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

Unassociated Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2011

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

For the transition period from ____________ to ____________

Commission File Number 000-29829

PACIFIC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

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

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 o

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).

o Large Accelerated Filer

o Accelerated Filer

o 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 o No x

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

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	1

ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)	1

	CONDENSED CONSOLIDATED BALANCE SHEETS JUNE 30, 2011 AND DECEMBER 31, 2010	1

	CONDENSED CONSOLIDATED STATEMENTS OF INCOME THREE AND SIX MONTHS ENDED JUNE 30, 2011 AND 2010	3

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED JUNE 30, 2011 AND 2010	4

	CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY SIX MONTHS ENDED JUNE 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	23

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	37

ITEM 4.	CONTROLS AND PROCEDURES	37

PART II	OTHER INFORMATION	38

ITEM 1.	LEGAL PROCEEDINGS	38

ITEM 1A.	RISK FACTORS	38

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	38

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	38

ITEM 4.	[RESERVED]	38

ITEM 5.	OTHER INFORMATION	38

ITEM 6.	EXHIBITS	38

	SIGNATURES	39

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Balance Sheets

June 30, 2011 and December 31, 2010

(Dollars in thousands) (Unaudited)

	June 30, 2011			December 31, 2010
Assets
Cash and due from banks	$	11,431		$	7,428
Interest bearing deposits in banks		34,394			54,330
Investment securities available-for-sale (amortized cost of
$47,822 and $42,402)		47,990			41,893
Investment securities held-to-maturity (fair value of $7,269
and $6,584)		7,151			6,454
Federal Home Loan Bank stock, at cost		3,182			3,182
Loans held for sale		9,618			10,144

Loans		477,349			465,681
Allowance for credit losses		10,966			10,617
Loans, net		466,383			455,064

Premises and equipment		15,024			15,181
Other real estate owned		6,785			6,580
Accrued interest receivable		2,371			2,334
Cash surrender value of life insurance		17,011			16,748
Goodwill		11,282			11,282
Other intangible assets		1,268			1,303
Other assets		9,766			12,480

Total assets	$	643,656		$	644,403

Liabilities and Shareholders' Equity
Deposits:
Demand, non-interest bearing	$	92,441		$	95,115
Savings and interest-bearing demand		271,401			253,347
Time, interest-bearing		180,101			196,492
Total deposits		543,943			544,954

Accrued interest payable		1,475			1,380
Secured borrowings		768			925
Short-term borrowings		9,000			10,500
Long-term borrowings		10,500			10,500
Junior subordinated debentures		13,403			13,403
Other liabilities		3,256			2,972
Total liabilities		582,345			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 June 30, 2011 and
December 31, 2010		10,122			10,122
Additional paid-in capital		41,328			41,316
Retained earnings		10,268			9,233
Accumulated other comprehensive loss		(407	)		(902	)
Total shareholders' equity		61,311			59,769

Total liabilities and shareholders' equity	$	643,656		$	644,403

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Income

Three and six months ended June 30, 2011 and 2010

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

	Three Months Ended June 30						Six Months Ended June 30,
	2011			2010			2011			2010
Interest and dividend income
Loans	$	6,773		$	7,179		$	13,598		$	14,413
Investment securities and FHLB dividends		516			551			1,032			1,210
Deposits with banks and federal funds sold		24			26			48			63
Total interest and dividend income		7,313			7,756			14,678			15,686

Interest Expense
Deposits		1,254			1,708			2,619			3,568
Other borrowings		294			368			609			736
Total interest expense		1,548			2,076			3,228			4,304

Net Interest Income		5,765			5,680			11,450			11,382
Provision for credit losses		—			1,200			500			2,000
Net interest income after provision for credit losses		5,765			4,480			10,950			9,382

Non-interest Income
Service charges on deposits		466			514			880			874
Net gain (loss) on sales of other real estate owned		(146	)		229			(143	)		254
Gain on sales of loans		546			1,105			1,099			1,849
Gain on sales of investments available-for-sale, net		74			173			184			402

Total other-than-temporary impairment losses (“OTTI”)		12						(610	)
Portion of loss recognized in other comprehensive		(62	)					367
income (before taxes)
Net OTTI losses recognized in earnings		(50	)		—			(243	)		—

Earnings on bank owned life insurance		134			134			263			265
Other operating income		350			301			664			542
Total non-interest income		1,374			2,456			2,704			4,186

Non-interest Expense
Salaries and employee benefits		3,397			3,298			6,825			6,535
Occupancy and equipment		641			682			1,285			1,374
Other real estate owned write-downs		422			343			537			491
Other real estate owned operating costs		112			137			204			259
Professional services		225			183			400			378
FDIC and State assessments		183			343			496			711
Data processing		302			243			584			557
Other		1,312			1,278			2,402			2,284
Total non-interest expense		6,594			6,507			12,733			12,589

Income before income taxes		545			429			921			979
Benefit for income taxes		(58	)		(74	)		(114	)		(158	)
Net Income	$	603		$	503		$	1,035		$	1,137

Earnings per common share:
Basic	$	0.06		$	0.05		$	0.10		$	0.11
Diluted		0.06			0.05			0.10			0.11
Weighted Average shares outstanding:
Basic		10,121,853			10,121,853			10,121,853			10,121,853
Diluted		10,121,853			10,121,853			10,121,853			10,121,853

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Cash Flows

Six months ended June 30, 2011 and 2010

(Dollars in thousands)

(Unaudited)

	2011			2010
OPERATING ACTIVITIES
Net income	$	1,035		$	1,137
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		500			2,000
Depreciation and amortization		753			796
Origination of loans held for sale		(60,088	)		(84,957	)
Proceeds of loans held for sale		61,713			86,959
Gain on sales of loans		(1,099	)		(1,849	)
Gain on sale of investments available-for-sale		(184	)		(402	)
Net OTTI losses recognized in earnings		243			—
Net (gain) loss on sale of other real estate owned		143			(254	)
Loss on sale of premises and equipment		—			4
(Increase ) decrease in accrued interest receivable		(37	)		139
Increase in accrued interest payable		95			63
Other real estate owned write-downs		537			491
Other, net		2,582			(69	)
Net cash provided by operating activities		6,193			4,058

INVESTING ACTIVITIES
Net decrease in federal funds sold		—			5,000
Net (increase) decrease in interest bearing balances with banks		19,936			(4,612	)
Purchase of securities held-to-maturity		(828	)		(56	)
Purchase of securities available-for-sale		(13,169	)		(5,711	)
Proceeds from maturities of investments held-to-maturity		130			862
Proceeds from sales of securities available-for-sale		5,089			15,669
Proceeds from maturities of securities available-for-sale		2,473			2,906
Net (increase) decrease in loans		(13,413	)		7,728
Additions to other real estate owned		(183	)		—
Proceeds from sales of other real estate owned		859			3,140
Purchase of premises and equipment		(416	)		(213	)
Net cash provided by investing activities		478			24,713

FINANCING ACTIVITIES
Net decrease in deposits		(1,011	)		(28,880	)
Net decrease in short-term borrowings		(1,500	)		(1,500	)
Proceeds from issuance of long-term borrowings		5,000			—
Repayment of long-term borrowings		(5,000	)		—
Net decrease in secured borrowings		(157	)		(25	)
Net cash used in financing activities		(2,668	)		(30,405	)

Net increase (decrease) in cash and due from banks		4,003			(1,634	)

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

End of period	$	11,431		$	11,202

(continued)

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	3,133		$	4,241
Income taxes		20			725

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Change in fair value of securities available-for-sale, net of tax	$	449		$	664
Other real estate owned acquired in settlement of loans		(2,383	)		(3,599	)
Financed sale of other real estate owned		822			351
Reclass of long-term borrowings to short-term borrowings		—			1,500

See notes to condensed consolidated financial statements.

PACIFIC FINANCIAL CORPORATION

Condensed Consolidated Statements of Shareholders' Equity

Six months ended June 30, 2011 and 2010

(Dollars in thousands)

(Unaudited)

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

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

Other comprehensive income:
Net income								1,137					1,137
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)										664			664
Amortization of unrecognized prior service costs and net (gains)/losses										38			38
Comprehensive income													1,839

Stock compensation expense						23							23

Balance June 30, 2010		10,121,853	$	10,122	$	41,293	$	8,736	$	(640	)	$	59,511

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

Other comprehensive income:
Net income								1,035					1,035
Unrealized holding gain on securities of $488 (net of tax of $251) less reclassification adjustment for net losses included in net income of $39 (net of tax of $20)										449			449
Amortization of unrecognized prior service costs and net (gains)/losses										46			46
Comprehensive income													1,530

Stock compensation expense						12							12

Balance June 30, 2011		10,121,853	$	10,122	$	41,328	$	10,268	$	(407	)	$	61,311

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 six months ended June 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 June 30,				Six Months Ended June 30,
	2011		2010		2011		2010
Basic:
Net income	$	603	$	503	$	1,035	$	1,137
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Basic earnings per share	$	0.06	$	0.05	$	0.10	$	0.11
Diluted:
Net income	$	603	$	503	$	1,035	$	1,137
Weighted average shares outstanding		10,121,853		10,121,853		10,121,853		10,121,853
Effect of dilutive stock options		—		—		—		—
Weighted average shares outstanding assuming dilution		10,121,853		10,121,853		10,121,853		10,121,853
Diluted earnings per share	$	0.06	$	0.05	$	0.10	$	0.11

As of June 30, 2011 and 2010, there were 608,608 and 820,462 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
June 30, 2011
State and municipal securities	$	6,829	$	89	$	—	$	6,918
Agency MBS		322		29		—		351
Total	$	7,151	$	118	$	—	$	7,269

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
June 30, 2011
U.S. Government securities	$	6,658	$	127	$	3	$	6,782
State and municipal securities		20,929		729		30		21,628
Agency MBS		10,641		207		18		10,830
Non-agency MBS		8,578		6		844		7,740
Corporate bonds		1,016		—		6		1,010
Total	$	47,822	$	1,069	$	901	$	47,990

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 June 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
June 30, 2011
U.S. Government securities	$	996	$	3	$	—	$	—	$	996	$	3
State and municipal securities		2,460		30		—		—		2,460		30
Agency MBS		3,916		18		—		—		3,916		18
Non-agency MBS		1,850		97		4,944		747		6,794		844
Corporate bonds		1,010		6		—		—		1,010		6
Total	$	10,232	$	154	$	4,944	$	747	$	15,176	$	901

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 June 30, 2011, there were 20 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 June 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 six months ended June 30, 2011, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $367 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 $184 and $513 and gross losses realized were $0 and $111 during the six months ended June 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 (including loans held for sale) at June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011			December 31, 2010

Commercial and industrial	$	88,421		$	84,575
Residential real estate:
Residential 1-4 family		86,767			89,212
Multi-family		10,452			9,113
Commercial real estate:
Construction and land development		47,040			46,256
Commercial real estate – owner occupied		116,240			109,936
Commercial real estate – non owner occupied		108,226			106,079
Farmland		21,505			22,354
Installment		9,177			9,128
Less unearned income		(861	)		(828	)

Total Loans	$	486,967		$	475,825

Changes in the allowance for credit losses and recorded investment in loans for the three months ended June 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	$	843		$	5,610		$	1,885		$	673		$	1,763		$	10,774		$	11,827
Charge-offs		(52	)		(252	)		(58	)		(17	)		—			(379	)		(1,788	)
Recoveries		59			511			—			1			—			571			5
Provision for credit losses		(21	)		541			(229	)		(254	)		(37	)		—			1,200

Ending balance	$	829		$	6,410		$	1,598		$	403		$	1,726		$	10,966		$	11,244

Ending balance: individually evaluated for impairment		—			64			16			—			—			80			407

Ending balance: collectively evaluated for impairment		829			6,346			1,582			403			1,726			10,886			10,837

Loans:
Ending balance individually evaluated for impairment	$	193		$	12,399		$	766		$	—		$	—		$	13,358		$	14,619

Ending balance: collectively evaluated for impairment		88,228			280,612			96,453			9,177			—			474,470			467,964

Ending balance	$	88,421		$	293,011		$	97,219		$	9,177		$	—		$	487,828		$	482,583

Less unearned income																	(861	)		(753	)

Ending balance total loans																$	486,967		$	481,830

Changes in the allowance for credit losses and recorded investment in loans for the six months ended June 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		(98	)		(550	)		(90	)		(25	)		—			(763	)		(1,868	)
Recoveries		68			514			25			5			—			612			20
Provision for credit losses		43			1,061			(91	)		(267	)		(246	)		500			2,000

Ending balance	$	829		$	6,410		$	1,598		$	403		$	1,726		$	10,966		$	11,244

Ending balance: individually evaluated for impairment		—			64			16			—			—			80			407

Ending balance: collectively evaluated for impairment		829			6,346			1,582			403			1,726			10,886			10,837

Loans:
Ending balance: individually evaluated for impairment	$	193		$	12,399		$	766		$	—		$	—		$	13,358		$	14,619

Ending balance: collectively evaluated for impairment		88,228			280,612			96,453			9,177			—			474,470			467,964

Ending balance	$	88,421		$	293,011		$	97,219		$	9,177		$	—		$	487,828		$	482,583

Less unearned income																	(861	)		(753	)

Ending balance total loans																$	486,967		$	481,830

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. In the table below Watch loans are included in the Pass category. 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 June 30, 2011 are as follows:

	Pass		Other Loans Especially Mentioned		Substandard		Doubtful		Total
Commercial	$	84,857	$	2,767	$	797	$	—	$	88,421

Real estate:
Construction and development		33,874		2,816		10,350		—		47,040
Residential 1-4 family		81,348		1,454		3,965		—		86,767
Multi-family		9,618		—		834		—		10,452
CRE – owner occupied		111,400		682		4,158		—		116,240
CRE – non owner occupied		64,911		27,415		15,900		—		108,226
Farmland		21,328		115		62		—		21,505
Total real estate		322,479		32,482		35,269		—		390,230

Consumer		9,021		75		59		22		9,177

Subtotal	$	416,357	$	35,324	$	36,125	$	22	$	487,828
Less unearned income										(861	)

Total loans									$	486,967

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:

	June 30, 2011		December 31, 2010

Commercial	$	193	$	1,251
Real estate
Construction and development		6,304		5,529
Residential 1-4 family		764		2,246
Commercial real estate – owner occupied		1,564		470
Commercial real estate – non-owner occupied (1)		4,133		333
Farmland		—		170
Total real estate		12,765		8,748

Total	$	12,958	$	9,999

(1)	Includes one loan at June 30, 2011 totaling $3,997,000 of which 80% is guaranteed by the United States Department of Agriculture.

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

	Recorded Investment		Unpaid Principal Balance		Related Allowance		3 Month Average Recorded Investment		6 Month Average Recorded Investment		3 Months Interest Income Recognized		6 Months Interest Income Recognized
With no related allowance recorded:
Commercial	$	193	$	206	$	—	$	154	$	355	$	3	$	11
Residential real estate		695		879		—		1,215		1,878		8		11
Commercial real estate:
CRE – owner occupied		1,564		1,607		—		1,535		1,265		—		2
CRE – non-owner occupied		4,133		4,133		—		2,135		2,337		21		21
Construction and development		4,858		5,512		—		6,011		6,252		5		72

With an allowance recorded:
Commercial		—		—		—		251		337		—		5
Residential real estate		71		71		16		36		24		—		—
Construction and development		1,844		3,266		64		922		615		—		52

Total:
Commercial		193		206		—		405		692		3		16
Residential real estate		766		950		16		1,251		1,902		8		11
Commercial real estate:
CRE – owner occupied		1,564		1,607		—		1,535		1,265		—		2
CRE – non-owner occupied		4,133		4,133		—		2,135		2,337		21		21
Construction and development		6,702		8,778		64		6,933		6,867		5		124

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

The following table provides an age analysis of past due loans at June 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	$	789	$	39	$	189	$	1,017	$	87,404		$	88,421		$	—

Real estate:
Construction & development		—		—		1,075		1,075		45,965			47,040			—
Residential 1-4 family		—		252		381		633		86,134			86,767			—
Multi-family		—		—		—		—		10,452			10,452			—
CRE owner occupied		771		917		1,544		3,232		113,008			116,240			—
CRE non-owner occupied (1)		—		129		4,133		4,262		103,964			108,226			—
Farmland		62		—		—		62		21,443			21,505			—
Total real estate		833		1,298		7,133		9,264		380,966			390,230			—

Consumer		43		—		—		43		9,134			9,177			—

Less unearned income		—		—		—		—		(861	)		(861	)		—

Total	$	1,665	$	1,337	$	7,322	$	10,324	$	476,643		$	486,967		$	—

(1)	Includes one loan past due more than 90 days totaling $3,997,000 of which 80% 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		$	—

Note 5 – Stock Based Compensation

The Company’s 2000 Stock Incentive Plan (the “2000 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
June 30, 2010		6.5 years			3.20	%			18.95	%			—	%		$	0.34

There were no options granted during the six months ended June 30, 2011.

A summary of stock option activity under the stock option plan as of June 30, 2011 and 2010, and changes during the six months then ended are presented below:

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term ( Years)		Aggregate Intrinsic Value
June 30, 2011
Outstanding beginning of period		818,612		$	11.07
Granted		—			—
Exercised		—			—
Forfeited		(32,225	)		10.40
Expired		(177,779	)		10.10

Outstanding end of period		608,608		$	11.39		4.8	$	—
Exercisable end of period		426,358		$	12.93		3.6	$	—

June 30, 2010

Outstanding beginning of period		820,837		$	11.08
Granted		1,000			7.00
Exercised		—			—
Forfeited		(1,375	)		11.75

Outstanding end of period		820,462		$	11.07		4.8	$	—
Exercisable end of period		550,217		$	12.42		2.9	$	—

A summary of the status of the Company’s nonvested options as of June 30, 2011 and 2010 and changes during the six 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		—			—		1,000			0.34
Vested		(17,765	)		1.77		(20,680	)		2.02
Forfeited		(18,870	)		0.49		(990	)		0.92
Non-vested end of period		182,250		$	0.38		270,245		$	0.49

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 six months ended June 30, 2011 and 2010 was $12 and $23 ($8 and $15 net of tax), respectively. Future compensation expense for unvested awards outstanding as of June 30, 2011 is estimated to be $40 recognized over a weighted average period of 1.7 years. There were no options exercised during the six months ended June 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 June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011		December 31, 2010
Commitments to extend credit	$	91,845	$	90,888
Standby letters of credit		1,263		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. Retroactive application to January 1, 2011 is required. The Company is currently evaluating the impact of ASU No. 2011-02 on its consolidated financial statements.

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.

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 June 30, 2011 and December 31, 2010.

June 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	$	—	$	6,782	$	—	$	6,782
State and municipal securities		—		20,493		1,135		21,628
Agency MBS		—		10,830		—		10,830
Non-agency MBS		—		7,740		—		7,740
Corporate bonds		—		1,010		—		1,010

Total	$	—	$	46,855	$	1,135	$	47,990

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 six months ended June 30, 2011 and 2010, respectively. There were no transfers of assets in to or out of Level 3 for the six months ended June 30, 2011.

	2011			2010
Beginning balance	$	1,157		$	1,593
Included in other comprehensive loss		(22	)		(109	)

Balance end of period	$	1,135		$	1,484

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 June 30, 2011 and December 31, 2010.

	Readily Available Market Prices Level 1		Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Total
June 30, 2011
Impaired loans	$	—	$	—	$	3,490	$	3,490
OREO	$	—	$	—	$	4,610	$	4,610

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 $2,456 was acquired during the six months ended June 30, 2011. Upon foreclosure, these assets were written down $62 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 June 30, 2011 and December 31, 2010 are as follows:

	2011 Carrying Amount		Fair Value		2010 Carrying Amount		Fair Value
Financial Assets
Cash and due from banks, interest-bearing
deposits in banks, and federal funds sold	$	45,825	$	45,825	$	61,758	$	61,758
Investment securities available-for-sale		47,990		47,990		41,893		41,893
Investment securities held–to-maturity		7,151		7,269		6,454		6,584
Loans held for sale		9,618		9,618		10,144		10,144
Loans, net		466,383		428,646		455,064		408,261

Financial Liabilities
Deposits	$	543,943	$	533,073	$	544,954	$	546,753
Short-term borrowings		9,000		9,179		10,500		10,775
Long-term borrowings		10,500		10,786		10,500		10,858
Secured borrowings		768		768		925		925
Junior subordinated debentures		13,403		6,107		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 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 results of the Company’s step one test indicated that the reporting unit’s fair value was less than its carrying value, requiring the Company to perform step two of the goodwill impairment analysis. As of the date of this filing, we have not completed this step two analysis due to the complexities involved in determining the implied fair value of the goodwill for the reporting unit. However, based on work performed to date, we do not believe that an impairment loss is probable. We expect to finalize our goodwill impairment analysis during the third quarter of 2011. No assurance can be given that the Company will not be required to record an impairment loss on goodwill then or in the future. Valuation methodologies and material assumptions utilized are described in greater detail under “Goodwill Valuation” in the next section titled Management’s Discussion and Analysis of Financial Condition and Results of Operations and in the 2010 10-K under the subheading "Critical Accounting Policies.".

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, eliminate insurance currently available on some deposit products, significantly increase our costs, including compliance and insurance costs, limit our opportunties 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 six months ended June 30, 2011 and financial condition as of that date:

Net income for the three months ended June 30, 2011 was $603,000, an increase of $100,000 compared to the same period of the prior year, and represents the sixth consecutive quarter of profitability. The increase in net income in the current quarter was primarily related to a decrease in provision for credit losses which was partially offset by a decrease in gain on sale of loans. Net income for the six months ended June 30, 2011 was $1,035,000, a decrease of $102,000 compared to net income of $1,137,000 in the first half of 2010.

·	Return on average assets and return on average equity were 0.32% and 3.41%, respectively, for the six months ended June 30, 2011, compared to 0.35% and 3.92%, respectively, for the same period in 2010.

Net interest income of $5,765,000 for the three months ended June 30, 2011 increased $85,000 compared to the same period of the prior year. Net interest income of $11,450,000 for the six months ended June 30, 2011 increased $68,000 compared to the same period of the prior year. The increase is primarily the result of decreased funding costs. Net interest margin improved to 3.99% and 3.97%, respectively, for the three and six months ended June 30, 2011 compared to 3.94% and 3.89%, respectively, in the same periods one year ago.

·	The Bank remains well capitalized with a tier 1 leverage ratio of 10.05% and a total risk-based capital ratio of 14.48% at June 30, 2011, compared to 9.80% and 14.62%, respectively, at December 31, 2010.

Total assets were $643,656,000 at June 30, 2011, a decrease of $747,000, or 0.12%, over year-end 2010. Reduction in interest bearing deposits in banks was the primary contributor to overall asset decline, which was used to fund run-off in brokered deposits, and an increase in loans. Total loans of $486,967,000 at June 30, 2011 increased $11,668,000, or 2.51%, compared to year-end 2010.

Non-performing assets (“NPAs”) totaled $20,154,000 at June 30, 2011, which represents 3.13% 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 $3,997,000 to non-performing loans, of which 80% 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 $10,328,000, or 51.2%, of non-performing assets.

Provision for credit losses decreased to zero and $500,000 for the three and six months ended June 30, 2011, respectively, compared to $1,200,000 and $2,000,000 for the same periods one year ago. The decrease in the current quarter is due partly to net recoveries of $192,000 recognized in the second quarter of 2011 compared to net charge-offs of $1,783,000 for the same period in the prior year. 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.

·	The Company’s exposure to construction and land development loans totals $47.0 million at June 30, 2011, and accounts for approximately 9.7% of the total loan portfolio (including loans held for sale), as opposed to $56.2 million and 11.7% one year ago.

Total deposits of $543,943,000 at June 30, 2011 decreased $1,011,000, or 0.19%, for the six months ended June 30, 2011, compared to December 31, 2010, partly as a result of the maturity of $9,657,000 in brokered deposits. The maturity of brokered deposits was partially offset by growth in non-maturity deposits (total deposits less time certificates of deposits) of $15,380,000.

·	The Company’s liquidity ratio of approximately 39% at June 30, 2011 remains strong and translates into over $253 million in available funding to meet loan and deposit needs.

Results of Operations

Net income. For the three and six months ended June 30, 2011, net income was $603,000 and $1,035,000, respectively, compared to $503,000 and $1,137,000 for the same periods in 2010. The increase in net income for the three month period was primarily related to a decrease in provision for credit losses, which was zero in the current quarter. The decrease in net income for the six month period was primarily related to a decrease in the gain on sale of loans and an other-than-temporary impairment loss on investments available-for-sale, which were partially offset by a decrease in provision for credit losses.

Net interest income. Net interest income for the three and six months ended June 30, 2011 increased $85,000 and $68,000, or 1.50% and 0.60%, 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 3.99% for the three months ended June 30, 2011 from 3.94% for the same period of the prior year. Net interest margin increased to 3.97% for the six months ended June 30, 2011 from 3.89% for the same period last year. The increase in the current three and six month period is due to an improvement in the average cost of funds to 1.32% at June 30, 2011 from 1.70% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.51% to 5.23%.

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 June 30,

(dollars in thousands)	Average Balance			2011 Interest Income (Expense)			Avg Rate			Average Balance			2010 Interest Income (Expense)			Avg Rate
Interest Earning Assets
Loans (1)	$	480,874		$	6,850	*		5.70	%	$	491,056		$	7,260	*		5.91	%
Taxable securities		29,799			270			3.62			25,145			298			4.74
Tax-exempt securities		23,719			373	*		6.29			24,967			383	*		6.14
Federal Home Loan Bank Stock		3,183			- -			- -			3,183			- -			- -
Interest earning balances with banks		39,882			24			0.24			32,829			26			0.32

Total interest earning assets	$	577,457		$	7,517			5.21	%	$	577,180		$	7,967			5.52	%

Cash and due from banks		10,100									10,171
Bank premises and equipment (net)		15,129									15,669
Other real estate owned		7,221									7,831
Other assets		41,730									43,648
Allowance for credit losses		(11,099	)								(11,374	)

Total assets	$	640,538								$	643,125

Interest Bearing Liabilities
Savings and interest bearing demand	$	268,164		$	(424	)		0.63	%	$	233,198		$	(442	)		0.76	%
Time deposits		183,779			(830	)		1.81			227,322			(1,266	)		2.23
Total deposits		451,943			(1,254	)		1.11			460,520			(1,708	)		1.48

Short-term borrowings		9,940			(95	)		3.82			- -			- -			- -
Long-term borrowings		10,500			(89	)		3.39			25,005			(229	)		3.66
Secured borrowings		770			(10	)		5.19			964			(15	)		6.22
Junior subordinated debentures		13,403			(100	)		2.98			13,403			(124	)		3.70
Total borrowings		34,613			(294	)		3.40			39,372			(368	)		3.74

Total interest-bearing liabilities	$	486,556		$	(1,548	)		1.27	%	$	499,892		$	(2,076	)		1.66	%

Demand deposits		88,293									81,399
Other liabilities		4,564									3,826
Shareholders’ equity		61,125									58,008

Total liabilities and shareholders’ equity	$	640,538								$	643,125

Net interest income				$	5,969	*							$	5,891	*
Net interest spread								4.13	%								4.08	%
Net interest margin								3.99	%								3.94	%
Tax equivalent adjustment				$	204	*							$	211	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $75 and $138 in 2011 and 2010, respectively.

Six Months Ended June 30,

(dollars in thousands)	Average Balance			2011 Interest Income (Expense)			Avg Rate			Average Balance			2010 Interest Income (Expense)			Avg Rate
Interest Earning Assets
Loans (1)	$	480,463		$	13,749	*		5.72	%	$	490,948		$	14,565	*		5.93	%
Taxable securities		29,745			549			3.69			27,811			701			5.04
Tax-exempt securities		23,375			732	*		6.26			25,122			770	*		6.13
Federal Home Loan Bank Stock		3,183			- -			- -			3,183			- -			- -
Interest earning balances with banks		39,712			48			0.24			37,537			63			0.34

Total interest earning assets	$	576,478		$	15,078			5.23	%	$	584,601		$	16,099			5.51	%

Cash and due from banks		9,834									10,155
Bank premises and equipment (net)		15,148									15,766
Other real estate owned		6,997									7,498
Other assets		41,771									43,529
Allowance for credit losses		(10,984	)								(11,451	)

Total assets	$	639,244								$	650,098

Interest Bearing Liabilities
Savings and interest bearing demand	$	265,662		$	(867	)		0.65	%	$	230,795		$	(876	)		0.76	%
Time deposits		187,491			(1,752	)		1.87			236,746			(2,692	)		2.27
Total deposits		453,153			(2,619	)		1.16			467,541			(3,568	)		1.53

Short-term borrowings		10,218			(195	)		3.82			- -			- -			- -
Long-term borrowings		10,500			(178	)		3.39			25,251			(460	)		3.64
Secured borrowings		838			(23	)		5.49			958			(31	)		6.47
Junior subordinated debentures		13,403			(213	)		3.18			13,403			(245	)		3.66
Total borrowings		34,959			(609	)		3.48			39,612			(736	)		3.72

Total interest-bearing liabilities	$	488,112		$	(3,228	)		1.32	%	$	507,153		$	(4,304	)		1.70	%

Demand deposits		85,940									80,912
Other liabilities		4,515									4,025
Shareholders’ equity		60,677									58,008

Total liabilities and shareholders’ equity	$	639,244								$	650,098

Net interest income				$	11,850	*							$	11,795	*
Net interest spread								4.11	%								4.04	%
Net interest margin								3.97	%								3.89	%
Tax equivalent adjustment				$	400	*							$	413	*

* Tax equivalent basis – 34% tax rate used

(1) Interest income on loans includes loan fees of $241 and $296 in 2011 and 2010, respectively.

Interest and dividend income on a tax equivalent basis for the three and six months ended June 30, 2011 decreased $450,000 and $1,021,000, or 5.65% and 6.34%, 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 $480,463,000 with an average yield of 5.72% for the six months ended June 30, 2011, compared to average loans of $490,948,000 with an average yield of 5.93% for the same period in 2010. Interest and dividend income on investment securities on a tax equivalent basis for the six months ended June 30, 2011 decreased $192,000, or 12.92%, 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 six months ended June 30, 2011 were $39,712,000 with an average yield of 0.24% compared to $37,537,000 with an average yield of 0.34% for the same period in 2010.

Interest expense for the three and six months ended June 30, 2011 decreased $528,000 and $1,076,000, or 25.43% and 25.00%, 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 six months ended June 30, 2011 and 2010 were $453,153,000 and $467,541,000, respectively, with an average cost of 1.16% and 1.53%, respectively.

Average borrowings for the six months ended June 30, 2011 were $34,959,000 with an average cost of 3.48% compared to $39,612,000 with an average cost of 3.72% for the same period in 2010. The decrease in average borrowing balances outstanding is primarily due to the maturity of $4,500,000 in FHLB advances in late 2010. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits. Additionally, during the 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 1.88% and further improving net interest margin during the current period.

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 six months ended June 30, 2011, the loss factors used in the allowance for credit losses were updated specifically on pass rated non-owner occupied commercial real estate, from 1.00% to 1.50%, and on home equity and consumer loans, from 1.50% to 0.75%, 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 six months ended June 30, 2011, provision for credit losses totaled $0 and $500,000 compared to $1,200,000 and $2,000,000 for the same periods in 2010. The decrease in provision for credit losses in the current year is due to a decrease in charge-offs and a decrease in non-performing loans from $10,596,000 at June 30, 2010 to $10,158,000 (excluding government guarantees of $3,198,000) at June 30, 2011.

For the three and six months ended June 30, 2011, net charge-offs (recoveries) were $(192,000) and $151,000 compared to $1,783,000 and $1,848,000 for the same periods in 2010. Net charge-offs for the twelve months ended December 31, 2010 were $4,075,000. The net charge-off (recoveries) in the current three month period was largely due to a single recovery of $510,000 on a land development loan, which was partially offset by other construction and land related charge-offs. The ratio of net charge-offs to average loans outstanding for the six months ended June 30, 2011 and 2010 was 0.03% and 0.38%, respectively.

At June 30, 2011, the allowance for credit losses was $10,966,000 compared to $10,617,000 at December 31, 2010, and $11,244,000 at June 30, 2010. The increase compared to year-end 2010 is due to provision for credit losses of $500,000 in 2011, which exceeded net charge-offs of $151,000 for the six months ended June 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 2.33%, at June 30, 2011, December 31, 2010 and June 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 $53,866,000, $51,310,000, and $46,330,000 at June 30, 2011, December 31, 2010 and June 30, 2010, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.53%, 2.50%, and 2.58%, 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 monthly 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 June 30, 2011.

Non-performing assets and other real estate owned. Non-performing assets totaled $20,154,000 at June 30, 2011. This represents 3.13% of total assets, compared to $16,579,000, or 2.57%, at December 31, 2010, and $17,531,000, or 2.74%, at June 30, 2010. Construction and land development loans, including related OREO balances, continue to be the primary component of non-performing assets, representing $10,328,000, or 51.2%, of non-performing assets.

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

SUMMARY OF NON-PERFORMING ASSETS (in thousands)	June 30, 2011			December 31, 2010			June 30, 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		6,304			5,529			6,090
Residential real estate 1-4 family		764			2,246			1,493
Multi-family real estate		—			—			151
Commercial real estate (3)		5,697			803			1,555
Farmland		—			170			—
Consumer		—			—			29
Commercial and industrial		193			1,251			1,278
Total non-accrual loans (2)		12,958			9,999			10,596

Total non-performing loans		13,356			9,999			10,596

OREO and repossessions		6,798			6,580			6,935
Total Non-Performing Assets	$	20,154		$	16,579		$	17,531

Allowance for credit losses	$	10,966		$	10,617		$	11,244
Allowance for credit losses to non-performing loans		82.11	%		106.18	%		106.12	%
Allowance for credit losses to non-performing assets		63.93	%		64.04	%		64.14	%
Non-performing loans to total loans (1)		2.80	%		2.15	%		2.26	%
Non-performing assets to total assets		3.13	%		2.57	%		2.74	%

(1)	Excludes loans held for sale.

(2)	Includes $5,555,000 and $932,000 in non-accrual troubled debt restructured loans (“TDRs”) as of June 30, 2011 and December 31, 2010, respectively. There were no TDRs as of June 30, 2010.

(3)	Includes one loan totaling $3,997,000 at June 30, 2011 of which 80% is guaranteed by the United States Department of Agriculture (“USDA”).

Non-performing loans increased $3,357,000, or 33.6%, 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 $3,997,000, of which 80% 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.

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 $5,953,000 and $932,000 at June 30, 2011 and December 31, 2010, respectively, of which $5,555,000 were on non-accrual status at June 30, 2011 and $398,000 were accruing interest. TDRs as of December 31, 2011 were all on non-accrual status. There were no TDRs as of June 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. This process enables the Company to adequately reserve for non-performing loans within the allowance for credit losses. During the six months ended June 30, 2011 and 2010, as a result of these appraisals and other factors, the Company recorded OREO write-downs of $537,000 and $491,000, respectively, and net charge-offs of $151,000 and $1,848,000, respectively. The Company will continue to reevaluate non-performing assets over the coming months as market conditions change.

OREO at June 30, 2011 totaled $6,785,000 and is made up as follows: seven land or land development properties totaling $2,627,000, three residential construction properties totaling $999,000, four commercial real estate properties totaling $1,201,000, and seven residential single family residences valued at $1,958,000. 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 and six months ended June 30, 2011 decreased by $1,082,000 and $1,482,000, or 28.68% and 16.71%, respectively, compared to the same periods 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 $546,000 and $1,099,000 for the three and six months ended June 30, 2011 compared to $1,105,000 and $1,849,000 for the same periods in 2010. The decrease for the three and six 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. Origination of loans held for sale were $60,088,000 for the six months ended June 30, 2011, compared to $84,957,000 for the same period in 2010.

Services charges on deposits for the three months ended June 30, 2011 decreased $48,000, or 9.34%, compared to the same period in 2010. The decrease is due to declining overdraft revenue due to regulations requiring opt-in provisions which became effective in August, 2010. Service charges on deposits for the six months ended June 30, 2011 were relatively flat at $880,000 compared $874,000 for the same period in 2010.

The Bank recorded net gains on sale of securities available-for-sale of $184,000 and $402,000, during the six months ended June 30, 2011 and 2010, respectively. For the three and six months ended June 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 $50,000 and $193,000, respectively, in impairment charges related to credit losses through earnings for a year-to-date total of $243,000. As of June 30, 2011 an additional $367,000 in impairments not related to credit losses have been recorded through other comprehensive income. There were no additional OTTI securities at June 30, 2011 or December 31, 2010.

Total non-interest expense for the three and six months ended June 30, 2011 slightly increased $87,000 and $144,000, or 1.34% and 1.14%, respectively, compared to the same periods in 2010. The increases were primarily related to increases in salary and employee benefit costs and OREO write-downs, which were partially offset by decreases in expenses for occupancy and equipment, and FDIC assessments.

Salaries and employee benefits for the three and six months ended June 30, 2011 and 2010, increased $99,000 and $290,000, or 3.00% and 4.44%, respectively. The increases were mostly 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 June 30, 2011 were 213 compared to 223 at December 31, 2010.

Income taxes. The federal income tax benefit for the three and six months ended June 30, 2011 was $58,000 and $74,000, respectively, as compared to $114,000 and $158,000, respectively, for the three and six months ended June 30, 2010. The effective tax rate for the six months ended June 30, 2011 was 12.4%. 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 $643,656,000 at June 30, 2011, a decrease of $747,000, or 0.12%, over year-end 2010. Decreases in interest bearing cash and other assets were the primary contributors to overall asset decline, which was 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 June 30, 2011 was $55,141,000 compared to $48,347,000 at the end of 2010, an increase of $6,794,000, or 14.05%. During 2011, the Company sold $5,089,000 in securities for a gain of $184,000. 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 $11,142,000, or 2.34%, to $486,967,000 at June 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 June 30, 2011 and December 31, 2010 follows (in thousands):

	June 30, 2011			December 31, 2010

Commercial and industrial	$	88,421		$	84,575
Real estate:
Construction and land development		47,040			46,256
Residential 1-4 family		86,767			89,212
Multi-family		10,452			9,113
Commercial real estate – owner occupied		116,240			109,936
Commercial real estate – non owner occupied		108,226			106,079
Farmland		21,505			22,354
Installment		9,177			9,128
Less unearned income		(861	)		(828	)
Total Loans		486,967			475,825
Allowance for credit losses		(10,966	)		(10,617	)
Net Loans	$	476,001		$	465,208

Interest and fees earned on our loan portfolio is our primary source of revenue. Gross loans represented 75.7% of total assets as of June 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 9.7% of our loan portfolio at June 30, 2011 and at December 31, 2010. We believe this segment will remain challenged in 2011, 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 June 30, 2011, concentration in land and residential construction as a percentage of risk based capital stood at 61% and concentration in commercial real estate as a percentage of risk-based capital was 246%.

Deposits. Total deposits were $543,943,000 at June 30, 2011, a decrease of $1,011,000, or 0.19%, compared to December 31, 2010. Deposit detail by category as of June 30, 2011 and December 31, 2010 follows (in thousands):

	June 30, 2011		December 31, 2010

Demand, non-interest bearing	$	92,441	$	95,115
Interest bearing demand		112,425		103,358
Money market		98,766		93,996
Savings		60,210		55,993
Time, interest bearing		180,101		196,492
Total deposits	$	543,943	$	544,954

Non-interest bearing demand deposits decreased $2,674,000, or 2.81%, due to a change in the mix of deposits from non-interest bearing demand to interest bearing demand and money market accounts. Since December 31, 2010, non-maturity deposits (total deposits less time certificates of deposits) have increased $15,380,000, or 4.41%, to $363,842,000.

Time deposits decreased $16,391,000, or 8.34%, which is largely due to a planned decrease in brokered deposits of $9,657,000. As a result, the percentage of time certificates of deposit to total deposits decreased to 33.1% at June 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 believes it has a strong liquidity position at June 30, 2011, with $45.8 million in cash and interest bearing deposits with banks and $48.0 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 June 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 $19,500,000 was used at June 30, 2011. Based on current pledged collateral, the Bank had $108 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 $50 million at the Federal Reserve Bank subject to pledged collateral, of which none was used at June 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 June 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 June 30, 2011, deferred interest totaled $1,113,000 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 June 30, 2011 and December 31, 2010, were as follows:

	Company						Bank						Requirements
	June 30, 2011			December 31, 2010			June 30, 2011			December 31, 2010			Adequately Capitalized			Well Capitalized
Tier 1 leverage ratio		9.91	%		9.72	%		10.05	%		9.80	%		4	%		5	%
Tier 1 risk-based capital ratio		13.02	%		13.21	%		13.23	%		13.35	%		4	%		6	%
Total risk-based capital ratio		14.28	%		14.48	%		14.49	%		14.62	%		8	%		10	%

Total shareholders' equity was $61,311,000 at June 30, 2011, an increase of $1,542,000, or 2.6%, compared to December 31, 2010.

Goodwill Valuation. Goodwill is assigned to reporting units for purposes of impairment testing. The Company has one reporting unit, the Bank, for purposes of computing goodwill. The Company performs an annual review in the second quarter of each fiscal year, or more frequently if indications of potential impairment exist, to determine if the recorded goodwill is impaired. During the current quarter, the Company updated its annual assessment for potential impairment of goodwill.

A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include, among others; a significant decline in expected future cash flows; a sustained, significant decline in our stock price and market capitalization; a significant adverse change in legal factors or in the business climate; adverse assessment or action by a regulator; and unanticipated competition. Any adverse change in these factors could have a significant impact on the recoverability of such assets and could have a material impact on the Company’s Consolidated Financial Statements.

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. 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 allocation of corporate value approach, the income approach and the market approach in order to derive an enterprise value of the Company. The allocation of corporate value approach applies the aggregate market value of the Company and divides it among the reporting units. A key assumption in this approach is the control premium applied to the aggregate market value. A control premium is utilized as the value of a company from the perspective of a controlling interest is generally higher than the widely quoted market price per share. The Company used an expected control premium of 35%, which was based on comparable transactional history.

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.

As of the date of this filing, we have not completed this step two analysis due to the complexities involved in determining the implied fair value of the goodwill for the reporting unit. However, based on work performed to date, we do not believe that an impairment loss is probable. We expect to finalize our goodwill impairment analysis during the third quarter of 2011 and the results thereof will be disclosed in the third quarter financial statements. No assurance can be given that the Company will not record an impairment loss on goodwill in the future.

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 conservative modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of June 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: August 15, 2011	By:	/s/
		Dennis A. Long
		Chief Executive Officer


	By:	/s/
		Denise Portmann
		Chief Financial Officer

EXHIBIT INDEX

EXHIBIT NO.		EXHIBIT
10.1		2011 Equity Incentive Plan.
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.