**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARKONE)**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period ended September 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**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 |       | (I.R.S. Employer    |
| of incorporation)            |       | 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)

 

----

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

 

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

 

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

 

| Large accelerated filer o                   |   | Accelerated filer o         |
|---------------------------------------------|--------|-----------------------------|
|                                        |   |                        |
| Non-accelerated o                           |   | Smaller reporting company x |
| (do not check if smaller reporting company) |   |                        |

 

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

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

2,085,010 shares of common stock, $.01 par value per share, were issuedand outstanding as of November 5, 2010.

 

 

 

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**Independence Bancshares, Inc.**

 

**Part I - Financial Information**

 

**Item 1. Financial Statements**

 

**Consolidated Balance Sheets**

** **
| ** **                                                                                                     | ** ** | **September 30, 2010** | ** **  | **December 31, 2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                     | ** ** | **(unaudited)**                  | ** **  | **(audited)**                   | ** ** |
| **Assets**                                                                                                     | ** ** | ** **                       | ** **  | ** **                      | ** ** |
| Cash and due from banks                                                                                        |       | $                                | 5,656,596   |                            | $          | 4,929,360 |   |
| Federal funds sold                                                                                             |       | 5,780,000                        |        | 5,295,000                       |       |
| Investment securities available for sale                                                                       |       | 10,014,546                       |        | 8,171,648                       |       |
| Non-marketable equity securities                                                                               |       | 1,438,850                        |        | 1,546,100                       |       |
| Loans, net of allowance for loan losses of $2,781,168 and $1,847,513,  respectively                            |       | 93,005,838                       |        | 106,129,956                     |       |
| Accrued interest receivable                                                                                    |       | 311,914                          |        | 401,386                         |       |
| Property and equipment, net                                                                                    |       | 3,680,014                        |        | 3,771,983                       |       |
| Other real estate owned and repossessed assets                                                                 |       | 2,949,852                        |        | 2,411,890                       |       |
| Other assets                                                                                                   |       | 1,079,083                        |        | 2,653,876                       |       |
| Total assets                                                                                                   |       | $                                | 123,916,693 |                            | $          | 135,311,199 |   |
|                                                                                                           |       |                             |        |                            |       |
| **Liabilities**                                                                                                | ** ** | ** **                       |        |                            |       |
| Deposits:                                                                                                      |       |                             |        |                            |       |
| Noninterest bearing                                                                                            |       | $                                | 5,983,014   |                            | $          | 5,243,210 |   |
| Interest bearing                                                                                               |       | 98,882,639                       |        | 99,032,246                      |       |
| Total deposits                                                                                                 |       | 104,865,653                      |        | 104,275,456                     |       |
|                                                                                                           |       |                             |        |                            |       |
| Borrowings                                                                                                     |       | 7,049,926                        |        | 14,157,992                      |       |
| Accrued interest payable                                                                                       |       | 34,816                           |        | 97,269                          |       |
| Accounts payable and accrued expenses                                                                          |       | 149,441                          |        | 93,615                          |       |
| Total liabilities                                                                                              |       | 112,099,836                      |        | 118,624,332                     |       |
|                                                                                                           |       |                             |        |                            |       |
| 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                                                                                     |       | 21,077,535                       |        | 20,997,135                      |       |
| Accumulated other comprehensive income                                                                         |       | 117,128                          |        | 23,052                          |       |
| Accumulated deficit                                                                                            |       | (9,398,656                       | )           | (4,354,170                      | )          |
| Total shareholders’ equity                                                                                |       | 11,816,857                       |        | 16,686,867                      |       |
| Total liabilities and shareholders’ equity                                                                |       | $                                | 123,916,693 |                            | $          | 135,311,199 |   |

 

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

 

2

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**IndependenceBancshares, Inc.**

 

**Consolidated Statements ofOperations**

**(unaudited)**

** **
| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                               | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Interest income**                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Loans                                                                    |       | $                                                    | 1,181,010  |                                                | $          | 1,425,590 |   | $ | 3,655,015 |   | $ | 4,187,037 |   |
| Investment securities                                                    |       | 73,057                                               |       | 59,735                                              |       | 201,507 |   | 151,898 |   |
| Federal funds sold and other                                             |       | 12,921                                               |       | 11,490                                              |       | 38,624 |   | 26,758 |   |
| Total interest income                                                    |       | 1,266,988                                            |       | 1,496,815                                           |       | 3,895,146 |   | 4,365,693 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **Interest expense**                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Deposits                                                                 |       | 487,490                                              |       | 645,775                                             |       | 1,590,619 |   | 2,083,786 |   |
| Borrowings                                                               |       | 80,249                                               |       | 147,172                                             |       | 322,259 |   | 442,975 |   |
| Total interest expense                                                   |       | 567,739                                              |       | 792,947                                             |       | 1,912,878 |   | 2,526,761 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net interest income                                                      |       | 699,249                                              |       | 703,868                                             |       | 1,982,268 |   | 1,838,932 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Provision for loan losses                                                |       | 1,220,000                                            |       | 137,000                                             |       | 2,055,000 |   | 787,000 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net interest income (expense) after provision for loan losses            |       | (520,751                                             | )          | 566,868                                             |       | (72,732 | ) | 1,051,932 |   |
| ** **                                                               | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Noninterest income**                                                   |       | 76,004                                               |       | 68,155                                              |       | 188,418 |   | 176,730 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **Noninterest expenses**                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Compensation and benefits                                                |       | $                                                    | 484,498    |                                                | $          | 526,499 |   | $ | 1,488,624 |   | $ | 1,604,321 |   |
| Write-downs on real estate owned and repossessed assets                  |       | 318,131                                              |       | 7,832                                               |       | 692,290 |   | 7,832 |   |
| Occupancy and equipment                                                  |       | 142,763                                              |       | 140,602                                             |       | 432,282 |   | 411,395 |   |
| Insurance                                                                |       | 125,818                                              |       | 110,726                                             |       | 383,876 |   | 373,214 |   |
| Data processing and related costs                                        |       | 70,085                                               |       | 71,434                                              |       | 215,666 |   | 245,834 |   |
| Professional fees                                                        |       | 92,848                                               |       | 50,384                                              |       | 226,272 |   | 181,685 |   |
| Marketing                                                                |       | 18,727                                               |       | 20,993                                              |       | 79,458 |   | 101,341 |   |
| Telephone and supplies                                                   |       | 12,724                                               |       | 18,717                                              |       | 45,227 |   | 60,008 |   |
| Other                                                                    |       | 80,716                                               |       | 61,995                                              |       | 221,540 |   | 139,663 |   |
| Total noninterest expenses                                               |       | 1,346,310                                            |       | 1,009,182                                           |       | 3,785,235 |   | 3,125,293 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Loss before income tax benefit (expense)                                 |       | (1,791,057                                           | )          | (374,159                                            | )          | (3,669,549 | ) | (1,896,631 | ) |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **Income tax benefit (expense)**                                         |       | (1,374,937                                           | )          | —                                              |       | (1,374,937 | ) | 492,550 |   |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss                                                                 |       | $                                                    | (3,165,994 | )                                                   | $          | (374,159 | ) | $ | (5,044,486 | ) | $ | (1,404,081 | ) |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **Loss per common share — basic and diluted**                       |       | $                                                    | (1.52      | )                                                   | $          | (0.18 | ) | $ | (2.42 | ) | $ | (0.67 | ) |
|                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| **Weighted average common shares outstanding —  basic and diluted** |       | 2,085,010                                            |       | 2,085,010                                           |       | 2,085,010 |   | 2,085,010 |   |

 

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

 

3

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**Independence Bancshares, Inc.**

 

**Consolidated Statements ofChanges**

**In Shareholders’ Equityand Comprehensive Income (Loss)**

**(unaudited)**

 
| ** **                                                               | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|---------------------------------------|------------|-----------------|------------|-------------|------------|
| ** **                                                               | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital**              | ** ** | **income**      | ** ** | **deficit** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | ** **            | ** ** | ** **     | ** ** | ** **                            | ** ** | ** **      | ** ** | ** **  | ** ** | ** ** | ** ** |
| **December 31, 2008**                                               |       | 2,085,010             |       | $              | 20,850     |                                  | $          | 20,840,248      |       | $           | 40,715     |   | $ | (2,193,081 | ) | $ | 18,708,732 |   |
| Compensation expense related to stock options granted                    |       | —                |       | —         |       | 119,387                               |       | —          |       | —      |       | 119,387 |   |
| Net loss                                                                 |       | —                |       | —         |       | —                                |       | —          |       | (1,404,081  | )          | (1,404,081 | ) |
| Unrealized gain on investment securities available for sale, net of  tax |       | —                |       | —         |       | —                                |       | 9,193           |       | —      |       | 9,193 |   |
| Total comprehensive loss                                                 |       | —                |       | —         |       | —                                |       | —          |       | —      |       | (1,394,888 | ) |
| **September 30, 2009**                                              |       | 2,085,010             |       | $              | 20,850     |                                  | $          | 20,959,635      |       | $           | 49,908     |   | $ | (3,597,162 | ) | $ | 17,433,231 |   |
|                                                                     |       |                  |       |           |       |                                  |       |            |       |        |       |   |   |
| **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                    |       | —                |       | —         |       | 80,400                                |       | —          |       | —      |       | 80,400 |   |
| Net loss                                                                 |       | —                |       | —         |       | —                                |       | —          |       | (5,044,486  | )          | (5,044,486 | ) |
| Unrealized gain on investment securities available for sale, net of  tax |       | —                |       | —         |       | —                                |       | 94,076          |       | —      |       | 94,076 |   |
| Total comprehensive loss                                                 |       | —                |       | —         |       | —                                |       | —          |       | —      |       | (4,950,410 | ) |
| **September 30, 2010**                                              |       | 2,085,010             |       | $              | 20,850     |                                  | $          | 21,077,535      |       | $           | 117,128    |   | $ | (9,398,656 | ) | $ | 11,816,857 |   |

 

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

 

4

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**IndependenceBancshares, Inc.**

 

**Consolidated Statements ofCash Flows**

**(unaudited)**

 
| ** **                                                              | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                              | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
| **Operating activities**                                                |       |                                                |       |   |   |
| Net loss                                                                |       | $                                                   | (5,044,486 | ) | $ | (1,404,081 | ) |
| Adjustments to reconcile net loss to cash used in operating  activities |       |                                                |       |   |   |
| Provision for loan losses                                               |       | 2,055,000                                           |       | 787,000 |   |
| Depreciation                                                            |       | 145,308                                             |       | 135,922 |   |
| Amortization of investment securities premiums, net                     |       | 40,716                                              |       | 2,717 |   |
| Compensation expense related to stock options granted                   |       | 80,400                                              |       | 119,387 |   |
| Other-than-temporary impairment on non-marketable equity securities     |       | —                                              |       | 60,404 |   |
| Write downs of real estate owned and repossessed assets                 |       | 692,290                                             |       | 7,832 |   |
| (Increase) decrease in other assets, net                                |       | 1,615,801                                           |       | (536,898 | ) |
| Increase (decrease) in other liabilities,  net                          |       | (6,627                                              | )          | 76,144 |   |
| Net cash used in operating activities                                   |       | (421,598                                            | )          | (751,573 | ) |
|                                                                    |       |                                                |       |   |   |
| **Investing activities**                                                |       |                                                |       |   |   |
| Repayments of loans, net                                                |       | 8,895,930                                           |       | 12,819,273 |   |
| Purchase of investment securities available for sale                    |       | (6,000,000                                          | )          | (7,102,773 | ) |
| Maturity of investment securities available for sale                    |       | 3,000,000                                           |       | 3,000,000 |   |
| Repayments of investment securities available for sale                  |       | 1,258,926                                           |       | 519,956 |   |
| Redemption (purchase) of non-marketable equity securities, net          |       | 107,250                                             |       | (6,700 | ) |
| Purchase of property and equipment, net                                 |       | (53,339                                             | )          | (607,502 | ) |
| Sale of repossessed assets                                              |       | 942,936                                             |       | 354,161 |   |
| Net cash provided by investing activities                               |       | 8,151,703                                           |       | 8,976,415 |   |
|                                                                    |       |                                                |       |   |   |
| **Financing activities**                                                |       |                                                |       |   |   |
| Increase in deposits, net                                               |       | 590,197                                             |       | 5,028,475 |   |
| Decrease in borrowings                                                  |       | (7,108,066                                          | )          | (3,017,516 | ) |
| Net cash used in financing activities                                   |       | (6,517,869                                          | )          | 2,010,959 |   |
|                                                                    |       |                                                |       |   |   |
| **Net increase in cash and cash equivalents**                           |       | 1,212,236                                           |       | 10,235,801 |   |
|                                                                    |       |                                                |       |   |   |
| **Cash and cash equivalents at beginning of the period**                |       | 10,224,360                                          |       | 4,117,886 |   |
|                                                                    |       |                                                |       |   |   |
| **Cash and cash equivalents at end of the period**                      |       | $                                                   | 11,436,596 |   | $ | 14,353,687 |   |
|                                                                    |       |                                                |       |   |   |
| **Supplemental information:**                                           |       |                                                |       |   |   |
| **Cash paid for**                                                       |       |                                                |       |   |   |
| Interest                                                                |       | $                                                   | 1,975,331  |   | $ | 2,560,964 |   |
| **Schedule of non-cash transactions**                                   |       |                                                |       |   |   |
| Change in unrealized gain on securities,  net of tax                    |       | $                                                   | 94,076     |   | $ | 9,193 |   |
| Loans transferred to other real estate owned                            |       | $                                                   | 2,173,188  |   | $ | 2,677,016 |   |

 

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

 

5

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**Notes to UnauditedConsolidated Financial Statements**

 

**NOTE 1 — NATURE OF BUSINESS ANDBASIS OF PRESENTATION**

 

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

 

**Basisof Presentation**

 

Theaccompanying unaudited consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q.  Accordingly, they do notinclude all information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financial statements.  However,in the opinion of management, all adjustments (consisting of normal recurringadjustments) considered necessary for a fair presentation have beenincluded.  Operating results for the three and nine month periods ended September 30,2010 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2010.  Forfurther information, refer to the financial statements and footnotes theretoincluded in our Annual Report on Form 10-K for 2009 as filed with theSecurities and Exchange Commission.

 

**SubsequentEvents**

 

Subsequentevents are events or transactions that occur after the balance sheet date butbefore financial statements are issued. Recognized subsequent events are eventsor transactions that provide additional evidence about conditions that existedat the date of the balance sheet, including the estimates inherent in theprocess of preparing financial statements. Non-recognized subsequent events are events that provide evidence aboutconditions that did not exist at the date of the balance sheet but arose afterthat date. Management performed an evaluation to determine whether or not therehave been any subsequent events since the balance sheet date, and concludedthat no subsequent events occurred requiring accrual or disclosure.

 

**RecentRegulatory Developments**

 

On January 20,2010, the Bank entered into a Formal Agreement (the “Formal Agreement”) withits primary regulator, the Office of the Comptroller of the Currency (the “OCC”).  The Formal Agreement seeks to enhance theBank’s existing practices and procedures in the areas of management oversight,strategic and capital planning, credit risk management, credit underwriting,liquidity, and funds management.  Inaddition, the OCC has established Individual Minimum Capital Ratio levels ofTier 1 and total capital for the Bank that are higher than the minimum andwell capitalized ratios applicable to all banks.  The Bank must maintain total risk-based capitalof at least 12%, Tier 1 capital of at least 10%, and a leverage ratio of atleast 9%.  The Board of Directors andmanagement of the Bank have been aggressively working to address the findingsof the exam and will continue to work to comply with all the requirements ofthe Formal Agreement.  As of September 30,2010, the Bank fell below the Individual Minimum Capital Ratio levels for Totalrisk-based capital, which was 11.8% compared to the required 12%, as well asleverage ratio, which was 8.7% compared to the required 9%.  However, the Bank’s capital levels remainabove the well capitalized ratio levels applicable to all banks.  For additional information on the FormalAgreement, including actions the Bank has taken in response to the FormalAgreement, see “Management’s Discussion and Analysis — Recent RegulatoryDevelopments” and “Management’s Discussion and Analysis — Results of Operations— Capital Resources.”

 

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

 

Asummary of significant accounting policies is included in our Annual Report on Form 10-Kfiled with the Securities and Exchange Commission for the year ended December 31,2009.  For further information, refer to the consolidated financialstatements and footnotes thereto included in our Annual Report on Form 10-Kfor 2009 as filed with the Securities and Exchange Commission.  Accountingstandards that have been issued or proposed by the Financial AccountingStandards Board that do not require adoption until a future date are notexpected to have a material impact on the consolidated balance sheet orstatement of operations upon adoption.

 

6

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**Cash and Cash Equivalents**- For purposesof reporting cash flows, cash and cashequivalents include cash, amounts due from banks and federal funds sold.  Generally, federal funds are sold for one-dayperiods.

 

**Loss per Share** - Basic loss per share represents net lossdivided by the weighted-average number of common shares outstanding during theperiod.  Dilutive loss per share reflectsadditional common shares that would have been outstanding if dilutive potentialcommon shares had been issued.  Potentialcommon shares that may be issued by the Company relate to outstanding stockoptions and warrants, and are determined using the treasury stock method.  For the three and nine month periods ended September 30,2010 and 2009, as a result of the Company’s net loss, all of the potentialcommon shares were considered anti-dilutive.

 

**Fair Value Measurements -**The Companyapplies the provisions of FASB ASC Topic 820, “Fair Value Measurements andDisclosures” (“ASC Topic 820”), which provides a framework for measuring anddisclosing fair value under generally accepted accounting principles.  ASCTopic 820 requires disclosures about the fair value of assets and liabilitiesrecognized 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 (forexample, impaired loans).

 

ASC Topic 820 defines fair value as the exchange price that would bereceived for an asset or paid to transfer a liability (an exit price) in theprincipal or most advantageous market for the asset or liability in an orderlytransaction between market participants on the measurement date.  ASCTopic 820 also establishes a fair value hierarchy which requires an entity tomaximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value.  The standard describes three levels ofinputs that may be used to measure fair value:  Level 1 - quoted prices inactive markets for identical assets or liabilities; Level 2 - observable inputsother than Level 1 prices such as quoted prices for similar assets orliabilities, quoted prices in markets that are not active, or other inputs thatare observable or can be corroborated by observable market data forsubstantially the full term of the assets or liabilities; and Level 3 -unobservable inputs that are supported by little or no market activity and thatare significant to the fair value of the assets or liabilities.

 

The Company is predominantly an asset-based lender with real estateserving as collateral on approximately 84% of loans.  Loans which are deemed to be impaired are valuedon a nonrecurring basis at the lower of cost or market value of the underlyingcollateral.  Such market values aregenerally obtained using independent appraisals or other market data, which theCompany considers to be Level 2 inputs (other observable inputs).  The aggregate carrying amount, net ofspecific reserves, of impaired loans at September 30, 2010 was $11.0 million.

 

Available-for-sale investment securities which were $10,014,546 at September 30,2010 are the only assets whose fair values are measured on a recurring basisusing Level 2 inputs (other observable inputs).

 

Other real estate owned and repossessed assets, consisting ofproperties or other collateral obtained through foreclosure or in satisfactionof loans, are carried at fair value. Market values are generally obtained using independent appraisals orother current market information, including but not limited to offers receivedon the property, which the Company considers to be Level 2 inputs (otherobservable inputs).  The carrying amountof other real estate owned and repossessed assets at September 30, 2010was $2,949,852.

 

The Company has no liabilities carried at fair value or measured atfair value on a recurring or nonrecurring basis.  The Company also has noassets or liabilities whose fair values are measured using Level 1 or Level 3inputs.

 

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

 

Fairvalue approximates carrying value for the following financial instruments dueto the short-term nature of the instrument: cash and due from banks, federal funds sold, and securities sold underagreements to repurchase.  Investmentsecurities are valued using quoted market prices.  No ready market exists for non-marketableequity securities, and they have no quoted market value.  However, redemption of these stocks hashistorically been at par value. Accordingly, the carrying amounts are deemed to be a reasonable estimateof fair value.  Fair value of loans isbased on the discounted present value of the estimated future cash flows.  Discount rates used in these computationsapproximate the rates currently offered for similar loans of comparable termsand credit quality.

 

7

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Fairvalue for demand deposit accounts and interest bearing accounts with no fixedmaturity date is equal to the carrying value. The fair value of certificate of deposit accounts are estimated bydiscounting cash flows from expected maturities using current interest rates onsimilar instruments.  Fair value forFederal Home Loan Bank (“FHLB”) advances is based on discounted cash flowsusing the Company’s current incremental borrowing rate.

 

TheCompany has used management’s best estimate of fair value based on the aboveassumptions.  Thus, the fair values presentedmay not be the amounts that could be realized in an immediate sale orsettlement of the instrument.  Inaddition, any income taxes or other expenses, which would be incurred in anactual sale or settlement, are not taken into consideration in the fair valuepresented.  The estimated fair values ofthe Company’s financial instruments at September 30, 2010 and December 31,2009 are as follows:

 
| ** **                                     | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **Carrying**                     | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                     | ** ** | **Amount**                       | ** ** | **Value**                       | ** ** | **Amount** | ** ** | **Value** | ** ** |
| **Financial Assets:**                          | ** ** | ** **                       |       |                            |       |   |   |   |   |
| Cash and due from banks                        |       | $                                | 5,656,596  |                            | $          | 5,656,596 |   | $ | 4,929,360 |   | $ | 4,929,360 |   |
| Federal funds sold                             |       | 5,780,000                        |       | 5,780,000                       |       | 5,295,000 |   | 5,295,000 |   |
| Investment securities available for sale       |       | 10,014,546                       |       | 10,014,546                      |       | 8,171,648 |   | 8,171,648 |   |
| Non-marketable equity securities               |       | 1,438,850                        |       | 1,438,850                       |       | 1,546,100 |   | 1,546,100 |   |
| Loans, net                                     |       | 93,005,838                       |       | 85,721,256                      |       | 106,129,956 |   | 94,600,335 |   |
| **Financial Liabilities:**                     | ** ** | ** **                       |       |                            |       |   |   |   |   |
| Deposits                                       |       | 104,865,653                      |       | 105,278,733                     |       | 104,275,456 |   | 105,094,907 |   |
| Federal Home Loan Bank advances                |       | 7,000,000                        |       | 7,438,597                       |       | 14,000,000 |   | 14,506,533 |   |
| Securities sold under agreements to repurchase |       | 49,926                           |       | 49,926                          |       | 157,992 |   | 157,992 |   |
|                                                |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**IncomeTaxes** - The Company accounts for income taxes inaccordance with FASB ASC Topic 740, “Income Taxes”. Deferred tax assets andliabilities are recognized for the expected future tax consequences of eventsthat have been recognized in the consolidated financial statements or taxreturns.  Deferred tax assets and liabilities are measured using the enactedtax rates expected to apply to taxable income in the years in which thosetemporary differences are expected to be realized or settled. The effect ondeferred tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date.  Valuation allowances are established toreduce 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 berealized.  For further information, refer to the consolidated financial statementsand footnotes thereto included in our Annual Report on Form 10-K for 2009as filed with the Securities and Exchange Commission.

 

Incometax expense for the three and nine months ended September 30, 2010 was $1,374,937.  Accounting literature states that a deferredtax asset should be reduced by a valuation allowance if, based on the weight ofall available evidence, it is more likely than not (a likelihood of more than50%) that some portion or the entire deferred tax asset will not berealized.  The determination of whether adeferred 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 thevaluation allowance recorded against our deferred tax assets, we determinedthat it was not more likely than not that they will be recognized in futureyears due to the continued decline in credit quality and the resultingincreased net losses and negative impact on capital as a result of provisionfor loan losses and other real estate owned write downs.  In addition, credit quality has impacted ournet interest margin during 2010 due to interest reversals and interest lost onnon-accrual loans.  During third quarter2009, it became evident that the unprecedented economic conditions specificallyaffecting the banking industry had increased the uncertainty as to the timingof the expected recovery period of the industry as a whole.  Although later than many areas of the UnitedStates, it also became more evident that our local market and our Bank wereaffected by these deteriorating economic conditions.  These events led us to record a valuationallowance of 100% on all deferred tax assets generated beginning July 1,2009 through September 30, 2010. The expense recorded for the quarter and nine months ended September 30,2010 represents a 100% valuation allowance on all prior deferred tax assets(those generated prior to July 1, 2009). The Company also believes that its income tax filing positions taken orexpected to be taken in its tax returns will more likely than not be sustainedupon audit by the taxing authorities, and does not anticipate any adjustmentsthat will result in a material adverse impact on the Company’s financialcondition, results of operations, or cash flows. Therefore, no reserves foruncertain income tax positions have been recorded pursuant to ASC 740, “IncomeTaxes”.

 

8

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**Reclassifications -**Certain amounts have beenreclassified to state all periods on a comparable basis.  Reclassifications had no effect onshareholders’ equity or net loss.

 

**NOTE 3 — INVESTMENT SECURITIES**

 

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

 
| ** **                       | ** ** | **September 30, 2010** | ** **    |
|----------------------------------|------------|----------------------------------|---------------|
| ** **                       | ** ** | **Amortized**                    | ** **    | **Gross Unrealized** | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**                         | ** **    | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Government-sponsored enterprises |       | $                                | 6,000,000     |   | $ | 31,533 |   | $ | (164 | ) | $ | 6,031,369 |   |
| Mortgage-backed securities       |       | 3,463,687                        |          | 126,524 |   | — |   | 3,590,211 |   |
| Municipals, taxable              |       | 373,393                          |          | 19,573 |   | — |   | 392,966 |   |
| Total investment securities      | ** ** | **$**                            | **9,837,080** | ** ** | **$** | **177,630** | ** ** | **$** | **(164** | **)** | **$** | **10,014,546** | ** ** |

 
| ** **                       | ** ** | **December 31, 2009** | ** **    |
|----------------------------------|------------|---------------------------------|---------------|
| ** **                       | ** ** | **Amortized**                   | ** **    | **Gross Unrealized** | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**                        | ** **    | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Government-sponsored enterprises |       | $                               | 3,031,796     |   | $ | — |   | $ | (8,139 | ) | $ | 3,023,657 |   |
| Mortgage-backed securities       |       | 4,731,232                       |          | 53,868 |   | (9,795 | ) | 4,775,305 |   |
| Municipals, taxable              |       | 373,693                         |          | — |   | (1,007 | ) | 372,686 |   |
| Total investment securities      | ** ** | **$**                           | **8,136,721** | ** ** | **$** | **53,868** | ** ** | **$** | **(18,941** | **)** | **$** | **8,171,648** | ** ** |

 

At September 30, 2010, the investment portfolioincluded an unrealized gain of approximately $177,000. At September 30,2010, the investment portfolio included one security with a fair value of$999,836 and an amortized cost of $1,000,000 that had been in an unrealizedloss position for less than twelve months and no securities in a loss positionfor more than twelve months.  The Companybelieves, based on industry analyst reports and credit ratings, that thedeterioration in the fair value of this investment security available for saleis attributed to changes in market interest rates and not in the credit qualityof the issuer and therefore, this loss is not consideredother-than-temporary.  The Company hasthe ability and intent to hold this security until such time as the valuerecovers or the security matures.

 

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

 

*Thefollowing discussion reviews our results of operations and assesses ourfinancial condition.  You should read thefollowing discussion and analysis in conjunction with the accompanyingconsolidated financial statements.  Thecommentary should be read in conjunction with the discussion of forward-lookingstatements, the financial statements, and the related notes and the otherstatistical information included in this report.*

 

**DISCUSSIONOF FORWARD-LOOKING STATEMENTS**

 

This report contains statements which constituteforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934.  Forward-looking statements mayrelate to our financial condition, results of operation, plans, objectives, orfuture performance.  These statements arebased on many assumptions and estimates and are not guarantees of futureperformance.  Our actual results maydiffer materially from those anticipated in any forward-looking statements, asthey will depend on many factors about which we are unsure, including manyfactors 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 suchforward-looking statements.  Potentialrisks and uncertainties that could cause our actual results to differ fromthose anticipated in our forward-looking statements include, but are notlimited, to the following:

 

·                  reduced earnings due tohigher credit losses generally and specifically because losses in the sectorsof our loan portfolio secured by real estate are greater than expected due toeconomic factors, including, but not limited to, declining real estate values,increasing interest rates, increasing unemployment, or changes in paymentbehavior or other factors;

·                  reduced earnings due tohigher credit losses because our loans are concentrated by loan type, industrysegment, borrower type, or location of the borrower or collateral;

·                  high concentration of realestate-based loans collateralized by real estate in a weak commercial realestate market;

·      ourability to comply with our Formal Agreement and potential regulatory actions ifwe fail to comply;

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

·                  changes in the interest rateenvironment which could reduce anticipated margins;

·                  changes in politicalconditions or the legislative or regulatory environment, including the effectof recent financial reform legislation on the banking industry;

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

·                  changes occurring inbusiness conditions and inflation;

·                  changes in deposit flows;

·                  changes in technology;

·                  changes in monetary and taxpolicies;

·                  adequacy of the level of ourallowance for loan losses;

·                  the rate of delinquenciesand amount of loans charged-off;

·                  the rate of loan growth;

·                  adverse changes in assetquality and resulting credit risk-related losses and expenses;

·                  loss of consumer confidenceand economic disruptions resulting from terrorist activities;

·                  changes in the securitiesmarkets; and

·                  other risks anduncertainties detailed from time to time in our filings with the Securities andExchange Commission.

 

These risks are exacerbated by the developments over the last threeyears in national and international financial markets, and we are unable topredict what effect these uncertain market conditions will continue to have onour Company.  Beginning in 2008 andcontinuing through the first nine months of 2010, the capital and creditmarkets experienced unprecedented levels of extended volatility anddisruption.  There can be no assurancethat these unprecedented developments will not continue to materially andadversely affect our business, financial condition and results of operations.

 

All forward-looking statements in this report are based on informationavailable to us as of the date of this report. Although we believe that the expectations reflected in ourforward-looking statements are reasonable, we cannot guarantee you that theseexpectations will be achieved.  Weundertake no obligation to publicly update or otherwise revise anyforward-looking statements, whether as a result of new information, futureevents, or otherwise.

 

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**CriticalAccounting Policies**

 

Wehave adopted various accounting policies that govern the application ofaccounting principles generally accepted in the United States of America andwith general practices within the banking industry in the preparation of ourfinancial statements.  Our significantaccounting policies are described in the footnotes to our audited consolidatedfinancial statements as of December 31, 2009, as filed in our AnnualReport on Form 10-K.

 

Certainaccounting policies involve significant judgments and assumptions by us thathave a material impact on the carrying value of certain assets andliabilities.  We consider theseaccounting policies to be critical accounting policies.  The judgments and assumptions we use arebased on historical experience and other factors, which we believe to bereasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actualresults could differ from these judgments and estimates that could have amaterial impact on the carrying values of our assets and liabilities and ourresults of operations.

 

**Allowancefor Loan Losses**

 

Webelieve the allowance for loan losses is the critical accounting policy thatrequires the most significant judgments and estimates used in preparation ofour consolidated financial statements. Some of the more critical judgments supporting the amount of ourallowance for loan losses include judgments about the credit worthiness ofborrowers, the estimated value of the underlying collateral, the assumptionsabout cash flow, determination of loss factors for estimating credit losses,the impact of current events and conditions, and other factors impacting thelevel of probable inherent losses.  Underdifferent conditions or using different assumptions, the actual amount ofcredit losses incurred by us may be different from management’s estimatesprovided in our consolidated financial statements.  Refer to the portion of this discussion thataddresses our allowance for loan losses for a more complete discussion of ourprocesses and methodology for determining our allowance for loan losses.

 

**RealEstate Acquired in Settlement of Loans**

 

Realestate acquired through foreclosure is initially recorded and subsequentlycarried at the lower of cost or estimated fair value, adjusted for net sellingcosts.  Fair values of real estate owned are reviewed regularly andwrite-downs are recorded when it is determined that the carrying value of realestate exceeds the fair value less estimated costs to sell.  Costs relatingto the development and improvement of such property are capitalized, whereasthose costs relating to holding the property are expensed.

 

**IncomeTaxes**

 

We use assumptions and estimates in determining incometaxes payable or refundable for the current year, deferred income taxliabilities and assets for events recognized differently in our consolidatedfinancial statements and income tax returns, and income tax benefit orexpense.  Determining these amountsrequires analysis of certain transactions and interpretation of tax laws andregulations.  Management exercisesjudgment in evaluating the amount and timing of recognition of resulting taxliabilities and assets.  These judgmentsand estimates are reevaluated on a continual basis as regulatory and businessfactors change.  Valuationallowances are established to reduce deferred tax assets if it is determined tobe “more likely than not” that all or some portion of the potential deferredtax asset will not be realized.  No assurance can be given that either the tax returnssubmitted by us or the income tax reported on the financial statements will notbe adjusted by either adverse rulings by the United States Tax Court, changesin the tax code, or assessments made by the Internal Revenue Service.  We are subject to potential adverseadjustments, including, but not limited to, an increase in the statutoryfederal or state income tax rates, the permanent non-deductibility of amountscurrently considered deductible either now or in future periods, and thedependency on the generation of future taxable income, including capital gains,in order to ultimately realize deferred income tax assets.

 

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**Overview**

 

The following discussion describes our results ofoperations for the three and nine month periods ended September 30, 2010and 2009 and also analyzes our financial condition as of September 30,2010.

 

Like most community banks, we derive the majority of ourincome from interest we receive on our loans and investments.  Our primary source of funds for making theseloans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of oursuccess is our amount of net interest income, or the difference between theincome on our interest-earning assets, such as loans and investments, and theexpense on our interest-bearing liabilities, such as deposits andborrowings.  Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

There are risks inherent in all loans, so we maintain anallowance for loan losses to absorb probable losses on existing loans that maybecome uncollectible.  We establish andmaintain this allowance by charging a provision for loan losses against ouroperating earnings.  In the followingsection we have included a detailed discussion of this process.

 

In addition to earning interest on our loans andinvestments, we earn income through fees and other expenses we charge to ourcustomers.  We describe the variouscomponents of this noninterest income, as well as our noninterest expenses, inthe following discussion.

 

Marketsin the United States and elsewhere have experienced extreme volatility anddisruption over the past three years.  Thesecircumstances have exerted significant downward pressure on prices of equitysecurities and virtually all other asset classes, and have resulted insubstantially increased market volatility, severely constrained credit andcapital markets, particularly for financial institutions, and an overall lossof investor confidence.  Loan portfolioperformances have deteriorated at many institutions resulting from, among otherfactors, a weak economy and a decline in the value of the collateral supportingtheir loans.  Dramatic slowdowns in thehousing industry, due in part to falling home prices and increasingforeclosures and unemployment, have created strains on financialinstitutions.  Many borrowers are nowunable to repay their loans, and the collateral securing these loans has, insome cases, declined below the loan balance. In response to the challenges facing the financial services sector,several regulatory and governmental actions have been announced including:

 

·                  The Emergency EconomicStabilization Act, approved by Congress and signed by President Bush on October 3,2008, which, among other provisions, allowed the U.S. Treasury to purchasetroubled assets from banks, authorized the Securities and Exchange Commissionto suspend the application of marked-to-market accounting, and raised the basiclimit of FDIC deposit insurance from $100,000 to $250,000 through December 31,2013;

 

·                  On October 7, 2008, theFDIC approved a plan to increase the rates banks pay for deposit insurance;

 

·                  On October 14, 2008,the U.S. Treasury announced the creation of a new program, the Capital PurchaseProgram, that encourages and allows financial institutions to build capitalthrough the sale of senior preferred shares to the U.S. Treasury on terms thatare non-negotiable;

 

·                  On October 14, 2008,the FDIC announced the creation of the Temporary Liquidity Guarantee Program (“TLGP”),which seeks to strengthen confidence and encourage liquidity in the bankingsystem.  The TLGP has two primarycomponents that are available on a voluntary basis to financial institutions:

 

·                                      Guarantee of newly-issuedsenior unsecured debt; the guarantee would apply to new debt issued on orbefore October 31, 2009 and would provide protection until December 31,2012; issuers electing to participate would pay a 75 basis point fee for theguarantee; and

 

·                                      Unlimited deposit insurancefor non-interest bearing deposit transaction accounts; financial institutionselecting to participate will pay a 10 basis point premium in addition to theinsurance premiums paid for standard deposit insurance.

 

·                  On February 10, 2009,the U.S. Treasury announced the Financial Stability Plan, which earmarked $350billion of the TARP funds authorized under EESA. Among other things, theFinancial Stability Plan includes:

 

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·                                    A capital assistance programthat will invest in mandatory convertible preferred stock of certain qualifyinginstitutions determined on a basis and through a process similar to the CapitalPurchase Program;

 

·                                    A consumer and businesslending initiative to fund new consumer loans, small business loans andcommercial mortgage asset-backed securities issuances;

 

·                                    A new public-privateinvestment fund that will leverage public and private capital with publicfinancing to purchase up to $500 billion to $1 trillion of legacy “toxic assets”from financial institutions; and

 

·                                    Assistance for homeowners byproviding up to $75 billion to reduce mortgage payments and interest rates andestablishing loan modification guidelines for government and private programs.

 

·                  On February 17, 2009, the AmericanRecovery and Reinvestment Act (the “Recovery Act”) was signed into law in aneffort to, among other things, create jobs and stimulate growth in the UnitedStates economy.  The Recovery Actspecifies appropriations of approximately $787 billion for a wide range ofFederal programs and will increase or extend certain benefits payable under theMedicaid, unemployment compensation, and nutrition assistance programs.  The Recovery Act also reduces individual andcorporate income tax collections and makes a variety of other changes to taxlaws.  The Recovery Act also imposescertain limitations on compensation paid by participants in the U.S. Treasury’sTroubled Asset Relief Program (“TARP”).

 

·                  On March 23,2009, the U.S. Treasury, in conjunction with the FDIC and the Federal Reserve,announced the Public-Private Partnership Investment Program for Legacy Assetswhich consists of two separate plans, addressing two distinct asset groups:

 

·                                       The first planis the Legacy Loan Program, which has a primary purpose to facilitate the saleof troubled mortgage loans by eligible institutions, including FDIC-insuredfederal or state banks and savings associations. Eligible assets are notstrictly limited to loans; however, what constitutes an eligible asset will bedetermined by participating banks, their primary regulators, the FDIC and theTreasury. Under the Legacy Loan Program, the FDIC has sold certain troubledassets out of an FDIC receivership in two separate transactions relating to thefailed Illinois bank, Corus Bank, NA, and the failed Texas bank, Franklin Bank,S.S.B. These transactions were completed in September 2009 and October 2009,respectively.

 

·                                       The second planis the Securities Program, which is administered by the Treasury and involvesthe creation of public-private investment funds (“PPIFs”) to target investmentsin eligible residential mortgage-backed securities and commercialmortgage-backed securities issued before 2009 that originally were rated AAA orthe equivalent by two or more nationally recognized statistical ratingorganizations, without regard to rating enhancements (collectively, “LegacySecurities”). Legacy Securities must be directly secured by actual mortgageloans, leases or other assets, and may be purchased only from financialinstitutions that meet TARP eligibility requirements. The U.S. Treasuryreceived over 100 unique applications to participate in the Legacy SecuritiesPPIP and in July 2009 selected nine PPIF managers.  As of September 30, 2010, the PPIFs hadcompleted their fundraising and have closed on approximately $7.4 billion ofprivate sector equity capital, which was matched 100 percent by Treasury,representing $14.7 billion of total equity capital. The U.S. Treasury has alsoprovided $14.7 billion of debt capital, representing $29.4 billion of totalpurchasing power. As of September 30, 2010, PPIFs have drawn-downapproximately $18.6 billion of total capital which has been invested ineligible assets and cash equivalents pending investment.

 

·                  On May 22, 2009, the FDIC levied aone-time special assessment on all banks due on September 30, 2009;

 

·                  On November 12, 2009, the FDIC issued afinal rule to require banks to prepay their estimated quarterly risk-basedassessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012and to increase assessment rates effective on January 1, 2011;

 

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·                  On July 21, 2010, the U.S. Presidentsigned into law the Dodd-Frank Wall Street Reform and Consumer Protection Actof 2010 (the “Dodd-Frank Act”), a comprehensive regulatory framework that willaffect every financial institution in the U.S. The Dodd-Frank Act includes, among other measures, changes to the depositinsurance and financial regulatory systems, enhanced bank capital requirements,and provisions designed to protect consumers in financial transactions.  The Dodd-Frank Act also alters certaincorporate governance matters affecting public companies.  Over the next 6 to 18 months, regulatoryagencies will implement new regulations which will establish the parameters ofthe new regulatory framework and provide a clearer understanding of thelegislation’s effect on banks;

 

·                  Internationally, both the Basel Committee onBanking Supervision (the “Basel Committee”) and the Financial Stability Board(established in April 2009 by the Group of Twenty (“G-20”) FinanceMinisters and Central Bank Governors to take action to strengthen regulationand supervision of the financial system with greater international consistency,cooperation, and transparency) have committed to raise capital standards andliquidity buffers within the banking system (“Basel III”).  On September 12, 2010, the Group ofGovernors and Heads of Supervision agreed to the calibration and phase-in ofthe Basel III minimum capital requirements (raising the minimum Tier 1 commonequity ratio to 4.5% and minimum Tier 1 equity ratio to 6.0%, with fullimplementation by January 2015) and introducing a capital conservationbuffer of common equity of an additional 2.5% with implementation by January 2019.  The U.S. federal banking agencies supportthis agreement.  The Basel Committee isexpected to finalize the new capital and liquidity standard later this year andto present them for approval of the G-20 Finance Minister and Central BankGovernors in November 2010; and

 

·                  On September 27, 2010, the U.S.President signed into law the Small Business Jobs and Credit Act which, amongother things, creates a $30 billion fund to provide capital for banks withassets under $10 billion to increase their small-business lending. The U.S.Treasury is currently working to finalize terms of participation for this fund.

 

Weare participating in the unlimited deposit insurance component of the TLGP;however, we did not issue unsecured debt before the termination of thatcomponent of the TLGP.  On April 13,2010, the FDIC approved an interim rule that extends the TransactionAccount Guarantee Program (“TAGP”) to December 31, 2010.  We have elected to continue our voluntaryparticipation in the program. Coverage under the program is in addition to andseparate from the basic coverage available under the FDIC’s general depositinsurance rules.  We believeparticipation in the program is enhancing our ability to retain customerdeposits.  As a result of theenhancements to deposit insurance protection and the expectation that therewill be demands on the FDIC’s deposit insurance fund, our deposit insurancecosts increased significantly.  We haveelected not to participate in the TARP Capital Purchase Program, but willconsider participating in similar programs, if any, announced in thefuture.  Specifically, we will evaluateparticipating in the fund pursuant to the Small Business Jobs and Credit Actonce further information regarding eligibility and terms are madeavailable.  Regardless of our lack ofparticipation, governmental intervention and new regulations under theseprograms could materially and adversely affect our business, financialcondition and results of operations.

 

Althoughthe TAGP expires on December 31, 2010, a provision of the Dodd-Frank Actrequires the FDIC to provide unlimited deposit insurance for all deposits innon-interest-bearing transaction accounts. This deposit insurance mandate created by the Dodd-Frank Act will takeeffect on December 31, 2010, and will continue through December 31,2012.  The deposit insurance mandatecreated by the Dodd-Frank Act is not an extension of the TAGP.  Although the TAGP and the Dodd-Frank Actestablish unlimited deposit insurance for certain types of non-interest-bearingdeposit accounts, unlike the TAGP, the coverage provided by the Dodd-Frank Actdoes not apply to NOW accounts or IOLTAs and will be funded through generalFDIC assessments, not special assessments.

 

Althoughit is likely that further regulatory actions will arise as the Federalgovernment attempts to address the economic situation, we cannot predict thecontinuing effect that fiscal or monetary policies, economic control, or newfederal or state legislation may have on our business and earnings in thefuture.

 

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**Recent Regulatory Developments**

 

OnJanuary 20, 2010, the Bank entered into a Formal Agreement (the “FormalAgreement”) with its primary regulator, the Office of the Comptroller of theCurrency (the “OCC”).  The FormalAgreement seeks to enhance the Bank’s existing practices and procedures in theareas of management oversight, strategic and capital planning, credit riskmanagement, credit underwriting, liquidity, and funds management.  In response, the Bank has formed a ComplianceCommittee of its Board of Directors (the “Compliance Committee”) to overseemanagement’s response to all sections of the Formal Agreement.  The Compliance Committee also monitorsadherence to deadlines for submission to the OCC of information required underthe Formal Agreement.  The Board ofDirectors and management of the Bank have been aggressively working to addressthe findings of the exam and will continue to work to comply with all therequirements of the Formal Agreement.  Asummary of the requirements of the Formal Agreement and the Bank’s status oncomplying 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 its annual  update of the strategic plan which will be submitted to the OCC upon  completion during the fourth quarter. |

 

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| 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  December 2009 which was submitted to the OCC on March 8, 2010. The  Bank is currently in the process of updating this three-year profit plan  based on actual results for the first nine months of 2010 compared to the  original profit plan as well as changes in assumptions for future years.                                                         |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                              |   |                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 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 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, 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 September 30, 2010, the Bank has increased  its liquidity position to 17.31% from 13.60% as of December 31, 2009. In  addition, the Bank has decreased wholesale funding reliance by $18.0 million  in the first nine months of 2010.                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                              |   |                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 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.                                                                                                                                                                                                                                                   |

 

16

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| Take immediate and continuing action to protect the  Bank’s interest in certain assets identified by the OCC or any other bank  examiner. Adopt and implement, within 60 days of the effective date of the  Formal Agreement, a written program designed to eliminate the basis of  criticism of assets criticized by the OCC or any other bank examiner, or in  any list provided to management by the OCC during any examination as  “doubtful,” “substandard,” or “special mention.” In addition, provide to the  OCC a copy of the program for all criticized assets equal to or exceeding  $300,000. Conduct a monthly review to determine the status of each criticized  asset that equals or exceeds $300,000 and management’s adherence to and the  status and effectiveness of the criticized asset program adopted. |   | The Bank is utilizing a criticized assets report  covering the entire credit relationship with respect to such assets. Initial  reports were submitted to the OCC on March 30, 2010, and ongoing monthly  monitoring is being performed by management and the Board of Directors.                                                                                                                                                                          |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 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 September 30, 2010, we are not aware of  any violations of this provision of the Formal Agreement.                                                                                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 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. Revisions were finalized prior to September 30, 2010  and management will resubmit this information to the OCC in  November 2010. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 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, re-appraisal, 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, management has provided detailed  monthly reports to the Board of Directors detailing information required in  this provision of the Formal Agreement.                                                                                                                                                                                                                                                                                         |

 

17

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| 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 September 30, 2010, 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 September 30, 2010, 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 September 30, 2010, 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.                                                                                                                        |

 

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

 

18

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Inaddition, the OCC has established Individual Minimum Capital Ratio levels ofTier 1 and total capital for the Bank that are higher than the minimum andwell capitalized ratios applicable to all banks.  Specifically, the Bank must maintain totalrisk-based capital of at least 12%, Tier 1 capital of at least 10%, and aleverage ratio of at least 9%.  As of September 30,2010, the Bank fell below the established Individual Minimum CapitalRatios.  See “Management’s Discussion andAnalysis — Results of Operations — Capital Resources” for more discussion.

 

Currently, the Company also has to obtain the priorwritten approval of the Federal Reserve Bank of Richmond before (1) declaringor paying any dividends, (2) directly or indirectly accepting dividends orany other form of payment representing a reduction in capital from the Bank,(3) making any distributions of interest, principal or other sums onsubordinated debentures or trust preferred securities, (4) directly orindirectly, incurring, increasing or guaranteeing any debt, and(5) directly or indirectly, purchasing or redeeming any shares of itsstock.  Pursuant to our plans to preserve capital, the Company has noplans to undertake any of the foregoing activities.

 

**Results of Operations**

 

*Threemonths ended September 30, 2010 and 2009*

 

Weincurred a net loss of $3,165,994, or $1.52 per diluted share, for the quarterended September 30, 2010 compared to a net loss of $374,159, or $0.18 perdiluted share, for the quarter ended September 30, 2009, a difference of$2.8 million.  As described below, theincrease in net loss is primarily due to an increase in income tax expense inaddition to an increase in provision for loan losses.  Our noninterest expenses also increased dueto write downs on other real estate owned and repossessed assets.

 

The following table sets forth information related to ouraverage balance sheet, average yields on assets, and average costs ofliabilities for the three months ended September 30, 2010 and 2009.  We derived these yields by dividingannualized income or expense by the average balance of the corresponding assetsor liabilities.  We derived averagebalances from the daily balances throughout the periods indicated.  The net amount of capitalized loan fees areamortized into interest income on loans.

 
| ** **                                       | ** ** | **For the Three Months Ended September 30,** | ** **  |
|--------------------------------------------------|------------|----------------------------------------------------------------------------|-------------|
| ** **                                       | ** ** | **2010**                                                                   | ** **  | **2009** | ** ** |
| ** **                                       | ** ** | **Average  Balance**                                                       | ** **  | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** |
|                                             |       |                                                                       |        |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and other                     |       | $                                                                          | 10,038,217  |   | $ | 12,921 |   | 0.51 | % | $ | 6,084,384 |   | $ | 11,490 |   | 0.75 | % |
| Investment securities (1)                        |       | 9,649,805                                                                  |        | 73,057 |   | 3.00 |   | 5,558,605 |   | 59,735 |   | 4.26 |   |
| Loans (2)                                        |       | 96,573,968                                                                 |        | 1,181,010 |   | 4.85 |   | 113,170,781 |   | 1,425,590 |   | 5.00 |   |
| Total interest-earning assets                    |       | $                                                                          | 116,261,990 |   | $ | 1,266,988 |   | 4.32 | % | $ | 124,813,770 |   | $ | 1,496,815 |   | 4.76 | % |
|                                             |       |                                                                       |        |   |   |   |   |   |   |   |   |   |   |
| NOW accounts                                     |       | $                                                                          | 6,187,086   |   | $ | 11,884 |   | 0.76 | % | $ | 5,844,955 |   | $ | 8,949 |   | 0.61 | % |
| Savings & money market                  |       | 35,712,345                                                                 |        | 141,151 |   | 1.57 |   | 15,765,694 |   | 74,678 |   | 1.88 |   |
| Time deposits (excluding brokered time deposits) |       | 28,700,939                                                                 |        | 135,446 |   | 1.87 |   | 32,728,882 |   | 241,045 |   | 2.92 |   |
| Brokered time deposits                           |       | 30,385,324                                                                 |        | 199,009 |   | 2.60 |   | 41,788,842 |   | 321,103 |   | 3.05 |   |
| Total interest-bearing deposits                  |       | 100,985,694                                                                |        | 487,490 |   | 1.92 |   | 96,128,373 |   | 645,775 |   | 2.67 |   |
| Borrowings                                       |       | 7,742,892                                                                  |        | 80,249 |   | 4.11 |   | 16,168,165 |   | 147,172 |   | 3.61 |   |
| Total interest-bearing liabilities               |       | $                                                                          | 108,728,586 |   | $ | 567,739 |   | 2.07 | % | $ | 112,296,538 |   | $ | 792,947 |   | 2.80 | % |
|                                             |       |                                                                       |        |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                              |       |                                                                       |        |   |   | 2.25 | % |   |   |   |   | 1.96 | % |
| Net interest income/ margin                      |       |                                                                       |        | $ | 699,249 |   | 2.39 | % |   |   | $ | 703,868 |   | 2.24 | % |

 

----

(1)                                  The averagebalances for investment securities exclude the unrealized gain recorded foravailable for sale securities.

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

 

19

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Forthe three months ended September 30, 2010, we recognized $1.3 million ininterest income and $567,739 in interest expense, resulting in net interestincome of $699,249, a small decrease of $4,619, or less than 1%, over the sameperiod in 2009.  Average earning assetsdecreased to $116.3 million for the three months ended September 30, 2010from $124.8 million for the three months ended September 30, 2009, adecrease of $8.6 million, or 7%.  Averageinterest bearing liabilities decreased to $108.7 million for the three monthsended September 30, 2010 from $112.3 million for the three months ended September 30,2009, a decrease of $3.6 million, or 3%. Net interest margin, calculated as annualized net interest incomedivided by average earning assets, increased from 2.24% for the quarter ended September 30,2009 to 2.39% for the quarter ended September 30, 2010, primarily due to adecrease in cost of interest-bearing liabilities from 2.80% to 2.07% betweenperiods due to the mix of liabilities and the timing of their repricing.  This decrease was offset somewhat by a decreasein yield on earning assets from 4.76% to 4.32% between periods.

 

Provisionfor loan losses was $1,220,000 for the quarter ended September 30, 2010representing an increase of $1.1 million, or 791%, compared to the expense of$137,000 for the quarter ended September 30, 2009.  The increase in provision for loan losses isdue to the increase in impaired and non-accrual loans and their relatedspecific reserves in addition to an increase in the general allowanceallocation due to declining economic conditions and the resulting decline inour borrowers’ ability to repay their loans. The total allowance as a percentage of gross loans increased to 2.90% atSeptember 30, 2010 from 1.71% at December 31, 2009.  Specific reserves were $1.4 million onimpaired loans of $12.4 million as of September 30, 2010.  As of September 30, 2010, the generalreserve allocation was 1.64% of gross loans not impaired compared to 1.62% asof December 31, 2009. The provision for loan losses is discussed furtherbelow under “Provision and Allowance for Loan Losses.”

 

Forthe three months ended September 30, 2010, noninterest income was $76,004compared to $68,155 for the three months ended September 30, 2009, anincrease of $7,849 between comparable periods. This increase is primarily due to an increase of almost $8,000 inservices charges on deposits and customer service fees.  Mortgage origination income remained stablebetween comparable periods representing approximately $48,000 of thenoninterest income in each period.   Noninterestincome for the three months ended September 30, 2010 and 2009 was derivedfrom service charges on deposits, customer service fees, rental income, andmortgage origination income.

 

Duringthe three months ended September 30, 2010, we incurred noninterestexpenses of $1.3 million, compared to noninterest expenses of $1.0 million forthe three months ended September 30, 2009, an increase of $337,128, or33%.  This increase of noninterestexpenses for the three month period ended September 30, 2010 primarilyresulted from write downs of $318,131 on other real estate owned andrepossessed assets discussed in greater detail below.  Other expense also increased $18,721 comparedto the three month period ended September 30, 2009, primarily due toincreased expenses related to other real estate owned, such as taxes andmaintenance. Insurance expense increased $15,092 due to increased Bond andD&O insurance premiums.  Professionalfees increased $42,464 due to increased legal and consulting fees related to creditissues arising from the economic downturn. These increases were offset bydecreases in other expense categories. Compensation and benefits decreased $42,001 due to a decrease insalaries and stock-based compensation as well as the discontinuation of our401k match beginning April 1, 2010. We have focused on expense controlover the past year which has resulted in small decreases in expenses related tomarketing and telephone and supplies.

 

Incometax expense for the three months ended September 30, 2010 was $1,374,937compared to zero for the three months ended September 30, 2009.  Accounting literature states that a deferredtax asset should be reduced by a valuation allowance if, based on the weight ofall available evidence, it is more likely than not (a likelihood of more than50%) that some portion or the entire deferred tax asset will not berealized.  The determination of whether adeferred 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 thevaluation allowance recorded against our deferred tax assets, we determinedthat it was not more likely than not that they will be recognized in futureyears due to the continued decline in credit quality and the resultingincreased net losses and negative impact on capital as a result of provisionfor loan losses and other real estate owned write downs.  In addition, credit quality has impacted ournet interest margin during 2010 due to interest reversals and interest lost onnon-accrual loans.   During third quarter2009, it became evident that the unprecedented economic conditions specificallyaffecting the banking industry had increased the uncertainty as to the timingof the expected recovery period of the industry as a whole.  Although later than many areas of the UnitedStates, it also became more evident that our local market and our Bank wereaffected by these deteriorating economic conditions.  These events led us to record a valuationallowance of 100% on all deferred tax assets generated beginning July 1,2009 through September 30, 2010. The expense recorded for the quarter ended September 30, 2010 representsa 100% valuation allowance on all prior deferred tax assets (those generatedprior to July 1, 2009).   We willcontinue to analyze our deferred tax assets and related valuation allowanceeach quarter taking into account performance compared to forecast and currenteconomic or internal information that would impact forecasted earnings.

 

20

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*Ninemonths ended September 30, 2010 and 2009*

 

Weincurred a net loss of $5,044,486, or $2.42 per diluted share, for the ninemonths ended September 30, 2010 compared to a net loss of $1,404,081, or$0.67 per diluted share, for the nine months ended September 30, 2009, adifference of $3.6 million.  As describedbelow, the increase in net loss is primarily due to income tax expense duringthe current year compared to income tax benefit in 2009 in addition to anincrease in provision for loan losses. Our noninterest expenses increased due to write downs on other realestate owned and repossessed assets which more than offset an increase in netinterest income, discussed in greater detail below.

 

The following table sets forth information related to ouraverage balance sheet, average yields on assets, and average costs ofliabilities for the nine months ended September 30, 2010 and 2009.  We derived these yields by dividingannualized income or expense by the average balance of the corresponding assetsor liabilities.  We derived averagebalances from the daily balances throughout the periods indicated.  The net amount of capitalized loan fees areamortized into interest income on loans.

 
| ** **                                       | ** ** | **For the Nine Months Ended September 30,** | ** **  |
|--------------------------------------------------|------------|---------------------------------------------------------------------------|-------------|
| ** **                                       | ** ** | **2010**                                                                  | ** **  | **2009** | ** ** |
| ** **                                       | ** ** | **Average  Balance**                                                      | ** **  | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** | **Average  Balance** | ** ** | **Income/  Expense** | ** ** | **Yield/  Rate** | ** ** |
|                                             |       |                                                                      |        |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and other                     |       | $                                                                         | 10,833,056  |   | $ | 38,624 |   | 0.48 | % | $ | 4,593,833 |   | $ | 26,758 |   | 0.78 | % |
| Investment securities (1)                        |       | 8,608,399                                                                 |        | 201,507 |   | 3.13 |   | 4,651,833 |   | 151,898 |   | 4.37 |   |
| Loans (2)                                        |       | 101,537,328                                                               |        | 3,655,015 |   | 4.81 |   | 117,639,350 |   | 4,187,037 |   | 4.76 |   |
| Total interest-earning assets                    |       | $                                                                         | 120,978,783 |   | $ | 3,895,146 |   | 4.30 | % | $ | 126,885,016 |   | $ | 4,365,693 |   | 4.60 | % |
|                                             |       |                                                                      |        |   |   |   |   |   |   |   |   |   |   |
| NOW accounts                                     |       | $                                                                         | 5,607,114   |   | $ | 28,675 |   | 0.68 | % | $ | 5,576,853 |   | $ | 24,882 |   | 0.60 | % |
| Savings & money market                  |       | 32,064,244                                                                |        | 414,694 |   | 1.73 |   | 14,225,464 |   | 201,268 |   | 1.89 |   |
| Time deposits (excluding brokered time deposits) |       | 29,364,941                                                                |        | 452,216 |   | 2.06 |   | 31,264,728 |   | 750,273 |   | 3.21 |   |
| Brokered time deposits                           |       | 34,426,433                                                                |        | 695,034 |   | 2.70 |   | 45,557,637 |   | 1,107,363 |   | 3.25 |   |
| Total interest-bearing deposits                  |       | 101,462,732                                                               |        | 1,590,619 |   | 2.10 |   | 96,624,682 |   | 2,083,786 |   | 2.88 |   |
| Borrowings                                       |       | 11,024,597                                                                |        | 322,259 |   | 3.91 |   | 17,741,760 |   | 442,975 |   | 3.34 |   |
| Total interest-bearing liabilities               |       | $                                                                         | 112,487,329 |   | $ | 1,912,878 |   | 2.27 | % | $ | 114,366,442 |   | $ | 2,526,761 |   | 2.95 | % |
|                                             |       |                                                                      |        |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                              |       |                                                                      |        |   |   | 2.03 | % |   |   |   |   | 1.65 | % |
| Net interest income/ margin                      |       |                                                                      |        | $ | 1,982,268 |   | 2.19 | % |   |   | $ | 1,838,932 |   | 1.94 | % |

 

----

(1)                                  The averagebalances for investment securities exclude the unrealized gain recorded foravailable for sale securities.

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

 

Forthe nine months ended September 30, 2010, we recognized $3.9 million ininterest income and $1.9 million in interest expense, resulting in net interestincome of $2.0 million, an increase of $143,336, or 8%, over the same period in2009.  Average earning assets decreasedto $121.0 million for the nine months ended September 30, 2010 from $126.9million for the nine months ended September 30, 2009, a decrease of $5.9million, or 5%.  Average interest bearingliabilities decreased to $112.5 million for the nine months ended September 30,2010 from $114.4 million for the nine months ended September 30, 2009, adecrease of $1.9 million, or 2%.  Netinterest margin, calculated as annualized net interest income divided byaverage earning assets, increased from 1.94% for the nine months ended September 30,2009 to 2.19% for the nine months ended September 30, 2010, primarily dueto a decrease in cost of interest-bearing liabilities from 2.95% to 2.27%between periods due to the mix of liabilities and the timing of theirrepricing.  This decrease was offsetsomewhat by a decrease in yield on earning assets from 4.60% to 4.30% betweenperiods.

 

Provisionfor loan losses was $2,055,000 for the nine months ended September 30,2010 representing an increase of $1.3 million, or 161%, compared to the expenseof $787,000 for the nine months ended September 30, 2009.  The increase in provision for loan losses isdue to the increase in impaired and non-accrual loans and their relatedspecific reserves in addition to an increase in the general allowanceallocation due to declining economic conditions and increased charge offlevels.  The provision for loan losses isdiscussed further below under “Provision and Allowance for Loan Losses.”

 

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Forthe nine months ended September 30, 2010, noninterest income was $188,418compared to $176,730 for the nine months ended September 30, 2009, anincrease of $11,688 between comparable periods. This small increase is mainly due to the fact that we recognized another than temporary impairment charge of $60,404 during the nine months ended September 30,2009 which drove noninterest income down in 2009 compared to the nine monthsended September 30, 2010.   Thissmall increase also reflects increases in services charges on deposits andcustomer service fees of approximately $33,000 offset by a decrease of morethan $80,000 in mortgage origination income. Mortgage origination incomedecreased significantly during the current year due to the loss of anoriginator who was not replaced until later in the second quarter.   Noninterest income for the nine months endedSeptember 30, 2010 and 2009 was derived from service charges on deposits,customer service fees, rental income, and mortgage origination income.

 

Duringthe current nine months, we incurred noninterest expenses of $3.8 million,compared to noninterest expenses of $3.1 million for the nine months ended September 30,2009, an increase of $659,942, or 21%. This increase of noninterest expenses for the nine month period ended September 30,2010 primarily resulted from write downs of $692,290 on other real estate ownedand repossessed assets discussed in greater detail below.  Other expense also increased by $81,877compared to the nine months ended September 30, 2009, primarily due toincreased expenses related to other real estate owned, such as taxes andmaintenance. Occupancy and equipment expenses increased $20,887 for the ninemonths ended September 30, 2010 compared to the nine months ended September 30,2009 due to the opening of the Simpsonville branch in February 2009, whichresulted in fewer number of months expense in 2009 compared to 2010.  Professional fees increased $44,587 due toincreased legal and consulting fees related to credit issues arising from theeconomic downturn. Insurance expense increased by $10,662 due to an increase inBond and D&O insurance premiums which was offset by a decrease in FDICinsurance premiums.  These increases wereoffset by decreases in other expense categories.  Compensation and benefits decreased $115,697due to a decrease in commissions on mortgage origination fees, a small decreasein salaries and stock-based compensation as well as the discontinuation of our401k match beginning April 1, 2010. We have been focusing on expense control over the past year which hasresulted in small decreases in expenses related to marketing and telephone andsupplies.  We also renegotiated andrenewed our data processing contract in May 2009 resulting in decreaseddata processing expenses.

 

Incometax expense for the nine months ended September 30, 2010 was $1,374,937compared to an income tax benefit of $492,550 for the nine months ended September 30,2009.  Accounting literature states thata deferred tax asset should be reduced by a valuation allowance if, based onthe weight of all available evidence, it is more likely than not (a likelihoodof more than 50%) that some portion or the entire deferred tax asset will notbe realized.  The determination ofwhether a deferred tax asset is realizable is based on weighting all availableevidence, including both positive and negative evidence. In making suchjudgments, significant weight is given to evidence that can be objectivelyverified.  During our quarterly analysisof the valuation allowance recorded against our deferred tax assets, wedetermined that it was not more likely than not that they will be recognized infuture years due to the continued decline in credit quality and the resultingincreased net losses and negative impact on capital as a result of provisionfor loan losses and other real estate owned write downs.  In addition, credit quality has impacted ournet interest margin during 2010 due to interest reversals and interest lost onnon-accrual loans.   During third quarter2009, it became evident that the unprecedented economic conditions specificallyaffecting the banking industry had increased the uncertainty as to the timingof the expected recovery period of the industry as a whole.  Although later than many areas of the UnitedStates, it also became more evident that our local market and our Bank wereaffected by these deteriorating economic conditions.  These events led us to record a valuationallowance of 100% on all deferred tax assets generated beginning July 1,2009 through September 30, 2010. The expense recorded for the nine months ended September 30, 2010represents a 100% valuation allowance on all prior deferred tax assets (thosegenerated prior to July 1, 2009).   Wewill continue to analyze our deferred tax assets and related valuationallowance each quarter taking into account performance compared to forecast andcurrent economic or internal information that would impact forecasted earnings.

 

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**Assetsand Liabilities**

 

*General*

 

Totalassets as of September 30, 2010 were $123.9 million, representing adecrease of $11.4 million, or 8%, compared to December 31, 2009.  The decrease in assets is due to a $13.1million decrease in net loans which is the result of $8.9 million of net loanpayoffs, $2.2 million in transfers to other real estate owned and $2.1 millionin provision for loan losses.  Otherassets decreased by $1.6 million primarily due to the increase in the deferredtax asset valuation allowance of $1.4 million. These decreases were offset by increases in cash and cash equivalents of$1.2 million and a $1.8 million increase in investment securities.  At September 30, 2010, our total assetsconsisted principally of $11.4 million in cash and due from banks, $10.0million in investment securities, $93.0 million in net loans, $3.7 million inproperty and equipment, and $2.9 million in other real estate owned andrepossessed assets.  Our managementclosely monitors and seeks to maintain appropriate levels of interest-earningassets and interest-bearing liabilities so that maturities of assets are suchthat adequate funds are provided to meet customer withdrawals and demand.

 

Liabilitiesat September 30, 2010 totaled $112.1 million, representing a decrease of$6.5 million, or 6%, compared to December 31, 2009, and consistedprincipally of $104.9 million in deposits and $7.0 million in borrowings.  Our borrowings consisted of FHLB advances andcustomer repurchase agreements.  At September 30,2010, shareholders’ equity was $11.8 million compared to $16.7 million at December 31,2009. The decrease in shareholders’ equity is primarily due to the net loss of$5,044,486 for the nine months ended September 30, 2010.

 

*Loans*

 

Since loans typically provide higher interest yields than other typesof interest-earning assets, we invest a substantial percentage of our earningassets in our loan portfolio.  At September 30,2010, our gross loan portfolio consisted primarily of $62.9 million of commercialreal estate loans, $14.1 million of commercial business loans, and $18.9million of consumer and home equity loans. Our current loan portfolio composition is not materially different thanthe loan portfolio composition disclosed in the footnotes to the consolidatedfinancial statements included in our Annual Report on Form 10-K for 2009as filed with the SEC.  We experiencednet payoffs of $8.9 million during the nine months ended September 30,2010 due to low market demand, careful consideration of liquidity needs andcredit risk management.

 

We discontinue accrual of interest on a loan when we conclude it isdoubtful that we will be able to collect interest from the borrower.  We reach this conclusion by taking intoaccount factors such as the borrower’s financial condition, economic andbusiness conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan innon-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status,we reverse all interest which has been accrued on the loan but remains unpaidand deduct this interest from earnings as a reduction of reported interestincome.  We do not accrue any additionalinterest on the loan balance until we conclude the collection of both principaland interest is reasonably certain. We had approximately $10.3 million and $6.7million in non-accrual loans at September 30, 2010 and December 31,2009, respectively.  This increasebetween periods is due to seven loans which were moved to non-accrual statusduring the nine month period as a result of a review of these relationships,their payment history and the current economic environment.  However, we also successfully took possessionof the collateral of three loans that were non-accrual as of December 31,2009 as discussed below.  Non-accrualloans represented 10.8% of gross loans at September 30, 2010.  We continue to carefully monitor each ofthese loans and have established specific reserves as warranted based on a reviewof the underlying collateral of each loan as well as the financial condition ofeach borrower.

 

At September 30, 2010, we had 15 loans totaling $12.4 million thatwere considered impaired with specific reserves of approximately $1.4 millionallocated in the allowance for loan losses. The Company identifies impaired loans through its normal internal loanreview process.  Impairment is measuredon a loan-by-loan basis for commercial and construction loans by either thepresent value of expected future cash flows discounted at the loan’s effectiveinterest rate, the loan’s obtainable market price, or the fair value of thecollateral if the loan is collateral dependent. The resultant shortfall is charged to provision for loan losses and isclassified as specific reserves.  When animpaired loan is ultimately charged-off, the charge-off is taken against thespecific reserve.  Impaired loansconsisted of $12.4 million of loans secured by real estate and approximately$44,000 of unsecured commercial lines of credit.  Loans which are deemed to be impaired arevalued on a nonrecurring basis at the lower of cost or market value of theunderlying collateral.  Such marketvalues are generally obtained using independent appraisals, updated inaccordance with our reappraisal policy, or other market data such as recentoffers to the borrower.  As of September 30,2010, we had loans totaling $1.4 million that were classified in accordancewith our loan rating policies but were not considered impaired.  Classified asset levels are considered indetermining management’s assessment of the adequacy of the allowance for loanlosses.

 

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Asof September 30 2010, we had loans totaling $3.1 million on the watchlist.  The watch list is the classification utilized by us when we have aninitial concern about the financial health of a borrower.  These loans aredesignated as such in order to be monitored more closely than other credits inour portfolio.  We then gather currentfinancial information about the borrower and evaluate our current risk in thecredit.  We will then either reclassify the loan as “substandard” or backto its original risk rating after a review of the information.  There aretimes when we may leave the loan on the watch list, if, in management’sopinion, there are risks that cannot be fully evaluated without the passage oftime, and we determine to review the loan on a more regular basis.  Loanson the watch list are not considered “potential problem loans” until they aredetermined by management to be classified as substandard.

 

Loanspast due 30-89 days amounted to $2.6 million at September 30, 2010,compared to approximately $497,000 at December 31, 2009.  At September 30,2010, we did not have any loans past due greater than 90 days that were notalready placed in non-accrual status.

 

*Provision and Allowance for Loan Losses*

 

We have established an allowance for loan losses through a provisionfor loan losses charged to expense on our consolidated statement ofoperations.  The allowance for loanlosses for the three and nine months ended September 30, 2010 and 2009 ispresented below:

 
| ** **                                 | ** ** | **Three Months Ended********September 30,** | ** ** | **Nine Months Ended********September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                 | ** ** | **2010**                                                   | ** ** | **2009**                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| Balance at beginning of the period         |       | $                                                          | 2,122,456  |                                                      | $          | 2,261,977 |   | $ | 1,847,513 |   | $ | 1,611,977 |   |
| Provision for loan losses                  |       | 1,220,000                                                  |       | 137,000                                                   |       | 2,055,000 |   | 787,000 |   |
| Loans charged-off                          |       | (561,288                                                   | )          | (252,442                                                  | )          | (1,161,345 | ) | (252,442 | ) |
| Recoveries of loans previously charged-off |       | —                                                     |       | —                                                    |       | 40,000 |   | — |   |
| Balance at end of the period               |       | $                                                          | 2,781,168  |                                                      | $          | 2,146,535 |   | $ | 2,781,168 |   | $ | 2,146,535 |   |
| Net charge-offs to average loans           |       | 2.31                                                       | %          | 0.88                                                      | %          | 1.48 | % | 0.29 | % |

 

Asof September 30, 2010, the allowance for loan losses was $2.8 million, or2.90% of gross loans, compared to $1.8 million, or 1.71% of gross loans, as of December 31,2009 and $2.1 million, or 1.99% of gross loans, as of September 30,2009.  Provision for loan losses was $1,220,000for the three months ended September 30, 2010, an increase of $1.1million, or 791%, compared to the expense of $137,000 for the three monthsended September 30, 2009.  For thenine months ended September 30, 2010, provision for loan losses was $2,055,000,an increase of $1.3 million, or 161%, over the nine months ended September 30,2009.  During the nine months ended September 30,2010, we charged off $1.2 million related to ten relationships.  Of these charge-offs, $350,000 related to anunsecured commercial loan which had no prior signs of deterioration,approximately $28,000 represented a home equity line of credit and $13,000represented a commercial loan.  Theremaining $768,000 in charge offs were due to recent appraisals and evaluationson commercial real estate loans in the process of foreclosure.

 

The increase in the allowance for loan losses is a result, inlarge part, of the general conditions of the current economic climate,including, among other things, a rise in unemployment, which affects borrowers’ability to repay, and the decrease in values in the real estate market, whichaffects the value of collateral securing certain loans with the Bank.  The allowance for loan losses represents anamount which we believe will be adequate to absorb probable losses on existingloans that may become uncollectible.  Westrive to follow a comprehensive, well-documented, and consistently appliedanalysis of our loan portfolio in determining an appropriate level for theallowance for loan losses.  Our judgmentas to the adequacy of the allowance for loan losses is based on a number ofassumptions about future events, which we believe to be reasonable, but whichmay or may not prove to be accurate.  Ourdetermination of the allowance for loan losses is based on what we believe areall significant factors that impact the collectability of loans, includingconsideration of factors such as the balance of impaired loans, the quality,mix, and size of our overall loan portfolio, economic conditions that mayaffect the borrower’s ability to repay, the amount and quality of collateralsecuring the loans, our historical loan loss experience, and a review ofspecific problem loans.  We also considersubjective issues such as changes in lending policies and procedures, changesin the local/national economy, changes in volume or type of credits, changes involume/severity of problem loans, quality of loan review and Board of Directoroversight, concentrations of credit, and peer group comparisons.  Due to our limited operating history, to datethe provision for loan losses has been made primarily as a result of ourassessment of general loan loss risk compared to banks of similar size andmaturity.  Due to our short operating history,the loans in our loan portfolio and our lending relationships are of recentorigin.  In general, loans do not beginto show signs of credit deterioration or default until they have beenoutstanding for some period of time, a process known as seasoning.  As a result, a portfolio of older loans willusually behave more predictably than a newer portfolio.  Because our loan portfolio is new, thecurrent level

 

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of delinquencies and defaults may not be representative ofthe level that will prevail when the portfolio becomes more seasoned, which maybe higher than current levels.   Ifdelinquencies and defaults increase, we may be required to increase ourprovision for loan losses, which would adversely affect our results ofoperations and financial condition. Periodically, we will adjust the amount of the allowance based onchanging circumstances.  We will chargerecognized losses to the allowance and add subsequent recoveries back to theallowance for loan losses.  There can beno assurance that charge-offs of loans in future periods will not exceed theallowance for loan losses as estimated at any point in time or that provisionsfor loan losses will not be significant to a particular accounting period.

 

The downturn in the real estate market over the past threeyears has resulted in increased loan delinquencies, defaults and foreclosures,primarily in our commercial real estate portfolio.  In some cases, thisdownturn has resulted in a significant impairment to the value of our collateraland our ability to sell the collateral upon foreclosure, and there is a riskthat this trend will continue.  The real estate collateral in each caseprovides an alternate source of repayment in the event of default by theborrower and may deteriorate in value during the time the credit isextended.  If real estate values continue to decline, it is also morelikely that we would be required to increase our allowance for loanlosses.  This downturn in the real estate market has resulted in an increasein our nonperforming loans, and there is a risk that this trend will continue,which could result in additional losses of earnings and increases in ourprovision for loan losses and loans charged-offs.

 

*OtherReal Estate Owned and Repossessed Assets*

 

Asof September 30, 2010 we had $2.9 million in other real estate owned and$56,712 in repossessed assets.  Otherreal estate owned consists of approximately $282,000 of residential properties,$2.5 million of land and $118,000 of commercial office space.  Repossessed assets consists ofequipment.  Charge-offs of $205,297 weretaken on these relationships at the time of transfer to other real estate ownedand repossessed assets.   During thethree and nine months ended September 30, 2010, based on new marketinformation, $318,131 and $692,290, respectively, was charged to expense towrite down the value of other real estate owned and repossessed assets.  These write-downs were a result of thereceipt of new appraisals, changes in listing prices, and offers received on theproperties owned.  Management reviews thefair values of real estate owned and repossessed assets on a regular basis, andwrite-downs are recorded when it is determined that the carrying value of realestate exceeds the fair value less estimated costs to sell.  Other realestate owned of approximately $416,000 was sold during the nine months ended September 30,2010 at a very small gain of less than $1,000. In addition, guarantor funds of approximately $178,000 were received in August 2010on one property held in other real estate, and these funds were used to reducethe balance in other real estate owned. Repossessed assets of approximately $357,000 were sold during the ninemonths ended September 30, 2010 at zero gain or loss as these assets hadbeen written down to market value earlier in the period based on new marketinformation.

 

*Deposits*

 

Ourprimary source of funds for loans and investments is our deposits.  At September 30, 2010, we had $104.9million in deposits, representing an increase of $590,197, or less than 1%,compared to December 31, 2009. Deposits at September 30, 2010 consisted primarily of $12.1 millionin demand deposit accounts, $35.0 million in money market accounts and $57.6million in time deposits.  During thefourth quarter of 2006, we began obtaining deposits outside of our local marketarea in the form of brokered time deposits. Due to the interest rate environment in our market, as well as strongcompetition from other banking and financial services companies in gathering deposits,brokered time deposits allow us to obtain funding in order to support loangrowth.  At September 30, 2010, wehad $27.9 million in brokered time deposits, a decrease of approximately $11.0million, or 28%, compared to December 31, 2009.  Since January 20, 2010, we have had toobtain written approval from the OCC to accept, renew or rollover brokereddeposits pursuant to the terms of the Formal Agreement.  Our strong customer deposit growth during2010 has enabled us to maintain a strong liquidity position while decreasingour reliance on brokered deposits, thereby lowering our cost of interest-bearing liabilities. We will continue to reduce our reliance on brokered timedeposits and other noncore funding sources, while focusing our efforts to gathercore deposits in our local market.

 

Aspreviously reported, the Dodd-Frank Act permanently raises the current standardmaximum deposit insurance amount to $250,000. In addition, we have elected to continue our voluntary participation inthe FDIC’s TAGP, which we believe is enhancing our ability to retain customerdeposits.

 

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*Borrowings*

 

Weuse borrowings to fund growth of earning assets in excess of depositgrowth.  Borrowings totaled $7.0 millionat September 30, 2010, compared to $14.2 million at December 31,2009.  FHLB advances accounted for $7.0million of total borrowings, a decrease of $7.0 million, or 50%, compared to December 31,2009.  These advances are secured withapproximately $31.0 million of first and second mortgage loans and $1.0 millionof stock in the FHLB.  The remaining balance in borrowings representscustomer repurchase agreements.

 

**Liquidity**

 

Liquidity  isthe  ability  to meet  current  and future  obligations  through liquidation or maturity ofexisting  assets or the acquisitionof  liabilities.  We manage both assets and liabilities toachieve appropriate levels of liquidity. Cash and short-term investments are our primary sources of assetliquidity.  These funds provide a cushionagainst short-term fluctuations in cash flow from both deposits and loans.  The investment portfolio is our principalsource of secondary asset liquidity. However, the availability of this source of funds is influenced bymarket conditions and pledging agreements. Individual and commercial deposits, brokered deposits and borrowings areour primary source of funds for credit activities.  As brokered deposits or advances have maturedin 2010, we have replaced these funds with new brokered deposits or advances tothe extent necessary after considering core deposit growth, although overall wehave sought to reduce our reliance on brokered time deposits and other noncorefunding sources.  Since January 20,2010, we have had to obtain written approval from the OCC to accept, renew orrollover brokered deposits pursuant to the terms of the Formal Agreement.

 

We are a member of the Federal Home Loan Bank ofAtlanta, from which applications for borrowings can be made for leveragepurposes, if so desired, in an amount up to 15% of the total assets of theBank, assuming that the Bank’s investment in FHLB stock, as well as qualifyingmortgages or investment securities, would be available to secure any futureborrowings.  We also pledge collateral tothe Federal Reserve Bank’s Borrower-in-Custody of Collateral program, and ouravailable credit under this program was approximately $8.2 million as of September 30,2010.  We have federal funds purchasedlines of credit through two correspondent banks totaling $5.0 million thatwould need to be secured by investment securities if utilized.

 

Likeall banks, we are subject to the FHLB’s credit risk rating policy which assignsmember institutions a rating which is reviewed quarterly.  The ratingsystem utilizes key factors such as loan quality, capital, liquidity,profitability, etc.  Our ability to access our availableborrowing capacity from the FHLB in the future is subject to our rating and anysubsequent changes based on our financial performance as compared to factorsconsidered by the FHLB in their assignment of our credit risk rating eachquarter.  In addition, the Federal Reserve Bank as well as ourcorrespondent banks review our financial results and could limit our creditavailability based on their review.

 

We believe our liquidity sources are adequate to meetour operating needs. The level of liquidity is measured by the cash, cashequivalents, and investment securities available for sale to total assetsratio, which was at 17.31% at September 30, 2010 compared to 13.60% as of December 31,2009.  The increase in liquidity is dueto net loan payoffs of $8.9 million during the nine months ended September 30,2010.  Loan payoffs were used to payoff$7.0 million in FHLB advances and reinvest in new investment securities. Retaildeposit growth during the nine months ended September 30, 2010 allowed usto reduce brokered deposits by approximately $11.0 million as discussed above.We continue to carefully focus on liquidity management during 2010.  We plan to continue reducing brokered timedeposits as cash balances, retail deposit growth and operating needs allow.

 

**Impactof Off-Balance Sheet Instruments**

 

Throughthe operations of our Bank, we have made contractual commitments to extendcredit in the ordinary course of our business activities.  These commitments are legally bindingagreements to lend money to our customers at predetermined interest rates for aspecified period of time. At September 30, 2010, we had issued commitmentsto extend credit of $15.0 million through various types of lendingarrangements.  We evaluate each customer’scredit 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 creditevaluation of the borrower.  Collateralvaries but may include accounts receivable, inventory, property, plant andequipment, and commercial and residential real estate.  We manage the credit risk on thesecommitments by subjecting them to normal underwriting and risk managementprocesses.

 

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**Commitments and Contingencies**

 

Asof September 30, 2010, there were no significant firm commitmentsoutstanding for capital expenditures.

 

**Capital Resources**

 

Total shareholders’ equity decreased to $11.8 million at September 30,2010 from $16.7 million at December 31, 2009, primarily due to our netloss for the nine months of $5,044,486. Webelieve that our capital is sufficient to fund the activities of our Bank’soperations; however, the rate of net losses have deteriorated our capital basebelow our Individual Minimum Capital Ratios as discussed in greater detailbelow. We have not been immune to the unprecedented levels of extendedvolatility and disruption in the capital and credit markets and can giveno assurances with respect to our capital levels.

 

Our Bank and Company are subject to various regulatory capitalrequirements administered by the federal banking agencies.  However, the Federal Reserve guidelinescontain an exemption from the capital requirements for “small bank holdingcompanies,” which in 2006 were amended to cover most bank holding companieswith less than $500 million in total assets that do not have a material amountof debt or equity securities outstanding registered with the SEC.  Although our class of common stock isregistered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the Federal Reserve Board will interpret its new guidelines to meanthat we qualify as a small bank holding company.  Nevertheless, our Bank remains subject tothese capital requirements.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance-sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classifications are also subject to qualitative judgments by theregulators 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 andtotal  capital as a percentage of assetsand 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 forsale,  less certain intangibleassets.  The Bank’s Tier 2 capitalconsists of the allowance for loan losses subject to certain limitations.  Total capital for purposes of computing thecapital 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.

 

The Bank is also  required  to maintain  capital  at a minimum level  based on quarterly  average assets,  which  is known as the leverage ratio.  Onlythe strongest banks are allowed to maintain capital at the minimum requirementof 3%.  All others are subject tomaintaining ratios 1% to 2% above the minimum. The Bank exceeded its minimum regulatory capital ratios as of September 30,2010, as well as the ratios to be considered “well capitalized”; however, theBank fell below its Individual Minimum Capital Ratio levels as discussed below.

 

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

 

Inresponse, the Bank has formed a Compliance Committee of its Board of Directorsto oversee management’s response to all sections of the Formal Agreement.  The Compliance Committee also monitorsadherence to deadlines for submission to the OCC of information required underthe Formal Agreement.  The Board of Directorsand management of the Bank have been aggressively working to address thefindings of the exam and will continue to work to comply with all therequirements of the Formal Agreement. For additional information on the Formal Agreement, including actionsthe Bank has taken in response to the Formal Agreement, see “Management’sDiscussion and Analysis — Recent Regulatory Developments.”

 

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Inaddition, the OCC has established Individual Minimum Capital Ratio levels ofTier 1 and total capital for the Bank that are higher than the minimum andwell capitalized ratios applicable to all banks.  The Bank must maintain total risk-basedcapital of at least 12%, Tier 1 capital of at least 10%, and a leverage ratio ofat least 9%.  As of September 30,2010, we fell below the Individual Minimum Capital Ratio levels for totalrisk-based capital and leverage ratio. Noncompliance with our Individual Minimum Capital Ratio levels may bedeemed an unsafe and unsound banking practice by the OCC, which could result inthe Bank becoming subject to a capital directive, a consent order, or suchother administrative actions or sanctions as the OCC considers necessary.  It is uncertain what actions, if any, the OCCwould take with respect to noncompliance with these ratios, what action stepsthe OCC might require the Bank to take to remedy this situation, and whethersuch actions would be successful.  TheBank is currently working with several advisors and consultants regarding strategiesto increase capital.  As of September 30,2010, the Bank’s capital levels remain above the well capitalized ratio levelsapplicable to all banks.

 

The following table summarizes the capital amounts and ratios of theBank and the regulatory minimum requirements at September 30, 2010 and December 31,2009.

 
| ** **                                | ** ** | ** ** | ** ** | ** **  | ** ** | ** **                  | ** ** | ** **                 | ** ** | ** **                            | ** ** | ** ** | ** ** | **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 September 30, 2010**        |       |       |       |        |       |                        |       |                       |       |                                  |       |       |       |                                      |   |   |   |
| Total Capital (to  risk weighted assets)  |       | $          | 12,442,000 |        | 11.8       | %                           | $          | 12,697,000                 |       | 12.0                                  | %          | $          | 8,465,000  |                                      | 8.0 | % | $ | 10,581,000 |   | 10.0 | % |
| Tier 1 Capital  (to risk weighted assets) |       | 11,101,000 |       | 10.5        |       | 10,581,000                  |       | 10.0                       |       | 4,232,000                             |       | 4.0        |       | 6,349,000                                 |   | 6.0 |   |
| Tier 1 Capital  (to average assets)       |       | 11,101,000 |       | 8.7         |       | 11,503,000                  |       | 9.0                        |       | 5,113,000                             |       | 4.0        |       | 6,391,000                                 |   | 5.0 |   |
|                                      |       |       |       |        |       |                        |       |                       |       |                                  |       |       |       |                                      |   |   |   |
| **As  of December 31, 2009**         |       |       |       |        |       |                        |       |                       |       |                                  |       |       |       |                                      |   |   |   |
| Total Capital (to  risk weighted assets)  |       | $          | 14,712,000 |        | 12.7       | %                           | $          | 13,864,000                 |       | 12.0                                  | %          | $          | 9,243,000  |                                      | 8.0 | % | $ | 11,553,000 |   | 10.0 | % |
| Tier 1 Capital  (to risk weighted assets) |       | 13,263,000 |       | 11.5        |       | 11,553,000                  |       | 10.0                       |       | 4,621,000                             |       | 4.0        |       | 6,932,000                                 |   | 6.0 |   |
| Tier 1 Capital  (to average assets)       |       | 13,263,000 |       | 9.9         |       | 12,013,000                  |       | 9.0                        |       | 5,339,000                             |       | 4.0        |       | 6,674,000                                 |   | 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 anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as defined in ExchangeAct Rule 13a-15(e).  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that our current disclosure controls and procedures are effective asof September 30, 2010.  There havebeen no significant changes in our internal controls over financial reportingduring the fiscal quarter ended September 30, 2010 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting.

 

The design of any system of controls and procedures is based in partupon certain assumptions about the likelihood of future events.  There can be no assurance that any designwill succeed in achieving its stated goals under all potential futureconditions, regardless of how remote.

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings**

 

Thereare no material pending legal proceedings to which we are a party or of whichany 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

 

**Item 6. Exhibits**

 

31.1        Rule 13a-14(a) Certificationof the Principal Executive Officer.

 

31.2        Rule 13a-14(a) Certificationof the Principal Financial Officer.

 

32           Section 1350Certifications.

 

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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 undersignedthereunto duly authorized.

 

 
| Date:  November 5, 2010 | By:                                                                   | /s/  Lawrence R. Miller |
|------------------------------|-----------------------------------------------------------------------|-------------------------|
|                         | Lawrence  R. Miller                                                   |
|                         | Chief  Executive Officer (Principal Executive Officer)                |
|                         |                                                                  |                    |
| Date:  November 5, 2010 | 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.                                          |

 

31

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