10-K 1 ffis_10k.htm ANNUAL REPORT ffis_10k.htm


UNITED STATES
SECURITIES EXCHANGE COMMISSION
Washington, D.C. 20429
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2012
_____________
 
1st FINANCIAL SERVICES CORPORATION
(Name of Registrant as specified in its charter)
 
North Carolina
 
000-53264
 
26-0207901
(State or other jurisdiction of
incorporation or organization)
 
(Commission
File Number)
 
(I.R.S. Employer
Identification No.)
 
101 Jack Street
Hendersonville, North Carolina 28792
(Address of principal executive offices, including Zip Code)
 
(828) 697-3100
Registrant’s telephone number, including area code
_____________
 
Securities registered under Section 12(b) of the Act:
None
Securities registered under Section 12(g) of the Act:
Common Stock, $5.00 par value per share
 
(Title of class)
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o    No  þ
 
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 o   No  þ
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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  þ    No  o
 
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  þ   No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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.   o
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  
 
Large accelerated filer
o
Accelerated filer
o
Non-accelerated filer
o
Smaller reporting company
þ

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o   No  þ
 
The aggregate market value of the Registrant’s common stock held by non-affiliates (stockholders holding less than 5% of an outstanding class of stock, excluding directors and executive officers) of the Registrant as of June 30, 2012, was $1.2 million based on the closing sale price of the Registrant’s common stock as reported on the OTC Bulletin Board.
 
On February 25, 2013, there were 5,204,385 outstanding shares of the Registrant’s common stock.
 
Documents Incorporated by Reference
 
Portions of Registrant’s definitive Proxy Statement to be filed with the SEC in connection with its 2013 Annual Meeting are incorporated into Part III of this Report.
 


 
 

 

FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2012

TABLE OF CONTENTS

PART I

     
Page
 
    3-17  
    18-28  
    29  
    29  

PART II


PART III


PART IV


 
2

 

PART I
 
 
CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  These statements represent expectations and beliefs of 1st Financial Services Corporation (1st Financial or the Company) including but not limited to 1st Financial’s operations, performance, financial condition, growth or strategies.  These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimates”, “believes” and variations of these words and other similar statements.  For this purpose, any statements contained in this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  These forward-looking statements involve estimates, assumptions, risks, and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation:
 
  
there is substantial doubt about the ability of 1st Financial to continue as a going concern;

  
1st Financial and its subsidiary, Mountain 1st Bank and Trust Company (the Bank) may be subject to additional, heightened enforcement actions, and ultimately, the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order (the Consent Order) with the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Commissioner of Banks (the Commissioner) and the Written Agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (Federal Reserve Bank), or if our condition continues to deteriorate;

  
difficult market conditions and economic trends have adversely affected our industry and our business;

  
financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations;

  
our participation in the TARP Capital Purchase Program imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity;

  
we are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our preferred stock;

  
the limitations on incentive compensation contained in the American Recovery and Reinvestment Act of 2009  and subsequent regulations may adversely affect our ability to retain our highest performing employees;

  
the soundness of other financial institutions could adversely affect us;

  
increases in FDIC insurance premiums may adversely affect our net income and profitability;

  
1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue;

  
we need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed;

  
our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio;

  
we continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values;

  
a significant percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio;

  
our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability;

  
our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio;

  
our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations;
 
 
  
the Company will be unable to grow in the short term;

  
our business depends on the condition of the local and regional economies where we operate;

  
our profitability is subject to interest rate risk and changes in interest rates could have an adverse effect on our operating results;

  
competition from financial institutions and other financial service providers may adversely affect our profitability;

  
we are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings;

  
if the Bank loses key employees with significant business contacts in its market areas, its business may suffer;

  
we may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability;

  
negative publicity could damage our reputation;

  
the Bank is subject to environmental liability risk associated with lending activities;

  
financial services companies depend on the accuracy and completeness of information about customers and counterparties;

  
liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows;

  
changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition;

  
impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations;

  
premiums for D&O insurance may increase; we may be unable to renew our D&O insurance policy on acceptable terms;

  
we rely on other companies to provide key components of our business infrastructure;

  
our information systems may experience an interruption or breach in security;

  
unpredictable catastrophic events could have a material adverse effect on 1st Financial;

  
we may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock;

  
our ability to pay dividends is limited and we may be unable to pay future dividends;

  
there may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock;

  
the trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could adversely impact the price of our stock and make it difficult for common stockholders to sell their shares;

  
our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders;

  
1st Financial has issued preferred stock, which ranks senior to our common stock;

  
our preferred stock reduces net income available to holders of our common stock and earnings per common share and the warrant may be dilutive to holders of our common stock;

  
our stock price can be volatile;

  
our common stock is not FDIC insured; and
 
 
  
other risks and uncertainties detailed in Part I, Item 1A of this Annual Report on Form 10-K and from time to time in our filings with the Securities and Exchange Commission (the SEC).

All forward-looking statements in this report are based on information available to us as of the date of this report.  Although we believe the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee you these expectations will be achieved.  We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

General

1st Financial Services Corporation (1st Financial, or the Company), incorporated under the laws of North Carolina, became the bank holding company for Mountain 1st Bank & Trust Company (the Bank) in May 2008.  1st Financial has essentially no other assets or liabilities other than its investment in the Bank.  1st Financial’s business activity consists of directing the activities of the Bank.  The Bank has a wholly owned subsidiary, Clear Focus Holdings LLC.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.  1st Financial and the Bank are both headquartered at 101 Jack Street, Hendersonville, North Carolina 28792.

The Bank was incorporated under the laws of the state of North Carolina on April 30, 2004, and opened for business on May 14, 2004, as a North Carolina chartered commercial bank.  At December 31, 2012, the Bank was engaged in general commercial banking primarily in nine western North Carolina counties: Buncombe, Catawba, Cleveland, Haywood, Henderson, McDowell, Polk, Rutherford, and Transylvania.  The Bank operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the FDIC).

As a North Carolina bank, the Bank is subject to examination and regulation by the FDIC and the North Carolina Commissioner of Banks (the Commissioner).  The Bank is further subject to certain regulations of the Board of Governors of the Federal Reserve System (the Federal Reserve) governing reserve requirements to be maintained against deposits and other matters.  The business and regulation of the Bank are also subject to legislative changes from time to time.  See “Supervision and Regulation.”

The Bank’s primary market area is southwestern North Carolina.  Its main office and Hendersonville South office are located in Hendersonville, North Carolina.  At December 31, 2012, the Bank also had full service branch offices in Asheville, Brevard, Columbus, Etowah, Forest City, Fletcher, Hickory, Marion, Shelby, and Waynesville, North Carolina.  The Bank’s loans and deposits are primarily generated from within its local market area.

The Company’s primary source of revenue is interest and fee income from its lending activities.  These lending activities consist principally of originating commercial operating and working capital loans, residential mortgage loans, home equity lines of credit, other consumer loans and loans secured by commercial real estate.  Management targets a loan-to-asset ratio of 80% or less.  It is management’s opinion that maintaining a loan-to-asset ratio in this range maximizes earnings potential while still providing adequate liquidity for the safe and sound operation of the Company.  At December 31, 2012, the Company’s loan-to-asset ratio was 54.6%.  This number, while below the targeted range, reflects the Bank’s desire to maintain higher liquidity levels and lower risk in the portfolio.  In addition, the economic downturn has led to a reduction in general business activity and demand for commercial and consumer credit, and as a result there is increased competition among financial institutions for loans from qualified borrowers.

Interest and dividend income from investment activities generally provides the second largest source of income to the Company after interest on loans.  Management has chosen to restrict the level of credit risk in the Company’s investment portfolio and as such it is comprised primarily of debt and mortgage-backed securities issued by agencies of the United States and government-sponsored enterprises.  Management expects to continue this practice for the foreseeable future.  Furthermore, management has historically chosen to maintain a relatively short duration with respect to the investment portfolio as a whole.  Because of the Federal Reserve’s stance of maintaining interest rates at the current low levels through mid-2015, during 2012, the Bank purchased mainly callable U.S. government agency securities, with longer stated maturities, but which are expected to be called in the current rate environment.  While this strategy has resulted in an improvement in portfolio yield, it has generally increased the market price volatility and consequently, potential mark-to-market charges against the Company’s capital.

Deposits are the primary source of the Company’s funds for lending and other investment purposes.  The Company attracts both short and long-term deposits from the general public by offering a variety of accounts and rates.  In addition to noninterest bearing checking accounts, the Company offers statement savings accounts, negotiable order of withdrawal (NOW) accounts, money market demand accounts, fixed interest rate certificates with varying maturities, and IRA deposit accounts.
 
Enforcement Policies and Actions

Federal and state laws give the Federal Reserve, the FDIC, and the Commissioner substantial powers to enforce compliance with laws, rules, and regulations.  Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices.  The banking regulators have the power to impose civil money penalties against individuals or institutions for certain violations.
 

Persons who are affiliated with depository institutions and their holding companies can be removed from any office held in that institution and banned from participating in the affairs of any financial institution.  The banking regulators frequently employ the enforcement authorities provided in federal and state law.

Enforcement Action - Consent Order

During 2009, the FDIC conducted a periodic examination of the Bank.  As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the North Carolina Commissioner of Banks (the Commissioner).

Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions:
 
 
 
enhance its supervision of the Bank’s activities.
 
 
 
assess the management team to ensure executive officers have the skills, training, abilities, and experience needed.
 
 
 
develop and implement a plan for achieving and maintaining Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses.
 
 
 
strengthen the allowance for loan and lease losses policy of the Bank.
 
 
 
develop and implement a strategic plan.
 
 
 
not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.
 
 
 
formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans.
 
 
 
reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.
 
 
 
cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies.
 
 
 
adopt a loan review and grading system.
 
 
 
develop a plan to systematically reduce the concentration in a limited group of borrowers.
 
 
 
enhance its review of its liquidity and implement a liquidity contingency and asset/liability management plan.
 
  
 
implement a plan and 2010 budget designed to improve and sustain earnings.
 
 
 
implement internal routine and control policies addressing concerns to enhance its safe and sound operation.
 
  
 
implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
 
 
 
implement a policy for managing its “owned real estate”.
 
 
 
forbear from soliciting and accepting “brokered deposits” without approval.

 
 
limit growth to 10% per year.
 
 
 
not pay dividends without prior approval.
 
 
 
 
implement policies to enhance the handling of transactions with officers and directors.
 
 
 
correct any violations of laws and regulations.
 
 
 
make quarterly progress reports.
 
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order.  A copy of the Consent Order has been filed with the Securities and Exchange Commission (the SEC) and is available on the SEC’s Internet website at www.sec.gov.  The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation.  During the period a consent order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches.  Accordingly, the Bank will defer expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.
 
Enforcement Action - Written Agreement

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, the Company executed a written agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (the Federal Reserve Bank), effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions, including, among other things that the Company or its Board of Directors shall:

  
take appropriate steps to fully utilize the Company’s financial and managerial resources, to serve as a source of strength to the Bank.

  
not declare or pay any dividends without approval.

  
not directly or indirectly take dividends from the Bank without approval.

  
not directly or indirectly, incur, increase, or guarantee any debt without approval.

  
not directly or indirectly, purchase or redeem any shares of its stock without approval.

  
comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve related to changes in executive officers and compensation matters.

  
submit a written capital plan that is acceptable to the Federal Reserve Bank, implement the approved plan, and thereafter fully comply with it.

The foregoing description is a summary of the material terms of the Written Agreement, and is qualified in its entirety by reference to the Written Agreement.  A copy of the Written Agreement has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov. Each provision of the Written Agreement shall remain effective and enforceable until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

The Company and the Bank have taken and continue to take action to respond to the issues raised in the Consent Order and the Written Agreement.

"Significantly Undercapitalized" Capital Category

As of December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to the restrictions in Section 38 of the FDI Act and the related FDIC rules and regulations that apply to "significantly undercapitalized" institutions, including restrictions on:

  
the compensation paid to senior executive officers;

  
capital distributions;
 
 
  
payment of management fees;

  
asset growth;

  
acquiring any interest in any company or insured depository institution;

  
establishing or acquiring any additional branch office; and

  
engaging in any new line of business.

Because of its capital category, the Bank may not accept, renew, or roll over brokered deposits, and is subject to restrictions on the rate of interest it may pay on deposits.  Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.

Going Concern Considerations

As discussed in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and in Note 2 to the accompanying consolidated financial statements, although the Company was profitable in 2012, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels.  These considerations raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans are further discussed in Note 2 to the accompanying consolidated financial statements.  These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.

Competition and Market Area

Commercial banking in North Carolina is highly competitive, due in large part to our state’s early adoption of statewide branching.  Over the years, federal and state legislation (including the elimination of restrictions on interstate banking) has heightened the competitive environment in which all financial institutions conduct their business, and the potential for competition among financial institutions of all types has increased significantly.

Banking also is highly competitive in our market.  North Carolina is home to several of the largest commercial banks in the United States, all of which have branches located in our nine-county banking market. We compete with numerous national, regional, and community commercial banks in our markets, as well as several savings institutions, credit unions, and nonbank financial service providers.

Interest rates, both on loans and deposits, and prices of fee-based services are significant competitive factors among financial institutions generally.  Other important competitive factors include office location, office hours, quality of customer service, community reputation, continuity of personnel and services, and in the case of larger commercial customers, relative lending limits and the ability to offer sophisticated cash management and other commercial banking services.  Many of our competitors have greater resources, broader geographic markets, more extensive branch networks, and higher lending limits than we do.  They also may offer a broader menu of products and services and can better afford and make more effective use of media advertising, support services, and electronic technology than we can.  In terms of assets, we are one of the smaller commercial banks in North Carolina, and we cannot assure you we will be or continue to be an effective competitor in our banking market.  However, we believe community banks can compete successfully by providing personalized service and making timely, local decisions, and further consolidation in the banking industry is likely to create additional opportunities for community banks to capture deposits from customers who become dissatisfied as their financial institutions grow larger.  We also believe the continued growth of our banking market affords an opportunity to capture new deposits.

Substantially all of our customers are individuals, and small and medium-sized businesses.  We differentiate ourselves from our larger competitors with our focus on relationship banking, personalized service, direct customer contact, and our ability to make credit and other business decisions locally.  We also depend on our reputation as a community bank in our banking markets, our involvement in the communities we serve, the experience of our senior management team, and the quality of the members of our teams charged with the day-to-day operation of the Company.  We believe our focus allows us to be more responsive to our customers’ needs and more flexible in approving loans and customizing deposit products based on our personal knowledge of our customers.

The Company’s primary market area is the southwestern mountain region of North Carolina.  The primary economic drivers of the area are tourism and a burgeoning retirement industry, which has provided a significant stimulus to residential and resort development.  Although this area has relatively few large manufacturing facilities, it has numerous small to mid-sized businesses, which are our primary business customers.  These businesses include agricultural producers, artisans and specialty craft manufacturers, small industrial manufacturers, and a variety of service oriented industries.
 

Services

Our banking operations are primarily retail oriented and directed toward small to medium-sized businesses and individuals located in our banking market.  We derive the majority of our deposits and loans from customers in our banking market, but we also make loans and have deposit relationships with commercial and consumer customers in areas surrounding our immediate banking market.  We provide most traditional commercial and consumer banking services, but our principal activities are taking demand and time deposits and making commercial and consumer loans.  Our primary source of revenue is the interest income we derive from our lending activities.

Lending Activities

General.  We provide a variety of commercial and consumer lending products to small to medium-sized businesses and individuals for various business and personal purposes, including term and installment loans, business and personal lines of credit, equity lines of credit, and overdraft checking credit.  These lending products are offered through both conventional avenues, as well as government guaranteed lending programs such as Small Business Administration (SBA) and U.S. Department of Agriculture (USDA) loans.  For financial reporting purposes, our loan portfolio generally is divided into real estate loans, consumer installment loans, commercial and industrial loans (including agricultural production loans), and revolving consumer related loans.  We currently make credit card services available to our customers through a correspondent relationship.  Statistical information about our loan portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Loan Approval.  Certain credit risks are inherent in making loans.  These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers.  We attempt to mitigate repayment risks by adhering to internal credit policies and procedures.  These policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for exceptions to credit policies.  Our loan approval policies provide for various levels of officer lending authority.  When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, the loan request will be considered by an executive officer with a higher lending limit, executive officers combining authority or the directors’ loan committee.  We do not make any loans to any director or executive officer of the Bank unless the loan is approved by the full Board of Directors of the Bank (excluding the prospective borrower) and is on terms not more favorable than would be available to a person not affiliated with the Bank.

Credit Administration and Loan Review.  We maintain a continuous loan review system.  We also apply a credit grading system to each loan, and we use an independent consultant to review the loan files on a test basis to confirm our loan grading.  Each loan officer is responsible for each loan he or she makes, regardless of whether other individuals or committees joined in the approval.  This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.

Lending Limits.  Our lending activities are subject to a variety of lending limits imposed by federal law.  In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital.  These limits will increase or decrease in response to increases or decreases in the Bank’s level of capital.  We are able to sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.

Real Estate Loans.  Our real estate loan classification includes all loans secured by real estate.  Real estate loans include those loans made to purchase, refinance, construct, or improve residential or commercial real estate, for real estate development purposes, and for various other commercial, agricultural and consumer purposes (which may or may not be related to our real estate collateral).  At December 31, 2012, loans amounting to 90.2% of our loan portfolio, excluding loans held for sale, were classified as real estate loans, up from 88.1% at December 31, 2011.  While we do originate long-term (defined as a 30-year term), fixed-rate residential first mortgages, we generally only retain a small portion of these loans in our loan portfolio.  Rather, the majority of these long-term, fixed-rate loans are sold on a flow basis to other lenders after closing and are reflected in the accompanying consolidated financial statements as “loans held for sale”.  This arrangement permits us to make long-term residential loans available to our customers and to generate fee income, while avoiding the credit and interest rate risks associated with holding a large balance of such loans in our loan portfolio.  At December 31, 2012, we had a total of $98.3 million in residential first mortgages in the loan portfolio, excluding loans held for sale, amounting to 25.4% of the total portfolio, which compares with $85.9 million, or 20.5% of the portfolio, at December 31, 2011.  These portfolio loans are predominantly variable rate or short maturity mortgages.  As of December 31, 2012, 30-year, fixed-rate residential mortgage loans held in our portfolio, totaled $13.5 million.
 
At December 31, 2012, our construction and acquisition and development loans (consumer and commercial) amounted to $69.0 million, or 17.8% of our loan portfolio, excluding loans held for sale.  This compares with $87.1 million, or 20.8% at December 31, 2011.  Other commercial real estate loans totaled $147.9 million, or 38.2% of our loan portfolio, excluding loans held for sale, at the end of 2012.  This compares with $159.1 million, or 38.0% at December 31, 2011.
 

Real estate loans also include home equity lines of credit that generally are used for consumer purposes and usually are secured by junior liens on residential real property.  Our commitment on each line is generally for a term of 15 years.  During the terms of the lines of credit, borrowers may either pay accrued interest only (calculated at variable interest rates), with their outstanding principal balances becoming due in full at the maturity of the lines, or they may make monthly payments of principal and interest.  At December 31, 2012, draws made under our home equity lines of credit accounted for $25.3 million, or 6.5% of our loan portfolio, as compared with $28.1million, or 6.7%, at December 31, 2011.

Many of our real estate loans, while secured by real estate, were made for purposes unrelated to the real estate collateral.  This generally reflects our efforts to reduce credit risk by taking real estate as collateral, whenever possible, without regard to loan purpose.  Substantially all of our real estate loans are secured by real property located in or near our market.  As such, we are impacted by the adverse changes in the real estate values in the market we serve.  Our real estate loans may be made at fixed or variable interest rates, and they generally have maturities that do not exceed five years (with the exception of home equity lines of credit as discussed above) and provide for payments based on typical amortization schedules of 25 years or less.  A real estate loan with a maturity of more than five years or that is based on an amortization schedule of more than five years generally will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period generally not exceeding five years.

Commercial and Industrial Loans.  Our commercial and industrial loan classification includes loans to small to medium-sized businesses and individuals for working capital, equipment purchases and various other business and agricultural purposes.  This classification excludes loans secured by real estate.  These loans generally are secured by business assets, such as inventory, accounts receivable, equipment, or similar assets, but they also may be made on an unsecured basis.  At December 31, 2012, our commercial and industrial loans totaled $35.2 million and accounted for 9.1% of our loan portfolio, excluding loans held for sale.  This compares with $46.9 million, or 11.2% of our loan portfolio, excluding loans held for sale, at December 31, 2011.  In addition to loans classified on our books as commercial and industrial loans, many of our loans included in the real estate loan classification are made for commercial or industrial purposes, but are classified as real estate loans on our books because they are secured by first or junior liens on real estate.  Commercial and industrial loans may be made at variable or fixed rates of interest.  However, any loan that has a maturity or amortization schedule of longer than five years normally will be made at an interest rate that varies with our prime lending rate and will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period generally not exceeding five years.  Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from business cash flow.  As a result, the ability of borrowers to repay commercial loans may be substantially dependent on the success of their businesses, and the collateral for commercial loans may depreciate over time and cannot be appraised with as much precision as real estate.
 
Loan Pricing.  Generally, we price our loans based on the level of risk identified in a particular loan transaction within market constraints and conditions and in conjunction with objectives established as a part of our asset/liability management function and annual budgeting process.  At December 31, 2012, 61.2% of the total dollar amount of our loans accrued interest at variable rates, compared to 54.5% at December 31, 2011.  Management believes maintenance of the portfolio at this or higher levels of floating rate loans provides for the best earnings performance under most economic environments.

Allowance for Loan Losses.  Our Board of Directors reviews all impaired loans at least quarterly, and our management reviews asset quality trends at least monthly.  Based on these reviews and our current judgments about the credit quality of our loan portfolio and other relevant internal and external factors, we have established an allowance for loan losses.  The adequacy of the allowance is assessed by our management and reviewed by our Board of Directors at least quarterly.  Under the Consent Order, our Board is required to strengthen our allowance policy and enhance its periodic reviews of the allowance to ensure its continuing adequacy.  At December 31, 2012, our allowance was $10.7 million, or 2.76% of our total loans, excluding loans held for sale.  This compares with $10.7 million, or 2.54% at year-end 2011.  Although we increased our allowance by $5.3 million through provisions for loan losses charged to earnings, net charge-offs totaled $5.2 million and was the primary reason that there was not a change in the overall allowance from 2012 to 2011.  At December 31, 2012, we had a total of $28.6 million of nonaccrual loans, $9.8 million in foreclosed real estate and no repossessed property or loans past due 90 days or more.  At December 31, 2011, we had $33.7 million of nonaccrual loans, $19.3 million in foreclosed real estate, $1.6 million in repossessed property, and no loans past due 90 days or more.

Deposit Activities

Our deposit services include business and individual checking accounts, NOW accounts, money market checking accounts, savings accounts, and certificates of deposit.  We monitor our competition in order to keep the rates paid on our deposits at a competitive level.  Under the terms of the Consent Order, the Bank is required to comply with restrictions issued by the FDIC on the effective yields of deposit products offered by among others, banks subject to consent orders.  At December 31, 2012, our time deposits of $100,000 or more amounted to $151.6 million, or 22.2% of our total deposits, including $937,000 in brokered certificates of deposit.  Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposit), unless it first receives an appropriate waiver from the FDIC.  Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into another certificate.

Statistical information about our deposit accounts is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 

Other Banking Services

We offer other bank services including cashier’s checks, banking by mail, direct deposit and remote deposit capture.  We earn fees for most of these services, in addition to fees earned from debit and credit card transactions, sales of checks, and wire transfers.  We are associated with the Plus and Star ATM networks, which are available to our clients throughout the country.  We offer merchant banking and credit card services through a correspondent bank.  We also offer internet banking services, bill payment services, and cash management services.  We do not expect to exercise trust powers during the foreseeable future.

Investment Portfolio

At December 31, 2012, our investment portfolio totaled $255.1 million, of which $253.8 million was classified as “available for sale”.  Available-for-sale securities include mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA) or issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), including collateralized mortgage obligations.  Also included in the Company’s available-for-sale investment portfolio are debt instruments issued by U.S. governmental agencies or by government-sponsored enterprises, including FNMA, FHLMC, Federal Farm Credit Bureau (FFCB), Federal Home Loan Bank (FHLB), and the SBA.  We analyze their performance at least quarterly.  Our securities have various interest rate features, maturity dates, and call options.

Statistical information about our investment portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Employees

At December 31, 2012, the Company had 146 full-time equivalent employees, including 138 full-time employees (including our executive officers) and 15 part-time employees.  We are not a party to any collective bargaining agreement with our employees, and we consider our relations with our employees to be good.

Supervision and Regulation

Our business and operations are subject to extensive federal and state governmental regulation and supervision.  The following is a brief summary of certain statutes and rules and regulations that affect or will affect us.  This summary is qualified in its entirety by reference to the particular statute and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to our business.  Supervision, regulation, and examination of the Company by the regulatory agencies are intended primarily for the protection of depositors rather than our stockholders.

General.  We are a bank holding company registered with the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the BHCA).  We are subject to supervision and examination by, and the regulations and reporting requirements of, the Federal Reserve.  Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in other activities the Federal Reserve determines are closely related and a proper incident to banking, managing, or controlling banks.

The BHCA prohibits a bank holding company from acquiring direct or indirect control of more than 5% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without the Federal Reserve’s prior approval.  Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of 1st Financial.  Control is deemed to exist if, among other things, a person acquires more than 25% of any class of voting stock of 1st Financial or controls in any manner the election of a majority of the directors of 1st Financial.  Control is presumed to exist if a person acquires more than 10% of any class of voting stock, the stock is registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act), and the acquirer will be the largest shareholder after the acquisition.

Additionally, the BHCA generally prohibits bank holding companies from engaging in a nonbanking activity, or acquiring ownership or control of more than 5% of the outstanding voting stock of any company that engages in a nonbanking activity, unless that activity is determined by the Federal Reserve to be closely related and a proper incident to banking.  In approving an application to engage in a nonbanking activity, the Federal Reserve must consider whether that activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.
 
 
The law imposes a number of obligations and restrictions on a bank holding company and its insured bank subsidiaries designed to minimize potential losses to depositors and the FDIC insurance funds.  For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee the bank’s compliance (subject to certain limits) with the terms of any capital restoration plan filed with its federal banking agency.  A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances in which, absent that policy, it might not do so.  Under the BHCA, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the Federal Reserve determines the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of a bank holding company.

The Bank is a North Carolina chartered bank.  Its deposits are insured under the FDIC’s Deposit Insurance Fund (DIF), and the Bank is subject to supervision and examination by, and the regulations and reporting requirements of the FDIC and the Commissioner.  The FDIC and the Commissioner are the Bank’s primary federal and state banking regulators.  The Bank is not a member bank of the Federal Reserve System.

As an insured bank, the Bank is prohibited from engaging as principal in any activity that is not permitted for national banks unless (1) the FDIC determines the activity or investment would not pose a significant risk to the DIF, and (2) the Bank is, and continues to be, in compliance with the capital standards that apply to it.  The Bank also is prohibited from directly acquiring or retaining any equity investment of a type or in an amount that is not permitted for national banks.

The FDIC and the Commissioner regulate all areas of the Bank’s business, including its payment of dividends and other aspects of its operations.  They examine the Bank regularly, and the Bank must furnish them with periodic reports containing detailed financial and other information about its affairs.  The FDIC and the Commissioner have broad powers to enforce laws and regulations that apply to the Bank and to require it to correct conditions that affect its safety and soundness.  These powers include issuing cease and desist orders (often referred to as ‘consent orders’), imposing civil penalties, removing officers and directors, and otherwise intervening in the Bank’s operations if they believe their examinations of the Bank, or the reports it files, indicate a need for them to exercise these powers.

The Bank’s business also is influenced by prevailing economic conditions and governmental policies, both foreign and domestic, and by the monetary and fiscal policies of the Federal Reserve.  Although the Bank is not a member bank of the Federal Reserve System, the  Federal Reserve’s actions and policy directives determine to a significant degree the cost and availability of funds it obtains from money market sources for lending and investing.  These actions and policy directives also influence, directly and indirectly, the rates of interest the Bank pays on its time and savings deposits and the rates it charges on loans.

Capital Requirements for the Bank.  As a North Carolina chartered, FDIC-insured commercial bank that is not a member of the Federal Reserve System, the Bank is required to comply with the capital adequacy standards established by the FDIC. The FDIC has issued risk-based capital and leverage capital guidelines for measuring the adequacy of a bank's capital, and all applicable capital standards must be satisfied for the Bank to be considered in compliance with the FDIC's requirements.

Under the FDIC's risk-based capital measure, the minimum ratio of a bank's total capital (Total Capital) to its risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit) (Total Capital Ratio) is 8.0%.  At least half of Total Capital must be composed of common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and various other intangible assets (Tier 1 Capital).  The remainder (Tier 2 Capital) may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves.

Under the FDIC's leverage capital measure, the minimum ratio of Tier 1 Capital to average assets (Leverage Capital Ratio), less goodwill and various other intangible assets, generally is 3.0% for banks that meet specified criteria, including having the highest regulatory rating.  All other banks generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum.  The FDIC's guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets, and a bank's "Tangible Leverage Ratio" (deducting all intangible assets) and other indicators of a bank's capital strength also will be taken into consideration by banking regulators in evaluating proposals for expansion or new activities.

The FDIC also considers a bank's interest-rate risk (arising when the interest rate sensitivity of a bank's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of its capital adequacy.  The FDIC's methodology for evaluating interest rate risk requires banks with excessive interest rate risk exposure to hold additional amounts of capital against their exposure to losses resulting from that risk.  The regulators also require banks to incorporate market risk components into their risk-based capital.  Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.
 

The Bank's capital category is determined solely for the purpose of applying the FDIC's "prompt corrective action" rules described below, and it is not necessarily an accurate representation of its or 1st Financial’s overall financial condition or prospects for other purposes.  A failure to meet the FDIC's capital guidelines could subject the Bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC and other restrictions on our business.  As described below, the FDIC also can impose other substantial restrictions on banks that fail to meet applicable capital requirements.  The Bank was deemed “significantly undercapitalized” as of December 31, 2012.  As discussed under “Enforcement Policies and Actions” in Item 1of this report, and also under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this report and Note 2 to the accompanying consolidated financial statements, the Consent Order, and the Written Agreement impose substantial restrictions on the operation of 1st Financial and the Bank, including a prohibition on accepting, renewing, or rolling over brokered deposits.

Under the terms of the Consent Order, the Bank is required to maintain Tier 1 Capital of at least 8% of total assets and a Total Risk Based Capital Ratio of at least 12%.  The Bank’s Tier 1 Capital and Total Risk Based Capital Ratios were 2.64% and 6.11%, respectively, at December 31, 2012.

Prompt Corrective Action.  The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions.  The extent of these powers will depend upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.”  The FDIC is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories.  The severity of supervisory action will depend upon the capital category in which a bank is placed.  Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

Under the FDIC’s prompt corrective action rules, an institution is considered “well capitalized” if it has (i) a total risk-based capital ratio of 10.0% or greater, (ii) a Tier I risk-based capital ratio of 6.0% or greater, (iii) a leverage ratio of 5.0% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.  An “adequately capitalized” institution is defined as one that has (i) a total risk-based capital ratio of 8.0% or greater, (ii) a Tier I risk-based capital ratio of 4.0% or greater and (iii) a leverage ratio of 4.0% or greater (or 3% or greater in the case of an institution with the highest examination rating).  An institution is considered (A) “undercapitalized” if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (B) “significantly undercapitalized” if the institution has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (C) “critically undercapitalized” if the institution has a ratio of tangible equity to total assets equal to or less than 2%.

A bank that is categorized as "undercapitalized, "significantly undercapitalized," or "critically undercapitalized," is required to submit an acceptable capital restoration plan to the FDIC.  An "undercapitalized" bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC.  In addition, the FDIC is given authority with respect to any "undercapitalized" bank to take any of the actions it is required to or may take with respect to a "significantly undercapitalized" bank if it determines those actions are necessary to carry out the purpose of the law.

At December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to certain restrictions, as discussed under ""Significantly Undercapitalized" Capital Category" in Item 1.

Limitations on Payment of Cash Dividends. As a bank holding company, we are required to adhere to the Federal Reserve’s Policy Statement on the Payment of Cash Dividends, which generally requires that we act as a source of strength and not place an undue burden on the Bank.  Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis.  However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our stockholders is dividends we receive from the Bank.  For that reason, our ability to pay dividends is effectively subject to the same limitations that apply to the Bank.  Because the Consent Order and the Written Agreement prohibit the Bank from paying dividends or making other forms of payment reducing capital of the Bank without the prior approval of the banking regulators, we are effectively prohibited from paying cash dividends to our common stockholders for the foreseeable future and while the Bank remains subject to the Consent Order and/or we remain subject to the Written Agreement.

In addition to these restrictions, other state and federal statutory and regulatory restrictions apply to our payment of cash dividends on our common stock.  Both state and federal law prohibit the Bank from making any capital distributions, including payment of a cash dividend, if it is “undercapitalized” (as that term is defined in the FDI Act), or would become undercapitalized after making the distribution.  As December 31, 2012, the Bank was deemed to be “significantly undercapitalized”. Also, the FDIC has indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would constitute an unsafe and unsound banking practice.  The FDIC has issued policy statements that provide that insured banks generally should pay dividends only from their current operating earnings, and, under the FDI Act, no dividend may be paid by an insured bank while it is in default on any assessment due the FDIC.  If the FDIC believes the Bank is engaged in, or is about to engage in, an unsafe or unsound practice, the FDIC may require, after notice and hearing, that the Bank cease and desist from that practice.
 

In addition to the above restrictions, in the future, the Company’s ability to declare and pay cash dividends will be subject to our Board of Directors’ evaluation of operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. We are subject to further limitations on cash dividends due to the U.S. Department of Treasury (U.S. Treasury) purchase of our preferred stock.  See “CPP Participation” below.

We cannot assure you that, in the future, we will have funds available to pay cash dividends or that, even if funds are available, we will pay dividends in any particular amounts or at any particular times, or that we will pay dividends at all.

Repurchase Limitations.  As a bank holding company, 1st Financial must obtain Federal Reserve approval prior to repurchasing its common stock for consideration in excess of 10% of its net worth during any 12-month period unless (i) both before and after the redemption it satisfies capital requirements for “well capitalized” bank holding companies; (ii) it has received a “one” or “two” rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues.  Under the terms of the Written Agreement, prior approval of the Federal Reserve Bank is required before 1st Financial repurchases any shares of its stock.  In addition, we are subject to further repurchase limitations due to the U.S. Treasury’s purchase of our preferred stock.  See “CPP Participation” below.

Federal Home Loan Bank System.  The Federal Home Loan Bank system provides a central credit facility for member institutions. As a member of the Federal Home Loan Bank of Atlanta (FHLB), the Bank is required to own capital stock in the FHLB in an amount at least equal to 0.15% of the Bank’s total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB under the activity-based stock ownership requirement.  On December 31, 2012, the Bank was in compliance with this requirement.

Limits on Rates Paid on Deposits and Brokered Deposits.  FDIC regulations limit the ability of insured depository institutions to accept, renew or rollover deposits by offering rates of interest, which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution’s normal market area.  Under these regulations, “well capitalized” depository institutions may accept, renew or rollover such deposits without restriction, “adequately capitalized” depository institutions may accept, renew or rollover such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and “undercapitalized” depository institutions may not accept, renew, or rollover such deposits.  Definitions of “well capitalized,” “adequately capitalized” and “undercapitalized” are the same as the definitions adopted by the FDIC to implement the prompt corrective action provisions discussed above.  North Carolina is deemed to be a high-rate market area, and as a result the markets in which the Bank operates are determined to be in a high-rate area.  The Bank obtained a waiver from the FDIC to pay interest rates within 0.75% of the average rate paid on local market deposits.

FDIC Insurance Assessments.  The FDIC uses a revised risk-based assessment system to determine the amount of our deposit insurance assessment based on the evaluation of the probability the DIF will incur a loss with respect to the Bank.  That evaluation takes into consideration risks attributable to different categories and concentrations of our assets and liabilities and any other factors the FDIC considers to be relevant, including information obtained from the Commissioner.  A higher assessment rate results in an increase in the assessments we pay the FDIC for deposit insurance.

Under the FDI Act, the FDIC may terminate our deposit insurance if it finds we have engaged in unsafe and unsound practices, are in an unsafe or unsound condition to continue operation, or have violated applicable laws, regulations, rules, or orders.  The FDIC is responsible for maintaining the adequacy of the DIF, and the amount we pay for deposit insurance is influenced not only by the assessment of the risk it poses to the DIF, but also by the adequacy of the insurance fund at any time to cover the risk posed by all insured institutions.

Community Reinvestment.  Under the Community Reinvestment Act (CRA), as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods.  The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop, consistent with the CRA, the types of products and services it believes are best suited to its particular community.  The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take those records into account in its evaluation of certain applications by those institutions.  All institutions are required to make public disclosure of their CRA performance ratings.  In its most recent CRA examination, the Bank received a “satisfactory” rating.

Federal Securities Law.  The Company’s common stock is registered under Section 12(g) of the Exchange Act and the Company files reports under the Exchange Act with the Securities and Exchange Commission (the SEC).  As a result of this registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act apply to the Company.
 
 
Transactions with Affiliates.  Although the Bank is not a member of the Federal Reserve System, it is subject to the provisions of Sections 23A and 23B of the Federal Reserve Act.  Section 23A places limits on the amount of:

  
A bank’s loans or extensions of credit to, or investment in its affiliates;

  
Assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve;

  
The amount of loans or extensions of credit by a bank to third parties, which are collateralized by the securities or obligations of the bank’s affiliates; and

  
A bank’s guarantee, acceptance, or letter of credit issued on behalf of one of its affiliates.

Transactions of the type described above are limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus.  In addition to the limitation on the amount of these transactions, each of these transactions also must meet specified collateral requirements.  The Bank also must comply with other provisions designed to avoid purchasing low-quality assets from an affiliate.

Section 23B of the Federal Reserve Act, among other things, prohibits a bank from engaging in these affiliate transactions unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Federal law also places restrictions on the Bank’s ability to extend credit to executive officers, directors, principal stockholders, and their related interests.  These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

Loans to One Borrower.  The Bank is subject to the Commissioner’s loans-to-one-borrower limits, which are substantially the same as those applicable to national banks.  Under these limits, no loans or extensions of credit to any borrower outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the capital and surplus of the Bank.  Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of capital and surplus.

Reserve Requirements.  Under Federal Reserve regulations, the Bank must maintain average daily reserves against its transaction accounts.  For 2013, we are not required to maintain reserves on the first $12.4 million of net transaction accounts (up from $11.5 million in 2012), but must maintain reserves equal to 3.0% on the aggregate balances of those accounts over $12.4 million (up from $11.5 million in 2012), up to and including $79.5 million (up from $71.0 million in 2012), and reserves equal to 10.0% on aggregate balances in excess of $79.5 million (up from $71.0 million in 2012).  The Federal Reserve may adjust these percentages.  Because our reserves are required to be maintained in the form of vault cash or in a non-interest-bearing account at the Federal Reserve or a correspondent bank, one effect of the reserve requirement is to reduce the amount of our interest-earning assets.  During 2007, the Bank adopted an internal deposit reclassification system (approved by the Federal Reserve under Regulation D), whereby significant portions of interest-bearing and noninterest bearing transaction accounts are transferred to a non-reservable savings account status.  As a result, all required reserves at December 31, 2012 and 2011 were met by the Bank’s vault cash.

Gramm-Leach-Bliley Act.  The federal Gramm-Leach-Bliley Act enacted in 1999 (the GLB Act) dramatically changed various federal laws governing the banking, securities and insurance industries.  The GLB Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them.  However, this expanded authority also presents smaller financial institutions, such as the Bank, with challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community-oriented financial institutions.

USA Patriot Act of 2001.  The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in the United States on September 11, 2001.  The Act was intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts.  The Act's impact on financial institutions of all kinds has been significant and wide ranging.  The Act contains sweeping anti-money laundering and financial transparency requirements and imposes various other regulatory requirements, including standards for verifying customer identification at account opening and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act of 2002, which became effective during 2002, is sweeping federal legislation addressing accounting, corporate governance, and disclosure issues.  The impact of the Sarbanes-Oxley Act is wide ranging as it applies to all public companies and imposes significant requirements for public company governance and disclosure requirements.
 

In general, the Sarbanes-Oxley Act mandated corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results.  It established new responsibilities for corporate chief executive officers, principal accounting officers, and audit committees in the financial reporting process and created a new regulatory body to oversee auditors of public companies.  It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire, and securities fraud and created new criminal penalties for document and record destruction in connection with federal investigations.  It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

The economic and operational effects of the Sarbanes-Oxley Act on public companies, including 1st Financial, have been and will continue to be significant in terms of the time, resources, and costs associated with compliance.  Because the Act, for the most part, applies equally to larger and smaller public companies, we will continue to be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our markets.  In accordance with the requirements of Section 404(a), management’s report on internal control is included herein as Item 9A.  The Dodd-Frank Act permanently exempted smaller companies, such as the Company, from the requirements under Section 404(b) for auditor attestation on internal controls.

Emergency Economic Stabilization Act of 2008 (EESA).  Under the EESA, the U.S. Treasury implemented the Troubled Asset Relief Program (TARP), of which the Capital Purchase Program (CPP) is a part.  Under the CPP, certain U.S. qualifying financial institutions sold senior preferred stock and warrants to the U.S. Treasury.  Eligible institutions generally applied to issue preferred stock to the U.S. Treasury in aggregate amounts between 1% and 3% of the institution’s risk-weighted assets.  Smaller community banks and bank holding companies were later allowed to issue preferred stock up to 5% of the institution’s risk- weighted assets.

Institutions participating in the TARP or CPP are required to meet certain standards for executive compensation and corporate governance, including a prohibition against incentives to take unnecessary and excessive risks, recovery of bonuses paid to senior executives based on materially inaccurate earnings or other statements and a prohibition against agreements for the payment of golden parachutes.  Additional standards with respect to executive compensation and corporate governance for institutions that have participated or will participate in the TARP, including the CPP, were enacted as part of the American Recovery and Reinvestment Act of 2008 (ARRA), described below.

CPP Participation.  On November 14, 2008, 1st Financial entered into a Letter Agreement (the Purchase Agreement) with the U.S. Treasury under the CPP, pursuant to which 1st Financial issued 16,369 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the  Preferred Stock ), having a liquidation preference of $1,000 per share, for a total price of $16,369,000.  1st Financial is required to pay cumulative dividends on the Preferred Stock.  Under the ARRA, described below, 1st Financial may redeem the Preferred Stock at any time, provided it obtains the approval of its primary federal regulator.  The Preferred Stock is generally non-voting, but does have the right to vote as a class on the issuance of any preferred stock ranking senior, any change in its terms or any merger, exchange or similar transaction that would adversely affect its rights.  The holder(s) of Preferred Stock also have the right to elect two directors if dividends have not been paid for six periods.  Due to insufficient funding at the holding company level, the Company has deferred each of the past 11 quarterly dividend payments of $205,000 on its Preferred Stock.  The Company expects to again defer the $205,000 payment of the preferred dividend in May 2013.

As part of its purchase of the Preferred Stock, the U.S. Treasury received a warrant (the Warrant) to purchase 276,815 shares of 1st Financial’s common stock at an initial exercise price of $8.87 per share.  The Warrant provides for the adjustment of the exercise price and the number of shares of 1st Financial’s common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of 1st Financial’s common stock, and upon certain issuances of 1st Financial’s common stock at or below a specified price relative to the initial exercise price.  The Warrant expires ten years from the issuance date.  Pursuant to the Purchase Agreement, the U.S. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant.

Both the Preferred Stock and the Warrant are accounted for as components of Tier 1 capital.

Further, so long as the Preferred Stock remains outstanding, 1st Financial is prohibited from declaring or paying any dividend or distribution on its common stock (other than dividends payable solely in shares of common stock), and no common stock, may be, directly or indirectly, purchased, redeemed, or otherwise acquired for consideration by 1st Financial or the Bank, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside for the benefit of the holders of shares of Preferred Stock on the applicable record date).
 

American Recovery and Reinvestment Act of 2009 (ARRA).  The ARRA was enacted on February 17, 2009.  The ARRA included a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs.  In addition, the ARRA imposed certain new executive compensation and corporate governance requirements on all current and future CPP participants, including 1st Financial, until the institution has redeemed the Preferred Stock.  The executive compensation restrictions under the ARRA and regulations issued by U.S. Treasury are more stringent than those previously in effect under the CPP, and include in part, (1) prohibitions on making golden parachute payments to senior executive officers and the next five most highly-compensated employees during such time as any obligation arising from financial assistance provided under the TARP remains outstanding (the Restricted Period), (2) prohibitions on paying or accruing bonuses or other incentive awards for certain senior executive officers and employees, except for awards of long-term restricted stock with a value equal to no greater than 1/3 of the subject employee’s annual compensation that do not fully vest during the Restricted Period or unless such compensation is pursuant to a valid written employment contract prior to February 11, 2009, and (3) requirements that TARP CPP participants provide for the recovery of any bonus or incentive compensation paid to senior executive officers and the next 20 most highly-compensated employees based on statements of earnings, revenues, gains, or other criteria later found to be materially inaccurate, with the U.S. Treasury having authority to negotiate for reimbursement.

The ARRA also set forth additional corporate governance standards for TARP recipients, including semi-annual meetings of compensation committees of the board of directors to discuss and evaluate employee compensation plans in light of an assessment of any risk posed from such compensation plans.  TARP recipients are further required by the ARRA to have in place company-wide policies regarding excessive or luxury expenditures, permit non-binding shareholder “say-on-pay” proposals to be included in proxy materials, as well as require written certifications by the compensation committee, the principal executive officer, and principal financial officer with respect to compliance.
 
Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).  On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law.  The Dodd-Frank Act was intended primarily to overhaul the financial regulatory framework following the global financial crisis and has impacted, and will continue to impact, all financial institutions, including 1st Financial and the Bank.  The Dodd-Frank Act contains provisions that have, among other things, established a Bureau of Consumer Financial Protection, established a systemic risk regulator, consolidated certain federal bank regulators, and imposed increased corporate governance and executive compensation requirements.  The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations and to prepare numerous studies and reports for the U.S. Congress.  The federal agencies are given significant discretion in drafting and implementing regulations.  Although a significant number of these regulations have been promulgated, many additional regulations are expected to be issued in 2013 and thereafter.  Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Available Information.  Our Internet website address is www.mountain1st.com.  Electronic versions of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act are available on our website.  We will provide electronic or paper copies of those filings free of charge upon request.  Requests for copies should be directed by mail to Holly L. Schreiber, Chief Financial Officer, at 101 Jack Street, Hendersonville, North Carolina 28792, or by telephone at (828) 697-3100.

Other.  The federal banking agencies, including the FDIC, have developed joint regulations requiring annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state-chartered institutions examined by state regulators.  Such regulations also establish requirements for operational and managerial standards, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards when such compensation would endanger the insured depository institution or would constitute an unsafe practice.

In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking.  The Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.
 

An investment in our securities is subject to certain risks.  You should carefully review the following risk factors and other information contained in this report and the documents incorporated by reference before deciding whether an investment in our securities is suited to your particular circumstances.  Other risks and uncertainties not presently known to us or that we currently deem immaterial or unlikely also may impair our business operations.  If any of the following risks actually occur, our business, results of operations and financial condition could suffer.  In that event, the value of our securities could decline, and you may lose all or part of your investment.  The risks discussed below also include forward-looking statements, and our actual results may differ materially from those discussed in these forward-looking statements.

Risks Related to Recent Economic Conditions and Governmental Response Efforts

There is substantial doubt about the ability of 1st Financial to continue as a going concern.

In connection with its 2011 and 2012 annual audits, the Company’s independent auditors issued an opinion stating the consolidated financial statements were prepared assuming the Company will continue as a going concern, but that substantial doubt has been raised about its ability to continue as a going concern because the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Company’s sole asset, the Bank, is under the Consent Order that requires among other provision, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under the Written Agreement that requires, among other provisions, the submission and implementation of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Company and the Bank are considered “significantly undercapitalized” based on their respective regulatory capital levels.  Meanwhile, the Bank continues to have high levels of nonperforming and impaired assets.  The future of the Company is dependent on its ability to address these matters.  If the Company fails to do so for any reason, the banking regulators may place the Bank into conservatorship or receivership, with the FDIC or the Commissioner appointed as conservator or receiver.  If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank, be exposed to significant claims by the FDIC and/or the Commissioner, and would not be able to continue as a going concern.  Accordingly, such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.

1st Financial and the Bank may be subject to additional, heightened enforcement actions, and ultimately the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition does not improve.

The Consent Order and Written Agreement require us to take certain actions and to implement certain action plans, including a plan to materially improve the Bank’s capital ratios.  In the event we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition does not improve, the banking regulators may place the Bank under conservatorship or receivership, and/or force the sale or merger of the Bank.  Unexpected events or circumstances could further prejudice our ability to achieve the minimum capital ratios required under the Consent Order.  If we fail to comply with the requirements of the Consent Order or the Written Agreement for any reason or our condition does not improve, the banking regulators may impose additional, heightened enforcement actions against us, keep the Consent Order and Written Agreement in place longer than they may otherwise have been, and/or require the preparation of a plan to sell or merge the Bank.  Ultimately, the Bank may be placed into conservatorship or receivership by the FDIC or the Commissioner, with the FDIC or the Commissioner appointed as conservator or receiver.  If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank and be exposed to significant claims by the FDIC and/or the Commissioner.  Such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.

Difficult market conditions and economic trends have adversely affected our industry and our business.

Since 2008, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively affected the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions, including 1st Financial.  In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline.  General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write-downs.  Concerns over the stability of the financial markets and the economy caused a decrease in lending by financial institutions to their customers and to each other.  This market turmoil and tightening of credit led to increased commercial and consumer loan delinquencies, lack of consumer confidence, increased market volatility and widespread reduction in general business activity.  Financial institutions have experienced decreased access to capital and to deposits or borrowings.  The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses and the prices of securities in general, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations and stock price for the foreseeable future.
 
 
We do not believe these difficult conditions are likely to significantly improve in the near future.  A sustained weakness or worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers, and the other financial institutions in our market. Specifically, it could have one or more of the following adverse effects on our business:

  
A decrease in the demand for loans or other products and services offered by us;

  
A decrease in the value of our loans or other assets secured by consumer or commercial real estate;

  
A decrease in deposit balances due to overall reductions in the accounts of customers;

  
An impairment of investment securities;

  
A decreased ability to raise additional capital on terms acceptable to us or at all; or

  
An increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us.  An increase in the number of delinquencies, bankruptcies, or defaults could result in a higher level of nonperforming assets, net charge-offs, and provision for loan losses, which would reduce our earnings.

Until conditions improve, our business, financial condition and results of operations may continue to be adversely affected.

Financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations.

Congress enacted the Dodd-Frank Act in 2010.  This law has significantly changed the structure of the bank regulatory system and affects the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies.  The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress.  The federal agencies are given significant discretion in drafting the implementing rules and regulations.  Although a significant number of these regulations have been promulgated, many additional regulations are expected to be issued in 2013 and thereafter.  Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

The Dodd-Frank Act also broadens the base for FDIC insurance assessments.  Assessments are now being based on the average consolidated total assets less tangible equity capital of a financial institution.  The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions, and credit unions to $250,000 per depositor, retroactive to January 1, 2008 and provided for unlimited deposit insurance on noninterest bearing transaction accounts through December 31, 2012.

The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials.  The legislation also directs the Federal Reserve to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not.

The Dodd-Frank Act created the Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws.  The Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive, or abusive” acts and practices.  It also has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.  Banks and savings institutions with $10 billion or less in assets will be examined by their applicable bank regulators.  The Dodd-Frank Act also weakens the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.

It is difficult to quantify what specific impact the Dodd-Frank Act and related regulations have had on the Company to date and what impact yet to be written regulations will have on us in the future.  However, it is expected at a minimum, they will increase our operating and compliance costs and could increase our interest expense.

Our participation in the CPP imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity.

In November 2008, we issued Preferred Stock and a Warrant to the U.S. Treasury as part of its CPP.  The Securities Purchase Agreement, pursuant to which such securities were sold, among other things, grants the holders of such securities certain registration rights which, in certain circumstances, impose lock-up periods during which we would be unable to issue equity securities.  In addition, unless we are able to redeem the Preferred Stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% to 9%.  Depending on market conditions at the time, and whether or not we have resumed paying dividends, this increase in dividends could significantly impact our liquidity.
 

We are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our Preferred Stock.

So long as the Preferred Stock remains outstanding, no dividend or distribution may be declared or paid on our common stock (other than dividends payable solely in shares of common stock), and no common stock, may be, directly or indirectly, purchased, redeemed or otherwise acquired for consideration by 1st Financial or the Bank, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside for the benefit of the holders of shares of Preferred Stock on the applicable record date).  We have not paid dividends on the Preferred Stock since May 2010, and expect to again defer the $205,000 quarterly payment of the preferred dividend in May 2013.  As a consequence, it is unlikely 1st Financial will be permitted to pay any dividends on its common stock for at least the foreseeable future.

The limitations on incentive compensation contained in the ARRA and subsequent regulations may adversely affect our ability to retain our highest performing employees.

In the case of a company such as 1st Financial that received CPP funds, the ARRA, and subsequent regulations issued by the U.S. Treasury, contain restrictions on bonus and other incentive compensation payable to the Company’s senior executive officers.  As a consequence, we may be unable to create a compensation structure that permits us to retain our highest performing employees and attract new employees of a high caliber.  If this were to occur, our businesses and results of operations could be adversely affected.

The soundness of other financial institutions could adversely affect us.

In recent years, the financial services industry as a whole has been materially and adversely affected by significant declines in the value of real estate and other asset classes, as well as reduced capital levels and lack of liquidity.  Financial institutions have been subject to increased volatility and an overall loss in investor confidence, caused in large part by the unprecedented level of bank failures.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions, including the failure of other financial institutions, locally and nationally.  Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships.  We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients.

Increases in FDIC insurance premiums may adversely affect our net income and profitability.

Since 2008, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the DIF.  In addition, the FDIC instituted two temporary programs to further ensure customer deposits at FDIC insured banks:  deposit accounts are now insured up to $250,000 per customer (up from $100,000), made permanent in 2010 and noninterest-bearing transactional accounts were fully insured through December 31, 2012.  These programs have placed additional stress on the deposit insurance fund.  In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased assessment rates of insured institutions.  We are generally unable to control the amount of premiums the Bank is required to pay for FDIC insurance, which is determined, in part, by the risk profile of each depository institution.  If there are additional financial institution failures, the cost of resolving prior failures exceeds expectations, or the Bank’s risk profile further deteriorates, the Bank may be required to pay even higher FDIC premiums.  Any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings and financial condition.

Risks Associated to Our Business

1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue.

1st Financial is a separate and distinct legal entity from the Bank.  Historically, 1st Financial has received substantially all of its revenue from dividends received from the Bank.  These dividends have been the principal source of funds to pay dividends on 1st Financial’s common and preferred stock, and operating expense.  Various federal and/or state laws and regulations limit the amount of dividends the Bank may pay to 1st Financial, and the Bank is now further restricted with respect to the payment of dividends under the terms of the Consent Order, and by virtue of it being deemed to be “significantly undercapitalized.”  In the event the Bank continues to be unable to pay dividends to 1st Financial, 1st Financial may not be able to pay obligations, or pay dividends on its common and preferred stock.  The continuing inability to receive dividends from the Bank could have a material adverse effect on 1st Financial’s business, financial condition, and results of operations.  As discussed elsewhere, the Bank is not permitted to pay dividends to 1st Financial under the terms of the Consent Order without the prior consent of the FDIC and the Commissioner.
 
 
We need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed.

Federal and state banking regulators require us to maintain adequate levels of capital to support our operations.  On December 31, 2012, we were deemed “significantly undercapitalized” under bank regulatory guidelines and, in addition, our capital ratios were below the minimum levels required in the Consent Order and Written Agreement.  We need to increase our capital to satisfy regulatory requirements.  Management and our Board continue to pursue plans to improve our capital levels, including seeking to raise additional capital.  However, our ability to raise that additional capital depends on conditions at that time in the capital markets, economic conditions, our financial performance and condition, and other factors, many of which are outside our control.  Given the current state of the equity markets and our financial performance and condition, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.  If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company, and could result in the Bank being placed in conservatorship or receivership by the FDIC or the Commissioner.

Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.

Lending money is a substantial part of our business.  Every loan carries a degree of risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment.  This risk is affected by, among other things:

  
cash flows of the borrower and/or the business activity being financed;

  
in the case of a collateralized loan, changes in and uncertainties regarding future values of collateral;

  
the credit history of a particular borrower;

  
changes in economic and industry conditions; and

  
the duration of the loan.

We use underwriting procedures and criteria we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios.  However, regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and some of those losses will result from factors beyond our control.  These factors include, among other things, changes in market, economic, business or personal conditions, or other events (including changes in market interest rates) that affect our borrowers’ abilities to repay their loans and the value of properties that collateralize loans.  Recent difficulties in the national economy and housing market, declining real estate values, high unemployment, and loss of consumer confidence, have resulted and will continue to result in increasing loan delinquencies and loan losses for all financial institutions.

We maintain an allowance for loan losses based on our current judgments about the credit quality of our loan portfolio.  The amount of our allowance is determined by our management through a periodic review and consideration of internal and external factors that affect loan collectability, including, but not limited to:

  
an ongoing review of the quality, size, and diversity of our overall loan portfolio;

  
evaluation of nonperforming loans;

  
historical default and loss experience;

  
historical recovery experience;
 
  
existing economic conditions;

  
risk characteristics of various classifications of loans; and

  
the amount and quality of collateral, including guarantees, securing the loans.
 
There is no precise method of predicting credit losses since any estimate of loan losses is necessarily subjective and the accuracy of the estimate depends on the outcome of future events.  Therefore, we face the risk charge-offs in future periods will exceed our allowance for loan losses and additional increases in the allowance for loan losses will be required.  Additions to the allowance for loan losses would adversely affect our results of operations and financial condition, and possibly cause a decrease in our capital.
 

We continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values.

We foreclose on and take title to real estate serving as collateral for many of our loans as part of our business.  Real estate owned by us and not used in the ordinary course of our operations is referred to as “real estate acquired in settlement of loans” or “foreclosed real estate”.  At December 31, 2012, we had foreclosed real estate with an aggregate book value of $9.8 million.  We obtain appraisals prior to taking title to real estate and periodically thereafter.  However, due to the continued depressed real estate prices in our market, there can be no assurance such valuations will reflect the amount which may be paid by a willing purchaser in an arms-length transaction at the time of the final sale.  Moreover, we cannot provide assurance the losses associated with foreclosed real estate will not exceed the estimated amounts, which would adversely affect future results of our operations.

The calculation for the adequacy of write-downs of our foreclosed real estate is based on several factors, including the appraised value of the real property, economic conditions in the property’s sub-market, comparable sales, current buyer demand, availability of financing, entitlement and development obligations and costs and historic loss experience.  All of these factors have caused further write-downs in recent periods and can change without notice based on market and economic conditions.  High levels of nonperforming assets indicate that foreclosed real estate balances may continue to be high for the foreseeable future.  Increased foreclosed real estate balances have led to greater expense as we incur costs to manage and dispose of the properties.  We expect our earnings will continue to be negatively affected by various expenses associated with foreclosed real estate, including personnel costs, insurance, and taxes, completion and repair costs, valuation adjustments and other expenses associated with property ownership, as well as by the funding costs associated with assets that are tied up in foreclosed real estate.  Moreover, our ability to sell foreclosed real estate is affected by public perception that banks are inclined to accept large discounts from market value in order to quickly liquidate properties.  Any further decrease in market prices may lead to further write-downs, with a corresponding expense in our statement of operations.  Further write-downs on foreclosed real estate or an inability to sell foreclosed real estate could have a material adverse effect on our results of operations and financial conditions.  Furthermore, the management and resolution of nonperforming assets, which include foreclosed real estate, increases our costs and requires significant commitments of time from our management and directors, which can be detrimental to the performance of their other responsibilities.  The expense associated with foreclosed real estate and any further property write-downs could have a material adverse effect on our financial condition and results of operations.

A significant percentage of our loans are secured by real estate.  Continuing adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio.

While we do not have a subprime lending program, a significant percentage of our loans are secured by real estate.  Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and the level of our real estate loans reflects, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral.  However, adverse conditions in the real estate market and the economy in general have decreased real estate values in our banking markets.  If the value of our collateral for a loan falls below the outstanding balance of that loan, our ability to collect the balance of the loan by selling the underlying real estate in the event of a default will be diminished, and we would be more likely to suffer a loss on the loan.  An increase in our loan losses could have a material adverse effect on our operating results and financial condition.
 
The FDIC adopted rules aimed at placing additional monitoring and management controls on financial institutions whose loan portfolios are deemed to have concentrations in commercial real estate (CRE).  At December 31, 2012, our loan portfolio exceeded thresholds established by the FDIC for CRE concentrations and for additional regulatory scrutiny.  Indications from regulators are that strict limitations on the amount or percentage of CRE within any given portfolio are not expected, but, rather, additional reporting and analysis will be required to document management’s evaluation of the potential additional risks of such concentrations and the impact of any mitigating factors.  These rules could increase the costs of monitoring and managing this component of our loan portfolio.  This could have an adverse impact on our operating results and financial condition.
 
Our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability.

We regularly make loans secured by commercial real estate (CRE).  These types of loans generally have higher risk-adjusted returns and shorter maturities than traditional one-to-four family residential mortgage loans.  Further, loans secured by CRE properties are generally for larger amounts and involve a greater degree of risk than one-to-four family residential mortgage loans.  Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties.  Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy.  In addition, many economists believe deterioration in income-producing CRE is likely to worsen as vacancy rates continue to rise and absorption rates of existing square footage continue to decline.  Because of the current general economic slowdown, these loans represent higher risk, could result in an increase in our total net-charge offs and could require us to increase our allowance for loan losses, which could have a material adverse effect on our financial condition or results of operations.  At December 31, 2012, our loans secured by CRE totaled $147.9 million, which represented 38.2% of total loans.  For 2012 and 2011, respectively, net charge-offs on commercial real estate loans totaled $804,000 and $2.0 million respectively.  While we seek to minimize these risks in a variety of ways, there can be no assurance these measures will protect against credit-related losses.
 

Our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio.

Construction financing typically involves a higher degree of credit risk than financing on improved, owner-occupied real estate.  Risk of loss on a construction loan is largely dependent upon the accuracy of the initial estimate of the property’s value at completion of construction and the bid price and estimated cost (including interest) of construction.  If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project.  If the estimate of the value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project whose value is insufficient to assure full repayment.  When lending to builders, the cost of construction breakdown is provided by the builder, as well as supported by the appraisal.  Although our underwriting criteria are designed to evaluate and minimize the risks of each construction loan, there can be no guarantee these practices will safeguard against material delinquencies and losses to our operations.  Construction and land development loans are dependent on the successful completion of the projects they finance, however, in many cases, such construction and development projects in our primary market areas are not being completed in a timely manner, if at all.  At December 31, 2012, we had loans of $69.0 million, or 17.8% of total loans, outstanding to finance construction and land development.  For 2012, we had net charge-offs of $2.1 million.

Our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations.

A portion of our residential and commercial lending is secured by vacant or unimproved land.  Loans secured by vacant or unimproved land are generally more risky than loans secured by improved property for one-to-four-family residential mortgage loans.  Since vacant or unimproved land is generally held by the borrower for investment purposes or future use, payments on loans secured by vacant or unimproved land will typically rank lower in priority to the borrower than a loan the borrower may have on their primary residence or business.  These loans are susceptible to adverse conditions in the real estate market and local economy.  At December 31, 2012, loans secured by vacant or unimproved property totaled $43.3 million, or 11.2% of our loan portfolio.

The Company will be unable to grow in the short term.
 
As a strategy, the Company seeks to increase the size of its franchise by pursuing business development opportunities.  However, by virtue of being deemed "significantly undercapitalized" under the FDIC’s framework for prompt corrective action, the Bank may not permit its average total assets during any calendar quarter to exceed its average total assets during the preceding calendar quarter.  The Consent Order also places restrictions on asset growth.  As such, it is anticipated the Company will be unable to grow until it improves its capital condition, and will not be able to grow significantly until the Consent Order is removed.  Such restrictions on the Company’s growth are expected to adversely affect our revenue, operating results, and financial condition.

Our business depends on the condition of the local and regional economies where we operate.

We currently have offices only in western North Carolina.  Consistent with our community banking philosophy, our customer base is located in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking market.  Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate, and restructure possible problem loans.  The local economies of the communities in our banking market are relatively dependent on the tourism industry and the retirement and second home real estate market.  The economies of our banking market have been adversely affected by a general economic downturn and this downturn has affected the tourism industry and real estate values in our communities, which has adversely affected our operating results.  Further deterioration of economic conditions in our banking market could further affect our ability to generate new loan production, adversely affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results.  We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies.  And, we cannot assure you we will benefit from any market growth or favorable economic conditions in our banking market even if they do occur.

Adverse market and economic conditions in North Carolina, particularly in the real estate, agricultural, or tourism industries, disproportionately increase the risk our borrowers will be unable to make their loan payments and the risk the market value of real estate securing our loans will not be sufficient collateral.  On December 31, 2012, 90.2% of the total dollar amount of our loan portfolio was secured by liens on real estate, with 6.5% of our portfolio representing home equity lines of credit.  Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and those relatively high percentages reflect, at least in part, our policy to take real estate whenever possible as primary or additional collateral.  However, any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in North Carolina could adversely affect the value of our assets, revenue, operating results, and financial condition.
 

Our profitability is subject to interest rate risk.  Changes in interest rates could have an adverse effect on our operating results.
 
Changes in interest rates can have different effects on various aspects of our business, particularly our net interest income.  Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities.  Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control.  Interest rate risk arises in part from the mismatch (i.e., the interest rate sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets.  When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap.  When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap.  A liability-sensitive position (i.e., a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment.  An asset-sensitive position (i.e., a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment.  Our ability to manage our gap position determines to a great extent on our ability to operate profitably.  However, fluctuations in interest rates are not predictable or controllable, and we cannot assure you we will be able to manage our gap position in a manner that will allow us to be profitable.
 
At December 31, 2012, the Bank remained in an asset-sensitive position.  This reflects the construct of the Bank’s balance sheet whereby our interest-earning assets generally would be expected to reprice at a faster rate than our interest-bearing liabilities.  Therefore, a rising rate environment would generally be expected to have a positive effect on our earnings, while a falling rate environment generally would be expected to have a negative effect on our earnings.

If our historical experience with the relative insensitivity of these deposits to changes in market interest rates does not continue in the future and we experience more rapid repricing of interest-bearing liabilities than interest-earning assets in a near term rising interest rate environment, our net interest margin and net income may decline.

Competition from financial institutions and other financial service providers may adversely affect our profitability.

Commercial banking in our banking market and in North Carolina as a whole is extremely competitive.  In addition to community, super-regional, national, and international commercial banks, we compete against credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds.  We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents.  Our larger competitors have greater resources, broader geographic markets and higher lending limits than we do, and they may be able to offer more products and services and better afford and more effectively use media advertising, support services, and electronic technology than we can.  While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market.  Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts, and greater flexibility and responsiveness in working with local customers, we cannot assure you we will continue to be an effective competitor in our banking markets.

We are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings.
 
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various federal and state agencies.  Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, possible mergers and acquisitions, investments, loans and interest rates charged thereon, interest rates paid on deposits, and locations of offices.  We also are subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital.  Most of these regulations are primarily intended to protect depositors, the public and the FDIC’s deposit insurance fund, rather than stockholders.

The Sarbanes-Oxley Act of 2002, and the related rules and regulations issued by the SEC that are applicable to us, have vastly increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the costs of completing our audit and maintaining our internal controls.  The laws and regulations that apply to us could change at any time, and we cannot fully predict the effects of those changes on our business and profitability.  However, virtually any newly imposed governmental regulation is highly likely to create additional expense to the Bank and in cases such as Sarbanes-Oxley noted above, the cost can be very significant.  Implementation and adoption of regulatory and accounting rules greatly affects the business and financial results of all commercial banks and bank holding companies, and our cost of compliance would be expected to adversely affect our earnings.
 
If the Bank loses key employees with significant business contacts in its market areas, its business may suffer.
 
The Bank is largely dependent on the personal contacts of our officers and employees in its market areas.  If the Bank loses key employees temporarily or permanently, this could have a material adverse effect on the business.  The Bank could be particularly affected if its key employees go to work for competitors.  The Bank’s future success depends on the continued contributions of its existing senior management personnel, many of whom have significant local experience and contacts in its market areas.
 

We may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability.

Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market or other non-depository investments, as providing superior expected returns or seek to spread their deposits over several banks to maximize FDIC insurance coverage.  Furthermore, technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments, including products offered by other financial institutions or non-bank service providers.  Increases in short-term interest rates could increase transfers of deposits to higher yielding deposits.  Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs.  When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, or spread their accounts over several banks, we can lose a relatively inexpensive source of funds, thus increasing our funding costs.

Negative publicity could damage our reputation.

Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business.  Negative public opinion could adversely affect our ability to keep and attract customers and expose us to adverse legal and regulatory consequences.  Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct.

The Bank is subject to environmental liability risk associated with lending activities.

A significant portion of the Bank’s loan portfolio is secured by real property.  During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk hazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require the Bank to incur substantial expense and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property.  In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability.  Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards.  The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.

Financial services companies depend on the accuracy and completeness of information about customers and counterparties.

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information.  We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information.  Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows.

Liquidity is essential to our business.  Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital, possible acquisitions, and other general corporate purposes.  An inability to raise funds through deposits, borrowings, securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity.  Our retail and commercial deposits may not be sufficient to meet our funding needs in the foreseeable future.  We therefore may have to increase our reliance on funding obtained through FHLB advances, securities sold under agreements to repurchase, and other wholesale funding sources.

Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated, financial condition, including capitalization and asset quality, or adverse regulatory action against us.  Under our Consent Order, we are not permitted to accept, renew, or rollover brokered deposits.  Such restriction requires us to seek other permissible funding sources.  Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and continued deterioration in credit markets.  To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned, which could have a material adverse effect on our financial condition, results of operations and cash flows.
 

Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.

Our accounting policies are fundamental to understanding our financial results and condition.  Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results.  Some of our accounting policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain and because it is likely materially different amounts would be reported under different conditions or using different assumptions.

From time to time the Financial Accounting Standards Board (the FASB) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements.  These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition.  We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.

Impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations.

In assessing the impairment of investment securities, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuers, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.  The impact of an other-than-temporary impairment could have a material adverse effect on our business, results of operations, and financial condition.

Premiums for D&O insurance have increased.  We may be unable to renew our D&O insurance policy on acceptable terms.

Since 2008, higher levels of bank failures and the associated heightened risk of regulatory action and litigation against directors and officers of failed banks have increased the cost of directors and officers liability insurance (D&O insurance) premiums for many financial institutions.  Because of our recent losses and financial condition, the cost of D&O insurance has increased.  Any future increases in D&O insurance premiums will likely adversely impact our earnings and financial condition.  In addition, we may be unable to renew our D&O insurance coverage in the future, or we may be unable to obtain adequate replacement policies on acceptable terms.  If we are not able to secure appropriate D&O insurance coverage, we may be unable to retain our current officers and directors, or attract additional officers and directors.

We rely on other companies to provide key components of our business infrastructure.

Third-party vendors provide key components of our business infrastructure, such as internet connections, network access and core application processing.  While we have selected these third-party vendors carefully, we do not control their actions.  Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business.  Replacing these third-party vendors could also entail significant delay and expense.

Our information systems may experience an interruption or breach in security.
 
We rely heavily on communications and information systems to conduct our business.  Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, we cannot assure you any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

Unpredictable catastrophic events could have a material adverse effect on 1st Financial.

The occurrence of catastrophic events, such as hurricanes, tropical storms, earthquakes, pandemic disease, windstorms, floods, severe winter weather (including snow, freezing water, ice storms, and blizzards), fires and other catastrophes could adversely affect 1st Financial’s consolidated financial condition or results of operations.  Unpredictable natural and other disasters could have an adverse effect on the Bank in that such events could materially disrupt its operations or the ability or willingness of its customers to access the financial services offered by the Bank.  The incidence and severity of catastrophes are inherently unpredictable.  Although the Bank carries insurance to mitigate its exposure to certain catastrophic events, these events could nevertheless reduce the Company’s earnings and cause volatility in its financial results for any fiscal quarter or year and have a material adverse effect on the Company’s financial condition and results of operations.
 

We may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock.

The market for financial services, including banking services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, and Internet-based banking.  We depend on third-party vendors for portions of our data processing services.  In addition to our ability to finance the purchase of those services and integrate them into our operations, our ability to offer new technology-based services depends on our vendors’ abilities to provide and support those services.  Future advances in technology may require us to incur substantial expense that adversely affects our operating results, and our small size and limited resources may make it impractical or impossible for us to keep pace with our larger competitors.  Our ability to compete successfully in our banking markets may depend on the extent to which we and our vendors are able to offer new technology-based services and on our ability to integrate technological advances into our operations.

Risks Related to Our Common Stock

Our ability to pay dividends is limited and we may be unable to pay future dividends.

As discussed above under “Supervision and Regulation in Item 1, our ability to pay cash dividends is limited by regulatory restrictions as well as the need to maintain sufficient capital.  So long as our capital ratios and regulatory requirements are not satisfied, we will be unable to pay cash dividends on our common and preferred stock.

There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.

We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities.  The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.

The trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares.

Our common stock has been quoted “over-the-counter” on the Pink Sheets Electronic Quotation Service and the OTC Bulletin Board since August 2004.  However, our common stock is still relatively thinly traded.  Thinly traded stocks can be more volatile than stock trading in an active public market.  We cannot predict the extent to which an active public market for our common stock will develop or be sustained.  In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to operating performance.

We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock.  So, we cannot assure you that sales of substantial amounts of our common stock in the market, or the potential for large amounts of market sales, would not cause the price of our common stock to decline or potentially impair our ability to raise capital in the future.

Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders.

On February 15, 2013, our current directors and executive officers, as a group, had the sole or shared right to vote, or to direct the voting of, an aggregate of 560,355 shares, or 10.8%, of our outstanding common stock.  This group could purchase 297,648 additional shares under currently exercisable stock options they hold.  Because of their voting rights, in matters put to a vote of our stockholders’, it could be difficult for any group of our other stockholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management.

1st Financial has issued preferred stock, which ranks senior to our common stock.

The Company has issued 16,369 shares of Preferred Stock.  This series of preferred stock ranks senior to shares of our common stock.  As a result, 1st Financial must make dividend payments on the Preferred Stock before any dividends can be paid on the common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the Preferred Stock must be satisfied before any distributions can be made on the common stock.  Through the date of this report, the Company has deferred the payment of the last 11 quarterly preferred dividends, with the total amount deferred of $2.3 million.  Until 1st Financial pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.
 

Our Preferred Stock reduces net income available to holders of our common stock and earnings per common share and the Warrant may be dilutive to holders of our common stock.

Any dividends, whether declared or not, on our Preferred Stock will reduce any net income available to holders of common stock and our earnings per common share.  The Preferred Stock will also receive preferential treatment in the event of sale, merger, liquidation, dissolution or winding up of our company.  Additionally, the ownership interest of holders of our common stock will be diluted to the extent the Warrant is exercised.

Our stock price can be volatile.

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive.  Our stock price can fluctuate significantly in response to a variety of factors including, among other things:

  
actual or anticipated variations in quarterly results of operations;

  
operating results and stock price performance of other companies that investors deem comparable to us;

  
news reports relating to trends, concerns, and other issues in the financial services industry;

  
perceptions in the marketplace regarding us and/or our competitors;

  
new technology used or services offered by competitors;

  
regulatory actions against us;

  
significant acquisitions or business combinations, strategic partnerships, joint ventures, or capital commitments by or involving us or our competitors; and

  
changes in government regulations.

General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause our stock price to decrease regardless of operating results.

Our common stock is not FDIC insured.

The Company’s common stock is not a savings or deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental agency and is subject to investment risk, including the possible loss of principal.  Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company.  As a result, holders of our common stock may lose some or all of their investment.
 
 

The Company’s corporate offices are located in Hendersonville, North Carolina.  At December 31, 2012, the Company maintained 12 full-service banking offices and an operations center.  The following table contains information about our banking offices.

Office Location
Opening Date of Original Banking Office
Owned/Leased
52 Coxe Avenue
Asheville, NC
May 2005
Leased (1)
19 Chestnut Street, Suite 7
Brevard, NC
December 2005
Leased (1)
80 Walker Street
Columbus, NC
January 2005
Leased (1)
6534 Brevard Road
Etowah, NC
May 2006
Owned
3270 Hendersonville Road
Fletcher, NC
September 2005
Owned
102 West Main Street
Forest City, NC
July 2007
Leased (1)
101 Jack Street
Hendersonville, NC
November 2004
Leased (1), (3)
203 Greenville Highway
Hendersonville, NC
May 2004
Leased (1)
1880 North Center Street
Hickory, NC
November 2008
Leased (1)
174 Highway 70 West
Marion, NC
May 2006
Leased (2)
800 South Lafayette Street
Shelby, NC
September 2006
Owned
1637 South Main Street
Waynesville, NC
August 2004
Leased (1)

(1)  Leased from unrelated third party.
(2)  Leased from a related part on terms comparable to third-party leases.
(3)  Corporate Headquarters and Main Office

All the Company’s existing banking offices are in good condition and fully equipped for the Company’s purposes.  At December 31, 2012, the total net book value (cost less accumulated depreciation) of the Company’s premises, leasehold improvements, furniture, fixtures, and equipment was $4.4 million.  See Notes 9 and 12 to the accompanying consolidated financial statements for additional information about the Company’s property and lease obligations.
 
 
In the ordinary course of business, the Company and its subsidiaries are often involved in legal proceedings.  In the opinion of management, except as disclosed in Item 1 hereof, under the caption "Business - Enforcement Actions", neither the Company nor its subsidiaries is a party to, nor is their property the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to their business, nor has any such proceeding been terminated during the fourth quarter of the Company’s fiscal year ended December 31, 2012.
 
 
PART II
 
 
The Company’s common stock is traded over-the-counter with quotations available on the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service under the symbol “FFIS.”  There were approximately 2,400 stockholders of record as of December 31, 2012, not including the persons or entities whose stock is held in nominee or “street” name and by various banks and brokerage firms.

The table below presents the reported high and low closing prices for the Company’s common stock, along with the actual closing price for the previous eight quarters.  These quotations reflect inter-dealer prices, without retail mark up, mark down or commission and may not represent actual transactions.  No common stock dividend was declared or paid during any of the fiscal quarters listed.
 
   
High
   
Low
   
Close
 
2012
                 
First quarter
  $ 0.59     $ 0.12     $ 0.12  
Second quarter
    0.75       0.21       0.26  
Third quarter
    0.60       0.21       0.30  
Fourth quarter
    0.35       0.14       0.30  
                         
2011
                       
First quarter
  $ 0.65     $ 0.40     $ 0.45  
Second quarter
    0.60       0.31       0.38  
Third quarter
    0.51       0.30       0.30  
Fourth quarter
    0.60       0.15       0.25  

Securities Authorized for Issuance Under Equity Compensation Plans.  The following table summarizes all compensation plans and individual compensation arrangements which were in effect on December 31, 2012, and under which shares of the Company's common stock have been authorized for issuance.

EQUITY COMPENSATION PLAN INFORMATION
 
               
(c)
 
Plan category
 
(a)
Number of shares
to be issued upon exercise of outstanding options and awards
   
(b)
Weighted-average exercise price of outstanding options
and awards
   
Number of shares remaining available
for future issuance under equity compensations
plans (excluding
shares reflected in column (a))
 
                   
Equity compensation plans approved by the Company's security holders:
                 
                   
     2004 Employee and Director Stock Option Plans
    690,889     $ 8.30       273,399  
                         
     2008 Omnibus Equity Plan
    159,867       0.55       90,133  
                         
Equity compensation plans not approved by the Company's security holders
    -       -       -  
Total
    850,756     $ 6.84       363,532  
 
Dividends.  See “Item 1.  Description of Business – Supervision and Regulation” above for regulatory and CPP restrictions, which limit the ability of 1st Financial to pay dividends.

Recent Sales of Unregistered Securities.  The Company did not sell any securities within the last three fiscal years that were not registered under the Securities Act of 1933, as amended.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers.  The Company did not repurchase any shares of its common stock during the fourth quarter of 2012.
 
 
 
Not applicable.

 
Introduction

1st Financial Services Corporation (the Company or 1st Financial) is a North Carolina corporation headquartered in Hendersonville, North Carolina that when it was formed in May 2008 became the sole owner of all of the capital stock of Mountain 1st Bank & Trust Company (the Bank).  The Bank is a North Carolina state chartered, non-member bank, which was organized and incorporated under the laws of the State of North Carolina on April 30, 2004, and began operations on May 14, 2004.  As of December 31, 2012, the Bank conducted business through 12 full-service branch offices located in nine western North Carolina counties.

Because the Company has no separate operations and conducts no business on its own other than owning the Bank, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of the Bank.  However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the “Company” unless otherwise noted.

The Bank competes for loans and deposits throughout the markets it serves.  The Bank, like other financial institutions, derives most of its revenue from net interest income, which is the difference between the income it earns on loans and securities minus the interest expense it incurs on deposits and borrowings.

Management has provided the following discussion and analysis to address information about the Company’s financial condition and results of operations, which may not otherwise be apparent from the consolidated financial statements included in this Report.  Reference should be made to those statements for an understanding of the following discussion and analysis.

Factors That May Affect Future Results

The discussion and analysis that follows is intended to assist readers in the understanding and evaluation of the financial condition and results of operations of the Company.  It should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Annual Report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.

The following discussion contains certain forward-looking statements about the Company’s financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.  See also “Cautionary Note About Forward-Looking Statements” and “Risk Factor’’, which begin on pages 3 and 18, respectively.

Enforcement Policies and Actions

Federal and state laws give the Federal Reserve, the FDIC, and the Commissioner substantial powers to enforce compliance with laws, rules, and regulations.  Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices.  The banking regulators have the power to impose civil money penalties against individuals or institutions for certain violations.

Persons who are affiliated with depository institutions and their holding companies can be removed from any office held in that institution and banned from participating in the affairs of any financial institution.  The banking regulators frequently employ the enforcement authorities provided in federal and state law.

Enforcement Action - Consent Order

During 2009, the FDIC conducted a periodic examination of the Bank.  As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation agreeing to the issuance of a Consent Order with the FDIC and the Commissioner (the Consent Order).
 
Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Board of Directors or the Bank to undertake a number of actions:
 

  
the Board of Directors of the Bank will enhance its supervision of the Bank’s activities, including by increasing the formality of its meetings and appointing a special Directors’ Committee.  The Committee will oversee the efforts of the Bank’s management in complying with the Consent Order and will regularly report to the full Board.

  
the Bank Board will assess the Bank’s management team to ensure the Bank’s executive officers have the skills, training, abilities, and experience needed to cause the Bank to comply with the Consent Order, operate in a safe and sound manner, comply with applicable laws and regulations, and strengthen all areas of the Bank’s operations that are not currently in compliance with the Consent Order.  The Board will also assess the Bank’s management and staffing needs in order to determine if additional resources should be added to the management team.

  
during the effectiveness of the Consent Order, the Bank will maintain Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses (the “Allowance for Loan Losses” or “Allowance”).

  
the Bank will develop and implement a plan for achieving and maintaining the foregoing capital levels, which plan may include sales of stock by the Company and contributions of the sales proceeds by the Company to the capital of the Bank.

  
the Board will strengthen the Allowance for Loan Losses policy of the Bank, periodically review the Bank’s Allowance for Loan Losses to determine its adequacy and enhance its periodic reviews of the Allowance to ensure its continuing adequacy.  Deficiencies noted will be promptly remedied by charges to earnings.

  
the Bank will develop and implement a strategic plan covering at least three years and containing long-term goals designed to improve the condition of the Bank.

  
the Bank will not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.  The Bank also will not extend additional credit to any borrower who has a current loan that is classified “Substandard” or listed for “Special Mention.”  A further extension of credit may be made to a borrower with a “Substandard” or “Special Mention” loan if the Bank Board determines such extension would be in the best interests of the Bank.

  
the Bank will formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans as of August 31, 2009, of more than $250,000 and will promptly implement the plan.  The Board will closely monitor the Bank’s progress in fulfilling the requirements of this plan.

  
the Bank will reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.  The schedule targets an aggregate reduction by 75% within 720 days of the effectiveness of the Consent Order.  The Board will monitor this effort on a monthly basis.

  
the Bank will cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies within 90 days of the effectiveness of the Consent Order.

  
the Bank will adopt a loan review and grading system within 90 days of the Consent Order to provide for effective periodic reviews of the Bank’s loan portfolio.  The system shall address, among other things, loan grading standards, loan categorization, and credit risk analyses.

  
within 30 days of the effectiveness of the Consent Order, the Bank will develop a plan to systematically reduce the concentration of a significant portion of its extensions of credit in a limited group of borrowers. Additionally, the Bank will prepare a risk segmentation analysis with respect to certain real estate industry concentrations of credit identified by the supervisory authorities.

  
the Bank will enhance its review of its liquidity by engaging in monthly analyses.  It will also develop and implement a liquidity contingency and asset/liability management plan.

  
within 90 days from the effectiveness of the Consent Order, the Bank will implement a plan and 2010 budget designed to improve its net interest margin, increase interest income, reduce expenditures, and improve and sustain earnings.
 
 
  
the Bank will implement internal routine and control policies addressing concerns raised by its supervisory authorities and designed to enhance its safe and sound operation.

  
within 90 days of the Consent Order, the Bank will implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
 
  
the Bank will implement a policy for managing its “owned real estate”.

  
the Bank will forbear from soliciting and accepting “brokered deposits” unless it first receives an appropriate waiver from the FDIC; and will comply with restrictions issued by the FDIC on the effective yields of deposit products offered by, among others, banks subject to consent orders.

  
a limit upon growth of 10% per year will be observed by the Bank.

  
the Bank will not pay dividends or make other forms of payment reducing capital to the Company without the prior approval of the supervisory authorities while the Consent Order is in effect.

  
the Bank will implement policies to enhance the Board’s focus on conflicts of interest regulations and its handling of transactions with officers and directors.

  
the Bank will correct any violations of laws and regulations identified by the supervisory authorities.

  
the Bank will make quarterly progress reports to the supervisory authorities detailing the form and manner of actions taken to comply with the Consent Order.
 
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order.  A copy of the Consent Order has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov.  The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
 
The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation.  During the period a Consent Order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches.  Accordingly, the Bank has deferred pursuit of its previous strategy of expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.

Enforcement Action - Written Agreement

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, 1st Financial executed a written agreement (the Written Agreement) with the Federal Reserve Bank effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions:

  
the Board of Directors of 1st Financial shall take appropriate steps to fully utilize 1st Financial’s financial and managerial resources, to serve as a source of strength to the Bank, including, but not limited to, taking steps to ensure the Bank complies with the Consent Order and any other supervisory action taken by the Bank’s federal or state regulator.

  
1st Financial shall not declare or pay any dividends without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve.

  
1st Financial shall not directly or indirectly take dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank.

  
all requests for prior approval shall be received by the Federal Reserve Bank at least 30 days prior to the proposed dividend declaration date.  All requests shall contain, at a minimum, current, and projected information on 1st Financial’s capital, earnings, and cash flow; the Bank’s capital, asset quality, earnings, and allowance for loan and lease losses; and identification of the sources of funds for the proposed payment or distribution.

  
1st Financial shall not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Federal Reserve Bank.  All requests for prior written approval shall contain, but not be limited to, a statement regarding the purpose of the debt, the terms of the debt, and the planned source(s) for debt repayment, and an analysis of the cash flow resources available to meet such debt repayment.

  
1st Financial shall not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Federal Reserve Bank.
 
 
  
within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank an acceptable written plan to maintain sufficient capital at 1st Financial on a consolidated basis.  The plan shall, at a minimum, address, consider, and include:
 
Ø 
the consolidated organization’s and the Bank’s current and future capital requirements, including compliance with the Capital Adequacy Guidelines for Bank Holding Companies and the applicable capital adequacy guidelines for the Bank issued by the Bank’s federal regulator;

Ø 
the adequacy of the Bank’s capital, taking into account the volume of classified credits, concentrations of credit, allowance for loan and lease losses, current and projected asset growth, and projected retained earnings;

Ø 
the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Bank’s future capital requirements;

Ø 
supervisory requests for additional capital at the Bank or the requirements of any supervisory action imposed on the Bank by its federal regulator; and
 
Ø 
the requirements of Regulation Y of the Federal Reserve that 1st Financial serve as a source of strength to the Bank.
 
  
1st Financial shall notify the Federal Reserve Bank, in writing, no more than 45 days after the end of any quarter in which any of 1st Financial’s capital ratios fall below the approved plan’s minimum ratios.  Together with the notification, 1st Financial shall submit an acceptable written plan that details the steps that 1st Financial will take to increase 1st Financial’s capital ratios to or above the approved plan’s minimums.

  
within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank a written statement of its planned sources and uses of cash for debt service, operating expenses, and other purposes (Cash Flow Projection) for 2011. 1st Financial shall submit to the Federal Reserve Bank a Cash Flow Projection for each calendar year subsequent to 2011 at least one month prior to the beginning of that calendar year.
 
  
in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, 1st Financial shall comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve.

  
1st Financial shall comply with the restrictions on indemnification and severance payments of the FDI Act and the FDIC’s regulations.

  
within 30 days after the end of each calendar quarter following the date of the Written Agreement, the Board of Directors shall submit to the Federal Reserve Bank written progress reports detailing the form and manner of all actions taken to secure compliance with the provisions of the Written Agreement and the results thereof, and a parent company only balance sheet, income statement, and, as applicable, report of changes in stockholders’ equity.

  
1st Financial shall submit a written capital plan that is acceptable to the Federal Reserve Bank within the applicable time period set forth in the Written Agreement.  Within 10 days of approval by the Federal Reserve Bank, 1st Financial shall adopt the approved capital plan.  Upon adoption, 1st Financial shall promptly implement the approved plan, and thereafter fully comply with it.  During the term of the Written Agreement, the approved capital plan shall not be amended or rescinded without the prior written approval of the Federal Reserve Bank.

The foregoing description is a summary of the material terms of the Written Agreement and is qualified in its entirety by reference to the Written Agreement.  A copy of the Written Agreement has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov.  Each provision of the Written Agreement shall remain effective and enforceable until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

"Significantly Undercapitalized" Capital Category

At December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to the restrictions in Section 38 of the Federal Deposit Insurance Act and the related FDIC rules and regulations that apply to "significantly undercapitalized" institutions, including restrictions on:

the compensation paid to senior executive officers;
 
capital distributions;
 
 
payment of management fees;

asset growth;

acquiring any interest in any company or insured depository institution;

establishing or acquiring any additional branch office; and

engaging in any new line of business.

Because of its capital category, the Bank may not accept, renew, or rollover brokered deposits, and is subject to restrictions on the rate of interest it may pay on deposits.  Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.

Going Concern Considerations

As discussed in this Item under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations," and in Note 2 to the accompanying consolidated financial statements, although the Company was profitable in 2012, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels.  These considerations raise substantial doubt about the Company's ability to continue as a going concern.  Management’s plans are further discussed in Note 2 to the accompanying consolidated financial statements.  These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.

Proposed Legislation and Regulatory Action

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies.  Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system.  Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways.  If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions.  We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company.  A change in statutes, regulations, or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.

General Economic Conditions

Western North Carolina is undergoing one of the most severe economic recessions in our history.  Unemployment is close to record levels and both residential and commercial real estate values have been adversely impacted.  Since 2008, with the slowing economy, falling real estate values, and reducing interest rates, our Company experienced severe stress on our earnings from both depressed margins and worsening asset quality.  Continued weaknesses in the Western North Carolina real estate market was the primary reason for the Company’s providing an increase to the allowance for loans losses of $5.3 million and $15.8 million in 2012 and 2011, respectively.  We have experienced some margin contraction, as we are unable to reinvest proceeds from loan and security repayments at the same yields.  We also expect to continue to incur increased expense as we manage our troubled assets.  Our markets continue to feel the effects of the recession and we do not foresee substantial improvements in either unemployment levels or real estate values until late 2013 at the earliest.

Overview

The Company’s primary market area is located in the mountain region of southwestern North Carolina.  The principal business sectors in this region include service companies directly or indirectly linked to tourism, which is one of the largest economic drivers of the region, small to mid-sized manufacturing companies, real estate development, particularly relating to the ongoing growth of the area as a retirement and second home destination, the arts and crafts industry, and to a lesser degree, agriculture.
 

The Bank believes its current base of business is relatively well diversified as is the general economic base of the region as a whole.  The principal concentration identified by management within the Company’s lending portfolio is in loans secured by real estate.  At December 31, 2012, loans collateralized by real estate, comprised 90.2% of the Company’s total loan portfolio.  Management believes concentration risk within this sector of the loan portfolio is mitigated by the mix of different types of real estate held as collateral.  These include residential, multifamily, and both income-producing and owner-occupied commercial properties.  The Company’s loan portfolio includes $69.0 million in loans classified as construction or acquisition and development (of which $43.3 million are land loans) and $147.9 million in loans classified as commercial real estate (CRE), representing 17.8% and 38.2%, respectively of the total portfolio.  By way of comparison, at December 31, 2011, the Company’s loan portfolio included $87.1 million in loans classified as construction or acquisition and development (of which $44.9 million were land loans) and $159.1 million in loans classified as CRE, representing 20.8% and 38.0%, respectively, of the total portfolio.
 
In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans with high loan-to-value ratios.  At December 31, 2012, loans exceeding regulatory loan-to-value guidelines represented 111.8% of risk-based capital, primarily attributable to the Bank’s reduced capital due to losses incurred in the past several years, combined with market value declines on the underlying collateral of the Bank’s real estate loan portfolio.

Banking regulators have continued to issue guidance to banks concerning their perception of general risk levels associated with higher concentrations of CRE as a proportion of total loans and as a percentage of capital within bank loan portfolios.  It remains management’s understanding that regulatory interpretations of this guidance would not necessarily prohibit future growth for banks with concentrations of CRE, however, additional monitoring and risk management procedures are likely to be required for portfolios with higher levels of CRE and additional CRE lending may also be curtailed.  Management has continued efforts to refine enhanced monitoring systems pertaining to the Bank’s CRE portfolio, with particular emphasis on construction and land development lending, which comprises a material portion of the Bank’s CRE portfolio.  In addition to continued enhanced monitoring of this portion of the loan portfolio, management has curtailed lending to new acquisition and development projects and anticipates this component of the portfolio will decline substantially over time.

For the first five years of operation, management’s business plan had been predicated upon the relatively rapid growth and establishment of an initial branch network within the Company’s primary delineated market area.  However, due to the current economic environment, management does not expect to open new branch offices to augment the current branch network in the foreseeable future and may close certain offices to improve operating efficiencies.  Instead, management is focused on reducing its nonperforming loan portfolio and its foreclosed real estate holdings, while simultaneously growing existing branches in its primary market.

The Company’s primary source of revenue is derived from interest income produced through traditional banking activities, such as generating loans and earning interest on securities.  Additional sources of income are derived from fees on deposit accounts, Small Business Administration (SBA) and U.S. Department of Agriculture (USDA) loan originations and sales, and residential mortgage origination services.

Maintaining sound asset quality is another key focal point for the Company.  As a result of the current economic environment, the Bank experienced an increase in nonperforming assets (nonaccruing loans, foreclosed assets, and accruing loans past due 90 or more days) beginning in 2009, which resulted in a significant increase in our allowance for loan losses.  This development is further discussed under the heading “Asset Quality” below.  The business of lending to small businesses and consumers carriers with it significant credit risks, which must be continually managed.  Management monitors asset quality and credit risk on an ongoing basis and fully expects to experience credit losses in the future, but we believe we have made substantial progress in identifying and quantifying the impact of the current economic environment on our loan portfolio and overall financial condition.  Management continues to engage third-party consultants to assist in monitoring and evaluating the quality of the portfolio.  Although asset quality has significantly improved during 2012, problem assets continue to be elevated.

Financial Condition

December 31, 2012, Compared to December 31, 2011

The Company’s total assets were $710.4 million at December 31, 2012, an increase of $10.4 million, from $700.0 million at December 31, 2011.  Investment securities increased by $55.4 million, or 27.8%, from $199.7 million at December 31, 2011, to $255.1 million at December 31, 2012.  During 2012, gross loans, excluding loans held for sale, decreased by $31.2 million, or 7.5%, from $418.9 million at December 31, 2011, to $387.7 million at December 31, 2012, as management purposely slowed loan growth in response to current economic conditions.  In addition, certain customers are exhibiting a preference for deleveraging by paying off their loans.  Although the mix of deposits continued to shift from time deposits to transaction accounts, total deposits at December 31, 2012, were $683.9 million, an increase of $11.3 million, or 1.7%, from $672.6 million at December 31, 2011.  Excluding the reduction in brokered certificates of deposit of $1.6 million, retail deposits increased $12.9 million, or 1.9%.  Borrowings from the Federal Home Loan Bank, totaling $4.0 million were repaid during early 2012.  Securities sold under agreements to repurchase, the sole component of borrowings at December 31, 2012, decreased by $169,000 from year-end 2011.  The Company’s loan-to-asset ratio decreased from 59.8% at December 31, 2011, to 54.6% at December 31, 2012, principally reflecting an increase in loan repayments over loan production, combined with $5.8 million of gross charge-offs and the transfer of $7.4 million of portfolio loans to foreclosed assets during 2012.
 

As noted above, during 2012, gross loans decreased $31.2 million, or 7.5%.  The reduction in loans included declines totaling $18.1 million, or 20.8%, in construction and land development loans, $11.7 million, or 24.9%, in commercial and industrial loans, $119,000, or 4.0%, in consumer loans, $11.2 million, or 7.1%, in commercial real estate loans, and $2.8 million, or 9.8%, in home equity loans, offset by an increase of  $12.5 million, or 14.5%, in first liens on 1-4 family residential properties, excluding mortgage loans held for sale.  Overall growth plans for the Bank have been purposely slowed in response to the Consent Order and Written Agreement, the Bank’s asset quality deterioration, uncertainties with respect to the national economy, regional and local real estate markets, the domestic interest rate environment and global currency markets and in order to maintain satisfactory capital requirements.  Until the Bank’s capital levels are restored, the Bank is prohibited from increasing its assets.  The Company may achieve capital restoration through a capital raise, reducing the size of the Company’s consolidated balance sheet, or a combination of the two methods.  Management and the Board continue to pursue plans to achieve and maintain the regulatory directed capital levels.  Given the state of the current equity markets, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.  
 
Investment securities increased during the period by $55.4 million, or 27.8%.  At December 31, 2012, cash and cash equivalents increased by $1.3 million, compared with December 31, 2011.  Liquid assets, consisting of cash and demand balances due from banks, interest-earning deposits in other banks, balances due from the Federal Reserve Bank and available-for-sale investment securities totaled $292.5 million at December 31, 2012, constituting 41.2% of total assets.  This compares with $232.8 million, or 33.3% of total assets, at year-end 2011.  Proceeds from investment security sales and increased customer deposits, along with proceeds from secondary market mortgage loan sales and loan repayments continue to boost cash on deposit with the Federal Reserve Bank, providing sufficient liquidity to fund investment security purchases, combined with providing liquidity to meet depositor needs.

Foreclosed real estate decreased from $19.3 million at December 31, 2011, to $9.8 million at December 31, 2012, as the Company managed a larger volume of foreclosed real estate through the final disposition process.

Other assets decreased from $2.3 million at December 31, 2011, to $980,000 at December 31, 2012, as a result of the disposition of all the Company’s repossessed assets.  At December 31, 2011 repossessed assets totaled $1.6 million and consisted of three aircraft.

Deposits increased $11.3 million during 2012, during which time the composition of the Bank’s deposits shifted from certificates of deposit toward core transaction accounts, including checking, savings, and money market accounts.  At year-end 2012, noninterest-bearing demand accounts had increased $9.1 million, or 11.8%, to $86.0 million.  Other transaction accounts, including NOW, money market and savings accounts increased $45.8 million, or 17.9%.  At December 31, 2012, transaction accounts accounted for 56.7% of the Company’s total deposits, compared to 49.5% at December 31, 2011.  Certificates of deposit under $100,000 decreased $25.9 million, or 15.2%, while certificates of deposit over $100,000 decreased $17.7 million, or 10.5%.  The decrease in certificates of deposits was attributable to shifting customer preferences to maintain funds in more liquid accounts, such as the money market and savings accounts.  Brokered certificates of deposit totaled $937,000 at December 31, 2012, and were comprised entirely of internet certificates of deposit, compared to $2.6 million at December 31, 2011.  Management’s funding strategy remains centered around balanced growth in deposits generated through the Company’s retail branch network, supplemented through the selective use of permissible wholesale funding when such sources present a lower cost alternative to certificates of deposit pricing in the local markets in which the Company operates.  Under the Consent Order, and as a consequence of the Bank’s reduced capital levels, the Company may not attract, renew, or rollover brokered certificates of deposit, unless it first receives an appropriate waiver from the FDIC.  Accordingly, as existing brokered certificates of deposit mature, funds are being returned to the depositors.

Stockholders’ equity increased by $1.1 million, or 6.2%, during 2012, primarily as a result of the Company’s net income for the period.  At December 31, 2012, the Company’s capital ratios classified it as a “significantly undercapitalized” institution by regulatory measures.

Results of Operations

Summary

For 2012, the Company recorded net income of $1.3 million, representing an increase of $21.7 million as compared with a net loss of $20.5 million for 2011.  Net income available to common stockholders, after the effect of preferred stock dividend requirements, was $249,000 for 2012, or $0.05 per diluted share, compared with a net loss available to common stockholders of $21.5 million, or $(4.18) per diluted share, for 2011.  The increase in net income in 2012 was driven principally by a lower provision for loan losses of $10.5 million, coupled with a decrease in income tax expense of $9.4 million.  Also contributing to the change was an increase in noninterest income of $1.4 million and a decrease in noninterest expense of $914,000, partially offset by a decrease in net interest income of $512,000.  The Company recorded no income tax expense during 2012, due to the establishment of a full valuation allowance against its deferred tax asset at year-end 2011.  For 2011, the Company recorded income tax expense of $9.4 million based on a pre-tax book loss of $11.1 million.  Contributing to the income tax expense in the 2011 period was a provision of $12.9 million to increase the valuation allowance the Company maintains against its deferred tax asset.
 

For 2012, the Company’s net interest margin decreased to 2.98%, compared with 3.06% for 2011, primarily as a result of an asset shift from higher yielding loans to lower yielding investment securities.  As a result of the decline in the Company’s net interest margin, net interest income decreased $512,000 from $20.5 million for 2011 to $20.0 million for 2012 due to the adverse impact of nonaccrual loans and historically low interest rates.  Noninterest income for 2012, which primarily includes income from service charges on deposit accounts, mortgage services revenue, and gains on sale of securities sold, increased to $10.1 million, compared to $8.7 million recorded during 2011, principally due to mortgage services revenue, which totaled $2.5 million, compared to $2.0 million in 2011 and gains on sale of securities sold, which totaled $3.0 million in 2012, compared to $2.5 million in 2011.  Noninterest expense decreased $914,000 to $23.5 million for 2012, compared with $24.4 million for 2011.  Decreased problem asset management costs, including holding costs of and losses on the sale of other real estate owned and repossessed assets and loan related expense were partially offset by increased salaries and benefit expense and deposit insurance premiums.  The duration and severity of the current recession continue to have a substantial impact on the Company’s performance.  This increase in deposit insurance premiums is attributable to increased customer deposits and a higher year-over-year assessment rate based on the Bank’s capital and asset quality measures.  Strong cost control efforts continue to account for the moderate declines in a majority of operating expense categories.

Net Interest Income

The primary component of earnings for the Company is net interest income.  Net interest income is defined as the difference between interest income, principally from the loan and investment securities portfolios, and interest expense, principally on deposits and borrowings.  Changes in net interest income result from changes in volume, spread, and margin.  For this purpose, “volume” refers to the average dollar level of interest-earning assets and interest-bearing liabilities, “spread” refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities and “margin” refers to net interest income divided by average interest-earning assets.  Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-earning assets and noninterest-bearing liabilities.  During 2012 and 2011, average interest-earning assets were $671.3 million and $669.6 million, respectively.

The components of the decrease in net interest income for 2012 were a decrease in interest income of $2.3 million, or 8.3%, which was partially offset by a decrease in interest expense of $1.8 million, or 24.0%.  Interest on loans decreased by $3.0 million, or 13.0%, as a result of significantly reduced balances from loan repayments and lower yields on the loan portfolio.  Nonaccrual loans averaged $31.7 million in 2012, compared to $45.9 million in 2011 and the foregone interest on these loans decreased from $2.8 million in 2011 to $1.9 million in 2012.  The Bank reduced its deposit offering rates across all account categories during 2012 to ensure the Bank’s rates were priced competitively with market rates, in the generally declining rate environment of 2012.  Interest on deposits decreased by $1.8 million, or 23.8%, primarily due to the across-the-board rate reductions and the downward repricing of the Bank’s higher-costing time deposits during 2012, combined with a reduction in average balances, as customers moved their funds from maturing certificates of deposit into more liquid transactional accounts, such as savings and money market accounts, to maintain flexibility in their reinvestment options.

The Company’s net interest margin decreased from 3.06% for 2011 to 2.98% for 2012, primarily as a result of a shift in the composition of assets from higher-yielding loans to lower-yielding investment securities.  Average interest-earning assets for 2012 increased $1.7 million, or 0.3%, as compared to 2011.  Components of the decrease in margin were a 36 basis point decrease in the average yield on earning assets to 3.83%, partially offset by a 30 basis point reduction in the average cost of funds to 0.94%.  A shift in the composition of assets most notably contributed to the decrease in net interest income for 2012.  The Company’s decision to build and maintain a significant liquidity position in an uncertain regulatory and economic environment continues to have an adverse impact on the net interest margin.  The net interest margin will also be negatively affected if the economic environment remains sluggish, loan originations slow further, and nonaccrual loans continue at elevated levels.  Management strives to maintain a high interest-earning asset ratio, so as to maximize net interest income.  To that end, management targets an earning-asset ratio at or above 93%.  For 2012, that ratio was 94.2%, compared to 93.1% for 2011.
 

Average Balances, Income and Expenses, and Rates.  The following table sets forth certain information related to our average balance sheet and our average yields on earning assets and average costs of interest-bearing liabilities.  Such yields are derived by dividing income or expense by the average daily balance of the corresponding assets or liabilities.

Average Balances and Net Interest Income
                                                 
(dollars in thousands)
                                                     
   
For the Year
 
   
2012
   
2011
   
2010
 
    Average
Daily
Balance
   
Interest
          Average
Daily
Balance
   
Interest
          Average
Daily
Balance
   
Interest
       
       
Income/
    Average
Rate
       
Income/
    Average
Rate
       
Income/
    Average
Rate
 
       
Expense(1)(2)(3)
           
Expense(1)(2)
           
Expense(1)(2)
     
Interest-earning assets
                                                     
Loans and loans held for sale
  $ 401,427     $ 20,332       5.06 %   $ 462,885     $ 23,368       5.05 %   $ 527,650     $ 27,588       5.23 %
Investment securities
    234,104       5,260       2.25 %     164,841       4,500       2.73 %     129,877       2,884       2.22 %
Due from Federal Reserve Bank
    31,777       77       0.24 %     35,760       84       0.23 %     88,996       208       0.23 %
Interest-earning bank deposits
    4,020       41       1.02 %     6,151       76       1.24 %     3,888       56       1.44 %
Total interest-earning assets
    671,328       25,710       3.83 %     669,637       28,028       4.19 %     750,411       30,736       4.10 %
                                                                         
Noninterest-earning assets:
                                                                       
Cash and due from banks
    13,018                       15,968                       11,867                  
Property and equipment
    4,672                       5,421                       5,440                  
Interest receivable and other
    23,438                       28,199                       16,690                  
Total noninterest-earning assets
    41,128                       49,588                       33,997                  
Total assets
  $ 712,456                     $ 719,225                     $ 784,408                  
                                                                         
Interest-bearing liabilities
                                                                       
NOW accounts
    66,596       132       0.20 %     64,312       187       0.29 %     62,062       205       0.33 %
Money markets
    58,216       437       0.75 %     51,299       522       1.02 %     47,085       583       1.24 %
Savings deposits
    157,958       1,247       0.79 %     123,899       1,277       1.03 %     101,829       1,118       1.10 %
Retail time deposits
    320,920       3,852       1.20 %     332,197       4,906       1.48 %     345,906       6,906       2.00 %
Wholesale time deposits
    1,390       36       2.59 %     28,561       595       2.08 %     64,899       1,056       1.63 %
Federal funds purchased and securities sold under agreements to repurchase                                                                        
    481       1       0.26 %     910       6       0.66 %     1,096       8       0.73 %
Other borrowings
    22       -       0.53 %     3,952       18       0.46 %     46,617       415       0.89 %
Total interest-bearing liabilities
    605,583       5,705       0.94 %     605,130       7,511       1.24 %     669,494       10,291       1.54 %
                                                                         
Noninterest-bearing liabilities:
                                                                       
Demand deposits
    82,589                       72,792                       66,027                  
Interest payable and other
    4,772                       4,691                       6,170                  
Total noninterest-bearing liabilities
    87,361                       77,483                       72,197                  
Total liabilities
    692,944                       682,613                       741,691                  
                                                                         
Stockholders' equity
    19,512                       36,612                       42,717                  
Total liabilities and stockholders' equity
  $ 712,456                     $ 719,225                     $ 784,408                  
                                                                         
                                                                         
Net interest income and interest rate spread
          $ 20,005       2.89 %           $ 20,517       2.95 %           $ 20,445       2.56 %
                                                                         
Net yield on average interest-earning assets
                    2.98 %                     3.06 %                     2.72 %
                                                                         
Ratio of average interest-earning assets to average interest-bearing liabilities                                                                        
    110.86 %                     110.66 %                     112.09 %                
                                                                         
(1) Interest income includes amortization of deferred loan fees, net.
                                     
(2) Nonaccrual loans are included in gross loans but interest is not included in interest income.
               
(3) For amounts less than or equal to $1, yields are calculated using actual interest income and actual average assets not rounded values.
 

39

 
 
Rate/Volume Analysis.  The following table shows changes in interest income, interest expense, and net interest income arising from volume and rate changes for major categories of earning assets and interest-bearing liabilities.  The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar change in both.

Volume and Rate Variance Analysis
                                   
(in thousands)
                                   
   
2012 vs 2011
   
2011 vs 2010
 
   
Increase (Decrease) Due to
 
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
Interest income:
                                   
Loans and loans held for sale
  $ (3,113 )   $ 77     $ (3,036 )   $ (3,295 )   $ (925 )   $ (4,220 )
Investment securities
    1,655       (895 )     760       873       743       1,616  
Due from Federal Reserve Bank
    (7 )     -       (7 )     (124 )     -       (124 )
Interest-bearing bank deposits
    (23 )     (12 )     (35 )     29       (9 )     20  
Total interest income
    (1,488 )     (830 )     (2,318 )     (2,517 )     (191 )     (2,708 )
                                                 
Interest expense:
                                               
NOW accounts
  $ 6     $ (61 )   $ (55 )   $ 7     $ (25 )   $ (18 )
Money markets
    64       (149 )     (85 )     49       (110 )     (61 )
Savings deposits
    307       (337 )     (30 )     231       (72 )     159  
Retail time deposits
    (162 )     (892 )     (1,054 )     (264 )     (1,736 )     (2,000 )
Wholesale time deposits
    (676 )     117       (559 )     (702 )     241       (461 )
Federal funds purchased and securities
                                               
  sold under agreements to repurchase
    (2 )     (3 )     (5 )     (1 )     (1 )     (2 )
Other borrowings
    (9 )     (9 )     (18 )     (259 )     (138 )     (397 )
Total interest expense
    (472 )     (1,334 )     (1,806 )     (939 )     (1,841 )     (2,780 )
Net increase (decrease) in net interest income
  $ (1,016 )   $ 504     $ (512 )   $ (1,578 )   $ 1,650     $ 72  

Provision for Loan Losses

Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management.  In evaluating the allowance for loan losses, management considers factors that include growth, composition, diversification, or conversely, concentrations by industry, geography or collateral within the portfolio, historical loan loss experience, current seasoning of the portfolio, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors.

Provision for loan losses for 2012 totaled $5.3 million, a decrease of $10.5 million, compared with $15.8 million for 2011.  The reduction in the provision for loan losses is reflective of both the overall reduction in problem loans and the stabilization, for the most part, of the real estate values collateralizing our problem loans.  Higher provisioning in future quarters may occur if economic conditions do not improve, borrowers continue to experience financial difficulties, and real estate values decline.

Noninterest Income

Noninterest income increased to $10.1 million for 2012, compared to $8.7 million for 2011, representing an increase of $1.4 million, or 16.4%.  The principal components of this increase were increased mortgage services revenue and net gains on sales of investment securities.  Mortgage service revenue contributed $2.5 million to noninterest income for 2012, compared to $2.0 million for 2011, with the increase in revenue resulting from higher production and sales of residential mortgage loans to the secondary market.  During 2012, the Company sold $119.4 million of investment securities to recognize $3.0 million in gains inherent in the portfolio and to mitigate the risk of a decline in the fair value of the portfolio should market interest rates fluctuate.  During 2011, sales of investment securities totaled $94.2 million with recorded gains of $2.5 million.  Deposit service charges remained relatively constant at $1.4 million for 2012.  Also contributing to noninterest income for the period were USDA/SBA loan sale and servicing revenue, which contributed $725,000 in 2012 and $629,000 in 2011.  The Company may be unable to generate mortgage services revenue, gains on sales of investment securities, and USDA/SBA loan sale and servicing revenue in 2013, at levels comparable to those earned for this past year.  Such performance will be significantly affected by changes in market interest rates, the regulatory environment, and competition.
 

The following table is a comparative analysis of the components of noninterest income for 2012 and 2011.
 
Noninterest Income
           
(in thousands)
           
   
For the Year
 
   
2012
   
2011
 
Service charges on deposit accounts
  $ 1,419     $ 1,484  
Mortgage services revenue
    2,538       1,980  
Other service charges and fees
    574       614  
Increase in cash surrender value of life insurance
    374       435  
Gain on sale of investment securities, net
    2,965       2,458  
USDA/SBA loan sale and servicing revenue
    725       629  
Other income
    1,487       1,062  
Total
  $ 10,082     $ 8,662  
 
Noninterest Expense

Noninterest expense includes all of the operating costs of the Company, excluding interest, provision, and tax expense.  Noninterest expense totaled $23.5 million in 2012, down $914,000, or 3.7%, from $24.5 million in 2011.  Salaries and benefit expense for 2012 increased $834,000 over the 2011 period, principally due to higher commission expense related to the Company’s increased residential mortgage loan originations and sales, combined with a nonrecurring reduction in retirement benefits expense during 2011.  Loan related expense decreased $1.3 million from 2011, primarily due to the Company’s purchase of another member’s interest in an investment in real estate for $850,000, which is included in 2011 loan related expense.  Problem asset management costs, including holding costs of and losses on the sale of other real estate owned and repossessed assets, totaled $4.0 million, compared to $4.5 million in 2011.  The increase in deposit insurance premiums of $286,000 is attributable to a higher year-over-year assessment rate based on the Bank’s capital and asset quality measurements, along with increased customer deposits.  The Bank’s financial condition also led to the $189,000 year-over-year increase in corporate insurance expense.

The following table presents a comparison of the components of noninterest expense for 2012 and 2011.

Noninterest Expense
           
(in thousands)
           
   
For the Year
 
   
2012
   
2011
 
Salaries and employee benefits
  $ 9,958     $ 9,124  
Occupancy
    1,370       1,280  
Equipment
    898       934  
Advertising
    235       242  
Data processing and telecommunications
    1,910       2,112  
Deposit insurance premiums
    2,477       2,191  
Professional fees
    404       383  
Printing and supplies
    113       151  
Foreclosed assets
    4,002       4,499  
Dues and subscriptions
    148       180  
Postage
    193       187  
Loan legal
    368       434  
Loan appraisal
    114       334  
Other loan and real estate related expense
    189       1,179  
Corporate insurance
    387       198  
Other
    775       1,027  
Total
  $ 23,541     $ 24,455  
 
 
Income Taxes

The Company recorded no income tax expense during 2012, as it maintains a full valuation allowance against its deferred tax asset.  During 2011, the Company recorded income tax expense of $9.4 million based on a pre-tax loss of $11.1 million.  Included in the income tax expense for 2011 was a provision of $12.9 million to increase the valuation allowance.  See further discussion in Note 13 to the Company’s consolidated financial statements.

Liquidity
 
A function of the Bank’s Asset/Liability Management Committee is evaluating the current liquidity of the Bank and identifying and planning for future liquidity needs.  Such needs primarily consist of ensuring sufficient liquidity to meet current or expected needs for deposit withdrawals and the funding of investing activities, principally the making of loans and purchasing of securities.  Liquidity is provided by cash flows from maturing investments, loan payments and maturities, federal funds sold, and unpledged investment securities.  On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates of deposit and borrowings from the Federal Home Loan Bank (FHLB), as well as the ability to generate funds through the issuance of long-term debt and equity.  The Bank’s “on balance sheet” liquidity ratio was 37.3% at December 31, 2012.  Management considers this ratio to be more than adequate to meet known or anticipated liquidity needs.  The Company, however, has limited sources of revenue, and the Written Agreement and Consent Order do not permit the payment of dividends by the Bank to the Company.  Without this primary source of revenue from the Bank, the Company expects to continue to defer the payment of dividends on its preferred stock.

Total deposits were $683.9 million at December 31, 2012, up from $672.6 million at December 31, 2011.  Deposit growth and retention within the Company’s retail branch bank network was sufficient to meet the Company’s funding requirements during 2011 and 2012.  In prior years, the Company used brokered deposits as a supplemental liquidity source.  The Consent Order prohibits the Bank from soliciting and accepting additional brokered certificates of deposit (including the renewal of existing brokered certificates of deposit) without prior approval from the FDIC and limits the rates the Bank can offer on its deposit products.  At December 31, 2012, brokered deposits totaled $937,000, compared to $2.6 million at December 31, 2011.  It is expected sufficient funds will be available from cash on hand, investment security repayments, and loan repayments to fund maturities of certificates of deposit.  At December 31, 2012, time deposits represented 43.3% of the Bank’s total deposits, compared to 50.5% at December 31, 2011.  Certificates of deposit of $100,000 or more represented 22.2% of the Bank’s total deposits at December 31, 2012, down from 25.2% at year-end 2011.  Management believes a sizeable portion of the Bank’s certificates of deposit are relationship-oriented, and based upon prior experience, anticipates a substantial portion of outstanding certificates of deposit will renew upon maturity, or be retained in other deposit products at the Bank.  Deposit retention is also influenced by limits on the rates the Bank can offer.

Borrowings from the FHLB of $4.0 million at December 31, 2011 were repaid in early 2012.  The remaining borrowing at December 31, 2012, was securities sold under agreements to repurchase, which totaled $436,000, down from $605,000 at December 31, 2011.  Additional collateral could be provided to increase the borrowing line at the FHLB if additional liquidity is needed.  Secured borrowings lines with two financial institutions totaling $12.0 million are also available to meet liquidity needs.

Capital Resources

At December 31, 2012 and 2011, the Company’s equity totaled $19.7 million and $18.5 million, respectively.  The $1.2 million increase in equity is primarily attributable to the Company’s 2012 net income.  The Company’s equity-to-assets ratio on those dates was 2.8% and 2.6%, respectively.  The Company is subject to minimum capital requirements, which are further discussed in “PART 1, Item 1 – Business — Supervision and Regulation.”

All capital ratios categorize the Company as “significantly undercapitalized” by regulatory measures at December 31, 2012.  The Company’s regulatory capital ratios as of that date consisted of a leverage ratio of 2.64%, a Tier I risk-based capital ratio of 4.85%, and a total risk-based capital ratio of 6.11%.  At December 31, 2011, these ratios were 2.48%, 4.14%, and 5.41%, respectively.  Pursuant to the Consent Order and Written Agreement, the Company and the Bank are required to develop and adopt a plan for achieving and maintaining capital ratios in excess of the minimum thresholds for the Bank to be well-capitalized, specifically Tier 1 capital of at least 8% of total assets and a total risk-based capital ratio of at least 12%.  Given the current state of the equity markets, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.

Note 17 to the accompanying consolidated financial statements presents an analysis of the Company’s and Bank’s regulatory capital position as of December 31, 2012 and 2011.
 

Asset/Liability Management

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign exchange rates, commodity prices, and other relevant market rates and prices such as equity prices.  Due to the nature of our operations, we are primarily exposed to interest rate risk and liquidity risk.
 
Interest rate risk within our consolidated balance sheets consists of reprice, option, and basis risks.  Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios.  Option risk arises from “embedded options” present in many financial instruments, such as loan prepayment options, deposit early withdrawal options, and interest rate options.  These options allow customers opportunities to benefit when market interest rates change, which typically results in higher expense or lower income for us.  Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of the profit spread on an interest-earning asset or interest-bearing liability.  Basis risk is also present in administered rate liabilities, such as savings accounts, negotiable order of withdrawal accounts, and money market accounts with respect to which historical pricing relationships to market rates may change due to the level or directional change in market interest rates.
 
We seek to avoid fluctuations in our net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates.  Accordingly, our Asset/Liability Committee (ALCO) and the Board of Directors monitor our interest rate sensitivity and liquidity on an ongoing basis.  The Board of Directors and ALCO oversee market risk management and establish risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its impact on net interest income and capital.  ALCO uses a variety of measures to gain a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships.

Management has chosen to restrict the level of credit risk in the Company’s investment portfolio and as such it is comprised primarily of debt and mortgage-backed securities issued by agencies of the United States and government-sponsored enterprises.  Management expects to continue this practice for the foreseeable future.  Furthermore, management has historically chosen to maintain a relatively short duration with respect to the investment portfolio as a whole.  Because of the Federal Reserve’s stance of maintaining interest rates at the current low levels through mid-2015, during 2012, the Bank purchased mainly callable U.S. government agency securities, with longer stated maturities, but which are expected to be called in the current rate environment.  While this strategy has resulted in an improvement in portfolio yield, it has generally increased the market price volatility and consequently, potential mark-to-market charges against the Company’s capital.
 
We use a simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates.  The model measures the impact on net interest income relative to a base-case scenario of hypothetical fluctuations in interest rates over the upcoming 12 and 24-month periods.  These simulations incorporate assumptions regarding balance sheet growth and mix, pricing, and the repricing and maturity characteristics of the existing and projected consolidated balance sheets.  Other interest rate related risks, such as prepayment, basis, and option risk, are also considered in the model.
 
ALCO continuously monitors and manages the volume of interest-sensitive assets and interest-sensitive liabilities.  Interest-sensitive assets and liabilities are those that reprice or mature within a given timeframe.  The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels.  In order to meet this objective and mitigate potential market risk, management develops and implements investment, lending, funding, and pricing strategies.

As of December 31, 2012, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 200, 300 and 400 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates as of December 31, 2012.  Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant.  However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements.  Therefore, management’s assumptions may or may not prove valid.  No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions.  Although measured, we believe the downward movements included below are neither realistic nor anticipated in the current historically low interest rate environment and the monetary policy stance the Federal Reserve has taken regarding maintaining interest rates at the current low levels through mid-2015.
 

                         
   
Percentage Change in Net Interest Income from Base
 
   
Immediate Shock
   
Gradual Ramp
 
Interest Rate Scenario (1)
 
12 Months
   
24 Months
   
12 Months
   
24 Months
 
                         
Up 400 basis points
    18.1 %     13.7 %     10.8 %     17.5 %
Up 300 basis points
    16.0 %     13.8 %     9.0 %     15.2 %
Up 200 basis points
    12.8 %     12.6 %     8.3 %     13.5 %
Base
    -       -       -       -  
Down 200 basis points
    -22.4 %     -31.4 %     -9.4 %     -21.2 %
Down 300 basis points
    -32.4 %     -45.1 %     -10.8 %     -27.3 %
Down 400 basis points
    -32.5 %     -45.3 %     -14.1 %     -33.5 %
 
 (1)
The rising and falling interest rate scenarios in the first two columns assume an immediate and parallel change in interest rates along the entire yield curve.  The gradual ramp scenarios presented in the third and fourth columns assume a gradual rise or fall in interest rates during the periods indicated.

There are material limitations with the model presented above, which include, but are not limited to:
 
 
 
It presents the balance sheet in a static position.  When assets and liabilities mature or reprice, they do not necessarily keep the same characteristics.
 
 
 
The computation of prospective impacts of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results.
 
 
 
The computations do not contemplate any additional actions we could undertake in response to changes in interest rates.

Lending Activities

General

The Company provides a full range of short to medium-term commercial, mortgage, construction and personal loans, both secured and unsecured through conventional products and government guaranteed lending programs.  The Company’s loan policies and procedures establish the basic guidelines governing its lending operations.  Generally, the guidelines address the types of loans the Company seeks, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations.  All loans or credit lines are subject to approval procedures and amount limitations.  These limitations apply to the borrower’s total outstanding indebtedness to the Company, including the indebtedness of any guarantor.  The policies are reviewed and approved at least annually by the Board of Directors of the Company.  The Company supplements its own supervision of the loan underwriting and approval process with periodic loan audits by internal loan examiners, as well as by third-party professionals experienced in loan review work.  The Company has focused its portfolio lending activities on typically higher yielding commercial, construction, and consumer loans.  The Company also originates one-to-four family mortgages that are typically sold into the secondary market.
 
 
The following tables provide additional information regarding the Company’s loan portfolio as of December 31 of each year indicated.  The “Loan Summary” table provides an analysis of the composition of the loan portfolio by type of loan.  The “Loan Maturity Schedule” presents (i) the aggregate contractual maturities of commercial, industrial and commercial mortgage loans and of real estate constructions loans and (ii) the aggregate amounts of such loans by variable and fixed rates as of December 31, 2012.
 
Portfolio Loan Summary (1)