** **

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **x** | **QUARTERLY   REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE   ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------------------|

 

**For the Quarterly Period ended March 31, 2011**

 

**OR**

 

| **o** | **TRANSITION   REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE   ACT OF 1934** |
|-------|------------------------------------------------------------------------------------------------------------|

 

**For the Transition Period from                   to                  **

 

**Commission File No. 000-51907**

 

**Independence Bancshares, Inc.**

(Exact name of registrant as specified in its charter)

 

| **South Carolina**                               | ** ** | **20-1734180**                         |
|--------------------------------------------------|------------|----------------------------------------|
| (State or other   jurisdiction of incorporation) |       | (I.R.S. Employer   Identification No.) |

 

**500 East Washington Street**

**Greenville, South Carolina 29601**

(Address of principal executive offices)

 

**(864) 672-1776**

(Registrant’s telephone number, including area code)

 

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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 x No o

 

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

 

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

 

| Large accelerated filer o |   | Accelerated filer o         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated o         |   | Smaller reporting company x |

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  2,085,010 shares of common stock, $.01 par value per share, were issued and outstanding as of May 13, 2011.

 

 

 

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**Independence Bancshares, Inc.**

 

**Part I - Financial Information**

 

**Item 1. Financial Statements**

 

**Consolidated Balance Sheets**

** **
| ** **                                                                                                        | ** ** | **March 31, 2011** | ** **  | **December 31, 2010** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                        | ** ** | **(unaudited)**              | ** **  | **(audited)**                   | ** ** |
| **Assets**                                                                                                        | ** ** | ** **                   | ** **  | ** **                      | ** ** |
| Cash and due from banks                                                                                           |       | $                            | 5,501,648   |                            | $          | 2,993,102 |   |
| Federal funds sold                                                                                                |       | 8,885,000                    |        | 7,700,000                       |       |
| Investment securities   available for sale                                                                        |       | 10,177,676                   |        | 10,652,733                      |       |
| Non-marketable equity   securities                                                                                |       | 1,296,450                    |        | 1,400,350                       |       |
| Loans, net of allowance   for loan losses of $3,123,772 and $3,062,492, respectively                              |       | 87,306,593                   |        | 91,402,749                      |       |
| Accrued interest   receivable                                                                                     |       | 293,668                      |        | 291,499                         |       |
| Property and equipment,   net                                                                                     |       | 3,639,522                    |        | 3,687,386                       |       |
| Other real estate owned   and repossessed assets                                                                  |       | 2,256,717                    |        | 2,537,259                       |       |
| Other assets                                                                                                      |       | 1,278,181                    |        | 1,145,890                       |       |
| Total assets                                                                                                      |       | $                            | 120,635,455 |                            | $          | 121,810,968 |   |
|                                                                                                              |       |                         |        |                            |       |
| **Liabilities**                                                                                                   | ** ** | ** **                   |        |                            |       |
| Deposits:                                                                                                         |       |                         |        |                            |       |
| Noninterest bearing                                                                                               |       | $                            | 6,886,400   |                            | $          | 5,710,240 |   |
| Interest bearing                                                                                                  |       | 97,571,600                   |        | 98,370,429                      |       |
| Total deposits                                                                                                    |       | 104,458,000                  |        | 104,080,669                     |       |
|                                                                                                              |       |                         |        |                            |       |
| Borrowings                                                                                                        |       | 7,036,921                    |        | 7,065,479                       |       |
| Accrued interest payable                                                                                          |       | 64,677                       |        | 69,473                          |       |
| Accounts payable and   accrued expenses                                                                           |       | 102,120                      |        | 144,003                         |       |
| Total liabilities                                                                                                 |       | 111,661,718                  |        | 111,359,624                     |       |
|                                                                                                              |       |                         |        |                            |       |
| Commitments and   contingencies                                                                                   |       |                         |        |                            |       |
|                                                                                                              |       |                         |        |                            |       |
| **Shareholders’   equity**                                                                                   | ** ** | ** **                   |        |                            |       |
| Preferred stock, par value   $.01 per share; 10,000,000 shares authorized; no shares issued                       |       | —                       |        | —                          |       |
| Common stock, par value   $.01 per share; 10,000,000 shares authorized; 2,085,010 shares issued and   outstanding |       | 20,850                       |        | 20,850                          |       |
| Additional paid-in capital                                                                                        |       | 21,098,785                   |        | 21,095,485                      |       |
| Accumulated other   comprehensive income                                                                          |       | 35,120                       |        | 34,725                          |       |
| Accumulated deficit                                                                                               |       | (12,181,018                  | )           | (10,699,716                     | )          |
|                                                                                                              |       |                         |        |                            |       |
| Total shareholders’ equity                                                                                   |       | 8,973,737                    |        | 10,451,344                      |       |
|                                                                                                              |       |                         |        |                            |       |
| Total liabilities and   shareholders’ equity                                                                 |       | $                            | 120,635,455 |                            | $          | 121,810,968 |   |

 

**The accompanying notes are an integral part of these consolidated financial statements.**

 

2

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**Independence Bancshares, Inc.**

** **

**Consolidated Statements of Operations**

**(unaudited)**

** **
| ** **                                                                     | ** ** | **Three Months Ended   March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2011**                                          | ** ** | **2010** | ** ** |
| **Interest income**                                                            |       |                                              |       |   |   |
| Loans                                                                          |       | $                                                 | 1,115,729  |   | $ | 1,273,279 |   |
| Investment securities                                                          |       | 75,737                                            |       | 63,490 |   |
| Federal funds sold and   other                                                 |       | 12,226                                            |       | 11,085 |   |
| Total interest income                                                          |       | 1,203,692                                         |       | 1,347,854 |   |
|                                                                           |       |                                              |       |   |   |
| **Interest expense**                                                           |       |                                              |       |   |   |
| Deposits                                                                       |       | 387,278                                           |       | 563,094 |   |
| Borrowings                                                                     |       | 52,146                                            |       | 132,011 |   |
| Total interest expense                                                         |       | 439,424                                           |       | 695,105 |   |
|                                                                           |       |                                              |       |   |   |
| Net interest income                                                            |       | 764,268                                           |       | 652,749 |   |
|                                                                           |       |                                              |       |   |   |
| Provision for loan losses                                                      |       | 870,000                                           |       | 100,000 |   |
|                                                                           |       |                                              |       |   |   |
| Net interest income after   provision for loan losses                          |       | (105,732                                          | )          | 552,749 |   |
|                                                                           |       |                                              |       |   |   |
| **Noninterest income**                                                         |       | 54,734                                            |       | 72,025 |   |
|                                                                           |       |                                              |       |   |   |
| **Noninterest expenses**                                                       |       |                                              |       |   |   |
| Compensation and benefits                                                      |       | 413,973                                           |       | 527,480 |   |
| Net write-downs and losses   on other real estate owned and repossessed assets |       | 445,795                                           |       | 232,055 |   |
| Occupancy and equipment                                                        |       | 147,720                                           |       | 147,959 |   |
| Insurance                                                                      |       | 125,662                                           |       | 113,364 |   |
| Data processing and   related costs                                            |       | 76,316                                            |       | 73,799 |   |
| Professional fees                                                              |       | 72,815                                            |       | 63,050 |   |
| Marketing                                                                      |       | 15,292                                            |       | 25,131 |   |
| Telephone and supplies                                                         |       | 15,923                                            |       | 18,131 |   |
| Other                                                                          |       | 116,808                                           |       | 53,546 |   |
| Total noninterest expenses                                                     |       | 1,430,304                                         |       | 1,254,515 |   |
|                                                                           |       |                                              |       |   |   |
| Loss before income tax   benefit                                               |       | (1,481,302                                        | )          | (629,741 | ) |
|                                                                           |       |                                              |       |   |   |
| **Income tax benefit**                                                         |       | —                                            |       | — |   |
|                                                                           |       |                                              |       |   |   |
| Net loss                                                                       |       | $                                                 | (1,481,302 | ) | $ | (629,741 | ) |
|                                                                           |       |                                              |       |   |   |
| **Loss per common share —   basic and diluted**                           |       | $                                                 | (0.71      | ) | $ | (0.30 | ) |
|                                                                           |       |                                              |       |   |   |
| **Weighted average common   shares outstanding — basic and diluted**      |       | 2,085,010                                         |       | 2,085,010 |   |

 

**The accompanying notes are an integral part of these consolidated financial statements.**

 

3

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**Independence Bancshares, Inc.**

 

**Consolidated Statements of Changes**

**In Shareholders’ Equity and Comprehensive Income (Loss)**

**(unaudited)**

 
| ** **                                                                | ** ** | ** **            | ** ** | ** **     | ** ** | ** **               | ** ** | **Accumulated**        | ** ** | ** **  | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **                                                                | ** ** | ** **            | ** ** | ** **     | ** ** | ** **               | ** ** | **other**              | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **comprehensive**        | ** ** | **Accumulated**        | ** ** | ** **  | ** ** |
| ** **                                                                | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **income (loss)** | ** ** | **deficit** | ** ** | **Total**  | ** ** |
|                                                                      |       |                  |       |           |       |                     |       |                   |       |        |       |       |       |
| **December 31,   2009**                                              |       | 2,085,010             |       | $              | 20,850     |                     | $          | 20,997,135             |       | $           | 23,052     |       | $          | (4,354,170 | ) | $ | 16,686,867 |   |
| Compensation expense   related to stock options granted                   |       | —                |       | —         |       | 37,500                   |       | —                 |       | —      |       | 37,500     |       |
| Net loss                                                                  |       | —                |       | —         |       | —                   |       | —                 |       | (629,741    | )          | (629,741   | )          |
| Unrealized loss on   investment securities available for sale, net of tax |       | —                |       | —         |       | —                   |       | (18,114                | )          | —      |       | (18,114    | )          |
| Total comprehensive loss                                                  |       | —                |       | —         |       | —                   |       | —                 |       | —      |       | (647,855   | )          |
| **March 31,   2010**                                                 |       | 2,085,010             |       | $              | 20,850     |                     | $          | 21,034,635             |       | $           | 4,938      |       | $          | (4,983,911 | ) | $ | 16,076,512 |   |
|                                                                      |       |                  |       |           |       |                     |       |                   |       |        |       |       |       |
| **December 31,   2010**                                              |       | 2,085,010             |       | $              | 20,850     |                     | $          | 21,095,485             |       | $           | 34,725     |       | $          | (10,699,716 | ) | $ | 10,451,344 |   |
| Compensation expense   related to stock options granted                   |       | —                |       | —         |       | 3,300                    |       | —                 |       | —      |       | 3,300      |       |
| Net loss                                                                  |       | —                |       | —         |       | —                   |       | —                 |       | (1,481,302  | )          | (1,481,302 | )          |
| Unrealized gain on   investment securities available for sale, net of tax |       | —                |       | —         |       | —                   |       | 395                    |       | —      |       | 395        |       |
| Total comprehensive loss                                                  |       | —                |       | —         |       | —                   |       | —                 |       | —      |       | (1,480,907 | )          |
| **March 31,   2011**                                                 |       | 2,085,010             |       | $              | 20,850     |                     | $          | 21,098,785             |       | $           | 35,120     |       | $          | (12,181,018 | ) | $ | 8,973,737 |   |

 

**The accompanying notes are an integral part of these consolidated financial statements.**

 

4

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**Independence Bancshares, Inc.**

 

**Consolidated Statements of Cash Flows**

**(unaudited)**

 
| ** **                                                                     | ** ** | **Three Months Ended   March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2011**                                          | ** ** | **2010** | ** ** |
| **Operating activities**                                                       |       |                                              |       |   |   |
| Net loss                                                                       |       | $                                                 | (1,481,302 | ) | $ | (629,741 | ) |
| Adjustments to reconcile   net loss to cash used in operating activities       |       |                                              |       |   |   |
| Provision for loan losses                                                      |       | 870,000                                           |       | 100,000 |   |
| Depreciation                                                                   |       | 49,267                                            |       | 50,148 |   |
| Amortization of investment   securities discounts, net                         |       | 6,550                                             |       | 15,555 |   |
| Compensation expense   related to stock options granted                        |       | 3,300                                             |       | 37,500 |   |
| Net write-downs and losses   on other real estate owned and repossessed assets |       | 445,795                                           |       | 232,055 |   |
| (Increase) decrease in   other assets, net                                     |       | (134,460                                          | )          | 90,941 |   |
| Decrease   in other liabilities, net                                           |       | (46,883                                           | )          | (29,525 | ) |
| Net cash used in operating   activities                                        |       | (287,733                                          | )          | (133,067 | ) |
|                                                                           |       |                                              |       |   |   |
| **Investing   activities**                                                     |       |                                              |       |   |   |
| Repayments of loans, net                                                       |       | 2,516,656                                         |       | 2,689,213 |   |
| Purchase of investment   securities available for sale                         |       | (822,191                                          | )          | — |   |
| Maturity of investment   securities available for sale                         |       | 1,000,000                                         |       | — |   |
| Repayments of investment   securities available for sale                       |       | 291,297                                           |       | 648,189 |   |
| Redemption of   non-marketable equity securities, net                          |       | 103,900                                           |       | — |   |
| Purchase of property and   equipment, net                                      |       | (1,403                                            | )          | (10,989 | ) |
| Sale of other real estate   owned and repossessed assets                       |       | 544,247                                           |       | 317,945 |   |
| Net cash provided by   investing activities                                    |       | 3,632,506                                         |       | 3,644,358 |   |
|                                                                           |       |                                              |       |   |   |
| **Financing   activities**                                                     |       |                                              |       |   |   |
| Increase in deposits, net                                                      |       | 377,331                                           |       | 5,157,297 |   |
| Decrease in borrowings                                                         |       | (28,558                                           | )          | (2,103,898 | ) |
| Net cash provided by   financing activities                                    |       | 348,773                                           |       | 3,053,399 |   |
|                                                                           |       |                                              |       |   |   |
| **Net   increase in cash and cash equivalents**                                |       | 3,693,546                                         |       | 6,564,690 |   |
|                                                                           |       |                                              |       |   |   |
| **Cash and   cash equivalents at beginning of the period**                     |       | 10,693,102                                        |       | 10,224,360 |   |
|                                                                           |       |                                              |       |   |   |
| **Cash and   cash equivalents at end of the period**                           |       | $                                                 | 14,386,648 |   | $ | 16,789,050 |   |
|                                                                           |       |                                              |       |   |   |
| **Supplemental   information:**                                                |       |                                              |       |   |   |
| **Cash paid for**                                                              |       |                                              |       |   |   |
| Interest                                                                       |       | $                                                 | 444,220    |   | $ | 723,534 |   |
| **Schedule   of non-cash transactions**                                        |       |                                              |       |   |   |
| Change   in unrealized gain on securities, net of tax                          |       | $                                                 | 395        |   | $ | (18,114 | ) |
| Loans   transferred to other real estate owned                                 |       | $                                                 | 709,500    |   | $ | — |   |

 

**The accompanying notes are an integral part of these consolidated financial statements.**

 

5

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**Notes to Unaudited Consolidated Financial Statements**

 

**NOTE 1 — NATURE OF BUSINESS AND BASIS OF PRESENTATION**

 

***Independence Bancshares, Inc.*** (the “Company”) is a South Carolina corporation organized to operate as a bank holding company pursuant to the Federal Bank Holding Company Act of 1956 and the South Carolina Bank Holding Company Act, and to own and control all of the capital stock of Independence National Bank (the “Bank”).  The Bank is a national association organized under the laws of the United States to conduct general banking business in Greenville, South Carolina.

 

**Basis of Presentation**

 

The accompanying unaudited 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.  Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.  Operating results for the three month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.  For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.

 

**Subsequent Events**

 

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.  Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management performed an evaluation to determine whether or not there have been any subsequent events since the balance sheet date, and concluded that no subsequent events had occurred requiring accrual or disclosure through the date of this filing.

 

**Recent Regulatory Developments**

 

On January 20, 2010, the Bank entered into a Formal Agreement (the “Formal Agreement”) with its primary regulator, the Office of the Comptroller of the Currency (the “OCC”).  The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management.  In addition, the OCC has established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks.  The Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%.  The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam that led to the Formal Agreement and will continue to work to comply with all the requirements of the Formal Agreement.  As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital.  As of March 31, 2011, total risk-based capital was 10.3% compared to the required 12%, Tier 1 capital was 9.0% compared to the required 10%, and leverage ratio was 7.3% compared to the required 9%.  However, the Bank is still considered to be well capitalized by the OCC as the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives.  For additional information on the Formal Agreement, including actions the Bank has taken in response to the Formal Agreement, see “Management’s Discussion and Analysis — Recent Regulatory Developments” and “Management’s Discussion and Analysis — Results of Operations — Capital Resources.”

 

**NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

A summary of significant accounting policies is included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2010.  For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.  Accounting standards that have been issued or proposed by the Financial Accounting Standards Board that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.

 

6

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**Cash and Cash Equivalents**- For purposes of reporting cash flows, cash and cash equivalents include cash, amounts due from banks and federal funds sold.  Generally, federal funds are sold for one-day periods.  Due to the short term nature of cash and cash equivalents, the carrying amount of these instruments is deemed to be a reasonable estimate of fair value.

 

**Loss per Share** - Basic loss per share represents net loss divided by the weighted-average number of common shares outstanding during the period.  Dilutive loss per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method.  For the three month periods ended March 31, 2011 and 2010, as a result of the Company’s net loss, all of the potential common shares were considered anti-dilutive.

 

**Fair Value Measurements -**The Company determines the fair market values of its financial instruments based on the fair value hierarchy established in FASB ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”), which provides a framework for measuring and disclosing fair value under generally accepted accounting principles.  ASC Topic 820 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).

 

ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1 — Valuations are based on quoted prices in active markets for identical assets or liabilities.

 

Level 2 — Valuations are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3 — Valuations include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

**Income Taxes** - The Company accounts for income taxes in accordance with FASB ASC Topic 740, “Income Taxes”. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns.  Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.  Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized.  For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for 2010 as filed with the Securities and Exchange Commission.

 

We did not recognize any income tax benefit for the three months ended March 31, 2011 or 2010.  Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized.  The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified.  During our quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned.

 

7

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The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities, and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flows. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to ASC 740, “Income Taxes”.

 

**Recently Issued Accounting Pronouncements** - The following is a summary of recent authoritative pronouncements that may affect our accounting, reporting, and disclosure of financial information:

 

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis.  The Company is required to include these disclosures in its interim and annual financial statements.  See Note 4 for applicable disclosures.

 

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011, the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR.   The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present.  Disclosures related to TDRs under ASU 2010-20 will be effective for reporting periods beginning after June 15, 2011.

 

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.

 

**NOTE 3 — INVESTMENT SECURITIES**

 

Investment securities classified as “Available for Sale” are carried at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity (net of estimated tax effects).  Realized gains or losses on the sale of investments are based on the specific identification method.  The amortized costs and fair values of investment securities available for sale are as follows:

 
| ** **                         | ** ** | **March 31, 2011**    | ** **     |
|------------------------------------|------------|---------------------------------|----------------|
| ** **                         | ** ** | **Amortized**                   | ** **     | **Gross Unrealized** | ** ** | **Fair** | ** ** |
| ** **                         | ** ** | **Cost**                        | ** **     | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                               |       |                            |           |   |   |   |   |   |   |
| Government-sponsored   enterprises |       | $                               | 4,000,000      |   | $ | 3,594 |   | $ | (34,812 | ) | $ | 3,968,782 |   |
| Mortgage-backed securities         |       | 5,751,277                       |           | 93,494 |   | (22,442 | ) | 5,822,329 |   |
| Municipals, taxable                |       | 373,187                         |           | 13,378 |   | — |   | 386,565 |   |
|                               |       |                            |           |   |   |   |   |   |   |
| Total investment   securities      |       | **$**                           | **10,124,464** | ** ** | **$** | **110,466** | ** ** | **$** | **(57,254** | **)** | **$** | **10,177,676** | ** ** |
|                               |       |                            |           |   |   |   |   |   |   |   |   |   |   |
| ** **                         | ** ** | **December 31, 2010** | ** **     |
| ** **                         | ** ** | **Amortized**                   | ** **     | **Gross Unrealized** | ** ** | **Fair** | ** ** |
| ** **                         | ** ** | **Cost**                        | ** **     | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
|                               |       |                            |           |   |   |   |   |   |   |
| Government-sponsored   enterprises |       | $                               | 5,000,000      |   | $ | 12,723 |   | $ | (37,007 | ) | $ | 4,975,716 |   |
| Mortgage-backed securities         |       | 5,226,829                       |           | 87,186 |   | (24,588 | ) | 5,289,427 |   |
| Municipals, taxable                |       | 373,291                         |           | 14,299 |   | — |   | 387,590 |   |
|                               |       |                            |           |   |   |   |   |   |   |
| Total investment   securities      | ** ** | **$**                           | **10,600,120** | ** ** | **$** | **114,208** | ** ** | **$** | **(61,595** | **)** | **$** | **10,652,733** | ** ** |
|                                    |            |                                 |                |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At March 31, 2011, the investment portfolio included an unrealized gain of approximately $53,000. At March 31, 2011, the investment portfolio included five securities with a fair value of $4,940,429 and an amortized cost of $4,997,683 that had been in an unrealized loss position for less than twelve months and no securities in a loss position for more than twelve months.  The Company believes, based on industry analyst reports and credit ratings, that the deterioration in the fair value of these investment securities available for sale is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary.  The Company has the ability and intent to hold these securities until such time as the value recovers or the securities mature. At March 31, 2010, the investment portfolio included six securities with a fair value of $5,891,045 and an amortized cost of $5,930,480 that had been in an unrealized loss position for less than twelve months and no securities in a loss position for more than twelve months.

 

8

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**NOTE 4 — LOANS**

 

At March 31, 2011, our gross loan portfolio consisted primarily of $59.6 million of commercial real estate loans, $12.6 million of commercial business loans, and $18.3 million of consumer and home equity loans.  Our current loan portfolio composition is not materially different than the loan portfolio composition disclosed in the footnotes to the consolidated financial statements included in our Annual Report on Form 10-K for 2010 as filed with the SEC.

 

*Loan Performance and Asset Quality*

 

Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful.  When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed.  Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal.

 

The following table summarizes delinquencies and nonaccruals, by portfolio class, as of March 31, 2011 and December 31, 2010.

 
| ** **                      | ** ** | **Single and   multifamily   residential   real estate** | ** **     | **Construction   and   development** | ** ** | **Commercial   real estate -   other** | ** ** | **Commercial   business** | ** **     | **Consumer** | ** ** | **Total**      | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------|----------------|--------------|------------|----------------|------------|
| **March 31, 2011**         |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| 30-59 days past due             |       | $                                                                  | 1,027,731      |                                 | $          | —                                           |       | $                         | —         |         | $          | 78,767         |       | $ | — |   | $ | 1,106,498 |   |
| 60-89 days past due             |       | —                                                             |           | —                               |       | —                                           |       | 764                       |           | 6,979        |       | 7,743          |       |
| Nonaccrual                      |       | 2,017,236                                                          |           | 9,845,911                            |       | 1,430,870                                        |       | —                    |           | —       |       | 13,294,017     |       |
| Total past due and   nonaccrual |       | 3,044,967                                                          |           | 9,845,911                            |       | 1,430,870                                        |       | 79,531                    |           | 6,979        |       | 14,408,258     |       |
| Current                         |       | 22,723,793                                                         |           | 7,145,117                            |       | 32,196,165                                       |       | 12,559,412                |           | 1,488,919    |       | 76,113,406     |       |
| Total loans                     | ** ** | **$**                                                              | **25,768,760** | ** **                           | **$**      | **16,991,028**                                   | ** ** | **$**                     | **33,627,035** | ** **   | **$**      | **12,638,943** | ** ** | **$** | **1,495,898** | ** ** | **$** | **90,521,664** | ** ** |

 
| ** **                      | ** ** | **Single and   multifamily   residential   real estate** | ** **     | **Construction   and   development** | ** ** | **Commercial   real estate -   other** | ** ** | **Commercial   business** | ** **     | **Consumer** | ** ** | **Total**      | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------|----------------|--------------|------------|----------------|------------|
| **December 31, 2010**      |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| 30-59 days past due             |       | $                                                                  | 16,902         |                                 | $          | —                                           |       | $                         | 428,273        |         | $          | 1,409          |       | $ | 7,576 |   | $ | 454,160 |   |
| 60-89 days past due             |       | —                                                             |           | 145,718                              |       | 97,680                                           |       | —                    |           | —       |       | 243,398        |       |
| Nonaccrual                      |       | 3,098,499                                                          |           | 8,069,557                            |       | 861,432                                          |       | —                    |           | —       |       | 12,029,488     |       |
| Total past due and   nonaccrual |       | 3,115,401                                                          |           | 8,215,275                            |       | 1,387,385                                        |       | 1,409                     |           | 7,576        |       | 12,727,046     |       |
| Current                         |       | 24,292,606                                                         |           | 10,994,198                           |       | 32,630,608                                       |       | 12,260,814                |           | 1,651,994    |       | 81,830,220     |       |
| Total loans                     | ** ** | **$**                                                              | **27,408,007** | ** **                           | **$**      | **19,209,473**                                   | ** ** | **$**                     | **34,017,993** | ** **   | **$**      | **12,262,223** | ** ** | **$** | **1,659,570** | ** ** | **$** | **94,557,266** | ** ** |

 

At March 31, 2011 and December 31, 2010, there were nonaccrual loans of $13.3 million and $12.0 million, respectively.  Foregone interest income related to nonaccrual loans equaled $170,457 and $196,716 for the quarters ended March 31, 2011 and 2010, respectively.  No interest income was recognized on nonaccrual loans during for the quarters ended March 31, 2011 and 2010.  At both March 31, 2011 and December 31, 2010, there were no accruing loans which were contractually past due 90 days or more as to principal or interest payments.

 

As part of the loan review process, loans are given individual credit grades, representing the risk the Company believes is associated with the loan balance.  Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance.  Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy.  Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade.

 

9

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The following table summarizes management’s internal credit risk grades, by portfolio class, as of March 31, 2011 and December 31, 2010.

 
| ** **                          | ** ** | **Single and   multifamily   residential   real estate** | ** **     | **Construction   and   development** | ** ** | **Commercial   real estate -   other** | ** ** | **Commercial   business** | ** **     | **Consumer** | ** ** | **Total**      | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------|----------------|--------------|------------|----------------|------------|
| **March 31, 2011**             |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Pass Loans                          |       | $                                                                  | 15,053,301     |                                 | $          | 928,635                                          |       | $                         | —         |         | $          | —         |       | $ | 1,421,425 |   | $ | 17,403,361 |   |
| Grade 1 - Prime                     |       | —                                                             |           | —                               |       | —                                           |       | 65,429                    |           | —       |       | 65,429         |       |
| Grade 2 - Good                      |       | 43,664                                                             |           | 299,047                              |       | 494,770                                          |       | 140,092                   |           | —       |       | 977,573        |       |
| Grade 3 - Acceptable                |       | 2,023,803                                                          |           | 465,328                              |       | 16,324,265                                       |       | 6,318,615                 |           | —       |       | 25,132,011     |       |
| Grade 4 — Acceptable w/   Care |       | 5,883,609                                                          |           | 4,016,013                            |       | 12,511,197                                       |       | 5,906,481                 |           | —       |       | 28,317,300     |       |
| Grade 5 — Special Mention      |       | 733,473                                                            |           | 108,325                              |       | 1,491,327                                        |       | 208,326                   |           | —       |       | 2,541,451      |       |
| Grade 6 - Substandard               |       | 2,030,910                                                          |           | 11,173,680                           |       | 2,805,476                                        |       | —                    |           | 74,473       |       | 16,084,539     |       |
| Grade 7 - Doubtful                  |       | —                                                             |           | —                               |       | —                                           |       | —                    |           | —       |       | —         |       |
| Total loans                         | ** ** | **$**                                                              | **25,768,760** | ** **                           | **$**      | **16,991,028**                                   | ** ** | **$**                     | **33,627,035** | ** **   | **$**      | **12,638,943** | ** ** | **$** | **1,495,898** | ** ** | **$** | **90,521,664** | ** ** |

 
| ** **                          | ** ** | **Single and   multifamily   residential   real estate** | ** **     | **Construction   and   development** | ** ** | **Commercial   real estate -   other** | ** ** | **Commercial   business** | ** **     | **Consumer** | ** ** | **Total**      | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------|----------------|--------------|------------|----------------|------------|
| **December 31, 2010**          |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Pass Loans                          |       | $                                                                  | 15,304,972     |                                 | $          | 937,399                                          |       | $                         | —         |         | $          | —         |       | $ | 1,585,097 |   | $ | 17,827,468 |   |
| Grade 1 - Prime                     |       | —                                                             |           | —                               |       | —                                           |       | 65,429                    |           | —       |       | 65,429         |       |
| Grade 2 - Good                      |       | 44,312                                                             |           | 323,784                              |       | 253,851                                          |       | 130,628                   |           | —       |       | 752,575        |       |
| Grade 3 - Acceptable                |       | 1,936,575                                                          |           | 1,429,714                            |       | 16,769,211                                       |       | 5,964,501                 |           | —       |       | 26,100,001     |       |
| Grade 4 — Acceptable w/   Care |       | 5,488,792                                                          |           | 4,547,604                            |       | 14,142,081                                       |       | 5,884,011                 |           | —       |       | 30,062,488     |       |
| Grade 5 — Special Mention      |       | 1,534,857                                                          |           | 3,755,697                            |       | 1,381,947                                        |       | 217,654                   |           | —       |       | 6,890,155      |       |
| Grade 6 - Substandard               |       | 3,098,499                                                          |           | 8,215,275                            |       | 1,470,903                                        |       | —                    |           | 74,473       |       | 12,859,150     |       |
| Grade 7 - Doubtful                  |       | —                                                             |           | —                               |       | —                                           |       | —                    |           | —       |       | —         |       |
| Total loans                         | ** ** | **$**                                                              | **27,408,007** | ** **                           | **$**      | **19,209,473**                                   | ** ** | **$**                     | **34,017,993** | ** **   | **$**      | **12,262,223** | ** ** | **$** | **1,659,570** | ** ** | **$** | **94,557,266** | ** ** |

 

Loans graded one through four are considered “pass” credits.  As of March 31, 2011, approximately 59% of the loan portfolio had a credit grade of Acceptable or Acceptable with Care.  For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment. As of March 31, 2011, we had loans totaling $2.5 million classified as special mention.  This classification is utilized when an initial concern is identified about the financial health of a borrower.  Loans are designated as such in order to be monitored more closely than other credits in the loan portfolio.  At March 31, 2011, substandard loans totaled $16.1 million, with all but one loan being collateralized by real estate.  Substandard credits are evaluated for impairment on a quarterly basis.

 

The Company identifies impaired loans through its normal internal loan review process.  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.  Loans on the Company’s problem loan watch list are considered potentially impaired loans.  Generally, once loans are considered impaired, they are moved to nonaccrual status and recognition of interest income is discontinued.  Impairment is measured on a loan-by-loan basis based on the determination of the most probable source of repayment which is usually liquidation of the underlying collateral, but may also include discounted future cash flows, or in rare cases, the market value of the loan itself.

 

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.

 

10

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At March 31, 2011, impaired loans totaled $13.3 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral.  Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower.  As of March 31, 2011, we had loans totaling approximately $2.8 million that were classified in accordance with our loan rating policies but were not considered impaired.  The following table summarizes information relative to impaired loans, by portfolio class, at March 31, 2011 and December 31, 2010.

 
| ** **                                       | ** ** | **Unpaid   principal   balance** | ** **     | **Recorded   investment** | ** ** | **Related   allowance** | ** ** | **Average   impaired   investment** | ** **    | **Interest    income** | ** ** |
|--------------------------------------------------|------------|----------------------------------|----------------|---------------------------|------------|-------------------------|------------|-------------------------------------|---------------|-----------------------------|------------|
| **March 31,   2011**                        |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| With no related allowance   recorded:            |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | $                                | 102,083        |                      | $          | 102,083                 |       | $                                   | —        |                        | $          | 102,083 |   | $ | — |   |
| Construction and development                     |       | 2,786,299                        |           | 2,480,300                 |       | —                  |       | 1,466,650                           |          | —                      |       |
| Commercial real estate - other                   |       | 768,815                          |           | 768,815                   |       | —                  |       | 529,596                             |          | —                      |       |
| With related allowance recorded:                 |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | 2,148,731                        |           | 1,915,153                 |       | 196,154                 |       | 2,455,784                           |          | —                      |       |
| Construction and development                     |       | 8,458,792                        |           | 7,365,611                 |       | 879,993                 |       | 7,563,943                           |          | —                      |       |
| Commercial real estate - other                   |       | 754,482                          |           | 662,055                   |       | 152,000                 |       | 921,290                             |          | 9,907                       |       |
| Total:                                           |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | 2,250,814                        |           | 2,017,236                 |       | 196,154                 |       | 2,557,867                           |          | —                      |       |
| Construction and development                     |       | 11,245,091                       |           | 9,845,911                 |       | 879,993                 |       | 9,030,593                           |          | —                      |       |
| Commercial real estate - other                   |       | 1,523,297                        |           | 1,430,870                 |       | 152,000                 |       | 1,450,886                           |          | 9,907                       |       |
| ** **                                       | ** ** | **$**                            | **15,019,202** | ** **                | **$**      | **13,294,017**          | ** ** | **$**                               | **1,228,147** | ** **                  | **$**      | **13,039,346** | ** ** | **$** | **9,907** | ** ** |
| **December 31,   2010**                     |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| With no related allowance   recorded:            |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | $                                | 102,083        |                      | $          | 102,083                 |       | $                                   | —        |                        | $          | 248,045 |   | $ | — |   |
| Construction and development                     |       | 453,000                          |           | 453,000                   |       | —                  |       | 2,800,727                           |          | —                      |       |
| Commercial real estate - other                   |       | 290,377                          |           | 290,377                   |       | —                  |       | 58,075                              |          | —                      |       |
| Commercial business                              |       | —                           |           | —                    |       | —                  |       | 5,743                               |          | —                      |       |
| With related allowance recorded:                 |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | 3,413,462                        |           | 2,996,415                 |       | 551,415                 |       | 1,862,302                           |          | 13,222                      |       |
| Construction and development                     |       | 8,415,920                        |           | 7,762,275                 |       | 768,358                 |       | 5,141,497                           |          | 8,584                       |       |
| Commercial real estate - other                   |       | 1,218,225                        |           | 1,180,526                 |       | 251,971                 |       | 453,294                             |          | 10,152                      |       |
| Commercial business                              |       | —                           |           | —                    |       | —                  |       | 8,818                               |          | 441                         |       |
| Total:                                           |       |                             |           |                      |       |                    |       |                                |          |                        |       |
| Single and multifamily   residential real estate |       | 3,515,545                        |           | 3,098,498                 |       | 551,415                 |       | 2,110,347                           |          | 13,222                      |       |
| Construction and development                     |       | 8,868,920                        |           | 8,215,275                 |       | 768,358                 |       | 7,942,224                           |          | 8,584                       |       |
| Commercial real estate - other                   |       | 1,508,602                        |           | 1,470,903                 |       | 251,971                 |       | 511,369                             |          | 10,152                      |       |
| Commercial business                              |       | —                           |           | —                    |       | —                  |       | 14,561                              |          | 441                         |       |
| ** **                                       | ** ** | **$**                            | **13,893,067** | ** **                | **$**      | **12,784,676**          | ** ** | **$**                               | **1,571,744** | ** **                  | **$**      | **10,578,501** | ** ** | **$** | **32,399** | ** ** |

 

Troubled debt restructurings are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower.  Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note.  As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment.  The purpose of a troubled debt restructuring is to facilitate ultimate repayment of the loan.

 

At March 31, 2011, the principal balance of troubled debt restructurings totaled $1.3 million.  All troubled debt restructurings were considered classified, impaired, and in nonaccrual status at March 31, 2011.  All restructured loans are currently performing as expected under the new terms.  A troubled debt restructuring can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms.  We currently consider sufficient history to be approximately six months.

 

11

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*Provision and Allowance for Loan Losses*

 

An allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent losses in the loan portfolio.  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

 

The allowance consists of both a specific and a general component.  The specific component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”.  For such loans, an allowance is established when either 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 non-impaired loans and is based on historical loss experience adjusted for qualitative factors.

 

The following table summarizes activity related to our allowance for loan losses for the quarter ended March 31, 2011, by portfolio segment.

 
| ** **                             | ** ** | **Single and   multifamily   residential   real estate** | ** **     | **Construction   and   development** | ** ** | **Commercial   real estate -   other** | ** ** | **Commercial   business** | ** **     | **Consumer** | ** ** | **Total**      | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|----------------|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------|----------------|--------------|------------|----------------|------------|
| **March 31, 2011**                |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Allowance for loan losses:             |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Balance, beginning of year             |       | $                                                                  | 859,255        |                                 | $          | 1,365,914                                        |       | $                         | 473,504        |         | $          | 306,791        |       | $ | 57,028 |   | $ | 3,062,492 |   |
| Provision for loan losses              |       | 135,359                                                            |           | 740,328                              |       | 35,240                                           |       | (37,345                   | )              | (3,582       | )          | 870,000        |       |
| Loan charge-offs                       |       | (360,696                                                           | )              | (636,432                             | )          | (25,706                                          | )          | —                    |           | —       |       | (1,022,834     | )          |
| Loan recoveries                        |       | —                                                             |           | —                               |       | —                                           |       | 214,114                   |           | —       |       | 214,114        |       |
| Net loans charged-off                  |       | (360,696                                                           | )              | (636,432                             | )          | (25,706                                          | )          | 214,114                   |           | —       |       | (808,720       | )          |
| Balance, end of year                   | ** ** | **$**                                                              | **633,918**    | ** **                           | **$**      | **1,469,810**                                    | ** ** | **$**                     | **483,038**    | ** **   | **$**      | **483,560**    | ** ** | **$** | **53,446** | ** ** | **$** | **3,123.772** | ** ** |
|                                   |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Individually reviewed for   impairment |       | $                                                                  | 196,154        |                                 | $          | 879,993                                          |       | $                         | 152,000        |         | $          | —         |       | $ | — |   | $ | 1,228,147 |   |
| Collectively reviewed for   impairment |       | 437,764                                                            |           | 589,817                              |       | 331,038                                          |       | 483,560                   |           | 53,446       |       | 1,895,625      |       |
| Total allowance for loan   losses      | ** ** | **$**                                                              | **633,918**    | ** **                           | **$**      | **1,469,810**                                    | ** ** | **$**                     | **483,038**    | ** **   | **$**      | **483,560**    | ** ** | **$** | **53,446** | ** ** | **$** | **3,123.772** | ** ** |
|                                   |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Gross loans, end of   period:          |       |                                                               |           |                                 |       |                                             |       |                      |           |         |       |           |       |
| Individually reviewed for   impairment |       | $                                                                  | 2,017,236      |                                 | $          | 9,845,911                                        |       | $                         | 1,430,870      |         | $          | —         |       | $ | — |   | $ | 13,294,017 |   |
| Collectively reviewed for   impairment |       | 23,751,524                                                         |           | 7,145,117                            |       | 32,196,165                                       |       | 12,638,943                |           | 1,495,898    |       | 77,227,647     |       |
| Total gross loans                      | ** ** | **$**                                                              | **25,768,760** | ** **                           | **$**      | **16,991,028**                                   | ** ** | **$**                     | **33,627,035** | ** **   | **$**      | **12,638,943** | ** ** | **$** | **1,495,898** | ** ** | **$** | **90,521,664** | ** ** |

 

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments.  However, the entire allowance for loan losses is available for any loan that, in management’s judgment, should be charged-off. For the quarter ended March 31, 2011, we began using our own historical charge-off history versus that of our peers.  As a result, there were small decreases in the commercial real estate and consumer segments which were offset by increases in the other real estate segments.   While management utilizes the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications.  If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition.  There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

 

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**NOTE 5 — FAIR VALUE**

 

*Assets and Liabilities Measured at Fair Value*

 

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  The Company determines the fair values of its financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The three levels of inputs that may be used to measure fair value are detailed in Note 1.

 

Available-for-sale investment securities ($10.2 million at March 31, 2011) are carried at fair value and measured on a recurring basis using Level 2 inputs (other observable inputs).  Fair values are estimated by using bid prices and quoted prices of pools or tranches of securities with similar characteristics.

 

We do not record loans at fair value on a recurring basis.  However, from time to time, a loan is considered impaired and a specific reserve within the allowance for loan losses is established or the loan is charged down to the fair value less costs to sell.  At March 31, 2011, all impaired loans were evaluated on a nonrecurring basis based on the market value of the underlying collateral.  Market values are generally obtained using independent appraisals or other market data, which the Company considers to be level 2 inputs (other observable inputs).  The aggregate carrying amount, net of specific reserves, of impaired loans carried at fair value at March 31, 2011 was $8.7 million.

 

Other real estate owned and repossessed assets, consisting of properties or other collateral obtained through foreclosure or in satisfaction of loans, are carried at fair value and measured on a non-recurring basis.  Market values are generally obtained using independent appraisals or other current market information, including but not limited to offers received on a property, which the Company considers to be level 2 inputs (other observable inputs).  The carrying amount of other real estate owned and repossessed assets carried at fair value at March 31, 2011was $2.3 million.

 

The Company has no assets whose fair values are measured using Level 1 or Level 3 inputs.  The Company also has no liabilities carried at fair value or measured at fair value.

 

*Disclosures about Fair Value of Financial Instruments*

 

FASB ASC Topic 825, “Financial Instruments” requires disclosure of fair value information, whether or not recognized in the consolidated balance sheets, when it is practical to estimate the fair value.  FASB ASC Topic 825 defines a financial instrument as cash, evidence of an ownership interest in an entity or contractual obligations which require the exchange of cash or other financial instruments.  Certain items are specifically excluded from the disclosure requirements, including the Company’s common stock, property and equipment and other assets and liabilities.

 

Fair value approximates carrying value for the following financial instruments due to the short-term nature of the instrument:  cash and due from banks, federal funds sold, and securities sold under agreements to repurchase.  Investment securities are valued using quoted market prices.  No ready market exists for non-marketable equity securities, and they have no quoted market value.  However, redemption of these stocks has historically been at par value.  Accordingly, the carrying amounts are deemed to be a reasonable estimate of fair value.  Fair value of loans is based on the discounted present value of the estimated future cash flows.  Discount rates used in these computations approximate the rates currently offered for similar loans of comparable terms and credit quality.

 

Fair value for demand deposit accounts and interest bearing accounts with no fixed maturity date is equal to the carrying value. The fair value of certificate of deposit accounts are estimated by discounting cash flows from expected maturities using current interest rates on similar instruments.  Fair value for FHLB Advances is based on discounted cash flows using the Company’s current incremental borrowing rate.

 

The Company has used management’s best estimate of fair value based on the above assumptions.  Thus, the fair values presented may not be the amounts that could be realized in an immediate sale or settlement of the instrument.  In addition, any income taxes or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair value presented.

 

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The estimated fair values of the Company’s financial instruments at March 31, 2011 and December 31, 2010 are as follows:

 
| ** **                                       | ** ** | **March 31, 2011** | ** ** | **December 31, 2010** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **Carrying**                 | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                       | ** ** | **Amount**                   | ** ** | **Value**                       | ** ** | **Amount** | ** ** | **Value** | ** ** |
| **Financial   Assets:**                          | ** ** | ** **                   |       |                            |       |   |   |   |   |
| Cash and due from banks                          |       | $                            | 5,501,648  |                            | $          | 5,501,648 |   | $ | 2,993,102 |   | $ | 2,993,102 |   |
| Federal funds sold                               |       | 8,885,000                    |       | 8,885,000                       |       | 7,700,000 |   | 7,700,000 |   |
| Investment securities   available for sale       |       | 10,177,676                   |       | 10,177,676                      |       | 10,652,733 |   | 10,652,733 |   |
| Non-marketable equity   securities               |       | 1,296,450                    |       | 1,296,450                       |       | 1,400,350 |   | 1,400,350 |   |
| Loans, net                                       |       | 87,306,593                   |       | 77,267,469                      |       | 91,402,749 |   | 81,790,605 |   |
|                                             |       |                         |       |                            |       |   |   |   |   |
| **Financial   Liabilities:**                     | ** ** |                         |       |                            |       |   |   |   |   |
| Deposits                                         |       | 104,458,000                  |       | 104,820,754                     |       | 104,080,669 |   | 104,535,470 |   |
| Federal Home Loan Bank   advances                |       | 7,000,000                    |       | 7,302,628                       |       | 7,000,000 |   | 7,325,072 |   |
| Securities sold under   agreements to repurchase |       | 36,921                       |       | 36,921                          |       | 65,479 |   | 65,479 |   |
|                                                  |            |                              |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

 

*The following discussion reviews our results of operations and assesses our financial condition.  You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunction with the discussion of forward-looking statements, the financial statements, and the related notes and the other statistical information included in this report.*

 

**DISCUSSION OF FORWARD-LOOKING STATEMENTS**

 

This report contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance.  These statements are based on many assumptions and estimates and are not guarantees of future performance.  Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control.  The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements.  Potential risks and uncertainties that could cause our actual results to differ from those anticipated in our forward-looking statements include, but are not limited, to the following:

 

·                  general economic conditions, either nationally or regionally and especially in our primary service area, being less favorable than expected, resulting in, among other things, a deterioration in credit quality;

·                  greater than expected losses due to higher credit losses generally and specifically because losses in the sectors of our loan portfolio secured by real estate are greater than expected due to economic factors, including, but not limited to, declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;

·                  greater than expected losses due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

·                  the amount of our loan portfolio collateralized by real estate and weakness in the real estate market;

·                  the rate of delinquencies and amount of loans charged-off;

·                  the adequacy of the level of our allowance for loan losses and the amount of loan loss provisions required in future periods;

·                  the rate of loan growth in recent years and the lack of seasoning of our loan portfolio;

·      our ability to comply with our Formal Agreement and potential regulatory actions if we fail to comply;

·                  our ability to maintain appropriate levels of capital and to comply with our higher individual minimum capital ratios;

·                  our ability to attract and retain key personnel;

·                  our ability to retain our existing customers, including our deposit relationships;

·                  significant increases in competitive pressure in the banking and financial services industries;

·                  adverse changes in asset quality and resulting credit risk related losses and expenses;

·                  changes in the interest rate environment which could reduce anticipated or actual margins;

·                  changes in political conditions or the legislative or regulatory environment, including the effect of recent financial reform legislation on the banking and financial services industries;

·                  changes occurring in business conditions and inflation;

·                  increased funding costs due to market illiquidity, increased competition for funding, and/or increased regulatory requirements with regard to funding;

·                  changes in deposit flows;

·                  changes in technology;

·                  changes in monetary and tax policies;

·                  changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board and the Financial Accounting Standards Board;

·                  loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions; and

·                  other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

 

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These risks are exacerbated by the developments over the last three years in national and international financial markets, and we are unable to predict what effect these uncertain market conditions will continue to have on our Company.  Beginning in 2008 and continuing through the first quarter of 2011, the capital and credit markets experienced unprecedented levels of extended volatility and disruption.  There can be no assurance that these unprecedented developments will not continue to materially and adversely affect our business, financial condition and results of operations.

 

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

 

**Critical Accounting Policies**

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America and with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2010, as filed in our Annual Report on Form 10-K.

 

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

 

**Allowance for Loan Losses**

 

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 

**Other Real Estate Owned and Repossessed Assets**

 

Real estate and other property acquired in settlement of loans is recorded at the lower of cost or fair value less estimated selling costs, establishing a new cost basis when acquired.  Fair value of such property is reviewed regularly and write-downs are recorded when it is determined that the carrying value of the property exceeds the fair value less estimated costs to sell.  Write-downs resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income.  Costs relating to the development and improvement of such properties are capitalized.

 

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**Income Taxes**

 

We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in our consolidated financial statements and income tax returns, and income tax benefit or expense.  Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations.  Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets.  These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change.  Valuation allowances are established to reduce deferred tax assets if it is determined to be “more likely than not” that all or some portion of the potential deferred tax asset will not be realized.  No assurance can be given that either the tax returns submitted by us or the income tax reported on the financial statements will not be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service.  We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.

 

**Overview**

 

The following discussion describes our results of operations for the three month periods ended March 31, 2011 and 2010 and also analyzes our financial condition as of March 31, 2011.

 

Like most community banks, we derive the majority of our income from interest we receive on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We establish and maintain this allowance by charging a provision for loan losses against our operating earnings.  In the following section we have included a detailed discussion of this process.

 

In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers.  We describe the various components of this noninterest income, as well as our noninterest expenses, in the following discussion.

 

Markets in the United States and elsewhere have experienced extreme volatility and disruption over the past three plus years.  These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence.  Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans.  Dramatic slowdowns in the housing industry, due in part to falling home prices and increasing foreclosures and unemployment, have created strains on financial institutions.  Many borrowers are now unable to repay their loans, and the collateral securing these loans has, in some cases, declined below the loan balance.  In response to the challenges facing the financial services sector, beginning in 2008 a multitude of new regulatory and governmental actions have been announced including the Emergency Economic Stabilization Act, approved by Congress and signed by President Bush on October 3, 2008, and the American Recovery and Reinvestment Act on February 17, 2009, among others.  Some of the more recent actions include:

 

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·                  On July 21, 2010, the U.S. President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), a comprehensive regulatory framework that will likely result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates.  Implementation of the Dodd-Frank Act will require many new rules to be made by various federal regulatory agencies over the next several years.  Uncertainty remains as to the ultimate impact of the Dodd-Frank Act until final rulemaking is complete, which could have a material adverse impact either on the financial services industry as a whole or on our business, financial condition, results of operations, and cash flows.  Provisions in the legislation that affect consumer financial protection regulations, deposit insurance assessments, payment of interest on demand deposits, and interchange fees could increase the costs associated with deposits and place limitations on certain revenues those deposits may generate.  The Dodd-Frank Act includes provisions that, among other things, will:

 

·                                       Centralize responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, responsible for implementing, examining, and enforcing compliance with federal consumer financial laws;

 

·                                       Create the Financial Stability Oversight Council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as   companies grow in size and complexity;

 

·                                       Provide mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions;

 

·                                       Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund (“DIF”), and increase the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion;

 

·                                       Make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until December 31, 2012 for noninterest-bearing demand transaction accounts at all insured depository institutions;

 

·                                       Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, which apply to all public companies, not just financial institutions;

 

·                                       Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transactions and other accounts;

 

·                                       Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer;

 

·                                       Eliminate the Office of Thrift Supervision (“OTS”) one year from the date of the new law’s enactment.  The Office of the Comptroller of the Currency (“OCC”), which is currently the primary federal regulator for national banks, will become the primary federal regulator for federal thrifts.  In addition, the Federal Reserve will supervise and regulate all savings and loan holding companies that were formerly regulated by the OTS.

 

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·                  On September 27, 2010, the U.S. President signed into law the Small Business Jobs Act of 2010 (the “Act”).  The Small Business Lending Fund (the “SBLF”), which was enacted as part of the Act, is a $30 billion fund that encourages lending to small businesses by providing Tier 1 capital to qualified community banks with assets of less than $10 billion. On December 21, 2010, the U.S. Treasury published the application form, term sheet and other guidance for participation in the SBLF.  Under the terms of the SBLF, the Treasury will purchase shares of senior preferred stock from banks, bank holding companies, and other financial institutions that will qualify as Tier 1 capital for regulatory purposes and rank senior to a participating institution’s common stock. The application deadline for participating in the SBLF is May 16, 2011. Based on the program criteria, we do not plan to participate in the SBLF.

 

·                  Internationally, both the Basel Committee on Banking Supervision (the “Basel Committee”) and the Financial Stability Board (established in April 2009 by the Group of Twenty (“G-20”) Finance Ministers and Central Bank Governors to take action to strengthen regulation and supervision of the financial system with greater international consistency, cooperation, and transparency) have committed to raise capital standards and liquidity buffers within the banking system (“Basel III”).  On September 12, 2010, the Group of Governors and Heads of Supervision agreed to the calibration and phase-in of the Basel III minimum capital requirements (raising the minimum Tier 1 common equity ratio to 4.5% and minimum Tier 1 equity ratio to 6.0%, with full implementation by January 2015) and introducing a capital conservation buffer of common equity of an additional 2.5% with full implementation by January 2019.  The U.S. federal banking agencies support this agreement.  In December 2010, the Basel Committee issued the Basel III rules text, outlining the details and time-lines of global regulatory standards on bank capital adequacy and liquidity.  According to the Basel Committee, the framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build-up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.

 

·                  In November 2010, the Federal Reserve’s monetary policymaking committee, the Federal Open Market Committee (“FOMC”), decided that further support to the economy was needed. With short-term interest rates already nearing 0%, the FOMC agreed to deliver that support by committing to purchase additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term U.S. Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August 2010.

 

·                  In November 2010, the FDIC approved two proposals that amend the deposit insurance assessment regulations. The first proposal implements a provision in the Dodd-Frank Act that changes the assessment base from one based on domestic deposits (as it has been since 1935) to one based on assets. The assessment base changes from adjusted domestic deposits to average consolidated total assets minus average tangible equity.  The second proposal changes the deposit insurance assessment system for large institutions in conjunction with the guidance given in the Dodd-Frank Act.  In February 2011, the FDIC approved the final rules that change the assessment base from domestic deposits to average assets minus average tangible equity, adopt a new scorecard-based assessment system for financial institutions with more than $10 billion in assets, and finalize the designated reserve ratio target size at 2.0% of insured deposits.  We elected to voluntarily participate in the unlimited deposit insurance component of the Treasury’s Transaction Account Guarantee Program (“TAGP”) through December 31, 2010.  Coverage under the program was in addition to and separate from the basic coverage available under the FDIC’s general deposit insurance rules. As a result of the Dodd-Frank Act that was signed into law on July 21, 2010, the program ended on December 31, 2010, and all institutions are now required to provide full deposit insurance on noninterest-bearing transaction accounts until December 31, 2012. There will not be a separate assessment for this as there was for institutions participating in the deposit insurance component of the TAGP.

 

·                  On December 16, 2010, the Federal Reserve issued a proposal to implement a provision in the Dodd-Frank Act that requires the Federal Reserve to set debit card interchange fees. The proposed rule, if implemented in its current form, would result in a significant reduction in debit-card interchange revenue. Though the rule technically does not apply to institutions with less than $10 billion in assets, there is concern that the price controls may harm community banks, which could be pressured by the marketplace to lower their own interchange rates.

 

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Although it is likely that further regulatory actions will arise as the Federal government attempts to address the economic situation, we cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.

 

**Recent Regulatory Developments**

 

On January 20, 2010, the Bank entered into a Formal Agreement (the “Formal Agreement”) with its primary regulator, the Office of the Comptroller of the Currency (the “OCC”).  The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management.  In response, the Bank formed a Compliance Committee of its Board of Directors (the “Compliance Committee”) to oversee management’s response to all sections of the Formal Agreement.  The Compliance Committee also monitors adherence to deadlines for submission to the OCC of information required under the Formal Agreement.  The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam and will continue to work to comply with all the requirements of the Formal Agreement.  A summary of the requirements of the Formal Agreement and the Bank’s status on complying with the Formal Agreement is as follows:

 
| **Requirements of the Formal Agreement**                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **Bank’s Compliance Status**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Establish, within 30 days from the effective date of the Formal   Agreement, a Compliance Committee of at least five directors to be   responsible for monitoring and coordinating the Bank’s adherence to the   provisions of the Formal Agreement. The Compliance Committee is required to   meet at least monthly to receive written progress reports from management on   the results and status of actions needed to achieve full compliance with each   article of the Formal Agreement. |       | The Compliance Committee was     formed in January 2010 and has met monthly to review written   progress reports provided by management.                                                                                                                                                                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| Complete, within 60 days of the effective date of the Formal   Agreement, a thorough review and assessment of the Bank’s Board of Directors   and management supervision, management structure and staffing   requirements.                                                                                                                                                                                                                                                               |       | The Compliance Committee completed this review and assessment,   including obtaining Board approval of the findings and recommendations, in   April and June 2010, and submitted its report to the OCC   immediately thereafter.                                                                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| Adopt and implement, within 45 days of the effective date of the   Formal Agreement, an updated written strategic plan for the Bank covering at   least a three-year period including an updated three year capital program to   strengthen the Bank’s capital structure.                                                                                                                                                                                                                 |       | The Board adopted the Bank’s strategic plan, including the required   capital program, on March 3, 2010 which was submitted to the OCC on   March 8, 2010.  The Bank has also   taken steps to implement this strategic plan and capital program.  Management revised the capital program   based on the OCC’s review.  The revised   plan was resubmitted to the OCC on November 1, 2010.  Management is in the process of updating   the strategic plan which will be submitted to the OCC by June 30, 2011. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| Develop and implement, within 45 days of the effective date of the   Formal Agreement, an updated written profit plan to improve and sustain the   earnings of the Bank.                                                                                                                                                                                                                                                                                                                       |       | The Board adopted the Bank’s profit plan in November 2010 which   was submitted to the OCC on December 14, 2010.                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

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| **Requirements of the Formal Agreement**                                                                                                                                                                                                                                                                                                                | ** ** | **Bank’s Compliance Status**                                                                                                                                                                                                                                                                                                                                                                                                |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Adopt and implement, within 45 days of the effective date of the   Formal Agreement, an updated written liquidity, asset/liability management   policy addressing liquidity, contingency funding and asset/liability   management.                                                                                                                           |       | The Bank’s Liquidity and Funding Policy, Contingency Funding Policy   and Asset Liability Management Policy were reviewed and approved by the   Bank’s Board of Directors on March 3, 2010 and were submitted to the OCC   on March 8, 2010.  Management   revised our Contingency Funding Policy based on the OCC’s review.  The revised policy was resubmitted to the   OCC on November 1, 2010. |
|                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| Review the Bank’s liquidity on a monthly basis and provide the full   Board of Directors with a written report of the results of this review to   ensure adequate sources of liquidity in relation to the Bank’s needs.                                                                                                                                      |       | Throughout 2010 and thus far in 2011, management has actively   monitored liquidity and has provided detailed monthly reports to the Asset   Liability Committee and the full Board of Directors for review.                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| Adopt and implement, within 60 days of the effective date of the   Formal Agreement, an updated written interest rate risk policy addressing   management reports used for decision-making, interest rate risk tolerance,   tools used to measure and monitor the Bank’s overall interest rate risk   profile, and model validation and back-testing procedures.  |       | The Bank’s Interest Rate Risk Policy, which addresses management   reports, interest rate risk tolerance, measuring and monitoring the Bank’s   risk profile and model validation and back-testing, was reviewed and approved   by the Bank’s Board of Directors on March 3, 2010 and was submitted to   the OCC on March 8, 2010.                                                                                |
|                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| Improve, within 90 days of the effective date of the Formal   Agreement, the Bank’s liquidity position and maintain adequate sources of   stable funding given the Bank’s anticipated liquidity and funding needs by   reducing wholesale or credit sensitive liabilities and/or increasing liquid   assets.                                                      |       | As of March 31, 2011, the Bank has increased its liquidity   position to 20.3% from 13.6% as of December 31, 2009.  In addition, the Bank decreased wholesale   funding reliance by $19.9 million in 2010 and an additional $3.0 million in   the first quarter of 2011.                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| Accept, renew or rollover brokered deposits for deposit at the Bank   only after obtaining a prior written determination of no supervisory   objection from the OCC.                                                                                                                                                                                                        |       | The Bank has obtained required written approvals from the OCC for all   new and renewed brokered deposit requests since the effective date of the   Formal Agreement.                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                       |

 

21

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| **Requirements of the Formal Agreement**                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **Bank’s Compliance Status**                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Extend credit, including renewals or extensions, to a borrower whose   loans or other extensions of credit exceed $300,000 and are criticized by the   OCC or any other bank examiner, only after the Board or designated committee   finds that the extension of additional credit is necessary to promote the   best interests of the Bank.                                                                                                                                                                              |       | Through March 31, 2011, we are not aware of any violations of   this provision of the Formal Agreement. All extensions of credit or   modifications related to a criticized borrower have been properly approved by   the Board.                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Adopt and implement, within 60 days of the effective date of the   Formal Agreement, an updated and comprehensive policy for determining the   adequacy of the Bank’s allowance for loan losses, which must provide for a   review of the Bank’s allowance for loan losses by the Board at least once   each calendar quarter.                                                                                                                                                                                   |       | The Bank’s Allowance for Loan Losses methodology and model was   reviewed and approved by the Bank’s Board of Directors on April 28, 2010   and was submitted to the OCC on May 3, 2010. Management revised the   Allowance for Loan Losses methodology and model based on the OCC’s review.   Management resubmitted this information to the OCC in December 2010 and   updated the written policy to reflect these revisions. The updated policy was   submitted on May 4, 2011. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Develop and implement, within 60 days of the effective date of the   Formal Agreement, an updated written program to improve the Bank’s loan   portfolio management including a pricing policy, guidelines for loans to   insiders, guidelines on concentrations of credit, lending procedures,   underwriting, documentation, exception tracking, re-appraisal guidelines and   a comprehensive loan review process.                                                                                                 |       | The Bank’s General Loan Policy, which addresses loans to insiders,   guidelines on concentrations of credit, lending procedures, underwriting,   documentation, exception tracking, and re-appraisals, was reviewed and   approved by the Bank’s Board of Directors on April 28, 2010 and was   submitted to the OCC on May 3, 2010.                                                                                                                                                              |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Develop and implement, within 60 days of the effective date of the   Formal Agreement, updated systems which provide for effective monitoring of   early problem loan identification and sources of problem loans by various   factors, previously charged-off assets and their recovery potential,   compliance with the Bank’s lending policies and laws, rules, and regulations   pertaining to the Bank’s lending function, adequacy of credit and collateral   documentation, and concentrations of credit. |       | Since the effective date of the Formal Agreement, the Bank has   developed new loan tracking reports, has engaged a third party to perform   loan portfolio stress testing, and has increased the scope of external   quarterly loan review procedures.                                                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| Provide to the Board of Directors, within 60 days of the effective   date of the Formal Agreement, written reports on a monthly basis, including   problem loans, delinquent loans, documentation exceptions, regulatory   violations, concentrations of credit, significant economic factors, and   general conditions and their impact on the credit quality of the Bank’s loan   and lease portfolios, loans to insiders, and policy exceptions.                                                                   |       | Throughout 2010 and thus far in 2011, management has provided detailed   monthly reports to the Board of Directors detailing information required in   this provision of the Formal Agreement.                                                                                                                                                                                                                                                                                                                        |

 

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| **Requirements of the Formal Agreement**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **Bank’s Compliance Status**                                                                                                                                                                                                                                                                                                                                                                             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Adopt and implement, within 60 days of the effective date of the   Formal Agreement, a written asset diversification program including policies   and procedures to control and monitor concentrations of credit and an action   plan to reduce the risk of current concentrations of credit.                                                                                                                                                                                                                                                                                                                                                                                                                         |       | The Board of Directors has approved the updated General Loan Policy   and has adopted a Commercial Real Estate Action Plan to ensure a reduction in   the Bank’s commercial real estate portfolio. The General Loan Policy and   Commercial Real Estate Action Plan were reviewed and approved by the Bank’s   Board of Directors on April 28, 2010 and were submitted to the OCC on   May 3, 2010. |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                    |       |
| Obtain, within 90 days of the effective date of the Formal Agreement,   current and satisfactory credit information on all loans lacking such   information, including those criticized by the OCC or any other bank   examiner.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       | As of March 31, 2011, we are not aware of any violations of this   provision of the Formal Agreement.                                                                                                                                                                                                                                                                                                              |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                    |       |
| Ensure, within 60 days of the effective date of the Formal Agreement,   proper collateral documentation is maintained on all loans and correct each   collateral exception listed by the OCC or any other bank examiner.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       | As of March 31, 2011, we are not aware of any violations of this   provision of the Formal Agreement.                                                                                                                                                                                                                                                                                                              |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                    |       |
| Effective immediately, the Bank may grant, extend, renew, alter or   restructure any loan or other extension of credit only after:   (1) documenting the specific reason or purpose for the extension of   credit; (2) identifying the expected source of repayment in writing;   (3) structuring the repayment terms to coincide with the expected source   of repayment; (4) obtaining and analyzing current and satisfactory   credit information, including cash flow analysis, where loans are to be   repaid from operations; and (5) documenting, with adequate supporting   material, the value of collateral and properly perfecting the Bank’s lien on   it where applicable. |       | As of March 31, 2011, we are not aware of any violations of this   provision of the Formal Agreement.                                                                                                                                                                                                                                                                                                              |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                    |       |
| Adopt and implement, within 90 days of the effective date of the   Formal Agreement, an updated written, comprehensive conflict of interest   policy applicable to the Bank’s and the Bank holding company’s directors,   principal shareholders, executive officers, affiliates, and employees   (“Insiders”) and related interests of such Insiders.                                                                                                                                                                                                                                                                                                                                            |       | The Bank’s Conflict of Interest and Code of Ethics Policy was   reviewed and approved by the Bank’s Board of Directors on December 9,   2009 and was submitted to the OCC on March 8, 2010.                                                                                                                                                                                                         |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                    |       |
| Within 30 days of the effective date of the Formal Agreement, the   Board of Directors must reduce to conforming amounts all loans or other   extensions of credit which exceed the Bank’s legal lending limit. The Board   is also required to establish, implement, and thereafter ensure Bank   adherence to written procedures to prevent future violations.                                                                                                                                                                                                                                                                                                                                                 |       | The Bank is in the process of reducing non-conforming loan   relationships at the time of each renewal through the requirement of   principal reductions or payoff. The Bank is regularly reporting to the OCC   the status of its progress related to this provision of the Formal Agreement.                                                                                                                          |       |

 

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We intend to take all actions necessary to enable the Bank to comply with the requirements of the Formal Agreement, and as of the date hereof we believe we have submitted all documentation required as of this date to the OCC.  There can be no assurance that the Bank will be able to comply fully with the provisions of the Formal Agreement, and the determination of our compliance will be made by the OCC.  However, we have taken significant steps as noted above in an effort to comply with the provisions of the Formal Agreement and are continuing to work toward full compliance.  Since the effective date of the Formal Agreement, management and the Board of Directors have adjusted a number of policies and initiated many actions.  However, additional time is needed to show compliance with established policies and to see new initiatives result in improved performance.  Failure to meet the requirements of the Formal Agreement could result in additional regulatory requirements, which could result in regulators taking additional enforcement actions against the Bank.

 

In addition, the OCC has established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks.  Specifically, the Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%.  As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital.  As of March 31, 2011, total risk-based capital was 10.3% compared to the required 12%, Tier 1 capital was 9.0% compared to the required 10%, and leverage ratio was 7.3% compared to the required 9%.  However, the Bank is still considered to be well capitalized by the OCC as the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives.  See “Management’s Discussion and Analysis — Results of Operations — Capital Resources” for more discussion.

 

Currently, the Company also has to obtain the prior written approval of the Federal Reserve Bank of Richmond before (1) declaring or paying any dividends, (2) directly or indirectly accepting dividends or any other form of payment representing a reduction in capital from the Bank, (3) making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, (4) directly or indirectly, incurring, increasing or guaranteeing any debt, and (5) directly or indirectly, purchasing or redeeming any shares of its stock.  Pursuant to our plans to preserve capital, the Company has no plans to undertake any of the foregoing activities.

 

**Results of Operations**

 

*Three months ended March 31, 2011 and 2010*

 

We incurred a net loss of $1.5 million, or $0.71 per diluted share, for the quarter ended March 31, 2011, an increase of $851,561, or 135%, compared to a net loss of $629,741, or $0.30 per diluted share, for the quarter ended March 31, 2010.  This increase in net loss between comparable quarters was primarily driven by an increase in provision for loan losses and increases in noninterest expenses related to other real estate owned and repossessed assets.  Each of these components is discussed in greater detail below.

 

24

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The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities for the three months ended March 31, 2011 and 2010.  We derived these yields by dividing annualized income or expense by the average balance of the corresponding assets or liabilities.  We derived average balances from the daily balances throughout the periods indicated.  The net amount of capitalized loan fees are amortized into interest income on loans.

 
| ** **                                         | ** ** | **For the Three Months Ended March 31,** | ** **  |
|----------------------------------------------------|------------|------------------------------------------------------------------------|-------------|
| ** **                                         | ** ** | **2011**                                                               | ** **  | **2010** | ** ** |
| ** **                                         | ** ** | **Average   Balance**                                                  | ** **  | **Income/   Expense** | ** ** | **Yield/   Rate** | ** ** | **Average   Balance** | ** ** | **Income/   Expense** | ** ** | **Yield/   Rate** | ** ** |
|                                               |       |                                                                   |        |   |   |   |   |   |   |   |   |   |   |
| Federal   funds sold and other                     |       | $                                                                      | 8,585,734   |   | $ | 12,226 |   | 0.58 | % | $ | 8,146,244 |   | $ | 11,085 |   | 0.55 | % |
| Investment   securities (1)                        |       | 10,515,426                                                             |        | 75,737 |   | 2.92 |   | 7,759,665 |   | 63,490 |   | 3.32 |   |
| Loans (2)                                          |       | 92,937,199                                                             |        | 1,115,729 |   | 4.87 |   | 106,599,093 |   | 1,273,279 |   | 4.84 |   |
| Total   interest-earning assets                    |       | $                                                                      | 112,038,359 |   | $ | 1,203,692 |   | 4.36 | % | $ | 122,505,002 |   | $ | 1,347,854 |   | 4.46 | % |
|                                               |       |                                                                   |        |   |   |   |   |   |   |   |   |   |   |
| NOW   accounts                                     |       | $                                                                      | 6,144,809   |   | $ | 10,659 |   | 0.70 | % | $ | 4,903,290 |   | $ | 8,170 |   | 0.68 | % |
| Savings &   money market                  |       | 33,983,710                                                             |        | 100,850 |   | 1.20 |   | 26,819,689 |   | 126,885 |   | 1.92 |   |
| Time   deposits (excluding brokered time deposits) |       | 32,933,151                                                             |        | 136,486 |   | 1.68 |   | 30,048,435 |   | 164,493 |   | 2.22 |   |
| Brokered   time deposits                           |       | 24,681,697                                                             |        | 139,283 |   | 2.29 |   | 37,950,711 |   | 263,546 |   | 2.82 |   |
| Total   interest-bearing deposits                  |       | 97,743,367                                                             |        | 387,278 |   | 1.61 |   | 99,722,125 |   | 563,094 |   | 2.29 |   |
| Borrowings                                         |       | 7,085,742                                                              |        | 52,146 |   | 2.98 |   | 14,153,216 |   | 132,011 |   | 3.78 |   |
| Total   interest-bearing liabilities               |       | $                                                                      | 104,829,109 |   | $ | 439,424 |   | 1.70 | % | $ | 113,875,341 |   | $ | 695,105 |   | 2.48 | % |
|                                               |       |                                                                   |        |   |   |   |   |   |   |   |   |   |   |
| Net   interest spread                              |       |                                                                   |        |   |   | 2.66 | % |   |   |   |   | 1.98 | % |
| Net   interest income/ margin                      |       |                                                                   |        | $ | 764,268 |   | 2.77 | % |   |   | $ | 652,749 |   | 2.16 | % |

 

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(1)                                  The average balances for investment securities exclude the unrealized gain recorded for available for sale securities.

(2)                                  Nonaccrual loans are included in average balances for yield computations.

 

For the three months ended March 31, 2011, we recognized $1.2 million in interest income and $439,424 in interest expense, resulting in net interest income of $764,268, an increase of $111,519, or 17%, over the same period in 2010.  Average earning assets decreased to $112.0 million for the three months ended March 31, 2011 from $122.5 million for the three months ended March 31, 2010, a decrease of $10.5 million, or 9%.  This decrease in earning assets was due to a $13.7 million decrease in average loans between periods, partially offset by a $2.8 million increase in investment securities.  Average interest bearing liabilities decreased to $104.8 million for the three months ended March 31, 2011 from $113.9 million for the three months ended March 31, 2010, a decrease of $9.0 million, or 8%.  During 2009, we adopted measures to promote the long term stability of the Bank.  These measures included restructuring the balance sheet to focus on credit quality and management of our funding sources to increase liquidity and the net interest margin.  As a result, average loans decreased between periods, with funds from net loan payoffs used to repay FHLB advances and brokered time deposits as well as to strengthen our liquidity position through cash and the investment securities portfolio.  Net interest margin, calculated as annualized net interest income divided by average earning assets, increased from 2.16% for the quarter ended March 31, 2010 to 2.77% for the quarter ended March 31, 2011, primarily due to a decrease in cost of funds from 2.48% to 1.70% between periods due to the mix of liabilities and the timing of their repricing.  This decrease was offset by a decrease in yield on earning assets from 4.46% to 4.36% between periods.

 

Provision for loan losses was $870,000 for the quarter ended March 31, 2011 representing an increase of $770,000, or 770%, compared to the expense of $100,000 for the quarter ended March 31, 2010.  The increase in provision for loan losses is due to the increase in impaired and nonaccrual loans and their related specific reserves in addition to an increase in the general allowance allocation due to declining economic conditions and increased charge-off levels.  The allowance as a percentage of gross loans increased to 3.45% as of March 31, 2011 compared to 3.24% at December 31, 2010.  Specific reserves were $1.3 million on impaired loans of $13.3 million as of March 31, 2011 compared to specific reserves of approximately $1.6 million on impaired loans of $12.8 million as of December 31, 2010.  As of March 31, 2011, the general reserve allocation was 2.45% of gross loans not impaired compared to 1.82% as of December 31, 2010. The provision for loan losses is discussed further below under “Provision and Allowance for Loan Losses.”

 

25

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For the three months ended March 31, 2011, noninterest income was $54,734 compared to $72,025 for the three months ended March 31, 2010, a decrease of $17,291, or 24%, between comparable periods.  The decrease in noninterest income is due to a $19,660 decrease in mortgage origination income from $44,872 for the quarter ended March 31, 2010 to $25,212 for the quarter ended March 31, 2011.  This decrease in mortgage origination income is due to increased regulatory and underwriting requirements as well as the expiration of tax incentives in 2010.  Noninterest income for the three months ended March 31, 2011 and 2010 was derived from service charges on deposits, customer service fees, rental income, and mortgage origination income.

 

During the current quarter, we incurred noninterest expenses of $1.4 million, compared to noninterest expenses of $1.3 million for the quarter ended March 31, 2010, an increase of $175,789, or 14%.  This increase in noninterest expenses for the three month period ended March 31, 2011 primarily resulted from an increase of $213,740 in net write-downs and losses on other real estate owned and repossessed assets due to the receipt of updated third party appraisals.  Write-downs and losses are charged against income, if necessary, as a result of our regular review of the fair value of repossessed property.  Along with this increase, we also had an increase in other noninterest expenses of $63,262 due to increased expenses related to other real estate owned, such as taxes, maintenance and legal fees, an increase in insurance expense of $12,298 due to increased insurance premiums as a result of the Formal Agreement, and an increase in professional fees due to an increase in consulting services between periods.  These increases were offset by decreases in other expense categories.  Compensation and benefits decreased $113,507 due to a decrease in salaries and stock-based compensation as well as the discontinuation of our 401k match beginning April 1, 2010.  We have focused on expense control over the past year which has resulted in small decreases in expenses related to marketing and telephone and supplies.

 

We did not recognize any income tax benefit for the three months ended March 31, 2011 or 2010.  Accounting literature states that a deferred tax asset should be reduced by a valuation allowance if, based on the weight of all available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or the entire deferred tax asset will not be realized.  The determination of whether a deferred tax asset is realizable is based on weighting all available evidence, including both positive and negative evidence. In making such judgments, significant weight is given to evidence that can be objectively verified.  During our quarterly analysis of the valuation allowance recorded against our deferred tax assets, we determined that it was not more likely than not that our deferred tax assets will be recognized in future years due to the continued decline in credit quality and the resulting impact on net interest margin, increased net losses, and negative impact on capital as a result of provision for loan losses and write-downs on other real estate owned.  We will continue to analyze our deferred tax assets and related valuation allowance each quarter taking into account performance compared to forecast and current economic or internal information that would impact forecasted earnings.

 

**Assets and Liabilities**

 

*General*

 

Total assets as of March 31, 2011 were $120.6 million, representing a decrease of $1.2 million, or 1%, compared to December 31, 2010.  The decrease in assets is due to a $4.1 million decrease in net loans, which is the result of $2.5 million of net loan payoffs, $709,500 in transfers to other real estate owned and $870,000 in provision for loan losses.  Other real estate owned decreased due to the sale of one property as well as write-downs taken during the quarter, and investment securities decreased due to mortgage-backed securities repayments.  These decreases were offset by an increase in cash and cash equivalents of $3.7 million.  At March 31, 2011, our total assets consisted principally of $14.4 million in cash and due from banks, $10.2 million in investment securities, $87.3 million in net loans, $3.6 million in property and equipment and $2.3 million in other real estate owned and repossessed assets.  Our management closely monitors and seeks to maintain appropriate levels of interest-earning assets and interest-bearing liabilities so that maturities of assets are such that adequate funds are provided to meet customer withdrawals and demand.

 

Liabilities at March 31, 2011 totaled $111.7 million, representing an increase of $302,094, or less than 1%, compared to December 31, 2010, and consisted principally of $104.5 million in deposits and $7.0 million in borrowings.  Our borrowings consisted of Federal Home Loan Bank (“FHLB”) Advances and customer repurchase agreements.  At March 31, 2011, shareholders’ equity was $9.0 million compared to $10.5 million at December 31, 2010. The decrease in shareholders’ equity was primarily due to the net loss of $1,481,302 for the quarter ended March 31, 2011.

 

26

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*Loans*

 

Since loans typically provide higher interest yields than other types of interest-earning assets, we invest a substantial percentage of our earning assets in our loan portfolio.  At March 31, 2011, our gross loan portfolio consisted primarily of $59.6 million of commercial real estate loans, $12.6 million of commercial business loans, and $18.3 million of consumer and home equity loans.  Our current loan portfolio composition is not materially different than the loan portfolio composition disclosed in the footnotes to the consolidated financial statements included in our Annual Report on Form 10-K for 2010 as filed with the SEC.  We experienced net payoffs of $2.5 million during the three months ended March 31, 2011 due to low market demand, careful consideration of liquidity needs and credit risk management.

 

*Loan Performance and Asset Quality*

 

The downturn in general economic conditions over the past three years has resulted in increased loan delinquencies, defaults and foreclosures within our loan portfolio.  The declining real estate market has had a significant impact on the performance of our loans secured by real estate.  In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure.  Although the real estate collateral provides an alternate source of repayment in the event of default by the borrower, in our current market the value of the collateral has deteriorated in value during the time the credit is extended.  There is a risk that this trend will continue, which could result in additional loss of earnings, increases in our provision for loan losses and loan charge-offs.

 

Past due payments are often one of the first indicators of a problem loan.  We perform a continuous review of our past due report in order to identify trends that can be resolved quickly before a loan becomes significantly past due.  We determine past due and delinquency status based on the contractual terms of the note.  When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees.  Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful.  When a loan is placed in nonaccrual status, interest accruals are discontinued and income earned but not collected is reversed.  Cash receipts on nonaccrual loans are not recorded as interest income, but are used to reduce principal.

 

Refer to Note 4 for a table summarizing delinquencies and nonaccruals, by portfolio class, as of March 31, 2011 and December 31, 2010.  Total delinquent and nonaccrual loans increased from $12.7 million at December 31, 2010 to $14.4 million at March 31, 2011, an increase of $1.7 million or 13%.  This increase was a result of movement in nonaccrual loans, which increased by $1.3 million, or 11%, during the quarter ended March 31, 2011.  Nonaccrual increases were seen in commercial real estate loans as well as construction and development loans as a result of detailed review of relationships within these portfolio classes, loan payment history and the current economic environment.  At March 31, 2011, nonaccrual loans represented 14.7% of gross loans compared to 12.7% of gross loans as of December 31, 2010.  Loans past due 30-89 days are considered potential problem loans and amounted to $1.1 million at March 31, 2011 compared to $697,558 at December 31, 2010.

 

Another method used to monitor the loan portfolio is credit grading.  As part of the loan review process, loans are given individual credit grades, representing the risk we believe is associated with the loan balance.  Credit grades are assigned based on factors that impact the collectability of the loan, the strength of the borrower, the type of collateral, and loan performance.  Commercial loans are individually graded at origination and credit grades are reviewed on a regular basis in accordance with our loan policy.  Consumer loans are assigned a “pass” credit rating unless something within the loan warrants a specific classification grade.  Refer to Note 4 for a table summarizing management’s internal credit risk grades, by portfolio class, as of March 31, 2011 and December 31, 2010.

 

Loans graded one through four are considered “pass” credits.  As of March 31, 2011, approximately 59% of the loan portfolio had a credit grade of Acceptable or Acceptable with Care.  For loans to qualify for this grade, they must be performing relatively close to expectations, with no significant departures from the intended source and timing of repayment.

 

27

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Loans with a credit grade of five are not considered classified; however they are categorized as a special mention or watch list credit, and are considered potential problem loans.  This classification is utilized by us when we have an initial concern about the financial health of a borrower.  These loans are designated as such in order to be monitored more closely than other credits in our portfolio.  We then gather current financial information about the borrower and evaluate our current risk in the credit.  We will then either reclassify the loan as “substandard” or back to its original risk rating after a review of the information.  There are times when we may leave the loan on the watch list, if, in management’s opinion, there are risks that cannot be fully evaluated without the passage of time, and we determine to review the loan on a more regular basis.  Loans on the watch list are not considered problem loans until they are determined by management to be classified as substandard.  As of March 31, 2011, we had loans totaling $2.5 million on the watch list compared to $6.9 million as of December 31, 2010, a decrease of $4.4 million or 63%.  This decrease in watch list loans was primarily due to the downgrade of loans within this category to substandard due to receipt of additional information and continued analysis of credit deterioration in these credit relationships.

 

Loans graded six or greater are considered classified credits.  At March 31, 2011 and December 31, 2010, classified loans totaled $16.1 million and $12.9 million, respectively.  As mentioned above, the increase in this category of $3.2 million, or 25%, is due to the reclassification of watch list loans to substandard during the quarter ended March 31, 2011.  During 2011, we also had one loan relationship move out of substandard into other real estate owned at the time of collateral repossession.  Classified credits are evaluated for impairment on a quarterly basis.

 

A loan is considered impaired when, based on current information and events, it is probable that we 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.  Impairment is measured on a loan-by-loan basis by calculating 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.  The resultant shortfall is charged to provision for loan losses and is classified as a specific reserve.  When an impaired loan is ultimately charged-off, the charge-off is taken against the specific reserve.

 

At March 31, 2011, impaired loans totaled $13.3 million, all of which were valued on a nonrecurring basis at the lower of cost or market value of the underlying collateral.   Market values were obtained using independent appraisals, updated in accordance with our reappraisal policy, or other market data such as recent offers to the borrower.  As of March 31, 2011, we had loans totaling approximately $2.8 million that were classified in accordance with our loan rating policies but were not considered impaired.  Refer to Note 4 for a table summarizing information relative to impaired loans, by portfolio class, at March 31, 2011 and December 31, 2010.

 

Troubled debt restructurings are loans which have been restructured from their original contractual terms and include concessions that would not otherwise have been granted outside of the financial difficulty of the borrower.  Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note.  As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment.  The purpose of a troubled debt restructuring is to facilitate ultimate repayment of the loan.

 

At March 31, 2011, the principal balance of troubled debt restructurings totaled $1.3 million.  All troubled debt restructurings were considered classified, impaired, and in nonaccrual status at March 31, 2011.  All restructured loans are currently performing as expected under the new terms.  A troubled debt restructuring can be removed from “troubled’ status once there is sufficient history of demonstrating the borrower can service the credit under market terms.  We currently consider sufficient history to be approximately six months.

 

*Provision and Allowance for Loan Losses*

 

We have established an allowance for loan losses through a provision for loan losses charged to expense on our consolidated statement of operations.  At March 31, 2011, the allowance for loan losses was $3.1 million, or 3.45% of gross loans, compared to $3.1 million at December 31, 2010, or 3.24% of gross loans.

 

The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible.  We strive to follow a comprehensive, well-documented, and consistently applied analysis of our loan portfolio in determining an appropriate level for the allowance for loan losses.  Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate.  Our determination of the allowance for loan losses is based on what we believe are all significant factors that impact the collectability of loans, including consideration of factors such as

 

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the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical loan loss experience, and a review of specific problem loans.  We also consider subjective issues such as changes in lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and Board of Director oversight, concentrations of credit, and peer group comparisons.

 

Our allowance for loan losses consists of both specific and general reserve components.  The specific reserve component relates to loans that are impaired loans as defined in FASB ASC Topic 310, “Receivables”.  Loans determined to be impaired are excluded from the general reserve calculation described below and evaluated individually for impairment.  Impaired loans totaled $13.3 million at March 31, 2011, with an associated specific reserve of $1.3 million.  See Note 4 as well as above discussion under “Loan Performance and Credit Quality” for additional information related to impaired loans.

 

The general reserve component covers non-impaired loans and is calculated by applying historical loss factors to each sector of the loan portfolio and adjusting for qualitative environmental factors.  Qualitative adjustments are used to adjust the historical average for changes to loss indicators within the economy, our market, and specifically our portfolio.  The general reserve component is then combined with the specific reserve to determine the total allowance for loan losses.

 

Refer to Note 4 for a table summarizing activity related to our allowance for loan losses for the quarter ended March 31, 2011, by portfolio segment.  As of March 31, 2011, the allowance for loan losses was $3.1 million, or 3.45% of gross loans, compared to $3.1 million, or 3.24% of gross loans, as of December 31, 2010 and $2.0 million, or 1.88% of gross loans, as of March 31, 2010.  Provision for loan losses was $870,000 for the three months ended March 31, 2011, an increase of $770,000 million, or 770%, compared to the expense of $100,000 for the three months ended March 31, 2010.  Net loan charge-offs increased during the quarter ended March 31, 2011, from net recoveries of $37,780 for the three months ended March 31, 2010 to net charge-offs of $808,720 for the three months ended March 31, 2011, an increase of $846,500 or more than 100%.  This increase was due to the impact of the extended duration of this economic deterioration on our borrowers as well as declining asset quality trends in our loan portfolio.  All charge-offs in 2011 were partial charge-offs taken on certain collateral-dependent loans within our real estate portfolio segments.  Partial charge-offs were based on recent appraisals and evaluations on commercial real estate loans in the process of foreclosure.  Loans with partial charge-offs are considered impaired loans and remain on nonaccrual status.

 

*Other Real Estate Owned and Repossessed Assets*

 

As of March 31, 2011, we had $2.2 million in other real estate owned and $39,457 in repossessed assets.  This compares to $2.5 million in other real estate owned and $70,712 in repossessed assets as of December 31, 2010.  During 2011, collateral was obtained from one loan relationship that went through the foreclosure process.  We also completed the sale of one repossessed property and one repossessed automobile.  The following table summarizes changes in other real estate owned and repossessed assets for the quarter ended March 31, 2011:

 
| ** **                                                  | ** ** | **2011** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|
| Balance at beginning of   period                            |       | $        | 2,537,259  |   |
| Repossessed property   acquired in settlement of loans      |       | 709,500  |       |
| Sale of repossessed   property                              |       | (544,247 | )          |
| Loss on sale and   write-downs of repossessed property, net |       | (445,795 | )          |
| Balance at end of period                                    |       | $        | 2,256,717  |   |

 

As of March 31, 2011, other real estate owned consisted of residential land lots valued at $1.4 million, a 1-4 family residential dwelling valued at $709,500 and commercial office space valued at $117,500.  Repossessed assets consisted of equipment valued at $39,457.  These assets are being actively marketed with the primary objective of liquidating the collateral at a level which most accurately approximates fair value and allows recovery of as much of the unpaid principal loan balance as possible upon the sale of the asset within a reasonable period of time.  Based on currently available valuation information, the carrying value of these assets is believed to be representative of their fair value less estimated costs to sell, although there can be no assurance that the ultimate proceeds from the sale of these assets will be equal to or greater than their carrying values, particularly in the current real estate environment and the continued downward trend in third party appraised values.

 

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* *

*Deposits*

 

Our primary source of funds for loans and investments is our deposits.  At March 31, 2011, we had $104.5 million in deposits, representing an increase of $377,331, or less than 1%, compared to December 31, 2010.  Deposits at March 31, 2011 consisted primarily of $13.5 million in demand deposit accounts, $34.7 million in money market accounts and $56.1 million in time deposits.  During the fourth quarter of 2006, we began obtaining deposits outside of our local market area in the form of brokered time deposits.  Due to the interest rate environment in our market, as well as strong competition from other banking and financial services companies in gathering deposits, brokered time deposits allowed us to obtain funding in order to support loan growth.  At March 31, 2011, we had $23.1 million in brokered time deposits, a decrease of approximately $3.0 million compared to December 31, 2010.

 

Since January 20, 2010, we have had to obtain written approval from the OCC to accept, renew or rollover brokered time deposits pursuant to the terms of the Formal Agreement.  Requests have been made to the OCC on a quarterly basis for permission to renew up to 90% of brokered time deposits maturing during each respective quarter.  Approval was granted by the OCC for each request submitted in 2010; however due to strong customer deposit growth, we only renewed approximately 39% of 2010 maturing brokered deposits.  During the first quarter of 2011, we renewed approximately 61% of maturing brokered deposits in order to ensure our liquidity position remained strong.  Our most recent request to renew maturing brokered time deposits was partially declined by the OCC due to continuing credit quality issues which have led to increased net losses and declining capital.  For the remainder of 2011, or nine months, we have $13.6 million of brokered deposits maturing.  We believe we have adequate funding sources available to pay off brokered deposits as they mature.  See additional discussion below under “Liquidity.”

 

Our strong customer deposit growth during 2010 and first quarter of 2011 has enabled us to maintain a strong liquidity position while decreasing our reliance on brokered deposits, thereby lowering our cost of interest-bearing liabilities. We will continue to reduce our reliance on brokered time deposits and other noncore funding sources, while focusing our efforts to gather core deposits in our local market.  Our loan-to-deposit ratio was 86.6% and 90.8% at March 31, 2011 and December 31, 2010, respectively.

 

*Borrowings*

 

We use borrowings to fund growth of earning assets in excess of deposit growth.  Borrowings totaled $7.0 million at March 31, 2011, compared to $7.1 million at December 31, 2010.  FHLB Advances accounted for $7.0 million of total borrowings as of March 31, 2011 and December 31, 2010.  These advances are secured with approximately $27.5 million of first and second mortgage loans and $1.0 million of stock in the FHLB.  The remaining balance in borrowings represents customer repurchase agreements.

 

**Liquidity**

 

Liquidity  is the  ability  to  meet  current  and  future  obligations  through liquidation or maturity of existing  assets or the acquisition of  liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash and short-term investments are our primary sources of asset liquidity.  These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans.  The investment portfolio is our principal source of secondary asset liquidity.  However, the availability of this source of funds is influenced by market conditions and pledging agreements.  Individual and commercial deposits, internet time deposits, and borrowings are our primary source of funds for credit activities.  As brokered deposits or advances mature, we intend to replace these funds with new advances or other borrowings to the extent necessary after considering core deposit growth, although overall we will seek to reduce our reliance on noncore funding sources.

 

We are a member of the FHLB, from which applications for borrowings can be made for leverage purposes.  The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB.  At March 31, 2011, we had collateral that would support approximately $4.3 million in additional borrowings.  Like all banks, we are subject to the FHLB’s credit risk rating policy which assigns member institutions a rating which is reviewed quarterly.  The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc.  During the fourth quarter of 2010, the FHLB downgraded our credit risk rating, which resulted in decreased borrowing availability (total line reduced to 15% of total assets from 20% of total assets) and increased collateral requirements (moved to 125% of borrowings from 115%).  Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter.

 

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We also pledge collateral to the Federal Reserve Bank’s Borrower-in-Custody of Collateral program, and our available credit under this program was approximately $9.5 million as of March 31, 2011.  We have federal funds purchased lines of credit through two correspondent banks totaling $5.0 million that would need to be secured by investment securities if utilized.

 

We believe our liquidity sources are adequate to meet our operating needs. The level of liquidity is measured by the cash, cash equivalents, and investment securities available for sale to total assets ratio, which was at 20.36% at March 31, 2011 compared to 17.52% as of December 31, 2010.  The increase in liquidity is due to net loan payoffs of $2.5 million, repayments of mortgage-backed securities and the sale of one property in other real estate owned during the quarter ended March 31, 2011.  We continue to carefully focus on liquidity management during 2011.  We plan to continue reducing brokered time deposits as cash balances, retail deposit growth and operating needs allow.

 

**Impact of Off-Balance Sheet Instruments**

 

Through the operations of our Bank, we have made contractual commitments to extend credit in the ordinary course of our business activities.  These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time. At March 31, 2011, we had issued commitments to extend credit of $12.5 million through various types of lending arrangements.  We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower.  Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.  We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

 

**Commitments and Contingencies**

 

As of March 31, 2011, there were no significant firm commitments outstanding for capital expenditures.

 

**Capital Resources**

 

Total shareholders’ equity decreased to $9.0 million at March 31, 2011 from $10.5 million at December 31, 2010, primarily due to our net loss for the three months of $1.5 million. We believe that our capital is sufficient to fund the activities of our Bank’s operations; however, the rate of net losses have deteriorated our capital base below our established individual minimum capital ratios as discussed in greater detail below. We have not been immune to the unprecedented levels of extended volatility and disruption in the capital and credit markets and can give no assurances with respect to our capital levels.

 

Our Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies.  However, the Federal Reserve guidelines contain an exemption from the capital requirements for “small bank holding companies,” which in 2006 were amended to cover most bank holding companies with less than $500 million in total assets that do not have a material amount of debt or equity securities outstanding registered with the SEC.  Although our class of common stock is registered under Section 12 of the Securities Exchange Act, we believe that because our stock is not listed on any exchange or otherwise actively traded, the Federal Reserve Board will interpret its new guidelines to mean that we qualify as a small bank holding company.  Nevertheless, our Bank remains subject to these capital requirements.  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 Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classifications 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 Bank to  maintain  minimum  ratios of Tier 1 and total  capital as a percentage of assets and off-balance-sheet exposures,  adjusted for risk weights ranging  from  0% to  100%.  Tier 1  capital  of the  Bank  consists  of  common shareholders’  equity,  excluding  the  unrealized  gain or  loss on  securities available for sale,  less certain intangible assets.  The Bank’s Tier 2 capital consists of the allowance for loan losses subject to certain limitations.  Total capital for purposes of computing the capital ratios consists of the sum of Tier 1 and Tier 2 capital.  The regulatory minimum requirements are 4% for Tier 1 capital and 8% for total risk-based capital.

 

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The Bank is also  required  to  maintain  capital  at a minimum  level  based on quarterly  average  assets,  which  is  known as the leverage ratio.  Only the strongest banks are allowed to maintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios 1% to 2% above the minimum.  The Bank exceeded its minimum regulatory capital ratios as of March 31, 2011, as well as the ratios to be considered “well capitalized.”

 

As previously discussed, on January 20, 2010, the Bank entered into the Formal Agreement with its primary regulator, the OCC.  The Formal Agreement seeks to enhance the Bank’s existing practices and procedures in the areas of management oversight, strategic and capital planning, credit risk management, credit underwriting, liquidity, and funds management.

 

In response, the Bank formed a Compliance Committee of its Board of Directors to oversee management’s response to all sections of the Formal Agreement.  The Compliance Committee also monitors adherence to deadlines for submission to the OCC of information required under the Formal Agreement.  The Board of Directors and management of the Bank have been aggressively working to address the findings of the exam and will continue to work to comply with all the requirements of the Formal Agreement.  For additional information on the Formal Agreement, including actions the Bank has taken in response to the Formal Agreement, see above under “Recent Regulatory Developments.”

 

In addition, the OCC established individual minimum capital ratio levels for the Bank that are higher than the minimum and well capitalized ratios applicable to all banks.  The Bank must maintain total risk-based capital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of at least 9%.  As of September 30, 2010, the Bank fell below the established individual minimum capital ratios for leverage and total risk-based capital, and as of March 31, 2011, the Bank also fell below the established individual minimum capital ratio for Tier 1 capital.  As of March 31, 2011, total risk-based capital was 10.3% compared to the required 12%, Tier 1 capital was 9.0% compared to the required 10%, and leverage ratio was 7.3% compared to the required 9%.  However, the Bank is still considered to be well capitalized by the OCC as the Bank’s capital levels remain above the well capitalized ratio levels applicable to banks not subject to formal capital directives.  The OCC has instructed the Bank to achieve individual minimum capital ratio levels by June 30, 2011.  Noncompliance with these ratio levels may be deemed an unsafe and unsound banking practice by the OCC, which could result in the Bank becoming subject to a formal capital directive, a consent order, or such other administrative actions or sanctions as the OCC considers necessary.  It is uncertain what actions, if any, the OCC will take with respect to noncompliance with these ratios, what action steps the OCC might require the Bank to take to remedy this situation, and whether such actions would be successful.  The Bank is currently working with several advisors and consultants regarding strategies to increase capital.

 

The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements at March 31, 2011 and December 31, 2010.

 

(Dollars in thousands)

 
| ** **                               | ** ** | ** ** | ** ** | ** **  | ** ** | ** **                  | ** ** | ** **                 | ** ** | ** **                         | ** ** | ** ** | ** ** | **To be well capitalized** | ** ** |
|------------------------------------------|------------|------------|------------|-------------|------------|-----------------------------|------------|----------------------------|------------|------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **  | ** ** | **Individual Minimum** | ** ** | **For capital**       | ** ** | **under prompt   corrective** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **  | ** ** | **Capital Ratio**      | ** ** | **adequacy purposes** | ** ** | **action provisions**         | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Minimum** | ** ** | **Minimum**                 | ** ** | **Minimum**                | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**   | ** ** | **Amount**                  | ** ** | **Ratio**                  | ** ** | **Amount**                         | ** ** | **Ratio**  | ** ** | **Amount**                                | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |        |       |                        |       |                       |       |                               |       |       |       |                                      |       |   |   |
| **As of March 31, 2011**            |       |       |       |        |       |                        |       |                       |       |                               |       |       |       |                                      |       |   |   |
| Total Capital (to risk weighted assets)  |       | $          | 10,161,000 |        | 10.3       | %                           | $          | 11,857,000                 |       | 12.0                               | %          | $          | 7,905,000  |                                      | 8.0        | % | $ | 9,881,000 |   | 10.0 | % |
| Tier 1 Capital (to risk weighted assets) |       | 8,903,000  |       | 9.0         |       | 9,881,000                   |       | 10.0                       |       | 3,952,000                          |       | 4.0        |       | 5,929,000                                 |       | 6.0 |   |
| Tier 1 Capital (to average assets)       |       | 8,903,000  |       | 7.3         |       | 10,911,000                  |       | 9.0                        |       | 4,849,000                          |       | 4.0        |       | 6,062,000                                 |       | 5.0 |   |
|                                     |       |       |       |        |       |                        |       |                       |       |                               |       |       |       |                                      |       |   |   |
| **As of December 31, 2010**         |       |       |       |        |       |                        |       |                       |       |                               |       |       |       |                                      |       |   |   |
| Total Capital (to risk weighted assets)  |       | $          | 11,670,000 |        | 11.5       | %                           | $          | 12,169,000                 |       | 12.0                               | %          | $          | 8,112,000  |                                      | 8.0        | % | $ | 10,141,000 |   | 10.0 | % |
| Tier 1 Capital (to risk weighted assets) |       | 10,381,000 |       | 10.2        |       | 10,141,000                  |       | 10.0                       |       | 4,056,000                          |       | 4.0        |       | 6,084,000                                 |       | 6.0 |   |
| Tier 1 Capital (to average assets)       |       | 10,381,000 |       | 8.4         |       | 11,137,000                  |       | 9.0                        |       | 4,950,000                          |       | 4.0        |       | 6,187,000                                 |       | 5.0 |   |

 

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**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 this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective as of March 31, 2011.  There have been no significant changes in our internal controls over financial reporting during the fiscal quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

 

The design of any system of controls and procedures 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 goals under all potential future conditions, regardless of how remote.

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings**

 

There are no material pending legal proceedings to which we are a party or of which any of our properties are the subject.

 

**Item 1A. Risk Factors**

 

Not applicable

 

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

 

Not applicable

 

**Item 3. Default Upon Senior Securities**

 

Not applicable

 

**Item 4.****  (Removed and Reserved.)**

 

**Item 5. Other Information**

 

Not applicable

 

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** **

**Item 6. Exhibits**

 
| 31.1   |   | Rule 13a-14(a) Certification of the Principal Executive   Officer. |
|--------|--------|------------------------------------------------------------------------------|
|   |   |                                                                         |
| 31.2   |   | Rule 13a-14(a) Certification of the Principal Financial   Officer. |
|   |   |                                                                         |
| 32     |   | Section 1350 Certifications.                                            |

 

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**SIGNATURES**

 

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

 

 
| Date: May 13, 2011 | By:                                                                  | /s/ Lawrence R. Miller |
|-------------------------|----------------------------------------------------------------------|------------------------|
|                    | Lawrence R. Miller                                                   |
|                    | Chief Executive Officer (Principal Executive Officer)                |
|                    |                                                                 |                   |
| Date: May 13, 2011 | By:                                                                  | /s/ Katie N. Tuttle    |
|                    | Katie N. Tuttle                                                      |
|                    | Chief Financial Officer (Principal Accounting and Financial Officer) |
|                         |                                                                      |                        |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                   |
|-------------|------------|------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                              |
|        |       |                                                                         |
| 31.1        |       | Rule 13a-14(a) Certification of the Principal Executive   Officer. |
|        |       |                                                                         |
| 31.2        |       | Rule 13a-14(a) Certification of the Principal Financial   Officer. |
|        |       |                                                                         |
| 32          |       | Section 1350 Certifications.                                            |

 

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