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

Unassociated Document
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2011
 
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ____________
 
Commission File Number  000-29829
 
PACIFIC FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
 
Washington
91-1815009
(State or other jurisdiction of
(IRS Employer Identification No.)
incorporation or organization)
 
1101 S. Boone Street
Aberdeen, Washington 98520-5244
(360) 533-8870
(Address, including zip code, and telephone number,
including area code, of Registrant's principal executive offices)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:
Yes x  No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes ¨  No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  (See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).
¨ Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer x Smaller Reporting Company
 
    Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x
 
The number of shares of the issuer's common stock, par value $1.00 per share, outstanding as of April 30, 2011, was 10,121,853 shares.
 
 

 

TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION
3
     
ITEM 1.
FINANCIAL STATEMENTS (UNAUDITED)
3
     
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
MARCH 31, 2011 AND DECEMBER 31, 2010
3
     
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
 
THREE MONTHS ENDED MARCH 31, 2011 AND 2010
4
     
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
THREE MONTHS ENDED MARCH 31, 2011 AND 2010
5
     
 
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS'
 
 
EQUITY THREE MONTHS ENDED MARCH 31, 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
22
     
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
 
 
MARKET RISK
33
     
ITEM 4.
CONTROLS AND PROCEDURES
34
     
PART II
OTHER INFORMATION
34
     
ITEM 1.
LEGAL PROCEEDINGS
34
     
ITEM 1A.
RISK FACTORS
34
     
ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND
 
 
USE OF PROCEEDS
34
     
ITEM 3.
DEFAULTS UPON SENIOR SECURITIES
34
     
ITEM 4.
[RESERVED]
34
     
ITEM 5.
OTHER INFORMATION
34
     
ITEM 6.
EXHIBITS
34
     
 
SIGNATURES
35
 
 
 

 

PART I – FINANCIAL INFORMATION
 
ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Balance Sheets
March 31, 2011 and December 31, 2010
(Dollars in thousands) (Unaudited)

   
March 31, 2011
   
December 31, 2010
 
Assets
           
Cash and due from banks
  $ 13,443     $ 7,428  
Interest bearing deposits in banks
    40,487       54,330  
Investment securities available-for-sale (amortized cost of
               
$45,789 and $42,402)
    45,668       41,893  
Investment securities held-to-maturity (fair value of $6,546
               
and $6,584)
    6,423       6,454  
Federal Home Loan Bank stock, at cost
    3,182       3,182  
Loans held for sale
    5,526       10,144  
                 
Loans
    470,472       465,681  
Allowance for credit losses
    10,774       10,617  
Loans, net
    459,698       455,064  
                 
Premises and equipment
    15,140       15,181  
Other real estate owned
    6,664       6,580  
Accrued interest receivable
    2,542       2,334  
Cash surrender value of life insurance
    16,877       16,748  
Goodwill
    11,282       11,282  
Other intangible assets
    1,268       1,303  
Other assets
    10,186       12,480  
                 
Total assets
  $ 638,386     $ 644,403  
                 
Liabilities and Shareholders' Equity
               
Deposits:
               
Demand, non-interest bearing
  $ 84,459     $ 95,115  
Savings and interest-bearing demand
    265,700       253,347  
Time, interest-bearing
    188,056       196,492  
Total deposits
    538,215       544,954  
                 
Accrued interest payable
    1,425       1,380  
Secured borrowings
    780       925  
Short-term borrowings
    10,500       10,500  
Long-term borrowings
    10,500       10,500  
Junior subordinated debentures
    13,403       13,403  
Other liabilities
    3,075       2,972  
Total liabilities
    577,898       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 March 31, 2011 and December 31, 2010
    10,122       10,122  
Additional paid-in capital
    41,322       41,316  
Retained earnings
    9,665       9,233  
Accumulated other comprehensive loss
    (621 )     (902 )
Total shareholders' equity
    60,488       59,769  
                 
Total liabilities and shareholders' equity
  $ 638,386     $ 644,403  

See notes to condensed consolidated financial statements.

 
3

 

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Income
Three months ended March 31, 2011 and 2010
(Dollars in thousands, except per share data) (Unaudited)

   
Three Months Ended
 March 31,
 
   
2011
   
2010
 
Interest and dividend income
           
Loans
  $ 6,825     $ 7,234  
Investment securities and FHLB dividends
    516       659  
Deposits with banks and federal funds sold
    24       37  
Total interest and dividend income
    7,365       7,930  
                 
Interest Expense
               
Deposits
    1,365       1,860  
Other borrowings
    315       368  
Total interest expense
    1,680       2,228  
                 
Net Interest Income
    5,685       5,702  
Provision for credit losses
    500       800  
Net interest income after provision for credit losses
    5,185       4,902  
                 
Non-interest Income
               
Service charges on deposits
    414       360  
Net gain on sales of other real estate owned
    3       25  
Gain on sales of loans
    553       744  
Gain on sales of investments available-for-sale
    110       229  
Other-than-temporary-impairment (“OTTI”)
    (193 )      
Earnings on bank owned life insurance
    130       131  
Other operating income
    316       241  
Total non-interest income
    1,333       1,730  
                 
Non-interest Expense
               
Salaries and employee benefits
    3,428       3,237  
Occupancy and equipment
    644       692  
Other real estate owned write-downs
    116       148  
Other real estate owned operating costs
    92       122  
Professional services
    175       195  
FDIC and State assessments
    313       368  
Data processing
    282       314  
Other
    1,092       1,006  
Total non-interest expense
    6,142       6,082  
                 
Income before income taxes
    376       550  
Benefit for income taxes
    (56 )     (84 )
Net Income
  $ 432     $ 634  
                 
Earnings per common share:
               
Basic
  $ 0.04     $ 0.06  
Diluted
    0.04       0.06  
Weighted Average shares outstanding:
               
Basic
    10,121,853       10,121,853  
Diluted
    10,121,853       10,121,853  

See notes to condensed consolidated financial statements.
 
 
4

 
 
PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 2011 and 2010
(Dollars in thousands)
(Unaudited)

   
2011
   
2010
 
OPERATING ACTIVITIES
           
Net income
  $ 432     $ 634  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for credit losses
    500       800  
Depreciation and amortization
    407       391  
Origination of loans held for sale
    (30,461 )     (41,818 )
Proceeds of loans held for sale
    35,632       45,766  
Gain on sales of loans
    (553 )     (744 )
Gain on sale of investments available for sale
    (110 )     (229 )
OTTI write-down
    193        
Net gain on sale of other real estate owned
    (3 )     (25 )
Increase in accrued interest receivable
    (208 )     (90 )
Increase (decrease) in accrued interest payable
    45       (2 )
Other real estate owned write-downs
    116       148  
Additions to other real estate owned
    (50 )      
Other, net
    2,192       209  
Net cash provided by operating activities
    8,132       5,040  
                 
INVESTING ACTIVITIES
               
Net decrease in federal funds sold
          5,000  
Net decrease in interest bearing balances with banks
    13,843       4,164  
Purchase of securities held-to-maturity
          (56 )
Purchase of securities available-for-sale
    (8,265 )      
Proceeds from maturities of investments held-to-maturity
    30       726  
Proceeds from sales of securities available-for-sale
    3,119       9,515  
Proceeds from maturities of securities available-for-sale
    1,620       1,425  
Net increase in loans
    (5,540 )     (4,203 )
Proceeds from sales of other real estate owned
    200       445  
Purchase of premises and equipment
    (240 )     (107 )
Net cash provided by investing activities
    4,767       16,909  
                 
FINANCING ACTIVITIES
               
Net decrease in deposits
    (6,739 )     (23,020 )
Net decrease in secured borrowings
    (145 )     (12 )
Net cash used in financing activities
    (6,884 )     (23,032 )
                 
Net increase (decrease) in cash and due from banks
    6,015       (1,083 )
                 
Cash and due from Banks
               
Beginning of period
    7,428       12,836  
                 
End of period
  $ 13,443     $ 11,753  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash payments for:
               
Interest
  $ 1,635     $ 2,230  
Income taxes
           
                 
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
               
Change in fair value of securities available-for-sale, net of tax
  $ 258     $ 103  
Other real estate owned acquired in settlement of loans
    (966 )     (2,359 )
Financed sale of other real estate owned
    619       268  

See notes to condensed consolidated financial statements.

 
5

 
 
PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Shareholders' Equity
Three months ended March 31, 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
                            634               634  
Unrealized holding gain on securities of $48 (net of tax of $16) less reclassification adjustment for net gains included in net income of $151 (net of tax of $78)
                                    (103 )     (103 )
Amortization of unrecognized prior service costs and net (gains)/losses
                                    19       19  
Comprehensive income
                                            550  
                                                 
Stock compensation expense
                    11                       11  
     
 
   
 
         
 
         
 
 
Balance March 31, 2010
    10,121,853     $ 10,122     $ 41,281     $ 8,233     $ (1,426 )   $ 58,210  
                                                 
Balance January 1, 2011
    10,121,853     $ 10,122     $ 41,316     $ 9,233     $ (902 )   $ 59,769  
                                                 
Other comprehensive income:
                                               
Net income
                            432               432  
Unrealized holding gain on securities of $313 (net of tax of $161) less reclassification adjustment for net loss included in net income of $55 (net of tax of $28)
                                          258             258  
Amortization of unrecognized prior service costs and net (gains)/losses
                                    23       23  
Comprehensive income
                                            713  
                                                 
Stock compensation expense
                    6                       6  
                                                 
Balance March 31, 2011
    10,121,853     $ 10,122     $ 41,322     $ 9,665     $ (621 )   $ 60,488  

See notes to condensed consolidated financial statements.
 
 
6

 
 
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 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 accounting principles generally accepted in the United States of America 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 three months ended March 31, 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 accounting principles generally accepted in the United States of America (“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
March 31,
 
   
2011
   
2010
 
Basic:
           
Net income
  $ 432     $ 634  
Weighted average shares outstanding
    10,121,853       10,121,853  
Basic earnings per share
  $ 0.04     $ 0.06  
                 
Diluted:
               
Net income
  $ 432     $ 634  
Weighted average shares outstanding
    10,121,853       10,121,853  
Effect of dilutive stock options
           
Weighted average shares outstanding assuming dilution
    10,121,853       10,121,853  
Diluted earnings  per share
  $ 0.04     $ 0.06  

As of March 31, 2011 and 2010, there were 616,608 and 819,736 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.
 
 
7

 
 
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
 
                         
March 31, 2011
                       
State and municipal securities
  $ 6,082     $ 97     $     $ 6,179  
Agency MBS
    341       26             367  
Total
  $ 6,423     $ 123     $     $ 6,546  
                                 
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
 
                         
March 31, 2011
                       
U.S. Government securities
  $ 6,686     $ 12     $ 33     $ 6,665  
State and municipal securities
    19,798       768       18       20,548  
Agency MBS
    8,996       129       29       9,096  
Non-agency MBS
    9,291       5       956       8,340  
Corporate bonds
    1,018       1             1,019  
Total
  $ 45,789     $ 915     $ 1,036     $ 45,668  
                                 
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  
 
8

 
 
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 March 31, 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
 
                                     
March 31, 2011
                                   
U.S. Government securities
  $ 6,552     $ 33     $     $     $ 6,552     $ 33  
State and municipal securities
    1,064       18                   1,064       18  
Agency MBS
    3,198       29                   3,198       29  
Non-agency MBS
    1,962       95       5,297       861       7,259       956  
Total
  $ 12,776     $ 175     $ 5,297     $ 861     $ 18,073     $ 1,036  
                                                 
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 March 31, 2011, there were 19 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 March 31, 2011, except as described below.
 
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 three months ended March 31, 2011, one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $429 in impairments not related to credit losses through other comprehensive income and $193 in impairments related to credit losses through earnings.  There were no additional other-than-temporarily-impaired securities at March 31, 2011 or December 31, 2010.

Gross gains realized on sales of securities were $110 and $229 during the three months ended March 31, 2011 and 2010, respectively.  There were no realized losses in either period.
 
The Company did not engage in originating subprime mortgage loans, and it does not believe that it has 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.
 
 
9

 
Note 4 – Loans
 
Loans (including loans held for sale) at March 31, 2011 and December 31, 2010 are as follows:
   
   
March 31,
2011
   
December 31,
2010
 
             
Commercial and industrial
  $ 87,880     $ 84,575  
Residential real estate:
               
Residential 1-4 family
    84,567       89,212  
Multi-family
    10,530       9,113  
Commercial real estate:
               
Construction and land development
    45,307       46,256  
Commercial real estate – owner occupied
    112,879       109,936  
Commercial real estate – non owner occupied
    105,037       106,079  
Farmland
    21,648       22,354  
Installment
    9,047       9,128  
Less unearned income
    (897 )     (828 )
                 
Total Loans
  $ 475,998     $ 475,825  

Changes in the allowance for credit losses and recorded investment in loans for the three months ended March 31, 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
    (46 )     (298 )     (32 )     (8 )           (384 )     (80 )
Recoveries
    9       3       25       4             41       15  
Provision for credit losses
    64       520       138       (13 )     (209 )     500       800  
                                                         
Ending balance
  $ 843     $ 5,610     $ 1,885     $ 673     $ 1,763     $ 10,774     $ 11,827  
                                                         
Ending balance:  individually evaluated for impairment
    128                               128       627  
                                                         
Ending balance:  collectively evaluated for impairment
    715       5,610       1,885       673       1,763       10,646       11,200  
                                                         
Loans:
                                                       
Ending balance:  individually evaluated for impairment
  $ 616     $ 8,806     $ 1,734     $     $     $ 11,156     $ 24,729  
                                                         
Ending balance:  collectively evaluated for impairment
    87,264       276,065       93,363       9,047             465,739       469,642  
                                                         
Less unearned income
                                  (897 )     (816 )
                                                         
Ending balance total loans
  $ 87,880     $ 284,871     $ 95,097     $ 9,047     $     $ 475,998     $ 493,555  
  
 
10

 
 
Changes in the allowance for credit losses and recorded investment in loans for the years ended December 31, 2010 and 2009 are as follows:

   
 
Commercial
   
Commercial
Real Estate
(“CRE”)
   
Residential
Real Estate
   
 
Consumer
   
 
Unallocated
   
2010
Total
   
2009
Total
 
                                           
Allowance for Credit Losses:
                                         
Beginning balance
  $ 1,307     $ 5,864     $ 2,477     $ 261     $ 1,183     $ 11,092     $ 7,623  
Charge-offs
    (469 )     (2,055 )     (1,518 )     (119 )           (4,161 )     (6,524 )
Recoveries
    13       19       48       6             86       49  
Provision for credit losses
    (35 )     1,557       747       542       789       3,600       9,944  
                                                         
Ending balance
  $ 816     $ 5,385     $ 1,754     $ 690     $ 1,972     $ 10,617     $ 11,092  
                                                         
Ending balance:  individually evaluated for impairment
    142                               142       638  
                                                         
Ending balance:  collectively evaluated for impairment
    674       5,385       1,754       690       1,972       10,475       10,454  
                                                         
Loans:
                                                       
Ending balance:  individually evaluated for impairment
  $ 1,267     $ 10,201     $ 3,205     $     $     $ 14,673     $ 25,738  
                                                         
Ending balance:  collectively evaluated for impairment
    83,308       274,424       95,120       9,128             461,980       469,778  
                                                         
Less unearned income
                                  (828 )     (881 )
                                                         
Ending balance total loans
  $ 84,575     $ 284,625     $ 98,325     $ 9,128     $     $ 475,825     $ 494,635  

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 that the institution will sustain some loss 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 Watch or Other Loans Especially Mentioned (“OLEM”). Loans classified as “Watch” are performing assets and classified as pass credits but have elements of risk that require more monitoring than other performing loans. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring.
 
11

 
 
Loans by credit quality risk rating at March 31, 2011 are as follows:

   
 
Pass
   
Other Loans
Especially
Mentioned
   
 
Substandard
   
 
Doubtful
   
 
Total
 
                               
Commercial
  $ 84,148     $ 2,286     $ 944     $ 502     $ 87,880  
                                         
Real estate:
                                       
Construction and development
    29,323       4,295       11,689             45,307  
Residential 1-4 family
    76,794       2,403       5,370             84,567  
Multi-family
    9,687             843             10,530  
CRE – owner occupied
    107,964       794       4,121             112,879  
CRE – non owner occupied
    70,586       23,570       10,881             105,037  
Farmland
    21,363       115       170             21,648  
Total real estate
    315,717       31,177       33,074             379,968  
                                         
Consumer
    8,891       71       63       22       9,047  
                                         
Subtotal
  $ 408,756     $ 33,534     $ 34,081     $ 524     $ 476,895  
Less unearned income
                                    (897 )
                                         
Total loans
                                  $ 475,998  

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  
 
12

 
 
Non-accrual loans are as follows:

   
March 31,
   
December 31,
 
   
2011
   
2010
 
             
Commercial
  $ 616     $ 1,251  
Real estate
               
Construction and development
    6,765       5,529  
Residential 1-4 family
    1,734       2,246  
Commercial real estate – owner occupied
    1,506       470  
Commercial real estate – non-owner occupied
    136       333  
Farmland
          170  
Total real estate
    10,141       8,748  
                 
Total
  $ 10,757     $ 9,999  

Following is a summary of information pertaining to impaired loans at March 31, 2011:

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With no related allowance recorded:
                             
Commercial
  $ 114     $ 128     $     $ 437     $ 8  
Residential real estate
    1,734       2,295             2,470       5  
Commercial real estate:
                                       
CRE – owner occupied
    1,507       1,549             1,116       2  
CRE – non-owner occupied
    136       136             1,439        
Construction and development
    7,163       9,066             6,949       67  
                                         
With an allowance recorded:
                                       
Commercial
    502       502       128       505       5  
                                         
Total:
                                       
Commercial
    616       630       128       942       13  
Residential real estate
    1,734       2,295             2,470       5  
Commercial real estate:
                                       
CRE – owner occupied
    1,507       1,549             1,116       2  
CRE – non-owner occupied
    136       136             1,439        
Construction and development
    7,163       9,066             6,949       67  
 
13

 
 
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 March 31, 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
  $ 266     $ 17     $ 195     $ 478     $ 87,402     $ 87,880     $ 85  
                                                         
Real estate:
                                                       
Construction & development
          1,000       1,314       2,314       42,993       45,307        
Residential 1-4 family
    458       70       1,328       1,856       82,711       84,567        
Multi-family
                            10,530       10,530        
CRE owner occupied
    274       56       1,485       1,815       111,064       112,879        
CRE non-owner occupied
    5,848             136       5,984       99,053       105,037        
Farmland
    63                   63       21,585       21,648        
Total real estate
    6,643       1,126       4,263       12,032       367,936       379,968        
                                                         
Consumer
          34             34       9,013       9,047        
                                                         
Less unearned income
                            (897 )     (897 )      
                                                         
Total
  $ 6,909     $ 1,177     $ 4,458     $ 12,544     $ 463,454     $ 475,998     $ 85  
 
 
14

 
 
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     $  
  
Troubled debt restructurings (“TDRs”) as of March 31, 2011 are as follows:

   
Current TDRs
   
Subsequently Defaulted TDRs
 
   
 
Number
of
Contracts
   
Pre-TDR
Outstanding
Recorded
Investment
   
Post-TDR
Outstanding
Recorded
Investment
   
 
Number
of
Contracts
   
Pre-TDR
Outstanding
Recorded
Investment
   
Post-TDR
Outstanding
Recorded
Investment
 
                                     
Residential real estate
    1     $ 417     $ 324                    
Construction & development
    2       2,561       2,607                    
                                                 
Ending balance
    3     $ 2,978     $ 2,931                    

Troubled debt restructurings (“TDRs”) as of December 31, 2010 are as follows:

   
Current TDRs
   
Subsequently Defaulted TDRs
 
   
 
Number
of
Contracts
   
Pre-TDR
Outstanding
Recorded
Investment
   
Post-TDR
Outstanding
Recorded
Investment
   
 
Number
of
Contracts
   
Pre-TDR
Outstanding
Recorded
Investment
   
Post-TDR
Outstanding
Recorded
Investment
 
                                     
Residential real estate
    1     $ 417     $ 324                    
Construction & development
    1       561       608                    
                                                 
Ending balance
    2     $ 978     $ 932                    
 
15

 
 
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.  There were no options granted during the three months ended March 31, 2011 and 2010.

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.
 
A summary of stock option activity under the stock option plan as of March 31, 2011 and 2010, and changes during the three months then ended are presented below:
 
   
 
 
 
Shares
   
 
Weighted
Average
Exercise Price
   
Weighted
Average
Remaining
Contractual
Term ( Years)
   
 
Aggregate
Intrinsic
Value
 
March 31, 2011
                       
                         
Outstanding beginning of period
    818,612     $ 11.07              
Granted
                       
Exercised
                   
 
 
Forfeited
    (24,225 )     10.00              
Expired
    (177,779 )     10.10              
                             
Outstanding end of period
    616,608     $ 11.40       5.2     $  
                                 
Exercisable end of period
    413,933     $ 12.87       3.8     $  
                                 
March 31, 2010
                               
                                 
Outstanding beginning of period
    820,837     $ 11.08                  
Granted
                           
Exercised
                           
Forfeited
    (1,100 )     11.27                  
                                 
Outstanding end of period
    819,737     $ 11.08       5.1     $  
                                 
Exercisable end of period
    531,902     $ 12.33       3.1     $  
 
 
16

 
 
A summary of the status of the Company’s nonvested options as of March 31, 2011 and 2010 and changes during the three 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
                       
Vested
                (2,200 )     4.11  
Forfeited
    (16,210 )     0.46       (880 )     0.83  
                                 
Non-vested end of period
    202,675     $ 0.51       287,835     $ 0.57  

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 three months ended March 31, 2011 and 2010 was $6 and $11 ($4 and $7 net of tax), respectively.  Future compensation expense for unvested awards outstanding as of March 31, 2011 is estimated to be $47 recognized over a weighted average period of 1.8 years.  There were no options exercised during the three months ended March 31, 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 March 31, 2011 and December 31, 2010 is as follows:

   
March 31,
   
December 31,
 
   
2011
   
2010
 
             
Commitments to extend credit
  $ 106,739     $ 90,888  
Standby letters of credit
    1,142       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.

 
17

 
 
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 about the underlying loans conforming 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 consolidated financial statements.

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

Note 7 – Recent Accounting Pronouncements

In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.”  The provisions of ASU No. 2011-02 provide additional guidance related to determining whether a creditor has granted a concession, include factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibit creditors from using the borrower’s effective rate test to evaluate whether a concession has been granted to the borrower, and add factors for creditors to use in determining whether a borrower is experiencing financial difficulties.  A provision in ASU No. 2011-02 also ends the FASB’s deferral of the additional disclosures about troubled debt restructurings as required by ASU No. 2010-20.  The provisions of ASU No. 2011-02 are effective for the Company’s reporting period ending September 30, 2011.  The Company is currently evaluating the impact of ASU No. 2011-02 on its consolidated financial statements.

Note 8 – Fair Value Measurements

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

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

Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets.  Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model –derived valuations whose inputs are observable or whose significant value drivers are observable.  Valuations may be obtained from, or corroborated by, third-party pricing services.  This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale.
 
Level 3 – Valuation based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.  Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services.
 
18

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

 
 
 
 
 
Readily Available
Market Prices
Level 1
   
Observable
Inputs
Level 2
   
Significant
Unobservable
Inputs
 Level 3
   
 
 
Total
 
                         
March 31, 2011
                       
                         
Securities available-for-sale
                       
U.S. Government securities
  $     $ 6,665     $     $ 6,665  
State and municipal securities
          19,396       1,152       20,548  
Agency MBS
          9,096             9,096  
Non-agency MBS
          8,340             8,340  
Corporate bonds
          1,019             1,019  
Total
  $     $ 44,516     $ 1,152     $ 45,668  
                                 
December 31, 2010
                               
                                 
Securities available-for-sale
                               
U.S. Government securities
  $     $ 1,109     $     $ 1,109  
State and municipal securities
          19,995       1,157       21,152  
Agency MBS
          7,730             7,730  
Non-agency MBS
          8,884             8,884  
Corporate bonds
    1,069       1,949             3,018  
Total
  $ 1,069     $ 39,667     $ 1,157     $ 41,893  

The Company uses a third party pricing service to assist the Company in determining the fair value of the investment portfolio.  The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three months ended March 31, 2011 and 2010, respectively.  There were no transfers of assets in to or out of Level 3 for the three months ended March 31, 2011.
 
   
2011
   
2010
 
             
Beginning balance
  $ 1,157     $ 1,593  
Included in other comprehensive loss
    (5 )     (16 )
                 
Balance end of period
  $ 1,152     $ 1,577  

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.
 
 
19

 
 
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 March 31, 2011 and December 31, 2010

   
Readily Available
 Market Prices
Level 1
   
Observable
Inputs
Level 2
   
Significant
Unobservable
Inputs
 Level 3
   
 
 
Total
 
March 31, 2011
                       
Impaired loans
  $     $     $ 2,065     $ 2,065  
OREO
  $     $     $ 645     $ 645  
                                 
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 $1,009 was acquired during the three months ended March 31, 2011.  Upon foreclosure, these assets were written down $32 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.
 
 
20

 
 
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 March 31, 2011 and December 31, 2010 are as follows:

   
2011
         
2010
       
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Amount
   
Value
   
Amount
   
Value
 
Financial Assets
                       
Cash and due from banks, interest-bearing deposits in banks, and federal funds sold
  $ 53,930     $ 53,930     $ 61,758     $ 61,758  
Investment securities available for sale
    45,668       45,668       41,893       41,893  
Investment securities held to maturity
    6,423       6,546       6,454       6,584  
Loans held for sale
    5,526       5,526       10,144       10,144  
Loans, net
    459,698       412,663       455,064       408,261  
                                 
Financial Liabilities
                               
Deposits
  $ 538,215     $ 539,751     $ 544,954     $ 546,753  
Short-term borrowings
    10,500       10,740       10,500       10,775  
Long-term borrowings
    10,500       10,829       10,500       10,858  
Secured borrowings
    780       780       925       925  
Junior subordinated debentures
    13,403       5,606       13,403       6,916  

 
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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 risks 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, and place additional burdens on our limited management resources or lead us to change our strategies;
 
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;
 
5.           our growth strategy, particularly if accomplished through acquisitions, which may not be successful if we fail to accurately assess market opportunities, asset quality, anticipated cost savings, and transaction costs, or experience significant difficulty integrating acquired businesses or assets or opening new branches or lending offices; and
 
6.           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.

 
22

 

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 pooled 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.
 
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 months ended March 31, 2011 and financial condition as of that date:
 
 
·
Net income for the three months ended March 31, 2011 was $432,000, a decrease of $202,000 compared to net income of $634,000 in the first quarter of 2010, which represents the fifth consecutive quarter of profitability.  The decrease in net income in the current quarter was primarily related to a decrease in gain on sale of loans and an other-than-temporary-impairment (“OTTI”) loss of $193,000.
 
 
·
Return on average assets and return on average equity were 0.27% and 2.89%, respectively, for the three months ended March 31, 2011, compared to 0.39% and 4.40%, respectively, for the same period in 2010.
 
 
·
Net interest income was flat at $5,685,000 for the three months ended March 31, 2011, compared to $5,702,000 for the same period of the prior year.  However, the net interest margin improved to 3.95% for the three months ended March 31, 2011 compared to 3.85% one year ago.  The increase is primarily the result of decreased funding costs.
 
 
·
The Bank remains well capitalized with a total risk-based capital ratio of 14.65% at March 31, 2011, compared to 14.62% at December 31, 2010.

 
23

 
 
 
·
Total assets were $638,386,000 at March 31, 2011, a decrease of $6,017,000, or 0.93%, over year-end 2010.  Reduction in interest bearing deposits in banks, which were used to fund run-off in brokered deposits, and a decrease in loans held for sale were the primary contributors to the overall asset decline.
 
 
·
Non-performing assets (“NPAs”) totaled $17,506,000 at March 31, 2011, which represents 2.74% of total assets, and is an increase from $16,579,000 at December 31, 2010 and a decrease from March 31, 2010 when NPAs were $22,944,000.  Non-performing assets continue to be concentrated in construction and land development loans and related OREO, which represented $11,035,000, or 63.0%, of non-performing assets.
 
 
·
Provision for credit losses decreased to $500,000 for the three months ended March 31, 2011, compared to $800,000 for the same period one year ago.  The allowance for credit losses increased to 2.26% of total loans (including loans held for sale) compared to 2.23% at year-end 2010.
 
 
·
The Company continues to be successful in reducing overall exposure to construction and land development loans.  This segment of the portfolio, totaling $45.3 million at March 31, 2011, accounts for approximately 9.5% of the total loan portfolio (including loans held for sale), as opposed to $62.6 million and 12.7% one year ago.
 
 
·
Total deposits decreased $6,739,000, or 1.24%, for the three months ended March 31, 2011, compared to December 31, 2010, as a result of the maturity of $9,657,000 in brokered deposits.  The maturity of brokered deposits was partially offset by growth in retail deposits of $2,918,000.  Due to excess liquidity, management’s strategy has been to reduce higher cost time deposits, including brokered deposits, in order to improve the cost of funds and net interest margin.
 
 
·
The Company’s liquidity ratio of approximately 41% at March 31, 2011 remains strong and translates into over $263 million in available funding to meet loan and deposit needs.
 
Results of Operations
 
Net income.  For the three months ended March 31, 2011, net income was $432,000, compared to $634,000 for the same period in 2010.   The decrease in net income for the three month period was primarily related to a decrease in the gain on sale of loans and an OTTI 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 months ended March 31, 2011 decreased $17,000, or 0.30%, compared to the same period 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) increased to 3.95% for the three months ended March 31, 2011 from 3.85% for the same period last year.  The increase in the current three month period is due to an improvement in the average cost of funds to 1.37% at March 31, 2011 from 1.73% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.49% to 5.26%.  In addition, decreasing levels of nonperforming loans placed on non-accrual status have also positively affected our net interest margin.

 
24

 

The Federal Open Market Committee (“FOMC”) of the Federal Reserve heavily influences market interest rates, including deposit and loan rates offered by many financial institutions.  As a bank holding company, we derive the greatest portion of our income from net interest income.  Approximately 78% of the Company’s loan portfolio is tied to short-term rates, and therefore, re-price immediately when interest rate changes occur.  The Company’s funding sources also re-price when rates change, however, there is a meaningful lag in the timing of the re-pricing of deposits as compared to loans and the benefits of declining rates paid decrease as rates approach zero.
 
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 March 31,
 
    2011     2010  
         
Interest
               
Interest
       
(dollars in thousands)
 
Average
   
Income
   
Avg
   
Average
   
Income
   
Avg
 
   
Balance
   
(Expense)
   
Rate
   
Balance
   
(Expense)
   
Rate
 
Interest Earning Assets
                                   
Loans (1)
  $ 480,063     $ 6,900 *     5.75 %   $ 490,858     $ 7,305 *     5.95 %
Taxable securities
    29,693       280       3.77       30,507       404       5.30  
Tax-exempt securities
    23,027       358 *     6.22       25,279       386 *     6.11  
Federal Home Loan Bank Stock
    3,183                   3,183              
Interest earning balances with banks
    39,539       24       0.24       42,298       37       0.35  
                                                 
Total interest earning assets
  $ 575,505     $ 7,562       5.26 %   $ 592,125     $ 8,132       5.49 %
                                                 
Cash and due from banks
    9,565                       10,139                  
Bank premises and equipment (net)
    15,167                       15,863                  
Other real estate owned
    6,770                       7,161                  
Other assets
    41,814                       43,409                  
Allowance for credit losses
    (10,870 )                     (11,530 )                
                                                 
Total assets
  $ 637,951                     $ 657,167                  
                                                 
Interest Bearing Liabilities
                                               
Savings and interest bearing demand
  $ 263,132     $ (443 )     0.67 %   $ 228,365     $ (434 )     0.76 %
Time deposits
    191,244       (922 )     1.93       246,276       (1,426 )     2.32  
Total deposits
    454,376       (1,365 )     1.20       474,641       (1,860 )     1.57  
                                                 
Short-term borrowings
    10,500       (100 )     3.81                    
Long-term borrowings
    10,500       (89 )     3.39       25,500       (231 )     3.62  
Secured borrowings
    921       (13 )     5.65       971       (16 )     6.59  
Junior subordinated debentures
    13,403       (113 )     3.37       13,403       (121 )     3.61  
Total borrowings
    35,324       (315 )     3.57       39,874       (368 )     3.69  
                                                 
Total interest-bearing liabilities
  $ 489,700     $ (1,680 )     1.37 %   $ 514,515     $ (2,228 )     1.73 %
                                                 
Demand deposits
    83,562                       81,116                  
Other liabilities
    4,905                       3,879                  
Shareholders’ equity
    59,784                       57,657                  
                                                 
Total liabilities and shareholders’ equity
  $ 637,951                     $ 657,167                  
                                                 
Net interest income
          $ 5,882 *                   $ 5,904 *        
Net interest spread
                    4.09 %                     3.99 %
Net interest margin
                    3.95 %                     3.85 %
Tax equivalent adjustment
          $ 197 *                   $ 202 *        

* Tax equivalent basis – 34% tax rate used
(1) Interest income on loans includes loan fees of $166 and $158 in 2011 and 2010, respectively.

 
25

 

Interest and dividend income on a tax equivalent basis for the three months ended March 31, 2011 decreased $570,000, or 7.01%, compared to the same period 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 $480.1 million with an average yield of 5.75% for the three months ended March 31, 2011, compared to average loans of $490.9 million with an average yield of 5.95% for the same period in 2010.  Interest and dividend income on investment securities on a tax equivalent basis for the three months ended March 31, 2011 decreased $152,000, or 19.24%, 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 three months ended March 31, 2011 were $39.5 million with an average yield of 0.24% compared to $42.3 million with an average yield of 0.35% for the same period in 2010.  The decrease in average interest earning balances with banks is mostly due to the planned pay off of maturing brokered deposits throughout 2010 and into 2011.
 
Interest expense for the three months ended March 31, 2011 decreased $548,000, or 24.60%, compared to the same period 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 three months ended March 31, 2011 and 2010 were $454.4 million and $474.6 million, respectively, with an average cost of 1.20% and 1.57%, respectively.
 
Average borrowings for the three months ended March 31, 2011 were $35.3 million with an average cost of 3.57% compared to $39.9 million with an average cost of 3.69% for the same period in 2010.  The decrease in average borrowing balances outstanding is primarily due to the maturity of $4.5 million 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 $5.2 million 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 1.75% 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.  There were no changes to loss factors during the three months ended March 31, 2011.For additional information, please see the discussion under the heading “Critical Accounting Policies” in Item 7 of our 2010 10-K.
 
During the three months ended March 31, 2011, provision for credit losses totaled $500,000 compared to $800,000 for the same three month period in 2010, and compared to $3,600,000 for the twelve months ended December 31, 2010.  The decrease in provision for credit losses in the current year is the result of decreases in non-performing loans outstanding from $14,357,000 at March 31, 2010 compared to $10,842,000 at March 31, 2011.

 
26

 

For the three months ended March 31, 2011, net charge-offs were $343,000 compared to $65,000 for the same period in 2010 and $1,730,000 for the fourth quarter in 2010.  Net charge-offs for the twelve months ended December 31, 2010 were $4,075,000.  Net charge-offs continue to be centered in the residential construction and land development portfolios, which accounted for approximately $146,000, or 42.6%, of total net charge-offs for the current quarter.  The ratio of net charge-offs to average loans outstanding for the three months ended March 31, 2011 and 2010 was 0.07% and 0.01%, respectively.
 
At March 31, 2011, the allowance for credit losses was $10,774,000 compared to $10,617,000 at December 31, 2010, and $11,827,000 at March 31, 2010.  The increase compared to year-end 2010 is due to provision for credit losses of $500,000 in the quarter, which exceeded net charge-offs of $343,000 for the three months ended March 31, 2011.  The ratio of the allowance for credit losses to total loans outstanding (including loans held for sale) was 2.26%, 2.23% and 2.40%, at March 31, 2011, December 31, 2010 and March 31, 2010, respectively.  The slight increase in the allowance for credit losses as a percentage of total loans in the current three month period 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 $52,836,000, $51,310,000, and $54,209,000 at March 31, 2011, December 31, 2010 and March 31, 2010, respectively.  The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.55%, 2.50%, and 2.69%, 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 March 31, 2011.
 
Non-performing assets and other real estate owned.  Non-performing assets totaled $17,506,000 at March 31, 2011.  This represents 2.74% of total assets, compared to $16,579,000, or 2.57%, at December 31, 2010, and $22,944,000, or 3.55%, at March 31, 2010.  Construction and land development loans, including related OREO balances, continue to be the primary component of non-performing assets, representing $11,035,000, or 63.0%, of non-performing assets.

 
27

 
 
The following table presents information related to the Company’s non-performing assets:
 
SUMMARY OF NON-PERFORMING ASSETS
(in thousands)
 
March 31,
2011
   
December 31,
2010
   
March 31,
2010
 
                   
Accruing loans past due 90 days or more
  $ 85     $     $  
Restructured loans on accrual status
                 
                         
Non-accrual loans:
                       
Construction, land development and other land loans
    6,765       5,529       8,710  
Residential real estate 1-4 family
    1,734       2,246       1,551  
Multi-family real estate
                151  
Commercial real estate
    1,642       803       3,275  
Farmland
          170        
Consumer
                 
Commercial and industrial
    616       1,251       670  
Total non-accrual loans (2)
    10,757       9,999       14,357  
                         
Total non-performing loans
    10,842       9,999       14,357  
                         
OREO and repossessions
    6,664       6,580       8,587  
Total Non-Performing Assets
  $ 17,506     $ 16,579     $ 22,944  
                         
Allowance for credit losses
  $ 10,774     $ 10,617     $ 11,827  
Allowance for credit losses to non-performing loans
    99.37 %     106.18 %     82.38 %
Allowance for credit losses to non-performing assets
    61.54 %     64.04 %     51.55 %
Non-performing loans to total loans (1)
    2.30 %     2.15 %     2.91 %
Non-performing assets to total assets
    2.74 %     2.57 %     3.55 %

 
(1)
excludes loans held for sale
 
(2)
Includes $2,931,000 and $932,000 in non-accrual troubled debt restructured loans (“TDRs”) as of March 31, 2011 and December 31, 2010, respectively.  There were no TDRs as of March 31, 2010.

Non-performing loans increased $843,000, or 8.4%, from the balance at December 31, 2010 due to an increase in non-accrual construction and development loans.  While non-performing assets have improved over March 31, 2010, the level of non-performing assets is still considered elevated by historical standards and reflects the continued weakness in the real estate market.  The Company continues to aggressively monitor and identify non-performing assets and take action based upon available information.

The Company had troubled debt restructures totaling $2,931,000 and $932,000 at March 31, 2011 and December 31, 2010, respectively, which were on non-accrual status.  There were no TDRs as of March 31, 2010.  A 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” to the financial statements included in this report.

 
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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 cost or market (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 may 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 three months ended March 31, 2011 and 2010, as a result of these appraisals and other factors, the Company recorded OREO write-downs of $116,000 and $148,000, respectively, and net charge-offs of $343,000 and $65,000, respectively.  The Company will continue to reevaluate non-performing assets over the coming months as market conditions change.

OREO at March 31, 2011 totaled $6,664,000 and is made up as follows:  nine land or land development properties totaling $2,770,000, two residential construction properties totaling $1,500,000, six commercial real estate properties totaling $1,523,000, and five residential single family residences valued at $871,000.  The balances are recorded at the estimated net realizable value of the real estate less selling costs.
 
Non-interest income and expense.  Non-interest income for the three months ended March 31, 2011 decreased by $397,000, or 22.9%, compared to the same period in 2010.  The decrease is mostly attributable to a decrease in gain on sales of loans and investments, as well as an OTTI loss of $193,000.  These were partially offset by increases in services charges on deposits and 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 $553,000 and $744,000 for the three months ended March 31, 2011 and 2010. The decrease for the three 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 $30,461,000 for the three months ended March 31, 2011, compared to $41,818,000 for the same period in 2010.
 
Services charges on deposits for the three months ended March 31, 2011 increased $54,000, or 15.00%,  compared to the same period in 2010.  The increase is primarily the result of an automated overdraft privilege program that was implemented on April 1, 2010.  However, with overdraft regulations requiring opt-in provisions effective August, 2010, management does not expect future growth in overdraft revenue.
 
The Bank recorded gains on sale of securities available-for-sale of $110,000 and $229,000, during the three months ended March 31, 2011 and 2010, respectively.  For the three months ended March 31, 2011 one non-agency MBS was determined to be other-than-temporarily-impaired resulting in the Company recording $429,000 in impairments not related to credit losses through other comprehensive income and $193,000 in impairments related to credit losses through earnings.  There were no additional OTTI securities at March 31, 2011 or December 31, 2010.
 
Total non-interest expense for the three months ended March 31, 2011 slightly increased $60,000 to $6,142,000 compared to the same period in 2010.  The increase was primarily related to increases in salary and employee benefit costs, which were partially offset by decreases in expenses for occupancy and equipment, OREO, FDIC assessments and data processing
 
Salaries and employee benefits for the three months ended March 31, 2011 and 2010, were $3,428,000 and $3,237,000, respectively. The increase is 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 March 31, 2011 were 223 compared to 222 at December 31, 2010.

 
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Income taxes.  The federal income tax benefit for the three months ended March 31, 2011 and 2010 was $56,000 and $84,000, respectively.  The effective tax rate for the three months ended March 31, 2011 was 14.9%.  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 $638,386,000 at March 31, 2011, a decrease of $6,017,000, or 0.93%, 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 March 31, 2011 was $52,091,000 compared to $48,347,000 at the end of 2010, an increase of $3,744,000, or 7.74%.  During the first quarter, the Company sold $3,119,000 in securities for a gain of $110,000.  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, were flat at $475,998,000 at March 31, 2011, compared to $475,825,000 at December 31, 2010.  The decreases in construction and land development loans and residential 1-4 family loans were offset by increases in commercial and industrial loans and owner occupied commercial real estate loans.  Loan detail by category, including loans held for sale, as of March 31, 2011 and December 31, 2010 follows (in thousands):
 
   
March 31,
2011
   
December 31,
2010
 
             
Commercial and industrial
  $ 87,880     $ 84,575  
Real estate:
               
Construction and land development
    45,307       46,256  
Residential 1-4 family
    84,567       89,212  
Multi-family
    10,530       9,113  
Commercial real estate – owner occupied
    112,879       109,936  
Commercial real estate – non owner occupied
    105,037       106,079  
Farmland
    21,648       22,354  
Installment
    9,047       9,128  
Less unearned income
    (897 )     (828 )
Total Loans
    475,998       475,825  
Allowance for credit losses
    (10,774 )     (10,617 )
                 
Net Loans
  $ 465,224     $ 465,208  

Interest and fees earned on our loan portfolio is our primary source of revenue.  Gross loans represented 74.6% of total assets as of March 31, 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 large businesses for purposes ranging from working capital needs to term financing of equipment.

 
30

 

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 portfolio and continue to be successful at reducing our overall exposure in the residential construction and land development segments.   While these segments have historically played a significant role in our loan portfolio, balances are declining.  Construction and land development loans represent 9.5% and 9.7%, respectively, of our loan portfolio at March 31, 2011 and December 31, 2010.  We believe this segment will remain challenged into 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 very select and small 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 March 31, 2011, concentration in land and residential construction as a percentage of risk based capital stood at 62% and concentration in commercial real estate as a percentage of risk-based capital was 243%.

Deposits. Total deposits were $538,215,000 at March 31, 2011, a decrease of $6,739,000 or 1.24%, compared to December 31, 2010.  Deposit detail by category as of March 31, 2011 and December 31, 2010 follows (in thousands):

   
March 31,
2011
   
December 31,
2010
 
             
Demand, non-interest bearing
  $ 84,459     $ 95,115  
Interest bearing demand
    109,165       103,358  
Money market
    99,294       93,996  
Savings
    57,241       55,993  
Time, interest bearing
    188,056       196,492  
                 
Total deposits
  $ 538,215     $ 544,954  
 
Non-interest bearing demand deposits decreased $10,656,000, or 11.2%, 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 slightly $1,697,000 to $350,159,000.
 
Time deposits decreased $8,436,000, or 4.29%, 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 34.9% at March 31, 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.

 
31

 
 
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 March 31, 2011, with $53.9 million in cash and interest bearing deposits with banks and $45.7 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 $11,000,000, of which none was used as of March 31, 2011.  In addition, the Bank has a credit line with the Federal Home Loan Bank (“FHLB”) of Seattle for up to 20% of assets, of which $21,000,000 was used at March 31, 2011.  Based on current pledged collateral, the Bank had $107 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 $45 million at the Federal Reserve Bank subject to pledged collateral, of which none was used at March 31, 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.
 
At March 31, 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 March 31, 2011, deferred interest totaled $1,013,000 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, banks must have a Tier 1 leverage ratio of 5%, a Tier 1 risk-based 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.

 
32

 
 
The Company and the Bank qualify as well capitalized at March 31, 2011 and December 31, 2010 as demonstrated in the table below.
 
   
Company
   
Bank
   
Requirements
 
   
March
31, 2011
   
December
31, 2010
   
March
31, 2011
   
December
31, 2010
   
Adequately
Capitalized
   
Well
Capitalized
 
                                     
Tier 1 leverage ratio
    9.86 %     9.72 %     9.97 %     9.80 %     4 %     5 %
Tier 1 risk-based capital ratio
    13.21 %     13.21 %     13.38 %     13.35 %     4 %     6 %
Total risk-based capital ratio
    14.47 %     14.48 %     14.65 %     14.62 %     8 %     10 %

The Company and the Bank are subject to certain restrictions on the payment of dividends without prior regulatory approval.
 
Total shareholders' equity was $60,488,000 at March 31, 2011, an increase of $719,000, or 1.2%, compared to December 31, 2010.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Interest rate, credit, and operations risks are the most significant market risks that affect the Company's performance.  The Company relies on loan review, prudent loan underwriting standards, and an adequate allowance for possible credit losses to mitigate credit risk.
 
An asset/liability management simulation model is used to measure interest rate risk.  The model produces regulatory oriented measurements of interest rate risk exposure.  The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios.  The present value of equity is defined as the difference between the market value of assets less current liabilities.  By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.
 
The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period.  Therefore, a significant increase in market rates of interest could improve net interest income.  Conversely, a decreasing rate environment may adversely affect net interest income.
 
It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year.  Also, the simulation model results are not exact measures of the Company's actual interest rate risk.  They are only indicators of rate risk exposure based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates.  The rate risk exposure results of the simulation model typically are greater than the Company's actual rate risk.  That is due to the conservative modeling environment, which generally depicts a worst-case situation.  Management has assessed the results of the simulation reports as of March 31, 2011 and believes that there has been no material change since December 31, 2010.

 
33

 
 
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.

 
34

 
 
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:  May 10, 2011
By:
/s/ Dennis A. Long
   
Dennis A. Long
   
Chief Executive Officer
     
 
By:
/s/ Denise Portmann
   
Denise Portmann
   
Chief Financial Officer

 
35

 

EXHIBIT INDEX
 
EXHIBIT NO.
 
EXHIBIT
     
31.1
 
Certification of CEO under Rule 13a – 14(a) of the Exchange Act.
31.2
 
Certification of CFO under Rule 13a – 14(a) of the Exchange Act.
32
  
Certification of CEO and CFO under 18 U.S.C. Section 1350.

 
36