has caused the Company to experience losses in selling foreclosed properties, and the continuation of this decline could cause a significant portion of the Company's loan portfolio to be under-collateralized and lead to additional future losses. The market value of real estate, particularly real estate held for investment, can fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located. The Company's business activities and credit exposures are primarily concentrated in the Hampton Roads MSA.  If the value of the real estate serving as collateral for the Company's loan portfolio were to decline materially, a significant part of the loan portfolio could become under-collateralized. If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then, in the event of foreclosure, the Company may not be able to realize the dollar value from the collateral that it anticipated at the time of originating the loan. If real estate values decline, it is also more likely that the Company would be required to increase the allowance for loan losses, which could also adversely affect the Company's business, financial condition and results of operations.

In recent years, the market value of real estate declined considerably and has failed to materially recover, leaving the Company with certain loans that are under-collateralized. Some of these loans have become troubled and have been foreclosed upon, and the Company was unable to realize the expected value of the collateral. Due to these events, the Company has established a valuation reserve for other real estate owned (OREO), including foreclosed assets, which negatively affects the Company's earnings in periods in which a provision is added to the valuation reserve.

In addition, the decline in real estate values and recent inability to materially recover has caused and could continue to cause the Company to experience losses when selling OREOs. These factors have had an adverse affect on operating results.

The ownership of foreclosed property exposes the Company to significant costs, some of which are uncertain.  When the Company has to foreclose upon real property held as collateral, the Company is exposed to the risks inherent in the ownership of real estate. The amount that the Company may realize after a loan default is dependent upon factors outside of the Company's control, including environmental cleanup liability, especially with regard to non-residential real estate, neighborhood values, real estate tax rates, operating or maintenance expenses of the foreclosed properties, and supply of and demand for properties.  Significant costs associated with the ownership of real estate may materially and adversely affect the Company's business, financial condition, cash flows and result of operations.

The allowance for loan losses may not be adequate to cover actual losses. A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans and leases. Like all financial institutions, the Company maintains an allowance for loan losses to provide for loan defaults and non-performance. The allowance for loan losses may not be adequate to cover actual loan losses. In addition, future provisions for loan losses could materially and adversely affect, and have in recent years materially and adversely affected, the Company's operating results.

The allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolutions, changes in the size and composition of the loan portfolio and industry information. Also included in management's estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and judgment. The amount of future losses is susceptible to changes in economic and other conditions, including changes in interest rates, that may be beyond the Company's control and these future losses may exceed current estimates. If management's assumptions prove to be incorrect or if the Company experiences significant loan losses in future periods, the current level of the allowance for loan losses may not be adequate to cover actual loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio. In addition, federal regulatory agencies, as an integral part of their examination process, review the Company's loans and allowance for loan losses. While management believes that the Company's allowance is adequate to cover current losses, the Company cannot assure investors that it will not need to increase the allowance or that regulators will not require the allowance to be increased. Either of these occurrences could materially and adversely affect earnings and profitability.

Market risk affects the earnings of Trust. The fee structure of Trust is generally based upon the market value of accounts under administration. Most of these accounts are invested in equities of publicly traded companies and debt obligations of both government agencies and publicly traded companies. As such, fluctuations in the equity and debt markets in general have had a direct impact upon the earnings of Trust.

The Company may be adversely affected by changes in government monetary policy. As a bank holding company, the Company's business is affected by the monetary policies established by the FRB, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. In setting its policy, the FRB may utilize techniques such as the following:

·
Engaging in open market transactions in U.S. Government securities;
·
Setting the discount rate on member bank borrowings; and
·
Determining reserve requirements.
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These techniques, all of which are outside the Company's control, may have an adverse effect on deposit levels, net interest margin, loan demand or the Company's business and operations.

The Dodd-Frank Act has increased the Company's regulatory compliance burden and associated costs, placed restrictions on certain products and services and limited its future capital raising strategies. A wide range of regulatory initiatives directed at the financial services industry has been proposed and/or implemented in recent years. One of those initiatives, the Dodd-Frank Act, was enacted in 2010 and mandates significant changes in the financial regulatory landscape that will impact all financial institutions, including the Company and the Bank. Since its enactment, the Dodd-Frank Act has increased the Company's regulatory compliance burden and its continuing implementation will likely continue to increase the Company's regulatory compliance burden and may have a material adverse effect on the Company, by increasing the costs associated with regulatory examinations and compliance measures.

One of the Dodd-Frank Act's significant regulatory changes is the creation of the CFPB, a financial consumer protection agency that has the authority to impose new regulations and include its examiners in routine regulatory examinations conducted by the Comptroller. The CFPB may reshape the consumer financial laws through rulemaking and enforcement of the Dodd-Frank Act's prohibitions against unfair, deceptive and abusive business practices, which may directly impact the business operations of financial institutions offering consumer financial products or services, including the Company and the Bank. This agency's broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service. Although the CFPB generally has jurisdiction over banks with $10 billion or more in assets, rules, regulations and policies issued by the CFPB may also apply to the Company, the Bank and/or Trust through the adoption of such policies and best practices by the FRB, Comptroller and FDIC. The full costs and limitations related to this additional regulatory agency and the limitations and restrictions that may be placed upon the Company with respect to its consumer product and service offerings have yet to be determined. However, these costs, limitations and restrictions may have a material impact on the Company's business, financial condition and results of operations.

The Dodd-Frank Act also increases regulatory supervision and examination of bank holding companies and their banking and non-banking subsidiaries. These and other regulations included in the Dodd-Frank Act could increase the Company's regulatory compliance burden and costs, restrict the financial products and services the Bank can offer to its customers and restrict the Company's ability to generate revenues from non-banking operations. The Dodd-Frank Act imposes more stringent capital requirements on bank holding companies, which could limit the Company's future capital strategies.

The Basel III Final Rules will require higher levels of capital and liquidity, which could adversely affect the Company's net income and return on equity. The capital adequacy and liquidity guidelines applicable to the Company and the Bank under the Basel III Final Rules began to be phased-in beginning in 2015.  The Basel III Final Rules, when fully-phased in, will require the Company and the Bank to maintain substantially more capital as a result of higher minimum capital levels and more demanding regulatory capital risk-weightings and calculations. The changes to the standardized calculations of risk-weighted assets are complex and may create enormous compliance burdens for the Company and the Bank.  The Basel III Final Rules will require the Company and the Bank to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and may increase dramatically risk-weighted assets as a result of applying higher risk-weightings to many types of loans and securities. As a result, the Company and the Bank may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio, which may have a detrimental impact on the Company's net income.

If the Company were to require additional capital as a result of the Basel III Final Rules, it could be required to access the capital markets on short notice and in relatively weak economic conditions, which could result in raising capital that significantly dilutes existing shareholders. Additionally, the Company may be forced to limit banking operations and activities, and growth of loan portfolios and interest income, to focus on retention of earnings to improve capital levels. Higher capital levels may also lower the Company's return on equity.

The repeal of federal prohibitions on payment of interest on demand deposits could increase interest expense. As part of the Dodd-Frank Act, the prohibition on the ability of financial institutions to pay interest on commercial demand deposit accounts was repealed. As a result, beginning in 2011, financial institutions could begin offering interest on demand deposits. Although the Company cannot be certain what interest rates other institutions may offer, the Company expects the impact of offering interest on demand deposits to remain minimal as long as the low interest rate environment continues. When interest rates begin to increase, however, the Company's interest expense may increase and the net interest margin may decline, which could adversely affect the Company's business, financial condition and results of operations.

Deposit insurance premiums could increase in the future, which may adversely affect future financial performance. The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges insured financial institutions premiums to maintain the DIF at a certain level. Economic conditions since 2008 have increased the rate of bank failures and expectations for further bank failures, requiring the FDIC to make payments for insured deposits from the DIF and prepare for future payments from the DIF.
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During 2009, the FDIC imposed a special deposit insurance assessment on all institutions which it regulates, including the Bank. This special assessment was imposed due to the need to replenish the DIF, as a result of increased bank failures and expected future bank failures. In addition, the FDIC required regulated institutions to prepay their fourth quarter 2009, and estimates of their 2010, 2011 and 2012 assessments in December 2009. Any similar, additional measures taken by the FDIC to maintain or replenish the DIF may have an adverse effect on the Company's financial condition, results of operations and liquidity.

In 2011, the FDIC adopted final rules to implement changes required by the Dodd-Frank Act with respect to the FDIC assessment rules. A depository institution's deposit insurance assessment is now calculated based on the institution's total assets less tangible equity, rather than the previous base of total deposits. These changes did not increase the Company's FDIC insurance assessments for comparable asset and deposit levels. However, if the Bank's asset size increases or the FDIC takes other actions to replenish the DIF, the Bank's FDIC insurance premiums could increase, which could have an adverse affect on the Company's results of operations.

The Company and its subsidiaries are subject to extensive regulation which could adversely affect them. The Company is subject to extensive regulation by federal, state and local governmental authorities and is subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of operations, including those referenced above. Regulations adopted by these agencies, which are generally intended to protect depositors and customers rather than to benefit stockholders, govern a comprehensive range of matters including, without limitation, ownership and control of the Company's shares, acquisition of other companies and businesses, permissible activities that the Company and its subsidiaries may engage in, maintenance of adequate capital levels and other aspects of operations. These regulations could limit the Company's growth by restricting certain of its activities. The laws, rules and regulations applicable to the Company are subject to regular modification and change. Regulatory changes could subject the Company to more demanding regulatory compliance requirements which could affect the Company in unpredictable and adverse ways. Such changes could subject the Company to additional costs, limit the types of financial services and products it may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or damage to the Company's reputation, which could have a material adverse effect on the Company's business, financial condition and results of operations. Legislation and regulatory initiatives containing wide-ranging proposals for altering the structure, regulation and competitive relationship of financial institutions are introduced regularly. The Company cannot predict in what form or whether a proposed statute or regulation will be adopted or the extent to which such adoption may affect its business.

The Company is dependent on key personnel and the loss of one or more of those key personnel could harm its business.  The banking business in Virginia, and in the Company's primary service area in the Hampton Roads MSA, is highly competitive and dominated by a relatively small number of large banks. Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of and experience in the Virginia community banking industry. The Company's success depends to a significant degree upon its ability to attract and retain qualified management, loan origination, administrative, marketing and technical personnel and upon the continued contributions of and customer relationships developed by management and personnel. In particular, the Company's success is highly dependent upon the capabilities of its senior executive management. The Company believes that its management team, comprised of individuals who have worked in the banking industry for many years, is integral to implementing the Company's business plan. The Company has not entered into employment agreements with any of its executive management employees, and the loss of the services of one or more of them could harm the Company's business.

The Company's future success depends on its ability to compete effectively in the highly competitive financial services industry. The Company faces substantial competition in all phases of its operations from a variety of different competitors. Growth and success depends on the Company's ability to compete effectively in this highly competitive financial services environment. Many competitors offer products and services that are not offered by the Company, and many have substantially greater resources, name recognition and market presence that benefit them in attracting business. In addition, larger competitors may be able to price loans and deposits more aggressively and may have larger lending limits that would allow them to serve the credit needs of larger customers. Some of the financial services organizations with which the Company competes are not subject to the same degree of regulation as is imposed on bank holding companies and federally insured national banks. As a result, these non-bank competitors have certain advantages over the Company in accessing funding and in providing various services. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Failure to compete effectively to attract new and retain current customers in the Company's markets could cause it to lose market share, slow its growth rate and may have an adverse effect on its financial condition and results of operations.

The Company may not be able to compete effectively without the appropriate use of current technology.  The use of technology in the financial services market, including the banking industry, evolves frequently. The Company may be unable to attract and maintain banking relationships with certain customers if it does not offer appropriate technology-driven products and services. In addition to better serving customers, the effective use of technology may increase efficiency and reduce costs. The Company may not be able to effectively implement new technology-driven products or services or be successful in marketing these products and services to its customers. As a result, the Company's ability to compete effectively may be impaired, which could lead to a material adverse effect on the Company's financial condition and results of operations.
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System failures, interruptions, breaches of security, or the failure of a third-party provider to perform its obligations could adversely impact the Company's business operations and financial condition. Communications and information systems are essential to the conduct of the Company's businesses, as such systems are used to manage customer relationships, general ledger, deposits and loans. While the Company has established policies and procedures to prevent or limit the impact of systems failures, interruptions and security breaches, the Company's information, security, and other systems may stop operating properly or become disabled or damaged as a result of a number of factors, including events beyond the Company's control, such as sudden increases in customer transaction volume, electrical or telecommunications outages, natural disasters, and cyber-attacks. Information security risks have increased in recent years in part because of the proliferation of new technologies to conduct financial transactions and the increased sophistication and activities of hackers, activists and other external parties. The Company may not have the resources or technical sophistication to anticipate or prevent rapidly evolving types of cyber-attacks. In addition, any compromise of the security systems could deter customers from using the Bank's website and online banking service, both of which involve the transmission of confidential information. Although the Company and the Bank rely on commonly used security and processing systems to provide the security and authentication necessary to effect the secure transmission of data, these precautions may not protect the systems from compromises or breaches of security, which would adversely affect the Company's results of operations and financial condition.

In addition, the Company outsources certain data processing to certain third-party providers. Accordingly, the Company's operations are exposed to risk that these third-party providers will not perform in accordance with the contracted arrangements under service agreements. If the third-party providers encounter difficulties, or if the Company has difficulty in communicating with them, the Company's ability to adequately process and account for customer transactions could be affected, and the Company's business operations could be adversely impacted. Further, a breach of a third-party provider's technology may cause loss to the Company's customers. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.

The occurrence of any systems failure, interruption or breach of security, or the failure of a third-party provider to perform its obligations, could expose the Company to risks of data loss or data misuse, could damage the Company's reputation and result in a loss of customers and business, could subject it to additional regulatory scrutiny or could expose it to civil litigation, possible financial liability and costly response measures. Any of these occurrences could have a material adverse effect on the Company's financial condition and results of operations.

Negative public opinion could damage the Company's reputation and adversely impact the Company's business, financial condition and results of operation. Reputation risk, or the risk to the Company's business, financial condition and results of operation from negative public opinion, is inherent in the financial services industry. Negative public opinion can result from actual or alleged conduct in any number of activities, including lending practices and corporate governance, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion could adversely affect the Company's ability to keep and attract customers and employees, could expose it to litigation and regulatory action, and could adversely affect its access to the capital markets. Damage to the Company's reputation could adversely affect deposits and loans and otherwise negatively affect the Company's business, financial condition and results of operation.

The Company may need to raise additional capital in the future and such capital may not be available when needed or at all. The Company may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs, particularly if its asset quality or earnings were to deteriorate significantly. Economic conditions and the loss of confidence in financial institutions may increase the Company's cost of funding and limit access to certain customary sources of capital, including inter-bank borrowings, repurchase agreements and borrowings from the Federal Reserve Bank's discount window. The Company's ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of the Company's control, and the Company's financial performance.

The Company cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit the Company's access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets, or a downgrade of the parent company or the Bank's ratings, may adversely affect the Company's capital costs and its ability to raise capital and, in turn, its liquidity. Moreover, if the Company needs to raise capital in the future, it may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a material adverse effect on the Company's liquidity, business, financial condition and results of operations.
- 13 -


The Company and its subsidiaries are subject to operational risk, which could adversely affect business, financial condition and results of operation. The Company and its subsidiaries, like all businesses, are subject to operational risk, including the risk of loss resulting from human error, fraud or unauthorized transactions due to inadequate or failed internal processes and systems, and external events that are wholly or partially beyond the Company's control (including, for example, computer viruses or electrical or telecommunications outages). Operational risk also encompasses compliance (legal) risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, regulations, prescribed practices or ethical standards. The Company and its subsidiaries have established a system of internal controls to address these risks, but there are inherent limitations to such risk management strategies as there may exist, or develop in the future, risks that are not anticipated, identified or monitored. Any losses resulting from operational risk could take the form of explicit charges, increased operational costs, litigation costs, harm to reputation or forgone opportunities, any and all of which could have a material adverse effect on the Company's business, financial condition and results of operations.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

As of December 31, 2014, the Company owned the main office, which includes a branch, located in Hampton, Virginia: the corporate headquarters, which includes a branch; six office buildings; and 12 branches. All of these are owned directly and free of any encumbrances. The land at the Fort Monroe branch is leased by the Company under an agreement that expires in June 2017. Two of the remaining three branches are leased from unrelated parties. The Crown Center branch is leased from Crown Center Associates, LLC, which is indirectly owned by Michael Glasser, a member of the Company's Board of Directors. These three branch leases have renewal options that expire anywhere within three to ten years from December 31, 2014.

For more information concerning the commitments under current leasing agreements, see Note 6 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this report on Form 10-K.

Item 3. Legal Proceedings

Neither the Company nor any of its subsidiaries is a party to any material pending legal proceedings before any court, administrative agency, or other tribunal.

Item 4. Mine Safety Disclosures

None.
 
EXECUTIVE OFFICERS OF THE REGISTRANT

Name (Age) And Present Position
Served in
Current Position
Since
 
Principal
Occupation During Past Five Years
 
 
 
 
Robert F. Shuford, Sr. (77)
1965
 
Banker
Chairman, President & Chief Executive Officer
 
 
 
Old Point Financial Corporation
 
 
 
 
 
 
 
Louis G. Morris (60)
1988
 
Banker
Executive Vice President & Secretary/Bank
 
 
 
Old Point Financial Corporation
 
 
 
 
 
 
 
Laurie D. Grabow (57)
1999
 
Banker
Chief Financial Officer & Senior Vice President/Finance
 
 
 
Old Point Financial Corporation
 
 
 
 
 
 
 
Eugene M. Jordan, II (60)
2003
 
Banker
Executive Vice President/Trust
 
 
 
Old Point Financial Corporation
 
 
 
 
 
 
 
Robert F. Shuford, Jr. (50)
2003
 
Banker
Chief Operating Officer & Senior Vice President/Operations
 
 
 
Old Point Financial Corporation
 
 
 
 
 
 
 
Joseph R. Witt (54)
2008
 
Banker
Chief Administrative Officer & Senior Vice President/Administration
 
 
 
Old Point Financial Corporation
 
 
 

- 14 -



Part II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The common stock of the Company is quoted on the NASDAQ Capital Market under the symbol "OPOF". The approximate number of stockholders of record as of March 17, 2015 was 1,157. On that date, the closing price of the Company's common stock on the NASDAQ Capital Market was $15.15. The range of high and low sale prices and dividends paid per share of the Company's common stock for each quarter during 2014 and 2013 is presented in Item 7 of this report on Form 10-K under "Capital Resources" and is incorporated herein by reference. Additional information related to funds available for dividend declaration can be found in Note 16 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this report on Form 10-K.

On January 12, 2010, the Company authorized a program to repurchase during any given calendar year up to an aggregate of 5 percent of the shares of the Company's common stock outstanding as of January 1 of that calendar year. The Company did not repurchase any shares of the Company's common stock under this plan during 2014. There is currently no stated expiration date for this program.

Pursuant to the Company's stock option plans, participants may exercise stock options by surrendering shares of the Company's common stock that the participants already own. Shares surrendered by participants of these plans are repurchased at current market value pursuant to the terms of the applicable stock options. No such repurchases occurred during 2014.
- 15 -


Item 6. Selected Financial Data

The following table summarizes the Company's performance for the past five years.

SELECTED FINANCIAL HIGHLIGHTS
                   
 
 
   
   
   
   
 
Years ended December 31,
 
2014
   
2013
   
2012
   
2011
   
2010
 
(in thousands except per share data)
 
RESULTS OF OPERATIONS
                   
                     
Interest income
 
$
30,289
   
$
29,823
   
$
32,580
   
$
36,251
   
$
40,890
 
Interest expense
   
3,849
     
4,680
     
5,774
     
6,715
     
9,982
 
Net interest income
   
26,440
     
25,143
     
26,806
     
29,536
     
30,908
 
Provision for loan losses
   
600
     
1,300
     
2,400
     
3,700
     
8,800
 
Net interest income after provision for loan losses
   
25,840
     
23,843
     
24,406
     
25,836
     
22,108
 
Net gains (losses) on available-for-sale securities
   
2
     
(26
)
   
2,313
     
787
     
541
 
Noninterest income
   
12,642
     
12,799
     
12,646
     
11,409
     
12,098
 
Noninterest expenses
   
34,172
     
33,105
     
34,183
     
33,679
     
33,051
 
Income before income taxes
   
4,312
     
3,511
     
5,182
     
4,353
     
1,696
 
Income tax expense
   
196
     
348
     
995
     
1,063
     
149
 
Net income
 
$
4,116
   
$
3,163
   
$
4,187
   
$
3,290
   
$
1,547
 
                                         
FINANCIAL CONDITION
                                       
                                         
Total assets
 
$
876,280
   
$
864,288
   
$
907,499
   
$
849,504
   
$
886,842
 
Total deposits
 
$
716,654
   
$
725,405
   
$
753,816
   
$
690,879
   
$
679,214
 
Total loans
 
$
535,994
   
$
500,699
   
$
471,133
   
$
520,327
   
$
586,619
 
Stockholders' equity
 
$
88,497
   
$
80,761
   
$
89,300
   
$
85,865
   
$
80,952
 
Average assets
 
$
869,965
   
$
881,378
   
$
869,436
   
$
853,849
   
$
924,709
 
Average equity
 
$
85,550
   
$
84,695
   
$
87,912
   
$
83,322
   
$
82,513
 
                                         
PERTINENT RATIOS
                                       
                                         
Return on average assets
   
0.47
%
   
0.36
%
   
0.48
%
   
0.39
%
   
0.17
%
Return on average equity
   
4.81
%
   
3.73
%
   
4.76
%
   
3.95
%
   
1.87
%
Dividends paid as a percent of net income
   
31.32
%
   
34.49
%
   
23.67
%
   
30.12
%
   
79.64
%
Average equity as a percent of average assets
   
9.83
%
   
9.61
%
   
10.11
%
   
9.76
%
   
8.92
%
                                         
PER SHARE DATA
                                       
                                         
Basic earnings per share
 
$
0.83
   
$
0.64
   
$
0.84
   
$
0.66
   
$
0.31
 
Diluted earnings per share
 
$
0.83
   
$
0.64
   
$
0.84
   
$
0.66
   
$
0.31
 
Cash dividends declared
 
$
0.26
   
$
0.22
   
$
0.20
   
$
0.20
   
$
0.25
 
Book value
 
$
17.85
   
$
16.29
   
$
18.01
   
$
17.31
   
$
16.40
 
                                         
GROWTH RATES
                                       
                                         
Year-end assets
   
1.39
%
   
-4.76
%
   
6.83
%
   
-4.21
%
   
-3.75
%
Year-end deposits
   
-1.21
%
   
-3.77
%
   
9.11
%
   
1.72
%
   
2.52
%
Year-end loans
   
7.05
%
   
6.28
%
   
-9.45
%
   
-11.30
%
   
-7.65
%
Year-end equity
   
9.58
%
   
-9.56
%
   
4.00
%
   
6.07
%
   
-0.80
%
Average assets
   
-1.29
%
   
1.37
%
   
1.83
%
   
-7.66
%
   
6.52
%
Average equity
   
1.01
%
   
-3.66
%
   
5.51
%
   
0.98
%
   
-0.31
%
Net income
   
30.13
%
   
-24.46
%
   
27.26
%
   
112.67
%
   
-8.03
%
Cash dividends declared
   
18.18
%
   
10.00
%
   
0.00
%
   
-20.00
%
   
-46.81
%
Book value
   
9.58
%
   
-9.55
%
   
4.04
%
   
5.55
%
   
-1.20
%

- 16 -



Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist readers in understanding and evaluating the financial condition, changes in financial condition and the results of operations of the Company, consisting of the parent company (the Parent) and its wholly-owned subsidiaries, the Bank and Trust. This discussion should be read in conjunction with the Consolidated Financial Statements and other financial information contained elsewhere in this report.

Caution About Forward-Looking Statements
In addition to historical information, this report may contain forward-looking statements. For this purpose, any statement that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, including the focus on reducing time deposits; the net interest margin; strategies for managing the net interest margin and the expected impact of such efforts; liquidity; the loan portfolio and expected trends in the quality of the loan portfolio; the allowance and provision for loan losses; the effect of a sustained increase in nonperforming assets; the securities portfolio; interest rate sensitivity; asset quality; levels of net loan charge-offs and nonperforming assets; levels of interest expense; levels and components of noninterest income and noninterest expense; lease expense; income taxes: intentions regarding the Company's FHLB advance: expected impact of efforts to restructure the balance sheet; expected yields on the loan and securities portfolios; expected rates on interest-bearing liabilities; market risk; business and growth strategies; investment strategy; and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. These statements can also be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to, changes in interest rates and yields; general economic conditions; uncertainty over future federal spending or the effects of federal budget cuts, particularly to the Department of Defense, on the Company's service area; the quality or composition of the loan or securities portfolios; changes in the volume and mix of interest-earning assets and interest-bearing liabilities; the effects of management's investment strategy and strategy to manage the net interest margin; the adequacy of the Company's credit quality review processes; the level of nonperforming assets and related charge-offs and recoveries; the ability of the Company to diversify its sources of noninterest income; the effect of the Company's sales training efforts for branch staff; the local real estate market; volatility and disruption in national and international financial markets; government intervention in the U.S. financial system; FDIC premiums and/or assessments; penalties paid if the Company were to prepay its FHLB advance; demand for loan products; levels of noninterest income and expense; deposit flows; competition; the use of inaccurate assumptions in management's modeling systems; technology; reliance on third parties for key services; adequacy of the allowance for loan losses; and changes in accounting principles, policies and guidelines. The Company could also be adversely affected by monetary and fiscal policies of the U.S. Government, as well as any regulations or programs implemented pursuant to the Dodd-Frank Act or other legislation and policies of the Comptroller, U.S. Treasury and the Federal Reserve Board.

The Company has experienced losses due to the current economic climate. Dramatic declines in the residential and commercial real estate market during the recent economic crisis resulted in significant write-downs of asset values by the Company as well as by other financial institutions in the U.S.

In July 2010, the President signed into law the Dodd-Frank Act, which implements far-reaching changes across the financial regulatory landscape. It is not clear what other impacts the Dodd-Frank Act, regulations promulgated thereunder and other regulatory initiatives of the Treasury and other bank regulatory agencies will have on the financial markets and the financial services industry.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements. Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made. In addition, past results of operations are not necessarily indicative of future results.

Executive Overview
Description of Operations
Headquartered in Hampton, Virginia, the Company is the parent company of Trust and the Bank. Trust is a wealth management services provider. The Bank offers a complete line of consumer, mortgage and business banking services, including loan, deposit, and cash management services to individual and business customers. The Bank is an independent community bank. The Bank has 18 branches throughout the Hampton Roads localities of Chesapeake, Hampton, Isle of Wight County, Newport News, Norfolk, Virginia Beach, Williamsburg/James City County and York County.
- 17 -


Management Initiatives in 2014
In 2014, management continued its 2013 initiatives to improve asset quality, grow the loan portfolio, expand the Company's fee based revenue (defined as service charges on deposit accounts and other service charges, commissions and fees) and concentrate on improving Company efficiency. Management believes substantial progress was made with respect to all four initiatives. Management was able to improve asset quality as is evident by a $1.4 million reduction in net charge-offs when comparing charge-offs for 2014 to those of 2013, and a $3.4 million reduction in risk rated loans in the Other Assets Especially Mentioned and Substandard categories when comparing December 31, 2014 to December 31, 2013. Details of the improvement of asset quality can be found in Note 4 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this report on Form 10-K. In addition, fee based revenue was higher for the year ended December 31, 2014 as compared to 2013. The loan portfolio grew by $35.3 million when comparing total loans on December 31, 2014 to December 31, 2013. Finally, the Company continued to focus on efficiency, with a net increase of only three employees during 2014 to 301 employees, still significantly lower than the 319 employees on December 31, 2012.

Primary Financial Data for 2014
The Company earned $4.1 million in 2014, as compared to net income of $3.2 million in 2013, an increase of $953 thousand or 30.13%. The increase in net income was due to higher net interest income and a lower provision for loan losses. Total interest and dividend income increased $466 thousand, while total interest expense decreased $831 thousand and the provision for loan losses decreased $700 thousand. A decrease in net charge-offs and improvement in loan quality between the two periods allowed management to reduce the provision for loan losses in 2014. Net loans charged off for the year ended December 31, 2014 were 80.15% lower than net charge-offs for the year ended December 31, 2013.

Assets as of December 31, 2014 were $876.3 million, an increase of $12.0 million or 1.39% compared to assets as of December 31, 2013. During 2014, the Company continued the loan growth seen in 2013, funding this growth mainly from the securities portfolio. Net loans grew $35.1 million, or 7.10%, over the year, while securities declined $23.1 million. In years prior to 2013, the Company experienced a lack of quality loan demand in its market area and invested excess funds in securities that could be readily liquidated as the Company waited for loan demand to recover. This recovery began in the second half of 2013 and continued through 2014.

Critical Accounting Estimates
The accounting and reporting policies of the Company are in accordance with U.S. generally accepted accounting principles (GAAP) and conform to general practices within the banking industry. The Company's financial position and results of operations are affected by management's application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company's consolidated financial position and/or results of operations. The accounting policy that required management's most difficult, subjective or complex judgments is the Company's allowance for loan losses, which is described below.

Allowance for Loan Losses
The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on three basic principles of accounting which require: (i) that losses be accrued when they are probable of occurring and estimable, (ii) that losses be accrued based on the differences between the loan balances and the value of collateral, present value of expected future cash flows or values that are observable in the secondary market and (iii) that adequate documentation exist to support the allowance for loan losses estimate.

The Company's allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. Management's estimate is based on certain observable, historical data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; discounted cash flow analysis; loan volumes; geographic, borrower and industry concentrations; the findings of internal credit quality assessments; and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

Authoritative accounting literature requires that the impairment of loans that have been separately identified for evaluation be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting literature, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.
- 18 -


The loan portfolio is segmented into pools, based on the loan classifications as defined by Schedule RC-C of the Federal Financial Institutions Examination Council Consolidated Reports of Condition and Income Form 041 (Call Report) and collectively evaluated for impairment. Consumer loans not secured by real estate and made to individuals for household, family and other personal expenditures are segmented into pools based on whether the loan's payments are current (including loans 1-29 days past due), or are 30 – 59 days past due, 60 – 89 days past due, or 90 days or more past due.  All other loans, including loans to consumers that are secured by real estate, are segmented by the Company's internally assigned risk grades: substandard, other assets especially mention (rated just above substandard), and pass (all other loans).

Specific reserves are determined on a loan-by-loan basis based on management's evaluation of the Company's exposure for each credit, given the current payment status of the loan and the net market value of any underlying collateral.

While management uses the best information available to establish the allowance for loan losses, future adjustment to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

Income Taxes
The Company recognizes expense for federal income and state bank franchise taxes payable as well as deferred federal income taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the Consolidated Financial Statements. Income and franchise tax returns are subject to audit by the Internal Revenue Service (IRS) and state taxing authorities. Income and franchise tax expense for current and prior periods is subject to adjustment based on the outcome of such audits. The Company believes it has adequately provided for all taxes payable.

Earnings Summary
Net income was $4.1 million, or $0.83 per diluted share, in 2014 compared to $3.2 million, or $0.64 per diluted share, in 2013.  This increase was primarily attributable to higher interest income, lower interest expense, and lower provision for loan losses, partially offset by lower noninterest income and higher noninterest expense. A shift in assets from securities to loans increased interest income, while decreases in higher-cost time accounts reduced interest expense.  Continued improvement in asset quality, as evidenced by lower charge-offs and a reduction in loans categorized as Other Assets Especially Mentioned or Substandard in 2014 when compared to 2013, allowed management to reduce the provision.  Noninterest expense was $1.1 million higher in 2014 than in 2013, due primarily to increases in salaries and employee benefits and occupancy and equipment expenses.

Net Interest Income
The principal source of earnings for the Company is net interest income. Net interest income is the difference between interest and fees generated by earning assets and interest expense paid to fund them. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. Net interest income, on a fully tax-equivalent basis, was $27.4 million in 2014, an increase of $1.5 million from 2013 and an increase of $176 thousand from 2012. The net interest margin was 3.57% in 2014 as compared to 3.23% in 2013 and 3.40% in 2012.

When comparing 2014 to 2013, the following changes were noted. Tax equivalent interest income increased $693 thousand, or 2.27%. Average earning assets decreased $31.9 million, or 3.98%. Total average loans increased $46.0 million, or 9.76%, and average investment securities decreased $46.8 million, or 16.38%, as continued loan demand allowed the company to shift its assets from securities and interest-bearing due from banks to loans.  Average interest-bearing due from banks, which has a significantly lower yield than investment securities and other investments, decreased $32.2 million, or 85.75%.  The Company also sold certain investment securities to reduce the portfolio's susceptibility to interest rate risk. As loans typically bear higher yields than securities, this change in asset composition led to an increase of 25 basis points in the yield on earning assets, partially offset by a lower average yield on loans.  Management expects that the Company's loan yields will continue to decline, due to intense competition for quality loans and rate reductions on loans currently held in the portfolio.  The reduction in loan yields will likely continue in 2015 at approximately the same pace seen in 2014, depending on monetary policy actions taken by the Federal Open Market Committee.  To partially offset this anticipated decline in loan yields, management has placed an increased focus on managing the mix of the liabilities in order to increase low cost funds and reduce high cost funds when possible.

Interest expense decreased $831 thousand, or 17.76% in 2014 as compared to 2013, while average interest-bearing liabilities decreased $15.6 million, or 2.55%. The cost of interest-bearing liabilities decreased 12 basis points due to the low interest rate environment. As discussed above, management has focused on adjusting the composition of its interest-bearing liabilities, specifically by allowing high-cost time deposits to reduce. Management expects that the reduction of the Company's interest expense will continue to slow in the future, because the majority of the higher cost time deposits have repriced to current, lower market rates. However, Management will continue to focus on the mix of deposits as stated above, by actively targeting new noninterest bearing deposits.
- 19 -

The following table shows an analysis of average earning assets, interest-bearing liabilities and rates and yields. Nonaccrual loans are included in loans outstanding.

TABLE I
 
AVERAGE BALANCE SHEETS, NET INTEREST INCOME* AND RATES*
 
                                   
Years ended December 31,
2014
   
2013
   
2012
 
     
Interest
           
Interest
           
Interest
     
 
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
 
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
 
(dollars in thousands)
 
ASSETS
                                 
                                   
Loans
 
 
$
517,183
   
$
24,959
     
4.83
%
 
$
471,203
   
$
23,769
     
5.04
%
 
$
478,220
   
$
26,565
     
5.55
%
Investment securities:
                                                                         
Taxable
     
164,755
     
3,562
     
2.16
%
   
229,914
     
4,547
     
1.98
%
   
263,532
     
5,238
     
1.99
%
Tax-exempt
     
74,112
     
2,580
     
3.48
%
   
55,745
     
2,042
     
3.66
%
   
25,053
     
1,032
     
4.12
%
Total investment securities
     
238,867
     
6,142
     
2.57
%
   
285,659
     
6,589
     
2.31
%
   
288,585
     
6,270
     
2.17
%
Interest-bearing due from banks
     
5,356
     
13
     
0.24
%
   
37,581
     
96
     
0.26
%
   
28,460
     
56
     
0.20
%
Federal funds sold
     
3,515
     
5
     
0.14
%
   
1,906
     
1
     
0.05
%
   
1,780
     
2
     
0.11
%
Other investments
     
2,944
     
125
     
4.25
%
   
3,374
     
96
     
2.85
%
   
3,967
     
100
     
2.52
%
Total earning assets
     
767,865
     
31,244
     
4.07
%
   
799,723
     
30,551
     
3.82
%
   
801,012
     
32,993
     
4.12
%
Allowance for loan losses
     
(7,062
)
                   
(7,239
)
                   
(7,771
)
               
       
760,803
                     
792,484
                     
793,241
                 
                                                                           
Cash and due from banks
     
25,700
                     
13,446
                     
8,589
                 
Bank premises and equipment, net
     
42,277
                     
36,188
                     
30,728
                 
Other assets
     
41,185
                     
39,260
                     
36,878
                 
                                                                           
Total assets
 
 
$
869,965
                   
$
881,378
                   
$
869,436
                 
                                                                         
                                                                         
LIABILITIES AND STOCKHOLDERS' EQUITY
                                                                 
                                                                         
Time and savings deposits:
                                                                         
Interest-bearing transaction accounts
 
 
$
11,537
   
$
5
     
0.04
%
 
$
11,129
   
$
6
     
0.05
%
 
$
11,600
   
$
7
     
0.06
%
Money market deposit accounts
     
213,918
     
179
     
0.08
%
   
199,848
     
234
     
0.12
%
   
180,106
     
322
     
0.18
%
Savings accounts
     
73,576
     
46
     
0.06
%
   
62,562
     
62
     
0.10
%
   
53,054
     
53
     
0.10
%
Time deposits, $100,000 or more
     
108,630
     
1,038
     
0.96
%
   
126,127
     
1,436
     
1.14
%
   
131,020
     
1,613
     
1.23
%
Other time deposits
     
128,383
     
1,316
     
1.03
%
   
157,154
     
1,683
     
1.07
%
   
172,230
     
2,228
     
1.29
%
                                                                           
Total time and savings deposits
     
536,044
     
2,584
     
0.48
%
   
556,820
     
3,421
     
0.61
%
   
548,010
     
4,223
     
0.77
%
Federal funds purchased, repurchase
                                                                         
   agreements and other borrowings
     
32,848
     
32
     
0.10
%
   
31,182
     
35
     
0.11
%
   
29,917
     
55
     
0.18
%
Federal Home Loan Bank advances
     
28,507
     
1,233
     
4.33
%
   
25,000
     
1,224
     
4.90
%
   
30,574
     
1,496
     
4.89
%
                                                                           
Total interest-bearing liabilities
     
597,399
     
3,849
     
0.64
%
   
613,002
     
4,680
     
0.76
%
   
608,501
     
5,774
     
0.95
%
Demand deposits
     
184,555
                     
180,538
                     
170,792
                 
Other liabilities
     
2,461
                     
3,143
                     
2,231
                 
                                                                           
Total liabilities
     
784,415
                     
796,683
                     
781,524
                 
Stockholders' equity
     
85,550
                     
84,695
                     
87,912
                 
                                                                           
Total liabilities and stockholders' equity
 
 
$
869,965
                   
$
881,378
                   
$
869,436
                 
                                                                           
Net interest margin
           
$
27,395
     
3.57
%
         
$
25,871
     
3.23
%
         
$
27,219
     
3.40
%
                                                                         
* Computed on a fully taxable equivalent basis using a 34% rate.
                                                 

- 20 -

The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities and changes in interest rates.

   
Table II
 
   
VOLUME AND RATE ANALYSIS*
 
   
(in thousands)
 
     
   
2014 vs. 2013
   
2013 vs. 2012
   
2012 vs. 2011
 
   
Increase (Decrease)
   
Increase (Decrease)
   
Increase (Decrease)
 
   
Due to Changes in:
   
Due to Changes in:
   
Due to Changes in:
 
     
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
EARNING ASSETS:
                                   
Loans
 
$
2,319
   
$
(1,129
)
 
$
1,190
   
$
(390
)
 
$
(2,406
)
 
$
(2,796
)
 
$
(3,918
)
 
$
(1,693
)
 
$
(5,611
)
Investment securities
                                                                       
Taxable
   
(1,289
)
   
304
     
(985
)
   
(668
)
   
(23
)
   
(691
)
   
1,153
     
201
     
1,354
 
Tax-exempt
   
673
     
(135
)
   
538
     
1,264
     
(254
)
   
1,010
     
1,347
     
(553
)
   
794
 
Total investment securities
   
(616
)
   
169
     
(447
)
   
596
     
(277
)
   
319
     
2,500
     
(352
)
   
2,148
 
                                                                         
Federal funds sold
   
1
     
3
     
4
     
0
     
(1
)
   
(1
)
   
(18
)
   
(1
)
   
(19
)
Other investments **
   
(153
)
   
99
     
(54
)
   
41
     
(5
)
   
36
     
105
     
(33
)
   
72
 
Total earning assets
   
1,551
     
(858
)
   
693
     
247
     
(2,689
)
   
(2,442
)
   
(1,331
)
   
(2,079
)
   
(3,410
)
                                                                         
Interest-Bearing Liabilities
                                                                       
Interest-bearing transaction accounts
   
0
     
(1
)
   
(1
)
   
0
     
(1
)
   
(1
)
   
0
     
0
     
0
 
Money market deposit accounts
   
16
     
(71
)
   
(55
)
   
35
     
(123
)
   
(88
)
   
21
     
(51
)
   
(30
)
Savings accounts
   
11
     
(27
)
   
(16
)
   
9
     
0
     
9
     
5
     
(1
)
   
4
 
Time deposits, $100,000 or more
   
(199
)
   
(199
)
   
(398
)
   
(60
)
   
(117
)
   
(177
)
   
63
     
(312
)
   
(249
)
Other time deposits
   
(308
)
   
(59
)
   
(367
)
   
(195
)
   
(350
)
   
(545
)
   
(116
)
   
(290
)
   
(406
)
Total time and savings deposits
   
(480
)
   
(357
)
   
(837
)
   
(211
)
   
(591
)
   
(802
)
   
(27
)
   
(654
)
   
(681
)
Federal funds purchased, repurchase
                                                                       
agreements and other borrowings
   
2
     
(5
)
   
(3
)
   
2
     
(22
)
   
(20
)
   
(43
)
   
(8
)
   
(51
)
Federal Home Loan Bank advances
   
172
     
(163
)
   
9
     
(273
)
   
1
     
(272
)
   
(216
)
   
7
     
(209
)
Total interest-bearing liabilities
   
(306
)
   
(525
)
   
(831
)
   
(482
)
   
(612
)
   
(1,094
)
   
(286
)
   
(655
)
   
(941
)
                                                                         
Change in net interest income
 
$
1,857
   
$
(333
)
 
$
1,524
   
$
729
   
$
(2,077
)
 
$
(1,348
)
 
$
(1,045
)
 
$
(1,424
)
 
$
(2,469
)
                                                                         
* Computed on a fully tax-equivalent basis using a 34% rate.
 
** Other investments include interest-bearing balances due from banks.
 

Interest Sensitivity
An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. This gap can be managed by repricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management's expectations regarding future interest rate movements, the state of the national and regional economy, and other financial and business risk factors. The Company uses computer simulations to measure the effect of various interest rate scenarios on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

Based on scheduled maturities only, the Company was liability sensitive at the one-year timeframe as of December 31, 2014. It should be noted, however, that non-maturing, interest-bearing deposit liabilities, which consist of interest checking, money market and savings accounts, are less interest sensitive than other market driven deposits. On December 31, 2014 non-maturing, interest-bearing deposit liabilities totaled $307.1 million, or 57.90%, of total interest-bearing deposits. In a rising rate environment these deposit rates have historically lagged behind the changes in earning asset rates, thus mitigating the impact from the liability-sensitive position. The asset/liability model allows the Company to reflect the fact that non-maturing deposits are less rate sensitive than other deposits by using a decay rate. The decay rate is a type of artificial maturity that simulates maturities for non-maturing deposits over the number of months that more closely reflects historic data. Using the decay rate, the model reveals that the Company is asset sensitive at the one-year timeframe as of December 31, 2014.
- 21 -


When the Company is liability sensitive, net interest income should decrease if interest rates rise since liabilities will reprice faster than assets. Conversely, if interest rates fall, net interest income should increase, depending on the optionality (prepayment speeds) of the assets. When the Company is asset sensitive, net interest income should rise if rates rise and should fall if rates fall.

The Company's interest rate sensitivity position is illustrated in the following table. The carrying amounts of assets and liabilities are presented in the periods they are expected to reprice or mature.

TABLE III
 
INTEREST SENSITIVITY ANALYSIS
 
 
As of December 31, 2014
 
Within
     
4-12
     
1-5
   
Over 5
   
Total
 
(in thousands)
 
3 Months
   
Months
   
Years
   
Years
 
                             
Uses of Funds
                           
Interest-bearing due from banks
 
$
833
   
$
0
   
$
0
   
$
0
   
$
833
 
Federal funds sold
   
1,391
     
0
     
0
     
0
     
1,391
 
Taxable investments
   
20,719
     
100
     
3,092
     
132,011
     
155,922
 
Tax-exempt investments
   
0
     
0
     
8,612
     
64,901
     
73,513
 
Total federal funds sold and investment securities
   
22,943
     
100
     
11,704
     
196,912
     
231,659
 
                                         
Loans
                                       
Commerical
 
$
9,135
   
$
7,303
   
$
11,545
   
$
9,715
   
$
37,698
 
Consumer
   
10,204
     
737
     
6,774
     
12,778
     
30,493
 
Real estate
   
41,433
     
26,769
     
266,915
     
109,879
     
444,996
 
Other
   
12,406
     
577
     
4,143
     
5,681
     
22,807
 
Total loans
   
73,178
     
35,386
     
289,377
     
138,053
     
535,994
 
Total earning assets
 
$
96,121
   
$
35,486
   
$
301,081
   
$
334,965
   
$
767,653
 
                                         
Sources of funds
                                       
Interest-bearing transaction accounts
 
$
14,722
   
$
0
   
$
0
   
$
0
   
$
14,722
 
Money market deposit accounts
   
220,298
     
0
     
0
     
0
     
220,298
 
Savings accounts
   
72,058
     
0
     
0
     
0
     
72,058
 
Time deposits $100,000 or more
   
33,228
     
24,840
     
46,964
     
0
     
105,032
 
Other time deposits
   
22,594
     
44,254
     
51,416
     
0
     
118,264
 
Federal funds purchased and other borrowings
   
0
     
0
     
0
     
0
     
0
 
Overnight repurchase agreements
   
37,404
     
0
     
0
     
0
     
37,404
 
Term repurchase agreements
   
412
     
0
     
0
     
0
     
412
 
FHLB advances
   
25,000
     
5,000
     
0
     
0
     
30,000
 
Total interest bearing liabilities
 
$
425,716
   
$
74,094
   
$
98,380
   
$
0
   
$
598,190
 
                                         
Rate sensitivity GAP
 
$
(329,595
)
 
$
(38,608
)
 
$
202,701
   
$
334,965
   
$
169,463
 
                                         
Cumulative GAP
 
$
(329,595
)
 
$
(368,203
)
 
$
(165,502
)
 
$
169,463
         


The most likely scenario represents the rate environment as management forecasts it to occur. Management uses a "static" test to measure the effects of changes in interest rates on net interest income. This test assumes that management takes no steps to adjust the balance sheet to respond to the shock by repricing assets/liabilities, as discussed in the first paragraph of this section.

Under the rate environment forecasted by management, rate shocks in 50 to 100 basis point increments are applied to estimate the impact on the Company's net interest income. The table below shows the estimated impact of changes in interest rates on net interest income as of December 31, 2014, assuming gradual and parallel changes in interest rates, and consistent levels of assets and liabilities. Net interest income for the following twelve months is projected to increase when interest rates are higher than current rates. Due to the current low interest rate environment, no measurement was considered necessary for a further decline in interest rates.

Estimated Changes in Net Interest Income
 
(dollars in thousands)
 
As of December 31, 2014
 
Changes in Net Interest Income
 
Changes in Interest Rates
Amount
   
Percent
 
Up 4.00%
 
$
425
     
1.62
%
Up 3.00%
 
$
386
     
1.47
%
Up 2.00%
 
$
314
     
1.20
%
Up 1.00%
 
$
251
     
0.96
%
Up 0.50%
 
$
181
     
0.69
%
No change
 
$
0
     
0.00
%
- 22 -


Management cannot predict future interest rates or their exact effect on net interest income. Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Certain limitations are inherent in such computations. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect the Company's interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

Provision for Loan Losses
The provision for loan losses is a charge against earnings necessary to maintain the allowance for loan losses at a level consistent with management's evaluation of the loan portfolio. The provision for loan losses is an expense that is based on management's estimate of credit losses that are probable of being sustained in the loan portfolio.

The provision for loan losses was $600 thousand for the year ended December 31, 2014 as compared to $1.3 million for 2013. Loans that were charged off during 2014 totaled $1.2 million compared to $2.7 million in 2013. Recoveries amounted to $882 thousand in 2014 and $913 thousand in 2013. The Company's net loans charged off to year-end loans were 0.07% in 2014 as compared to 0.36% in 2013. The allowance for loan losses, as a percentage of year-end loans, was 1.32% in 2014 and 1.36% in 2013. Net loan charge-offs for 2014 were lower than in 2013 due to continued improvements in asset quality and the concomitant reduction in charge-offs. Management believes that net loan charge-offs in subsequent years will be higher than what was experienced in 2014, as no similarly large recoveries are anticpated in the future.  The state of the local economy also significantly impacts the level of loan charge-offs, and if the economic recovery does not continue, nonperforming assets could increase as a result of declines in real estate values and home sales or increases in unemployment rates and financial stress on borrowers. Increased nonperforming assets would cause increased charge-offs and lower earnings due to larger contributions to the loan loss provision.

In 2014, management contributed $600 thousand to the allowance for loan losses through the provision, or $700 thousand less than the provision for the year ended December 31, 2013. This decision was based on management's evaluation of loan losses in the loan portfolio. Management's evaluation included credit quality trends, collateral values, discounted cash flow analysis, loan volumes, geographic, borrower and industry concentrations, the findings of internal credit quality assessments and results from external regulatory examinations. These factors, as well as identified impaired loans, historical losses and current economic and business conditions, were used in developing estimated loss factors for determining the loan loss provision. Management's evaluation identified improvement in the credit quality of the Company's loan portfolio, including a $1.4 million reduction in net charge-offs when comparing the year ended December 31, 2014 to 2013, and a $3.4 million reduction in risk rated loans in the Other Assets Especially Mentioned and Substandard categories when comparing December 31, 2014 to December 31, 2013. This improvement supported the decrease in the provision for loan losses and the allowance for loan losses as a percent of total loans when comparing the year ended December 31, 2014 to 2013. Management believes that smaller contributions to the provision for loan losses, relative to the contributions made in recent years, will continue if current economic conditions remain stable or improve.

Noninterest Income
Noninterest income decreased $129 thousand or 1.01% for the year ended December 31, 2014 as compared to the year ended December 31, 2013. This decrease was driven by a reduction in income from Old Point Mortgage LLC, a joint venture between the Bank and Tidewater Mortgage Services. Income from Old Point Mortgage was elevated in 2013 by the recognition of fair value accounting. In addition, low interest rates in recent years resulted in an unusually high number of borrowers refinancing their mortgages. By the end of 2013, management believes most eligible borrowers interested in refinancing had done so.

The reduction in income from Old Point Mortgage was mostly offset by the $378 thousand increase in other service charges, commissions and fees. In the fourth quarter of 2013, Trust acquired Penact, a company that provides consultation, administration and valuation services for retirement plans. Revenue from Penact was $359 thousand for the year ended December 31, 2014, $328 thousand higher than in 2013. As Penact was acquired in the fourth quarter of 2013, 2014 is the first full year of revenue.

Small decreases were seen in income from fiduciary activities, service charges on deposit accounts, and other operating income.  When comparing 2014 to 2013, service charges on deposit accounts decreased $64 thousand due to decreases in nonsufficient funds and overdraft fees.  The decrease of $34 thousand in other operating income in 2014, compared to 2013, was driven by the Bank's sale of a foreclosed property, which was occupied by a rent-paying tenant.  This property was sold in the first quarter of 2014, reducing other income by $33 thousand. While this sale did reduce the Company's noninterest income, it is important to note that the sale also reduced foreclosed property expenses, and that the Company recorded a gain on the sale.
- 23 -


Income from fiduciary activities decreased $47 thousand in 2014, when compared to 2013, due to Trust's determination that certain customer fees had been inadvertently charged. The Company recognized an adjustment in the financial statements for the second quarter of 2014, which reduced noninterest income by $135 thousand in that quarter. The affected customers were credited in the third quarter of 2014.  Other than the impact of the inadvertent fee charges, other income from fiduciary activities increased during 2014 as compared to 2013, and management expects this positive trend to continue in 2015.

In addition to the increase in other service charges, commissions and fees discussed above, the Company also had a relatively small improvement in gain (loss) on sale of available-for-sale securities between 2013 and 2014.  During both years, the Company has focused on restructuring its securities portfolio to improve the portfolio's cash flow, increase its yields, and reduce its susceptibility to interest rate risk.  As a result of this restructuring, the Company recorded a net gain on sales of $2 thousand in 2014, compared to a net loss on sales of $26 thousand in 2013.

The Company continues to focus on diversifying noninterest income through efforts to expand Trust relationships and a continued focus on business checking and other corporate services.  The portions of the Dodd-Frank Act that have been fully implemented have increased, and the Company expects the Dodd-Frank Act when fully implemented to further increase, government regulation of consumer financial products and services, including fees generated on consumer financial transactions. Although the impact of the Dodd-Frank Act and regulations promulgated thereunder is not yet fully known, the Company expects that this additional regulation of consumer financial products, services and transactions may materially impact the Company's ability to generate future noninterest income.

Noninterest Expenses
The Company's noninterest expense increased $1.1 million or 3.22% for the year ended December 31, 2014 as compared to the year ended December 31, 2013.  The largest increases were in salaries and employee benefits and occupancy and equipment expenses. Occupancy and equipment expenses increased $490 thousand, or 11.15% when comparing 2014 and 2013, due to the completion of the Company's new corporate headquarters. Salaries and employee benefits increased $776 thousand, or 4.06%, when comparing 2014 to 2013, mainly due to an increase in the cost of employer-provided medical insurance of $424 thousand. Staffing was also increased by the addition of four employees when Trust acquired Penact in the fourth quarter of 2013. The Company expects that future revenues will more than offset the increased salaries and benefits, as evidenced by the increase in income from other service charges, commissions and fees when comparing the years ended December 31, 2014 and 2013.

Other outside services, employee professional development, and capital stock tax also increased in 2014, when compared to 2013. Other outside services increased $125 thousand, mainly as a result of outsourcing of certain information technology and audit functions requiring extremely specialized skills and expertise. Employee professional development increased $126 thousand as the Company provided sales training for all branch staff to improve future revenues.

Capital stock tax is paid to the state of Virginia instead of state income tax, and is based on the subsidiaries' capital less certain allowances.  One such allowance is based on holdings of U.S. Government agency securities and is calculated as of each quarter-end during the fiscal year, rather than on an average or year-end balance.  As the composition of the Company's securities portfolio has changed between 2012, 2013, and 2014, the level of U.S. Government agency securities decreased significantly and provided a smaller deduction for the purposes of calculating the capital stock tax.

These increases in noninterest expense were partially offset by decreases in other operating expenses and loss on write-down/sale of other real estate owned. Loan expenses, which are included in other operating expenses, were lower in 2014 than in 2013 due to recoveries of funds as a result of settlements on problem loans.  Losses on other real estate owned were elevated in 2013 due to the write-down on a single piece of property. The value of this property declined sharply due to the foreclosure by other banks of similar property in the area. There were no similarly large write-offs on other real estate owned in 2014.

Income tax expense was also lower in 2014 than in 2013, due to a shift in the securities portfolio toward tax-exempt securities. The Company also took advantage of several tax credits during 2014; together, the tax credits and shift in the securities portfolio reduced 2014 income tax expense by 43.68% compared to 2013.

Balance Sheet Review
At December 31, 2014, the Company had total assets of $876.3 million, an increase of $12.0 million or 1.39% compared to assets as of December 31, 2013. Net loans increased $35.1 million or 7.10%, from $493.9 million at December 31, 2013 to $528.9 million at December 31, 2014. Loan demand began to increase in 2013 and continued throughout 2014, but until loan demand recovers significantly, the Company will likely continue to manage the interest margin by allowing higher cost funds, such as time deposits, to decrease. High-cost time deposits decreased $33.5 million or 13.05% between December 31, 2013 and December 31, 2014, while low-cost funds in the form of noninterest-bearing and savings deposits increased $24.8 million or 5.28% in the same time period.
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The Company's holdings of Alternative A-paper, or "Alt-A", type mortgage loans such as adjustable rate and nontraditional type loans were inconsequential, amounting to less than 1.00% of the Company's loan portfolio as of December 31, 2014.

The Company does not have a formal program for subprime lending. The Company is, however, required by law to comply with the CRA, which imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low- and moderate-income borrowers. In order to comply with the CRA and meet the credit needs of its local communities, the Company finds it necessary to make certain loans with subprime characteristics.

For the purposes of this discussion, a "subprime loan" is defined as a loan to a borrower having a credit score of 660 or below. The majority of the Company's subprime loans are to customers in the Company's primary service area.

The following table details, as of December 31, 2014, the Company's loans with subprime characteristics that were secured by 1-4 family first mortgages, 1-4 family open-end and 1-4 family junior lien loans for which the Company has recorded a credit score in its system.

Loans Secured by 1 - 4 Family First Mortgages,
 
1 - 4 Family Open-end and 1 - 4 Family Junior Liens
 
As of December 31, 2014
 
(dollars in thousands)
 
         
   
Amount
   
Percent
 
Subprime
 
$
20,200
     
14.9
%
Non-subprime
   
115,685
     
85.1
%
   
$
135,885
     
100.0
%
                 
Total loans
 
$
535,994
         
                 
Percentage of Real Estate-Secured Subprime Loans to Total Loans
     
3.77
%

In addition to the subprime loans secured by real estate discussed above, as of December 31, 2014, the Company had an additional $1.4 million in subprime consumer loans that were either unsecured or secured by collateral other than real estate. Together with the subprime loans secured by real estate, the Company's total subprime loans as of December 31, 2014 were $21.6 million, amounting to 4.03% of the Company's total loans at December 31, 2014.

The Company has no investments secured by "Alt-A" type mortgage loans such as adjustable rate and nontraditional type mortgages or subprime loans.

Securities Portfolio
When comparing December 31, 2014 to December 31, 2013, securities available-for-sale decreased $16.3 million and securities held-to-maturity decreased $6.8 million. In December 2014, as part of a strategy to reduce its capital stock tax expense, the Company purchased $20.0 million in short-term U.S Treasury securities.  U.S. Treasury securities have very low yields.  However, the anticipated future reduction in capital stock tax, included in noninterest expense, should more than offset the reduction in interest income.  If the Company had not purchased these U.S. Treasuries, securities available-for-sale would have decreased $36.3 million.  Securities were sold to reduce the portfolio's susceptibility to interest rate risk and to fund loan demand, which began to recover in the second quarter of 2013 and continued in 2014.  The Company's goal is to provide maximum return on the securities portfolio within the framework of its asset/liability objectives and consistent with its need to manage tax exposure when necessary. The asset/liability objectives include managing interest sensitivity, liquidity and pledging requirements.
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The following table sets forth a summary of the securities portfolio:

TABLE IV
 
SECURITIES PORTFOLIO
 
             
As of December 31, 
 
2014
   
2013
   
2012
 
   
(in thousands)
 
Available-for-sale securities, at fair value:
           
U.S. Treasury securities
 
$
20,000
   
$
0
   
$
0
 
Obligations of U.S. Government agencies
   
4,618
     
15,024
     
37,088
 
Obligations of state and political subdivisions
   
50,246
     
47,100
     
43,774
 
Mortgage-backed securities
   
60,888
     
90,750
     
247,355
 
Money market investments
   
719
     
691
     
541
 
Corporate bonds
   
2,790
     
2,074
     
698
 
Other marketable equity securities
   
85
     
0
     
0
 
   
$
139,346
   
$
155,639
   
$
329,456
 
Held-to-maturity securities, at cost:
                       
Obligations of U.S. Government agencies
 
$
100
   
$
400
   
$
570
 
Obligations of state and political subdivisions
   
29,529
     
30,120
     
0
 
Mortgage-backed securities
   
60,460
     
66,327
     
0
 
   
$
90,089
   
$
96,847
   
$
570
 
Restricted securities:
                       
Federal Home Loan Bank stock
 
$
2,124
   
$
2,209
   
$
2,393
 
Federal Reserve Bank stock
   
169
     
169
     
169
 
   
$
2,293
   
$
2,378
   
$
2,562
 
                         
Total
 
$
231,728
   
$
254,864
   
$
332,588
 

The following table summarizes the contractual maturity of the securities portfolio and their weighted average yields as of December 31, 2014:

   
1 year
     
1-5
     
5-10
   
Over 10
     
   
or less
   
years
   
years
   
years
   
Total
 
   
(dollars in thousands)
 
U.S. Treasury securities
 
$
20,000
   
$
0
   
$
0
   
$
0
   
$
20,000
 
Weighted average yield
   
0.00
%
   
0.00
%
   
0.00
%
   
0.00
%
   
0.00
%
                                         
Obligations of U.S. Government Agencies
 
$
0
   
$
402
   
$
0
   
$
4,316
   
$
4,718
 
Weighted average yield
   
0.00
%
   
1.10
%
   
0.00
%
   
1.83
%
   
1.77
%
                                         
Obligations of state and political subdivisions
 
$
0
   
$
8,613
   
$
25,502
   
$
45,660
   
$
79,775
 
Weighted average yield
   
0.00
%
   
1.86
%
   
2.20
%
   
2.53
%
   
2.36
%
                                         
Mortgage-backed securities
 
$
0
   
$
0
   
$
0
   
$
121,348
   
$
121,348
 
Weighted average yield
   
0.00
%
   
0.00
%
   
0.00
%
   
2.81
%
   
2.81
%
                                         
Money market investments
 
$
719
   
$
0
   
$
0
   
$
0
   
$
719
 
Weighted average yield
   
0.01
%
   
0.00
%
   
0.00
%
   
0.00
%
   
0.01
%
                                         
Corporate bonds