7.	LOANS AND ALLOWANCE FOR PROBABLE LOAN LOSSES

Loans in the accompanying consolidated balance sheets are classified as follows:

	December 31,		December 31,
	2011		2010
	(in thousands)
Real Estate Loans:
Construction	$	111,361	$	115,094
1-4 family residential		247,479		219,031
Other		206,519		200,723
Commercial loans		143,552		148,761
Municipal loans		207,261		196,594
Loans to individuals		171,058		197,717
Total loans		1,087,230		1,077,920
Less: Allowance for loan losses		18,540		20,711
Net loans	$	1,068,690	$	1,057,209

Loans to Affiliated Parties

In the normal course of business, we make loans to certain of our own executive officers and directors and their related interests. As of December 31, 2011 and 2010, these loans totaled $4.1 million and $4.7 million, respectively. These loans represented 1.6% and 2.2% of shareholders' equity as of December 31, 2011 and 2010, respectively. Such loans are made in the normal course of business at normal credit terms, including interest rate and collateral requirements and do not represent more than normal credit risks contained in the rest of the loan portfolio for loans of similar types.

Allowance for Loan Losses

The allowance for loan losses is based on the most current review of the loan portfolio and is validated by multiple processes. First, the bank utilizes historical data to establish general reserve amounts for each class of loans. While we track several years of data, we primarily review one year data because we have found that longer periods will not respond quickly enough to market conditions. Second, our lenders have the primary responsibility for identifying problem loans and estimating necessary reserves based on customer financial stress and underlying collateral. These recommendations are reviewed by the Senior lender, the Special Assets department, and the Loan Review department and are reviewed by the President. Third, the Loan Review department does independent reviews of the portfolio on an annual basis. The Loan Review department follows a board-approved annual loan review scope. The loan review scope encompasses a number of metrics that takes into consideration the size of the loan, the type of credit extended, the seasoning of the loan along with the performance of the loan. The loan review scope as it relates to size, focuses more on larger dollar loan relationships, typically, for example, aggregate debt of $500,000 or greater. The Loan Review officer also tracks specific reserves for loans by type compared to general reserves to determine trends in comparative reserves as well as losses not reserved for prior to charge off to determine the efficiency of the specific reserve process.

At each review, a subjective analysis methodology is used to grade the respective loan. Categories of grading vary in severity from loans that do not appear to have a significant probability of loss at the time of review to loans that indicate a probability that the entire balance of the loan will be uncollectible. If full collection of the loan balance appears unlikely at the time of review, estimates of future expected cash flows or appraisals of the collateral securing the debt are used to allocate the necessary allowances. The internal loan review department maintains a list of all loans or loan relationships that are graded as having more than the normal degree of risk associated with them. In addition, a list of specifically reserved loans or loan relationships of $50,000 or more is updated on a quarterly basis in order to properly allocate necessary allowances and keep management informed on the status of attempts to correct the deficiencies noted with respect to the loan.

For loans to individuals, the methodology associated with determining the appropriate allowance for losses on loans primarily consists of an evaluation of individual payment histories, remaining term to maturity and underlying collateral support.

Industry experience indicates that a portion of our loans will become delinquent and a portion of the loans will require partial or entire charge-off. Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of properties used as collateral for loans and problems affecting the credit of the borrower and the ability of the borrower to make payments on the loan. Our determination of the adequacy of allowance for loan losses is based on various considerations, including an analysis of the risk characteristics of various classifications of loans, previous loan loss experience, specific loans which would have loan loss potential, delinquency trends, estimated fair value of the underlying collateral, current economic conditions, the views of the bank regulators (who have the authority to require additional allowances), and geographic and industry loan concentration.

Consumer loans at SFG are reserved for based on general estimates of loss at the time of purchase for current loans. SFG loans experiencing past due status or extension of maturity characteristics are reserved at significantly higher levels based on the circumstances associated with each specific loan. In general, the reserves for SFG are calculated based on the past due status of the loan. For reserve purposes, the portfolio has been segregated by past due status and by the remaining term variance from the original contract. During repayment, loans that pay late will take longer to pay out than the original contract. Additionally, some loans may be granted extensions for extenuating payment circumstances. The remaining term extensions increase the risk of collateral deterioration and, accordingly, reserves are increased to recognize this risk.

For loans originated after August 1, 2010, additional reserve methods have been added. New pools purchased are reserved at their estimated annual loss. Thereafter, the reserve is adjusted based on the actual performance versus projected performance. Additionally, beginning with the fourth quarter of 2010, data mining measures were further enhanced to track migration within risk tranches. Reserves are adjusted quarterly to match the migration metrics.

Credit Quality Indicators

We categorize loans into risk categories on an ongoing basis, based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We use the following definitions for risk ratings:

Satisfactory (Rating 1 – 4) – This rating is assigned to all satisfactory loans. This category, by definition, should consist of completely acceptable credit. Credit and collateral exceptions should not be present, although their presence would not necessarily prohibit a loan from being rated Satisfactory, if deficiencies are in process of correction. These loans will not be included in the Watch List.

Satisfactory (Rating 5) – Special Treatment Required – (Pass Watch) – These loans require some degree of special treatment, but not due to credit quality. This category does not include loans specially mentioned or adversely classified by the Loan Review Officer or regulatory authorities; however, particular attention must be accorded such credits due to characteristics such as:

A lack of, or abnormally extended payment program;

A heavy degree of concentration of collateral without sufficient margin;

A vulnerability to competition through lesser or extensive financial leverage; and

A dependence on a single, or few customers, or sources of supply and materials without suitable substitutes or alternatives.

Special Mention (Rating 6) – A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution's credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard (Rating 7) – Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful (Rating 8) – Loans classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation, in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.

Loss (Rating 9) – Loans classified as Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

Loans not meeting risk ratings five through nine are reserved for as a group of similar type pass rated credits and included in the general portion of the allowance for loan losses.

The general portion of the loan loss allowance is reflective of historical charge-off levels for similar loans adjusted for changes in current conditions and other relevant factors. These factors are likely to cause estimated losses to differ from historical loss experience and include:

Changes in lending policies or procedures, including underwriting, collection, charge-off, and recovery procedures;

Changes in local, regional and national economic and business conditions including entry into new markets;

Changes in the volume or type of credit extended;

Changes in the experience, ability, and depth of lending management;

Changes in the volume and severity of past due, nonaccrual, restructured, or classified loans;

Changes in loan review or Board oversight; and

Changes in the level of concentrations of credit.

The following table details activity in the Allowance for Loan Losses by portfolio segment for the periods presented (in thousands):

	Year Ended December 31, 2011
	Real Estate
	Construction			1-4 Family Residential			Other			Commercial Loans			Municipal Loans		Loans to Individuals			Unallocated		Total

Balance at beginning of period	$	2,585		$	1,988		$	3,354		$	3,746		$	607	$	7,978		$	453	$	20,711
Provision (reversal) for loan losses		20			546			(307	)		(64	)		12		6,570			719		7,496
Loans charged off		(46	)		(675	)		(271	)		(1,254	)		–		(10,231	)		–		(12,477	)
Recoveries of loans charged off		61			98			275			449			–		1,927			–		2,810
Balance at end of period	$	2,620		$	1,957		$	3,051		$	2,877		$	619	$	6,244		$	1,172	$	18,540

	Year Ended December 31, 2010
	Real Estate
	Construction			1-4 Family Residential			Other			Commercial Loans			Municipal Loans		Loans to Individuals			Unallocated			Total

Balance at beginning of period	$	3,080		$	1,460		$	3,175		$	3,184		$	400	$	7,321		$	1,276		$	19,896
Provision (reversal) for loan losses		213			803			756			2,311			207		10,270			(823	)		13,737
Loans charged off		(873	)		(288	)		(577	)		(2,603	)		–		(12,072	)		–			(16,413	)
Recoveries of loans charged off		165			13			–			854			–		2,459			–			3,491
Balance at end of period	$	2,585		$	1,988		$	3,354		$	3,746		$	607	$	7,978		$	453		$	20,711

	Year Ended December 31, 2009
	Real Estate
	Construction			1-4 Family Residential			Other			Commercial Loans			Municipal Loans		Loans to Individuals			Unallocated		Total

Balance at beginning of period	$	2,757		$	1,567		$	2,701		$	2,496		$	341	$	6,206		$	44	$	16,112
Provision (reversal) for loan losses		1,253			155			796			2,621			59		8,977			1,232		15,093
Loans charged off		(932	)		(267	)		(322	)		(2,037	)		–		(9,589	)		–		(13,147	)
Recoveries of loans charged off		2			5			–			104			–		1,727			–		1,838
Balance at end of period	$	3,080		$	1,460		$	3,175		$	3,184		$	400	$	7,321		$	1,276	$	19,896

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as described in the allowance for loan losses methodology discussion as of December 31, 2011 (in thousands):

	Year Ended December 31, 2011
	Real Estate
	Construction		1-4 Family Residential		Other		Commercial Loans		Municipal Loans		Loans to Individuals		Unallocated		Total

Ending balance – individually evaluated for impairment	$	888	$	788	$	511	$	1,108	$	110	$	347	$	–	$	3,752
Ending balance – collectively evaluated for impairment		1,732		1,169		2,540		1,769		509		5,897		1,172		14,788
Balance at end of period	$	2,620	$	1,957	$	3,051	$	2,877	$	619	$	6,244	$	1,172	$	18,540

	Year Ended December 31, 2010
	Real Estate
	Construction		1-4 Family Residential		Other		Commercial Loans		Municipal Loans		Loans to Individuals		Unallocated		Total

Ending balance – individually evaluated for impairment	$	1,214	$	832	$	914	$	1,986	$	125	$	442	$	–	$	5,513
Ending balance – collectively evaluated for impairment		1,371		1,156		2,440		1,760		482		7,536		453		15,198
Balance at end of period	$	2,585	$	1,988	$	3,354	$	3,746	$	607	$	7,978	$	453	$	20,711

The following table details activity of the Reserve for Unfunded Loan Commitments for the periods presented (in thousands):

	Years Ended December 31,
	2011			2010		2009
Reserve For Unfunded Loan Commitments:
Balance at beginning of period	$	30		$	5	$	7
Provision (reversal) for losses on unfunded loan commitments		(4	)		25		(2	)
Balance at end of period	$	26		$	30	$	5

The following table sets forth the balance in the recorded investment in loans by portfolio segment based on impairment method as described in the allowance for loan losses methodology discussion for the periods presented (in thousands):

	Real Estate
December 31, 2011	Construction		1-4 Family Residential		Other		Commercial Loans		Municipal Loans		Individuals		Total

Loans individually evaluated for impairment	$	6,274	$	12,453	$	9,394	$	5,986	$	651	$	1,320	$	36,078
Loans collectively evaluated for impairment		105,087		235,026		197,125		137,566		206,610		169,738		1,051,152
Total ending loans balance	$	111,361	$	247,479	$	206,519	$	143,552	$	207,261	$	171,058	$	1,087,230

	Real Estate
December 31, 2010	Construction		1-4 Family Residential		Other		Commercial Loans		Municipal Loans		Loans to Individuals		Total

Loans individually evaluated for impairment	$	10,355	$	8,331	$	10,688	$	12,144	$	738	$	1,625	$	43,881
Loans collectively evaluated for impairment		104,739		210,700		190,035		136,617		195,856		196,092		1,034,039
Total ending loans balance	$	115,094	$	219,031	$	200,723	$	148,761	$	196,594	$	197,717	$	1,077,920

The following table sets forth loans by credit quality indicator for the periods presented (in thousands):

December 31, 2011	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Loss		Total

Real Estate Loans:
Construction	$	105,087	$	785	$	20	$	5,285	$	184	$	–	$	111,361
1-4 Family residential		235,026		1,763		5,299		4,345		1,046		–		247,479
Other		197,126		2,911		2,877		3,475		130		–		206,519
Commercial loans		137,565		908		242		4,772		55		10		143,552
Municipal loans		206,610		231		–		420		–		–		207,261
Loans to individuals		169,738		81		–		976		236		27		171,058
Total	$	1,051,152	$	6,679	$	8,438	$	19,273	$	1,651	$	37	$	1,087,230

December 31, 2010	Pass		Pass Watch		Special Mention		Substandard		Doubtful		Loss		Total

Real Estate Loans:
Construction	$	104,739	$	761	$	1,420	$	8,174	$	–	$	–	$	115,094
1-4 Family residential		210,699		812		1,379		5,332		809		–		219,031
Other		190,036		102		4,784		5,418		298		85		200,723
Commercial loans		136,617		2,273		1,224		8,403		199		45		148,761
Municipal loans		195,856		258		–		480		–		–		196,594
Loans to individuals		182,174		8,766		27		4,564		2,175		11		197,717
Total	$	1,020,121	$	12,972	$	8,834	$	32,371	$	3,481	$	141	$	1,077,920

The following table sets forth nonperforming assets for the periods presented (in thousands):

	At December 31, 2011		At December 31, 2010

Nonaccrual loans	$	10,299	$	14,524
Accruing loans past due more than 90 days		5		7
Restructured loans		2,109		2,320
Other real estate owned		453		220
Repossessed assets		322		638
Total Nonperforming Assets	$	13,188	$	17,709

Nonaccrual and Past Due Loans

Nonaccrual loans are those loans which are 90 days or more delinquent and collection in full of both the principal and interest is in doubt. Additionally, some loans that are not delinquent may be placed on nonaccrual status due to doubts about full collection of principal or interest. When a loan is categorized as nonaccrual, the accrual of interest is discontinued and the accrued balance is reversed for financial statement purposes. Payments of contractual interest are recognized as income only to the extent that full recovery of the principal balance of the loan is reasonably certain. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Other factors, such as the value of collateral securing the loan and the financial condition of the borrower must be considered in judgments as to potential loan loss.

Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of the expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. In measuring the fair value of the collateral, in addition to relying on third party appraisals, we use assumptions such as discount rates, and methodologies, such as comparison to the recent selling price of similar assets, consistent with those that would be utilized by unrelated third parties performing a valuation.

Nonaccrual loans and accruing loans past due more than 90 days include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

The following table sets forth the recorded investment in nonaccrual and accruing loans past due more than 90 days by class of loans for the periods presented (in thousands):

	December 31, 2011				December 31, 2010
	Nonaccrual		Accruing Loans Past Due More Than 90 Days		Nonaccrual		Accruing Loans Past Due More Than 90 Days
Real Estate Loans:
Construction	$	3,894	$	–	$	4,730	$	–
1-4 Family residential		2,362		–		2,353		–
Other		781		–		1,428		–
Commercial loans		1,353		–		1,799		–
Loans to individuals		1,909		5		4,214		7
Total	$	10,299	$	5	$	14,524	$	7

The following tables present the aging of the recorded investment in past due loans by class of loans (in thousands):

	December 31, 2011
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Loans Not Past Due		Total
Real Estate Loans:
Construction	$	185	$	146	$	3,894	$	4,225	$	107,136	$	111,361
1-4 Family residential		4,289		1,051		2,362		7,702		239,777		247,479
Other		1,129		296		781		2,206		204,313		206,519
Commercial loans		1,353		129		1,353		2,835		140,717		143,552
Municipal loans		–		–		–		–		207,261		207,261
Loans to individuals		4,614		960		1,914		7,488		163,570		171,058
Total	$	11,570	$	2,582	$	10,304	$	24,456	$	1,062,774	$	1,087,230

	December 31, 2010
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Loans Not Past Due		Total
Real Estate Loans:
Construction	$	515	$	655	$	4,730	$	5,900	$	109,194	$	115,094
1-4 Family residential		3,437		641		2,353		6,431		212,600		219,031
Other		350		399		1,428		2,177		198,546		200,723
Commercial loans		500		227		1,799		2,526		146,235		148,761
Municipal loans		–		–		–		–		196,594		196,594
Loans to individuals		6,477		1,306		4,221		12,004		185,713		197,717
Total	$	11,279	$	3,228	$	14,531	$	29,038	$	1,048,882	$	1,077,920

Impaired loans, primarily nonaccrual loans, were as follows (in thousands):

	December 31,		December 31,
	2011		2010
Loans with no allocated allowance for loan losses	$	4	$	69
Loans with allocated allowance for loan losses		12,366		16,699
Total	$	12,370	$	16,768

Amount of the allowance for loan losses allocated	$	2,639	$	3,864

At any time a potential loss is recognized in the collection of principal, proper reserves should be allocated. Loans are charged off when deemed uncollectible. Loans are charged down as soon as collection by liquidation is evident to the liquidation value of the collateral net of liquidation costs, if any, and placed in nonaccrual status.

The following table sets forth interest income recognized on nonaccrual and restructured loans by class of loans for the periods presented (in thousands):

	December 31, 2011				December 31, 2010
	Interest Income Recognized		Accruing Interest at Original Contracted Rate		Interest Income Recognized		Accruing Interest at Original Contracted Rate

Real Estate Loans:
Construction	$	18	$	292	$	4	$	356
1-4 Family residential		112		153		49		139
Other		50		130		16		117
Commercial loans		2		65		8		48
Loans to individuals		761		1,191		980		1,547
Total	$	943	$	1,831	$	1,057	$	2,207

The amount of interest recognized on loans that were nonaccruing or restructured during the year was $1.2 million for the year ended December 31, 2009. If these loans had been accruing interest at their original contracted rates, related income would have been $1.7 million for the year ended December 31, 2009.

The following table sets forth impaired loans by class of loans for the periods presented (in thousands). Average recorded investment is reported on a year-to-date basis.

December 31, 2011	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Total Recorded Investment		Loan Losses Allocated		Average Recorded Investment

Real Estate Loans:
Construction	$	4,909	$	–	$	3,895	$	3,895	$	597	$	4,054
1-4 Family residential		2,449		–		2,362		2,362		320		2,362
Other		1,930		–		1,508		1,508		380		1,744
Commercial loans		1,570		–		1,493		1,493		485		1,748
Loans to individuals		3,389		4		3,108		3,112		857		4,508
Total	$	14,247	$	4	$	12,366	$	12,370	$	2,639	$	14,416

December 31, 2010	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Total Recorded Investment		Loan Losses Allocated		Average Recorded Investment

Real Estate Loans:
Construction	$	6,045	$	–	$	4,730	$	4,730	$	562	$	6,013
1-4 Family residential		2,453		–		2,354		2,354		426		1,250
Other		1,807		–		1,428		1,428		179		1,445
Commercial loans		1,826		–		1,799		1,799		719		1,950
Loans to individuals		6,854		69		6,388		6,457		1,978		7,904
Total	$	18,985	$	69	$	16,699	$	16,768	$	3,864	$	18,562

Troubled Debt Restructurings

The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Effective July 1, 2011, we adopted the provisions of Accounting Standards Update No. 2011-02, “Receivables (Topic 310) – A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” We reassessed all loan modifications occurring since January 1, 2011 for identification as troubled debt restructurings.

The following table sets forth troubled debt restructurings for the period presented (in thousands):

	Year Ended December 31, 2011
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Real Estate Loans:
Construction		2	$	93	$	87
1-4 Family residential		4		325		320
Other		1		732		728
Commercial loans		2		141		141
Loans to individuals		12		111		89
Total			$	1,402	$	1,365

The loans identified as troubled debt restructurings were previously reported as impaired loans prior to restructuring. The loan modifications related to extending the amortization periods were $963,000, lowering interest rates were $358,000 and principal forgiveness of the loans were $37,000. In addition, loan modifications extending the amortization period, lowering interest rates and principal forgiveness were $7,000. Of the loans restructured during the year ended December 31, 2011, $473,000 were on nonaccrual status as of December 31, 2011. Because the loans were classified and on nonaccrual status both before and after restructuring, the modifications did not impact our determination of the allowance for loan losses. For the year ended December 31, 2011, there have been no defaults on any loans that were modified as troubled debt restructurings during the preceding twelve months.