vyfc-2013.06.30-10Q

10-Q 1 vyfc-20130630x10q.htm 10-Q vyfc-2013.06.30-10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the Quarterly Period Ended	June 30, 2013

[ ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the transition period from _____________________________to_____________________________________

Commission File Number: 000-28342

VALLEY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)



VIRGINIA	54-1702380
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

36 Church Avenue, S.W.
Roanoke, Virginia	24011
(Address of principal executive offices)	(Zip Code)
(540) 342-2265
(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address, and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þNo 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 (Section 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 Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer o	Accelerated filer o

Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company þ

Indicate by checkmark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act.)

Yes o No þ

At August 13, 2013, 4,787,269 shares of common stock, no par value, of the registrant were outstanding.

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VALLEY FINANCIAL CORPORATION

FORM 10-Q

June 30, 2013



TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets	4
Consolidated Statements of Income	5
Consolidated Statements of Comprehensive Income	6
Consolidated Statements of Cash Flows	7
Notes to Consolidated Financial Statements	8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	36
Item 3. Quantitative and Qualitative Disclosures about Market Risk	43
Item 4. Controls and Procedures	43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings	43
Item 1A. Risk Factors	44
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	44
Item 3. Defaults Upon Senior Securities	44
Item 4. Mine Safety Disclosures	44
Item 5. Other Information	44
Item 6. Exhibits	45
SIGNATURES	46
EXHIBIT INDEX	47

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Forward-Looking and Cautionary Statements

The Private Securities Litigation Reform Act of 1995 (the “1995 Act”) provides a safe harbor for forward-looking statements made by or on our behalf. These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of our management and on information available at the time these statements and disclosures were prepared.

This report includes forward-looking statements within the meaning of the 1995 Act. These statements are included throughout this report and relate to, among other things, projections of revenues, earnings, earnings per share, cash flows, capital expenditures, or other financial items, expectations regarding acquisitions, discussions of estimated future revenue enhancements, potential dispositions, and changes in interest rates. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins, profitability, liquidity, and capital resources. The words “believe”, “anticipate”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “will”, and similar terms and phrases identify forward-looking statements in this report.

Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside of our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct. Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a number of factors. Factors that may cause actual results to differ materially from those expected include the following:


•	General economic conditions may deteriorate and negatively impact the ability of borrowers to repay loans and depositors to maintain balances;


•	General decline in the residential real estate construction and finance market;


•	Decline in market value of real estate in the Company’s markets;


•	Changes in interest rates could reduce net interest income and/or the borrower’s ability to repay loans;


•	Competitive pressures among financial institutions may reduce yields and profitability;


•	Legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses that the Company is engaged in;


•	Increased regulatory supervision could limit our ability to grow and could require considerable time and attention of our management and board of directors;


•	New products developed or new methods of delivering products could result in a reduction in business and income for the Company;


•	The Company’s ability to continue to improve operating efficiencies;


•	Natural events and acts of God such as earthquakes, fires and floods;


•	Loss or retirement of key executives; and


•	Adverse changes may occur in the securities market.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

VALLEY FINANCIAL CORPORATION

Consolidated Balance Sheets

(In 000s, except share data)



	(Unaudited)			(Audited)
Assets	June 30, 2013			December 31, 2012
Cash and due from banks	$	9,292		$	9,576
Interest bearing deposits	10,084			10,227
Total cash and cash equivalents	19,376			19,803
Securities available for sale	153,899			124,220
Securities held to maturity (fair value 6/30/13: $24,730; 12/31/12: $27,791)	23,954			26,252
Loans, net of allowance for loan losses, 6/30/13: $8,030; 12/31/12: $8,060	544,894			533,893
Foreclosed assets	22,264			21,364
Premises and equipment, net	8,687			8,291
Bank owned life insurance	18,539			18,206
Accrued interest receivable	2,646			2,434
Other assets	12,080			10,121
Total assets	$	806,339		$	764,584
Liabilities and Shareholders' Equity
Liabilities:
Non-interest bearing deposits	$	27,120		$	24,289
Interest bearing deposits	638,855			596,812
Total deposits	665,975			621,101
Securities sold under agreements to repurchase	20,474			19,745
FHLB borrowings	38,000			38,000
Junior subordinated debentures	16,496			16,496
Accrued interest payable	335			337
Other liabilities	4,659			4,674
Total liabilities	745,939			700,353
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; 11,219 shares issued and outstanding at June 30, 2013 and 14,419 shares issued and outstanding at December 31, 2012	11,160			14,256
Common stock, no par value; 10,000,000 shares authorized; 4,787,269 shares issued and outstanding at June 30, 2013 and 4,760,095 shares issued and outstanding at December 31, 2012	24,150			23,940
Retained earnings	28,299			25,458
Accumulated other comprehensive income (loss)	(3,209		)	577
Total shareholders' equity	60,400			64,231
Total liabilities and shareholders' equity	$	806,339		$	764,584

See accompanying notes to consolidated financial statements

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VALLEY FINANCIAL CORPORATION

Consolidated Income Statements

(In 000s, except share and per share data)



	Three Months Ended (Unaudited)						Six Months Ended (Unaudited)
	6/30/2013			6/30/2012			6/30/2013		6/30/2012
Interest income
Interest and fees on loans	$	6,832		$	6,752		$	13,672	$	13,480
Interest on securities - taxable	831			1,126			1,531		2,207
Interest on securities - nontaxable	155			132			295		265
Interest on deposits in banks	7			14			13		26
Total interest income	7,825			8,024			15,511		15,978
Interest expense
Interest on deposits	670			1,082			1,352		2,358
Interest on borrowings	408			445			826		898
Total interest expense	1,078			1,527			2,178		3,256
Net interest income	6,747			6,497			13,333		12,722
Provision for loan losses	(130		)	(53		)	65		(53		)
Net interest income after provision for loan losses	6,877			6,550			13,268		12,775
Noninterest income
Service charges on deposit accounts	452			375			867		726
Mortgage fee income	213			173			396		305
Brokerage fee income, net	259			201			499		472
Realized gain on sale of securities	—			—			68		40
Other income	381			242			625		479
Total noninterest income	1,305			991			2,455		2,022
Noninterest expense
Compensation expense	2,970			2,609			5,930		5,239
Occupancy and equipment expense	459			393			922		770
Data processing expense	382			322			748		630
Insurance expense	210			317			402		617
Professional fees	199			237			362		460
Foreclosed asset expense, net	329			169			501		442
Other operating expense	860			794			1,660		1,554
Total noninterest expense	5,409			4,841			10,525		9,712
Income before income taxes	2,773			2,700			5,198		5,085
Income tax expense	845			831			1,577		1,557
Net income	$	1,928		$	1,869		$	3,621	$	3,528
Preferred dividends and accretion of discounts on warrants	198			245			425		489
Net income available to common shareholders	$	1,730		$	1,624		$	3,196	$	3,039
Earnings per share
Basic earnings per common share	$	0.36		$	0.34		$	0.67	$	0.64
Diluted earnings per common share	$	0.35		$	0.33		$	0.65	$	0.63
Weighted average common shares outstanding	4,789,813			4,742,222			4,784,631		4,735,826
Diluted average common shares outstanding	4,920,264			4,830,005			4,908,923		4,807,817
Dividends declared per common share	$	0.035		$	—		$	0.07	$	—

See accompanying notes to consolidated financial statements

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VALLEY FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income

(In 000s)



	Three Months Ended (Unaudited)						Six Months Ended (Unaudited)
	6/30/2013			6/30/2012			6/30/2013			6/30/2012
Net Income	$	1,928		$	1,869		$	3,621		$	3,528
Other comprehensive income (loss) ("OCI"):
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period	(5,289		)	791			(5,667		)	1,244
Tax related to unrealized gains (losses)	1,798			(269		)	1,927			(423		)
Reclassification adjustment for gains included in net income	—			—			(68		)	(40		)
Tax related to realized gains	—			—			23			14
Holding gains on securities transferred to HTM from AFS:
Holding gains amortized during period	(1		)	(4		)	(2		)	(8		)
Tax related to amortized holding gains	—			1			1			3
Total other comprehensive income (loss)	(3,492		)	519			(3,786		)	790
Total comprehensive income (loss)	$	(1,564	)	$	2,388		$	(165	)	$	4,318

See accompanying notes to consolidated financial statements

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VALLEY FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(In 000s)



	Six Months Ended (Unaudited)
	6/30/2013			6/30/2012
Cash flows from operating activities
Net income	$	3,621		$	3,528
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Provision for loan losses	65			(53		)
Depreciation and amortization of bank premises, equipment and software	408			346
Net amortization of bond premiums/discounts	822			1,154
Stock compensation expense	209			161
Net gains on sale of securities	(68		)	(40		)
Net losses and impairment writedowns on foreclosed assets and premises	202			89
Increase in value of life insurance contracts	(333		)	(316		)
(Increase) decrease in other assets	(2,021		)	1,429
Increase (decrease) in other liabilities	(18		)	244
Net cash and cash equivalents provided by operating activities	2,887			6,542
Cash flows from investing activities
Purchases of bank premises, equipment and software	(811		)	(740		)
Purchases of securities available-for-sale	(59,873		)	(56,579		)
Proceeds from maturities, calls, and paydowns of securities available-for-sale	25,704			62,317
Proceeds from maturities, calls, and paydowns of securities held-to-maturity	2,248			1,649
Proceeds from sale of foreclosed assets	894			162
Capitalized costs related to foreclosed assets	(263		)	(864		)
Increase in loans, net	(12,942		)	(27,464		)
Net cash and cash equivalents used in investing activities	(45,043		)	(21,519		)
Cash flows from financing activities
Increase in non-interest bearing deposits	2,831			283
Increase in interest bearing deposits	42,043			31,158
Principal repayments of borrowings	—			(10,000		)
Increase (decrease) in securities sold under agreements to repurchase	729			(2,988		)
Net proceeds from issuance of common stock	4			3
Redemptions of preferred stock	(3,200		)	—
Excess tax benefits from share-based payment agreements	52			—
Purchase and retirement of treasury stock	(54		)	—
Cash dividends paid	(676		)	(400		)
Net cash and cash equivalents provided by financing activities	41,729			18,056
Net increase (decrease) in cash and cash equivalents	(427		)	3,079
Cash and cash equivalents at beginning of period	19,803			30,724
Cash and cash equivalents at end of period	$	19,376		$	33,803
Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	2,180		$	3,307
Cash paid during the period for income taxes	$	1,782		$	1,224
Noncash financing and investing activities
Transfer of loans to foreclosed property	$	1,733		$	4,060

See accompanying notes to consolidated financial statements.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Note 1. Organization and Summary of Significant Accounting Policies

Valley Financial Corporation (the "Company") was incorporated under the laws of the Commonwealth of Virginia on March 15, 1994, primarily to serve as a holding company for Valley Bank (the "Bank"), which opened for business on May 15, 1995. The Company's fiscal year end is December 31.

The consolidated financial statements of the Company conform to generally accepted accounting principles and to general banking industry practices. The interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments of a normal recurring nature which are necessary for a fair presentation of the consolidated financial statements herein have been included. The consolidated financial statements herein should be read in conjunction with the Company's 2012 Annual Report on Form 10-K.

Interim financial performance is not necessarily indicative of performance for the full year.

The Company reports its activities as a single business segment.

Use of Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Subsequent Events

In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure.

Recent and Future Accounting Considerations

On April 22, 2013, the FASB issued guidance addressing application of the liquidation basis of accounting. The guidance is intended to clarify when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting. The amendments will be effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein and those requirements should be applied prospectively from the day that liquidation becomes imminent. Early adoption is permitted. The Company does not expect these amendments to have any effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations or cash flows.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Note 2. Securities

The carrying values, unrealized gains, unrealized losses, and approximate fair values of available-for-sale and held-to-maturity investment securities at June 30, 2013 are shown in the tables below. As of June 30, 2013, investments (including both available-for-sale and held-to-maturity) and restricted equity securities with amortized costs and fair values of $98,523 and $96,875 respectively, were pledged as collateral for public deposits, a line of credit available from the Federal Home Loan Bank, customer sweep accounts, and for other purposes as required or permitted by law.

The recent and rapid increase in long-term interest rates after the Federal Reserve signaled that tapering of its asset purchases in the market could come around the end of 2013 has resulted in a shift in the Company's investment portfolio from a net unrealized gain position to a net unrealized loss position. The Company's liquidity and capital positions are very strong and as such, the Company does not foresee a need to divest of these securities in the near future that could result in any significant loss. The amortized costs, gross unrealized gains and losses, and approximate fair values of securities available-for-sale (“AFS”) as of June 30, 2013 and December 31, 2012 were as follows:



	Amortized		Unrealized		Unrealized
June 30, 2013	Cost		Gains		Losses			Fair Values
U.S. Government and federal agency	$	10,012	$	—	$	(348	)	$	9,664
Government-sponsored enterprises *	33,584		—		(1,564		)	32,020
Mortgage-backed securities	73,037		131		(1,561		)	71,607
Collateralized mortgage obligations	10,851		78		(61		)	10,868
States and political subdivisions	31,433		1		(1,694		)	29,740
	$	158,917	$	210	$	(5,228	)	$	153,899



December 31, 2012
U.S. Government and federal agency	$	5,016	$	115	$	—		$	5,131
Government-sponsored enterprises *	34,138		79		(137		)	34,080
Mortgage-backed securities	51,856		696		(45		)	52,507
Collateralized mortgage obligations	10,537		135		(13		)	10,659
States and political subdivisions	21,956		53		(166		)	21,843
	$	123,503	$	1,078	$	(361	)	$	124,220

* Such as FNMA, FHLMC and FHLB.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

The amortized costs, gross unrealized gains and losses, and approximate fair values of securities held-to-maturity (“HTM”) as of June 30, 2013 and December 31, 2012 were as follows:



	Amortized		Unrealized		Unrealized
June 30, 2013	Cost		Gains		Losses			Fair Values
U.S. Government and federal agency	$	7,896	$	202	$	—		$	8,098
Mortgage-backed securities	192		11		—			203
Collateralized mortgage obligations	115		6		—			121
States and political subdivisions	15,751		559		(2		)	16,308
	$	23,954	$	778	$	(2	)	$	24,730



December 31, 2012
U.S. Government and federal agency	$	8,258	$	380	$	—	$	8,638
Mortgage-backed securities	231		16		—		247
Collateralized mortgage obligations	1,644		96		—		1,740
States and political subdivisions	16,119		1,047		—		17,166
	$	26,252	$	1,539	$	—	$	27,791

The amortized costs and approximate fair values of our total private-label collateralized mortgage obligations were $8 and $8, respectively, as of June 30, 2013. The amortized costs and approximate fair values of our total private-label collateralized mortgage obligations were $1,607 and $1,520, respectively, as of December 31, 2012.

The following tables present the maturity ranges of securities available-for-sale and held-to-maturity as of June 30, 2013 and the weighted average yields of such securities. Maturities may differ from scheduled maturities on mortgage-backed securities and collateralized mortgage obligations because the mortgages underlying the securities may be repaid prior to the scheduled maturity date. Maturities on all other securities are based on the contractual maturity. The weighted average yields are calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. Weighted average yields on tax-exempt obligations have been computed on a taxable equivalent basis using a tax rate of 34%.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



Investment Portfolio Maturity Distribution
	Available-for-Sale						Held-to-Maturity
	Amortized		Fair				Amortized		Fair
In thousands	Costs		Value		Yield		Costs		Value		Yield
U.S. Government and federal agency:
After five but within ten years	$	5,558	$	5,382	2.18	%	$	4,265	$	4,426	3.43	%
After ten years	4,454		4,282		2.32	%	3,631		3,672		3.22	%
Government-sponsored enterprises:
After five but within ten years	23,613		22,792		1.60	%	—		—		—	%
After ten years	9,971		9,228		2.79	%	—		—		—	%
Obligations of states and subdivisions:
Less than one year	—		—		—	%	300		304		3.75	%
After one but within five years	5,528		5,409		1.84	%	—		—		—	%
After five but within ten years	8,123		7,799		2.08	%	3,772		3,891		4.05	%
After ten years	17,782		16,532		3.06	%	11,679		12,113		4.59	%
Mortgage-backed securities	73,037		71,607		1.90	%	192		203		4.77	%
Collateralized mortgage obligations	10,851		10,868		1.69	%	115		121		4.16	%
Total	$	158,917	$	153,899			$	23,954	$	24,730

Total Securities by Maturity Period
Less than one year	$	—	$	—			$	300	$	304
After one but within five years	5,528		5,409				—		—
After five but within ten years	37,294		35,973				8,037		8,317
After ten years	32,207		30,042				15,310		15,785
Mortgage-backed securities*	73,037		71,607				192		203
Collateralized mortgage obligations*	10,851		10,868				115		121
Total by Maturity Period	$	158,917	$	153,899			$	23,954	$	24,730

* Maturities on mortgage-backed securities and collateralized mortgage obligations are not presented in this table because maturities may differ substantially from contractual terms due to early repayments of principal.

The following tables detail unrealized losses and related fair values in the Company’s available-for-sale and held-to-maturity investment securities portfolios. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of June 30, 2013 and December 31, 2012, respectively.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



	Temporarily Impaired Securities in AFS Portfolio
In thousands	Less than 12 months					Greater than 12 months					Total
			Unrealized					Unrealized					Unrealized
June 30, 2013	Fair Value		Losses			Fair Value		Losses			Fair Value		Losses
U.S. Government and federal agency	$	9,656	$	(348	)	$	—	$	—		$	9,656	$	(348	)
Government-sponsored enterprises	32,020		(1,564		)	—		—			32,020		(1,564		)
Mortgage-backed securities	59,560		(1,561		)	—		—			59,560		(1,561		)
Collateralized mortgage obligations	4,522		(53		)	549		(8		)	5,071		(61		)
States and political subdivisions	28,625		(1,646		)	1,063		(48		)	29,688		(1,694		)
	$	134,383	$	(5,172	)	$	1,612	$	(56	)	$	135,995	$	(5,228	)



December 31, 2012
Government-sponsored enterprises	$	16,930	$	(137	)	$	—	$	—	$	16,930	$	(137	)
Mortgage-backed securities	7,630		(45		)	—		—		7,630		(45		)
Collateralized mortgage obligations	2,921		(13		)	9		—		2,930		(13		)
States and political subdivisions	13,205		(166		)	—		—		13,205		(166		)
	$	40,686	$	(361	)	$	9	$	—	$	40,695	$	(361	)



	Temporarily Impaired Securities in HTM Portfolio
In thousands	Less than 12 months					Greater than 12 months				Total
			Unrealized					Unrealized				Unrealized
June 30, 2013	Fair Value		Losses			Fair Value		Losses		Fair Value		Losses
States and political subdivisions	442		(2		)	—		—		442		(2		)
	$	442	$	(2	)	$	—	$	—	$	442	$	(2	)

There were no securities with unrealized losses in the HTM portfolio at December 31, 2012.

Management considers the nature of the investment, the underlying causes of the decline in the market value and the severity and duration of the decline in market value in determining if impairment is other than temporary. Consideration is given to (1)the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) 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. At June 30, 2013, there were three securities in the portfolio with an unrealized loss for a period greater than 12 months of $56. As of June 30, 2013, management believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe such securities are other-than-temporarily impaired due to reasons of credit quality. Accordingly, as of June 30, 2013, management believes the impairments detailed in the table above are temporary and no impairment loss has been realized in the Company's consolidated income statement.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Note 3. Loans and Allowance for Loan and Lease Losses

The major components of loans in the consolidated balance sheets at June 30, 2013 and December 31, 2012 are as follows:



In thousands	6/30/2013			12/31/2012
Commercial	$	95,364		$	92,512
Real estate:
Commercial real estate	269,469			261,724
Construction real estate	41,807			41,690
Residential real estate	141,429			141,598
Consumer	4,723			4,154
Deferred loan fees, net	132			275
Gross loans	552,924			541,953
Allowance for loan losses	(8,030		)	(8,060		)
Net loans	$	544,894		$	533,893

Substantially all one-four family residential and commercial real estate loans collateralize the line of credit available from the Federal Home Loan Bank and substantially all commercial and construction loans collateralize the line of credit with the Federal Reserve Bank of Richmond Discount Window. The aggregate amount of deposit overdrafts that have been reclassified as loans and included in the consumer category in the above table as of June 30, 2013 and December 31, 2012 was $55 and $49, respectively.

Loan Origination. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management and the Board of Directors review and approve these policies and procedures on a periodic basis. A reporting system supplements the review process by providing management and the Board of Directors with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Company’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate market or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus income producing loans. At June 30, 2013, approximately 43% of the outstanding principal balance of the Company’s commercial real estate loans was secured by owner-occupied properties and 50% was secured by income-producing properties.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

With respect to construction and development loans that the Company may originate from time to time, the Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by recurring on-site inspections during the construction phase and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Residential real estate loans are secured by deeds of trust on 1-4 family residential properties. The Bank also serves as a broker for residential real estate loans placed in the secondary market. There are occasions when a borrower or the real estate does not qualify under secondary market criteria, but the loan request represents a reasonable credit risk. On these occasions, if the loan meets the Bank’s internal underwriting criteria, the loan will be closed and placed in the Company’s portfolio. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of collateral.

The Company routinely makes consumer loans, both secured and unsecured, for financing automobiles, home improvements, education, and personal investments. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative changes in a customer’s financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans.

Risk Management. It is the Company’s policy that loan portfolio credit risk shall be continually evaluated and categorized on a consistent basis. The Board of Directors recognizes that commercial, commercial real estate and construction lending involve varying degrees of risk, which must be identified, managed, and monitored through established risk rating procedures. Management’s ability to accurately segment the loan portfolio by the various degrees of risk enables the Bank to achieve the following objectives:


1.	Assess the adequacy of the Allowance for Loan and Lease Losses;


2.	Identify and track high risk situations and ensure appropriate risk management;


3.	Conduct portfolio risk analysis and make informed portfolio planning and strategic decisions; and


4.	Provide risk profile information to management, regulators and independent accountants as requested in a timely manner.

There are three levels of accountability in the risk rating process:

Risk Identification - The primary responsibility for risk identification lies with the account officer. It is the account officer's responsibility for the initial and ongoing risk rating of all notes and commitments in his or her portfolio. The account officer is the one individual who is closest to the credit relationship and is in the best position to identify changing risks. Account officers are required to continually review the risk ratings for their credit relationships and make timely adjustments, up or down, at the time the circumstances warrant a change. Account officers are responsible for ensuring that accurate and timely risk ratings are maintained at all times. Account officers are allowed a maximum 30-day period to assess current financial information (e.g. prepare credit analysis) which may influence the current risk rating. Account officers are required to review the risk ratings of loans assigned to their portfolios on a monthly basis and to certify to the accuracy of the ratings. Certifications are submitted to the Chief Credit Officer and Chief Lending Officer for review. All risk rating changes (upgrades and downgrades) must be approved by the Chief Credit Officer prior to submission for input into the Commercial Loan System.

Risk Supervision - In addition to the account officer’s process of assigning and managing risk ratings, the Chief Credit Officer is responsible for periodically reviewing the risk rating process employed by the account officers. Through credit administration, the Chief Credit Officer manages the credit process which, among other things, includes maintaining and managing the risk identification process. The Chief Credit Officer is responsible for the accuracy and timeliness of account officer risk ratings and has the authority to override account officer risk ratings and initiate rating changes, if warranted. Upgrades from a criticized or classified category to a pass category or upgrades within the criticized/classified categories require the approval of the Senior Loan Committee or Directors’ Loan Committee based

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

upon aggregate exposure. Upgrades must be reported to the Directors' Loan Committee and Board of Directors at their next scheduled meetings.

Risk Monitoring - Valley Bank has a loan review program to provide an independent validation of portfolio quality. This independent review is intended to assess adherence to underwriting guidelines, proper credit analysis and documentation. In addition, the loan review process is required to test the integrity, accuracy, and timeliness of account officer risk ratings and to test the effectiveness of the credit administration function's controls over the risk identification process. Portfolio quality and risk rating accuracy are evaluated during regularly scheduled portfolio reviews. Risk Management is required to report all loan review findings to the quarterly joint meeting of the Audit Committee and Directors’ Loan Committee.

Related party loans. In the ordinary course of business, the Company has granted loans to certain directors, executive officers, significant shareholders and their affiliates (collectively referred to as “related parties”). These loans were made on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other unaffiliated persons, and do not involve more than normal credit risk or present other unfavorable features.

Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The following schedule is an aging of past due loans receivable by portfolio segment as of June 30, 2013 and December 31, 2012:



In thousands	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days, Accruing
June 30, 2013
Commercial	$	30	$	129	$	1,041	$	1,200	$	94,164	$	95,364	$	—
Commercial real estate
Owner occupied	—		—		461		461		114,838		115,299		—
Income producing	—		—		—		—		135,129		135,129		—
Multifamily	—		—		—		—		19,041		19,041		—
Construction real estate
1 - 4 Family	—		—		—		—		18,303		18,303		—
Other	—		—		3,161		3,161		19,140		22,301		—
Farmland	—		—		—		—		1,203		1,203		—
Residential real estate
Equity Lines	24		—		59		83		28,079		28,162		—
1 - 4 Family	159		50		556		765		104,602		105,367		—
Junior Liens	24		—		—		24		7,876		7,900		—
Consumer
Credit Cards	9		5		—		14		1,212		1,226		—
Other	27		9		—		36		3,461		3,497		—
Deferred loan fees, net	—		—		—		—		132		132		—
Total	$	273	$	193	$	5,278	$	5,744	$	547,180	$	552,924	$	—

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



In thousands	30 - 59 Days Past Due		60 - 89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days, Accruing
December 31, 2012
Commercial	$	—	$	396	$	1,009	$	1,405	$	91,107	$	92,512	$	—
Commercial real estate
Owner occupied	185		466		408		1,059		112,852		113,911		—
Income producing	389		3,339		—		3,728		126,202		129,930		—
Multifamily	—		—		—		—		17,883		17,883		—
Construction real estate
1 - 4 Family	—		—		72		72		21,481		21,553		—
Other	—		—		4,233		4,233		14,680		18,913		—
Farmland	—		—		—		—		1,224		1,224		—
Residential real estate
Equity Lines	48		669		462		1,179		27,104		28,283		400
1 - 4 Family	612		50		659		1,321		104,892		106,213		—
Junior Liens	25		—		—		25		7,077		7,102		—
Consumer
Credit Cards	22		8		1		31		1,225		1,256		—
Other	—		5		3		8		2,890		2,898		1
Deferred loan fees, net	—		—		—		—		275		275		—
Total	$	1,281	$	4,933	$	6,847	$	13,061	$	528,892	$	541,953	$	401

As noted in the chart above, the Company made significant progress in reducing the level of past due loans from December 31, 2012 to June 30, 2013. During this period, total loans past due decreased $7,317 or 56% from $13,061 to $5,744. The greatest success was in the 30 - 89 day category, as these totals declined $5,748 or 93%.

Nonaccrual Loans. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Loans will be placed on nonaccrual status automatically when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of collection. In this case, the loan will continue to accrue interest despite its past due status. When interest accrual is discontinued, all unpaid accrued interest is reversed and any subsequent payments received are applied to the outstanding principal balance. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. The following is a schedule of loans receivable, by portfolio segment, on nonaccrual status as of June 30, 2013 and December 31, 2012:

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



In thousands	June 30, 2013		December 31, 2012
Commercial	$	1,170	$	1,498
Commercial real estate
Owner occupied	461		408
Construction real estate
1 - 4 Family	—		73
Other	3,161		4,233
Residential real estate
Equity Lines	59		62
1 - 4 Family	563		863
Junior Liens	—		45
Consumer
Other	—		3
Total	$	5,414	$	7,185

Had nonaccrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income in the amount of $164 during the six months ended June 30, 2013; $329 during the year ended December 31, 2012, and $165 during the six months ended June 30, 2012. There were four restructured loans totaling $2,923 at June 30, 2013 and there were six restructured loans totaling $3,201 at December 31, 2012.

Impaired Loans. Impaired loans are identified by the Company as loans in which it is determined to be probable that the borrower will not make interest and principal payments according to the contract terms of the loan. In determining impaired loans, our credit administration department reviews past-due loans, examiner classifications, Bank classifications, and a selection of other loans to provide evidence as to whether the loan is impaired. All loans rated as substandard are evaluated for impairment by the Bank’s Allowances for Loan and Lease Losses (“ALLL”) Committee. Once classified as impaired, the ALLL Committee individually evaluates the total loan relationship, including a detailed collateral analysis, to determine the reserve appropriate for each one. Any potential loss exposure identified in the collateral analysis is set aside as a specific reserve (valuation allowance) in the allowance for loan and lease losses. If the impaired loan is subsequently resolved and it is determined the reserve is no longer required, the specific reserve will be taken back into income during the period the determination is made. Impaired loans, or portions thereof, are charged off when deemed uncollectible. Impaired loans as of June 30, 2013 and December 31, 2012 are set forth in the following table:

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



In thousands	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
June 30, 2013
With no related allowance:
Commercial	$	1,752	$	1,962	$	—	$	1,967	$	26
Commercial real estate
Owner occupied	5,711		5,711		—		5,742		170
Income producing	4,573		4,573		—		4,602		143
Construction real estate
1 - 4 Family	337		337		—		557		13
Other	4,423		6,408		—		5,348		104
Farmland	175		175		—		177		5
Residential real estate
Equity Lines	498		503		—		502		11
1 - 4 Family	517		592		—		601		13
Consumer
Other	11		11		—		12		—
Total loans with no allowance	$	17,997	$	20,272	$	—	$	19,508	$	485
With an allowance recorded:
Commercial	554		554		121		554		1
Construction real estate
Other	2,566		8,139		1,337		2,566		—
Residential real estate
1 - 4 Family	491		491		6		491		—
Total loans with an allowance	$	3,611	$	9,184	$	1,464	$	3,611	$	1
Total:
Commercial	2,306		2,516		121		2,521		27
Commercial real estate	10,284		10,284		—		10,344		313
Construction real estate	7,501		15,059		1,337		8,648		122
Residential real estate	1,506		1,586		6		1,594		24
Consumer	11		11		—		12		—
Totals	$	21,608	$	29,456	$	1,464	$	23,119	$	486

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



In thousands	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
December 31, 2012
With no related allowance:
Commercial	$	2,527	$	2,796	$	—	$	2,959	$	94
Commercial real estate
Owner occupied	9,503		9,503		—		10,698		672
Income producing	4,627		4,627		—		3,000		179
Construction real estate
1 - 4 Family	798		1,047		—		1,363		46
Other	2,467		4,892		—		3,218		90
Farmland	179		179		—		182		13
Residential real estate
Equity Lines	551		555		—		569		24
1 - 4 Family	6,429		6,694		—		6,300		279
Consumer
Other	16		16		—		18		—
Total loans with no allowance	$	27,097	$	30,309	$	—	$	28,307	$	1,397
With an allowance recorded:
Commercial	94		106		10		120		—
Construction real estate
Other	2,566		8,139		1,338		2,566		—
Residential real estate
Junior Liens	45		48		11		49		—
Total loans with an allowance	$	2,705	$	8,293	$	1,359	$	2,735	$	—
Total:
Commercial	2,621		2,902		10		3,079		94
Commercial real estate	14,130		14,130		—		13,698		851
Construction real estate	6,010		14,257		1,338		7,329		149
Residential real estate	7,025		7,297		11		6,918		303
Consumer	16		16		—		18		—
Totals	$	29,802	$	38,602	$	1,359	$	31,042	$	1,397

Cash basis interest income on impaired loans was $550 for the six months ended June 30, 2013 and $1,375 for the year ended December 31, 2012.

Credit Quality Indicators. The Company categorizes loans and leases 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. This categorization is made on all commercial, commercial real estate and construction and development loans. The Company analyzes loans and leases individually by classifying the loans and leases as to credit risk. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

Risk rated 1

Highest Caliber Credit – to qualify as a “1”, a credit must be either fully secured by cash or secured by a portfolio of marketable securities within margin.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Risk rated 2

Very High Caliber Credit – to qualify as a “2”, a credit must be a borrower within an industry exhibiting strong trends. The borrower must be a highly-rated individual or company whose management, profitability, liquidity, and leverage are very strong and above industry averages. Borrower should show substantial liquidation net worth and income or alternative fund sources to retire the debt as agreed.

Risk rated 3

High Caliber Credit - to qualify as a “3”, the criteria of management, industry, profitability, liquidity, and leverage must be generally strong and comparable to industry averages. Borrower should show above average liquidation net worth and sufficient income or alternative fund sources to retire the debt as agreed.

Risk rated 4

Satisfactory Credit – to qualify as a “4”, a credit should be performing relatively close to expectations, with adequate evidence that the borrower is continuing to generate adequate cash flow to service debt. There should be no significant departure from the intended source and timing of repayment, and there should be no undue reliance on secondary sources of repayment. To the extent that some variance exists in one or more criteria being measured, it may be offset by the relative strength of other factors and/or collateral pledged to secure the transaction. A credit secured by a portfolio of marketable securities in an out-of-margin condition would qualify as a “4”. Borrower should show average liquidation net worth and income sufficient to retire the debt on an amortizing basis.

Risk rated 5

Monitored Satisfactory Credit – there are certain satisfactory credits, which have elements of risk that the Bank chooses to monitor formally. The objective of the monitoring process is to assure that no weaknesses develop in credits with certain financial or operating leverage, or credits, which are subject to cyclical economic or variable industry conditions. Also included in this category are credits with positive operating trends and satisfactory financial conditions, which are achieving performance expectations at a slower pace than anticipated. This rating may also include loans which exhibit satisfactory credit quality but which are improperly structured as evidenced by excessive renewals, unusually long repayment schedules, the lack of a specific repayment plan, or which exhibit loan policy exceptions or documentation deficiencies.

Risk rated 6

Special Mention – assets in this category are still adequately protected by the borrower’s capital adequacy and payment capability, but exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

Risk rated 7

Substandard - substandard loans are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.

Risk rated 8

Doubtful – an asset classified as doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimate loss is deferred until its more exact status may be determined. The Company’s practice is to charge-off the portion of the loan amount determined to be doubtful in the quarter that the determination is made if the repayment of the loan is collateral dependent.

Risk rated 9

Loss – assets classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

As of June 30, 2013 and December 31, 2012, and based on the most recent analysis performed at those dates, the risk category of loans and leases is as follows:



Internal Risk Rating Grades
In thousands	1-4		5		6		7
June 30, 2013
Commercial	$	27,580	$	63,569	$	1,484	$	2,731
Commercial real estate
Owner occupied	35,562		68,781		3,012		7,944
Income producing	17,175		102,817		5,957		9,180
Multifamily	10,022		9,019		—		—
Construction real estate
1 - 4 Family	5,561		10,053		1,367		1,322
Other	776		11,668		441		9,416
Farmland	225		317		486		175
Totals	$	96,901	$	266,224	$	12,747	$	30,768
Total:
Commercial	27,580		63,569		1,484		2,731
Commercial real estate	62,759		180,617		8,969		17,124
Construction real estate	6,562		22,038		2,294		10,913
Totals	$	96,901	$	266,224	$	12,747	$	30,768



December 31, 2012
Commercial	$	26,134	$	61,980	$	1,736	$	2,662
Commercial real estate
Owner occupied	36,195		62,662		2,557		12,497
Income producing	14,253		99,055		6,329		10,293
Multifamily	10,103		7,780		—		—
Construction real estate
1 - 4 Family	3,176		14,902		1,864		1,611
Other	—		9,489		2,505		6,919
Farmland	233		326		487		178
Totals	$	90,094	$	256,194	$	15,478	$	34,160
Total:
Commercial	26,134		61,980		1,736		2,662
Commercial real estate	60,551		169,497		8,886		22,790
Construction real estate	3,409		24,717		4,856		8,708
Totals	$	90,094	$	256,194	$	15,478	$	34,160

There are no loans classified as 8 or 9 as of June 30, 2013 and December 31, 2012.

As can be seen from the table above, the Company continues to make progress in reducing its problem assets. Loans risk rated 6 or 7 have decreased 12% from $49,638 at December 31, 2012 to $43,515 at June 30, 2013. Senior management remains focused on continued improvement of these "watch-list" loans.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

All consumer-related loans, including residential real estate are evaluated and monitored based upon payment activity. Once a consumer-related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment. At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances.



Risk Based on Payment Activity	Performing				Non-Performing
In thousands	6/30/2013		12/31/2012		6/30/2013		12/31/2012
Residential real estate
Equity Lines	$	28,103	$	28,221	$	59	$	62
1 - 4 Family	104,804		105,350		563		863
Junior Liens	7,900		7,057		—		45
Consumer
Credit Cards	1,226		1,256		—		—
Other	3,497		2,895		—		3
Totals	$	145,530	$	144,779	$	622	$	973
Total:
Residential real estate	140,807		140,628		622		970
Consumer	4,723		4,151		—		3
Totals	$	145,530	$	144,779	$	622	$	973

Allowance for Loan Losses

The allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Specific Valuation

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan is added to the internal watch list, the ALLL Committee analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, and economic conditions affecting the borrower’s industry, among other things.

Historical Valuation

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company uses a rolling 8-quarter analysis to determine its historical loss ratio for the specific pool. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the average balance of loans in the pool for the respective quarter. The loss factors used at June 30, 2013 and December 31, 2012 are as follows:



	6/30/2013	12/31/2012
Commercial	0.07%	0.03%
Commercial real estate - Owner occupied	0.10%	0.00%
Commercial real estate - Income producing	0.00%	0.00%
Commercial real estate - Multifamily	0.00%	0.18%
Construction real estate - 1-4 Family	0.42%	0.01%
Construction real estate - Other	3.09%	3.86%
Construction real estate - Farmland	0.00%	0.00%
Residential real estate - Equity lines	0.18%	0.07%
Residential real estate - 1-4 Family	0.37%	0.33%
Residential real estate - Junior Liens	0.00%	0.00%
Consumer & credit cards	0.31%	0.70%
Loans held for sale	0.00%	0.00%

The Company applies the historical loss ratios to balances of all loans within each category to establish a high range allowance. The Company applies the historical loss ratios to loan balances carrying risk ratings of 5 and higher to establish the low range allowance for this factor. The rationale behind excluding loans risk rated 1 – 4 from the low range is that these credits range from the very highest caliber to satisfactory and the Company has never had a loan move from a 4 rated credit to a watchlist rated credit (6 or higher) within a one-quarter timeframe. All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above.

As can be seen from the above table, the loss factors moved around in several categories at June 30, 2013 as compared to December 31, 2012 based upon historical charge-offs experienced during the respective 8-quarter look-back periods. The net effect of these changes is an approximate $200 reduction in the reserve requirement for the historical valuation section of the allowance calculation at both the high and low end of the range at June 30, 2013.

General Valuation

General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in credit quality; (ii) trends in the volume of loans; (iii) the experience, ability and effectiveness of the bank’s lending management and staff; (iv) local economic trends and conditions; (v) credit concentration risk; (vi) current industry conditions; (vii) real estate market conditions; (viii) and large relationship credit risk. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to have

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

either a high, moderate or low degree of risk. The results are then input into a general allocation matrix to determine an appropriate general valuation allowance, based on the risk assessment performed by management and the loss factors established for high and low ranges. Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.

The Company’s range for our environmental factors at June 30, 2013 remained constant from December 31, 2012 with the exception of our trend in volume of loans which fell to low risk based upon a decrease in actual loan volume during the past twelve months as seen below:



	6/30/2013		12/31/2012
	Low	High	Low	High
Levels and trends in credit quality	0.20%	0.30%	0.20%	0.30%
Trends in volume of loans	0.00%	1.00%	1.00%	1.50%
Experience, ability, and depth of lending management and staff	0.00%	0.05%	0.00%	0.05%
Local economic trends and conditions	0.25%	0.35%	0.25%	0.35%
Credit concentration risk	0.00%	0.05%	0.00%	0.05%
Current industry conditions/general economic conditions	0.05%	0.10%	0.05%	0.10%
Commercial Real Estate Devaluation	0.15%	0.25%	0.15%	0.25%
Residential Real Estate Devaluation	0.15%	0.25%	0.15%	0.25%
Credit concentration risk - large relationships > $8 Million	0.60%	0.90%	0.60%	0.90%

All impaired loans are excluded from this calculation as they are individually evaluated in the specific valuation section as described above. The loss factors are multiplied by the loan balances related to each environmental factor at quarter-end. Therefore for example, only commercial real estate balances are used in the determination for the estimated loss for the commercial real estate devaluation factor. As described in the historical valuation section, the Company applies the historical loss ratios to balances of all loans within each category to establish a high range allowance. The Company applies the historical loss ratios to loan balances carrying risk ratings of 5 and higher to establish the low range allowance for this factor.

Changes in the allowance for loan losses for the six months ended June 30, 2013 by segment are as follows:



In thousands	Beginning										Ending
June 30, 2013	Balance		Charge-offs			Recoveries		Provision			Balance
Commercial	$	449	$	(7	)	$	—	$	319		$	761
Commercial real estate	3,183		—			—		(125		)	3,058
Construction real estate	2,805		(39		)	75		223			3,064
Residential real estate	1,593		(100		)	7		(369		)	1,131
Consumer	30		(33		)	2		17			16
Total	$	8,060	$	(179	)	$	84	$	65		$	8,030

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

As of June 30, 2013 and December 31, 2012, loans individually and collectively evaluated for impairment, by loan portfolio segment, and the corresponding allowance are as follows:



	Individually Evaluated for Impairment
	6/30/2013				12/31/2012
In thousands	Allowance		Total Loans		Allowance		Total Loans
Commercial	$	121	$	2,306	$	10	$	2,621
Commercial real estate	—		10,284		—		14,130
Construction real estate	1,337		7,501		1,338		6,010
Residential real estate	6		1,506		11		7,025
Consumer	—		11		—		16
Total	$	1,464	$	21,608	$	1,359	$	29,802



	Collectively Evaluated for Impairment
	6/30/2013				12/31/2012
In thousands	Allowance		Total Loans		Allowance		Total Loans
Commercial	$	640	$	93,058	$	439	$	89,891
Commercial real estate	3,058		259,185		3,183		247,594
Construction real estate	1,727		34,306		1,467		35,680
Residential real estate	1,125		139,923		1,582		134,573
Consumer	16		4,712		30		4,138
Unallocated	—		132		—		275
Total	$	6,566	$	531,316	$	6,701	$	512,151

Troubled Debt Restructurings ("TDRs”)

Modifications of terms for loans and their inclusion as TDRs are based on individual facts and circumstances. Loan modifications that are included as TDRs may involve either an increase or reduction of the interest rate, extension of the term of the loan, or deferral of principal payments, regardless of the period of the modification. The loans included in all loan classes as TDRs at June 30, 2013 had either an interest rate modification or a deferral of principal payments, which we consider to be a concession. All loans designated as TDRs were modified due to financial difficulties experienced by the borrower.

TDR Defaults are those TDRs that were greater than 90 days past due, and aligns with our internal definition of default for those loans not identified as TDRs. The Company did not experience any TDR defaults during the three month period ended June 30, 2013 or 2012.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Note 4. Foreclosed Assets

The following table summarizes the activity in foreclosed assets for the six months ended June 30, 2013 and the year ended December 31, 2012:



	6/30/2013			12/31/2012
Balance, beginning of period	$	21,364		$	17,040
Additions	1,733			5,320
Capitalized items	263			1,337
Sales	(894		)	(531		)
Impairment writedowns	(206		)	(1,717		)
Gain (loss)	4			(85		)
Balance, end of period	$	22,264		$	21,364

Note 5. Earnings Per Share

Basic earnings per share are based upon the weighted average number of common shares outstanding during the period. The weighted average common shares outstanding for the diluted earnings per share computations were adjusted to reflect the assumed conversion of shares available under stock options. The following tables summarize earnings per share and the shares utilized in the computations for the three months ended June 30, 2013 and 2012, respectively:



	Net Income Available to Common Shareholders (000s)		Weighted Average Common Shares	Per Share Amount
Quarter ended June 30, 2013
Basic earnings per common share	$	1,730	4,789,813	$	0.36
Effect of dilutive stock options			39,354
Effect of dilutive stock warrants			91,097
Diluted earnings per common share	$	1,730	4,920,264	$	0.35

Quarter ended June 30, 2012
Basic earnings per common share	$	1,624	4,742,222	$	0.34
Effect of dilutive stock options			43,023
Effect of dilutive stock warrants			44,760
Diluted earnings per common share	$	1,624	4,830,005	$	0.33

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

The following tables summarize earnings per share and the shares utilized in the computations for the six months ended June 30, 2013 and 2012, respectively:



	Net Income Available to Common Shareholders (000s)		Weighted Average Common Shares	Per Share Amount
Year to date June 30, 2013
Basic earnings per common share	$	3,196	4,784,631	$	0.67
Effect of dilutive stock options			37,866
Effect of dilutive stock warrants			86,426
Diluted earnings per common share	$	3,196	4,908,923	$	0.65

Year to date June 30, 2012
Basic earnings per common share	$	3,039	4,735,826	$	0.64
Effect of dilutive stock options			44,248
Effect of dilutive stock warrants			27,743
Diluted earnings per common share	$	3,039	4,807,817	$	0.63

Note 6. Stock Based Compensation

The Company has two share-based compensation plans, which are described in the Company’s December 31, 2012 Annual Report on Form 10-K. The compensation cost that has been charged against income for those plans was approximately $209 and $161 for the six months ended June 30, 2013 and 2012, respectively. The Company has no nonqualified stock options outstanding at June 30, 2013.

A summary of option activity during the six months ended June 30, 2013 and 2012 is presented below:



June 30, 2013	Options Outstanding		Weighted Avg. Exercise Price		Weighted Avg. Grant Date Fair Value		Aggregate Intrinsic Value		Weighted Avg. Contractual Term
Balances at December 31, 2012	208,750		$	8.80	$	2.93	$	370	4.83 years
Granted	6,800		9.16		3.94
Exercised	(600	)	6.52		1.42		2
Expired	(1,700	)	7.14		1.09
Balances at June 30, 2013	213,250		8.83		2.98		606		4.55 years
Exercisable at June 30, 2013	173,348		$	9.57	$	3.18	$	386	3.89 years



June 30, 2012
Balances at December 31, 2011	221,290		$	8.59	$	2.74	$	62	5.28 years
Granted	5,300		6.96		3.12
Exercised	(1,000	)	3.41		1.10		4
Forfeited	(1,640	)	10.07		3.97
Expired	(13,100	)	5.33		0.51
Balances at June 30, 2012	210,850		8.76		2.89		273		5.21 years
Exercisable at June 30, 2012	156,178		$	10.01	$	3.26	$	113	4.43 years

Cash received from options exercised under all share-based payment arrangements for the three months and six months ended June 30, 2013 was $1 and $4, respectively.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Information regarding options vested during the six months ended June 30, 2013 and 2012 are as follows:



	Three months ended				Six months ended
	6/30/2013		6/30/2012		6/30/2013		6/30/2012
Number of options vested:	1,860		1,780		6,520		10,620
Total grant date fair value of options vested	$	12	$	6	$	18	$	33

A summary of restricted stock activity during the six months ended June 30, 2013 and 2012 is presented below:



	June 30, 2013				June 30, 2012
	Non-Vested Restricted Stock Outstanding		Weighted Average Grant Date Fair Value		Non-Vested Restricted Stock Outstanding		Weighted Average Grant Date Fair Value
Beginning balance outstanding	11,730		$	4.05	37,460		$	3.68
Granted	20,536		8.87		18,442		5.52
Vested	(32,266	)	7.12		(30,172	)	4.95
Ending balance outstanding	—		$	—	25,730		$	3.51

Note 7. Borrowings and Restricted Stock

Long-term Federal Home Loan Bank (“FHLB”) borrowings totaled $28,000 at June 30, 2013 and December 31, 2012. The Company had $10,000 short-term borrowings at June 30, 2013 and December 31, 2012.

Through the six months ended June 30, 2013, interest expense on FHLB borrowings was $612, on junior subordinated debt was $182 and on fed funds purchased and securities sold under agreements to repurchase was $32. In the same prior year period, interest expense on FHLB borrowings was $676, on junior subordinated debt was $200 and on fed funds purchased and securities sold under agreements to repurchase was $22.

On June 10, 2013, the Company restructured and extended two long-term FHLB advances totaling $18,000 and achieved a blended rate savings of 92 basis points.

Restricted stock, which represents a required investment in the common stock of a correspondent bank, is carried at cost, and as of June 30, 2013 and December 31, 2012, included the common stock of the FHLB which is included in other assets. Restricted stock totaled $3,996 at June 30, 2013 and $4,236 at December 31, 2012.

Management evaluates the restricted stock for impairment in accordance with authoritative accounting guidance under ASC Topic 320, “Investments – Debt and Equity Securities.” Management’s determination of whether these investments

are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of the cost of an investment is influenced by criteria such as (1) the significance of the decline in net assets of the issuing bank as compared to the capital stock amount for that bank and the length of time this situation has persisted, (2) commitments by the issuing bank to make payments required by law or regulation and the level of such payments in relation to the operating performance of that bank, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the issuing bank.

The FHLB of Atlanta neither provides dividend guidance prior to the end of each quarter, nor conducts repurchases of excess activity-based stock on a daily basis, instead making such determinations quarterly. Based on evaluation of criteria under ASC Topic 320, management believes that no impairment charge in respect of the restricted stock is necessary as of June 30, 2013.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Note 8. Fair Value

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. Generally accepted accounting principles regarding fair value measurements, establish a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value. The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter and based on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects changes in classifications between levels will be rare.

Securities: Investment securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relaying on the securities’ relationship to other benchmark quoted securities. Level 1 securities include those traded on nationally recognized securities exchanges, U.S. Treasury securities, and money market funds. Level 2 securities include U.S. Agency securities, mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans: Other than the Company’s Held For Sale portfolio, the Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.

At June 30, 2013, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Foreclosed assets: Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at net realizable value. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis as of June 30, 2013 and December 31, 2012 are summarized below:



In thousands
June 30, 2013	Total		Level 1		Level 2		Level 3
Investment securities available-for-sale:
U.S. Government and federal agency	$	9,664	$	—	$	9,664	$	—
Government-sponsored enterprises	32,020		—		32,020		—
Mortgage-backed securities	71,607		—		71,607		—
Collateralized mortgage obligations	10,868		—		10,868		—
State and political subdivisions	29,740		—		29,740		—
Held for sale loans	1,259		—		1,259		—
Total assets at fair value	$	155,158	$	—	$	155,158	$	—

Total liabilities at fair value	$	—	$	—	$	—	$	—

December 31, 2012
Investment securities available-for-sale:
U.S. Government and federal agency	$	5,131	$	—	$	5,131	$	—
Government-sponsored enterprises	34,080		—		34,080		—
Mortgage-backed securities	52,507		—		52,507		—
Collateralized mortgage obligations	10,659		—		10,659		—
State and political subdivisions	21,843		—		21,843		—
Held for sale loans	1,178		—		1,178		—
Total assets at fair value	$	125,398	$	—	$	125,398	$	—

Total liabilities at fair value	$	—	$	—	$	—	$	—

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company may be required from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis as of June 30, 2013 and December 31, 2012 are included in the tables below:



In thousands
June 30, 2013	Total		Level 1		Level 2		Level 3
Impaired Loans:
Commercial	$	956	$	—	$	—	$	956
Residential Real Estate	856		—		—		856
Construction Real Estate	2,074		—		—		2,074
Total Impaired Loans	$	3,886	$	—	$	—	$	3,886
Foreclosed Assets	22,264		—		—		22,264
Total assets at fair value	$	26,150	$	—	$	—	$	26,150

Total liabilities at fair value	$	—	$	—	$	—	$	—



December 31, 2012
Impaired Loans:
Commercial	$	582	$	—	$	—	$	582
Residential Real Estate	1,098		—		—		1,098
Construction Real Estate	3,218		—		—		3,218
Total Impaired Loans	$	4,898	$	—	$	—	$	4,898
Foreclosed Assets	21,364		—		—		21,364
Total assets at fair value	$	26,262	$	—	$	—	$	26,262

Total liabilities at fair value	$	—	$	—	$	—	$	—

For level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of June 30, 2013, the significant unobservable inputs used in the fair value measurements were as follows:



	Fair Value at June 30, 2013		Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Impaired Loans	$	3,886	Management estimate	Appraisals and/or sales of comparable properties	n/a
Foreclosed Assets	$	22,264	Management estimate	Appraisals and/or sales of comparable properties	n/a

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Accounting standards for financial instruments require disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. These accounting standards exclude certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The methodologies for estimating fair value of financial assets and liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and liabilities are discussed below:

Loans: For variable-rate loans that re-price frequently and with no significant changes in credit risk, fair values are based on carrying values. The fair values for other loans were estimated using discounted cash flow analysis, using interest rates currently being offered. An overall valuation adjustment is made for specific credit risks as well as general portfolio credit risk.

Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

Short-term borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analysis on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Federal Home Loan Bank of Atlanta advances: The fair values of the Company’s Federal Home Loan Bank of Atlanta advances are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Junior Subordinated Debentures: The values of the Company’s junior subordinated debentures are variable rate instruments that reprice on a quarterly basis; therefore, carrying value is adjusted for the three month repricing lag in order to approximate fair value.

Off-Balance-Sheet Financial Instruments: The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of stand-by letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At June 30, 2013, the fair value of loan commitments and stand-by letters of credit was immaterial.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



June 30, 2013	Carrying Amounts		Approximate Fair Value		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
In thousands
Financial assets
Securities held-to-maturity	$	23,954	$	24,730	$	—	$	24,730	$	—
Loans, net	544,894		555,842		—		—		555,842

Financial liabilities
Time deposits/IRAs	156,365		157,694		—		157,694		—
FHLB borrowings	38,000		40,910		—		40,910		—
Junior subordinated debentures	16,496		15,833		—		15,833		—



December 31, 2012
Financial assets
Securities held-to-maturity	$	26,252	$	27,791	$	—	$	27,791	$	—
Loans, net	533,893		546,347		—		—		546,347

Financial liabilities
Time deposits/IRAs	125,580		127,127		—		127,127		—
FHLB borrowings	38,000		42,115		—		42,115		—
Junior subordinated debentures	16,496		15,864		—		15,864		—

Note 9. Commitments and Contingencies

The income tax returns of the Company for 2009, 2010 and 2011 remain subject to examination.

Litigation

In the normal course of business the Bank may be involved in various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

Financial Instruments with Off-Balance-Sheet Risk

In the normal course of business to meet the financing needs of its customers, the Company is a party to financial instruments with off-balance-sheet risk, which involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of these instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.

Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract. The Bank’s maximum exposure to credit loss under commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At June 30, 2013 outstanding commitments to extend credit were $153,737 as compared to $146,449 at December 31, 2012.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)

Commitments to extend credit are agreements to lend to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments may be at fixed or variable rates and generally expire within one year. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Derivative Financial Instruments

For asset/liability management purposes, we may use interest rate swap agreements to hedge interest rate risk exposure to declining rates. Such derivatives are used as part of the asset/liability management process and are linked to specific assets, and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. Cash flows resulting from the derivative financial instruments that are accounted for as hedges of assets and liabilities are classified in the cash flow statement in the same category as the cash flow of the items being hedged. At June 30, 2013 and December 31, 2012 the Company did not have any derivative agreements related to interest rate hedging in place.

Note 10. Regulatory Matters

Dividends

The Company's principal source of funds for dividend payments is dividends received from the Bank. The amount of dividends that may be paid by the Bank to the Company will depend on the Bank’s earnings and capital position and is limited by state law, regulations and policies. A state bank may not pay dividends from its capital; all dividends must be paid out of net undivided profits then on hand. Before any dividend is declared, any deficit in capital funds originally paid in shall have been restored by earnings to their initial level, and no dividend shall be declared or paid by any bank which would impair the paid-in-capital of the bank. As of June 30, 2013 and December 31, 2012, the amount available from the Bank’s retained earnings for payment of dividends was $37,828 and $37,172 respectively. The Company is current on all dividend payments for the Series A Preferred Stock and current on all dividend payments on its Trust Preferred Securities. Additionally, the Company declared a quarterly cash dividend of $0.035 per share to be paid September 3, 2013 to common shareholders of record August 15, 2013.

Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of June 30, 2013 and December 31, 2012 that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of June 30, 2013 and December 31, 2012, the Company and the Bank were categorized as “well capitalized” as defined by applicable regulations. To be categorized as “well capitalized”, the Company and Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There are no conditions or events since that date that management believes have changed the Company's or the Bank's category. The Company received regulatory permission and paid the third 10% redemption increment of its Series A Preferred Stock in the amount of $1.6 million to the U.S. Treasury on May 15, 2013. The Company's and the Bank's actual capital amounts and ratios are also presented in the table below.

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VALLEY FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

June 30, 2013 (Unaudited)

(In thousands, except share and per share data)



	Actual		Minimum Required for Capital Adequacy Purposes		Minimum to be Well Capitalized Under Prompt Corrective Action Provisions
June 30, 2013	Amount	Ratio	Amount	Ratio	Amount	Ratio
Total Capital (to risk weighted assets):
Valley Financial Corporation	$87,220	14.3%	$48,675	8.0%	n/a	n/a
Valley Bank	86,075	14.2%	48,656	8.0%	60,820	10.0%
Tier 1 Capital (to risk weighted assets):
Valley Financial Corporation	79,609	13.1%	24,338	4.0%	n/a	n/a
Valley Bank	78,467	12.9%	24,328	4.0%	36,492	6.0%
Tier 1 Capital - Leverage (to average assets):
Valley Financial Corporation	79,609	10.0%	31,813	4.0%	n/a	n/a
Valley Bank	78,467	9.9%	31,784	4.0%	39,730	5.0%

December 31, 2012
Total Capital (to risk weighted assets):
Valley Financial Corporation	$87,030	14.8%	$47,153	8.0%	n/a	n/a
Valley Bank	85,185	14.5%	47,134	8.0%	58,917	10.0%
Tier 1 Capital (to risk weighted assets):
Valley Financial Corporation	79,654	13.5%	23,576	4.0%	n/a	n/a
Valley Bank	77,812	13.2%	23,567	4.0%	35,350	6.0%
Tier 1 Capital - Leverage (to average assets):
Valley Financial Corporation	79,654	10.3%	30,935	4.0%	n/a	n/a
Valley Bank	77,812	10.1%	30,905	4.0%	38,631	5.0%

Note 11. Subsequent Events

On July 25, 2013, the Company’s Board of Directors declared a quarterly cash dividend in the amount of $0.035 per share, payable on September 3, 2013 to common shareholders of record August 15, 2013.

On July 25, 2013, with regulatory permission, the Board of Directors authorized the Company's redemption of the fourth 10%, or $1,600, of its TARP preferred stock currently held by the U. S. Treasury. This redemption payment is scheduled to close August 14, 2013.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis of the financial condition and results of operations of the Company as of June 30, 2013 and December 31, 2012 and for the six months ended June 30, 2013 and 2012 is as follows. The discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Critical Accounting Estimates

General

The Company’s financial statements are prepared in accordance with Accounting Principles Generally Accepted in the United States (“GAAP”) and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates, which in the case of the determination of our allowance for loan losses, deferred tax assets, and foreclosed assets have been critical to the determination of our financial position and results of operations.

Management considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s financial statements.

For a discussion on the Company’s critical accounting estimates, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Non-GAAP Financial Measures

The Company measures the net interest margin as an indicator of profitability. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax-equivalent net interest income is considered in the calculation of this ratio. Tax-equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for 2013 and 2012 is 34%. The reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.



	Three months ended						Six months ended
In thousands	6/30/2013			6/30/2012			6/30/2013			6/30/2012
Net interest income, non tax-equivalent	$	6,747		$	6,497		$	13,333		$	12,722
Less: tax-exempt interest income	(155		)	(132		)	(295		)	(265		)
Add: tax-equivalent of tax-exempt interest income	235			200			447			402
Net interest income, tax-equivalent	$	6,827		$	6,565		$	13,485		$	12,859

Results of Operations

The Company delivered another record quarter of financial results for our shareholders. A 16 basis point increase in the net interest margin combined with strong noninterest income and improved credit quality fueled our performance for the quarter. Total noninterest income increased to 0.71% of quarterly average earning assets compared to 0.54% for the same quarter of 2012. Additionally, during the second quarter we saw significant improvement in our asset quality indicators driven by a number of credit risk upgrades and the successful resolution of one large nonaccrual relationship. These improvements supported a reduction in our total allowance for loan and lease losses at the end of the quarter.

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Select highlights:


•	Record net income of $1,928,000 and $0.35 per diluted share, producing a return on average total assets of 0.97% and annualized return on average shareholder's equity of 12.13%.


•	Increase in net interest margin of 16 basis points to 3.73% as compared to the 3.57% reported for the same quarter last year.


•	Noninterest income growth of $314,000 or 32% as compared to the same quarter last year.


•	Nonperforming loans decreased $3.2 million or 28% as compared to March 31, 2013. This reduction drove a reduction in the Company's nonperforming assets ("NPAs") as a percentage of total assets from 4.27% at March 31, 2013 to 3.80% at June 30, 2013.


•	The Company's Allowance for Loan and Lease Losses (“ALLL”) to total loans decreased from 1.51% at March 31, 2013 to 1.45% at June 30, 2013.


•	Loan demand continued to improve with an increase in average loans outstanding of $26.6 million or 5% from June 30, 2012 to June 30, 2013. However, in comparison to the quarter ended March 31, 2013, average loans outstanding decreased $1.5 million primarily due to a large construction loan that moved to VHDA permanent financing at the end of the first quarter.


•	Average deposit balances decreased $4.5 million, or 1% from June 30, 2012 to June 30, 2013. However, in comparison to the quarter ended March 31, 2013, average deposits increased $33.2 million, an annualized growth rate of 21%.


•	The Company redeemed an additional $1.6 million of its preferred stock held by the US Treasury during the second quarter bringing the total redemption amount as of June 30, 2013 to $4.8 million.

The following table shows our key performance ratios for the periods ended June 30, 2013, December 31, 2012 and June 30, 2012:



Key Performance Ratios(1)
	Six months ended			Twelve months ended			Six months ended
	6/30/2013			12/31/2012			6/30/2012
Return on average assets	0.93		%	0.83		%	0.90		%
Return on average equity(2)	11.44		%	10.31		%	11.56		%
Net interest margin(3)	3.77		%	3.57		%	3.54		%
Cost of funds	0.62		%	0.85		%	0.91		%
Yield on earning assets	4.38		%	4.41		%	4.44		%
Basic net earnings per common share	$	0.67		$	1.16		$	0.64
Diluted net earnings per common share	$	0.65		$	1.14		$	0.63

1. Ratios are annualized.

2. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities available-for-sale.

3. Calculated on a fully taxable equivalent basis (“FTE”).

Net Income

2013 Compared to 2012

Net income for the three months ended June 30, 2013 was $1,928,000, an increase of $59,000 or 3% over the $1,869,000 then record net income reported for the same quarter last year. After deducting dividends and discount accretion on preferred stock from net income, net income available to common shareholders increased 7% to $1,730,000 as compared to $1,624,000 for the prior year's second quarter, while diluted earnings per share increased 6% to $0.35 as compared to $0.33. The Company's earnings for the three-month period produced an annualized return on average total assets of 0.97% and an annualized return on average shareholder's equity of 12.13% as compared to 0.94% and 12.09% for the prior year. For the six months ended June 30, 2013, net income available to common shareholders was $3,196,000 as compared to $3,039,000 for the same period last year, an increase of $157,000, or 5%.

2012 Compared to 2011

Net income for the three-month period ending June 30, 2012 was $1,869,000 as compared to net income of $1,216,000 for the same period in 2011, an increase of $653,000 or 54%. After the dividend on preferred stock and accretion of discounts on warrants, net income available to common shareholders was $1,624,000, or $0.33 per diluted common share, as compared to $974,000 or $0.21 per diluted common share for the second quarter of 2011, an increase of 67%. The Company's earnings for the second quarter of 2012 produced an annualized return on average total assets of 0.94% and an annualized return on average shareholders' equity of 12.09%, as compared to 0.61% and 8.50%, respectively for the same period in 2011. For the six-month period ending June 30, 2012, net income available to common shareholders was $3,039,000 as compared to $1,833,000 for the

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same period in 2011, an increase of $1,206,000 or 66%.

Net Interest Income

The primary source of the Company’s banking revenue is net interest income, which represents the difference between interest income on earning assets and interest expense on liabilities used to fund those assets. Earning assets include loans, securities, and federal funds sold. Interest bearing liabilities include deposits and borrowings. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 34% federal corporate income tax rate.

Net interest income is affected by changes in interest rates, volume of interest bearing assets and liabilities, and the composition of those assets and liabilities. The “interest rate spread” and “net interest margin” are two common statistics related to changes in net interest income. The interest rate spread represents the difference between the yields earned on interest earning assets and the rates paid for interest bearing liabilities. The net interest margin is defined as the percentage of net interest income to average earning assets. Earning assets obtained through noninterest bearing sources of funds such as regular demand deposits and shareholders’ equity result in a net interest margin that is higher than the interest rate spread.

2013 Compared to 2012

Net interest income for the three months ended June 30, 2013 was $6,747,000, a $250,000 or 4% increase when compared to the $6,497,000 reported for the same prior year period. The Company’s net interest margin, at 3.73%, increased by 16 basis points as compared to the 3.57% reported for the same quarter last year. For the six months ended June 30, 2013, net interest income was $13,333,000 as compared to $12,722,000 for the same period last year, an increase of $611,000, or 5%.

The increase in net interest margin during the second quarter was the result of continued funding cost reductions as the Company’s average cost of funds was 0.60%, down 24 basis points from the 0.84% reported in the same period last year. As anticipated, asset yields continue to compress as the yield on assets during the second quarter of 2013 was 4.31% compared to 4.39% in the same quarter last year. Effective June 1, 2013, we implemented additional cost reductions on our primary money market account with balances totaling over $300 million which should result in a 9 basis point reduction on those accounts. Additionally during June 2013, we restructured and extended two FHLB advances totaling $18 million and achieved a blended rate savings of 92 basis points as detailed in the following table:



Origination Date	Original Maturity	Original Rate	New Maturity	New Rate	Balance
June 29, 2006	June 29, 2016	5.03%	June 10, 2019	3.97%	$	13,000,000
November 9, 2006	November 9, 2016	4.28%	June 10, 2019	3.70%	$	5,000,000

We believe the effect of these two cost reduction initiatives should offset the downward pressure on asset yields and stabilize the margin for the remainder of the year.

2012 Compared to 2011

Net interest income for the three-month period ended June 30, 2012 was $6,497,000, a $212,000 or 3% increase when compared to the $6,285,000 reported for the same period in 2011. The Company's net interest margin, at 3.57%, increased by 16 basis points over the 3.41% reported for the same quarter in 2011. Net interest income for the six-month period ended June 30, 2012 was $12,722,000, a $521,000 or 4% increase when compared to the $12,201,000 reported for the same period in 2011.

Noninterest Income

2013 Compared to 2012

Noninterest income increased $314,000 for the three months ended June 30, 2013, or 32%, compared to the same period last year, from $991,000 to $1,305,000, a record quarter when excluding gains realized on the sale of securities. Valley Wealth Management Services produced another strong quarter with $259,000 earned, an increase of $58,000 or 29% in comparison to the same quarter last year. Mortgage fee income increased $40,000 or 23% while service charges on deposit accounts increased $77,000 or 21%. Additionally, other noninterest income increased $139,000 or 57% in comparison to the second quarter of 2012. This increase is due primarily to income earned on an individual loan swap transaction. Annualized total noninterest income, exclusive of gains realized on the sale of securities, was a record 0.71% of average earning assets for the period, compared to 0.54% in the prior year.

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Our strategic initiative to increase noninterest income by expanding our mortgage department, increasing referrals to our brokerage and mortgage departments from other lines of business, as well as improving our collection efforts on service charges across all business lines is producing tangible results. While our mortgage volume is currently made up of approximately 65% purchase loans and 35% refinancings, we are starting to see a softening in mortgage application volume which we attribute to the recent increase in mortgage rates. If this trend continues, we anticipate some reduction in mortgage fee income generated from sales to the secondary market. Additionally, the first six months of the year have been significantly above expectations for Valley Wealth Management. While we would hope this level of activity could be sustained, a more realistic view anticipates revenues returning to a more normalized level for the remaining six months of the year.

2012 Compared to 2011

Noninterest income for the three-month period ended June 30, 2012 was $991,000, a decrease of $183,000 or 16% compared to the $1,174,000 for the same period in 2011. However, included in the 2011 results were gains taken on the sale of securities totaling $462,000. Absent these gains, noninterest income improved $279,000, or 39%, for the three-month period led by the Company's wealth management and mortgage divisions. Noninterest income for the six-month period ended June 30, 2012 was $2,022,000, a $207,000 or 11% increase when compared to the $1,815,000 reported for the same period in 2011. Excluding realized gains on the sale of securities, noninterest income increased $643,000, or 48%, as compared to the six-month period ended June 30, 2011.

Noninterest Expense

2013 Compared to 2012

Non-interest expense for the second quarter of 2013 totaled $5.4 million, up $568,000 or 12% as compared to the $4.8 million recorded for the quarter ended June 30, 2012. The Company's efficiency ratio (a non-GAAP metric that measures the costs expended to generate a dollar of revenue) for the second quarter of 2013 increased to 65.81% as compared to 63.37% for the same quarter last year. Specific items to note are as follows:


•	Compensation expense increased $361,000 in comparison to the second quarter of 2012. The increase is the result of equity and merit increases for all employees which went into effect January 1, 2013 as well as personnel costs associated with mortgage loan originators and support personnel who were added after the second quarter of 2012.


•	Occupancy and equipment expense increased $66,000 in comparison to the second quarter of 2012 as a result of our expansion of office space in our downtown location and the new mortgage office at The Shoppes at West Village.


•	Data processing expense increased $60,000 due to an improvement and enhancement of our corporate-wide network and telecommunications infrastructure as well as increased customer transactions across all business lines.


•	Foreclosed asset expense increased $160,000 due to an impairment charge taken on three OREO properties which went under contract during the second quarter.

•

These increases were partially offset by reduced insurance expense of $107,000 and reduced professional fees of $38,000 in comparison to the second quarter of 2012. The reduction in insurance expense is primarily related to reduced FDIC assessment while professional fees decreased due to lower expenses associated with vendor reviews, external loan review, payroll processing, and business consulting.

2012 Compared to 2011

Noninterest expense for the three-month period ended June 30, 2012 was $4,841,000, a decrease of $173,000, or 4%, compared to the $5,014,000 recorded in same period in 2011. The Company's efficiency ratio for the second quarter of 2012 was 63.37%, as compared to 65.86% for the same period in 2011. Insurance expense decreased $215,000 based on decreased FDIC insurance premiums, professional fees decreased $152,000 due to reduced legal expenses and net foreclosed asset expense decreased $247,000 due to reduced impairment losses taken on foreclosed assets during the second quarter of 2012 as compared to 2011. These reductions were offset by a $428,000 increase in compensation expense, which is the result of equity and merit increases for all employees which went into effect January 1, 2012, increased commissions earned in our Mortgage and Valley Wealth Management areas, and increased incentive and profit sharing accruals based upon the Company's performance during the first 6 months of 2012. Noninterest expense for the six-month period ended June 30, 2012 was $9,712,000, a $760,000 or 7% decrease when compared to the $10,472,000 reported for the same period in 2011.

Asset Quality

Non-Performing Assets

Non-performing assets include nonaccrual loans, loans past due 90 days or more, restructured loans and foreclosed/ repossessed property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will be placed on nonaccrual status automatically when principal or interest is past due 90 days or more,

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unless the loan is both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.

A restructured loan is a loan in which the original contract terms have been modified due to a borrower’s financial condition or there has been a transfer of assets in full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not normally consider.

Based on generally accepted accounting standards for receivables, a loan is impaired when, based on current information and events, it is likely that a creditor will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the loan agreement.

The Company’s ratio of non-performing assets as a percentage of total assets decreased 19 basis points to 3.80% as compared to 3.99% one year earlier and decreased 40 basis points from the 4.20% reported at December 31, 2012.

Nonperforming assets at June 30, 2013, December 31, 2012 and June 30, 2012 are presented in the following table:



Nonperforming Assets
In thousands	6/30/2013		12/31/2012		6/30/2012
Nonaccrual loans	$	5,414	$	7,185	$	6,353
Loans past due 90 days or more and still accruing	—		401		—
Restructured loans	2,923		3,201		3,733
Total nonperforming loans	$	8,337	$	10,787	$	10,086

Foreclosed, repossessed and idled properties	22,264		21,364		21,713
Total nonperforming assets	$	30,601	$	32,151	$	31,799

Nonaccrual Loans

Nonaccrual loans decreased $3,168,000 during the second quarter of 2013. The primary decrease is attributable to the upgrade of one borrower with loans totaling $3,250,000. This borrower filed bankruptcy in late March and as a result the loans were placed on nonaccrual status. Subsequent to June 30, 2013, the Bank received all interest and principal due and the loans were placed in accrual status retroactively to April 1, 2013. We also received principal payments totaling $324,000 on three loans on nonaccrual status and two smaller properties totaling $82,000 were foreclosed upon during the second quarter. These decreases were offset slightly by one residential loan which was added to nonaccrual status during the second quarter totaling $491,000. Subsequent to June 30, 2013, this property has been foreclosed upon and we have received a contract for sale whereby the Bank will net $485,000.

If nonaccrual loans had performed in accordance with their original terms, additional interest income would have been recorded in the amount of $164,000 for the six months ended June 30, 2013; $329,000 for the year ended December 31, 2012; and $165,000 for the six months ended June 30, 2012.

Foreclosed Assets

During the second quarter the Company sold two of its OREO properties totaling $261,000 and realized a net loss of $17,500 on the transactions. Additionally, the Company entered into contracts for the sale of three additional OREO properties totaling $1,030,000. The Company took an aggregate impairment charge of $157,500 during the second quarter on these properties. Two of the three contracts were closed in July 2013 and the third one is scheduled to close in August. Development work of $121,000 was completed and capitalized on three additional properties held in OREO during the quarter. The net effect of the OREO activity during the second quarter resulted in an decrease in Foreclosed Assets of $146,000.

Impaired Loans

The Company's impaired loans decreased by $5,215,000 or 19% during the quarter to $21,608,000. The decrease is due to credit risk upgrades totaling $4,906,000, net principal payments received of $771,000 and foreclosures/charge-offs totaling $85,000, offset by credit risk downgrades totaling $547,000. The valuation allowance on impaired loans increased slightly by $14,000 as new specific reserves were added to two impaired borrowers based upon updated collateral exposure analyses.

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Past Due Loans

At June 30, 2013, total total loans past due 30-89 days were $336,000, or 0.1% of total loans, a significant decrease from $3,612,000, or 0.7% at March 31, 2013 and from $5,707,000, or 1.1% one year ago. The favorable trend in decreased past due loans is primarily a result of management's diligence in handling problem loans.

Provision/Charge-offs

The Company recorded a negative $130,000 provision for loan losses during the second quarter of 2013, as compared to a negative $53,000 provision for the same period last year. The reduction in ALLL at June 30, 2013 was determined in consideration of a number of factors including the decreased level of past due loans, impaired loans, nonaccrual loans, and charge-offs during the 8-quarter historical look-back period. The Company recorded net charge-offs of $110,000 during the second quarter of 2013 as compared to net charge-offs of $243,000 for second quarter of 2012.

The ratio of allowance for loan and lease losses as a percentage of total loans decreased from 1.69% at June 30, 2012 to 1.45% at June 30, 2013. At June 30, 2013, the Company's total reserves amounted to $8,030,000, of which $1,464,000 are specific reserves on impaired loans and $6,566,000 are general reserves to cover inherent risks in the loan portfolio based on the current economic environment. Total reserves represented 148% of the non-accrual loan balances as of June 30, 2013 as compared to 142% reported at June 30, 2012.

Summary of Allowance for Loan Losses

2013 Compared to 2012

The allowance for loan and lease losses (“ALLL”) was $8,030,000 as of June 30, 2013, compared to $8,060,000 as of December 31, 2012 and $8,991,000 reported a year earlier. The ratio of the ALLL to total loans outstanding was approximately 1.45% at June 30, 2013, which compares to approximately 1.49% of total loans at December 31, 2012 and 1.69% of total loans at June 30, 2012. A total of $1,464,000 in specific reserves was included in the balance of the ALLL as of June 30, 2013 for impaired loans, which compares to a total of $1,359,000 as of December 31, 2012 and $2,000,000 at June 30, 2012. These estimates are primarily based on our historical loss experience, portfolio concentrations, evaluation of individual loans and economic conditions. We believe the ALLL is adequate to provide for expected losses in the loan portfolio, but there are no assurances that it will be. Total reserves represented 148% of the non-accrual loan balances as of June 30, 2013, as compared to 142% reported in the same period last year.

The Company recorded a net reduction of $130,000 in provision for loan losses during the second quarter of 2013 compared to a net reduction of $53,000 for the same period last year. The reduction in ALLL at June 30, 2013 was determined in consideration of a number of factors including the decreased level of past due loans, impaired loans, nonaccrual loans, and charge-offs during the 8-quarter historical look-back period. The Company recorded net charge-offs of $110,000 during the second quarter of 2013 as compared to net charge-offs of $243,000 for the same quarter one year ago.

2012 Compared to 2011

The ALLL was $8,991,000 as of June 30, 2012, compared to $9,650,000 as of December 31, 2011 and $10,300,000 reported a year earlier. The ratio of the allowance for loan losses to total loans outstanding was approximately 1.69% at June 30, 2012, which compares to approximately 1.90% of total loans at December 31, 2011 and 1.96% of total loans at June 30, 2011. A total of $2,000,000 in specific reserves was included in the balance of the allowance for loan losses as of June 30, 2012 for impaired loans, which compares to a total of $2,099,000 as of December 31, 2011 and $1,156,000 at June 30, 2011. Total reserves represented 142% of the non-accrual loan balances as of June 30, 2012, up significantly from the 103% reported in the same period in 2011.

The Company recorded a net reduction of $53,000 in provision for loan losses during the second quarter of 2012 compared to a net provision expense of $697,000 in the second quarter of 2011. The negative provision for the second quarter of 2012 was the result of principal payments made on impaired loans with valuation allowances, which reduced the valuation allowance required at June 30, 2012.

Higher Risk Loans

Certain types of loans, such as option ARM products, interest-only loans, sub-prime loans, and loans with initial teaser rates, can have a greater risk of non-collection than other loans. We do not offer option ARM, interest-only, or sub-prime mortgage loans.

Junior-lien mortgages can also be considered higher risk loans and our junior lien portfolio currently consists of balances totaling $23,980,000 (4.6% of total portfolio) at June 30, 2013. Loans included in this category that were initially made with

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high loan-to-value ratios of 100% or greater have current balances totaling $1,502,000 at June 30, 2013. Since 2003, we have experienced net charge-offs totaling $930,000 in junior lien mortgages.

Financial Condition

Total assets at June 30, 2013 were $806,339,000, up $41,755,000 or 5% from $764,584,000 at December 31, 2012. The principal components of the Company’s assets at the end of the period were $19,376,000 in cash and cash equivalents, $153,899,000 in securities available-for-sale, $23,954,000 in securities held-to-maturity and $552,924,000 in gross loans. Total assets at December 31, 2012 were $764,584,000 with the principal components consisting of $19,803,000 in cash and cash equivalents, $124,220,000 in securities available-for-sale, $26,252,000 in securities held-to-maturity and $541,953,000 in gross loans.

Total liabilities at June 30, 2013 were $745,939,000, up from $700,353,000 at December 31, 2012, an increase of $45,586,000 or 7%. Deposits increased $44,874,000 or 7% to $665,975,000 from the $621,101,000 level at December 31, 2012. Total shareholders’ equity at June 30, 2013 was $60,400,000, down from $64,231,000 at December 31, 2012, a decrease of $3,831,000 or 6%. The decline in shareholder’s equity is attributable to the redemption of $3,200,000 of preferred stock from the U.S. Treasury during the six months of 2013 as well as a reduction in accumulated other comprehensive income ("AOCI") of $3,786,000 due to increased unrealized losses in our AFS portfolio. The recent and rapid increase in long-term interest rates after the Federal Reserve signaled that tapering of its asset purchases in the market could come around the end of 2013 has resulted in a shift in our investment portfolio from an unrealized gain position to an unrealized loss position. Our liquidity and capital positions are very strong and as such, we do not foresee a need to divest of these securities in the near future that could result in any significant loss. The Company’s tangible book value per share (including AOCI) decreased 2% from $10.50 at December 31, 2012 to $10.29 at June 30, 2013.

Capital Adequacy

Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company's capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company's resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

The primary source of additional capital to the Company is earnings retention, which represents net income less dividends declared. The Company is current on all dividend payments for the Series A Preferred Stock. The Company’s Board of Directors declared a quarterly cash dividend in the amount of $0.035 per share, payable September 3, 2013 to common shareholders of record August 15, 2013. Additionally, the Company has obtained regulatory permission to make its fourth TARP redemption payment in the amount of $1,600,000. With this fourth redemption payment scheduled to be made on August 14, 2013, the Company has successfully redeemed 40% of the Series A Preferred Stock and expects to submit a plan to the Federal Reserve later this year for future redemptions.

The Company and its banking subsidiary also are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and the subsidiary bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), the Company and its banking subsidiary must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and its banking subsidiary to maintain minimum amounts and ratios of total and Tier 1 capital to average assets. As of June 30, 2013 and December 31, 2012, the Company and the subsidiary bank met all minimum capital adequacy requirements to which they are subject and are categorized as “well capitalized”. These capital amounts and ratios are included in Note 10 of the consolidated financial statements incorporated by reference herein.

Interest Rate Risk

Interest rate risk is the exposure to fluctuations in the Company’s future earnings (earnings at risk) and value (economic value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest earning assets and interest bearing liabilities that reprice within a specified time period as a result of scheduled maturities and

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repayment and contractual interest rate changes. At June 30, 2013 the Company remains asset sensitive as simulation results indicate that net interest income would rise by approximately 6% if rates were to rise 200 basis points. For a further discussion on interest rate risks, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Liquidity

One of the principal goals of the Bank’s asset and liability management strategy is to maintain adequate liquidity. Liquidity measures our ability to meet our maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund our operations and to provide for customers’ credit needs. Liquidity represents a financial institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds from alternative funding sources. We sell excess funds overnight to provide an immediate source of liquidity and as of June 30, 2013 we had a total of $10,059,000 in overnight funds at the Reserve Bank. The Company also maintains approved lines of credit with correspondent banks as backup liquidity sources.

The secondary liquidity source for both short-term and long-term borrowings consists of a secured line of credit from the Federal Home Loan Bank (“FHLB”). At June 30, 2013, the line of credit had $38,000,000 outstanding under a total available line of $83,215,000. Borrowings from the FHLB are secured by a blanket collateral agreement on a pledged portion of the Bank’s 1-4 family residential real estate loans, multifamily mortgage loans, and commercial mortgage collateral. Additionally, we have an established line of credit with the Reserve Bank’s Discount Window that had no outstanding balance under a total available line of $57,877,000 at June 30, 2013. Borrowings from the FRB Discount Window are secured by a collateral agreement on a pledged portion of the Bank’s commercial and real estate construction collateral.

The Company maintains a liquidity policy as a means to manage liquidity and the associated risk. The policy includes a Liquidity Contingency Plan (“the Liquidity Plan”) that is designed as a tool for the Company to detect liquidity issues in order to protect depositors, creditors and shareholders. The Liquidity Plan includes monitoring various internal and external indicators such as changes in core deposits and changes in the market conditions. It provides for timely responses to a wide variety of funding scenarios ranging from changes in loan demand to a decline in the Company’s quarterly earnings to a decline in market price of the Company’s stock. The Liquidity Plan calls for specific responses designed to meet a wide range of liquidity needs based upon assessments that are performed on a recurring basis by the Company and its Board of Directors.

As a result of our management of liquid assets and our ability to generate liquidity through alternative funding sources, we believe we maintain overall liquidity sufficient to meet our depositors’ requirements and satisfy our customers’ credit needs.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Not applicable.

Item 4. Controls and Procedures.

As of the end of the period covered by the report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There has not been any change in our internal control over financial reporting that occurred during the last quarter that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

The design of any system of controls is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goal under every potential condition, regardless of how remote. In addition, the operation of any system of controls and procedures is dependent upon the employees responsible for executing it. While we have evaluated the operation of our disclosure controls and procedures and found them effective, there can be no assurance that they will succeed in every instance to achieve their objective.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

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aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

Item 1A. Risk Factors.

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2012.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

The table below presents share repurchase activity for the three months ended June 30, 2013. The repurchase activity represents shares of common stock withheld to satisfy income tax obligations upon the vesting of restricted stock.



Period	Total number of shares (or units) purchased	Average price paid per share (or unit)		Total number of shares (or units) purchased as part of publicly announced plans or programs	Maximum number (or approximate dollar value) of shares (or units) that may yet be purchased under the plans or programs
April 1 - 30, 2013
May 1 - 31, 2013	5,692	$	9.50
June 1 - 30, 2013
Three Months Ended June 30, 2013	5,692	$	9.50

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

None.

Item 5. Other Information.

None.

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Item 6. Exhibits



Exhibit Number		Description

31.1		Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2		Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1		Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

32.2		Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

101		Pursuant to Rule 405 of Regulation S-T, the following financial information from the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2013, is formatted in XBRL interactive data files: (i) Consolidated Statements of Income for the three and six months ended June 30, 2013 and 2012; (ii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2013 and 2012; (iii) Consolidated Balance Sheets at June 30, 2013 and December 31, 2012; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012; and (v) Notes to Consolidated Financial Statements.

* Filed herewith.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		VALLEY FINANCIAL CORPORATION



August 13, 2013		/s/ Ellis L. Gutshall
Date		Ellis L. Gutshall, President and Chief Executive Officer



August 13, 2013		/s/ Kimberly B. Snyder
Date		Kimberly B. Snyder, Executive Vice President and
		Chief Financial Officer

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EXHIBIT INDEX



Exhibit Number		Description

31.1		Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

31.2		Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*

32.1		Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

32.2		Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

101		Pursuant to Rule 405 of Regulation S-T, the following financial information from the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2013, is formatted in XBRL interactive data files: (i) Consolidated Statements of Income for the three and six months ended June 30, 2013 and 2012; (ii) Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2013 and 2012; (iii) Consolidated Balance Sheets at June 30, 2013 and December 31, 2012; (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012; and (v) Notes to Consolidated Financial Statements.

* Filed herewith.