6. Loans and Allowance for Probable Loan Losses

The following table sets forth loan totals for the periods presented (in thousands):

	At			At
	March 31,			December 31,
	2011			2010
Real Estate Loans:
Construction		$	111,635	$	115,094
1-4 Family residential			218,178		219,031
Other			202,986		200,723
Commercial loans			143,265		148,761
Municipal loans			198,561		196,594
Loans to individuals			189,019		197,717
Total loans		$	1,063,644	$	1,077,920

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 found during the 1980's that longer periods would 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 signed off on 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 and 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 for 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, during 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 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;

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 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 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 six 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):

	Three Months Ended March 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 for loan losses		247		74			(148	)		190			(2	)		1,634			143		2,138
Loans charged off		-		(319	)		(80	)		(550	)		-			(3,099	)		-		(4,048	)
Recoveries of loans charged off		-		65			195			111			-			608			-		979
Balance at end of period	$	2,832	$	1,808		$	3,321		$	3,497		$	605		$	7,121		$	596	$	19,780

Ending balance - individually evaluated for impairment	$	1,157	$	763		$	835		$	1,798		$	118		$	427		$	-	$	5,098
Ending balance - collectively evaluated for impairment		1,675		1,045			2,486			1,699			487			6,694			596		14,682
Balance at end of period	$	2,832	$	1,808		$	3,321		$	3,497		$	605		$	7,121		$	596	$	19,780

	Three Months Ended March 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 for loan losses		195			234			144			590			114		2,523			67		3,867
Loans charged off		(873	)		(108	)		(200	)		(613	)		-		(3,132	)		-		(4,926	)
Recoveries of loans charged off		15			3			-			58			-		555			-		631
Balance at end of period	$	2,417		$	1,589		$	3,119		$	3,219		$	514	$	7,267		$	1,343	$	19,468

Ending balance - individually evaluated for impairment	$	1,172		$	451		$	550		$	1,293		$	133	$	473		$	-	$	4,072
Ending balance - collectively evaluated for impairment		1,245			1,138			2,569			1,926			381		6,794			1,343		15,396
Balance at end of period	$	2,417		$	1,589		$	3,119		$	3,219		$	514	$	7,267		$	1,343	$	19,468

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

	Three Months Ended March 31,
	2011		2010
	(in thousands)
Reserve For Unfunded Loan Commitments:
Balance at beginning of year	$	30	$	5
Provision for losses on unfunded loan commitments		-		15
Balance at end of year	$	30	$	20

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
March 31, 2011	Construction		1-4 Family Residential		Other		Commercial Loans		Municipal Loans		Loans to Individuals		Total

Loans individually evaluated for impairment	$	9,826	$	7,832	$	10,294	$	10,978	$	709	$	1,474	$	41,113
Loans collectively evaluated for impairment		101,809		210,346		192,692		132,287		197,852		187,545		1,022,531
Total ending loans balance	$	111,635	$	218,178	$	202,986	$	143,265	$	198,561	$	189,019	$	1,063,644

	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):

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

Real Estate Loans:
Construction	$	101,810	$	760	$	1,362	$	7,623	$	80	$	-	$	111,635
1-4 Family residential		210,346		634		1,347		5,093		758		-		218,178
Other		192,692		100		4,732		5,364		98		-		202,986
Commercial loans		132,287		1,983		1,186		7,459		350		-		143,265
Municipal loans		197,852		258		-		451		-		-		198,561
Loans to individuals		176,061		8,328		23		2,818		1,780		9		189,019
Total	$	1,011,048	$	12,063	$	8,650	$	28,808	$	3,066	$	9	$	1,063,644

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:

	At March 31, 2011		At December 31, 2010
	(in thousands)

Nonaccrual loans	$	14,289	$	14,524
Accruing loans past due more than 90 days		63		7
Restructured loans		2,036		2,320
Other real estate owned		452		220
Repossessed assets		353		638
Total Nonperforming Assets	$	17,193	$	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):

	March 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	$	4,225	$	-	$	4,730	$	-
1-4 Family residential		2,778		-		2,353		-
Other		2,006		-		1,428		-
Commercial loans		1,903		63		1,799		-
Loans to individuals		3,377		-		4,214		7
Total	$	14,289	$	63	$	14,524	$	7

The following table presents the aging of the recorded investment in past due loans as of March 31, 2011 by class of loans (in thousands):

	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	$	1,032	$	285	$	4,225	$	5,542	$	106,093	$	111,635
1-4 Family residential		3,536		762		2,778		7,076		211,102		218,178
Other		951		-		2,006		2,957		200,029		202,986
Commercial loans		600		522		1,966		3,088		140,177		143,265
Municipal loans		-		-		-		-		198,561		198,561
Loans to individuals		4,161		585		3,377		8,123		180,896		189,019
Total	$	10,280	$	2,154	$	14,352	$	26,786	$	1,036,858	$	1,063,644

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

	March 31,		December 31,
	2011		2010
Loans with no allocated allowance for loan losses	$	45	$	69
Loans with allocated allowance for loan losses		16,245		16,699
Total	$	16,290	$	16,768

Amount of the allowance for loan losses allocated	$	3,457	$	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.

Interest income recognized on nonaccrual and restructured loans by class of loans for the periods presented (in thousands):

	March 31, 2011
	Interest Income Recognized		Accruing Interest at Original Contracted Rate

Real Estate Loans:
Construction	$	3	$	80
1-4 Family residential		3		47
Other		15		38
Commercial loans		4		22
Municipal loans		-		-
Loans to individuals		120		351
Total	$	145	$	538

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.

March 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	$	5,564	$	-	$	4,225	$	4,225	$	512	$	4,290
1-4 Family residential		2,837		-		2,778		2,778		465		2,490
Other		2,398		-		2,006		2,006		219		1,633
Commercial loans		1,941		-		1,903		1,903		703		1,821
Municipal loans		-		-		-		-		-		-
Loans to individuals		5,668		45		5,333		5,378		1,558		6,003
Total	$	18,408	$	45	$	16,245	$	16,290	$	3,457	$	16,237

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
Municipal loans		-		-		-		-		-		-
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