M&F BANCORP INC /NC/ - Annual Report: 2012 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

______________________________________________________

FORM 10-K

______________________________________________________

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

Commission file number 000-027307

(Exact name of registrant as specified in charter)

(919) 687-7800

(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨      No S

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes S    No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. S

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

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

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

The aggregate market value of the registrant's common stock as of June 30, 2012, held by those persons deemed by the registrant to be non-affiliates was approximately $4,653,573. For purposes of the foregoing calculation only, all directors, executive officers, and 5% stockholders of the registrant have been deemed affiliates.

State the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of March 29, 2013, there were 2,031,337 shares outstanding of the issuer's common stock, no par value.

DOCUMENTS INCORPORATED BY REFERENCE

INDEX

Annual Report on Form 10-K for the Year Ended December 31, 2012

INDEX

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of M&F Bancorp, Inc. (the “Company”) and Mechanics and Farmers Bank (the “Bank”), including but not limited to the Company's operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimates”, “believes” and variations of these words and other similar statements. For this purpose, any statements contained in this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. These forward-looking statements involve estimates, assumptions, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation:

The Company cautions that the foregoing list of important factors is not exhaustive. See also “Risk Factors” which begins on page 9. The Company undertakes no obligation to update any forward-looking statement, whether written or oral, that may be made from time to time, by or on behalf of the Company.

PART I

ITEM 1. BUSINESS

GENERAL

Headquartered in Durham, North Carolina ("NC"), M&F Bancorp, Inc. (the "Company") is a bank holding company incorporated under the laws of NC in 1999, and is registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve") under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company's primary function is to serve as the holding company for its wholly-owned subsidiary, Mechanics and Farmers Bank (the "Bank"), a NC chartered commercial bank that was organized in 1907 and began operations in 1908.

As of December 31, 2012, the Company had assets of approximately $296.1 million, with gross loans of approximately $175.2 million and deposits of approximately $250.9 million. The Company's corporate office is located at 2634 Durham Chapel Hill Boulevard, Durham, NC, 27707, and its telephone number is 919-687-7800.

The Company's principal source of income is from dividends declared and paid by the Bank on its issued and outstanding capital stock. The Company uses such income to pay dividends to stockholders and fund its expenses. The majority of the Company's operations occur at the Bank level. Throughout this Annual Report on Form 10-K, results of operations will be discussed by referring to the Bank's operations, unless a specific reference is made to the Company and its operating results apart from those of the Bank.

The Bank is a community bank engaged in the general banking business in Wake, Durham, Guilford, Forsyth, and Mecklenburg Counties and the surrounding areas. Both the Company and the Bank are designated by the United States Department of the Treasury (the “Treasury”) as a Community Development Financial Institution (“CDFI”). As defined by the Treasury, a CDFI is a community-based organization that provides credit, financial services, and other related services in low-income urban and rural communities across America. These organizations have a common mission of working toward revitalizing economically depressed communities or communities underserved by mainstream financial institutions and improving the quality of life of those who live and work in these communities. CDFIs provide financing to residents who want to buy their first home, individuals who may want to start their own business and owners of existing businesses who would like to expand their businesses (helping to create new jobs). In addition, CDFIs offer financial literacy services to individuals on topics such as improving their credit ratings or creating monthly budgets.

The Bank offers a full range of banking services, including the following: checking accounts; savings accounts; Negotiable Order of Withdrawal ("NOW") accounts; money market accounts; certificates of deposit; individual retirement accounts; loans for real estate, construction, businesses, personal use, home improvement and automobiles; equity lines of credit; credit lines; consumer loans; credit cards; safe deposit boxes; bank money orders; internet banking; electronic funds transfer services including wire transfers; traveler's checks; and notary services. In addition, the Bank provides automated teller machine (“ATM”) access to its customers for cash withdrawals through nationwide ATM networks. At present, the Bank does not provide the services of a trust department.

GENERAL DESCRIPTION OF MARKET AREAS

The Bank has two branch offices in Durham, NC, two offices in Raleigh, NC, one office in Charlotte, NC, one office in Winston-Salem, NC, and one office in Greensboro, NC. All offices are located in metropolitan areas with employment spread primarily among service, health care, education, manufacturing and governmental activities. All offices are located in areas of high competition among financial service providers.

COMPETITION

Commercial banking in NC is extremely competitive. The Bank competes in its market areas with some of the largest banking organizations in the state and the country, other community financial institutions, such as federally and state-chartered banks or savings and loan institutions, credit unions, consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of the Bank's competitors have broader geographic markets, easier access to capital, lower cost of funding, and higher lending limits than the Bank, and are able to provide more services, and make greater use of media advertising.

Despite strong competition in its market areas, the Bank believes that it has certain competitive advantages that distinguish it from its competition. The Bank believes that its primary competitive advantages are its 106-year legacy, strong local identity, affiliation with the communities it serves, and its emphasis on providing specialized services to small- and medium-sized business and special purpose enterprises, faith-based non- profit organizations, and individuals. The Bank offers customers modern, high-tech banking without compromising community values such as prompt, personal service and friendliness. The Bank offers personalized services and attracts customers by being responsive and sensitive to their individual needs. The Bank relies on goodwill and referrals from stockholders, board members, employees, and satisfied customers, as well as traditional methods to attract new customers. To enhance a positive image in the communities in which it has branches, the Bank supports and participates in select local events and many of its officers and directors serve on boards of local civic and charitable organizations.

The ability of the Bank to attract and retain deposits generally depends on its ability to provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. As of June 30, 2012, based on the Federal Deposit Insurance Corporation (the “FDIC”) Summary of Deposits Report, the Bank's market share of the total deposits in Durham, NC was approximately 2.30%, and less than one percent in each of Raleigh, Charlotte, Greensboro and Winston-Salem, NC. Management believes that the Company is not dependent upon any single customer, or a few customers, the loss of which would have a material adverse effect on the Company's operations. However, the Company does serve a specialized niche market (faith-based non-profit organizations), the loss of which could have a material adverse effect on the Company's operations.

EMPLOYEES

As of December 31, 2012, the Company and the Bank had 80 employees, including 75 full-time employees. No employees are represented by a collective bargaining unit or agreement. Management considers relations with employees to be good.

EXECUTIVE OFFICERS

Kim D. Saunders serves and President and Chief Executive Officer for the Company and the Bank, overseeing day-to-day operations of the Bank. Ms. Saunders joined the Company in 2007. She previously served as President and Chief Executive Officer of Consolidated Bank and Trust Company from 2003 to 2007.

Randall C. Hall serves as Senior Vice President and Chief Financial Officer for the Company and the Bank, overseeing the financial operations of the Bank and the Company. Mr. Hall joined the Company in November 2012, and assumed the position of Chief Financial Officer following the retirement of Lyn Hittle in January 2013. Between 1997 and 2011, Hall served as Executive Vice President of The Bank of Asheville. During 2012 he was Senior Vice President and Chief Financial Officer of Clayton Bank and Trust, and later served as a consultant to troubled banks and bank holding companies before joining the Company.

AVAILABLE INFORMATION

The Company makes its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, available free of charge on its internet website www.mfbonline.com, as soon as reasonably practicable after the reports are electronically filed with the Securities and Exchange Commission (“SEC”). Any materials that the Company files with the SEC may be read and/or copied at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. These filings are accessible on the SEC's website at www.sec.gov.

The Company's corporate governance policies, including its Codes of Ethics and the charters of the Audit, Compensation, and Corporate Governance and Nominating Committees, may be found under the “Investor Relations” section of the Company's website. The Company elects to disclose any amendments to or waivers of any provisions of its Code of Ethics applicable to its principal executive officers and senior financial officers on its website. A written copy of the foregoing corporate governance policies is available upon written request to the Company.

SUPERVISION AND REGULATION

Bank holding companies and commercial banks are subject to extensive federal and state governmental regulation and supervision.

The following is a brief summary of certain statutes and regulations that apply to the Company and Bank. This summary is qualified in its entirety by reference to the particular statute and regulatory provisions cited below and are not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than stockholders of the Company.

Statutes and regulations, which contain wide-ranging proposals for altering the structures, regulations, and competitive relationship of financial institutions are introduced regularly. The Company cannot predict whether or in what form any proposed statute or regulation may be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.

In certain circumstances, the FDIC can require a holding company to guarantee the compliance of its subsidiary insured depository institution with any capital restoration plan. The FDIC's claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

Monetary Policy and Economic Controls

The Company and the Bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve, whose actions directly affect the money supply, which, in turn, affects banks' lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits.

Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks has eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks' cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of the Bank or the Company. As a result, banks, including the Bank, face a significant challenge to maintain acceptable net interest margins.

Company Regulation

General. The Company is a bank holding company registered with the Federal Reserve under the BHCA. As such, the Company is subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. The Federal Reserve has the power to order a bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company.

Dodd-Frank Wall Street Reform and Consumer Protection Act. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act was intended primarily to overhaul the financial regulatory framework following the global financial crisis and has impacted, and will continue to impact, all financial institutions including the Company and the Bank. The Dodd-Frank Act contains provisions that have, among other things, established a Bureau of Consumer Financial Protection (the "CFPB"), established a systemic risk regulator, consolidated certain federal bank regulators and imposed increased corporate governance and executive compensation requirements. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations and to prepare numerous studies and reports for the U.S. Congress. The federal agencies are given significant discretion in drafting and implementing regulations. Many regulations have been promulgated, and more additional regulations are expected to be issued in 2013 and thereafter. Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Federal Securities Law. The Company's common stock is registered with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”). As a result, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act are applicable to the Company. The regulatory compliance burden of being a publicly traded company has increased significantly .

The Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act (the "GLB Act") dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority presents the Company with challenges, as its larger competitors are able to expand their services and products into areas that are not feasible for smaller, community- oriented financial institutions. The GLB Act has had a significant economic impact on the banking industry and on competitive conditions in the financial services industry generally.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act was signed into law in 2002 (“Sarbanes-Oxley”) and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of Sarbanes-Oxley has been wide-ranging as it applies to all public companies and imposes significant requirements for public company governance and disclosure.

In general, Sarbanes-Oxley mandated important corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies' reported financial results. It established responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and created a regulatory body to oversee auditors of public companies. It backed these requirements with SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing federal corporate whistleblower protection.

The economic and operational effects of this legislation on public companies, including the Company, have been and will continue to be significant in terms of the time, resources and costs associated with complying with its requirements. Because Sarbanes-Oxley, for the most part, applies equally to larger and smaller public companies, the Company has additional challenges as a smaller financial institution seeking to compete with larger financial institutions in its market. In accordance with the requirements of Section 404(a), management's report on internal control is included herein as Item 9A. The Dodd-Frank Act permanently exempted smaller companies, such as the Company, from the requirements under Section 404(b) for auditor attestation on internal controls.

Prohibited and Permissible Activities of Bank Holding Companies. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity may be reasonably expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.

Pursuant to delegated authority, the Federal Reserve Bank of Richmond (the “FRB”) has authority to approve certain activities of holding companies within its district, including the Company, provided the nature of the activity has been approved by the Federal Reserve.

Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding Company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie -in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding Company or any of its other subsidiaries.

The Federal Reserve may issue cease and desist orders (often referred to as "consent orders") against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve regulates certain debt obligations, changes in control of bank holding companies, and capital requirements.

As a result of the Company's ownership of the Bank, the Company is registered under the bank holding company laws of NC. Accordingly, the Company is also subject to supervision and regulation by the NC Commissioner of Banks (the “NCCOB”).

Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and banks that are members of the Federal Reserve System. The minimum standard for the ratio of capital to risk-weighted assets (including certain off-balance-sheet obligations, such as standby letters of credit) is eight percent. At least half of this capital must consist of common equity, retained earnings, and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain goodwill items and other adjustments (“Tier 1 capital”). The remainder (“Tier 2 capital”) may consist of mandatorily redeemable debt securities, a limited amount of other preferred stock, subordinated debt, and loan loss reserves.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets less certain amounts equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four and five percent.

The guidelines provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, are expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution's risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 Leverage Ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised the Company that it is required to satisfy any heightened capital requirements.

As of December 31, 2012, the Company had Tier 1 risk-adjusted, total regulatory capital and leverage ratios of approximately 17.89%, 19.15% and 11.56%, respectively, all in excess of the minimum requirements. Those same ratios as of December 31, 2011 were 17.61%, 18.86% and 11.21%, respectively. As of December 31, 2012, the Bank had a leverage ratio of 11.02%, a Tier 1 capital ratio of 17.19%, and a total risk-based capital ratio of 18.45%. Those same ratios as of December 31, 2011 were 10.64%, 16.71% and 17.96%, respectively.

Emergency Economic Stabilization Act of 2008. Under the Emergency Economic Stabilization Act of 2008 (the “EESA”), as amended, the Treasury implemented the Troubled Asset Relief Program (“TARP”), of which the Capital Purchase Program (the “CPP”) is a part. Under the CPP, certain U.S. qualifying financial institutions sold senior preferred stock and warrants to the Treasury. Eligible institutions generally applied to issue preferred stock to the Treasury in aggregate amounts between 1% and 3% of the institution's risk-weighted assets. Smaller community banks and bank holding companies, such as the Company, were later allowed to issue preferred stock up to 5% of the institution's risk weighted assets.

The Treasury was given discretion to exempt certain financial institutions from having to issue warrants. The Treasury elected to exercise its discretion in favor of those financial institutions that are certified as CDFIs, and for whom the CPP investment was $50 million or less. Accordingly, the Company was exempted from issuing warrants. On June 26, 2009, the Company completed the issuance of 11,735 shares of $1,000 value Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") under the CPP. On August 20, 2010, the Company exchanged the Series A Preferred Stock for an equal number of shares of $1,000 liquidation value, Series B Fixed Rate Cumulative Perpetual Preferred Stock (“Series B Preferred Stock”), under the Community Development Capital Initiative (“CDCI”), also part of the TARP.

Executive Compensation. The EESA, as amended by the American Recovery and Reinvestment Act (“ARRA”), which was signed into law on February 17, 2009, introduced extensive restrictions on executive compensation arrangements of financial institutions participating in TARP programs, including the CPP and the CDCI. On June 15, 2009, the Treasury published the Interim Final Rules in the Federal Register, which further supplement these executive compensation restrictions.

Dividend and Repurchase Limitations. Under a Memorandum of Understanding ("MOU") with the FRB executed in August 2010, the Company agreed to obtain FRB approval prior to repurchasing or redeeming any shares of its stock, declaring or paying any dividends or taking dividends or any other form of payment representing a reduction in capital from the Bank.

Federal banking regulations applicable to all bank holding companies separately restrict the Company from repurchasing its common stock for consideration in excess of 10% of its net worth during any 12-month period unless the Company (i) both before and after the redemption satisfies capital requirements for "well capitalized" state bank holding companies; (ii) received a “one” or “two” rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues. In addition, as a bank holding company, the Company is required to adhere to the Federal Reserve's Policy Statement on Payment of Cash Dividends, which generally requires bank holding companies to act as a source of strength and not place undue burden on subsidiary banks.

Under NC corporation laws, the Company may not pay a dividend or distribution, if after giving its effect, the Company would not be able to pay its debts as they become due in the usual course of business or the Company's total assets would be less than its liabilities. In general, the Company's ability to pay cash dividends is dependent upon the amount of dividends paid to the Company by the Bank. NC commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. For instance, NC commercial banks may only pay dividends from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by NC law. In addition, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is defined in the applicable law and regulations). Further, under the terms of the MOU entered into with the FDIC and the NCCOB in April 2010, the Bank may not declare dividends to the Company without prior approval from the FDIC and NCCOB.

Participation in the CDCI places restrictions on the Company's ability to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its capital stock, including restrictions against the Company (i) increasing dividends payable on its common stock from the last quarterly cash dividend per share declared on the common stock prior to November 17, 2008; (ii) increasing its aggregate per share dividends and distributions above the aggregate dividends and distributions paid for the immediately prior fiscal year; and (iii) declaring or paying dividends or distributions on, or repurchasing, redeeming or otherwise acquiring for consideration, shares of its capital stock in the event that the Company fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on the Series B Preferred Stock. These restrictions will continue until all of the Series B Preferred Stock has been redeemed in full.

Bank Regulation

The Bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the NCCOB and the FDIC. The FDIC and the NCCOB regularly examine the operations of banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment or closing of branches, mergers, consolidations and other similar corporate actions. They have authority to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The FDIC and the NCCOB regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, capital adequacy, loss reserves and compliance with the Community Reinvestment Act (“CRA”) as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are subject to state usury laws and certain federal laws concerning interest rates.

Federal Deposit Insurance. The Deposit Insurance Fund ("DIF") of the FDIC insures deposit accounts in the Bank up to a maximum amount in per separately insured depositor. Under the Dodd-Frank Act, the maximum amount of federal deposit insurance coverage permanently increased to $250,000 per depositor, per institution. On November 9, 2010, the FDIC issued a final rule to implement a provision of the Dodd-Frank Act that provides temporary unlimited deposit insurance coverage for noninterest-bearing transaction accounts at all insured depository institutions. This unlimited coverage for noninterest-bearing transaction accounts terminated on December 31, 201.2.

Insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. In order to restore reserves and ensure that the DIF will adequately cover losses from future bank failures, the FDIC approved new deposit insurance rules in November 2009. These new rules required insured depository institutions to prepay their estimated quarterly risk-based assessments for all of 2010, 2011, and 2012. The Bank requested and received an exemption from the prepayment of assessments.

As required by the Dodd-Frank Act, on February 7, 2011, the FDIC finalized new rules, which redefined the assessment base as "average consolidated total assets minus average tangible equity." The revised rate schedule and other revisions to the assessment rules became effective April 1, 2011, and were used to calculate the quarterly assessments beginning with the June 2011 assessment. Institutions, such as the Bank, with less than $1 billion in average total assets share a more proportionate FDIC assessment under the new rules.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") the federal banking agencies possess broad powers to take prompt corrective action to resolve problems of insured depository institutions. FDICIA identifies five capital categories for insured depository institutions: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Under regulations established by the federal banking agencies, a "well capitalized" institution must have a Tier 1 Capital Ratio of at least 6%, a Total Capital Ratio of at least 10%, a Tier 1 Leverage Ratio of at least 5 and not be subject to a capital directive order. The Bank MOU requires the Bank to maintain a Tier 1 Capital Ratio of not less than 8% and a Total Risk Based Capital Ratio of not less than 10%. As of December 31, 2012, the Bank was classified as "well capitalized" and satisfied the heightened capital requirements of the Bank MOU. The classification of a depository institution under FDICIA is primarily for the purpose of applying the federal banking agencies' prompt corrective action provisions, and is not intended to be, nor should it be interpreted as, a representation of the overall financial condition or the prospects of any financial institution.

Community Reinvestment and Consumer Protection Laws In connection with its lending activities, the Bank is subject to a number of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. These include the Equal Credit Opportunity Act, the Truth-in-Lending Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, and the CRA. In addition, federal banking regulators, pursuant to the GLB Act, have enacted regulations limiting the ability of banks and other financial institutions to disclose nonpublic consumer information to non-affiliated third parties. The regulations require disclosure of privacy policies and allow consumers to prevent certain personal information from being shared with non-affiliated third parties.

The CRA requires the appropriate federal banking agency, in connection with its examination of a bank, to assess the bank's record in meeting the credit needs of the communities served by the bank, including low and moderate income neighborhoods. Under the CRA, institutions are assigned a rating of "outstanding," "satisfactory," "needs to improve," or "substantial non-compliance." The Bank received an "outstanding" rating in its most recent CRA evaluation.

The Dodd-Frank Act created the CFPB to take over responsibility for the federal consumer financial protection laws. The CFPB is an independent bureau within the Federal Reserve that has broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10 billion or more. The Dodd-Frank Act gives the CFPB expanded data-collecting powers for fair lending purposes for both small business and mortgage loans, as well as expanded authority to prevent unfair, deceptive and abusive practices. It is anticipated that certain of the CFPB's rules will be indirectly applied to the Bank, through their adoption by the Bank's regulators as “best practices.”

Bank Secrecy Act / Anti-Money Laundering Laws The Bank is subject to the Bank Secrecy Act and other anti-money laundering laws and regulations, including the USA PATRIOT Act of 2001. The USA PATRIOT Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by creating new laws, regulations, and penalties, imposing significant new compliance and due diligence obligations, and expanding the extra-territorial jurisdiction of the U.S. These laws and regulations require the Bank to implement policies, procedures, and controls to detect, prevent, and report potential money laundering and terrorist financing and to verify the identity of their customers. Violations of these requirements can result in substantial civil and criminal sanctions. In addition, provisions of the USA PATRIOT Act require the federal banking agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

Other Safety and Soundness Regulations As required by FDICIA, the federal banking agencies' prompt corrective action powers impose progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. These actions can include: requiring an insured depository institution to adopt a capital restoration plan guaranteed by the institution's parent company; placing limits on asset growth and restrictions on activities, including restrictions on transactions with affiliates; restricting the interest rates the institution may pay on deposits; prohibiting the payment of principal or interest on subordinated debt; prohibiting the holding company from making capital distributions without prior regulatory approval; and, ultimately, appointing a receiver for the institution.

The federal banking agencies also have adopted guidelines prescribing safety and soundness standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation and benefits. The federal regulatory agencies may take action against a financial institution that does not meet such standards.

Capital Requirements for the Bank. As an NC chartered, insured commercial bank, which is not a member of the Federal Reserve System, the Bank is also subject to capital requirements imposed by the FDIC. Under the FDIC's regulations, state nonmember banks that (i) receive the highest rating during the examination process and (ii) are not anticipating or experiencing any significant growth, are required to maintain a minimum leverage ratio of 3% of total consolidated assets; all other banks are required to maintain a minimum ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. The Bank exceeded all applicable capital requirements as of December 31, 201.2.

Federal Home Loan Bank System. The Federal Home Loan Bank system provides a central credit facility for member institutions. As a member of the Federal Home Loan Bank of Atlanta ("FHLB"), the Bank is required to own capital stock in the FHLB in an amount at least equal to 0.15% (or 15 basis points) of the Bank's total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB under the activity-based stock ownership requirement. On December 31, 2012, the Bank was in compliance with this requirement.

Restrictions on Transactions with Affiliates. The Bank is subject to the provisions of Sections 23A and 23B of the Federal Reserve Act and Regulation W. Section 23A places limits on the amount of:

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank's capital and surplus and, as to all affiliates combined, to 20% of a bank's capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must meet specified collateral requirements. The Bank must comply with other provisions designed to avoid the transfer of low-quality assets from an affiliate.

The Bank is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits a bank from engaging in the above transactions with its affiliates unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Under Section 22(h), loans to directors, executive officers and stockholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution's loans-to-one-borrower limit (as discussed below). Section 22 (h) prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and stockholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any "interested" director may not participate in the voting. The FDIC has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of directors approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the Federal Reserve requires that loans to directors, executive officers, and principal stockholders be made on terms substantially the same as offered in comparable transactions with non-executive employees of the Bank. The FDIC has imposed additional limits on the amount a bank can loan to an executive officer.

Limits on Rates Paid on Deposits and Brokered Deposits. FDIC regulations limit the ability of insured depository institutions to accept, renew or roll-over deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution's normal market area. Under these regulations, “well capitalized” depository institutions may accept, renew or roll-over such deposits without restriction, “adequately capitalized” depository institutions may accept, renew or roll-over such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and “undercapitalized” depository institutions may not accept, renew, or roll-over such deposits. Definitions of “well capitalized,” “adequately capitalized” and “undercapitalized” are the same as the definitions adopted by the FDIC to implement the prompt corrective action provisions discussed above.

The Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (“SAFE Act”). The SAFE Act was enacted to enhance consumer protection and reduce fraud by setting minimum standards for the licensing and registration of mortgage loan originators. The SAFE Act requires mortgage loan originators employed by insured depository institutions or their subsidiaries to register with the Nationwide Mortgage Licensing System and Registry and to maintain current registration in that system. Financial institutions are required by the SAFE Act to maintain adequate policies and practices which will ensure that all employees acting in the capacity of mortgage loan originators register in the Nationwide Mortgage Licensing System and update their registration annually during the annual renewal period in November and December of each year.

Other. Additional regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state chartered institutions examined by state regulators. Additional regulations establish operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards.

In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. The Bank, as an insured NC commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.

ITEM 1A. RISK FACTORS

An investment in the Company's common stock is subject to risks inherent in the Company's business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider these risks and uncertainties, together with all of the other information included or incorporated by reference in this Annual Report on Form 10-K. These risks and uncertainties are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company's business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, the Company's financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company's common stock could decline significantly, and you could lose all or part of your investment.

The Company’s business has been and may continue to be adversely affected by current conditions in the financial markets and economic conditions generally. The global, U.S. and NC economies are continuing to experience significantly reduced business activity and consumer spending as a result of, among other factors, disruptions in the capital and credit markets that first occurred during 2008. Since 2008, dramatic declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which we do business could have one or more of the following adverse effects on our business:

While conditions are gradually improving, we expect our business, financial condition and results of operations to continue to be adversely affected in the near term.

The Company and the Bank may be subject to additional, heightened enforcement actions if we do not comply with the MOUs. The Bank MOU requires the Bank to take certain actions to enhance its management of adversely classified assets, remain well-capitalized and maintain adequate liquidity. It also restricts the payment of dividends to the holding company without prior approval and requires reporting of progress of implementing additional management improvement plans. The Company MOU requires the Company to first obtain approval before it pays any dividends, repurchases stock, or receives any dividends from the Bank. In the event we do not comply with these MOUs, the banking regulators may impose additional, heightened enforcement actions against us and/or keep the MOUs in place longer than they may otherwise have been. Additional, heightened enforcement action, including any further restrictions on our lending and deposit gathering activities, which could negatively impact our interest income, interest expense, and liquidity, and have a material and adverse effect on our business, financial condition and results of operation.

Financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations. Congress enacted the Dodd-Frank Act in 2010. This law has significantly changed the structure of the bank regulatory system and affects the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations. Although some of the regulations have been promulgated, many additional regulations are expected to be issued in 2012 and thereafter. Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Certain provisions of the Dodd-Frank Act are having an effect on us. For example, a provision eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest-bearing checking accounts. Although not currently quantifiable, this significant change to existing law could have an adverse effect on our interest expense.

The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments are now being based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions, and credit unions to $250,000 per depositor, retroactive to January 1, 2008, and non-interest bearing transaction accounts had unlimited deposit insurance through December 31, 2012.

The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company's proxy materials. The legislation also directs the FRB to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not.

The Dodd-Frank Act created the CFPB with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. It also has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets will be examined by their applicable bank regulators. The Dodd-Frank Act also weakens the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.

It is difficult to quantify what specific impact the Dodd-Frank Act and related regulations have had on the Company to date and what impact yet to be written regulations will have on us in the future. However, it is expected at a minimum, they will increase our operating and compliance costs and could increase our interest expense.

Market developments may adversely affect our industry, business and results of operations. Significant declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by many financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. The Company has experienced significant challenges, its credit quality has deteriorated and its net income and results of operations have been adversely impacted. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers including other financial institutions. Although to date the Company and the Bank remain “well capitalized,” and have performed better than many of their peers, we are part of the financial system and a systemic lack of available credit, a lack of confidence in the financial sector, increased volatility in the financial markets and/or reduced business activity could materially adversely affect our business, financial condition and results of operations.

The soundness of other financial institutions could adversely affect us. Since 2008, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by significant declines in the values of nearly all asset classes. The Company's ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan due us. There is no assurance that any such losses would not materially and adversely affect our businesses, financial condition or results of operations.

Increases in FDIC insurance premiums may adversely affect the Company's net income and profitability. Since 2008, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the DIF. Deposit accounts are permanently insured up to $250,000 per customer, and other programs have temporarily increased levels of insurance coverage. These programs have placed additional stress on the DIF. In order to maintain a strong funding position and restore reserve ratios of the DIF, the FDIC increased assessment rates of insured institutions. The Company is generally unable to control the amount of premiums that the Bank is required to pay for FDIC insurance. If there are additional banks or financial institution failures, or the cost of resolving prior failures exceeds expectations, the Bank may be required to pay even higher FDIC premiums than the recently increased levels. These announced increases and any future increases or required prepayments of FDIC insurance premiums may adversely impact the Company's earnings and financial condition.

Additional requirements under our regulatory framework, especially those imposed under the Dodd-Frank Act, ARRA, EESA or other legislation or regulations intended to strengthen the U.S. financial system, could adversely affect us. Recent government efforts to strengthen the U.S. financial system, including the passage of the Dodd-Frank Act, implementation of ARRA, EESA, and special assessments imposed by the FDIC, subject participants to additional regulatory fees and requirements, including corporate governance requirements, executive compensation restrictions, restrictions on declaring or paying dividends, restrictions on share repurchases, limits on executive compensation tax deductions and prohibitions against golden parachute payments. These requirements, and any other requirements that may be subsequently imposed, may have a material and adverse affect on our business, financial condition, and results of operations.

Our participation in the CDCI imposes restrictions and obligations on us that limit our ability to increase dividends, repurchase shares of our common stock and access the capital markets. In 2010, the Company issued 11,735 shares of Series B Preferred Stock pursuant to the CDCI, a TARP program. Participation in the CDCI places restrictions on the Company's ability to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its capital stock, including restrictions against the Company (i) increasing dividends payable on its common stock from the last quarterly cash dividend per share declared on the common stock prior to November 17, 2008; (ii) increasing its aggregate per share dividends and distributions above the aggregate dividends and distributions paid for the immediately prior fiscal year; and (iii) declaring or paying dividends or distributions on, or repurchasing, redeeming or otherwise acquiring for consideration, shares of its capital stock in the event that the Company fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on the Series B Preferred Stock. The holders of these shares of Series B Preferred Stock have certain registration rights which, in certain circumstances, impose lock-up periods during which we would be unable to issue equity securities. These restrictions will continue until all of the Series B Preferred Stock has been redeemed in full. In addition, unless we are able to redeem the Series B Preferred Stock during the first eight years, the dividends on this capital will increase substantially at that point, from 2% to 9%, and no further common stock dividends will be allowed until the preferred stock has been fully redeemed. Depending on market conditions at the time, this increase in preferred stock dividends could significantly impact our liquidity.

The limitations on incentive compensation contained in the ARRA and subsequent regulations may adversely affect our ability to retain our highest performing employees. In the case of a company such as the Company that received TARP funds, the ARRA, and subsequent regulations issued by Treasury, contain restrictions on bonus and other incentive compensation payable to the company's senior executive officers. As a consequence, we may be unable to create a compensation structure that permits us to retain our highest performing employees and attract new employees of a high caliber. If this were to occur, our businesses and results of operations could be adversely affected.

The Company is subject to extensive governmental regulation, which could have an adverse impact on our operations. The banking industry is extensively regulated and supervised under both federal and state law. Current and future legislation and the policies established by federal and state regulatory authorities will affect the Company's operations. The Company is subject to supervision and periodic examination by the Federal Reserve and the NCCOB. The Bank, as a state chartered non-member commercial bank, receives regulatory scrutiny from the FDIC and the NCCOB. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in the Company, by restricting the Company’s activities, such as: the Company cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business. Given the disruption in the financial markets and regulatory initiatives that have been proposed or implemented by the Obama administration and Congress, new regulations and laws that may affect us are increasingly likely. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities. In addition, participation in additional programs may subject us to additional restrictions. We cannot assure you that such modifications or new laws will not adversely affect:

Our regulatory position is discussed in greater detail under Item 1. “Business-Supervision and Regulation” of this Annual Report on Form 10-K.

We may need to raise additional capital in the future and such capital may not be available when needed or at all. We may need additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. The ongoing loss of confidence in financial institutions may increase our cost of funding and limit our access to some of our customary sources of capital, including, but not limited to, inter-bank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve. We cannot assure you that such capital will be available to us on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on our businesses, financial condition and results of operations.

The Company relies on dividends from the Bank for most of its revenue. The Company is a separate and distinct legal entity from the Bank. It receives substantially all of its revenue from dividends received from the Bank. These dividends are the principal source of funds to pay dividends on the Company's common and preferred stock. Currently the regulators have restricted the Bank from up-streaming dividends to the Company without prior approval by the FDIC, NCCOB and the FRB, which is discussed in greater detail under Item 1. “Business-Supervision and Regulation” of this Annual Report on Form 10-K. Notwithstanding the current MOUs, various federal and/or state laws, regulations, and agreements, limit the amount of dividends that the Bank may pay to the Company. In the event the Bank is unable to pay dividends to the Company, the Company may not be able to service debt, pay obligations, or pay dividends on the Company's common and preferred stock. The inability to receive dividends from the Bank could have a material adverse effect on the Company's business, financial condition and results of operations. See Item 1 “Business - Supervision and Regulation.”

The Bank may have higher loan losses than the Bank's allowance for loan losses. The Bank maintains an allowance for loan losses ("ALLL"), which is a reserve established through a provision for loan losses charged to expense that represents management's best estimate of inherent risks of loss, as well as probable losses that will be incurred within the existing portfolio of loans. The level of the ALLL reflects management's continuing evaluation of industry concentrations; specific loan risks; credit loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the ALLL inherently involves a high degree of subjectivity and requires management to make significant estimates of current loan risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Bank's control, may require an increase in the ALLL. Repayment of commercial loans is generally considered more subject to market risk than residential mortgage loans. Bank regulatory agencies periodically review the Bank's ALLL and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the ALLL, the Bank will need additional provisions to increase the ALLL. Any increases in the ALLL will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Company's financial condition and results of operations. See "Provision and Allowance for Loan Losses" in the accompanying Management's Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to the Bank's process for determining the appropriate level of the ALLL.

Our commercial real estate and faith-based non-profit lending may expose us to a greater risk of loss and hurt our earnings and profitability. Our business strategy includes making loans secured by commercial and faith-based non-profit real estate. These types of loans generally have higher risk-adjusted returns and shorter maturities than traditional one-to-four family residential mortgage loans. At December 31, 2012, our real estate secured commercial real estate loans totaled $48.2 million which represented 27.49% of total loans, and our faith-based non-profit real estate totaled $85.9 million, which represented 49.02% of total loans. These two categories of loans may increase our credit risk profile relative to other financial institutions that have higher concentrations of one-to-four family residential mortgage loans. Further, loans secured by commercial real estate properties are generally for larger amounts and involve a greater degree of risk than one-to-four family residential mortgage loans. Payments on loans secured by commercial real estate properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties. Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy. For faith-based and non-profit institutions, payments on loans are largely dependent on voluntary contributions, which may be adversely affected during high unemployment periods, such as the economic conditions since late 2008. Because of the current general economic slowdown, these loans present higher risk, could result in an increase in our total net charge-offs and could require us to increase our allowance for loan losses, which could have a material adverse effect on our financial condition or results of operations.

Our faith-based and non-profit lending may expose us to a greater risk of loss and adversely impact our earnings and profitability. Our niche market is faith-based and non-profit lending. This specialization has historically experienced minimal losses, however, when unemployment is high, individuals may be unable to donate to support the missions of these organizations. In addition, many of the real estate secured properties are deemed to be special purpose structures that may not be conducive to other types of commercial activities, were foreclosure or sale necessary to enable principal and interest repayment. The Company has experienced recent deterioration in the credit quality of many of the loans in this niche market, and while we seek to minimize these risks in a variety of ways, there may be no assurance that these measures will protect against loan losses. At December 31, 2012, our loans to faith-based and non-profit entities totaled $85.9 million, which totaled 49.02% of total loans, as compared to $89.2 million, which totaled 47.70% of total loans at December 31, 2011. Such loans increase our credit risk profile relative to other financial institutions that have higher concentrations of one-to-four family residential loans.

Charge-offs may increase in all categories of lending, which may increase our earnings and profitability. Charge-offs reduce the ALLL and impact the quantitative factors in the estimated losses inherent in the loan portfolio. An additional provision for loan losses may be required because of any charge-offs. For the year ended December 31, 2012, we had net charge-offs of $0.5 million, a decrease $0.4 million when compared to the $0.9 million net charge-offs for the year ended December 31, 2011. While we seek to minimize loan loss risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.

The Company's growth strategy may not be successful. As a strategy, the Company seeks to increase the size of its franchise by pursuing business development opportunities, which include expanding deposit relationships, lending activity, and possible strategic expansion and/or acquisitions in new or existing markets. The Company can provide no assurance that it will be successful in increasing the volume of the Company's loans and deposits at acceptable risk levels and upon acceptable terms, or in expanding its asset base while managing the costs and implementation risks associated with this growth strategy. There can be no assurance that any expansion will be profitable or that the Company will be able to sustain its growth, either through internal growth or through successful expansions of its banking markets, that regulatory approval would be forthcoming for such growth, or that the Company will be able to maintain capital sufficient to support its continued growth.

The Bank is subject to interest rate risk. The Bank's earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and investment securities, and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Bank's control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Bank receives on loans and investment securities and the amount of interest it pays on deposits and borrowings, but such changes could affect (i) the Bank's ability to originate loans and obtain deposits, (ii) the fair value of the Bank's financial assets and liabilities, and (iii) the average duration of certain of the Bank's interest-rate sensitive assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Bank's net interest income and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. In addition, there are costs associated with the Bank's risk management techniques, and these costs could be material. Fluctuations in interest rates are not predictable or controllable by management; therefore, there can be no assurances of the Bank's ability to continue to maintain a consistent, positive spread between the interest earned on the Bank's earning assets and the interest paid on the Bank's interest-bearing liabilities. See "Asset/Liability Management” in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Company's management of interest rate risk.

If our investment in the common stock of the FHLB of Atlanta is classified as other-than-temporarily impaired or as permanently impaired, our earnings and stockholders' equity could decrease. We own common stock of the FHLB of Atlanta. We hold this stock to qualify for membership in the FHLB System and to be eligible to borrow funds under the FHLB of Atlanta's advance program. The aggregate cost and fair value of our FHLB of Atlanta common stock as of December 31, 2012 was $0.5 million based on its par value. There is no market for our FHLB of Atlanta common stock.

Published reports indicate that certain member banks of the FHLB System may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels. In an extreme situation, it is possible that the capital of an FHLB, including the FHLB of Atlanta, could be substantially diminished or reduced to zero. Consequently, we believe that there is a risk that our investment in FHLB of Atlanta common stock could be impaired at some time in the future, and if this occurs, it would cause our earnings and stockholders' equity to decrease by the after- tax amount of the impairment charge.

If the Bank loses key employees with significant business contacts in its market areas, its business may suffer. The Bank's success is largely dependent on the personal contacts of our officers and employees in our market areas. If the Bank loses key employees temporarily or permanently, this could have a material adverse effect on the business. The Bank could be particularly hurt if its key employees go to work for competitors. The Bank's future success depends on the continued contributions of its existing senior management personnel, many of whom have significant local experience and contacts in its market areas.

The Company's operating results and financial condition would likely suffer if there is continued deterioration in the general economic condition of the areas in which the Bank does business. Unlike larger national or other regional banks that are more geographically diversified, the Bank primarily provides services to customers located in the Raleigh, Durham, Winston-Salem, Greensboro, and Charlotte areas of NC. Because the Bank's lending and deposit-gathering activities are concentrated in these markets, the Bank is affected by the business activity, population, income levels, deposits and real estate activity in these markets. Adverse developments in local industries have had and could continue to have a negative effect on the Bank's financial condition and results of operations. Even though the Bank's customers' business and financial interests may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce the Bank's growth rate, affect the ability of the Bank's customers to repay their loans and generally affect the Company's financial condition and results of operations. A significant further decline in general economic conditions in the Bank's market areas, or the entire country, caused by inflation, recession, unemployment or other factors which are beyond the Bank's control, would also impact these local economic conditions and could have an adverse affect on the Company's financial condition and results of operations.

The Company is subject to security and operational risks related to the technology the Company uses that could result in a loss of customers, increased costs and other damages which could be material. The Company depends on data processing, software, and communication and information exchange on a variety of platforms, networks and over the internet. Despite safeguards, the Company cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. Any failure, interruptions, or breach of security of these systems could result in failures or disruptions in its customer relationships, general ledger, deposits and loan servicing or origination systems. The occurrence of any such failures or difficulties could result in a loss of customer business, damage the Bank's reputation, subject the Bank to additional regulatory scrutiny, or expose the Bank to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company's results of operations and financial condition.

The Bank faces strong competition in our market areas, which may limit our asset growth and profitability. The banking business in the Bank's market areas is very competitive, and the level of competition facing the Bank may increase further, which may limit the Bank's asset growth and/or profitability. The Bank experiences competition in both lending and attracting deposits from other banks and non-bank financial institutions located within its market areas, some of which are significantly larger institutions and may have more financial resources than the Bank. Such competitors primarily include national, regional and local financial institutions within the Bank's market areas. Additionally, various out-of-state banks may enter the market areas in which the Bank currently operates. Non-bank competitors for deposits and deposit-type accounts include savings associations, credit unions, savings banks, securities firms, money market funds, life insurance companies and the mutual funds industry. For loans, the Bank encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts, securities firms and major retail stores that offer competing financial services. Many of these competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services and better pricing for those products and services than the Bank can offer.

The Bank is exposed to risks in connection with the loans it makes. A significant source of risk for the Company and the Bank arises from the possibility that losses will be sustained by the Bank because borrowers, guarantors and related parties may fail to perform in accordance with the contractual terms of their loans. The Bank has underwriting and credit monitoring procedures and credit policies, including the establishment and review of the ALLL, that it believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying its loan portfolio. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect the Bank's results of operations.

The Bank is subject to environmental liability risk associated with lending activities. A significant portion of the Company's loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property's value or limit the Bank's ability to use or sell the affected property. In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase the Bank's exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company's financial condition and results of operations.

Negative publicity could damage our reputation. Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion could adversely affect our ability to keep and attract customers, and expose us to adverse legal and regulatory consequences. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices; corporate governance; regulatory compliance; mergers and acquisitions; disclosure, sharing or inadequate protection of customer information; and from actions taken by government regulators and community organizations in response to that conduct.

Financial services companies depend on the accuracy and completeness of information about customers and counterparties. In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations and cash flows. Liquidity is essential to our business. Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital and other general corporate purposes. An inability to raise funds through deposits, borrowings, securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity. We do not anticipate that our retail and commercial deposits will be sufficient to meet our funding needs in the foreseeable future. We therefore rely on Certificate of Deposit Account Registry Service ("CDARS") reciprocal deposits, or may use other sources such as FHLB advances or other wholesale funding sources to obtain the funds necessary to implement our growth strategy.

Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us, specifically, the financial services industry, or the economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets. To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned which could have a material adverse effect on our financial condition, results of operations and cash flows.

Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition. Our accounting policies are fundamental to understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Some of our accounting policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain, and because it is likely that materially different amounts would be reported under different conditions or using different assumptions.

From time to time the Financial Accounting Standards Board (the “FASB”) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.

Technological advances impact the Company's business. The banking industry continues to undergo technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Company's future success will depend, in part, on our ability to address the needs of the Bank's customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in operations. Many competitors have substantially greater resources to invest in technological improvements. The Bank may not be able to effectively implement new technology-driven products and services or successfully market such products and services to its customers.

Our stock price can be volatile. Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:

Unpredictable catastrophic events could have a material adverse effect on the Company. The occurrence of catastrophic events such as hurricanes, tropical storms, earthquakes, pandemic disease, windstorms, floods, severe winter weather (including snow, freezing water, ice storms and blizzards), fires, and other catastrophes could adversely affect the Company's consolidated financial condition or results of operations. Unpredictable natural and other disasters could have an adverse effect on the Bank in that such events could materially disrupt our operations or the ability or willingness of our customers to access the financial services offered by the Bank. The incidence and severity of catastrophes are inherently unpredictable. Although the Bank carries insurance to mitigate its exposure to certain catastrophic events, these events could nevertheless reduce the Company's earnings, cause volatility in our financial results for any fiscal quarter or year, and have a material adverse effect on the Company's financial condition and/or results of operations.

The Company's trading volume is low compared with larger national and regional banks. The Company's common stock is quoted on the Over The Counter Bulletin Board. The trading volume of the Company's common stock is very low when compared with more seasoned companies listed on the NASDAQ, the NYSE, other consolidated reporting systems, or stock exchanges. Thus, the market in the Company's common stock is limited in scope relative to other larger companies. In addition, the Company cannot say with any certainty that a more active and liquid trading market for its common stock will develop.

The Company has issued preferred stock, which ranks senior to our common stock. The Company has issued 11,735 shares of Series B Preferred Stock. This Series B Preferred Stock ranks senior to shares of our common stock. As a result, the Company must make dividend payments on the preferred stock before any dividends may be paid on the common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the preferred stock must be satisfied before any distributions can be made on the common stock. If the Company does not remain current in the payment of dividends on the Series B Preferred Stock, no dividends may be paid on the common stock.

Our preferred stock reduces net income available to holders of our common stock and earnings per common share. The dividends declared on our preferred stock reduce any net income available to holders of common stock and our earnings per common share. The preferred stock will receive preferential treatment in the event of sale, merger, liquidation, dissolution or winding up of our company.

There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock. We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.

The Company's common stock is not FDIC insured. The Company's common stock is not a savings or deposit account or other obligation of any bank, is not insured by the FDIC or any other governmental agency, and is subject to investment risk, including the possible loss of principal. Investment in the Company's common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any other company. As a result, holders of the Company's common stock may lose some or all of their investment.

The Bank has credit risks with some of its deposits. The Bank holds deposits that may exceed the FDIC federally insured balance at certain financial institutions. The Bank may lose all uninsured balances if one of the correspondent banks fails without warning. As of December 31, 2012, the Bank had deposits with the FHLB that exceeded the federally insured limit by $1.3 million as a result of recent mortgage backed securities (“MBS”) principal and interest payments.

Consumer protection initiatives related to the foreclosure process could affect our remedies as a creditor. Consumer protection initiatives related to the foreclosure process, including voluntary and/or mandatory programs intended to permit or require lenders to consider loan modifications or other alternatives to foreclosure, could increase our loan losses or increase our expense in pursuing our remedies as a creditor.

ITEM 2. PROPERTIES

The Company conducted its business from its corporate office in Durham, NC, and its seven branch offices in Durham, Raleigh, Charlotte, Greensboro and Winston-Salem, NC.

The following table sets forth certain information regarding the Bank's properties as of December 31, 2012. Rent expense incurred by the Bank under ongoing leases totaled approximately $47 thousand and $49 thousand for the years ended December 31, 2012 and 2011, respectively, including rent for an off-site ATM.

Management considers all of these properties to be in good condition and adequately covered by insurance. Additional information about the Company's property is set forth in Notes 7 and 9 to the Consolidated Financial Statements.

ITEM 3. LEGAL PROCEEDINGS

In the ordinary course of operations, the Company and the Bank are often involved in legal proceedings. In the opinion of management, neither the Company nor the Bank is a party to, nor is their property the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to their business, nor has any such proceeding been terminated during the fourth quarter of the Company's fiscal year ended December 31, 2012.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company's common stock is quoted on the OTC Bulletin Board under the symbol "MFBP".

As of March 29, 2013, there were 2,031,337 shares of the Company's common stock outstanding, held by approximately 990 stockholders of record (not including persons or entities whose stock is held in nominee or 'street' name through various brokerage firms or banks). The following table shows the high and low sale price of the Company's common stock for the previous eight quarters, as well as the per share amount of cash dividends declared during the same periods. These quotations reflect inter-dealer prices, without retail mark up, mark down or commission and may not represent actual transactions. No stock dividend was declared or paid during any of the fiscal quarters listed.

Dividends. See "Item 1. Description of Business - Supervision and Regulation - Dividend and Repurchase Limitations" above for regulatory and TARP restrictions, which limit the ability of the Company to pay dividends. During 2012 and 2011, the Company paid its stockholders annual dividends totaling $0.125 per share.

Dividend Policy. The Company's stockholders are entitled to receive such dividends or distributions as declared from time to time by the Board of Directors. During 2012, the Company declared and paid to its stockholders dividends totaling $0.125 per share. Subject to the regulatory and TARP restrictions discussed in “Item 1 Dividend and Repurchase Limitations”, the Company may continue to pay annual cash dividends to stockholders, if doing so is considered to be in the best interest of the Company and consistent with maintaining the Bank’s status as a “well capitalized” institution under applicable banking laws and regulations. In 2012, the dividends awarded to stockholders accounted for 250% of fully diluted earnings per share available to common stockholders.

Recent Sales of Unregistered Securities. Except for the sale of preferred stock to the Treasury in 2009 and the exchange thereof in 2010, the Company did not sell any securities within the last three fiscal years that were not registered under the Securities Act of 1933, as amended.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers. The Company did not repurchase any shares of its common stock in 2012.

ITEM 6. SELECTED FINANCIAL DATA

The following tables sets forth selected financial information for the Company, including balance sheets and operational data as of and for the years ended December 31, 2012, 2011 and 2010, portions of which have been derived from, and are qualified by reference to, and should be read in conjunction with, the Consolidated Financial Statements and notes thereto included elsewhere in this report.

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

INTRODUCTION

The following discussion and analysis is intended to aid the reader in understanding and evaluating the Company’s consolidated results of operations and financial condition. This discussion is designed to provide more comprehensive information about the major components of the Company’s results of operations, financial condition, liquidity, and capital resources than may be obtained from reading the financial statements alone. This discussion should be read in conjunction with, and is qualified in its entirety by reference to, the Company’s Consolidated Financial Statements, including the related notes thereto presented under Item I in this Annual Report on Form 10-K. This discussion contains certain forward-looking statements about the Company's financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. See also "Cautionary Statement Regarding Forward-Looking Statements" and "Risk Factors" which begin on pages 1 and 10, respectively. All information presented is consolidated data unless otherwise specified.

OVERVIEW

The Bank is a full-service NC state-chartered bank conducting business in the five largest urban areas of NC: Raleigh, the State's capitol, Durham, Winston-Salem, Greensboro, and Charlotte. In 2007, the Bank celebrated the 100th anniversary of its founding in 1907 and the opening of its first branch in 1908 on Parrish Street in Durham where the Bank continues to operate a branch. In 1999, the Company was created as a bank holding company. As of December 31, 2012, the Company conducted no business other than providing services and assistance to the Bank, its wholly owned subsidiary.

The Bank's business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial and faith-based non-profit real estate, secured and unsecured commercial, faith-based non-profit, and consumer loans, single-family residential mortgage loans, and home equity lines. As a community bank, the Bank's profitability depends primarily upon its levels of net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. When earnings from interest-earning assets approximate or exceed expenses for interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Bank's profitability is affected by its provision for loan losses, noninterest income, and other operating expenses. Noninterest income primarily consists of service charges, ATM fees, rental income, and the increase in cash surrender value of bank-owned life insurance. Operating expenses primarily consist of compensation and benefits, occupancy related expenses, marketing, data processing, professional fees, telecommunication, FDIC insurance expense, expenses related to foreclosed properties from defaulted loans, and other non-interest expenses.

The Bank's operations are influenced significantly by local economic conditions and by policies of bank regulatory authorities. The Bank's costs of funds are influenced by interest rates on deposits and borrowing rates offered by competing financial institutions in our market area, as well as general market interest rates. Lending activities are affected by the demand for financing, which in turn is affected by the prevailing interest rates, as well as the borrower's credit and risk profiles established under the Bank's lending policies.

EXECUTIVE SUMMARY

As discussed in more detail below, the following is an executive summary of the Company’s significant results for the year ended December 31, 2012.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The following discussion and analysis of the Company’s financial condition and results of operations are based on the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires the Company to make estimates and judgments regarding uncertainties that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis the Company evaluates its estimates, including those related to the allowance for loan losses, investment values, income taxes, contingencies, and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. However, because future events and their effects cannot be determined with certainty, actual results may differ from these estimates under different assumptions or conditions, and the Company may be exposed to gains or losses that could be material.

The Company's significant accounting policies are discussed below and in Item 8. Financial Statements and Supplementary Data--Notes to Consolidated Financial Statements--Note 1. Significant Accounting Policies. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating the Company's reported financial reported financial results, and these policies require management's most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Board of Directors.

RESULTS OF OPERATIONS

Year ended December 31, 2012 compared with year ended December 31, 2011

Net Interest Income. Net interest income, the difference between total interest income from loans and investments, and total interest expenses from deposits and borrowings, is the Company’s principal source of earnings. The amount of net interest income is determined by the volume of interest- earning assets, the level of rates earned on those assets, and the volume and cost of underlying funding from deposits and borrowings. Net interest income before the provision for loan losses decreased $0.4 million, or 3.21% from $10.9 million for the year ended December 31, 2011. Net interest spread is the difference between rates earned on interest-earning assets and the interest paid on deposits and borrowed funds. Net interest margin represents net interest income divided by average earning assets. Average earning assets for the year ended December 31, 2012 were $280.8 million compared to $290.0 million for the year ended December 31, 2011. On a fully tax-equivalent basis, net interest margin was 3.77% and 3.81% for the years ended December 31, 2012 and 2011, respectively. The net interest spread remained unchanged level at 3.64% for the years ended December 31, 2012 and 2011. The yield on interest-earning assets was 4.14% and 4.33% for the years ended December 31, 2012 and December 31, 2011, respectively, – reflecting a decrease of 19 bps. The interest rate on average interest-bearing liabilities for those same periods was 0.50% and 0.69%, respectively, - reflecting a decrease of 19 bps due to the ongoing low interest rate environment.

Interest income decreased 6.72% for the year ended December 31, 2012 to $11.6 million from $12.4 million for the year ended December 31, 2011. The average balance of outstanding loans, which yielded 5.84% for the year ended December 31, 2012 and 5.73% for the year ended December 31, 2011, decreased from $197.4 million for the year ended December 31, 2011 to $180.7 million for the year ended December 31, 2012. The average balance of investment securities increased $23.5 million from $28.4 million to $51.9 million for the year ended December 31, 2012. The tax-equivalent yield on investment securities decreased from 3.82% for the year ended December 31, 2011 to 1.80% for the year ended December 31, 2012. In the low interest rate environment, higher yield investments that are amortizing or being called are not being replaced by the same yields on new investments. In addition, management sold $12.7 million in certain fixed rate available for sale securities during 2012 to better position itself for a rising rate interest environment. The average balances of federal funds and other short-term investments decreased by $16.1 million to from $64.2 million to $48.1 million at December 31, 2012 as management sought to invest excess funds into its investment portfolio. The average yield in this category remained relatively flat at 0.25%. The decrease in higher yielding loans due to loan runoff accounted for the largest impact of the 19 bps decrease in yield on earning assets.

Interest expense decreased $0.5 million during the year ended December 31, 2012 to $1.0 million compared to $1.5 million during the year ended December 31, 2011. Average total interest-bearing deposits, including savings, interest-bearing demand deposits and time deposits, decreased from $214.2 million at December 31, 2011 to $203.4 million at December 31, 2012. The average rate paid on interest-bearing deposits decreased from 67 bps for the year ended December 31, 2011 to 45 bps for the year ended December 31, 2012, primarily due to lower interest rates paid on time deposits.

The average rate on borrowings increased from 2.06% for the year ended December 31, 2011 to 3.75% or the year ended December 31, 2012. The average borrowings outstanding decreased by $0.5 million from $3.6 million for the year ended December 31, 2011 to $3.1 million for the year ended December 31, 2012. The interest expense on borrowed funds increased slightly to $0.1 million in 2012.

The following table, Average Balances, Interest Earned or Paid, and Interest Yields/Rates reflects the Company’s effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. Changes in net interest income from year to year can be explained in terms of fluctuations in volume and rate. In the table, the amount earned on nontaxable securities is reflected as actual, whereas the rate on nontaxable securities is stated at the tax equivalent rate.

The following table, Rate and Volume Variance Analysis, presents further information on those changes. For each category of interest-earning asset and interest-bearing liability, we have provided information on changes attributable to:

Noninterest Income. Noninterest income decreased by $1.1 million in the year ended December 31, 2012 over the same period in 2011, primarily due to a $0.9 million in realized gain at foreclosure during 2011 and the sale of OREO at gains, which did not occur during the comparable period of 2012. The Company also earned $54 thousand less in service charge revenue during 2012 compared to 2011, partially offset with $105 thousand in increased gains on the sales of investments held available for sale and $17 thousand increase in rental income.

Noninterest Expense. Noninterest expense represents the cost of operating the Company and the Bank. Management regularly monitors all categories of noninterest expense with the goal of improving productivity and operating performance. Noninterest expense decreased from $0.4 million for the year ended December 31, 2012 from the year ended December 31, 2011. The largest impacts to noninterest expense were a $0.6 million decrease in net OREO expenses and $0.2 million decrease in professional fees, partially offset with a $0.4 million increase in salaries and employee benefits. Employee benefits increased $0.1 million in the year ended December 31, 2012 compared to the year ended December 31, 2011 primarily due to health insurance and payroll tax increases in 2012 from the 2011 levels.

Occupancy expense and Director Fees were unchanged at $1.5 million and $0.3 million, respectively, in both the year ended December 31, 2012 and December 31, 2011.

Information technology expense costs increased by $69 thousand or 8.19% in the year ended December 31, 2012 from $843 thousand to $912 thousand, primarily due to increased core processing charges.

Professional fees decreased $163 thousand during the year ended December 31, 2012 compared to the year ended December 31, 2011, primarily as a result of a reduction in legal fees.

OREO expenses decreased $0.6 million, which was primarily attributable to OREO write downs, which totaled $0.2 million and $0.9 million in the years ended December 31, 2012 and 2011, respectively.

In the year ended December 31, 2012, FDIC insurance premiums decreased $48 thousand compared to premiums paid during the year ended December 31, 2011, primarily due to a decrease in our insurance rate.

Other expenses increased $104 thousand primarily due to increases in franchise taxes of $59 thousand and increased appraisal fees of $73 thousand, which were partially offset with a $21 thousand decrease in printing and supplies.

Provision for Income Taxes. The Company recorded an income tax expense of $0.1 million for the year ended December 31, 2012 and December 31, 2011. The overall effective rate increased from 18.88% to 25.38% in the year ended December 31, 2012 due to a decrease in tax exempt interest income and permanent tax to book differences decreasing.

Year Ended December 31, 2011 Compared with Year Ended December 31, 2010

Net Interest Income. Net interest income, the difference between total interest income from loans and investments, and total interest expenses from deposits and borrowings, is the Company's principal source of earnings. The amount of net interest income is determined by the volume of interest- earning assets, the level of rates earned on those assets, and the volume and cost of underlying funding from deposits and borrowings. Net interest income before the provision for loan losses decreased $0.2 million, or 1.48%, from $11.0 million for the year ended December 31, 2011, to $10.9 million for the year ended December 31, 2011. Net interest spread is the difference between rates earned on interest-earning assets and the interest paid on deposits and borrowed funds. Net interest margin is the total of net interest income divided by average earning assets. Average earning assets for the year ended December 31, 2011 were $290.0 million, up 4.82% compared to $276.6 million for the year ended December 31, 2010. On a fully tax-equivalent basis, net interest margin was 3.81% and 4.06% for the years ended December 31, 2011 and 2010, respectively. The net interest spread decreased 15 bps to 3.64% for the year ended December 31, 2011, from 3.79% for the year ended December 31, 2010. The yield on average interest-earning assets was 4.33% and 4.84% for the years ended December 31, 2011 and 2010, respectively, a decrease of 51 bps, while the interest rate on average interest- bearing liabilities for those periods was 0.69% and 1.05%, respectively, a decrease of 36 bps due to the ongoing low interest rate environment.

Interest income decreased 6.20% for the year ended December 31, 2011 to $12.4 million, from $13.2 million for the year ended December 31, 2010. The average balances of loans, which had overall yields of 5.73% for the year ended December 31, 2011 and 5.92% for the year ended December 31, 2010, respectively, decreased from $209.3 million for the year ended December 31, 2010 to $197.4 million for the year ended December 31, 2011. The average balance of investment securities increased $10.4 million from $18.0 million for the year ended December 31, 2010 to $28.4 million for the year ended December 31, 2011. The tax-equivalent yield on investment securities decreased from 4.95% for the year ended December 31, 2010 to 3.82% for the year ended December 31, 2011. In the low interest rate environment, higher yield investments that are amortizing or being called are not being replaced by the same yields on new investment. The average balances on federal funds and other short-term investments increased from $49.3 million for the year ended December 31, 2010 to $64.2 million for the year ended December 31, 2011, and the average yield in this category increased 4 bps from 0.20% to 0.24% over the same period. The increase in average balances year over year for federal funds sold and other short-term investments combined with the decrease in loans outstanding had a negative impact on net interest margin. The average deposit yield increased due to actively managing the cash at a higher yielding deposit account.

Interest expense decreased $0.7 million in the year ended December 31, 2011 to $1.5 million, from $2.2 million for the year ended December 31, 2010. Average total interest-bearing deposits, including savings, interest-bearing demand deposits and time deposits increased from $202.0 million for the year ended December 31, 2010, to $214.2 million for the year ended December 31, 2011. The average rate paid on interest-bearing deposits decreased 35 bps from 1.02% for the year ended December 31, 2010 to 0.67% for the year ended December 31, 2011, primarily caused by the decreases in rates paid on time deposits.

The average rate paid on borrowings decreased from 2.93% for the year ended December 31, 2010 to 2.06% for the year ended December 31, 2011. The average borrowings outstanding increased $0.2 million from the year ended December 31, 2010 to the year ended December 31, 2011. The interest expense on borrowed funds decreased slightly to $0.1 million in 2011.

Noninterest Income. Noninterest income increased 55.09%, or $1.2 million, for the year ended December 31, 2011. The increase was primarily the result of realized gains from the sales of AFS securities, the disposal of a bank owned asset, and gains from foreclosures and sales of OREO. The realized gains were partially offset by a reduction in service charge fees. Rental income increased by $46.0 thousand for the year ended December 31, 2011 when compared to the same period in 2010. The increase in rental income was driven by improved occupancy rates in 2011.

Noninterest Expense. Noninterest expenses represent the costs of operating the Company and the Bank. Management regularly monitors all categories of noninterest expense with the goal of improving productivity and operating performance. Noninterest expense increased $0.8 million for the year ended December 31, 2011 from the year ended December 31, 2010. The largest impacts to noninterest expense were a $0.3 million increase in salaries and employee benefits, $0.5 million increase in OREO expenses mainly related to impairment charges, and a $0.2 million increase in professional fees, marketing and delivery costs, which were partially offset by the $0.2 million reduction in FDIC insurance expense.

Salary and employee benefits expenses for the year ended December 31, 2011 and December 31, 2010 were $5.6 million and $5.2 million, respectively. In the year ended December 31, 2011 the company hired a new Chief Credit Officer and granted cost of living and some performance based raises, resulting in $0.3 million higher salaries expenses than the year ended December 31, 2010. Benefits increased $0.1 million in the year ended December 31, 2011 compared to the year ended December 31, 2010, mainly due to health insurance and payroll tax increases in 2011 from the 2010 levels.

Occupancy expense and Director fees were unchanged, at $1.5 million and $0.3 million, respectively, in the year ended December 31, 2011 compared to the same period in 2010.

Data processing and communications costs decreased by 1.06%, or $9.0 thousand, to $843.0 thousand in the year ended December 31, 2011, mainly due to decreased core processing charges.

Professional fees increased by $0.2 million in the year ended December 31, 2011 compared to the year ended December 31, 2010, due to an increase in fees related to internal, external, and Sarbanes-Oxley internal controls audits.

In the year ended December 31, 2011, FDIC insurance premiums decreased $0.2 million from $0.8 to $0.6 million in the same period of 2010, due to a decrease in our insurance rate, as well as a special assessment that the Company paid in 2010 and not in 2011.

Other expenses increased $4.0 thousand for the year ended December 31, 2011 from the year ended December 31, 2010 due to general increases in operating the Company.

Provision for Income Taxes. The Company recorded an income tax expense of $0.1 million for the year ended December 31, 2011 and December 31, 2010. The overall effective rate increased from 9.86% in the year ended December 31, 2010 to 18.88% in the year ended December 31, 2011 due to a decrease in tax exempt interest income and permanent tax to book differences decreasing.

ASSET QUALITY

Allowances for Loan Losses ("ALLL") — The ALLL is management's estimate of losses inherent in the loan portfolio. The provision for loan losses is the amount charged against earnings to establish an adequate ALLL. Loan losses and recoveries are charged to or credited to the ALLL, rather than reported as a direct expense or recovery. The loan portfolio is segmented into three parts for the ALLL calculation: impaired commercial loans, smaller balance homogenous loans in the process of foreclosure, and TDRs (collectively referred to as "impaired loans"), and all other loans.

For all classes of commercial loans, a quarterly evaluation of individual borrowers is performed to identify impaired loans. The identification of specific borrowers for review is based on a review of non-accrual loans as well as those loans specifically identified by management as exhibiting above average levels of risk through the loan classification process. The ALLL attributed to impaired loans and TDRs considers all available evidence based on significant conditions or circumstances related to the specific credits. The specific allowance amounts are determined by a method prescribed by Accounting Standards Codification ("ASC") 310. The loans identified as impaired and TDRs are accounted for in accordance with one of three valuations: (i) the present value of future cash flows discounted at the loan’s effective interest rate; (ii) the loan’s observable market price, or (iii) the fair value of the collateral, if the loan is collateral dependent, less estimated liquidation costs. Factors considered management in determining impairment include payment status, collateral value, alternate use of special purpose real estate which could adversely impact resale, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. The significance of payment delays and payment shortfalls are considered on a loan by loan basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Interest payments made on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest income may be accrued or recognized on a cash basis.

Most consumer loans are evaluated for impairment on a collective basis, because these loans are for smaller balances and are homogeneous. Any loans, including commercial loans, not specifically identified as impaired or TDRs, are collectively evaluated segmented by loan type, applying two factors: the quantitative loss history by loan type for the previous eight quarters compared to average loans outstanding for the same period (the "quantitative factor"), and a qualitative factor that is comprised of quantitatively-driven calculations based on historical data, and subjective factors (the "qualitative factors"). The quantitative portion of the ALLL is adjusted for qualitative factors to account for model imprecision and to incorporate the range of probable outcome inherent in the estimates used for the allowance.

The quantitative factor by loan type is applied against the unimpaired loan balances and smaller-balance homogenous impaired loans not in the process of foreclosure for which there is no specific reserve to determine the quantitative reserve. The qualitative factors, including (i) policy underwriting, charge-off and collection, (ii) national and local economic conditions, (iii) nature and volume of the portfolio, (iv) experience, ability, and depth of lending team, (v) trends of past due, classified loans, and restructurings, (vi) quality of loan review and board oversight, (vii) existence, levels, and effect of loan concentrations and (viii) effects of external factors such as competition and regulatory oversight, are adjusted quarterly based on historical information for any quantifiable factors and qualitative judgments for subjective factors (those considered subjective are policy, underwriting, experience, ability and depth of lending team, quality of loan review and board oversight, and effects of external factors), and applied in total to each loan balance by loan type. The Company continues to enhance its modeling of the portfolio and underlying risk factors through quarterly analytical reviews with the goal of ensuring it captures all pertinent factors contributing to risk of loss inherent in the loan portfolio. The Company applies additional qualitative factors for non-homogenous classified loans including internal watch, special mention, and substandard loans not identified as impaired, when a loan has a loan to value ("LTV") exceeding 50% of the outstanding balance and is not current in its payments. Under ASC 310, the non-homogenous impaired loans, homogenous small balance real estate secured loans in process of foreclosure for which the value is less than the loan principal balance, and TDRs, are reviewed individually for impairment.

The process of assessing the adequacy of the ALLL is inherently subjective. Further, and particularly in terms of economic downturns, it is reasonably possible that future credit losses may exceed historical loss levels and may also exceed management’s current estimates of incurred credit losses inherent within the loan portfolio. As such, there can be no assurance that future loan charge-offs will not exceed management’s current estimate of what constitutes a reasonable allowance for loan losses.

The Company and the Bank are subject to periodic examination by their federal and state banking regulators, and may be required by their regulators to recognize additions to the allowance for loan losses based on their assessment of credit information available to them at the time of their examinations.

As of December 31, 2012 and December 31, 2011, the ALLL was $3.5 million and $3.9 million, respectively, which represented approximately 2.00% and 2.05% of loans outstanding, net of unearned income and deferred costs ("net loans outstanding"), on those respective dates. During the fourth quarter of 2012, the Company converted from a spreadsheet calculated ALLL to a more robust system provided by a third party servicing company. Historic quantitative and qualitative factors were carried forward to the new system as well as an eight quarter look back period for measuring loss histories. Slight variations in loss history calculations from the old system to the new resulted in a variance of approximately $261 thousand. Management elected to retain the variance as an unallocated reserve as the team continues to validate and integrate nuances in the new system. Nonperforming assets, defined as non-accruing loans, OREO and other repossessed assets, at December 31, 2012 were 4.18% of total assets compared to 6.09% at December 31, 2011. Nonperforming assets as a percentage of total loans as of December 31, 2012 were 7.06% compared to 9.86% at December 31, 2011. For the years ended December 31, 2012 and December 31, 2011, the provision for loan losses was $0.2 million and $0.9 million, respectively.

Of the non-accruing loans totaling $8.7 million at December 31, 2012, 99.82% of the outstanding balances were secured by real estate, which management believes mitigates the risk of loss. TDRs in compliance with modified terms totaled $12.6 million or 62.33% of total TDRs at December 31, 2012. GAAP does not provide specific guidance on when a loan may be returned to accrual status. Federal banking regulators have provided guidance that interest on impaired loans, including TDRs, should only be recorded when there has been a sustained period of repayment performance, the loan is well secured, and the collection under any revised terms is assessed as probable. The Company evaluates impaired loans and TDR performance under the applicable regulatory guidelines and returns loans to accruing after a sustained period of repayment performance.

Loans are generally placed on non-accrual status when the scheduled payments reach 90 days past due. Loans are charged-off, with Board approval, when the Chief Credit Officer and his staff determine that all reasonable means of collection of the outstanding balances, except foreclosure, have been exhausted. The Company continues its collection efforts subsequent to charge-off, which historically has resulted in some recoveries each year.

Loans at December 31, 2012, 2011 and 2010 were as follows:

In 2010, management changed its loan-related disclosure classification in its financial reports to better reflect the underlying collateral risk within the loan portfolio and to more closely align its financial disclosure with internally monitored classifications. For the above table, management has presented data from all periods to reflect this updated classification. However, data for certain year’s data was not available for the purposes of applying a consistent presentation. The following table and other tables as noted herein, presents loan and ALLL classifications as was previously reported.

The following table shows the summary activity in the ALLL for the three years ended December 31, 2012:

The following table shows the summary activity in the ALLL for the two years ended December 31, 2009 as was previously reported.

Activity in the ALLL for the years ended December 31, 2012, 2011 and 2010 was as follows:

For the years ended December 31, 2009 and 2008, the Company reported changes in the ALLL as follows:

The Company experienced $0.5 million in net loan charge-offs for the year ended December 31, 2012 compared to $0.9 million in net loan charge-offs for the year ended December 31, 2011. Net charge-offs to average loans totaled 0.29% and 0.46% during the years ended December 31, 2012 and 2011, respectively

In 2010, management changed its loan-related disclosure classifications in its financial reports to present portfolio segments. A portfolio segment is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for loan losses.

The following tables present the ALLL and the reported investment in loans by portfolio segment and based on impairment method as of December 31, 2012 and December 31, 2011:

Impaired loans at December 31, 2012 and 2011 were as follows: