PACIFIC FINANCIAL CORP - Quarter Report: 2011 September (Form 10-Q)

Unassociated Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2011

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

For the transition period from ____________ to ____________

Commission File Number 000-29829

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington		91-1815009
(State or other jurisdiction of		(IRS Employer Identification No.)
incorporation or organization)

1101 S. Boone Street

Aberdeen, Washington 98520-5244

(360) 533-8870

(Address, including zip code, and telephone number,

including area code, of Registrant's principal executive offices)

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

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x 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 the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).

¨ Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x Smaller Reporting Company

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

The number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of October 31, 2011, was 10,121,853 shares.

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	3

ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)	3

	CONDENSED CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2011 AND DECEMBER 31, 2010	3

	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010	4

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010	5

	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010	6

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	7

ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	25

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	38

ITEM 4.	CONTROLS AND PROCEDURES	39

PART II	OTHER INFORMATION	39

ITEM 1.	LEGAL PROCEEDINGS	39

ITEM 1A.	RISK FACTORS	39

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	39

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	39

ITEM 4.	[RESERVED]	39

ITEM 5.	OTHER INFORMATION	39

ITEM 6.	EXHIBITS	39

	SIGNATURES	40

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

September 30, 2011 and December 31, 2010

(Dollars in thousands) (Unaudited)

	September 30, 2011		December 31, 2010
Assets
Cash and due from banks	$	12,591	$	7,428
Interest bearing deposits in banks		39,349		54,330
Investment securities available-for-sale (amortized cost of $49,711 and $42,402)		50,636		41,893
Investment securities held-to-maturity (fair value of $7,241and $6,584)		7,130		6,454
Federal Home Loan Bank stock, at cost		3,182		3,182
Loans held for sale		11,845		10,144
Loans		474,463		465,681
Allowance for credit losses		10,923		10,617
Loans, net		463,540		455,064
Premises and equipment		14,837		15,181
Other real estate owned		8,696		6,580
Accrued interest receivable		2,445		2,334
Cash surrender value of life insurance		17,146		16,748
Goodwill		11,282		11,282
Other intangible assets		1,268		1,303
Other assets		9,610		12,480
Total assets	$	653,557	$	644,403

Liabilities and Shareholders' Equity
Deposits:
Demand, non-interest bearing	$	102,527	$	95,115
Savings and interest-bearing demand		295,018		253,347
Time, interest-bearing		163,392		196,492
Total deposits		560,937		544,954

Accrued interest payable		1,463		1,380
Secured borrowings		755		925
Short-term borrowings		—		10,500
Long-term borrowings		10,500		10,500
Junior subordinated debentures		13,403		13,403
Other liabilities		3,454		2,972
Total liabilities		590,512		584,634

Commitments and Contingencies (Note 6)		—		—

Shareholders' Equity
Common Stock (par value $1); 25,000,000 shares authorized; 10,121,853 shares issued and outstanding at September 30, 2011 and December 31, 2010		10,122		10,122
Additional paid-in capital		41,335		41,316
Retained earnings		11,472		9,233
Accumulated other comprehensive income (loss)		116		(902	)
Total shareholders' equity		63,045		59,769
Total liabilities and shareholders' equity	$	653,557	$	644,403

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three and nine months ended September 30, 2011 and 2010

(Dollars in thousands, except per share data) (Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011			2010
Interest and dividend income
Loans	$	6,861	$	7,086	$	20,459		$	21,499
Investment securities and FHLB dividends		516		516		1,548			1,726
Deposits with banks and federal funds sold		29		29		77			92
Total interest and dividend income		7,406		7,631		22,084			23,317

Interest Expense
Deposits		1,112		1,550		3,731			5,118
Other borrowings		224		338		833			1,074
Total interest expense		1,336		1,888		4,564			6,192

Net Interest Income		6,070		5,743		17,520			17,125
Provision for credit losses		1,050		850		1,550			2,850
Net interest income after provision for credit losses		5,020		4,893		15,970			14,275

Non-interest Income
Service charges on deposits		470		464		1,350			1,338
Net gain (loss) on sales of other real estate owned		17		19		(126	)		273
Gain on sales of loans		1,084		1,010		2,183			2,859
Gain on sales of investments available-for-sale, net		352		—		536			402
Net other-than-temporary impairment losses ( net of $338 recognized in other comprehensive income before taxes)		—		—		(243	)		—
Earnings on bank owned life insurance		135		144		398			409
Other operating income		397		378		1,061			920
Total non-interest income		2,455		2,015		5,159			6,201

Non-interest Expense
Salaries and employee benefits		3,363		3,378		10,188			9,913
Occupancy and equipment		623		669		1,908			2,043
Other real estate owned write-downs		62		73		599			564
Other real estate owned operating costs		89		166		293			425
Professional services		174		204		574			582
FDIC and State assessments		215		332		711			1,043
Data processing		336		245		920			802
Other		1,198		1,264		3,600			3,548
Total non-interest expense		6,060		6,331		18,793			18,920

Income before income taxes		1,415		577		2,336			1,556
Income taxes (benefit)		211		98		97			(60	)

Net Income	$	1,204	$	479	$	2,239		$	1,616

Earnings per common share:
Basic	$	0.12	$	0.05	$	0.22		$	0.16
Diluted		0.12		0.05		0.22			0.16
Weighted Average shares outstanding:
Basic		10,121,853		10,121,853		10,121,853			10,121,853
Diluted		10,121,919		10,121,853		10,121,875			10,121,853

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Nine months ended September 30, 2011 and 2010

(Dollars in thousands)

(Unaudited)

	2011			2010
OPERATING ACTIVITIES
Net income	$	2,239		$	1,616
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for credit losses		1,550			2,850
Depreciation and amortization		1,191			1,186
Origination of loans held for sale		(104,807	)		(141,541	)
Proceeds of loans held for sale		104,771			136,480
Gain on sales of loans		(2,183	)		(2,859	)
Gain on sale of investments available-for-sale		(536	)		(402	)
Net OTTI losses recognized in earnings		243			—
Net (gain) loss on sale of other real estate owned		126			(273	)
Loss on sale of premises and equipment		1			6
(Increase) decrease in accrued interest receivable		(111	)		102
Increase in accrued interest payable		83			125
Other real estate owned write-downs		599			564
Additions to other real estate owned		(215	)		—
Proceeds from Internal Revenue Service tax refund		1,876			—
Other, net		764			760
Net cash provided by (used in) operating activities		5,591			(1,386	)

INVESTING ACTIVITIES
Net decrease in federal funds sold		—			5,000
Net decrease in interest bearing balances with banks		14,981			10,313
Purchase of securities held-to-maturity		(828	)		(56	)
Purchase of securities available-for-sale		(24,425	)		(9,827	)
Proceeds from maturities of investments held-to-maturity		151			889
Proceeds from sales of securities available-for-sale		12,881			15,669
Proceeds from maturities of securities available-for-sale		4,309			6,195
Proceeds from sales of government loan pools		5,514			—
Net (increase) decrease in loans		(18,749	)		6,620
Proceeds from sales of other real estate owned		1,061			3,371
Purchase of premises and equipment		(636	)		(317	)
Net cash provided by (used in) investing activities		(5,741	)		37,857

FINANCING ACTIVITIES
Net increase (decrease) in deposits		15,983			(33,456	)
Net decrease in short-term borrowings		(10,500	)		(4,500	)
Proceeds from issuance of long-term borrowings		7,500			—
Repayment of long-term borrowings		(7,500	)		—
Net decrease in secured borrowings		(170	)		(38	)
Net cash provided by (used in) financing activities		5,313			(37,994	)

Net increase (decrease) in cash and due from banks		5,163			(1,523	)

Cash and due from Banks
Beginning of period		7,428			12,836

End of period	$	12,591		$	11,313

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	4,481		$	6,067
Income taxes		55			725

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	948		$	1,051
Transfer of loans held for sale to loans held for investment		300			—
Other real estate owned acquired in settlement of loans		(4,437	)		(7,056	)
Financed sale of other real estate owned		750			408
Reclass of long-term borrowings to short-term borrowings		—			10,500

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Nine months ended September 30, 2011 and 2010

(Dollars in thousands)

(Unaudited)

	Shares of Common Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Income (Loss)			Total

Balance January 1, 2010		10,121,853	$	10,122	$	41,270	$	7,599	$	(1,342	)	$	57,649

Other comprehensive income:
Net income								1,616					1,616
Unrealized holding gain on securities of $929 (net of tax of $316) less reclassification adjustment for net gains included in net income of $265 (net of tax of $137)										1,051			1,051
Amortization of unrecognized prior service costs and net (gains)/losses										56			56
Comprehensive income													2,723

Stock compensation expense						34							34

Balance September 30, 2010		10,121,853	$	10,122	$	41,304	$	9,215	$	(235	)	$	60,406

Balance January 1, 2011		10,121,853	$	10,122	$	41,316	$	9,233	$	(902	)	$	59,769

Other comprehensive income:
Net income								2,239					2,239
Unrealized holding gain on securities of $754 (net of tax of $389) less reclassification adjustment for net gains included in net income of $194 (net of tax of $100)										948			948
Amortization of unrecognized prior service costs and net (gains)/losses										70			70
Comprehensive income													3,257

Stock compensation expense						19							19

Balance September 30, 2011		10,121,853	$	10,122	$	41,335	$	11,472	$	116		$	63,045

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Notes to Condensed Consolidated Financial Statements

(Unaudited)

(Dollars in thousands, except per share amounts)

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Pacific Financial Corporation ("Pacific" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with instructions to Form 10-Q. Accordingly, these financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2011, are not necessarily indicative of the results anticipated for the year ending December 31, 2011. Certain information and footnote disclosures included in the Company's consolidated financial statements for the year ended December 31, 2010, have been condensed or omitted from this report. Accordingly, these statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2010.

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

Note 2 – Earnings per Share

The following table illustrates the computation of basic and diluted earnings per share.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
Basic:
Net income	$	1,204	$	479	$	2,239	$	1,616
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Basic earnings per share	$	0.12	$	0.05	$	0.22	$	0.16

Diluted:
Net income	$	1,204	$	479	$	2,239	$	1,616
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Effect of dilutive stock options		66		—		22		—
Weighted average shares outstanding assuming dilution		10,121,919		10,121,853		10,121,875		10,121,853
Diluted earnings per share	$	0.12	$	0.05	$	0.22	$	0.16

As of September 30, 2011 and 2010, there were 585,048 and 818,612 shares, respectively, subject to outstanding options and 699,642 and 699,642 shares, respectively, subject to outstanding warrants with exercise prices in excess of the current market value. These shares are not included in the table above, as exercise of these options and warrants would not be dilutive to shareholders.

Note 3 – Investment Securities

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations, and mortgage backed securities (“MBS”).

Securities Held-to-Maturity	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value

September 30, 2011
State and municipal securities	$	6,823	$	84	$	—	$	6,907
Agency MBS		307		27		—		334
Total	$	7,130	$	111	$	—	$	7,241

December 31, 2010
State and municipal securities	$	6,084	$	104	$	—	$	6,188
Agency MBS		370		26		—		396
Total	$	6,454	$	130	$	—	$	6,584

Securities Available-for-Sale	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value

September 30, 2011
U.S. Government securities	$	99	$	15	$	—	$	114
State and municipal securities		22,950		1,414		—		24,364
Agency MBS		17,368		267		30		17,605
Non-agency MBS		7,281		31		748		6,564
Corporate bonds		2,013		—		24		1,989
Total	$	49,711	$	1,727	$	802	$	50,636

December 31, 2010
U.S. Government securities	$	1,103	$	11	$	5	$	1,109
State and municipal securities		20,588		623		59		21,152
Agency MBS		7,555		187		12		7,730
Non-agency MBS		10,145		4		1,265		8,884
Corporate bonds		3,011		37		30		3,018
Total	$	42,402	$	862	$	1,371	$	41,893

Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of September 30, 2011 and December 31, 2010 are summarized as follows:

	Less than 12 Months				12 months or More				Total
Available-for-Sale	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses

September 30, 2011
Agency MBS	$	4,820	$	27	$	697	$	3	$	5,517	$	30
Non-agency MBS		1,333		77		4,104		671		5,437		748
Corporate bonds		1,989		24		—		—		1,989		24
Total	$	8,142	$	128	$	4,801	$	674	$	12,943	$	802

December 31, 2010
U.S. Government securities	$	995	$	5	$	—	$	—	$	995	$	5
State and municipal securities		4,825		59		—		—		4,825		59
Agency MBS		903		12		—		—		903		12
Non-agency MBS		2,071		154		6,503		1,111		8,574		1,265
Corporate bonds		1,949		30		—		—		1,949		30
Total	$	10,743	$	260	$	6,503	$	1,111	$	17,246	$	1,371

At September 30, 2011, there were 15 investment securities in an unrealized loss position, of which six were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, causing a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner. Based on management’s evaluation, and because the Company does not have the intent to sell these securities and it is not more likely than not that it will be required to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2011, except as described below with respect to one non-agency MBS.

For non-agency MBS we estimate expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the nine months ended September 30, 2011, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $338 in impairments not related to credit losses through other comprehensive income and $243 in impairments related to credit losses through earnings.

Gross gains realized on sales of securities were $557 and $513 and gross losses realized were $21 and $111 during the nine months ended September 30, 2011 and 2010, respectively.

The Company did not engage in originating subprime mortgage loans and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not have any investment in, or exposure to, collateralized debt obligations or structured investment vehicles.

Note 4 – Loans

Loans and Leases

Loans (including loans held for sale) at September 30, 2011 and December 31, 2010 are as follows:

	September 30, 2011			December 31, 2010

Commercial and industrial	$	91,886		$	84,575
Residential real estate:
Residential 1-4 family		88,960			89,212
Multi-family		7,433			9,113
Commercial real estate:
Construction and land development		46,202			46,256
Commercial real estate – owner occupied		118,452			109,936
Commercial real estate – non owner occupied		103,558			106,079
Farmland		21,728			22,354
Installment		8,957			9,128
Less unearned income		(868	)		(828	)

Total Loans	$	486,308		$	475,825

Allowance for Credit Losses

Changes in the allowance for credit losses and recorded investment in loans as of, and for the three months ended September 30, 2011 and 2010 are as follows:

	Commercial			Commercial Real Estate (“CRE”)			Residential Real Estate			Consumer			Unallocated		2011 Total			2010 Total

Allowance for Credit Losses:
Beginning balance	$	829		$	6,410		$	1,598		$	403		$	1,726	$	10,966		$	11,244
Charge-offs		(36	)		(916	)		(271	)		(30	)		—		(1,253	)		(639	)
Recoveries		—			126			32			2			—		160			56
Provision for credit losses		334			390			(112	)		31			407		1,050			850

Ending balance	$	1,127		$	6,010		$	1,247		$	406		$	2,133	$	10,923		$	11,511

Ending balance: individually evaluated for impairment		—			357			—			—			—		357			375

Ending balance: collectively evaluated for impairment		1,127			5,653			1,247			406			2,133		10,566			11,136

Loans:
Ending balance: individually evaluated for impairment	$	180		$	12,823		$	406		$	—		$	—	$	13,409		$	10,358

Ending balance: collectively evaluated for impairment		91,706			277,117			95,987			8,957			—		473,767			477,423

Ending balance	$	91,886		$	289,940		$	96,393		$	8,957		$	—	$	487,176		$	487,781

Less unearned income																(868	)		(857	)

Ending balance total loans															$	486,308		$	486,924

Changes in the allowance for credit losses and recorded investment in loans as of, and for the nine months ended September 30, 2011 and 2010 are as follows:

	Commercial			Commercial Real Estate (“CRE”)			Residential Real Estate			Consumer			Unallocated		2011 Total			2010 Total

Allowance for Credit Losses:
Beginning balance	$	816		$	5,385		$	1,754		$	690		$	1,972	$	10,617		$	11,092
Charge-offs		(134	)		(1,466	)		(361	)		(55	)		—		(2,016	)		(2,507	)
Recoveries		68			640			57			7			—		722			76
Provision for credit losses		377			1,451			(203	)		(236	)		161		1,550			2,850

Ending balance	$	1,127		$	6,010		$	1,247		$	406		$	2,133	$	10,923		$	11,511

Ending balance: individually evaluated for impairment		—			357			—			—			—		357			375

Ending balance: collectively evaluated for impairment		1,127			5,653			1,247			406			2,133		10,566			11,136

Loans:
Ending balance: individually evaluated for impairment	$	180		$	12,823		$	406		$	—		$	—	$	13,409		$	10,358

Ending balance: collectively evaluated for impairment		91,706			277,117			95,987			8,957			—		473,767			477,423

Ending balance	$	91,886		$	289,940		$	96,393		$	8,957		$	—	$	487,176		$	487,781

Less unearned income																(868	)		(857	)

Ending balance total loans															$	486,308		$	486,924

Credit Quality Indicators

Federal regulations require that the Bank periodically evaluates the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the Federal Deposit Insurance Corporation (“FDIC”) have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows:

“Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected.

“Doubtful” loans have the weaknesses of loans classified as "Substandard," with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions, and values. There is a high possibility of loss in loans classified as "Doubtful."

“Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as "Loss," it must be charged-off, meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing that reserve.

The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring than other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.

Loans by credit quality risk rating at September 30, 2011 are as follows:

	Pass		Other Loans Especially Mentioned		Substandard		Doubtful		Total

Commercial	$	85,152	$	2,406	$	4,328	$	—	$	91,886

Real estate:
Construction and development		35,172		2,243		8,787		—		46,202
Residential 1-4 family		84,091		2,269		2,600		—		88,960
Multi-family		7,433		—		—		—		7,433
CRE – owner occupied		112,031		1,054		5,367		—		118,452
CRE – non owner occupied		70,692		21,416		11,450		—		103,558
Farmland		20,491		115		1,122		—		21,728
Total real estate		329,910		27,097		29,326		—		386,333

Consumer		8,881		4		63		9		8,957

Subtotal	$	423,943	$	29,507	$	33,717	$	9	$	487,176
Less unearned income										(868	)

Total loans									$	486,308

Loans by credit quality risk rating at December 31, 2010 are as follows:

	Pass		Other Loans Especially Mentioned		Substandard		Doubtful		Total

Commercial	$	80,400	$	1,967	$	1,716	$	492	$	84,575

Real estate:
Construction and development		29,293		5,199		11,764		—		46,256
Residential 1-4 family		81,932		1,669		5,611		—		89,212
Multi-family		9,113		—		—		—		9,113
CRE – owner occupied		105,021		705		4,210		—		109,936
CRE – non owner occupied		75,002		14,983		16,094		—		106,079
Farmland		21,846		115		393		—		22,354
Total real estate		322,207		22,671		38,072		—		382,950

Consumer		8,987		50		67		24		9,128

Subtotal	$	411,594	$	24,688	$	39,855	$	516	$	476,653
Less unearned income										(828	)

Total loans									$	475,825

Non-accrual loans are as follows:

	September 30,		December 31,
	2011		2010

Commercial	$	180	$	1,251
Real estate
Construction and development		4,852		5,529
Residential 1-4 family		429		2,246
Commercial real estate – owner occupied		439		470
Commercial real estate – non-owner occupied (1)		5,980		333
Farmland		—		170
Total real estate		11,700		8,748

Total	$	11,880	$	9,999

(1)

Includes one loan at September 30, 2011 totaling $3,627,000 of which $3,198,000 is guaranteed by the United States Department of Agriculture.

Impaired Loans

Following is a summary of information pertaining to impaired loans at September 30, 2011:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		3 Month Average Recorded Investment		9 Month Average Recorded Investment		3 Months Interest Income Recognized		9 Months Interest Income Recognized
With no related allowance recorded:
Commercial	$	180	$	194	$	—	$	187	$	312	$	2	$	13
Residential real estate		406		521		—		551		1,510		4		15
Commercial real estate:
CRE – owner occupied		430		481		—		997		1,057		3		5
CRE – non-owner occupied		5,981		6,351		—		5,057		3,248		—		21
Construction and development		5,250		7,401		—		5,054		6,001		18		90

With an allowance recorded:
Commercial		—		—		—		—		253		—		5
Residential real estate		—		—		—		36		18		—		—
Construction and development		1,162		1,162		357		1,503		752		—		52

Total:
Commercial		180		194		—		187		565		2		18
Residential real estate		406		521		—		587		1,528		4		15
Commercial real estate:
CRE – owner occupied		430		481		—		997		1,057		3		5
CRE – non-owner occupied		5,981		6,351		—		5,057		3,248		—		21
Construction and development		6,412		8,563		357		6,557		6,753		18		142

Following is a summary of information pertaining to impaired loans at December 31, 2010:

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial	$	759	$	822	$	—	$	794	$	5
Residential real estate		3,205		3,766		—		3,674		12
Commercial real estate:
CRE – owner occupied		726		768		—		752		7
CRE – non-owner occupied		2,741		2,739		—		2,734		65
Construction and development		6,734		10,055		—		11,695		467

With an allowance recorded:
Commercial		508		492		142		506		37

Total:
Commercial		1,267		1,314		142		1,300		42
Residential real estate		3,205		3,766		—		3,674		12
Commercial real estate:
CRE – owner occupied		726		768		—		752		7
CRE – non-owner occupied		2,741		2,739		—		2,734		65
Construction and development		6,734		10,055		—		11,695		467

Aging Analysis

The following table provides an age analysis of past due loans at September 30, 2011.

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current			Total Loans			Recorded Investment > 90 Days and Still Accruing

Commercial	$	631	$	—	$	207	$	838	$	91,048		$	91,886		$	—

Real estate:
Construction & development		1,333		566		2,039		3,938		42,264			46,202			—
Residential 1-4 family		195		219		289		703		88,257			88,960			—
Multi-family		—		—		—		—		7,433			7,433			—
CRE owner occupied		622		885		862		2,369		116,083			118,452			—
CRE non-owner occupied (1)		121		455		5,980		6,556		97,002			103,558			—
Farmland		—		—		—		—		21,728			21,728			—
Total real estate		2,271		2,125		9,170		13,566		372,767			386,333			—

Consumer		—		—		—		—		8,957			8,957			—

Less unearned income		—		—		—		—		(868	)		(868	)		—

Total	$	2,902	$	2,125	$	9,377	$	14,404	$	471,904		$	486,308		$	—

(1)

Includes one loan past due more than 90 days totaling $3,627,000 of which $3,198,000 is guaranteed by the United States Department of Agriculture.

The following table provides an age analysis of past due loans at December 31, 2010.

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current			Total Loans			Recorded Investment > 90 Days and Still Accruing

Commercial	$	280	$	—	$	146	$	426	$	84,149		$	84,575		$	—

Real estate:
Construction & development		91		2,239		1,300		3,630		42,626			46,256			—
Residential 1-4 family		637		292		1,629		2,558		86,654			89,212			—
Multi-family		—		—		—		—		9,113			9,113			—
CRE owner occupied		256		1,056		447		1,759		108,177			109,936			—
CRE non-owner occupied		—		—		333		333		105,746			106,079			—
Farmland		—		—		170		170		22,184			22,354			—
Total real estate		984		3,587		3,879		8,450		374,500			382,950			—

Consumer		28		—		—		28		9,100			9,128			—

Less unearned income		—		—		—		—		(828	)		(828	)		—

Total	$	1,292	$	3,587	$	4,025	$	8,904	$	466,921		$	475,825		$	—

Modifications

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company. Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered. Additional collateral, a co-borrower, or a guarantor is often required. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower.

Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. The Company’s practice is to re-appraise collateral dependent loans at approximate six month intervals. During the three and nine months ended September 30, 2011, there was no impact on the allowance from TDRs during the periods, as the loans classified as TDRs during the periods did not have a specific reserve and were already considered impaired loans at the time of modification.

The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan.

The following tables present TDRs as of September 30, 2011 all of which were modified due to financial stress of the borrower.

	Current TDRs						Subsequently Defaulted TDRs

	Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment		Number of Contracts		Pre-TDR Outstanding Recorded Investment		Post-TDR Outstanding Recorded Investment

Residential real estate		1	$	70	$	70		—	$	—	$	—
CRE owner occupied		1		59		59		—		—		—
Construction & development (1)		6		5,723		5,211		2		2,561		2,465

Ending balance (2)		8	$	5,852	$	5,340		2	$	2,561	$	2,465

(1)

Includes two loans totaling $398 on accrual status which were accruing loans at the time of modification and are performing in accordance with the terms of the TDR. The remaining TDRs are all on non-accrual status as of September 30, 2011.

(2)

The period end balances are inclusive of all partial paydowns and charge-offs since the modification date. Loans modified in a TDR that were fully paid down, fully charged-off, or foreclosed upon by period end are not reported.

The construction and development loan TDRs that subsequently defaulted were modified by extending the maturity date. Both loans were on non-accrual status prior to and after the TDR. The subsequent default reported above occurred during the three months ended September 30, 2011. There were no other loans modified as a TDR within the previous 12 months that subsequently defaulted during the three and nine months ended September 30, 2011.

Troubled debt restructuring loans are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as troubled debt restructured at September 30, 2011.

Note 5 – Stock Based Compensation

The Company’s 2000 Stock Incentive Plan provided for incentive and non-qualified stock options and other types of stock based awards to key personnel. Under the plan, the Company was authorized to issue up to 1,100,000 shares; however the plan expired January 1, 2011.

On April 27, 2011, the shareholders of the Company approved the 2011 Equity Incentive Plan, pursuant to which the Company is authorized to issue up to 900,000 shares of common stock in connection with awards under the plan.

The fair value of stock options granted is determined using the Black-Scholes option pricing model based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common stock. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant.

Grant period ended	Expected Life	Risk Free Interest Rate			Expected Volatility			Dividend Yield			Average Fair Value

September 30, 2011	6.5 years		1.50	%		22.51	%		—	%	$	1.05
September 30, 2010	6.5 years		3.20	%		18.95	%		—	%	$	0.34

A summary of stock option activity under the stock option plans as of September 30, 2011 and 2010, and changes during the nine months then ended are presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term ( Years)		Aggregate Intrinsic Value
September 30, 2011

Outstanding beginning of period		818,612		$	11.07
Granted		5,000			3.95
Exercised		—			—
Forfeited		(55,125	)		11.16
Expired		(178,439	)		10.10

Outstanding end of period		590,048		$	11.30		4.8	$	—

Exercisable end of period		411,768		$	12.88		3.4	$	—

September 30, 2010

Outstanding beginning of period		820,837		$	11.08
Granted		1,000			7.00
Exercised		—			—
Forfeited		(3,225	)		11.27

Outstanding end of period		818,612		$	11.07		4.6	$	—

Exercisable end of period		554,727		$	12.43		2.7	$	—

A summary of the status of the Company’s nonvested options as of September 30, 2011 and 2010 and changes during the nine months then ended are presented below:

	2011					2010
	Shares			Weighted Average Fair Value		Shares			Weighted Average Fair Value

Non-vested beginning of period		218,885		$	0.51		290,915		$	0.60
Granted		5,000			1.05		1,000			0.34
Vested		(19,305	)		1.71		(25,850	)		1.89
Forfeited		(26,300	)		0.50		(2,180	)		0.67

Non-vested end of period		178,280		$	0.39		263,885		$	0.47

The Company accounts for stock based compensation in accordance with GAAP, which requires measurement of compensation cost for all stock-based awards based on the grant date fair value and recognition of compensation cost over the service period of stock-based awards. Stock-based compensation expense during the nine months ended September 30, 2011 and 2010 was $19 and $34 ($13 and $22 net of tax), respectively. Future compensation expense for unvested awards outstanding as of September 30, 2011 is estimated to be $39 recognized over a weighted average period of 1.8 years. There were no options exercised during the nine months ended September 30, 2011 and 2010.

Note 6 – Commitments and Contingencies

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s off-balance sheet commitments at September 30, 2011 and December 31, 2010 is as follows:

	September 30,		December 31,
	2011		2010

Commitments to extend credit	$	92,836	$	90,888
Standby letters of credit		1,386		1,123

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the condensed consolidated financial statements.

The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the results of operations or financial condition of the Company.

Note 7 – Recent Accounting Pronouncements

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The provisions of ASU No. 2011-02 provide additional guidance related to determining whether a creditor has granted a concession, include factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibit creditors from using the borrower’s effective rate test to evaluate whether a concession has been granted to the borrower, and add factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision in ASU No. 2011-02 also ends the FASB’s deferral of the additional disclosures about troubled debt restructurings as required by ASU No. 2010-20. The provisions of ASU No. 2011-02 are effective for the Company’s reporting period ending September 30, 2011. The Company adopted the provisions of ASU No. 2010-20 retrospectively to all modifications and restructuring activities that have occurred from January 1, 2011 and it did not have a material impact on the Company’s consolidated financial statements. See Note 4 to the Consolidated Financial Statements for the disclosures required by ASU No. 2010-20.

In May 2011, FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards. The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The Company is currently assessing the impact of ASU 2011-04 on its consolidated financial statements.

In June 2011, FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. This ASU amends guidance to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. ASU 2011-05 should be applied retrospectively and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011.

In September 2011, FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment.” The provisions of ASU No. 2011-08 permit an entity an option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further impairment testing is required. ASU No. 2011-08 includes examples of events and circumstances that may indicate that a reporting unit’s fair value is less than its carrying amount. The provisions of ASU No. 2011-08 are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted provided that the entity has not yet performed its annual impairment test for goodwill. The Company performs its annual impairment test for goodwill in the second quarter of each year. The adoption of ASU No. 2011-08 is not expected to have a material impact on the Company’s consolidated financial statements.

Note 8 – Fair Value Measurements

The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities and mutual funds actively traded in over-the-counter markets.

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third-party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.

Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2011 and December 31, 2010.

September 30, 2011	Readily Available Market Prices Level 1		Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Total

Securities available-for-sale
U.S. Government securities	$	—	$	114	$	—	$	114
State and municipal securities		—		23,198		1,166		24,364
Agency MBS		—		17,605		—		17,605
Non-agency MBS		—		6,564		—		6,564
Corporate bonds		—		1,989		—		1,989

Total	$	—	$	49,470	$	1,166	$	50,636

December 31, 2010

Securities available-for-sale
U.S. Government securities	$	—	$	1,109	$	—	$	1,109
State and municipal securities		—		19,995		1,157		21,152
Agency MBS		—		7,730		—		7,730
Non-agency MBS		—		8,884		—		8,884
Corporate bonds		1,069		1,949		—		3,018

Total	$	1,069	$	39,667	$	1,157	$	41,893

The Company uses a third party pricing service to assist the Company in determining the fair value of the investment portfolio. The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2011 and 2010, respectively. There were no transfers of assets in to or out of Level 3 for the nine months ended September 30, 2011.

	Three months ended September 30,				Nine months ended September 30,
	2011		2010		2011		2010

Balance beginning of period	$	1,135	$	1,484	$	1,157	$	1,593
Included in other comprehensive income (loss)		31		27		9		(82	)

Balance end of period	$	1,166	$	1,511	$	1,166	$	1,511

Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and other real estate owned (“OREO”). The following methods were used to estimate the fair value of each such class of financial instrument:

Loans held for sale – Loans held for sale are carried at the lower of cost or fair value. Loans held for sale are measured at fair value based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined based on an aggregated loan basis. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs.

Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent.

Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re-evaluation of the property fair value are charged to non-interest expense.

The following table presents the Company’s assets that were held at the end of each period that were accounted for at fair value on a nonrecurring basis at September 30, 2011 and December 31, 2010.

	Readily Available Market Prices Level 1		Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Total
September 30, 2011
Impaired loans	$	—	$	—	$	6,590	$	6,590
OREO	$	—	$	—	$	4,782	$	4,782

December 31, 2010
Loans held for sale	$	—	$	10,144	$	—	$	10,144
Impaired loans	$	—	$	—	$	2,755	$	2,755
OREO	$	—	$	—	$	5,245	$	5,245

Other real estate owned with a pre-foreclosure loan balance of $4,615 was acquired during the nine months ended September 30, 2011. Upon foreclosure, these assets were written down $178 to their fair value, less estimated costs to sell, which was charged to the allowance for credit losses during the period.

The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements:

Cash and due from banks, Interest bearing deposits in banks, and Federal funds sold

The carrying amounts of cash, interest bearing deposits at other financial institutions, and federal funds sold approximate their fair value.

Investment Securities Available-for-Sale and Held-to-Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and analysis of discounted cash flows.

Loans, net and Loans held for sale

The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair values of loans held for sale are based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was based on an aggregate loan basis.

Deposits

The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates.

Secured borrowings

For variable rate secured borrowings that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.

Short-term borrowings

The fair values of the Company’s short-term borrowings are estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

Long-term borrowings

The fair values of the Company’s long-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements.

Junior subordinated debentures

The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures.

Off-Balance-Sheet Instruments

The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off-balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value.

The estimated fair value of the Company’s financial instruments at September 30, 2011 and December 31, 2010 are as follows:

	2011				2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial Assets
Cash and due from banks, interest-bearing deposits in banks, and federal funds sold	$	51,940	$	51,940	$	61,758	$	61,758
Investment securities available-for-sale		50,636		50,636		41,893		41,893
Investment securities held–to-maturity		7,130		7,241		6,454		6,584
Loans held for sale		11,845		12,224		10,144		10,144
Loans, net		463,540		417,864		455,064		408,261

	2011				2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value

Financial Liabilities
Deposits	$	560,937	$	562,116	$	544,954	$	546,753
Short-term borrowings		—		—		10,500		10,775
Long-term borrowings		10,500		10,846		10,500		10,858
Secured borrowings		755		755		925		925
Junior subordinated debentures		13,403		6,515		13,403		6,916

Note 9 – Goodwill

The majority of goodwill and intangibles generally arise from business combinations accounted for under the purchase method. Goodwill and other intangibles deemed to have indefinite lives generated from purchase business combinations are not subject to amortization and are instead tested for impairment no less than annually. The Company has one reporting unit, the Bank, for purposes of computing goodwill.

During the second quarter of 2011, the Company initiated its annual goodwill impairment test to determine whether an impairment of its goodwill asset exists. The test was completed during the current quarter. The goodwill impairment test involves a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company is required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit and, in accordance with applicable GAAP standards, compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet. If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination. The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining whether a goodwill impairment exists and the amount of any such impairment. No assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process.

The Company estimates fair value using the best information available, including market information and a discounted cash flow analysis, which is also referred to as the income approach. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a rate that reflects current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in loans and deposits, estimates of future expected changes in net interest margins and cash expenditures. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting unit. We validate our estimated fair value by comparing the fair value estimates using the income approach to the fair value estimates using the market approach.

As part of our process for performing the step one impairment test of goodwill, the Company estimated the fair value of the reporting unit utilizing the income approach and the market approach in order to derive an enterprise value of the Company. In determining the discount rate for the discounted cash flow model, the Company used a modified capital asset pricing model that develops a rate of return utilizing a risk-free rate and equity risk premium resulting in a discount rate of 14.5%. This approach also includes adjustments for the industry the Company operates in and size of the Company. In addition, assumptions used by the Company in its discounted cash flow model (income approach) included an average annual revenue growth rate that approximated 2%; an asset growth of 1% in year one, 2% in year two, 3% annually in years three through five and 4% in year six; net interest margin of 4.21%; and a return on assets that ranged from 0.2% to 1.1%.

In applying the market approach method, the Company considered all acquired banks between January 1, 2010 and June 30, 2011 with total assets between $100 million and $5 billion and non-performing assets to total assets between 2% and 6%. This resulted in selecting 23 comparable institutions which were analyzed based on a variety of financial metrics (tangible equity, return on assets, return on equity, net interest margin, efficiency ratio, nonperforming assets, and reserves for loan losses). After selecting comparable institutions, the Company derived the fair value of the reporting unit by completing a comparative analysis of the relationship between their financial metrics listed above and their market values utilizing various market multiples. Focus was placed on the price to tangible book value of equity multiple as this multiple generally reflects returns on the capital employed within the industry and is generally correlated with the profitability of each individual company.

The Company concluded a fair value of its reporting unit of $69.0 million, by giving similar consideration to the values derived from 1) the corporate value approach of $69.0 million, 2) the income approach of $67.6 million, and 3) the market approach of $69.1 million; compared to a carrying value of its reporting unit of $75.2 million. Based on the results of the step one goodwill impairment analysis, the Company determined the second step must be performed.

In the second step the Company calculates the implied fair value of its reporting unit. Under the step two goodwill impairment analysis, the Company calculated the fair value for its unrecognized core deposit intangible, as well as the remaining assets and liabilities of the reporting unit. Significant adjustments were made to the fair value of the Company’s loans receivable compared to its recorded value. The fair value of loans was estimated by calculating the present value of the expected cash flows of the loans over their lives discounted by the applicable risk-adjusted market rate for each loan category. The discount rates used to calculate the present value of each of the loan categories were developed from the option-adjusted spreads over comparable maturity Treasury securities with adjustments for credit risk grades. Because credit risk grades for some loan categories fall between primary credit risk grades, a risk grade differential was calculated to allow for interpolation of the option-adjusted spreads. The Company segregated its loan portfolio into fourteen categories based on collateral type. The weighted average discount rates for these individual categories ranged from 5.0% to 11.4%. The calculated implied fair value of the Company’s goodwill totaled $14.7 million and exceeded the carrying value by $3.4 million, or 30.1%. Based on results of the second step of the impairment test, the Company determined no impairment charge of goodwill was required.

Even though the Company determined that there was no goodwill impairment, continued declines in the value of our stock price as well as values of others in the financial industry, declines in revenue for the Bank and significant adverse changes in the operating environment for the financial industry may result in a future impairment charge. It is possible that changes in circumstances existing at the measurement date or at other times in the future, or in the numerous estimates associated with management’s judgments, assumptions and estimates made in assessing the fair value of our goodwill, could result in an impairment charge of a portion or all of our goodwill. If the Company recorded an impairment charge, its financial position and results of operations would be adversely affected, however, such an impairment charge would have no impact on our liquidity, operations or regulatory capital.

ITEM 2 – MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A Warning About Forward-Looking Information

This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the present beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and statements preceded by, followed by or that include the words "believes," "expects," "anticipates," "intends," "plans," "estimates" or similar expressions.

Any forward-looking statements in this document are subject to the risks of our business, including risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 10-K”), as well as risks relating to, among other things, the following:

1. changing laws, regulations, standards, and government programs that may limit our revenue sources, significantly increase our costs, including compliance and insurance costs, limit our opportunities to generate noninterest income, and place additional burdens on our limited management resources;

2. poor economic or business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, a deterioration in credit quality and/or reduced demand for credit and other banking services, and additional workout and other real estate owned (“OREO”) expenses;

3. decreases in real estate and other asset prices, whether or not due to economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans;

4 competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, retain our key employees, and/or maintain and improve our net interest margin and income and non-interest income, such as fee income; and

5. a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.

Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

Overview

The Company is a bank holding company headquartered in Aberdeen, Washington. The Company's wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company also has two wholly-owned subsidiary trusts known as PFC Statutory Trust I and II (the “Trusts”) that were formed December 2005 and May 2006, respectively, in connection with the issuance of trust preferred securities. The Company was incorporated in the state of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through the Bank, which operates 16 branches located in communities in Grays Harbor, Pacific, Whatcom, Skagit and Wahkiakum counties in the state of Washington and one in Clatsop County, Oregon.

The Bank provides loan and deposit services to customers who are predominantly small and middle-market businesses and middle-income individuals.

Critical Accounting Policies

Critical accounting policies are discussed in the 2010 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies.” There have been no material changes in our critical accounting policies from the 2010 10-K. See the discussion under the subheading "Goodwill Valuation" below.

Recent Accounting Pronouncements

Please see Note 7 of the Company's Notes to Condensed Consolidated Financial Statements above for a discussion of recent accounting pronouncements and the likely effect on the Company.

Financial Summary

The following are significant trends reflected in the Company’s results of operations for the three and nine months ended September 30, 2011 and financial condition as of that date:

Net income for the three months ended September 30, 2011 was $1,204,000, an increase of $725,000 compared to the same period of the prior year, and represents the seventh consecutive quarter of profitability. The increase in net income in the current quarter was primarily related to increases in net interest income and gain on sale of investments coupled with decreases in FDIC assessments, which were partially offset by an increase in provision for credit losses. Net income for the nine months ended September 30, 2011 was $2,239,000, an increase of $623,000 compared to net income of $1,616,000 for the same period in 2010.

Return on average assets and return on average equity were 0.46% and 4.87%, respectively, for the nine months ended September 30, 2011, compared to 0.33% and 3.68%, respectively, for the same period in 2010.

Net interest income of $6,070,000 for the three months ended September 30, 2011 increased $327,000 compared to the same period of the prior year. Net interest income of $17,520,000 for the nine months ended September 30, 2011 increased $395,000 compared to the same period of the prior year. The increase is primarily the result of decreased funding costs. Net interest margin improved to 4.11% and 4.02%, respectively, for the three and nine months ended September 30, 2011 compared to 4.05% and 3.95%, respectively, in the same periods one year ago.

The Bank remains well capitalized with a tier 1 leverage ratio of 10.03% and a total risk-based capital ratio of 14.97% at September 30, 2011, compared to 9.80% and 14.62%, respectively, at December 31, 2010.

Total assets were $653,557,000 at September 30, 2011, an increase of $9,154,000, or 1.42%, over year-end 2010. Increases in investments, loans and OREO were the primary contributors to overall asset growth, which were partially offset by a decrease in cash as expected given planned run-off of brokered certificates of deposits. Total loans, including loans held for sale, of $486,308,000 at September 30, 2011 increased $10,483,000, or 2.20%, compared to year-end 2010.

Non-performing assets (“NPAs”) totaled $20,987,000 at September 30, 2011, which represents 3.21% of total assets, and is an increase from $16,579,000 at December 31, 2010. The increase is largely due to the addition of one loan totaling $3,627,000 to non-performing loans, of which $3,198,000 of the principal amount is guaranteed by the United States Department of Agriculture. Non-performing assets continue to be concentrated in construction and land development loans and related OREO, which represented $9,475,000, or 45.1%, of non-performing assets.

Provision for credit losses was $1,050,000 and $1,550,000 for the three and nine months ended September 30, 2011, respectively, compared to $850,000 and $2,850,000 for the same periods one year ago. The increase in the current quarter is primarily due to increased net charge-offs of $1,093,000 compared to $583,000 for the same period in 2010. The decrease in provision expense for the nine months ended is due to a decrease in year-to-date net charge-offs of $1,137,000 which was aided by a large recovery in the second quarter. The allowance for credit losses increased to 2.25% of total loans (including loans held for sale) compared to 2.23% at year-end 2010.

Total deposits of $560,937,000 at September 30, 2011 increased $15,983,000, or 2.93%, for the nine months ended September 30, 2011, compared to December 31, 2010, due to the cyclical nature of the Company’s tourist heavy branch locations and an increase in deposit balances held by escrow companies.

The Company’s liquidity ratio of approximately 42% at September 30, 2011 remains strong and translates into over $274 million in available funding to meet loan and deposit needs.

Results of Operations

Net income. For the three and nine months ended September 30, 2011, net income was $1,204,000 and $2,239,000, respectively, compared to $479,000 and $1,616,000 for the same periods in 2010. The increase in net income for the three month period was primarily related to increases in net interest income and gain on sale of investments. The increase in net income for the nine month period was primarily related to an increase in net interest income and a decrease in provision for credit losses which were partially offset by a decrease in gain on sale of loans.

Net interest income. Net interest income for the three and nine months ended September 30, 2011 increased $327,000 and $395,000, or 5.69% and 2.31%, respectively, compared to the same periods in 2010. See the table below and the accompanying discussion for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets and adjusted for tax on tax-exempt securities and loans) increased to 4.11% for the three months ended September 30, 2011 from 4.05% for the same period of the prior year. Net interest margin increased to 4.02% for the nine months ended September 30, 2011 from 3.95% for the same period last year. The increase in the current three and nine month period is due to a decrease in the average cost of funds to 1.25% at September 30, 2011 from 1.65% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.52% to 5.20%.

The following tables set forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

Three Months Ended September 30,

				2011									2010
				Interest									Interest
(dollars in thousands)	Average			Income			Avg			Average			Income			Avg
	Balance			(Expense)			Rate			Balance			(Expense)			Rate
Interest Earning Assets
Loans (1)	$	483,482		$	6,932	*		5.74	%	$	479,207		$	7,169	*		5.98	%
Taxable securities		30,473			260			3.41			24,758			275			4.44
Tax-exempt securities		25,083			388	*		6.19			23,826			366	*		6.14
Federal Home Loan Bank Stock		3,183			—			—			3,183			—			—
Interest earning balances with banks		48,627			29			0.24			35,992			29			0.32

Total interest earning assets	$	590,848		$	7,609			5.15	%	$	566,966		$	7,839			5.53	%

Cash and due from banks		10,700									11,006
Bank premises and equipment (net)		14,977									15,507
Other real estate owned		7,857									8,667
Other assets		41,980									44,326
Allowance for credit losses		(11,098	)								(11,524	)

Total assets	$	655,264								$	634,948

Interest Bearing Liabilities
Savings and interest bearing demand	$	282,974		$	(394	)		0.56	%	$	236,125		$	(425	)		0.72	%
Time deposits		174,513			(718	)		1.65			211,979			(1,125	)		2.12
Total deposits		457,487			(1,112	)		0.97			448,104			(1,550	)		1.38

Short-term borrowings		7,728			(69	)		3.57			8			—			—
Long-term borrowings		10,500			(79	)		3.01			21,261			(196	)		3.69
Secured borrowings		762			(9	)		4.72			945			(15	)		6.35
Junior subordinated debentures		13,403			(67	)		2.00			13,403			(127	)		3.79
Total borrowings		32,393			(224	)		2.77			35,617			(338	)		3.80

Total interest-bearing liabilities	$	489,880		$	(1,336	)		1.09	%	$	483,721		$	(1,888	)		1.56	%

Demand deposits		98,471									87,066
Other liabilities		4,273									4,129
Shareholders’ equity		62,640									60,032

Total liabilities and shareholders’ equity	$	655,264								$	634,948

Net interest income				$	6,273	*							$	5,951	*
Net interest spread								4.25	%								4.20	%
Net interest margin								4.11	%								4.05	%
Tax equivalent adjustment				$	203	*							$	208	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $138 and $112 in 2011 and 2010, respectively.

Nine Months Ended September 30,

				2011									2010
				Interest									Interest
(dollars in thousands)	Average			Income			Avg			Average			Income			Avg
	Balance			(Expense)			Rate			Balance			(Expense)			Rate
Interest Earning Assets
Loans (1)	$	481,470		$	20,681	*		5.73	%	$	486,996		$	21,734	*		5.95	%
Taxable securities		29,990			810			3.60			26,782			976			4.86
Tax-exempt securities		23,950			1,118	*		6.22			24,685			1,136	*		6.14
Federal Home Loan Bank Stock		3,183			—			—			3,183			—			—
Interest earning balances with banks		42,716			77			0.24			37,016			92			0.33

Total interest earning assets	$	581,309		$	22,686			5.20	%	$	578,662		$	23,938			5.52	%

Cash and due from banks		10,126									10,442
Bank premises and equipment (net)		15,090									15,679
Other real estate owned		7,287									7,892
Other assets		41,842									43,798
Allowance for credit losses		(11,022	)								(11,476	)

Total assets	$	644,632								$	644,997

Interest Bearing Liabilities
Savings and interest bearing demand	$	271,496		$	(1,261	)		0.62	%	$	232,591		$	(1,301	)		0.75	%
Time deposits		183,117			(2,470	)		1.80			228,400			(3,817	)		2.23
Total deposits		454,613			(3,731	)		1.09			460,991			(5,118	)		1.48

Short-term borrowings		9,205			(265	)		3.84			3			—			—
Long-term borrowings		10,500			(256	)		3.25			23,907			(656	)		3.66
Secured borrowings		802			(32	)		5.32			958			(46	)		6.40
Junior subordinated debentures		13,403			(280	)		2.79			13,403			(372	)		3.70
Total borrowings		33,910			(833	)		3.28			38,271			(1,074	)		3.74

Total interest-bearing liabilities	$	488,523		$	(4,564	)		1.25	%	$	499,262		$	(6,192	)		1.65	%

Demand deposits		90,163									83,002
Other liabilities		4,608									4,154
Shareholders’ equity		61,338									58,579

Total liabilities and shareholders’ equity	$	644,632								$	644,997

Net interest income				$	18,122	*							$	17,746	*
Net interest spread								4.16	%								4.09	%
Net interest margin								4.02	%								3.95	%
Tax equivalent adjustment				$	602	*							$	621	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $378 and $408 in 2011 and 2010, respectively.

Interest and dividend income on a tax equivalent basis for the three and nine months ended September 30, 2011 decreased $230,000 and $1,252,000, or 2.93% and 5.23%, respectively, compared to the same periods in 2010. The decrease was primarily due to the decline in income earned on our loan portfolio as a result of lower average balances outstanding. Loans averaged $481,470,000 with an average yield of 5.73% for the nine months ended September 30, 2011, compared to average loans of $486,996,000 with an average yield of 5.95% for the same period in 2010. Interest and dividend income on investment securities on a tax equivalent basis for the nine months ended September 30, 2011 decreased $184,000, or 8.71%, compared to the same period in 2010. The decrease was attributable to the reduction in rates earned on adjustable rate mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment.

Average interest earning balances with banks for the nine months ended September 30, 2011 were $42,716,000 with an average yield of 0.24% compared to $37,016,000 with an average yield of 0.33% for the same period in 2010.

Interest expense for the three and nine months ended September 30, 2011 decreased $552,000 and $1,628,000, or 29.24% and 26.29%, respectively, compared to the same periods in 2010. The decrease is primarily attributable to a decrease in rates paid on time certificates of deposits and junior subordinated debentures. Average interest-bearing deposit balances for the nine months ended September 30, 2011 and 2010 were $454,613,000 and $460,991,000, respectively, with an average cost of 1.09% and 1.48%, respectively.

Average borrowings for the nine months ended September 30, 2011 were $33,910,000 with an average cost of 3.28% compared to $38,271,000 with an average cost of 3.74% for the same period in 2010. The decrease in average borrowing balances outstanding is primarily due to the maturity of $10,500,000 in FHLB advances in 2011. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits. Additionally, during the nine month period, junior subordinated debentures totaling $5,155,000 converted from a fixed rate to a variable rate, resulting in a decrease in the rate paid on the balance outstanding from 6.39% to approximately 1.85% and further improving net interest margin during the current year.

Provision and allowance for credit losses. The allowance for credit losses reflects management's current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period. Loans deemed uncollectible are charged against, and reduce the allowance.

Periodic provisions for credit losses are charged to current expense to replenish the allowance for credit losses in order to maintain the allowance at a level management considers adequate. The amount of provision is based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. Estimated loss factors used in the allowance for credit loss analysis are established based in part on historic charge-off data by loan category and economic conditions. During the three months ended September 30, 2011, the loss factors used in the allowance for credit losses were updated specifically on non-owner occupied commercial real estate loans from 1.25% to 1.00%, on pass rated residential real estate from 2.00% to 1.25%, and on speculative residential construction from 3.00% to 1.75%, based upon charge-off experience and other factors. For additional information, please see the discussion under the heading “Critical Accounting Policies” in Item 7 of our 2010 10-K.

During the three and nine months ended September 30, 2011, provision for credit losses totaled $1,050,000 and $1,550,000 compared to $850,000 and $2,850,000 for the same periods in 2010. The decrease in provision for credit losses in the current nine-month period is due to improving credit quality as evidenced by a decrease in non-accrual loans (net of government guarantees), a decrease in loans classified substandard, and a decrease in net charge-offs. Non-performing loans decreased from $9,999,000 at December 31, 2010, to $9,080,000 (excluding government guarantees of $3,128,000) at September 30, 2011, and loans classified as substandard also decreased by $6,138,000 from year end 2010 through September 30, 2011.

For the three and nine months ended September 30, 2011, net charge-offs were $1,093,000 and $1,294,000 compared to $583,000 and $2,431,000 for the same periods in 2010. Net charge-offs for the twelve months ended December 31, 2010 were $4,075,000. The ratio of net charge-offs to average loans outstanding for the nine months ended September 30, 2011 and 2010 was 0.27% and 0.50%, respectively.

At September 30, 2011, the allowance for credit losses was $10,923,000 compared to $10,617,000 at December 31, 2010, and $11,511,000 at September 30, 2010. The increase compared to year-end 2010 is due to provision for credit losses of $1,550,000 in 2011, which exceeded net charge-offs of $1,294,000 for the nine months ended September 30, 2011. The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.25%, 2.23% and 2.36%, at September 30, 2011, December 31, 2010 and September 30, 2010, respectively. The slight increase in the allowance for credit losses as a percentage of total loans in the current year is reflective of management’s review of qualitative factors including the continued uncertainty in the economy and financial industry, pervasive high unemployment rates in our geographic markets, and continued deterioration in real estate values, albeit at a slower pace than in the last two years.

The Company’s loan portfolio includes a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $56,774,000, $51,310,000, and $47,835,000 at September 30, 2011, December 31, 2010 and September 30, 2010, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.54%, 2.50%, and 2.62%, respectively.

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of significant management judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers' financial data, together with industry data, the competitive situation, the borrowers' management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth review, at a minimum of quarterly or more frequently as considered necessary, of all loans judged to present a possibility of loss (if, as a result of such quarterly analysis, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the board of directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses to be adequate at September 30, 2011.

Non-performing assets and other real estate owned. Non-performing assets totaled $20,987,000 at September 30, 2011. This represents 3.21% of total assets, compared to $16,579,000, or 2.57%, at December 31, 2010, and $16,279,000, or 2.57%, at September 30, 2010. Construction and land development loans, including related OREO balances, continue to be the primary component of non-performing assets, representing $9,475,000, or 45.1%, of non-performing assets.

The following table presents information related to the Company’s non-performing assets:

SUMMARY OF NON-PERFORMING ASSETS	September 30,			December 31,			September 30,
(in thousands)	2011			2010			2010

Accruing loans past due 90 days or more	$	—		$	—		$	—
Restructured loans on accrual status		398			—			—

Non-accrual loans:
Construction, land development and other land loans		4,852			5,529			2,299
Residential real estate 1-4 family		429			2,246			1,142
Commercial real estate (3)		6,419			803			1,613
Farmland		—			170			186
Commercial and industrial		180			1,251			1,350
Total non-accrual loans (2)		11,880			9,999			6,590

Total non-performing loans		12,278			9,999			6,590

OREO and repossessions		8,709			6,580			9,689
Total Non-Performing Assets	$	20,987		$	16,579		$	16,279

Allowance for credit losses	$	10,923		$	10,617		$	11,511
Allowance for credit losses to non-performing loans		88.96	%		106.18	%		174.67	%
Allowance for credit losses to non-performing assets		52.05	%		64.04	%		70.71	%
Non-performing loans to total loans (1)		2.59	%		2.15	%		1.41	%
Non-performing assets to total assets		3.21	%		2.57	%		2.57	%

(3)

Excludes loans held for sale.

(4)

Includes $4,942,000 and $932,000 in non-accrual troubled debt restructured loans (“TDRs”) as of September 30, 2011 and December 31, 2010, respectively. There were no TDRs as of September 30, 2010.

(5)

Includes one loan totaling $3,627,000 at September 30, 2011 of which $3,198,000 is guaranteed by the United States Department of Agriculture (“USDA”).

Non-performing loans increased $2,279,000, or 22.8%, from the balance at December 31, 2010 due to an increase in non-accrual commercial real estate loans. The increase is made up primarily of one loan totaling $3,627,000, of which $3,198,000 is guaranteed by the USDA. The level of non-performing assets is still considered elevated by historical standards and reflects the continued weakness in the real estate market and economy. The Company continues to aggressively monitor and identify non-performing assets and take action based upon available information. In addition to the increase in non-performing loans, OREO increased $2,129,000, or 32.4%, from the balance at December 31, 2010 due largely to the addition of one commercial real estate property totaling $1,056,000 and four residential land lots totaling $844,000 which were transferred from non-performing loans during the current three month period.

A troubled debt restructuring (“TDR”) is a loan for which the terms have been modified in order to grant a concession to a borrower that is experiencing financial difficulty. Troubled debt restructurings are considered impaired loans and reported as such. For more information regarding TDRs, see Note 4-“Loans” of the condensed consolidated financial statements. The Company had troubled debt restructures totaling $5,340,000 and $932,000 at September 30, 2011 and December 31, 2010, respectively, of which $4,942,000 were on non-accrual status at September 30, 2011 and $398,000 were accruing interest. TDRs as of December 31, 2010 were all on non-accrual status. There were no TDRs as of September 30, 2010. The increase in the current period is largely due to restructured construction and land loans.

Currently, it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or OREO every six to nine months. Based upon the appraisal review for non-performing loans, the Company will record the loan at the lower of carrying value or fair value of collateral (less costs to sell) by recording a charge-off to the allowance for credit losses or by designating a specific reserve per accounting principles generally accepted in the United States. Generally, the Company will record the charge-off rather than designate a specific reserve. As a result, the carrying amount of non-performing loans will not exceed the estimated value of the underlying collateral. During the nine months ended September 30, 2011 and 2010, as a result of these appraisals and other factors, the Company recorded OREO write-downs of $599,000 and $564,000, respectively, and net charge-offs of $1,294,000 and $2,431,000, respectively. The Company will continue to reevaluate non-performing assets over the coming months as market conditions change.

OREO at September 30, 2011 totaled $8,696,000 and consists of properties as follows: ten land or land development properties totaling $3,230,000, three residential construction properties totaling $995,000, six commercial real estate properties totaling $2,400,000, and eight single family residences collectively valued at $2,071,000. The balances are recorded at the estimated net realizable value of the real estate less selling costs.

Non-interest income and expense. Non-interest income for the three months ended September 30, 2011 increased by $440,000, or 21.84%, compared to the same period in 2011. The increase was the result of an increase in gain on sale of investment securities of $352,000 and gain on sale of loans of $74,000. Non-interest income for the nine months ended September 30, 2011 decreased by $1,042,000, or 16.80%, compared to the same period in 2010. The decrease is mostly attributable to a decrease in gain on sales of loans and OREO, as well as other-than-temporary-impairment (“OTTI”) losses. These negative factors were only partially offset by an increase in interchange revenue on debit cards which is included in other operating income. Gain on sales of loans, the largest component of non-interest income, totaled $1,084,000 and $2,183,000 for the three and nine months ended September 30, 2011 compared to $1,010,000 and $2,859,000 for the same periods in 2010. The decrease for the nine month period is due to a decline in mortgage refinancing activity compared to 2010 when government incentive programs (including tax credits) and decreasing mortgage rates resulted in unprecedented new mortgage and refinance activity. However, with a decrease in long-term mortgage rates during the current quarter, mortgage refinance activity has increased. Management expects volume for the fourth quarter of 2011 to be similar to prior year volume based on internal reports regarding mortgage loans in the pipeline. Origination of loans held for sale were $104,507,000 for the nine months ended September 30, 2011, compared to $141,541,000 for the same period in 2010.

Services charges on deposits for the three and nine months ended September 30, 2011 were relatively unchanged at $470,000 and $1,350,000 compared to $464,000 and $1,338,000, for the same periods in 2010, respectively.

The Bank recorded net gains on sale of securities available-for-sale of $352,000 and $536,000, during the three and nine months ended September 30, 2011, compared to $0 and $402,000, respectively, for the same periods in the prior year. For the three and nine months ended September 30, 2011 one non-agency mortgage-backed security was determined to be other-than-temporarily-impaired resulting in the Company recording in the prior two quarters $243,000 in impairment charges related to credit losses through earnings. As of September 30, 2011 an additional $338,000 in impairments not related to credit losses have been recorded through other comprehensive income. There were no additional OTTI securities at September 30, 2011 or December 31, 2010.

Total non-interest expense for the three and nine months ended September 30, 2011 decreased $271,000 and $127,000, or 4.28% and 0.67%, respectively, compared to the same periods in 2010. The decreases were mostly related to reductions in FDIC assessments, OREO operating costs, and occupancy and equipment expenses. These were partially offset by increases in salaries and employee benefits related to annual performance and merit increases, as well as temporary additions to staff to assist with a core system conversion that occurred in April 2011. Full time equivalent employees at September 30, 2011 were 212 compared to 223 at December 31, 2010.

Income taxes. The federal income tax expense (benefit) for the three and nine months ended September 30, 2011 was $211,000 and $97,000, respectively, as compared to $98,000 and ($60,000), respectively, for the three and nine months ended September 30, 2010. The effective tax rate for the nine months ended September 30, 2011 was 4.2%. The effective tax rate differs from the statutory rate of 34.4% due to tax exempt income representing an increasing share of income as investments in municipal securities and loans, income earned on BOLI, and tax credits received on investments in low income housing partnerships remained at historical levels, while other earnings declined.

Financial Condition

Assets. Total assets were $653,557,000 at September 30, 2011, an increase of $9,154,000, or 1.42%, over year-end 2010. Increases in investments, loans and OREO were the primary contributors to overall asset growth, which were partially offset by a decrease in cash as expected given planned run-off of brokered certificates of deposits.

Investments. The investment portfolio provides the Company with an income alternative to loans. The Company’s investment portfolio at September 30, 2011 was $57,766,000 compared to $48,347,000 at the end of 2010, an increase of $9,419,000, or 19.48%. During 2011, the Company sold $12,881,000 in securities for a gain of $536,000. The proceeds from sales of investment securities were reinvested back into the investment portfolio. For additional information on investments, see Note 3 of the Notes to Condensed Consolidated Financial Statements contained in "Item 1, Financial Statements."

Loans. Total loans, including loans held for sale, increased $10,483,000, or 2.20%, to $486,308,000 at September 30, 2011, compared to $475,825,000 at December 31, 2010. The increases were primarily in commercial and industrial loans and commercial real estate loans. Loan detail by category, including loans held for sale, as of September 30, 2011 and December 31, 2010 follows (in thousands):

	September 30,			December 31,
	2011			2010

Commercial and industrial	$	91,886		$	84,575
Real estate:
Construction and land development		46,202			46,256
Residential 1-4 family		88,960			89,212
Multi-family		7,433			9,113
Commercial real estate – owner occupied		118,452			109,936
Commercial real estate – non owner occupied		103,558			106,079
Farmland		21,728			22,354
Installment		8,957			9,128
Less unearned income		(868	)		(828	)
Total Loans		486,308			475,825
Allowance for credit losses		(10,923	)		(10,617	)

Net Loans	$	475,385		$	465,208

Interest and fees earned on our loan portfolio is our primary source of revenue. Gross loans represented 74.4% of total assets as of September 30, 2011, compared to 73.8% at December 31, 2010. The majority of the Company’s loan portfolio is comprised of commercial and industrial loans and real estate loans. The commercial and industrial loans are a diverse group of loans to small, medium, and larger businesses for purposes ranging from working capital needs to term financing of equipment.

The commercial real estate loan category constitutes 46% of our loan portfolio and generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. Loan to value ratios for the Company’s commercial real estate loans at origination generally do not exceed 75% and debt service ratios are generally 125% or better. While we have significant balances within this lending category, we believe that our lending policies and underwriting standards are sufficient to reduce risk even in a downturn in the commercial real estate market. Additionally, this is a sector in which we have significant long-term management experience. It is our strategic plan to seek growth in commercial and small business loans where available and in owner occupied commercial real estate loans.

We remain aggressive in managing our construction loan and land development portfolios. While these segments have historically played a significant role in our loan portfolio, balances have declined over the last three years. Construction and land development loans represented 9.5% and 9.7% of our loan portfolio at September 30, 2011 and at December 31, 2010, respectively. We believe this segment will remain challenged, although to a lesser extent than the previous two years.

The Bank is not engaging in new land acquisition and development financing. Limited residential speculative construction financing is being provided for a select group of borrowers, which is designed to facilitate exit from the related loans. It was the Company’s strategic objective to reduce concentrations in land and residential construction and total commercial real estate below the regulatory guidelines of 100% and 300% of risk based capital, respectively, which was completed in the first quarter of 2010. As of September 30, 2011, concentration in land and residential construction as a percentage of risk based capital stood at 57% and concentration in commercial real estate as a percentage of risk-based capital was 233%.

Deposits. Total deposits were $560,937,000 at September 30, 2011, an increase of $15,983,000, or 2.93%, compared to December 31, 2010. Deposit detail by category as of September 30, 2011 and December 31, 2010 follows (in thousands):

	September 30,		December 31,
	2011		2010

Demand, non-interest bearing	$	102,527	$	95,115
Interest bearing demand		122,121		103,358
Money market		109,423		93,996
Savings		63,474		55,993
Time, interest bearing		163,392		196,492

Total deposits	$	560,937	$	544,954

Non-maturity deposits (total deposits less time deposits) increased $49,083,000, or 14.09%, which is consistent with the cyclical pattern of our deposits for our tourist heavy locations in which balances typically reach their highest point in the third quarter of the year, in addition to increased money market balances for escrow companies.

Time deposits decreased $33,100,000, or 16.85%, which is largely due to a planned decrease in brokered deposits of $10,363,000. As a result, the percentage of time certificates of deposit to total deposits decreased to 29.1% at September 30, 2011, from 36.1% at December 31, 2010, which favorably impacted net interest margin.

It is our strategic goal to grow core deposits through the quality and breadth of our branch network, increased brand awareness, superior sales practices and competitive rates. In the long-term we anticipate continued growth in our core deposits through both the addition of new customers and our current client base. In addition, management’s strategy for funding asset growth as opportunities arise may include use of brokered and other wholesale deposits on an as-needed basis.

Liquidity. We believe adequate liquidity continues to be available to accommodate fluctuations in deposit levels, fund operations, provide for customer credit needs, and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, loan sales, loan repayments, net income, and other borrowings which are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition. In addition to customer deposits, when necessary, liquidity can be increased by taking advances from credit available to the Bank.

The Bank’s liquidity position at September 30, 2011, includes $51.9 million in cash and interest bearing deposits with banks and $50.6 million in investments classified as available-for-sale. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. In addition, the Bank maintains credit facilities with correspondent banks totaling $16,000,000, of which none was used as of September 30, 2011. The Bank also has a credit line with the Federal Home Loan Bank (“FHLB”) of Seattle for up to 20% of assets, of which $10,500,000 was used at September 30, 2011. Based on current pledged collateral, the Bank had $109.2 million of available borrowing capacity on its line at the FHLB, although each advance is subject to prior consent. The Bank also has a borrowing facility of $47.6 million at the Federal Reserve Bank subject to pledged collateral, of which none was used at September 30, 2011. Borrowings may be used on a short-term basis to compensate for reductions in deposits, but are generally not considered a long-term solution to liquidity needs.

The holding company specifically relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of shares of common stock for its funds, which are used for various corporate purposes. Dividends from the Bank are the holding company's most important source of funds, and are subject to regulatory restrictions and the capital needs of the Bank, which are always primary. Sales of trust preferred securities (“TRUPs”) have historically also been a source of liquidity for the holding company and capital for both the holding company and the Bank; however, we have not issued TRUPs since 2006 and do not anticipate TRUPs will be a source of liquidity in 2011 or beyond. The Company and the Bank are subject to certain restrictions on the payment of dividends without prior regulatory approval.

At September 30, 2011, two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13,403,000 of trust preferred securities. During 2009, the Company elected to exercise the right to defer interest payments on trust preferred debentures. Under the terms of the indenture, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going into default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. As of September 30, 2011, deferred interest totaled $1,180,000 and is included in accrued interest payable on the balance sheet.

For additional information regarding trust preferred securities, see the 2010 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity”.

Capital. The Federal Reserve and the FDIC have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines under the Federal Reserve require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8% to be considered adequately capitalized. To qualify as well capitalized under the FDIC guidelines, banks must have a Tier 1 leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6%, and a Total risk-based capital ratio of 10%. Failure to qualify as well capitalized can negatively impact a bank’s ability to expand and to engage in certain activities.

The capital ratios for the Company and the Bank at September 30, 2011 and December 31, 2010, were as follows:

	Company						Bank						Requirements
	September			December 31,			September			December			Adequately			Well
	30, 2011			2010			30, 2011			31, 2010			Capitalized			Capitalized

Tier 1 leverage ratio		9.87	%		9.72	%		10.03	%		9.80	%		4	%		5	%
Tier 1 risk-based capital ratio		13.47	%		13.21	%		13.70	%		13.35	%		4	%		6	%
Total risk-based capital ratio		14.73	%		14.48	%		14.97	%		14.62	%		8	%		10	%

Total shareholders' equity was $63,045,000 at September 30, 2011, an increase of $3,276,000, or 5.48%, compared to December 31, 2010.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate, credit, and operations risks are the most significant market risks that affect the Company's performance. The Company relies on loan review, prudent loan underwriting standards, and an adequate allowance for possible credit losses to mitigate credit risk.

An asset/liability management simulation model is used to measure interest rate risk. The model produces regulatory oriented measurements of interest rate risk exposure. The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios. The present value of equity is defined as the difference between the market value of assets less current liabilities. By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.

The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period. Therefore, a significant increase in market rates of interest could improve net interest income. Conversely, a decreasing rate environment may adversely affect net interest income.

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the simulation model results are not exact measures of the Company's actual interest rate risk. They are only indicators of rate risk exposure based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company's actual rate risk. That is due to the modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of September 30, 2011 and believes that there has been no material change since December 31, 2010.

ITEM 4. CONTROLS AND PROCEDURES

The Company's disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934 ("Exchange Act") is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company's disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosures.

No change in the Company's internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1.

LEGAL PROCEEDINGS

Not applicable.

ITEM 1A.

RISK FACTORS

There has been no material change from the risk factors previously reported in the 2010 10-K.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

[Reserved]

ITEM 5.

OTHER INFORMATION

None.

ITEM 6.

EXHIBITS

See Exhibit Index immediately following signatures below.

SIGNATURES

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

	PACIFIC FINANCIAL CORPORATION

DATED: November 14, 2011		By:	/s/ Dennis A. Long
			Dennis A. Long
			Chief Executive Officer

		By:	/s/ Denise Portmann
			Denise Portmann
			Chief Financial Officer

EXHIBIT INDEX

EXHIBIT NO.		EXHIBIT

31.1		Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2		Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32		Certification of CEO and CFO under 18 U.S.C. Section 1350.
101.		INS XBRL Instance Document *
101.		SCH XBRL Taxonomy Extension Schema Document *
101.		CAL XBRL Taxonomy Extension Calculation Linkbase Document *
101.		DEF XBRL Taxonomy Extension Definition Linkbase Document *
101.		LAB XBRL Taxonomy Extension Label Linkbase Document *
101.		PRE XBRL Taxonomy Extension Presentation Linkbase Document *

* Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended and otherwise are not subject to liability under those sections.