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      September 30, 2010.


OR


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





For the transition period from __________________________ to__________________________





Commission file number    000-18261








COMMUNITY FINANCIAL CORPORATION(Exact name of registrant as specified in its charter)








VIRGINIA

54-1532044(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification Number)








38 North Central Ave., Staunton, VA 24401(Address of principal executive offices)








(540) 886-0796(Issuer’s telephone number)








(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 and 15(d) of the Securities Exchange Act of 1934  during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No ☐





Indicate by check mark whether the registrant (1) has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (& 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ☐   No ☐





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


Large accelerated filer ☐
Accelerated filer ☐
Non-Accelerated filer ☐
Smaller reporting company x(do not check if a smallreporting company)





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


Yes ☐                  No x





Number of shares of common stock, par value $.01 per share, outstanding at the close of business on November 12, 2010:4,361,658.





COMMUNITY FINANCIAL CORPORATION








INDEX








PART I.
FINANCIAL INFORMATIONItem 1.
Consolidated Financial StatementsConsolidated Balance Sheets at September 30, 2010 (unaudited)

and March 31, 2010
3Consolidated Statements of Operations for the

Three and Six Months Ended September 30, 2010 and 2009

(unaudited)
4Consolidated Statements of Cash Flows for the Six

Months Ended September 30, 2010 and 2009 (Unaudited)
5Notes to Unaudited Interim Consolidated

Financial Statements
6Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
15Item 3.
Quantitative and Qualitative Disclosures About Market Risk
24Item 4.
Controls and Procedures
24PART II.
OTHER INFORMATION
24Signature Page

26Exhibit Index

27





2


Part I. Financial Information


Item 1. Financial Statements


COMMUNITY FINANCIAL CORPORATIONCONSOLIDATED BALANCE SHEETSSeptember 30,


March 31,2010


2010(Unaudited)ASSETSCash (including interest-bearing deposits of  $476,470 and $3,824,672)

$
4,425,819


$
5,374,665SecuritiesHeld to maturity


1,698,000



1,698,000Available for sale, at fair value


73,397



73,397Restricted investment in Federal

Home Loan Bank stock, at cost


5,778,600



6,183,600Loans receivable, net of allowance for loan

losses of $8,359,350 and $8,052,875


491,716,709



502,125,963Real estate owned and repossessed assets


7,141,307



3,182,419Property and equipment, net


8,816,989



8,920,769Accrued interest receivableLoans


2,165,784



2,121,012Investments


11,243



7,599Prepaid expenses and other assets


17,280,150



17,492,388Total Assets

$
539,107,998


$
547,179,812LIABILITIES AND STOCKHOLDERS’ EQUITYLiabilitiesDeposits

$
386,931,704


$
398,420,330Borrowings


98,000,000



96,250,000Securities sold under agreement to repurchase


1,914,824



845,503Advance payments by borrowers for

taxes and insurance


211,805



192,360Other liabilities


2,891,389



2,459,744Total Liabilities


489,949,722



498,167,937Stockholders’ EquityPreferred stock $.01 par value, authorized 3,000,000shares, 12,643 shares outstanding


12,643,000



12,643,000Common stock, $0.01 par value, authorized

10,000,000 shares, 4,361,658 and 4,361,658

shares outstanding


43,617



43,617Warrants


603,153



603,153Discount on preferred


(388,019
)


(448,337
)Additional paid in capital


5,577,958



5,577,958Retained earnings


31,345,524



31,259,441Accumulated other comprehensive

(loss)


(666,957
)


(666,957
)Total Stockholders’ Equity


49,158,276



49,011,875Total Liabilities and Stockholders’ Equity

$
539,107,998


$
547,179,812





See accompanying notes to unaudited interim consolidated financial statements.


3





COMMUNITY FINANCIAL CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONSThree Months Ended


Six Months EndedSeptember 30


September 302010


2009


2010


2009(Unaudited)


(Unaudited)INTEREST INCOMELoans

$
6,753,841


$
7,115,854


$
13,955,904


$
13,974,885Investment securities


10,159



11,178



21,527



25,126Other


30,718



40,221



113,322



65,848Total interest income


6,794,718



7,167,253



14,090,753



14,065,859INTEREST EXPENSEDeposits


1,279,549



1,775,889



2,679,600



3,970,129Borrowed money


213,689



252,468



430,771



499,867Total interest expense


1,493,238



2,028,357



3,110,371



4,469,996NET INTEREST INCOME


5,301,480



5,138,896



10,980,382



9,595,863PROVISION FOR LOAN LOSSES


3,171,083



651,431



4,415,189



932,235NET INTEREST INCOME AFTER

PROVISION FOR LOAN LOSSES


2,130,397



4,487,465



6,565,193



8,663,628NONINTEREST INCOMEService charges, fees and commissions


989,779



862,449



1,880,808



1,717,032Other


94,895



135,733



186,524



225,428Total noninterest income


1,084,674



998,182



2,067,332



1,942,460NONINTEREST EXPENSECompensation & benefits


2,269,820



2,140,762



4,515,147



4,458,694Occupancy


409,762



402,482



802,315



802,422Data processing


422,937



407,839



796,398



785,188Federal insurance premium


173,853



139,909



345,496



454,408Advertising


119,199



105,965



254,048



228,413Other


697,998



511,298



1,236,976



914,893Total noninterest expense


4,093,569



3,708,255



7,950,380



7,644,018INCOME (LOSS) BEFORE TAXES


(878,498
)


1,777,392



682,145



2,962,070INCOME TAX EXPENSE (BENEFIT)


(353,409
)


655,275



219,668



1,120,371NET INCOME (LOSS)

$
(525,089
)

$
1,122,117


$
462,477


$
1,841,699Effective Dividend on Preferred Stock


188,197



188,197



376,394



376,394NET INCOME (LOSS) AVAILABLE

TO COMMON STOCKHOLDERS

$
(713,286
)

$
933,920


$
86,083


$
1,465,305BASIC EARNINGS (LOSS) PER

COMMON SHARE

$
(0.16
)

$
0.21


$
0.02


$
0.34DILUTED EARNINGS (LOSS) PER

COMMON SHARE

$
(0.16
)

$
0.21


$
0.02


$
0.34DIVIDENDS PER COMMON SHARE

$
0.00


$
0.00


$
0.00


$
0.00





See accompanying notes to unaudited interim consolidated financial statements.


4





COMMUNITY FINANCIAL CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWSSix Months EndedSeptember 30,2010


2009(Unaudited)


(Unaudited)OPERATING ACTIVITIESNet income

$
462,477


$
1,841,699Adjustments to reconcile net income tonet cash provided by operating activitiesProvision for loan losses


4,415,189



932,235Depreciation


318,887



310,483Amortization of premium and accretion

of discount on securities, net


---



2Increase (decrease) in net deferred loan fees


(21,682
)


85,475Deferred income tax benefit


(44,703
)


(1,266,085
)Increase (decrease) in other liabilities


451,090



(1,621,776
)Net cash provided by operating activities


5,745,080



880,252INVESTING ACTIVITIESProceeds from maturities of held to maturity securities


2,500,000



200,000Purchase of held to maturity securities


(2,500,000
)


(500,000
)Proceeds from sale of available for sale securities


---



42,499Net decrease (increase) in loans


6,060,449



(23,980,262
)Purchases of property and equipment


(215,107
)


(667,408
)Redemption (purchase) of FHLB stock


405,000



(945,000
)Proceeds from sales of foreclosed assets


2,033,904



---(Increase) in repossessed assets and real estate owned


(5,992,792
)


(1,239,228
)Net cash provided (absorbed) by investing activities


2,291,454



(27,089,399
)FINANCING ACTIVITIESDividends paid


(316,075
)


(316,076
)Net (decrease)increase in deposits


(11,488,626
)


23,459,232Proceeds from advances and other borrowed money


2,819,321



5,108,773Net cash (absorbed) provided by financing activities


(8,985,380
)


28,251,929(DECREASE)INCREASE IN CASH AND CASH EQUIVALENTS


(948,846
)


2,042,782CASH AND CASH EQUIVALENTS – beginning of period


5,374,665



2,482,182CASH AND CASH EQUIVALENTS – end of period

$
4,425,819


$
4,524,964See accompanying notes to unaudited interim consolidated financial statements







5






COMMUNITY FINANCIAL CORPORATION


NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER 30, 2010





NOTE 1. - BASIS OF PRESENTATION





The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.





The accompanying consolidated financial statements include the accounts of Community Financial Corporation ("Community" or the "Company") and its wholly-owned subsidiary, Community Bank (the "Bank").  All significant intercompany balances and transactions have been eliminated in consolidation.





In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentation have been included. Operating results for the three and six months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending March 31, 2011.





The Company made application to the Treasury Department to participate in the TARP program and received an investment by the Treasury Department of $12,643,000 in the form of preferred stock during the year ended March 31, 2009.  The Company also issued to the U.S. Treasury a warrant to purchase 351,194 shares of common stock at $5.40 per share.








NOTE 2. - STOCK-BASED COMPENSATION PLAN




The Company recognizes the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.




There were no stock options granted and no stock-based compensation expense was recognized during the three and six month periods ended September 30, 2010 and September 30, 2009.




The following summarizes the stock option activity for the six months ended September 30, 2010:





Weighted

IntrinsicWeighted


Average

Value ofAverage


Remaining

UnexercisedExercise


Contractual

In-the-MoneyShares


Price


Term

OptionsOptions outstanding, March 31, 2010


314,700


$
8.66Granted


---



---Exercised


---



---Forfeited


18,000



7.46Options outstanding September 30, 2010


296,700



8.73



3.4Options exercisable, September 30, 2010


296,700


$
8.73



3.4

$2,925




There were no options exercised during the six months ended September 30, 2010.







6


NOTE 3. - EARNINGS PER SHARE





Basic earnings per common share is based on net income available to common stockholders divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per common share shows the dilutive effect of additional common shares issuable under stock option plans and warrants. Diluted earnings per common share is computed by dividing net income available to common stockholders  by the weighted average number of common shares and common share equivalents outstanding. Basic and diluted earnings per common share are computed in the following table.





For the Three Months EndedSeptember 30, 2010


September 30, 2009Weighted Average


Per Share





Weighted Average


Per ShareIncome


Shares


Amount


Income


Shares


AmountBasic earnings (loss) per common share:Income (loss)available to common stockholders

$
(713,286
)


4,361,658


$
(0.16
)

$
933,920



4,361,658


$
0.21Diluted earnings (loss) per common share:Effect of Dilutive SecuritiesOptions and Warrants


---



---







---



---Income (loss) available to common stockholders

$
(713,286
)


4,361,658


$
(0.16
)

$
933,920



4,361,658


$
0.21




During the quarter ended September 30, 2010, 289,200 stock options and 351,194 warrants were excluded in the calculation of earnings per share because they would have been anti-dilutive. During the quarter ended September 30, 2009, 337,200 stock options and 351,194 warrants were excluded in the calculation of earnings per share because they would have been anti-dilutive.




For the Six Months EndedSeptember 30, 2010


September 30, 2009Weighted Average


Per Share





Weighted Average


Per ShareIncome


Shares


Amount


Income


Shares


AmountBasic earnings per share:Income available to common stockholders

$
86,083



4,361,658


$
0.02


$
1,465,305



4,361,658


$
0.34Diluted earnings per share:Effect of Dilutive SecuritiesOptions and Warrants


---



7,500







---



---Income available to common stockholders

$
86,083



4,369,158


$
0.02


$
1,465,305



4,361,658


$
0.34







7






NOTE 4. - STOCKHOLDERS' EQUITY





The following table presents the Bank's regulatory capital levels at September 30, 2010:





Well Capitalized Amount Required


Well Capitalized Percent

Required


Actual

Amount


Actual

Percent


Excess

AmountTangible Capital

$
27,062,000



5.00
%

$
48,690,000



9.00
%

$
21,628,000Core Capital


32,474,000



6.00



48,690,000



9.00



16,216,000Risk-based Capital


46,564,000



10.00



53,224,000



11.43



6,660,000





The Company’s primary source of funds for the payment of dividends to its stockholders is dividends from the Bank. Capital distributions by OTS-regulated savings banks, such as the Bank, are limited by regulation ("Capital Distribution Regulation").  Capital distributions are defined to include, in part, dividends, stock repurchases and cash-out mergers.  The Capital Distribution Regulation permits a savings bank to make capital distributions during a calendar year equal to net income for the current year plus the previous two years net income, less capital distributions paid over the same period. Any distributions in excess of that amount require prior OTS approval. The Capital Distribution Regulation requires that savings banks in holding company structures provide the applicable OTS Regional Director with a 30-day advance written notice of all proposed capital distributions whether or not advance approval is required by the regulation. The OTS may object to capital distributions if the bank is not meeting its regulatory capital requirements, the distribution raises safety and soundness concerns or is otherwise in violation of law. Issuance of preferred stock under the TARP Capital Purchase Plan restricts the Company from increasing its dividend distribution to stockholders without approval from the OTS and U.S Treasury.





NOTE 5. - SUPPLEMENTAL INFORMATION - STATEMENT OF CASH FLOWS





Total interest paid for the six months ended September 30, 2010 and 2009 was $3,116,486 and $6,220,251, respectively. Total income taxes paid for the six months ended September 30, 2010 and 2009 was $0 and $1,358,708.





NOTE 6. - COMPREHENSIVE INCOME





Comprehensive income is defined as "the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." Comprehensive income for the Company includes net income, unrealized gains and losses on securities available for sale and pension liability adjustments. For the six-month periods ended September 30, 2010 and 2009, net income and comprehensive income were the same.





8


NOTE 7. – DEFINED BENEFIT PENSION PLAN





The Company has a non-contributory defined benefit pension plan for which the components of net periodic benefit cost are as follows:





Three Months EndedSeptember 302010


2009Service cost

$
76,565


$
84,954Interest cost


59,549



58,964Expected return on plan assets


(61,538
)


(61,538
)Recognized net actuarial loss


4,941



4,984$
79,517


$
87,364







Six Months EndedSeptember 302010


2009Service cost

$
153,130


$
169,908Interest cost


119,098



117,928Expected return on plan assets


(123,076
)


(123,076
)Recognized net actuarial loss


9,882



9,968$
159,034


$
174,728




The Company made a contribution of $450,000 during the June 30, 2010 quarter for the fiscal year ended March 31, 2010.  The Company anticipates making all required contributions prior to March 31, 2011.





NOTE 8. – SECURITIES





Management evaluates securities for other than temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  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) whether the Company intends to sell the investments or it is more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis.




NOTE 9. - FAIR VALUE MEASUREMENTS




Generally accepted accounting principles define fair value, establish a framework for measuring fair value, establish a three-level valuation hierarchy for disclosure of fair value measurement and enhance disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follow:







·Level 1
Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.   9
    ·Level 2
Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instrument.·Level 3
Inputs to the valuation methodology are unobservable and significant to the fair value measurement.






Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:




Securities




Where quoted prices are available in an active market, securities are classified within level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within level 3 of the valuation hierarchy.  Currently, all of the Company’s securities are considered to be Level 2 securities.





The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2010:





Fair Value Measurements UsingDescription

Balance


Quoted Prices

in Active

Markets for

Identical

Assets

(Level 1)


Significant

Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)AssetsSeptember 30, 2010Available-for-sale securities

$
73,397


$
-


$
73,397


$
-March 31, 2010Available-for-sale securities

$
73,397


$
-


$
73,397


$
-





Certain assets are measured at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.





The following describes the valuation techniques used by the Corporation to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:




Impaired loans




Generally accepted accounting principles apply to loans measured for impairment using  practical expedients, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral.







10






The following table summarizes the Corporation’s financial assets that were measured at fair value on a nonrecurring basis during the period.





Carrying ValueDescription

Balance


Quoted Prices

in Active

Markets for

Identical

Assets

(Level 1)


Significant

Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)AssetsSeptember 30, 2010Impaired loans net of

valuation allowance

$
6,650,403


$
-


$
-


$
6,650,403March 31, 2010Impaired loans net of

valuation allowance

$
7,331,452


$
-


$
-


$
7,331,452





The Company uses real estate appraisals to value impaired loans and future cash flows or other appropriate methods to determine fair value. With the use of these methods, we provide valuation allowances for anticipated losses when management determines that a decline in the value of the collateral or expected cash flows has occurred. The Company does not generally believe obtaining real estate appraisals as frequently as quarterly is of significant value in determining fair value. The delay between ordering and receiving an appraisal and our historical experience that real estate values do not generally fluctuate significantly quarter to quarter are factors influencing this decision. Updated appraisals are obtained periodically and in those instances where management has reason to believe a material change may have occurred in the fair value of the collateral. Evaluation of impairment requires judgment and estimates, and management uses all relevant and timely information available to determine specific reserves on impaired loans, including appraisals and cash flow analysis. Loans are partially or completely charged off in the period when they are deemed uncollectible in accordance with ASC 310-35. .




Other real estate owned




Certain assets such as other real estate owned (OREO) are measured at the lesser of cost and fair value less cost to sell.





The following table summarizes the Corporation’s nonfinancial assets that were measured at fair value on a nonrecurring basis during the period:





Carrying ValueDescription

Balance


Quoted Prices

in Active

Markets for

Identical

Assets

(Level 1)


Significant

Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)AssetsSeptember 30, 2010Other real estate

$
7,141,307


$
-


$
-


$
7,141,307March 31, 2010Real estate owned

$
3,182,419


$
-


$
855,000


$
2,327,419






11







The accounting standard excludes certain financial instruments and all non-financial instruments from its disclosure requirements.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Corporation.





The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.





Cash and cash equivalents





For those short-term investments, the carrying amount is a reasonable estimate of fair value.





Securities





Fair values for securities, excluding Federal Home Loan Bank (“FHLB”) stock, are based on quoted market prices or dealer quotes.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.  The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank. The Corporation’s investment in Federal Home loan Bank stock totaled $5.8 million at September 30, 2010. FHLB stock is generally viewed as a long term investment and as a restricted investment security which is carried at cost, because there is no market for the stock other than the FHLBs or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing temporary declines in value. Despite the FHLBs temporary suspension of repurchases of excess capital stock in 2009, the Corporation does not consider this investment to be other than temporarily impaired at September 30, 2010 and no impairment has been recognized.





Loans receivable





For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  Fair values for certain mortgage loans (e.g., one-to four-family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics.  Fair values for other loans (e.g., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Fair values for non-performing loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.





Deposit liabilities





The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts).  The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date.  Fair values for fixed-rate 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 expected monthly maturities on time deposits.





Borrowings





For advances that mature within one year of the balance sheet date, carrying value is considered a reasonable estimate of fair value.  The fair values of all other advances are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rate for similar types of advances.





Securities sold under agreements to repurchase





Securities sold under agreements to repurchase are treated as short-term borrowings and the carrying value approximates fair value.






12





Accrued interest





The carrying amounts of accrued interest approximate fair value.





Off-balance sheet 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 credit worthiness 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 standby 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 September 30, 2010 and March 31, 2010, the fair value of loan commitments and standby letters of credit were deemed immaterial.





The estimated fair values of the Corporation’s financial instruments are as follows




September 30, 2010


March 31, 2010(In Thousands)

Carrying

Amount


Fair

Value


Carrying

Amount


Fair

ValueFinancial assetsCash and cash equivalents

$
4,426


$
4,426


$
5,375


$
5,375Securities


1,771



1,771



1,771



1,772Loans, net


491,717



504,080



502,126



514,522Accrued interest receivable


2,178



2,178



2,129



2,129Financial liabilitiesDeposits

$
386,932


$
395,686


$
398,420


$
403,330Borrowings


98,000



98,000



96,250



96,550Securities sold under agreements to repurchase


1,915



1,915



846



846Accrued interest payable


256



256



148



148





Note 10. Loans Receivable, Net





Loans receivable are summarized as follows:





September 30, 2010


March 31, 2010Residential real estate

$
149,563,213


$
144,951,059Commercial real estate


173,463,524



171,805,427Construction


49,340,534



63,806,643Commercial business


49,537,481



53,402,539Consumer


89,470,193



91,412,757511,374,945



525,378,425Less:Loans in process


12,103,728



16,158,845Deferred loan (costs), net


(804,842
)


(959,258
)Allowance for loan losses


8,359,350



8,052,87519,658,236



23,252,462$
491,716,709


$
502,125,963





Loans serviced for others amounted to approximately $224,791 at September 30, 2010, and $236,639 at March 31, 2010.  The loans are not included in the accompanying consolidated balance sheets.






13





Allowance for loan losses is summarized as follows:





Six Months Ended September 30, 2010


Year Ended

March 31, 2010Balance at beginning of year

$
8,052,875


$
5,955,847Provision for loan loss


4,415,189



4,031,454Loans charged-off


(4,343,987
)


(2,105,988
)Recoveries of loans previously charged-off


235,273



171,562Balance at end of period

$
8,359,350


$
8,052,875





Impaired loans with a valuation allowance of $3,814,856 totaled $10,465,259 at September 30, 2010 and impaired loans of $11,209,986 had a valuation allowance of $3,878,534 at March 31, 2010.





Impaired loans without a valuation allowance totaled $3,577,122and $3,713,249 as of September 30, 2010, and March 31, 2010, respectively.





No additional funds are committed to be advanced in connection with impaired loans. There were no loans past due 90 days and still accruing interest.





Nonaccrual loans excluded from impaired loan disclosure amounted to $8,866,258 at September 30, 2010 and $7,487,929 at March 31, 2010. If interest on nonaccrual loans had been accrued, such income would have been $254,387 for the six months ended September 30, 2010 and $668,028 for the year ended March 31, 2010.





The allowance for loan losses is maintained at a level considered by management to be adequate to absorb future loan losses currently inherent in the loan portfolio. The degree of impairment is measured on a loan-by-loan basis based on the fair value of the collateral if the loan is collateral dependent, the fair value of expected future cash flows or the loan’s market price. The degree of impairment and amount of allowance for each loan varies due to the above factors. The increase of $306,000 in the allowance for loan losses at September 30, 2010 compared to March 31, 2010reflects what management believes to be an appropriate change in the allowance for loan losses related to the change in non-performing assets. The decrease in the ratio of allowance to nonperforming assets from March 31, 2010 to September 30, 2010 reflects the transfer of certain loans to Real Estate Owned, the variability of the allowance on a loan by loan basis based on the current collateral value and the other above factors.





In accordance with ASC 310, Receivables, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately indentify individual consumer and residential loans for impairment disclosure. At September 30, 2010 and March 31, 2010, homogeneous loans totaling $8.9 million and $7.5 million were not included in the impaired loan disclosure and tested for specific impairment. These loans were included in the allowance calculation as pools of loans in the general component with allocations based on historic charge-offs and qualitative factor adjustments deemed appropriate by management for these types of loans and their nonaccrual status.





The Company uses real estate appraisals to value impaired loans and future cash flows or other appropriate methods to determine fair value. With the use of these methods, we provide valuation allowances for anticipated losses when management determines that a decline in the value of the collateral or expected cash flows has occurred. The Company does not generally believe obtaining real estate appraisals as frequently as quarterly is of significant value in determining fair value. The delay between ordering and receiving an appraisal and our historical experience that real estate values rarely fluctuate significantly quarter to quarter are factors influencing this decision. Updated appraisals are obtained periodically and in those instances where management has reason to believe a material change may have occurred in the fair value of the collateral. Evaluation of impairment requires judgment and estimates, and management uses all relevant and timely information available to determine specific reserves on








14











impaired loans, including appraisals and cash flow analysis. Loans are partially or completely charged off in the period when they are deemed uncollectible in accordance with ASC 310-35.





Regarding the fair value disclosures specifically included in the September 30, 2010 and March 31, 2010 disclosures, all impaired loans were included in Level 3 of the fair value hierarchy based on our methodology described above and in the relevant filings. The loans were disclosed in the fair value measurements disclosure net of the related specific impairments.





Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND


RESULTS OF OPERATIONS.





EXECUTIVE SUMMARY





The following information is intended to provide investors a better understanding of the financial position and the operating results of Community Financial Corporation (“Community” or the “Company” and its subsidiary, Community Bank (the “Bank”). The following is primarily from management’s perspective and may not contain all information that is of importance to the reader. Accordingly, the information should be considered in the context of the consolidated financial statements and other related information contained herein.





Net income (loss) for the quarter ended September 30, 2010 decreased $1.6 million to $(525,000) compared to $1.1 million for the quarter ended September 30, 2009.  Net income (loss) for the quarter decreased due primarily to a provision for loan loss increase of $2.5 million. Net income for the six months ended September 30, 2010 decreased $1.4 million to $462,000 compared to $1.8 million for the six months ended September 30, 2009.  Net income for the six months decreased due primarily to a provision for loan losses increase of $3.5 million, or 373.6%, partially offset by increases in net interest income. The increased provision for the periods was primarily related to higher charge-offs and management’s analysis of the Bank’s loan portfolio and the related likelihood of future loan losses.





Net interest income for the quarter ended September 30, 2010 increased $163,000, or 3.2%, to $5.3 million compared to the quarter ended September 30, 2009. Net interest income, which is the difference between the interest income we earn on our interest-earning assets, such as loans and investment securities, and the interest we pay on interest-bearing liabilities, which are primarily deposits and borrowings, was impacted by both the change in our volume of interest earning assets and the interest rate spread between interest-earning assets and interest-bearing liabilities. The primary factor contributing to the increase in net interest income for the quarter ended September 30, 2010 was lower rates paid on interest-bearing liabilities. We made limited investment securities purchases during the three months ended September 30, 2010 and anticipate limited securities purchases during the remainder of the current fiscal year.





Management will continue to monitor asset growth to manage the level of regulatory capital and funds acquisition. We continue to monitor the impact changing interest rates may have on both the growth in interest-earning assets and our interest rate spread. The Bank has approximately $373.7 million in adjustable rate loans, or 76.6% of total loans, which reprice in five years or less, many of which are subject to annual and lifetime interest rate limits. The pace and extent of future interest rate changes will impact the Company’s interest rate spread as will limitations on interest rate adjustments on certain adjustable rate loans.





Our continued emphasis on acquiring interest and non-interest bearing transaction accounts, combined with a falling interest rate environment, has impacted the composition of our interest-bearing liabilities. Deposits were down approximately $11.4 million or 2.9% at September 30, 2010 from March 31, 2010, due to decreases in time deposits, partially offset by increases in interest and non-interest bearing transaction accounts.  Management plans to remain competitive in our deposit pricing. Due to relative pricing advantages, we have utilized brokered deposits and borrowings during the September 30, 2010 quarter. During the September 30, 2010 quarter, we experienced continuing competition for time deposits. Management is cognizant of the potential for additional compression in the Bank’s margin related to the need to acquire funds and the pace of interest rate changes. Management will continue to monitor the level of deposits and borrowings in relation to the current interest rate environment.




The Bank’s loan portfolio decreased $10.4 million from March 31, 2010 to September 30, 2010.  This decrease was primarily in construction loans, commercial business loans and consumer loans, partially offset by increases to residential first mortgage and commercial real estate loans. We expect our future loan growth to be slow or moderate








15








due to a slower economy and underwriting changes to limit funding of speculative construction loans.  We have experienced reduced construction activity in our market areas while existing commercial real estate activity continues to be moderate. At September 30, 2010, our assets totaled $539.1 million, including net loans receivable of $491.7 million, compared to total assets of $547.2 million, including net loans receivable of $502.1 million, at March 31, 2010.  Commercial real estate loans were $173.5 million or 33.9%, residential first mortgage loans were $149.6 million or 29.2%, construction loans totaled $49.3 million or 9.6%, commercial business loans were $49.5 or 9.7%, and home equity loans and lines were $47.6 million or 9.3% of our total loan portfolio at September 30, 2010 compared to commercial real estate loans of $171.8 or 32.7%, residential first mortgage loans of $145.0 or 27.6%, construction loans of $63.8 million or 12.1%, commercial business loans of $53.4 million or 10.2%, and home equity loans and lines of $48.0 million or 9.1% at March 31, 2010.




At September 30, 2010, non-performing assets totaled $19.1 million or 3.54% of assets compared to $17.7 million or 3.24% of assets at March 31, 2010. Our allowance for loan losses to non-performing loans was 69.8% and to total loans was 1.7% at September 30, 2010 compared to 55.3% and 1.6%, respectively at March 31, 2010.  The increase in nonperforming assets consisted of $4.0 million of real estate owned and repossessed assets offset by a $2.6 million decrease in nonaccrual loans.  Due primarily to the slowing economy, we expect an increase in non-performing assets in the future.Charge-offs of $4.3 millionduring the six month period consisted primarily of $1.4 million of residential real estate loans, $1.5 million of commercial business loans, $622,000 of construction loans, $333,000 of land loans, $363,000 of commercial real estate loans and $144,000 of automobile loans.




Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions.  We have experienced stable to moderate declines in real estate values in our market areas. The Company has experienced moderate decreases in delinquencies for the 2011 fiscal year. Delinquencies have decreased from 6.28% at March 31, 2010 to 5.53% at September 30, 2010. General downward economic trends, reduced availability of commercial credit and continuing high unemployment have negatively impacted the performance of commercial and consumer credit, resulting in additional write-downs. While there have been increases in unemployment and announced layoffs by certain employers in our markets, there has not been a dramatic or widespread increase in unemployment to date.  Concerns over the stability of the financial markets and the economy have resulted in decreased lending by other financial institutions to their customers and to each other.  This market turmoil and tightening of credit has led to increased delinquencies relative to the historical norm, lack of customer confidence, increased market volatility and widespread reduction in general business activity.





Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more difficult and complex under these difficult market and economic conditions.  We also may be required to pay higher FDIC premiums if financial institution failures continue to deplete the FDIC insurance fund and reduce the FDIC’s ratio of reserves to insured deposits.





We do not expect these difficult conditions to improve in the near future.  A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market.  As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.


Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act that was enacted on July 21, 2010, provides, among other things, for new restrictions and an expanded framework of regulatory oversight for financial institutions and their holding companies, including the Company and the Bank.  Under the new law, the Bank’s primary regulator, the Office of Thrift Supervision, will be eliminated and existing federal thrifts will be subject to regulation and supervision by the Office of Comptroller of the Currency, which currently supervises and regulates all national banks. In addition, beginning in 2011, all financial institution holding companies, including the Company, will be regulated by the Board of Governors of the Federal Reserve System, including imposing federal capital requirements similar to those imposed on all commercial banks and may result in additional restrictions on investments and other holding company activities.  The law also creates a new consumer financial protection bureau that will have the authority to promulgate rules intended to protect consumers in the financial products and services market.  The creation of this independent bureau could result in new regulatory requirements and raise the cost of regulatory compliance. In addition, new regulations mandated by this Act could require changes in regulatory capital








16








requirements, loan loss provisioning practices, and compensation practices and require holding companies to serve as a source of strength for their financial institution subsidiaries.  Effective July 21, 2011, financial institutions may pay interest on demand deposits, which could increase our future interest expense.  We cannot determine the impact of the new law on our business and operations at this time.  Any legislative or regulatory changes in the future could adversely affect our operations and financial condition.




CRITICAL ACCOUNTING POLICIES




General




The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.




Allowance for Loan Losses




The allowance for loan losses is an estimate of the losses that are inherent in our loan portfolio. The allowance is based on generally accepted accounting principles which require that losses be accrued when they are probable of occurring and estimable and that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.




The allowance for loan losses is maintained at a level considered by management to be adequate to absorb future loan losses currently inherent in the loan portfolio.  Management's assessment of the adequacy of the allowance is based upon type and volume of the loan portfolio, past loan loss experience, existing and anticipated economic conditions, and other factors which deserve current recognition in estimating future loan losses.  This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Additions to the allowance are charged to operations.  Subsequent recoveries, if any, are credited to the allowance.  Loans are charged-off partially or wholly at the time management determines collectability is not probable.  Management's assessment of the adequacy of the allowance is subject to evaluation and adjustment by the Company's regulators.





The allowance consists of specific, general and unallocated components.  The specific component relates to loans that are classified as doubtful or substandard.  For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.  The general component covers special mention and non-classified loans and is based on historical loss experience adjusted for qualitative factors.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.





A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.  Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.





Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.






17





FINANCIAL CONDITION





The Company's total assets decreased $8.1 million to $539.1 million at September 30, 2010 from $547.2 million at March 31, 2010 due to decreases in cash of $1.0 million and loans receivable of $10.4 million, partially offset by an increase real estate owned of $4.0 million. As stated above, the decline in our loan portfolio was primarily in construction loans, commercial business loans and consumer loans, while our residential first mortgage and commercial real estate loans increased.  We expect our future loan growth to be slow or moderate due to a slower economy and underwriting changes to limit funding of speculative construction loans.  We have also experienced reduced construction activity in our market areas while existing commercial real estate activity continues to be moderate.





Deposits decreased $11.4 million, or 2.9% to $386.9 million at September 31, 2010, from $398.4 million at March 31, 2010.  The decrease was primarily due to decreases in time deposits of $14.5 million and non-interest bearing accounts of $701,000, partially offset by increases in money market and interest checking accounts of $3.7 million. The decrease in deposits was related to the decrease in our assets and funding needs. The decrease in deposits was generally achieved by lowering the rates offered on our deposits products. FHLB advances increased $1.8 million and other borrowings increased $1.1 million at September 30, 2010 from March 31, 2010 to partially offset the decrease in deposits with lower rate funds.





Stockholders’ equity increased $146,000 to $49.2 million at September 30, 2010, from $49.0 million at March 31, 2010, due to income for the six months ended September 30, 2010 of $463,000, partially offset by cash dividend payments on our preferred stock.





At September 30, 2010, non-performing assets totaled approximately $19.1 million or 3.54% of assets compared to $17.7 million or 3.24% of assets at March 31, 2010.Non-performing assets at September 30, 2010 were comprised of repossessed assets of $7.1 million and non accrual loans of $12.0 million. Included in the total non-performing assets at September 30, 2010, was one relationship of approximately $2.9 million which includes a loan totaling $1.9 million secured by raw land.  At September 30, 2010, our allowance for loan losses to non-performing loans was69.8% and to total loans was 1.7% compared to 55.3% and 1.6%, respectively at March 31, 2010. At September 30, 2010, the percentage of delinquent loans to total loans was 5.53% compared to 6.28% at March 31, 2010. Our allowance for loan losses increased $306,000 at September 30, 2010 compared to March 31, 2010 due to allowances for specific loans.  Based on current market values of the properties securing these loans, management anticipates no significant losses in excess of the allowance for losses previously recorded.  Although management believes that it uses the best information available to make such determinations, future adjustments to allowances may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations. We also had $5.7 million of loans that were classified as Troubled Debt Restructurings (TDR’s) at September 30, 2010 none of which were included in nonaccrual loans. These loans have had their original terms modified to facilitate payment by the borrower. The loans have been classified as TDRs primarily due to a change to interest only payments. The terms of these modified loans will remain until such time that the Bank deems it beneficial to change the terms. The largest loan in this category is a nonresidential property with a loan balance of $1.6 million.





As of September 30, 2010, there were also $33.6 million in loans with respect to which known information about the possible credit problems of the borrowers or the cash flows of the security properties have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing loan categories. These loans are comprised primarily of non-owner occupied residential real estate loans with an average balance of approximately $173,000.  The largest individual loan or lending relationship in this category has a balance of $3.5 million and is secured by a hotel. This loan is of concern due to cash flow concerns. There are also five additional loans with balances greater than $1.0 million. A loan 60 days delinquent is generally included in this category and monitored until it has been current for six months. Certain loans that are not delinquent may be included due to the nature of the loan’s purpose such as construction or exhibits other potential weaknesses.






18







LIQUIDITY AND CAPITAL RESOURCES





Our principal sources of funds are customer deposits, advances from the Federal Home Loan Bank of Atlanta, amortization and prepayment of loans, and funds provided from operations. Management maintains investments in liquid assets based upon its assessment of (i) the need for funds, (ii) expected deposit flows, (iii) the yields available on short-term liquid assets, (iv) the liquidity of our loan portfolio and (v) the objectives of our asset/liability management program. Management believes that the Bank will continue to have adequate liquidity for the foreseeable future. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is provided. As of September 30, 2010, the Bank’s liquidity ratio (liquid assets as a percentage of net withdrawable savings and current borrowings) was 2.5% compared to 2.3% for the same quarter last year.




The Bank has a line of credit with the FHLB equal to 26% of the Bank’s assets, subject to the amount of collateral pledged. Under the terms of its collateral agreement with the FHLB, the Bank provides a blanket lien covering all of its residential first mortgage loans, home equity lines of credit, multi-family loans and commercial loans. In addition, the Bank pledges as collateral its capital stock in and deposits with the FHLB. Based on the collateral pledged as of September 30, 2010, the total amount of borrowing available under the FHLB line of credit was approximately $135.4 million.AtSeptember 30, 2010, principal obligations to the FHLB consisted of $78,000,000 in fixed-rate short term borrowings, $20,000,000 in fixed-rate convertible advances and a $4,000,000 letter of credit to the Treasurer of Virginia for public deposits.




At September 30, 2010, we had commitments to purchase or originate $6.1 million of loans. Certificates of deposit scheduled to mature in one year or less at September 30, 2010, totaled $196.5 million. Based on our historical experience, management believes that a significant portion of such deposits will remain with us. Management further believes that loan repayments and other sources of funds will be adequate to meet our foreseeable short-term and long-term liquidity needs. Due to the weak economy, the Bank has experienced reduced loan demand and anticipates a reduced liquidity need for loan funding. At September 30, 2010, we had brokered or internet time deposits of $22.3 million compared to $22.5 million at March 31, 2010.





The Bank’s regulatory capital is characterized as “well capitalized” due to the issuance of preferred stock under the U.S. Treasury Capital Purchase Program. The Companyreceived $12,643,000 from the U.S. Treasury through the sale of 12,643 shares of preferred stock. The Company also issued to the U.S. Treasury a warrant to purchase 351,194 shares of common stock at $5.40 per share. The preferred shares pay a cumulative dividend of 5% per year for the first five years and 9% per year thereafter.  The preferred shares are repayable at any time by the Company at 100% of the issue price, subject to the approval of the Company’s federal regulator.


RESULTS OF OPERATIONS





Three Months Ended September 30, 2010 and 2009.





General.  Net income (loss) for the three months ended September 30, 2010 decreased $1.6 million or 146.8% to ($525,000) from $1.1 million for the three months ended September 30, 2009. Net interest income increased $163,000, the provision for loan losses increased $2.5 million, non-interest income increased $86,000 and non-interest expense increased $385,000 during the three months ended September 30, 2010 compared to the same period in 2009. Return on equity for the three months ended September 30, 2010 was (4.24)% compared to 9.47% for the three month period ended September 30, 2009. Return on assets was (.38)% for quarter ended September 30, 2010 compared to .84% for the same period in the previous fiscal year.





Interest Income. Total interest income decreased $373,000 to $6.8 million for the three months ended September 30, 2010, from $7.2 million for the three months ended September 30, 2009, due to both a decrease in the volume and yield of our portfolio.  The average yield earned on interest-earning assets was 5.58% for the three months ended September 30, 2010 compared to 5.68% for the three months ended September 30, 2009.





Interest Expense.  Total interest expense decreased $535,000 to $1.5 million for the quarter ended September 30, 2010, from $2.0 million for the quarter ended September 30, 2009. Interest on deposits decreased $496,000 to $1.3 million for the quarter ended September 30, 2010 from $1.8 million for the quarter ended September 30, 2009 due to a decrease in the average rate paid, partially offset by higher average deposit balances. The average rate paid on








19








deposits was 1.31% during the three months ended September 30, 2010 compared to 2.42% for the three months ended September 30, 2009. The decrease in the average rate paid on deposits was due primarily to market changes. Interest expense on borrowed money decreased $39,000 to $214,000 for the quarter ended September 30, 2010 compared to $253,000 for the quarter ended September 30, 2009. A decrease in the average balance of borrowings from $109.2 million for the September 30, 2009 quarter to $104.5 million for the September 30, 2010 quarter and a decrease in the average rate paid on borrowings from 0.92% to 0.81% accounted for the decrease. The average rate paid on interest-bearing liabilities was 1.21% during the three months ended September 30, 2010 compared to 1.67% for the three months ended September 30, 2009.




Provision for Loan Losses.  The provision for loan losses increased $2.5 million, or 384%, to $3.2 million for the three months ended September 30, 2010, from $651,000 for the three months ended September 30, 2009, primarily as a result of the increased level of charge-offs during the period.  Charge-offs totaling  $4.3 million during the six month period ended September 31, 2010, compared to $474,000 during the same period in 2009,  were primarily related to residential real estate loans, land loans, commercial real estate loans and repossessed vehicles.  The amount of the provision for loan losses for the quarter ended September 30, 2010 was based on management’s assessment of the inherent risk associated with the decrease in our loan portfolio and the level of our allowance for loan losses. We provide valuation allowances for anticipated losses on loans and real estate when management determines that a significant decline in the value of the collateral or cash flows has occurred, as a result of which the value of the collateral or cash flows is less than the amount of the unpaid principal of the related loan plus estimated costs of acquisition and sale. In addition, we also provide allowances based on the dollar amount and type of collateral securing our loans in order to protect against unanticipated losses. At September 30, 2010, management believes its allowance for loan losses was adequate to absorb any probable losses inherent in the Company’s loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to allowances may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.


Noninterest Income.  Noninterest income increased $86,000, or 0.1%, to $1.1 million for the three months ended September 30, 2010, from $998,000 for the three months ended September 30, 2009.  Service charges, fees and commissions increased $127,000, or 14.8%, due to an increase in services charges and fees on transactional accounts, secondary mortgage fee income and fees associated with loans. The Bank has established relationships with other institutions where the Bank receives fees in return for completed customer mortgage loan applications for the institution’s approval and funding. We anticipate these relationships will continue to be a source of fee and service charge income for the Bank.  Other noninterest income declined $41,000, or 30.1%, to $95,000 for the three months ended September 30, 2010 compared to the same period in 2009, primarily due to the gains on sale of investment securities during the 2009 period that were not present in the 2010 period.





Noninterest Expense.  Noninterest expense increased $385,000, or 10.4%, to $4.1 million for the three months ended September 30, 2010 compared to the same period last year. The increase in noninterest expense for the current period resulted primarily from a $129,000, or 6.0%, increase in compensation related expenses, due generally to merit increases, and a 187,000, or 36.5%, increase in other expenses.  The increase in other expenses was related to the increase in real estate owned properties and the efforts to dispose of these assets.





In addition to the regular quarterly assessments, due to losses and projected losses attributed to failed institutions, the FDIC imposed a special assessment of 5 basis points on the amount of each depository institution’s assets reduced by the amount of its Tier 1 capital (not to exceed 10 basis points of its assessment base for regular quarterly premiums) as of June 30, 2009, which was collected on September 30, 2009.




Taxes.  Taxes decreased $1.0 million to $(353,000) for the three months ended September 30, 2010, from a $655,000 tax provision for the three months ended September 30, 2009. The effective tax rate for the September 30, 2010 quarter was 40.2%.





Six Months Ended September 30, 2010 and 2009.





General.  Net income for the six months ended September 30, 2010 decreased $1.4 million to $462,000 from $1,842,000 for the six months ended September 30, 2009.  Net income for the six months decreased due primarily to an increase in the provision for loan losses and was partially offset by an increase in net interest income.  Return on equity for the six months ended September 30, 2010 was 1.84% compared to 7.78% for the six month period ended September 30, 2009. Return on assets was .17% for six months ended September 30, 2010 compared to .70% for the same period in the previous fiscal year.







20





Interest Income.  Total interest income increased $25,000, or 0.2%, to $14,091,000 for the six months ended September 30, 2010, from $14,066,000 for the six months ended September 30, 2009 due to a decrease in loan yields and a decrease in average investment security balances offset by an increase in average loan balances. The yield on loans and securities decreased from 5.70% to 5.52% for the same periods.





Interest Expense.  Total interest expense decreased $1.4 million, or 30.4%, to $3.1 million for the six months ended September 30, 2010, from $4.5 million for the six months ended September 30, 2009. Interest on deposits decreased to $2.7 million for the six months ended September 30, 2010, from $4.0 million for the same period last year due to a decrease in the average rate paid on deposit balances, partially offset by an increase in the average deposit balances. The rate paid on deposits decreased from 2.15% for the six months ended September 30, 2009 to 1.37% for the same period in the current fiscal year. The decrease in the average rate paid on deposits was due primarily to market changes.Interest expense on borrowed money decreased to $431,000 for the six months ended September 30, 2010 from $500,000 for the six months ended September 30, 2009 due to a decrease in the average rate on borrowing balances and decrease in the average outstanding balance on borrowings. The average balance on borrowings decreased from $108.9 million for the six months ended September 30, 2009 to $102.5 million for the six months ended September 30, 2010. The average rate paid on borrowings decreased from .92% for the six months ended September 30, 2009 to .84% for the six month period ended September 30, 2010.





Provision for Loan Losses.  The provision for loan losses increased $3.5 million, or 373%, to $4.4 million for the six months ended September 30, 2010 from $932,000 for the six months ended September 30, 2009 based on managements’ review of the inherent risk associated with the increase in the commercial real estate lending portfolio and anticipated charge-offs related to certain loans for which we have established specific reserves.





Noninterest Income.  Noninterest income increased $125,000, or 6.4%, to $2.1 million for the six months ended September 30, 2010, from $2.0 million for the six months ended September 30, 2010.  Service charges and fees increased $164,000, or 9.5%, due primarily from fees associated with loans and services charges and fees on transactional accounts.Other noninterest income declined $39,000, or 17.3%, to $186.524 for the six months ended September 30, 2010 compared to the same period in 2009, primarily due to the gains on sale of investment securities during the 2009 period that were not present in the 2010 period.





Noninterest Expenses.  Noninterest expenses increased $306,000, or 4.0%, for the six months ended September 30, 2010, compared to the same period last year.  The increase in noninterest expense resulted primarily from a $322,000, or 35.2%, increase in other expenses.  The increase in other expenses primarily was related to the increase in real estate owned properties and the efforts to dispose of these assets.  Compensation related expenses increased $56,000 due generally to merit increases. These increases were partially offset by a decrease in federal deposit insurance premiums of $109,000.


Taxes.  Taxes decreased to $220,000 for the six months ended September 30, 2010, from $1.1 million for the six months ended September 30, 2009. The effective tax rate decreased to 32.2% for the September 30, 2010 period from 37.9% for the same period ended September 30, 2009.




OFF BALANCE SHEET ARRANGEMENTS




There has not been a significant change in our off balance sheet arrangements from the information reported in our annual 10-K for the period ended March 31, 2010.




CONTRACTUAL OBLIGATIONS




There has not been a significant change in our contractual obligations from the information reported in our annual 10-K for the period ended March 31, 2010.






21







RECENT ACCOUNTING PRONOUNCEMENTS





In June 2009, the FASB issued new guidance relating to the accounting for transfers of financial assets. The new guidance, which was issued as SFAS No. 166, “Accounting for Transfers of Financial Assets, an amendment to SFAS No. 140”, was adopted into Codification in December 2009 through the issuance of Accounting Standards Update (ASU) 2009-16. The new standard provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  ASU 2009-16 was effective for transfers on or after January 1, 2010.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In June 2009, the FASB issued new guidance relating to variable interest entities.  The new guidance, which was issued as SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” was adopted into Codification in December 2009. The objective of the guidance is to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS No. 167 was effective as of January 1, 2010. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In October 2009, the FASB issued ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.” ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics – Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections to existing SEC guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residential method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring defined benefit obligation. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In February 2010, the FASB issued ASU 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements.”  ASU 2010-09 addresses both the interaction of the requirements of Topic 855 with the SEC’s reporting requirements and the intended breadth of the reissuance disclosures provisions related to subsequent events.  An entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated.  ASU 2010-09 is effective immediately. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.





In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.”  The new disclosure guidance will significantly expand the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements.  The extensive new disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending on or after December 15, 2010.  Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance rollforward and modification disclosures, will be required for periods beginning or or after December 15, 2010.  The Company is currently assessing the impact that ASU 2010-20 will have on its consolidated financial statements.






22





On September 15, 2010, the SEC issued Release No. 33-9142, “Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Non-Accelerated Filers.”  This release issued a final rule adopting amendments to its rules and forms to conform them to Section 404(c) of the Sarbanes-Oxley Act of 2002 (SOX), as added by Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  SOX Section 404(c) provides that Section 404(b) shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934. Release No. 33-9142 was effective September 21, 2010.





On September 17, 2010, the SEC issued Release No. 33-9144, “Commission Guidance on Presentation of Liquidity and Capital Resources Disclosures in Management’s Discussion and Analysis.”  This interpretive release is intended to improve discussion of liquidity and capital resources in Management’s Discussion and Analysis of Financial Condition and Results of Operations in order to facilitate understanding by investors of the liquidity and funding risks facing the registrant. This release was issued in conjunction with a proposed rule, “Short-Term Borrowings Disclosures,” that would require public companies to disclose additional information to investors about their short-term borrowing arrangements. Release No. 33-9144 was effective on September 28, 2010.




Disclosure Regarding Forward-Looking Statements




This document, including information incorporated by reference, contains, and future filings by Community Financial Corporation on Form 10-K, Form 10-Q and Form 8-K and future oral and written statements by Community Financial Corporation and its management may contain, forward-looking statements about Community Financial Corporation which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements with respect to anticipated future operating and financial performance, including revenue creation, lending origination, operating efficiencies, loan sales, charge-offs and loan loss provisions, growth opportunities, interest rates, acquisition and divestiture opportunities, and synergies, efficiencies, cost savings and funding advantages. These forward-looking statements are based on currently available competitive, financial and economic data and management's views and assumptions regarding future events. These forward-looking statements are inherently uncertain, and investors must recognize that actual results may differ from those expressed or implied in the forward-looking statements. Accordingly, Community Financial Corporation cautions readers not to place undue reliance on any forward-looking statements.




Many of these forward-looking statements appear in this document in Management's Discussion and Analysis. Words such as may, could, should, would, believe, anticipate, estimate, expect, intend, plan and similar expressions are intended to identify these forward-looking statements. The important factors discussed below, as well as other factors discussed elsewhere in this document and factors identified in our filings with the Securities and Exchange Commission and those presented elsewhere by our management from time to time, could cause actual results to differ materially from those indicated by the forward-looking statements made in this document. Among the factors that could cause our actual results to differ from these forward-looking statements are:




·
the strength of the United States economy in general and the strength of the local economies in which we conduct our operations; general economic conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, a deterioration in the credit quality of our loans and other assets and a reduction in the value of the collateral securing our loans;




·
the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board;




·
financial market, monetary and interest rate fluctuations, particularly the relative relationship of short-term interest rates to long-term interest rates;




·
the accuracy of our estimates in evaluating our allowance for loan losses or determining the fair value of our securities;






23








·
the credit risks of lending activities, including changes in the level and trend of loan delinquencies and charge-offs;




·
fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas;




·
results of examinations by the OTS or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to enter into a formal enforcement action  or to increase our allowance for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings;




·
our ability to attract and retain deposits;




·
further increases in premiums for deposit insurance;




·
our ability to control operating costs and expenses;




·
the timely development of and acceptance of new products and services of Community Financial Corporation and Community Bank, and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors' products and services;




·
the impact of changes in financial services laws and regulations (including laws concerning taxes, accounting standards, banking, securities and insurance) legislative or regulatory changes may adversely affect the business in which we are engaged;




·
the impact of technological changes;




·
changes in consumer spending and saving habits; and




·
our success at managing the risks involved in the foregoing.




ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





There have been no material changes in market risk since our March 31, 2010 year end. Market risk is discussed as part of management’s discussion and analysis under asset/liability management in the Company’s annual report for March 31, 2010.





ITEM 4.  CONTROLS AND PROCEDURES




An evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 (the "Act")) as of September 30, 2010, was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures in effect as of September 30, 2010, were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is: (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. In addition, there have been no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended September 30, 2010, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls may be circumvented by the individual acts of some persons, by collusion of two or more people, or by override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.





24


PART II.  OTHER INFORMATION





Item 1.  Legal Proceedings





Not Applicable.





Item 1A.  Risk Factors





Not required for smaller reporting company





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





Not Applicable.





Item 3.  Defaults Upon Senior Securities





Not Applicable.





Item 4.  (Removed and Reserved)





Not Applicable.





Item 5.  Other Information





Not Applicable.





Item 6.  Exhibits





See Exhibit Index


25





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.





COMMUNITY FINANCIAL CORPORATIONDate: November 12, 2010
By:
/s/ R. Jerry GilesR. Jerry Giles

Chief Financial Officer

(Duly Authorized Officer)











26





EXHIBIT INDEX




Exhibit Number

Document3.1

Amended and Restated Articles of Incorporation, filed on July 5, 1996 as an exhibit to the Registrant’s Definitive Proxy Statement on Schedule 14A (SEC File No. 000-18265), are incorporated herein by reference.3.2

Certificate of Amendment and Articles of Amendment for the Series A Preferred Stock, filed on December 22, 2008, as Exhibit 3.1 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.3.3

Bylaws, as amended and restated, filed on December 20, 2007 as Exhibit 3.2 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.4.1

Registrant’s Specimen Common Stock Certificate, filed on June 29, 1999 as Exhibit 4 to the Annual Report on Form 10-KSB (SEC File No. 000-18265) for the fiscal year ended March 31, 1999, is incorporated herein by reference.4.2

Registrant’s Form of Certificate for the Series A Preferred Stock, filed on December 22, 2008, as Exhibit 4.1 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.4.3

Registrant’s Form of Warrant for Purchase of Shares of Common Stock, filed on December 22, 2008, as Exhibit 4.2 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.1

Registrant’s 1996 Incentive Plan, filed on July 5, 1996 as an exhibit to the Registrant’s Definitive Proxy Statement on Schedule 14A (SEC File No. 000-18265), is incorporated herein by reference.10.2

Form of Change in Control Agreement by and between Community Financial Corporation and each of R. Jerry Giles and Benny N. Werner, filed on May 5, 2006 as Exhibit 99.5 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.3

Retirement Agreements by and between Community Bank and Non-Employee Directors filed on June 29, 2004 as an exhibit to the Registrant’s Annual Report on Form 10-KSB (SEC File No. 000-18265) for the fiscal year ended March 31, 2004, and incorporated here by reference.10.4

Form of First Amendment to the Retirement Agreements by and between Community Bank and Non-Employee Directors, filed on June 29, 2005 as an exhibit to the Registrant’s Annual Report on Form 10-K (SEC File No. 000-18265) for the fiscal year ended March 31, 2005, is incorporated here by reference.10.5

Salary Continuation Agreements by and between Community Bank and Officers Giles, Smiley and Werner filed on June 29, 2004 as an exhibit to the Registrant’s Annual Report on Form 10-KSB (SEC File No. 000-18265) for the fiscal year ended March 31, 2004, and incorporated herein by reference.10.6

Form of Director Deferred Fee Agreement, as amended, filed on June 29, 2005 as an exhibit to the Registrant’s Annual Report on Form 10-K (SEC File No. 000-18265) for the fiscal year ended March 31, 2005, is incorporated herein by reference.10.7

Registrant’s 2003 Stock Option and Incentive Plan, filed on December 27, 2003 as an exhibit to the Registrant’s Definitive Proxy Statement on Schedule 14A (SEC File No. 000-18265), is incorporated herein by reference.10.8

Form of Incentive Stock Option Agreement and Non-Qualified Stock Option Agreement for Registrant’s 2003 Stock Option and Incentive Plan, filed on August 12, 2005 as an exhibit to the Registrant’s Quarterly Report on Form 10-Q (SEC File No. 000-18265) for the quarter ended June 30, 2005, are incorporated herein by reference.














10.9

Employment Agreement by and between Community Bank and Norman C. Smiley, III, filed on June 16, 2008 as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.10

Change in Control Agreement by and between Community Financial Corporation and Norman C. Smiley, III, filed on June 16, 2008 as an exhibit to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.11

Form of Change in Control Agreement by and between Community Financial Corporation and Lyle Moffett, filed on July 1, 2008 as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.12

Form of Change in Control Agreement by and between Community Financial Corporation and John Howerton, filed on November 14, 2008 as an exhibit to the Registrant’s Report on Form 10-Q (SEC File No. 000-18265), is incorporated herein by reference.10.13

Letter Agreement, including Schedule A, and Securities Purchase Agreement, dated December 19, 2008, between Community Financial Corporation and United States Department of the Treasury, with respect to the issuance and sale of the Series A Preferred Stock and Warrant, filed on December 22, 2008, as Exhibit 10.1 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.10.14

Form of Compensation Modification Agreement and Waiver, executed by  Norman C. Smiley, III, filed on December 22, 2008, as Exhibit 10.2 to the Registrant’s Current Report on Form 8-K (SEC File No. 000-18265), is incorporated herein by reference.11

Statement re computation of per share earnings (see Note 3 of the Notes to Unaudited Interim Consolidated Financial Statements included in this Current Report on Form 10-Q).31.1

Rule 13(a)-14(a) Certification (Chief Executive Officer)31.2

Rule 13(a)-14(a) Certification (Chief Financial Officer)32

Section 1350 Certifications