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Village Bank & Trust Financial Corp. - Quarter Report: 2012 June (Form 10-Q)

f10qvillage.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

__________

FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE EXCHANGE ACT

For the transition period from ______ to ______

____________


Commission file number: 0-50765

VILLAGE BANK AND TRUST FINANCIAL CORP.
(Exact name of registrant as specified in its charter)

Virginia
16-1694602
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
   
15521 Midlothian Turnpike, Midlothian, Virginia
23113
(Address of principal executive offices)
(Zip code)
   
804-897-3900
(Registrant’s telephone number, including area code)

Indicate by check whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes S     No £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See 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 £  (Do not check if smaller reporting company)
Smaller Reporting Company x

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

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.
4,251,795 shares of common stock, $4.00 par value, outstanding as of August 3, 2012
 



 
 

 

Village Bank and Trust Financial Corp.
Form 10-Q

TABLE OF CONTENTS

Part I – Financial Information
       
 
Item 1.  Financial Statements
 
       
 
Consolidated Balance Sheets
 
 
June 30, 2012 (unaudited) and December 31, 2011
3
       
 
Consolidated Statements of Operations For the Three and Six Months Ended
 
 
June 30, 2012 and 2011 (unaudited)
4
       
 
Consolidated Statements of Comprehensive Income (Loss)
 
 
For the Three and Six Months Ended June 30, 2012 and 2011 (unaudited)
5
       
 
Consolidated Statements of Stockholders’ Equity For the Six Months Ended
 
 
June 30, 2012 and 2011 (unaudited)
6
       
 
Consolidated Statements of Cash Flows For the Six Months Ended
 
 
June 30, 2012 and 2011 (unaudited)
7
       
 
Notes to Condensed Consolidated Financial Statements (unaudited)
8
       
 
Item 2.  Management’s Discussion and Analysis of Financial Condition
 
   
  and Results of Operations
33
       
 
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
56
       
 
Item 4. Controls and Procedures
56
       
Part II – Other Information
 
       
 
Item 1.  Legal Proceedings
58
       
 
Item 1A. Risk Factors
58
       
 
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
58
       
 
Item 3.  Defaults Upon Senior Securities
58
       
 
Item 4.  Mine Safety Disclosures
58
       
 
Item 5.  Other Information
58
       
 
Item 6.  Exhibits
58
       
Signatures
59

 
2

 

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

Village Bank and Trust Financial Corp. and Subsidiary
 
Consolidated Balance Sheet
 
June 30, 2012 (Unaudited) and December 31, 2011
 
             
   
June 30,
   
December 31,
 
   
2012
   
2011
 
Assets
           
Cash and due from banks
  $ 23,271,435     $ 55,557,541  
Federal funds sold
    3,834,563       7,228,475  
Total cash and cash equivalents
    27,105,998       62,786,016  
Investment securities available for sale
    36,696,282       30,163,292  
Loans held for sale
    19,729,508       16,168,405  
Loans
               
Outstandings
    393,035,350       427,870,716  
Allowance for loan losses
    (14,865,722 )     (16,071,424 )
Deferred fees and costs
    751,748       767,775  
      378,921,376       412,567,067  
Premises and equipment, net
    26,286,493       26,826,524  
Accrued interest receivable
    1,910,147       2,046,524  
Bank owned life insurance
    6,159,335       6,065,305  
Other real estate owned
    17,677,080       9,177,167  
Restricted equity securities
    2,767,886       2,989,286  
Other assets
    7,208,307       12,914,733  
                 
    $ 524,462,412     $ 581,704,319  
                 
Liabilities and Stockholders' Equity
               
Liabilities
               
Deposits
               
Noninterest bearing demand
  $ 64,348,408     $ 66,534,956  
Interest bearing
    386,071,500       418,986,096  
Total deposits
    450,419,908       485,521,052  
Federal Home Loan Bank advances
    29,000,000       37,750,000  
Long-term debt - trust preferred securities
    8,764,000       8,764,000  
Other borrowings
    5,062,344       5,778,661  
Accrued interest payable
    703,817       592,283  
Other liabilities
    5,458,402       7,050,681  
Total liabilities
    499,408,471       545,456,677  
                 
Stockholders' equity
               
Preferred stock, $4 par value, $1,000 liquidation preference
    58,952       58,952  
1,000,000 shares authorized, 14,738 shares issued and outstanding
               
Common stock, $4 par value - 10,000,000 shares issued and outstanding
               
4,251,795 shares issued and outstanding at June 30, 2012
               
4,243,378 shares issued and outstanding at December 31, 2011
    17,007,180       16,973,512  
Additional paid-in capital
    40,704,021       40,732,178  
Retained earnings (deficit)
    (33,438,097 )     (21,895,557 )
Preferred stock warrant
    732,479       732,479  
Discount on preferred stock
    (272,921 )     (346,473 )
Accumulated other comprehensive income (loss)
    262,327       (7,449 )
Total stockholders' equity
    25,053,941       36,247,642  
                 
    $ 524,462,412     $ 581,704,319  
                 
                 
See accompanying notes to consolidated financial statements
               
 

 
 
3

 
Village Bank and Trust Financial Corp. and Subsidiary
 
Consolidated Statements of Operations
 
Three and Six Months Ended June 30, 2012 and 2011
 
(Unaudited)
 
                         
                         
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Interest income
                       
Loans
  $ 5,614,263     $ 6,767,421     $ 11,513,471     $ 13,808,189  
Investment securities
    215,196       352,798       365,545       653,124  
Federal funds sold
    11,621       20,481       32,553       38,804  
Total interest income
    5,841,080       7,140,700       11,911,569       14,500,117  
                                 
Interest expense
                               
Deposits
    1,245,465       1,905,320       2,604,018       3,944,196  
Borrowed funds
    244,135       297,158       535,121       579,849  
Total interest expense
    1,489,600       2,202,478       3,139,139       4,524,045  
                                 
Net interest income
    4,351,480       4,938,222       8,772,430       9,976,072  
Provision for loan losses
    6,660,000       900,000       8,395,000       1,903,000  
Net interest income (loss) after provision
                               
for loan losses
    (2,308,520 )     4,038,222       377,430       8,073,072  
                                 
Noninterest income
                               
Service charges and fees
    540,335       498,432       1,047,978       871,382  
Gain on sale of loans
    2,191,229       1,636,240       3,941,892       3,008,918  
Gain (loss) on sale of securities
    99,470       19       263,677       63,144  
Rental income
    182,199       164,620       393,197       299,069  
Other
    121,896       106,554       211,855       201,072  
Total noninterest income
    3,135,129       2,405,865       5,858,599       4,443,585  
                                 
Noninterest expense
                               
Salaries and benefits
    3,305,869       3,195,283       6,404,093       6,245,399  
Occupancy
    579,931       518,712       1,160,800       994,448  
Equipment
    202,616       224,150       407,980       444,220  
Supplies
    105,311       109,785       197,213       225,944  
Professional and outside services
    733,909       523,092       1,369,291       1,089,446  
Advertising and marketing
    47,983       111,584       124,046       234,423  
Expenses related to foreclosed real estate
    677,848       361,896       1,796,623       824,212  
Other operating expenses
    1,027,500       1,010,448       2,030,721       1,877,307  
Total noninterest expense
    6,680,967       6,054,950       13,490,767       11,935,399  
                                 
Net income (loss) before income taxes
    (5,854,358 )     389,137       (7,254,738 )     581,258  
Income tax expense
    3,881,914       132,306       3,881,914       241,706  
                                 
Net income (loss)
    (9,736,272 )     256,831       (11,136,652 )     339,552  
                                 
Preferred stock dividends and amortization of discount
    185,449       220,169       405,898       438,227  
Net income (loss) available to common
                               
shareholders
  $ (9,921,721 )   $ 36,662     $ (11,542,550 )   $ (98,675 )
                                 
Earnings (loss) per share, basic
  $ (2.33 )   $ 0.01     $ (2.72 )   $ (0.02 )
Earnings (loss) per share, diluted
  $ (2.33 )   $ 0.01     $ (2.72 )   $ (0.02 )
 

 
 
4

 
 
Village Bank and Trust Financial Corp. and Subsidiary
 
Consolidated Statements of Comprehensive Income (Loss)
 
Three and Six Months Ended June 30, 2012 and 2011
 
(Unaudited)
 
                                     
   
For the Three Months Ended June 30,
 
   
2012
   
2011
 
         
Tax
               
Tax
       
         
Expense
               
Expense
       
   
Amount
   
(Benefit)
   
Total
   
Amount
   
(Benefit)
   
Total
 
                                     
Net Income (loss)
  $ (5,854,358 )   $ 3,881,914     $ (9,736,272 )   $ 389,137     $ 132,306     $ 256,831  
                                                 
Other comprehensive income:
                                               
Unrealized holding gains arising during the period
    1,046,534       355,821       690,712       (692,993 )     (235,618 )     (457,375 )
Reclassification adjustment for gains realized in income
    (99,470 )     (33,820 )     (65,650 )     (19 )     (6 )     (13 )
Minimum pension adjustment
    3,250       1,105       2,145       3,250       1,105       2,145  
Total other comprehensive income
    950,314       323,107       627,207       (689,762 )     (234,519 )     (455,243 )
                                                 
        Total comprehensive income (loss)
  $ (4,904,044 )   $ 4,205,021     $ (9,109,065 )   $ (300,625 )   $ (102,213 )   $ (198,412 )
                                                 
     
For the Six Months Ended June 30,
 
      2012       2011  
           
Tax
                   
Tax
         
           
Expense
                   
Expense
         
   
Amount
   
(Benefit)
   
Total
   
Amount
   
(Benefit)
   
Total
 
                                                 
Net Income (loss)
  $ (7,254,738 )   $ 3,881,914     $ (11,136,652 )   $ 581,258     $ 241,706     $ 339,552  
                                                 
Other comprehensive income:
                                               
Unrealized holding gains arising during the period
    665,929       226,416       439,513       1,103,971       375,350       728,621  
Reclassification adjustment for gains realized in income
    (263,677 )     (89,650 )     (174,027 )     (63,144 )     (21,469 )     (41,675 )
Minimum pension adjustment
    6,500       2,210       4,290       6,500       2,210       4,290  
Total other comprehensive income
    408,752       138,976       269,776       1,047,327       356,091       691,236  
                                                 
        Total comprehensive income (loss)
  $ (6,845,986 )   $ 4,020,890     $ (10,866,876 )   $ 1,628,585     $ 597,797     $ 1,030,788  
                                                 
                                                 
See accompanying notes to consolidated financial statements
 
 
5

 

 
Village Bank and Trust Financial Corp. and Subsidiary
Consolidated Statements of Stockholders' Equity
Six Months Ended June 30, 2012 and 2011
(Unaudited)
                                 
                           
Accumulated
   
           
Additional
 
Retained
     
Discount on
 
Other
   
   
Preferred
 
Common
 
Paid-in
 
Earnings
     
Preferred
 
Comprehensive
   
   
Stock
 
Stock
 
Capital
 
(Deficit)
 
Warrant
 
Stock
 
Income (loss)
 
Total
                                 
Balance, December 31, 2005
     
            7,418,472
 
              9,191,567
 
              585,416
         
             (43,562)
 
             17,151,893
Issuance of common stock
     
            2,829,880
 
              4,374,314
 
                         -
         
                       -
 
              7,204,194
Stock based compensation
     
                          -
 
                   23,007
 
                         -
         
                       -
 
                   23,007
Minimum pension adjustment
                               
(net of income taxes of
                               
$75,112)
     
                          -
 
                            -
 
                         -
         
           (145,806)
 
                (145,806)
Balance, December 31, 2011
 
 $       58,952
 
 $        16,973,512
 
 $          40,732,178
 
 $      (21,895,557)
 
 $     732,479
 
 $    (346,473)
 
 $            (7,449)
 
 $          36,247,642
Amortization of preferred stock
                         
                       -
 
                            -
discount
 
                  -
         
               (73,552)
 
                  -
 
         73,552
     
                            -
Preferred stock dividend
 
                  -
 
                          -
     
             (332,336)
 
                  -
 
                  -
 
                       -
 
                (332,336)
Issuance of common stock
 
                  -
 
                 33,668
 
                  (33,668)
 
                         -
 
                  -
 
                  -
 
                       -
 
                            -
Stock based compensation
         
                     5,511
                 
                     5,511
Minimum pension adjustment
                               
(net of income taxes of $2,917)
 
                  -
 
                          -
 
                            -
 
                         -
 
                  -
 
                  -
 
                4,290
 
                     4,290
Net income (loss)
 
                  -
 
                          -
 
                            -
 
         (11,136,652)
 
                  -
 
                  -
 
                       -
 
            (11,136,652)
Change in unrealized gain on
                               
investment securities available-for-sale,
                               
net of reclassification and tax effect
 
                  -
 
                          -
 
                            -
 
                         -
 
                  -
 
                  -
 
            265,486
 
                 265,486
                                 
Balance, June 30, 2012
 
 $       58,952
 
 $        17,007,180
 
 $          40,704,021
 
 $      (33,438,097)
 
 $     732,479
 
 $    (272,921)
 
 $         262,327
 
 $          25,053,942
                                 
Balance, December 31, 2010
 
 $       58,952
 
 $        16,953,664
 
 $          40,633,581
 
 $        (9,192,552)
 
 $     732,479
 
 $    (492,456)
 
 $        (373,474)
 
 $          48,320,194
Amortization of preferred stock
                         
                       -
 
                            -
discount
 
                  -
         
               (72,806)
 
                  -
 
         72,806
     
                            -
Preferred stock dividend
 
                  -
 
                          -
     
             (365,421)
 
                  -
 
                  -
 
                       -
 
                (365,421)
Issuance of common stock
 
                  -
 
                 19,848
 
                  (19,848)
 
                         -
 
                  -
 
                  -
 
                       -
 
                            -
Stock based compensation
         
                   59,223
                 
                   59,223
Minimum pension adjustment
                               
(net of income taxes of $2,917)
 
                  -
 
                          -
 
                            -
 
                         -
 
                  -
 
                  -
 
                4,290
 
                     4,290
Net income (loss)
 
                  -
 
                          -
 
                            -
 
              339,552
 
                  -
 
                  -
 
                       -
 
                 339,552
Change in unrealized gain on
                               
investment securities available-for-sale,
                               
net of reclassification and tax effect
 
                  -
 
                          -
 
                            -
 
                         -
 
                  -
 
                  -
 
            686,946
 
                 686,946
                                 
Balance, June 30, 2011
 
 $       58,952
 
 $        16,973,512
 
 $          40,672,956
 
 $        (9,291,227)
 
 $     732,479
 
 $    (419,650)
 
 $         317,762
 
 $          49,044,784
                                 

 
6

 
Village Bank and Trust Financial Corp. and Subsidiary
 
Consolidated Statements of Cash Flows
 
Six Months Ended June 30, 2012 and 2011
 
(Unaudited)
 
   
Six Months Ended June 30,
 
   
2012
   
2011
 
Cash Flows from Operating Activities
           
Net income (loss)
  $ (11,136,652 )   $ 339,552  
Adjustments to reconcile net income (loss) to net
               
cash provided by (used in) operating activities:
               
Depreciation and amortization
    764,926       716,443  
Deferred income taxes
    (4,290,620 )     (3,710,085 )
Valuation allowance on deferred tax asset
    6,281,101       -  
Provision for loan losses
    8,395,000       1,903,000  
Write-down of other real estate owned
    943,560       427,237  
Gain on securities sold
    (263,678 )     (63,144 )
Gain on loans sold
    (3,941,892 )     (3,008,918 )
Loss on sale of other real estate owned
    43,618       86,824  
Stock compensation expense
    5,511       59,223  
Proceeds from sale of mortgage loans
    140,739,661       114,982,327  
Origination of mortgage loans for sale
    (140,358,872 )     (104,077,018 )
Amortization of premiums and accrection of discounts on securities, net
    130,888       56,757  
(Increase) decrease in interest receivable
    136,377       (231,244 )
Increase in bank owned life insurance
    (94,030 )     (100,228 )
Decrease  in other assets
    5,901,368       4,188,569  
Increase in interest payable
    111,534       82,335  
Decrease in other liabilities
    (4,021,112 )     1,176,406  
Net cash provided by (used in) operating activities
    (653,312 )     12,828,036  
                 
Cash Flows from Investing Activities
               
Purchases of available for sale securities
    (36,395,416 )     (62,377,306 )
Proceeds from the sale or calls of available for sale securities
    28,804,399       803,100  
Proceeds from maturities and principal payments of  available for sale securities
    1,593,068       62,996,221  
Net decrease in loans
    14,634,257       5,347,767  
Proceeds from sale of other real estate owned
    1,129,343       2,382,588  
Purchases of premises and equipment
    (224,896 )     (579,743 )
Net cash provided by investing activities
    9,540,755       8,572,627  
                 
Cash Flows from Financing Activities
               
Net increase (decrease) in deposits
    (35,101,144 )     6,964,761  
Net increase (decrease) in Federal Home Loan Bank Advances
    (8,750,000 )     10,000,000  
Net increase (decrease) in other borrowings
    (716,317 )     1,568,180  
Net cash provided by (used in) financing activities
    (44,567,461 )     18,532,941  
                 
Net increase (decrease) in cash and cash equivalents
    (35,680,018 )     39,933,604  
Cash and cash equivalents, beginning of period
    62,786,016       12,012,311  
                 
Cash and cash equivalents, end of period
  $ 27,105,998     $ 51,945,915  
                 
Supplemental Schedule of Non Cash Activities
               
Real estate owned assets acquired in settlement of loans
  $ 10,616,434     $ 2,850,739  
Dividends on preferred stock accrued
  $ 332,336     $ -  
                 
See accompanying notes to consolidated financial statements.
               
                 
 
7

 



Village Bank and Trust Financial Corp. and Subsidiary
Notes to Condensed Consolidated Financial Statements
Three and Six Months Ended June 30, 2012 and 2011 (Unaudited)

Note 1 - Principles of presentation

Village Bank and Trust Financial Corp. (the “Company”) is the holding company of Village Bank (the “Bank”).  The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s three wholly-owned subsidiaries, Village Bank Mortgage Company, Village Insurance Agency, Inc., and Village Financial Services Company.  All material intercompany balances and transactions have been eliminated in consolidation.

In the opinion of management, the accompanying condensed consolidated financial statements of the Company have been prepared on the accrual basis in accordance with generally accepted accounting principles for interim financial information.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  However, all adjustments that are, in the opinion of management, necessary for a fair presentation have been included.  The results of operations for the three and six month periods ended June 30, 2012 are not necessarily indicative of the results to be expected for the full year ending December 31, 2012.  The unaudited interim financial statements should be read in conjunction with the audited financial statements and notes to financial statements that are presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 as filed with the Securities and Exchange Commission.

Note 2 - Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and statements of income for the period.  Actual results could differ significantly from those estimates.  A material estimate that is particularly susceptible to significant change in the near term relates to the determination of the allowance for loan losses and the related provision.

Note 3 - Earnings (loss) per common share

The following table presents the basic and diluted earnings per share computations:

 
8

 
 
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Numerator
                       
Net income (loss) - basic and diluted
  $ (9,736,272 )   $ 256,831     $ (11,136,652 )   $ 339,552  
Preferred stock dividend and accretion
    185,449       220,169       405,898       438,227  
Net income (loss) available to common
                               
shareholders
  $ (9,921,721 )   $ 36,662     $ (11,542,550 )   $ (98,675 )
                                 
Denominator
                               
Weighted average shares outstanding - basic
    4,250,579       4,243,378       4,250,579       4,242,665  
Dilutive effect of common stock options and
                               
      restricted stock awards
    -       -       -       -  
                                 
Weighted average shares outstanding - diluted
    4,250,579       4,243,378       4,250,579       4,242,665  
                                 
Earnings (loss) per share - basic and diluted
                               
Earnings (loss) per share - basic
  $ (2.33 )   $ 0.01     $ (2.72 )   $ (0.02 )
Effect of dilutive common stock options
    -       -       -       -  
                                 
Earnings (loss) per share - diluted
  $ (2.33 )   $ 0.01     $ (2.72 )   $ (0.02 )

Outstanding options and warrants to purchase common stock were considered in the computation of diluted earnings per share for the periods presented.  Stock options for 261,530 shares of common stock were not included in computing diluted earnings per share for the three and six months ended June 30, 2012 because their effects were anti-dilutive.  Warrants for 499,029 shares of common stock were not included in computing earnings per share in 2012 and 2011 because their effects were also anti-dilutive.

Note 4 – Investment securities available for sale

At June 30, 2012 and December 31, 2011, all of our securities were classified as available-for-sale.  The following table presents the composition of our investment portfolio at the dates indicated (dollars in thousands).
 
 
9

 

               
Gross
   
Gross
   
Estimated
       
   
Par
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
   
Average
 
   
Value
   
Cost
   
Gains
   
Losses
   
Value
   
Yield
 
June 30, 2012
                                   
                                     
US Government Agencies
                                   
More than ten years
  $ 15,300     $ 18,264     $ 472     $ -     $ 18,736       3.27 %
      15,300       18,264       472       -       18,736       3.27 %
Mortgage-backed securities
                                               
One to five years
    3       3       -       -       3       0.01 %
More than ten years
    11,363       11,961       64       (10 )     12,016       1.51 %
Total
    11,366       11,964       64       (10 )     12,019       1.51 %
                                                 
Municipals
                                               
Five to ten years
    3,500       4,137       5       -       4,142       2.56 %
More than ten years
    1,550       1,784       15       -       1,799       3.52 %
Total
    5,050       5,921       20       -       5,941       2.85 %
                                                 
Total investment securities
  $ 31,716     $ 36,149     $ 557     $ (10 )   $ 36,696       2.63 %
                                                 
December 31, 2011
                                               
                                                 
US Government Agencies
                                               
More than ten years
  $ 2,000     $ 2,000     $ 1     $ -     $ 2,001       3.81 %
                                                 
Mortgage-backed securities
                                               
One to five years
    11       11       -       -       11       0.01 %
More than ten years
    19,870       20,621       220       (49 )     20,792       1.83 %
Total
    19,881       20,632       220       (49 )     20,803       1.83 %
                                                 
Other investments
                                               
More than ten years
    7,356       7,386       -       (27 )     7,359       0.55 %
                                                 
Total investment securities
  $ 29,237     $ 30,018     $ 221     $ (76 )   $ 30,163       1.65 %
 

Investment securities available for sale that have an unrealized loss position at June 30, 2012 and December 31, 2011 are detailed below (dollars in thousands).

   
Securities in a loss
   
Securities in a loss
             
   
Position for less than
   
Position for more than
             
   
12 Months
   
12 Months
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
June 30, 2012
 
(in Thousands)
 
Mortgage-backed securities
  $ 2,331     $ (10 )   $ 3     $ -     $ 2,334     $ (10 )
                                                 
Total
  $ 2,331     $ (10 )   $ 3     $ -     $ 2,334     $ (10 )
                                                 
December 31, 2011
     
US Treasuries
  $ 7,358     $ (27 )   $ -     $ -     $ 7,358     $ (27 )
Mortgage-backed securities
    10,221       (47 )     205       (2 )     10,426       (49 )
                                                 
Total
  $ 17,579     $ (74 )   $ 205     $ (2 )   $ 17,784     $ (76 )

 
10

 
Management does not believe that any individual unrealized loss as of June 30, 2012 and December 31, 2011 is other than a temporary impairment.  These unrealized losses are primarily attributable to changes in interest rates.  As of June 30, 2012, management does not have the intent to sell any of the securities classified as available for sale and management believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.

Note 5 – Loans and allowance for loan losses

The following table presents the composition of our loan portfolio (excluding mortgage loans held for sale) at the dates indicated (dollars in thousands).

   
June 30, 2012
   
December 31, 2011
 
   
Amount
   
%
   
Amount
   
%
 
Construction and land development
                       
Residential
  $ 7,442       1.89 %   $ 7,906       1.85 %
Commercial
    55,828       14.20 %     72,621       16.97 %
    Total construction and land development
    63,270       16.09 %     80,527       18.82 %
Commercial real estate
                               
Farmland
    2,447       0.62 %     2,465       0.58 %
Commercial real estate - owner occupied
    100,149       25.48 %     105,592       24.68 %
Commercial real estate - non-owner occupied
    55,891       14.22 %     54,059       12.63 %
Multifamily
    6,960       1.77 %     6,680       1.56 %
    Total commercial real estate
    165,447       42.09 %     168,796       39.45 %
Consumer real estate
                               
Home equity lines
    28,365       7.22 %     30,687       7.17 %
Secured by 1-4 family residential, secured by first deeds of trust
    84,775       21.58 %     93,219       21.79 %
Secured by 1-4 family residential, secured by second deeds of trust
    10,095       2.57 %     12,042       2.81 %
   Total consumer real estate
    123,235       31.37 %     135,948       31.77 %
Commercial and industrial loans (except those secured by real estate)
    37,529       9.55 %     37,734       8.82 %
Consumer and other
    3,554       0.90 %     4,865       1.14 %
                                 
Total Loans
    393,035       100.0 %     427,870       100.0 %
Deferred loan cost (unearned income), net
    752               768          
Less:  Allowance for loan losses
    (14,866 )             (16,071 )        
                                 
    $ 378,921             $ 412,567          

The Company assigns risk rating classifications to its loans.  These risk ratings are divided into the following groups:

 
·
Risk rated 1 to 4 loans are considered of sufficient quality to preclude an adverse rating.  1-4 assets generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral;
 
·
Risk rated 5 loans are defined as having potential weaknesses that deserve management’s close attention;
 
·
Risk rated 6 loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any, and;
 
·
Risk rated 7 loans have all the weaknesses inherent in substandard loans, with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

 
11

 
The following tables provide information on the risk rating of loans at the dates indicated:
 
   
June 30, 2012
 
   
Risk Rated
   
Risk Rated
   
Risk Rated
   
Risk Rated
   
Total
 
      1-4       5       6       7    
Loans
 
                                       
Construction and land development
                                     
Residential
  $ 6,197,776     $ 671,709     $ 572,439     $ -     $ 7,441,924  
Commercial
    29,535,994       1,403,600       24,388,336       500,472       55,828,402  
    Total construction and land development
    35,733,770       2,075,309       24,960,775       500,472       63,270,326  
                                         
Commercial real estate
                                       
Farmland
    1,397,310               1,049,489       -       2,446,799  
Commercial real estate - owner occupied
    73,149,268       11,261,166       15,480,900       257,898       100,149,232  
Commercial real estate - non-owner occupied
    25,607,380       11,142,004       19,141,489       -       55,890,873  
Multifamily
    4,702,665       1,091,058       1,166,632       -       6,960,355  
    Total commercial real estate
    104,856,623       23,494,228       36,838,510       257,898       165,447,259  
                                         
Consumer real estate
                                       
Home equity lines
    22,888,912       2,267,061       3,134,202       75,000       28,365,175  
Secured by 1-4 family residential, secured by first deeds of trust
    58,547,748       7,258,617       18,968,098       -       84,774,463  
Secured by 1-4 family residential, secured by second deeds of trust
    8,218,980       419,994       1,456,145       -       10,095,119  
   Total consumer real estate
    89,655,640       9,945,672       23,558,445       75,000       123,234,757  
                                         
Commercial and industrial loans (except those secured by real estate)
    29,206,043       1,732,430       5,740,435       850,305       37,529,213  
                                         
Consumer and other
    3,311,242       182,600       59,953       -       3,553,795  
                                         
Total Loans
  $ 262,763,318     $ 37,430,239     $ 91,158,118     $ 1,683,675     $ 393,035,350  
 
   
December 31, 2011
 
                               
   
Risk Rated
   
Risk Rated
   
Risk Rated
   
Risk Rated
   
Total
 
      1-4       5       6       7    
Loans
 
                                       
Construction and land development
                                     
Residential
  $ 4,943,061             $ 2,963,404     $ -     $ 7,906,465  
Commercial
    44,315,474       -       28,305,063       -       72,620,537  
    Total construction and land development
    49,258,535       -       31,268,467       -       80,527,002  
                                         
Commercial real estate
                                       
Farmland
    2,464,981       -       -       -       2,464,981  
Commercial real estate - owner occupied
    46,958,816       16,352,920       42,280,412       -       105,592,148  
Commercial real estate - non-owner occupied
    37,581,904       3,036,887       13,440,358       -       54,059,149  
Multifamily
    5,511,882       -       1,167,446       -       6,679,328  
    Total commercial real estate
    92,517,583       19,389,807       56,888,216       -       168,795,606  
                                         
Consumer real estate
                                       
Home equity lines
    26,403,850       1,373,002       2,910,374       -       30,687,226  
Secured by 1-4 family residential, secured by first deeds of trust
    80,670,887       6,052,128       6,495,783       -       93,218,798  
Secured by 1-4 family residential, secured by second deeds of trust
    9,960,928       706,484       1,374,651       -       12,042,063  
   Total consumer real estate
    117,035,665       8,131,614       10,780,808       -       135,948,087  
                                         
Commercial and industrial loans (except those secured by real estate)
    31,322,834       4,289,037       2,122,645       -       37,734,516  
                                         
Consumer and other
    3,508,768       384,387       972,350       -       4,865,505  
                                         
Total Loans
  $ 293,643,385     $ 32,194,845     $ 102,032,486     $ -     $ 427,870,716  
 
The following table presents the aging of the recorded investment in past due loans and leases as of the dates indicated:
 
 
12

 

June 30, 2012
 
                                       
Recorded
 
               
Greater
                     
Investment >
 
   
30-59 Days
   
60-89 Days
   
Than
   
Total Past
         
Total
   
90 Days and
 
   
Past Due
   
Past Due
   
90 Days
   
Due
   
Current
   
Loans
   
Accruing
 
                                           
                                           
Construction and land development
                                         
Residential
  $ -     $ -     $ -     $ -     $ 7,441,924     $ 7,441,924     $ -  
Commercial
    346,786       509,927       -       856,713       54,971,689       55,828,402       -  
    Total construction and land development
    346,786       509,927       -     $ 856,713     $ 62,413,613     $ 63,270,326       -  
                                                         
Commercial real estate
                                                       
Farmland
    -       -       -       -       2,446,799       2,446,799       -  
Commercial real estate - owner occupied
    2,873,063       341,526       -       3,214,589       96,934,643       100,149,232       -  
Commercial real estate - non-owner occupied
    543,138       2,772,366       -       3,315,504       52,575,369       55,890,873       -  
Multifamily
    -       -       -       -       6,960,355       6,960,355       -  
    Total commercial real estate
    3,416,201       3,113,892       -       6,530,093       158,917,166       165,447,259       -  
                                                         
Consumer real estate
                                                       
Home equity lines
    516,932       427,843       -       944,775       27,420,400       28,365,175       -  
Secured by 1-4 family residential, secured
   by first deeds of trust
    1,273,713       600,391       199,380       2,073,484       82,700,979       84,774,463       199,380  
Secured by 1-4 family residential,
   secured by second deeds of trust
    -       125,506       -       125,506       9,969,613       10,095,119       -  
   Total consumer real estate
    1,790,645       1,153,740       199,380       3,143,765       120,090,992       123,234,757       199,380  
                                                         
Commercial and industrial loans (except those 
    secured by real estate)
    3,202,797       -       -       3,202,797       34,326,416       37,529,213       -  
                                                         
Consumer and other
    57,795       6,018       -       63,813       3,489,982       3,553,795       -  
                                                         
Total Loans
  $ 8,814,224     $ 4,783,577     $ 199,380     $ 13,797,181     $ 379,238,169     $ 393,035,350     $ 199,380  
 
December 31, 2011
 
                                       
Recorded
 
               
Greater
                     
Investment >
 
   
30-59 Days
   
60-89 Days
   
Than
   
Total Past
         
Total
   
90 Days and
 
   
Past Due
   
Past Due
   
90 Days
   
Due
   
Current
   
Loans
   
Accruing
 
                                           
                                           
Construction and land development:
                                         
Residential
  $ 575,200     $ 251,799     $ -     $ 826,999     $ 7,079,466     $ 7,906,465     $ -  
Commercial
    1,367,360       408,000       36,770       1,812,130       70,808,407       72,620,537       36,770  
    Total construction and land development
    1,942,560       659,799       36,770     $ 2,639,129     $ 77,887,873     $ 80,527,002       36,770  
                                                         
Commercial real estate:
                                                       
Farmland
    -       -       -       -       2,464,981       2,464,981       -  
Commercial real estate - owner occupied
    598,006       36,972       -       634,978       104,957,170       105,592,148       -  
Commercial real estate - non-owner occupied
    55,709       673,561       -       729,270       53,329,879       54,059,149       -  
Multifamily
    111,571       255,196       -       366,767       6,312,561       6,679,328       -  
    Total commercial real estate
    765,286       965,729       -       1,731,015       167,064,591       168,795,606       -  
                                                         
Consumer real estate:
                                                       
Home equity lines
    323,349       99,494       299,783       722,626       29,964,600       30,687,226       299,783  
Secured by 1-4 family residential, secured
   by first deeds of trust
    985,116       1,572,973       624,740       3,182,829       90,035,969       93,218,798       624,740  
Secured by 1-4 family residential, secured
  by second deeds of trust
    12,673       132,928       156,026       301,627       11,740,436       12,042,063       156,026  
   Total consumer real estate
    1,321,138       1,805,395       1,080,549       4,207,082       131,741,005       135,948,087       1,080,549  
                                                         
Commercial and industrial loans (except those
   secured by real estate)
    46,392       3,313       54,918       104,623       37,629,893       37,734,516       54,918  
                                                         
Consumer and other
    59,697       3,176       -       62,873       4,802,632       4,865,505       -  
                                                         
Total Loans
  $ 4,135,073     $ 3,437,412     $ 1,172,237     $ 8,744,722     $ 419,125,994     $ 427,870,716     $ 1,172,237  

Loans are considered impaired when, based on current information and events it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by
 
 
13

 
management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired then a specific reserve is established for the amount of impairment.  Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans.  If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.  Impaired loans, or portions thereof, are charged off when deemed uncollectible.  June 30, 2012 and year-end impaired loans are set forth in the following table.

 
14

 
   
June 30, 2012
 
         
Unpaid
       
   
Recorded
   
Principal
   
Related
 
   
Investment
   
Balance
   
Allowance
 
                   
With no related allowance recorded
                 
                   
Construction and land development
                 
Residential
  $ 489,503     $ 978,503     $ -  
Commercial
    15,051,292       19,436,447       -  
    Total construction and land development
    15,540,795       20,414,950       -  
Commercial real estate
                       
Farmland
    1,049,489       1,049,489       -  
Commercial real estate - owner occupied
    6,872,799       6,903,383       -  
Commercial real estate - non-owner occupied
    8,374,527       8,549,256       -  
Multifamily
    941,632       941,632       -  
    Total commercial real estate
    17,238,447       17,443,760       -  
Consumer real estate
                       
Home equity lines
    1,725,387       1,887,187       -  
Secured by 1-4 family residential, secured by first deeds of trust
    10,988,639       13,033,493       -  
Secured by 1-4 family residential, secured by second deeds of trust
    836,754       1,012,754       -  
   Total consumer real estate
    13,550,780       15,933,434       -  
Commercial and industrial loans (except those secured by real estate)
    1,071,027       1,789,527       -  
Consumer and other
    36,987       36,987       -  
    $ 47,438,036     $ 55,618,658     $ -  
                         
With an allowance recorded
                       
                         
Construction and land development:
                       
Residential
  $ -     $ -     $ -  
Commercial
    6,509,162       8,711,930       1,133,647  
    Total construction and land development
    6,509,162       8,711,930       1,133,647  
Commercial real estate:
                       
Farmland
    -       -       -  
Commercial real estate - owner occupied
    7,020,688       7,277,790       1,852,684  
Commercial real estate - non-owner occupied
    5,008,676       5,008,676       1,338,605  
Multifamily
    -       -       -  
    Total commercial real estate
    12,029,364       12,286,466       3,191,289  
Consumer real estate:
                       
Home equity lines
    418,936       467,220       154,665  
Secured by 1-4 family residential, secured by first deeds of trust
    4,426,370       4,598,717       719,908  
Secured by 1-4 family residential, secured by second deeds of trust
    117,322       117,322       105,997  
   Total consumer real estate
    4,962,628       5,183,259       980,570  
Commercial and industrial loans (except those secured by real estate)
    1,515,187       1,852,776       831,471  
Consumer and other
    -       -       -  
    $ 25,016,341     $ 28,034,431     $ 6,136,977  
                         
Total
                       
Construction and land development
                       
Residential
  $ 489,503     $ 978,503     $ -  
Commercial
    21,560,454       28,148,377       1,133,647  
    Total construction and land development
    22,049,957       29,126,880       1,133,647  
Commercial real estate
                       
Farmland
    1,049,489       1,049,489       -  
Commercial real estate - owner occupied
    13,893,487       14,181,173       1,852,684  
Commercial real estate - non-owner occupied
    13,383,203       13,557,932       1,338,605  
Multifamily
    941,632       941,632       -  
    Total commercial real estate
    29,267,811       29,730,226       3,191,289  
Consumer real estate
                       
Home equity lines
    2,144,323       2,354,407       154,665  
Secured by 1-4 family residential, secured by first deeds of trust
    15,415,009       17,632,210       719,908  
Secured by 1-4 family residential, secured by second deeds of trust
    954,076       1,130,076       105,997  
   Total consumer real estate
    18,513,408       21,116,693       980,570  
Commercial and industrial loans (except those secured by real estate)
    2,586,214       3,642,303       831,471  
Consumer and other
    36,987       36,987       -  
    $ 72,454,377     $ 83,653,089     $ 6,136,977  
                         
 
 
15

 
   
December 31, 2011
 
         
Unpaid
       
   
Recorded
   
Principal
   
Related
 
   
Investment
   
Balance
   
Allowance
 
                   
With no related allowance recorded
                 
                   
Construction and land development
                 
Residential
  $ 624,651     $ 712,243     $ -  
Commercial
    9,722,132       11,094,408       -  
    Total construction and land development
    10,346,783       11,806,651       -  
Commercial real estate
                       
Farmland
    -       -       -  
Commercial real estate - owner occupied
    6,414,362       6,414,362       -  
Commercial real estate - non-owner occupied
    7,146,531       7,146,531       -  
Multifamily
    2,019,675       2,019,675       -  
    Total commercial real estate
    15,580,568       15,580,568       -  
Consumer real estate
                       
Home equity lines
    702,338       702,338       -  
Secured by 1-4 family residential, secured by first deeds of trust
    6,319,837       6,792,837       -  
Secured by 1-4 family residential, secured by second deeds of trust
    336,257       336,257       -  
   Total consumer real estate
    7,358,432       7,831,432       -  
Commercial and industrial loans (except those secured by real estate)
    1,194,913       1,494,913       -  
Consumer and other
    143,241       143,241       -  
    $ 34,623,937     $ 36,856,805     $ -  
                         
With an allowance recorded
                       
                         
Construction and land development
                       
Residential
  $ 587,235     $ 587,235     $ 320,250  
Commercial
    14,885,541       15,785,541       3,913,820  
    Total construction and land development
    15,472,776       16,372,776       4,234,070  
Commercial real estate
                       
Farmland
    -       -       -  
Commercial real estate - owner occupied
    9,508,393       9,652,393       2,031,740  
Commercial real estate - non-owner occupied
    1,719,690       1,719,690       450,000  
Multifamily
    -       -       -  
    Total commercial real estate
    11,228,083       11,372,083       2,481,740  
Consumer real estate
                       
Home equity lines
    756,892       756,892       233,606  
Secured by 1-4 family residential, secured by first deeds of trust
    4,224,325       4,749,325       1,007,155  
Secured by 1-4 family residential, secured by second deeds of trust
    167,523       167,523       119,524  
   Total consumer real estate
    5,148,740       5,673,740       1,360,285  
Commercial and industrial loans (except those secured by real estate)
    818,597       818,597       452,773  
Consumer and other
    267,166       267,166       266,178  
    $ 32,935,362     $ 34,504,362     $ 8,795,046  
                         
Total
                       
Construction and land development
                       
Residential
  $ 1,211,886     $ 1,299,478     $ 320,250  
Commercial
    24,607,673       26,879,949       3,913,820  
    Total construction and land development
    25,819,559       28,179,427       4,234,070  
Commercial real estate
                       
Farmland
    -       -       -  
Commercial real estate - owner occupied
    15,922,755       16,066,755       2,031,740  
Commercial real estate - non-owner occupied
    8,866,221       8,866,221       450,000  
Multifamily
    2,019,675       2,019,675       -  
    Total commercial real estate
    26,808,651       26,952,651       2,481,740  
Consumer real estate
                       
Home equity lines
    1,459,230       1,459,230       233,606  
Secured by 1-4 family residential, secured by first deeds of trust
    10,544,162       11,542,162       1,007,155  
Secured by 1-4 family residential, secured by second deeds of trust
    503,780       503,780       119,524  
   Total consumer real estate
    12,507,172       13,505,172       1,360,285  
Commercial and industrial loans (except those secured by real estate)
    2,013,510       2,313,510       452,773  
Consumer and other
    410,407       410,407       266,178  
    $ 67,559,299     $ 71,361,167     $ 8,795,046  
                         
 
The following is a summary of average recorded investment in impaired loans with and without
 
 
16

 
a valuation allowance and interest income recognized on those loans for the three and six months ended June 30, 2012.
 
   
For the Three Months
   
For the Six Months
 
   
Ended June 30, 2012
   
Ended June 30, 2012
 
                         
   
Average
   
Interest
   
Average
   
Interest
 
   
Recorded
   
Income
   
Recorded
   
Income
 
   
Investment
   
Recognized
   
Investment
   
Recognized
 
                         
Impaired loans with no related allowance recorded
                       
                         
Construction and land development
                       
Residential
  $ 1,301,243     $ 7,401     $ 978,503     $ 11,741  
Commercial
    17,785,898       55,716       21,838,440       181,033  
    Total construction and land development
    19,087,141       63,117       22,816,943       192,774  
Commercial real estate
                               
Farmland
    524,745       15,405       1,049,489       15,405  
Commercial real estate - owner occupied
    9,571,973       73,330       9,609,792       225,959  
Commercial real estate - non-owner occupied
    8,599,009       110,449       9,118,068       240,093  
Multifamily
    777,933       27,298       942,216       27,298  
    Total commercial real estate
    19,473,659       226,482       20,719,565       508,755  
Consumer real estate
                               
Home equity lines
    1,639,963       27,955       1,887,350       32,979  
Secured by 1-4 family residential, secured by first deeds of trust
    11,593,774       125,304       13,101,708       230,755  
Secured by 1-4 family residential, secured by second deeds of trust
    754,922       10,430       1,021,578       18,112  
   Total consumer real estate
    13,988,659       163,689       16,010,636       281,846  
Commercial and industrial loans (except those secured by real estate)
    1,524,274       13,297       1,792,752       21,909  
Consumer and other
    199,919       445       38,578       1,093  
    $ 54,273,651     $ 467,030     $ 61,378,474     $ 1,006,377  
                                 
Impaired loans with an allowance recorded
                               
                                 
Construction and land development:
                               
Residential
  $ -     $ -     $ -     $ -  
Commercial
    5,092,484       9,016       9,656,982       9,016  
    Total construction and land development
    5,092,484       9,016       9,656,982       9,016  
Commercial real estate:
                               
Farmland
                               
Commercial real estate - owner occupied
    6,864,617       31,174       7,438,497       46,386  
Commercial real estate - non-owner occupied
    3,406,420       21,158       5,043,459       35,586  
Multifamily
    -       -       -       -  
    Total commercial real estate
    10,271,037       52,332       12,481,956       81,972  
Consumer real estate:
                               
Home equity lines
    434,976       3,995       472,476       4,151  
Secured by 1-4 family residential, secured by first deeds of trust
    3,555,198       27,332       4,656,755       44,009  
Secured by 1-4 family residential, secured by second deeds of trust
    58,710       508       117,420       1,684  
   Total consumer real estate
    4,048,884       31,835       5,246,651       49,844  
Commercial and industrial loans (except those secured by real estate)
    1,873,540       25,072       1,873,540       32,588  
Consumer and other
    -       -       -       -  
    $ 21,285,944     $ 118,255     $ 29,259,129     $ 173,420  
                                 
Total
                               
Construction and land development
                               
Residential
  $ 1,301,243     $ 7,401     $ 978,503     $ 11,741  
Commercial
    22,878,382       64,732       31,495,422       190,049  
    Total construction and land development
    24,179,624       72,133       32,473,925       201,790  
Commercial real estate
                               
Farmland
    524,745       15,405       1,049,489       15,405  
Commercial real estate - owner occupied
    16,436,590       104,504       17,048,289       272,345  
Commercial real estate - non-owner occupied
    12,005,429       131,607       14,161,527       275,679  
Multifamily
    777,933       27,298       942,216       27,298  
    Total commercial real estate
    29,744,696       278,814       33,201,521       590,727  
Consumer real estate
                               
Home equity lines
    2,074,939       31,950       2,359,826       37,130  
Secured by 1-4 family residential, secured by first deeds of trust
    15,148,972       152,636       17,758,463       274,764  
Secured by 1-4 family residential, secured by second deeds of trust
    813,632       10,938       1,138,998       19,796  
   Total consumer real estate
    18,037,542       195,524       21,257,287       331,690  
Commercial and industrial loans (except those secured by real estate)
    3,397,814       38,369       3,666,292       54,497  
Consumer and other
    199,919       445       38,578       1,093  
    $ 75,559,595     $ 585,285     $ 90,637,603     $ 1,179,797  

Included in impaired loans are loans classified as troubled debt restructurings (TDRs).  A
 
 
17

 
modification of a loan’s terms constitutes a TDR if the creditor grants a concession to the borrower for economic or legal reasons related to the borrowers financial difficulties that it would not otherwise consider.  For loans classified as impaired TDRs, the Company further evaluates the loans as performing or nonperforming.  If, at the time of restructure, the loan is not considered nonaccrual, it will be classified as performing.  TDRs originally classified as nonperforming are able to be reclassified as performing if, subsequent to restructure, they experience six months of payment performance according to the restricted terms.  The following table provides certain information concerning TDRs as of June 30, 2012.

   
Three Months Ended June 30, 2012
 
                     
Specific
 
                     
Valuation
 
   
Total
   
Performing
   
Nonaccrual
   
Allowance
 
                         
Construction and land development:
                       
Commercial
  $ 625,764       -     $ 625,764       -  
    Total construction and land development
    625,764       -       625,764       -  
Commercial real estate:
                               
Commercial real estate - owner occupied
    1,398,661       -       1,398,661       196,000  
Commercial real estate - non-owner occupied
    2,626,306       -       2,626,306       663,570  
    Total commercial real estate
    4,024,967       -       4,024,967       859,570  
Consumer real estate:
                               
Secured by 1-4 family residential, secured by first deeds of trust
    416,598       -       416,598       50,713  
   Total consumer real estate
    416,598       -       416,598       50,713  
    $ 5,067,329     $ -     $ 5,067,329     $ 910,283  
 
   
Six Months Ended June 30, 2012
 
                     
Specific
 
                     
Valuation
 
   
Total
   
Performing
   
Nonaccrual
   
Allowance
 
                         
Construction and land development:
                       
Residential
  $ 360,343     $ -     $ 360,343     $ -  
Commercial
    14,540,256       3,785,942       10,754,314       996,602  
    Total construction and land development
    14,900,599       3,785,942       11,114,657       996,602  
Commercial real estate:
                               
Farmland
    -       -       -       -  
Commercial real estate - owner occupied
    10,580,554       537,029       10,043,525       1,025,656  
Commercial real estate - non-owner occupied
    9,068,618       4,475,603       4,593,015       753,170  
Multifamily
    575,679       575,679       -       -  
    Total commercial real estate
    20,224,851       5,588,311       14,636,540       1,778,826  
Consumer real estate:
                               
Home equity lines
    349,192       -       349,192       96,569  
Secured by 1-4 family residential, secured by first deeds of trust
    6,614,202       1,478,043       5,136,159       579,444  
Secured by 1-4 family residential, secured by second deeds of trust
    69,815       -       69,815       -  
   Total consumer real estate
    7,033,209       1,478,043       5,555,166       676,013  
Commercial and industrial loans (except those secured by real estate)
    269,659       6,552       263,107       83,400  
Consumer and other
    -       -       -       -  
    $ 42,428,318     $ 10,858,848     $ 31,569,470     $ 3,534,841  
 
 
18

 

The following table provides information about TDRs identified during the current period:

   
Three Months Ended
 
   
June 30, 2012
 
         
Pre-
   
Post-
 
         
Modification
   
Modification
 
   
Number of
   
Recorded
   
Recorded
 
   
Loans
   
Balance
   
Balance
 
                   
Construction and land development:
                 
Residential
    -     $ -     $ -  
Commercial
    4       625,764       625,764  
    Total construction and land development
    4       625,764       625,764  
Commercial real estate:
                       
Farmland
            -       -  
Commercial real estate - owner occupied
    1       1,398,661       1,398,661  
Commercial real estate - non-owner occupied
    1       2,626,306       2,626,306  
Multifamily
    -       -       -  
    Total commercial real estate
    2       4,024,967       4,024,967  
Consumer real estate:
                       
Home equity lines
    -       -       -  
Secured by 1-4 family residential, secured by first deeds of trust
    2       416,598       416,598  
Secured by 1-4 family residential, secured by second deeds of trust
    -       -       -  
   Total consumer real estate
    2       416,598       416,598  
Commercial and industrial loans (except those secured by real estate)
    -       -       -  
Consumer and other
    -       -       -  
      8       5,067,329       5,067,329  
 
There were no loans in default for the three month period ended June 30, 2012.

   
Six Months Ended
   
Year Ended
 
   
June 30, 2012
   
December 31, 2011
 
         
Pre-
   
Post-
         
Pre-
   
Post-
 
         
Modification
   
Modification
         
Modification
   
Modification
 
   
Number of
   
Recorded
   
Recorded
   
Number of
   
Recorded
   
Recorded
 
   
Loans
   
Balance
   
Balance
   
Loans
   
Balance
   
Balance
 
                                     
Construction and land development:
                                   
Residential
    5     $ 360,343     $ 360,343           $ -     $ -  
Commercial
    17       4,890,578       4,890,578       11       6,604,400       6,604,400  
    Total construction and land development
    22       5,250,921       5,250,921       11     $ 6,604,400       6,604,400  
Commercial real estate:
                                            -  
Farmland
            -       -                       -  
Commercial real estate - owner occupied
            -       -       9       9,748,062       9,748,062  
Commercial real estate - non-owner occupied
    3       5,185,649       5,185,649       5       4,031,868       4,031,868  
Multifamily
    -       -       -               -       -  
    Total commercial real estate
    3       5,185,649       5,185,649       14       13,779,930       13,779,930  
Consumer real estate:
                                               
Home equity lines
    1       349,192       349,192               -       -  
Secured by 1-4 family residential, secured by first deeds of trust
    36       3,578,561       3,578,561       2       1,422,772       1,422,772  
Secured by 1-4 family residential, secured by second deeds of trust
    1       69,815       69,815               -       -  
   Total consumer real estate
    38       3,997,568       3,997,568       2       1,422,772       1,422,772  
Commercial and industrial loans (except those secured by real estate)
    6       269,659       269,659       3       159,073       159,073  
Consumer and other
    -       -       -       1       128,419       128,419  
      69     $ 14,703,797     $ 14,703,797       31     $ 21,966,175     $ 21,966,175  
                                                 
   
Six Months Ended
           
Year Ended
         
   
June 30, 2012
           
December 31, 2011
         
   
Number of
   
Recorded
           
Number of
   
Recorded
         
Defaults on TDRs
 
Loans
   
Balance
           
Loans
   
Balance
         
Construction and land development:
                                               
Residential
    4       357,843                                  
Commercial
    18       6,295,206               8       11,389,291          
    Total construction and land development
    22       6,653,049               8       11,389,291          
Commercial real estate:
                                               
Farmland
    -       -                                  
Commercial real estate - owner occupied
    3       537,029               2       2,202,688          
Commercial real estate - non-owner occupied
    1       1,200,035                       -          
Multifamily
    4       1,737,064               2       2,202,688          
    Total commercial real estate
                                               
Consumer real estate:
                                               
Home equity lines
    1       343,937                                  
Secured by 1-4 family residential, secured by first deeds of trust
    31       3,910,895               2       1,422,772          
Secured by 1-4 family residential, secured by second deeds of trust
    1       69,815                       -          
   Total consumer real estate
    33       4,324,647               2       1,422,772          
Commercial and industrial loans (except those secured by real estate)
    5       263,107               2       151,790          
Consumer and other
    -       -               1       128,419          
Total
    64     $ 12,977,867               15     $ 15,294,960          


 
19

 
Activity in the allowance for loan losses is as follows for the periods indicated:

   
Construction and
   
Construction and
         
Commercial
   
Commercial
       
   
land development
   
land development
         
Real estate
   
Real estate
       
   
   Residential
   
Commercial
   
Farmland
   
owner occupied
   
non-owner occupied
   
Multifamily
 
Six months ended June 30, 2012
                                   
Beginning balance
  $ 704,728     $ 6,798,177     $ -     $ 1,496,466     $ 1,548,899     $ 406,635  
Provision for loan losses
    688,712       1,536,857       -       1,333,927       164,343       (313,907 )
Charge-offs
    (794,786 )     (3,773,205 )     -       (309,486 )     (313,354 )     -  
Recoveries
    900       500       -       -       205       -  
Ending balance
    599,554       4,562,330       -       2,520,907       1,400,093       92,728  
                                                 
Loans Individually Evaluated for Impairment
    2,244,282       37,911,902       1,397,461       71,103,069       43,283,999       5,068,253  
Loans collectively Evaluated for Impairment
    5,197,642       17,916,500       1,049,338       29,046,163       12,606,874       1,892,102  
    $ 7,441,924     $ 55,828,402     $ 2,446,799     $ 100,149,232     $ 55,890,873     $ 6,960,355  
                                                 
           
Consumer Secured
   
Consumer Secured
   
Commercial and
                 
   
Consumer
   
by 1-4 family residential
   
by 1-4 family residential
   
Industrial (except those
                 
   
Home equity
lines
   
first deeds
of trust
   
second deeds of trust
   
secured by real estate)
   
consumer and other
   
Total
 
                                                 
Beginning balance
  $ 860,307     $ 1,881,470     $ 397,504     $ 1,655,713     $ 321,525     $ 16,071,424  
Provision for loan losses
    206,929       2,666,051       170,024       1,710,826       231,238       8,395,000  
Charge-offs
    (291,820 )     (2,589,378 )     (196,609 )     (1,155,782 )     (402,305 )     (9,826,725 )
Recoveries
    1,317       80,804       4,633       134,488       3,175       226,023  
Ending balance
    776,732       2,038,947       375,552       2,345,245       153,633       14,865,722  
                                                 
Loans Individually Evaluated for Impairment
    1,416,634       14,559,314       565,686       16,350,363       -       193,900,963  
Loans collectively Evaluated for Impairment
    26,948,541       70,215,149       9,529,433       21,178,850       3,553,795       199,134,387  
    $ 28,365,175     $ 84,774,463     $ 10,095,119     $ 37,529,213     $ 3,553,795     $ 393,035,350  
 
 
                                     
   
Construction and
   
Construction and
         
Commercial
   
Commercial
       
   
land development
   
land development
         
Real estate
   
Real estate
       
   
Residential
   
Commercial
   
Farmland
   
owner occupied
   
non-owner occupied
   
Multifamily
 
Three months ended June 30, 2012
                                   
Beginning balance
  $ 629,376     $ 6,279,552     $ -     $ 1,846,730     $ 762,385     $ 91,775  
Provision for loan losses
    705,264       508,282       -       954,663       860,313       953  
Charge-offs
    (735,536 )     (2,226,005 )     -       (280,486 )     (222,605 )     -  
Recoveries
    450       500       -       -       -       -  
Ending balance
    599,554       4,562,330       -       2,520,907       1,400,093       92,728  
                                                 
Loans Individually Evaluated for Impairment
    2,244,282       37,911,902       1,397,461       71,103,069       43,283,999       5,068,253  
Loans collectively Evaluated for Impairment
    5,197,642       17,916,500       1,049,338       29,046,163       12,606,874       1,892,102  
    $ 7,441,924     $ 55,828,402     $ 2,446,799     $ 100,149,232     $ 55,890,873     $ 6,960,355  
                                                 
           
Consumer Secured
   
Consumer Secured
   
Commercial and
                 
   
Consumer
   
by 1-4 family residential
   
by 1-4 family residential
   
Industrial (except those
                 
   
Home equity lines
   
first deeds of trust
   
second deeds of trust
   
secured by real estate)
   
consumer and other
   
Total
 
                                                 
Beginning balance
  $ 770,598     $ 1,341,501     $ 335,352     $ 2,181,803     $ 122,881     $ 14,361,953  
Provision for loan losses
    174,830       2,301,071       41,730       951,701       161,192       6,660,000  
Charge-offs
    (169,321 )     (1,623,629 )     (5,970 )     (895,380 )     (132,510 )     (6,291,441 )
Recoveries
    625       20,004       4,440       107,121       2,070       135,210  
Ending balance
    776,732       2,038,947       375,552       2,345,245       153,633       14,865,721  
                                                 
Loans Individually Evaluated for Impairment
    1,416,634       14,559,314       565,686       16,350,363       -       193,900,963  
Loans collectively Evaluated for Impairment
    26,948,541       70,215,149       9,529,433       21,178,850       3,553,795       199,134,387  
    $ 28,365,175     $ 84,774,463     $ 10,095,119     $ 37,529,213     $ 3,553,795     $ 393,035,350  

 
20

 
 
   
Construction and
   
Construction and
         
Commercial
   
Commercial
       
   
land development
   
land development
         
Real estate
   
Real estate
       
   
Residential
   
Commercial
   
Farmland
   
owner occupied
   
non-owner occupied
   
Multifamily
 
Three months ended June 30, 2011
                                   
Beginning balance
  $ 629,376     $ 2,340,000     $ -     $ 150,000     $ 26,174     $ (82,501 )
Provision for loan losses
    (143,333 )     792,119       -       (71,555 )     -       -  
Charge-offs
    -       -       -       -       -       -  
Recoveries
    -       10,000       -       -       -       -  
Ending balance
    493,841       3,142,119       -       78,445       26,174       (82,501 )
                                                 
Loans Individually Evaluated for Impairment
    3,841,792       31,093,945       -       90,826,298       50,843,899       7,559,912  
Loans collectively Evaluated for Impairment
    5,516,724       44,650,193       2,174,778       10,486,423       5,870,224       872,835  
    $ 9,358,516     $ 75,744,138     $ 2,174,778     $ 101,312,721     $ 56,714,123     $ 8,432,747  
                                                 
           
Consumer Secured
   
Consumer Secured
   
Commercial and
                 
   
Consumer
   
by 1-4 family residential
   
by 1-4 family residential
   
Industrial (except those
                 
   
Home equity lines
   
first deeds of trust
   
second deeds of trust
   
secured by real estate)
   
consumer and other
   
Total
 
                                                 
Beginning balance
    770,598       1,703,207       500,000       1,046,967       350,462       7,434,283  
Provision for loan losses
    321,998       -       -       -       771       900,000  
Charge-offs
    (923,824 )     -       (35,152 )     (119,019 )     (10,661 )     (1,088,656 )
Recoveries
    725       -       -       -       262       10,987  
Ending balance
    169,497       1,703,207       462,249       927,948       335,635       7,256,614  
                                                 
Loans Individually Evaluated for Impairment
    4,150,919       11,490,868       1,559,932       15,964,672       2,116,151     $ 219,448,388  
Loans collectively Evaluated for Impairment
    30,746,189       85,113,770       11,554,541       23,955,772       2,619,519       223,560,968  
    $ 34,897,108     $ 96,604,638     $ 13,114,473     $ 39,920,444     $ 4,735,670     $ 443,009,356  
                                                 
                                                 
   
Construction and
   
Construction and
           
Commercial
   
Commercial
         
   
land development
   
land development
           
Real estate
   
Real estate
         
   
Residential
   
Commercial
   
Farmland
   
owner occupied
   
non-owner occupied
   
Multifamily
 
Six months ended June 30, 2011
                                               
Beginning balance
  $ 293,841     $ 2,832,119     $ -     $ 78,445     $ 20,477     $ -  
Provision for loan losses
    200,000       300,000       -       -       250,000       -  
Charge-offs
    -               -       -       (244,303 )     (82,501 )
Recoveries
    -       10,000       -       -       -       -  
Ending balance
    493,841       3,142,119       -       78,445       26,174       (82,501 )
                                                 
Loans Individually Evaluated for Impairment
    3,841,792       31,093,945       -       90,826,298       50,843,899       7,559,912  
Loans collectively Evaluated for Impairment
    5,516,724       44,650,193       2,174,778       10,486,423       5,870,224       872,835  
    $ 9,358,516     $ 75,744,138     $ 2,174,778     $ 101,312,721     $ 56,714,123     $ 8,432,747  
                                                 
           
Consumer Secured
   
Consumer Secured
   
Commercial and
                 
   
Consumer
   
by 1-4 family residential
   
by 1-4 family residential
   
Industrial (except those
                 
   
Home equity lines
   
first deeds of trust
   
second deeds of trust
   
secured by real estate)
   
consumer and other
   
Total
 
                                                 
Beginning balance
  $ 641,975     $ 1,403,207     $ 297,401     $ 1,315,582     $ 428,665     $ 7,311,712  
Provision for loan losses
    450,000       300,000       200,000       203,000       -     $ 1,903,000  
Charge-offs
    (923,824 )     -       (35,152 )     (592,634 )     (93,472 )     (1,971,886 )
Recoveries
    1,346       -       -       2,000       442       13,788  
Ending balance
    169,497       1,703,207       462,249       927,948       335,635       7,256,614  
                                                 
Loans Individually Evaluated for Impairment
    4,150,919       11,490,868       1,559,932       15,964,672       2,116,151     $ 219,448,388  
Loans collectively Evaluated for Impairment
    30,746,189       85,113,770       11,554,541       23,955,772       2,619,519       223,560,968  
    $ 34,897,108     $ 96,604,638     $ 13,114,473     $ 39,920,444     $ 4,735,670     $ 443,009,356  
 

 
21

 
                                     
   
Construction and
   
Construction and
         
Commercial
   
Commercial
       
   
land development
   
land development
         
Real estate
   
Real estate
       
   
   Residential
   
Commercial
   
Farmland
   
owner occupied
   
non-owner occupied
   
Multifamily
 
Year ended December 31, 2011
                                   
Beginning balance
  $ 293,841     $ 2,832,119     $ -     $ 78,445     $ 20,477     $ -  
Provision for loan losses
    467,187       8,249,320       -       1,568,052       1,871,804       489,136  
Charge-offs
    (65,500 )     (4,293,262 )     -       (150,031 )     (343,382 )     (82,501 )
Recoveries
    9,200       10,000       -       -       -       -  
Ending balance
    704,728       6,798,177       -       1,496,466       1,548,899       406,635  
                                                 
Loans Individually Evaluated for Impairment
    1,831,478       30,292,460       -       91,008,321       45,529,918       5,625,490  
Loans collectively Evaluated for Impairment
    6,074,987       42,328,077       2,464,981       14,583,827       8,529,231       1,053,838  
    $ 7,906,465     $ 72,620,537     $ 2,464,981     $ 105,592,148     $ 54,059,149     $ 6,679,328  
                                                 
           
Consumer Secured
   
Consumer Secured
   
Commercial and
                 
   
Consumer
   
by 1-4 family residential
   
by 1-4 family residential
   
Industrial (except those
                 
   
Home equity
lines
   
first deeds
of trust
   
second deeds of trust
   
secured by real estate)
   
consumer and other
   
Total
 
                                                 
Beginning balance
  $ 641,975     $ 1,403,207     $ 297,401     $ 1,315,582     $ 428,665     $ 7,311,712  
Provision for loan losses
    1,447,272       1,571,813       462,634       2,496,729       140,349       18,764,296  
Charge-offs
    (1,232,153 )     (1,129,509 )     (362,531 )     (2,159,669 )     (249,526 )     (10,068,063 )
Recoveries
    3,213       35,959       -       3,070       2,037       63,479  
Ending balance
    860,307       1,881,470       397,504       1,655,713       321,525       16,071,424  
                                                 
Loans Individually Evaluated for Impairment
    4,314,190       13,105,245       1,692,944       14,343,224       3,501,524       211,244,794  
Loans collectively Evaluated for Impairment
    26,373,036       80,113,553       10,349,119       23,391,292       1,363,981       216,625,922  
    $ 30,687,226     $ 93,218,798     $ 12,042,063     $ 37,734,516     $ 4,865,505     $ 427,870,716  

Note 6 – Deposits

Deposits as of June 30, 2012 and December 31, 2011 were as follows:

   
June 30, 2012
   
December 31, 2011
 
   
Amount
   
%
   
Amount
   
%
 
                         
Noninterest bearing demand
  $ 64,348,408       14.29 %   $ 66,534,956       13.70 %
Interest checking accounts
    43,542,588       9.67 %     40,237,146       8.29 %
Money market accounts
    65,933,468       14.64 %     75,487,907       15.55 %
Savings accounts
    18,688,852       4.15 %     15,166,012       3.12 %
Time deposits of $100,000 and over
    117,110,398       26.00 %     129,436,270       26.66 %
Other time deposits
    140,796,194       31.25 %     158,658,761       32.68 %
                                 
Total
  $ 450,419,908       100.00 %   $ 485,521,052       100.00 %
 
Note 7 – Trust preferred securities

During the first quarter of 2005, Southern Community Financial Capital Trust I, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On February 24, 2005, $5.2 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities have a LIBOR-indexed floating rate of interest (three-month LIBOR plus 2.15%) which adjusts, and is payable, quarterly. The interest rate at June 30, 2012 was 2.62%. The securities were redeemable at par beginning on March 15, 2010 and each quarter after such date until the securities mature on March 15, 2035.  No amounts have been redeemed at June 30, 2012 and there are no plans to do so.  The principal asset of the Trust is $5.2 million of the Company’s junior subordinated debt securities with like maturities and like interest rates to the Trust Preferred Capital Notes.

 
22

 
During the third quarter of 2007, Village Financial Statutory Trust II, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On September 20, 2007, $3.6 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities  have a five year fixed interest rate of 6.29% payable quarterly, converting after five years to a LIBOR-indexed floating rate of interest (three-month LIBOR plus 1.40%) which adjusts, and is also payable, quarterly.  The securities may be redeemed at par at any time commencing in December 2012 until the securities mature in 2037.  The principal asset of the Trust is $3.6 million of the Company’s junior subordinated debt securities with like maturities and like interest rates to the Trust Preferred Capital Notes.
 
The Trust Preferred Capital Notes may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion.  The portion of the Trust Preferred Capital Notes not considered as Tier 1 capital may be included in Tier 2 capital.
 
The obligations of the Company with respect to the issuance of the Trust Preferred Capital Notes constitute a full and unconditional guarantee by the Company of the Trust’s obligations with respect to the Trust Preferred Capital Notes.  Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Trust Preferred Capital Notes and require a deferral of common dividends.  In consideration of our agreements with our regulators, which require regulatory approval to make interest payments on these securities, the Company has deferred interest payments on the junior subordinated debt securities of $461,100 at June 30, 2012; the Company has been deferring interest payments since June 2011.  Although we elected to defer payment of the interest due, the amount has been accrued and is included in interest expense.

Note 8 – Stock incentive plan

The Company has a stock incentive plan which authorizes the issuance of up to 455,000 shares of common stock to assist the Company in recruiting and retaining key personnel.

The following table summarizes stock options outstanding under the stock incentive plan at the indicated dates:

   
Six Months Ended June 30,
   
2012
 
2011
         
Weighted
                 
Weighted
         
         
Average
                 
Average
         
         
Exercise
   
Fair Value
 
Intrinsic
       
Exercise
   
Fair Value
 
Intrinsic
   
Options
   
Price
   
Per Share
 
Value
 
Options
   
Price
   
Per Share
 
Value
                                         
Options outstanding,
                                       
beginning of period
    264,980     $ 9.48     $ 4.70         310,205     $ 9.48     $ 4.73    
Granted
    -       -       -         -       -       -    
Forfeited
    (3,450 )     4.98       3.12         -       -       -    
Exercised
    -       -       -         -       -       -    
Options outstanding,
                                                   
end of period
    261,530     $ 9.71     $ 4.73  
 $                -
    310,205     $ 9.48     $ 4.73  
 $                -
Options exercisable,
                                                   
end of period
    261,530                         291,350                    


 
23

 
During the first quarter of 2009, we granted to certain officers 26,592 restricted shares of common stock with a weighted average fair market value of $4.60 at the date of grant.  These restricted stock awards have three-year graded vesting.  Prior to vesting, these shares are subject to forfeiture to us without consideration upon termination of employment under certain circumstances.  The total number of shares underlying non-vested restricted stock and performance share awards was 6,271 and 14,881 at June 30, 2012 and 2011, respectively.

The fair value of the stock is calculated under the same methodology as stock options and the expense is recognized over the vesting period.  Unamortized stock-based compensation related to nonvested share based compensation arrangements granted under the Incentive Plan as of June 30, 2012 and 2011 was $1,666 and $65,556 respectively.  The time based unamortized compensation of $1,666 is expected to be recognized over a weighted average period of 0.25 years.

Stock-based compensation expense was $5,511 and $59,223 for the six months ended June 30, 2012 and 2011, respectively.

Note 9 — Fair value

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction between market participants.  A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability.  The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs.  An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transaction involving such assets and liabilities; it is not a forced transaction.  Market participants are buyers and sellers in the principal market that are independent, knowledgeable, able to transact and willing to transact.

FASB Codification Topic 820: Fair Value Measurements and Disclosures establishes a hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.  The fair values hierarch is as follows:

Level 1 Inputs — Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 Inputs — Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 Inputs- Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods to determine the fair value of each type of financial instrument:

 
24

 
Securities: Fair values for securities available-for-sale are obtained from an independent pricing service.  The prices are not adjusted.  The independent pricing service uses industry-standard models to price U.S. Government agency obligations and mortgage backed securities that consider various assumptions, including time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures.  Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating.  Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace (Levels 1 and 2).

Impaired loans: The fair values of impaired loans are measured for impairment using the fair value of the collateral for collateral-dependent loans on a nonrecurring basis. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The vast majority of the Company’s collateral is real estate.  The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2).  However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than two years old, then a Level 3 valuation is considered to measure the fair value.   The value of business equipment is based upon an outside appraisal if deemed significant using observable market data.  Likewise, values for inventory and account receivables collateral are based on financial statement balances or aging reports (Level 3).  Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Real Estate Owned: Real estate owned assets are adjusted to fair value upon transfer of the loans to foreclosed assets.  Subsequently, real estate owned assets are carried at net realizable value.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring level 3.

Assets and liabilities measured at fair value under Topic 820 on a recurring and non-recurring basis are summarized below for the indicated dates:

 
25

 
 
   
Fair Value Measurement
 
   
at June 30, 2012 Using
 
   
(In thousands)
 
         
Quoted Prices
             
         
in Active
   
Other
   
Significant
 
         
Markets for
   
Observable
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Inputs
   
Inputs
 
   
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Financial Assets - Recurring
                       
US Government Agencies
  $ 18,736     $ -     $ 18,736     $ -  
MBS
    12,019       -       12,019       -  
Municipals
    5,941       4,816       1,125       -  
Residential loans held for sale
    17,192       -       17,192       -  
                      -          
Financial Assets - Non-Recurring
                               
Impaired loans
    72,454       -       57,754       14,700  
Real estate owned
    17,677       -       11,212       6,465  
                                 
                                 
   
Fair Value Measurement
 
   
at December 31, 2011 Using
 
   
(in thousands)
 
           
Quoted Prices
                 
           
in Active
   
Other
   
Significant
 
           
Markets for
   
Observable
   
Unobservable
 
   
Carrying
   
Identical Assets
   
Inputs
   
Inputs
 
   
Value
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Financial Assets - Recurring
                               
US Government Agencies
  $ 2,001     $ -     $ 2,001     $ -  
MBS
    20,803       2,849       17,954       -  
Small Business Administration
    7,359       7,359       -       -  
Residential loans held for sale
    16,168       -       16,168       -  
                                 
Financial Assets - Non-Recurring
                               
Impaired loans
    64,655       -       51,868       12,787  
Real estate owned
    9,177       -       874       8,303  
 
The following table presents qualitative information about level 3 fair value measurements for financial instruments measured at fair value at June 30, 2012:

 
26

 
             
Range
 
   
Fair Value
 
Valuation
Unobservable
 
(Weighted
 
   
Estimate
 
Techniques
Input
 
Average)
 
   
(In thousands)
 
                 
Impaired Loans  -Real Estate Secured
    11,035  
Appraisal (1) or
Internal Valuation (2)
Appraisal Adjustments
Liquidation Expenses (3)
    10%-30 %
Impaired Loans - Non-Real Estate Secured
    3,665  
Appraisal (1) or
Discounted Cash Flow
Appraisal Adjustments
Liquidation Expenses (3)
    10%-20 %
Real Estate Owned
    6,465  
Appraisal (1) or
Internal Valuation (2)
Appraisal Adjustments
Liquidation Expenses (3)
    7%-30 %
                     
(1) Fair Value is generally determined through independent appraisals of the underlying collateral, which generally
 
included various level 3 inputs which are not identifiable
             
(2) Internal valuations may be conducted to determine Fair Value for assets with nominal carrying balances
 
(3) Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated
 
     liquidation expenses
                   
 
The following table presents the changes in the Level 3 fair value category for the six months ended June 30, 2012.

   
Impaired
   
Real Estate
       
   
Loans
   
Owned
   
Total Assets
 
   
(In thousands)
 
                   
Balance at December 31, 2011
  $ 12,787     $ 8,030     $ 20,817  
Total realized and unrealized gains (losses)
                       
Included in earnings
    -       (43 )     (43 )
Included in other comprehensive income
    -       -       -  
Net transfers in and/or out of Level 3
    1,913       (1,522 )     391  
                         
Balance at June 30, 2012
  $ 14,700     $ 6,465     $ 21,165  
 
In general, fair value of securities is based upon quoted market prices, where available.  If such quoted market prices are not available, fair value is based upon market prices determined by an outside, independent entity that primarily uses as inputs, observable market-based parameters.   Fair value of loans held for sale is based upon internally developed models that primarily use as inputs, observable market-based parameters.  Valuation adjustments may be made to ensure that financial instruments are recorded at fair value.  These adjustments may include amounts to reflect counterparty credit quality, among other things, as well as unobservable parameters.  Any such valuation adjustments are applied consistently over time.  The Company valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.  While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and or quarter valuation process.

 
27

 
Cash and cash equivalents – The carrying amount of cash and cash equivalents approximates fair value.

Investment securities – The fair value of investment securities available-for-sale is estimated based on bid quotations received from independent pricing services for similar assets.  The carrying amount of other investments approximates fair value.

Loans – For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.  For all other loans, fair values are calculated by discounting the contractual cash flows using estimated market discount rates which reflect the credit and interest rate risk inherent in the loans, or by using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Deposits – The fair value of deposits with no stated maturity, such as demand, interest checking and money market, and savings accounts, is equal to the amount payable on demand at year-end.  The fair value of certificates of deposit is based on the discounted value of contractual cash flows using the rates currently offered for deposits of similar remaining maturities.

Borrowings – The fair value of borrowings is based on the discounted value of contractual cash flows using the rates currently offered for borrowings of similar remaining maturities

Accrued interest – The carrying amounts of accrued interest receivable and payable approximate fair value.

Village Bank
 
Fair Value - Financial Instruments Summary
 
June 30, 2012
 
                           
     
June 30,
   
December 31,
 
     
2012
   
2011
 
 
Level in Fair
                       
 
Value
 
Carrying
   
Estimated
   
Carrying
   
Estimated
 
 
Hierarchy
 
Value
   
Fair Value
   
Value
   
Fair Value
 
                           
Financial assets
                         
Cash
Level 1
  $ 23,271,435     $ 23,271,435     $ 55,557,541     $ 55,557,541  
Cash equivalents
Level 2
    3,834,563       3,834,563       7,228,475       7,228,475  
Investment securities available for sale
Level 1
    4,816,213       4,816,213       10,207,805       10,207,805  
Investment securities available for sale
Level 2
    31,880,069       31,880,069       19,955,487       19,955,487  
Federal Home Loan Bank stock
Level 2
    2,396,600       2,396,600       2,647,000       2,647,000  
Loans held for sale
Level 2
    19,729,508       19,729,508       16,168,405       16,168,405  
Loans
Level 2
    306,467,001       305,208,432       353,186,646       353,349,981  
Impaired loans
Level 2
    57,753,817       57,753,817       51,867,625       51,867,625  
Impaired loans
Level 3
    14,700,558       14,700,558       12,787,473       12,787,473  
Other real estate owned
Level 2
    11,212,437       11,212,437       874,246       874,246  
Other real estate owned
Level 3
    6,464,625       6,464,625       8,302,921       8,302,921  
Bank owned life insurance
Level 3
    6,159,335       6,159,335       6,065,305       6,065,305  
Accrued interest receivable
Level 2
    1,910,147       1,910,147       2,046,524       2,046,524  
                                   
Financial liabilities
                                 
Deposits
Level 2
    450,419,908       454,971,918       485,521,052       487,915,609  
FHLB borrowings
Level 2
    29,000,000       29,167,554       37,750,000       37,963,672  
Trust preferred securities
Level 2
    8,764,000       8,764,000       8,764,000       8,764,000  
Other borrowings
Level 2
    5,062,344       5,062,344       5,778,661       5,778,661  
Accrued interest payable
Level 2
    703,817       703,817       592,283       592,283  


 
28

 

Note 10 – Capital Purchase Program

On May 1, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008 (“EESA”), the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 14,738 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $4.00 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 499,029 shares of the Company’s common stock at an initial exercise price of $4.43 per share, subject to certain anti-dilution and other adjustments, for an aggregate purchase price of $14,738,000 in cash.  The fair value of the preferred stock was estimated using discounted cash flow methodology at an assumed market equivalent rate of 13%, with 20 quarterly payments over a five year period.  The fair value of the warrant was estimated using the Black-Scholes option pricing model, with assumptions of 25% volatility, a risk-free rate of 2.03%, a yield of 6.162% and an estimated life of 5 years.  The value attributed to the warrant is being accreted as a discount on the preferred stock using the effective interest rate method over five years.

The Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and thereafter at a rate of 9% per annum.  The Preferred Stock is generally non-voting, other than on certain matters that could adversely affect the Preferred Stock.

In consideration of our agreements with our regulators, which require regulatory approval to make dividend payments on our preferred stock, the Company notified the U.S. Treasury in May 2011 that the Company was going to defer the payment of the quarterly cash dividend of $184,225 due on May 16, 2011, and subsequent quarterly payments, on the Preferred Stock.  The total arrearage on such preferred stock as of June 30, 2012 was $982,533.  In June 2012 as a result of the unpaid dividends, Treasury requested that an observer appointed by Treasury be allowed to attend the Company’s meetings of its board of directors.

The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements.  Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  See further discussion of capital requirements under Capital Resources in Management’s Discussion and Analysis of Financial Condition and Results of Operations following.

Note 11 – Commitments and contingencies

Off-balance-sheet risk – The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amounts recognized in the financial statements.  The contract amounts of these instruments reflect the extent of involvement that the Company has in particular classes of instruments.

 
29

 
The Company’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, and to potential credit loss associated with letters of credit issued, is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for loans and other such on-balance sheet instruments.

The Company had outstanding the following approximate off-balance-sheet financial instruments whose contract amounts represent credit risk at the dates indicated:

   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
Undisbursed credit lines
  $ 38,378,000     $ 40,661,000  
Commitments to extend or originate credit
    23,276,000       18,214,000  
Standby letter of credit
    7,217,000       3,719,000  
                 
Total commitments to extend credit
  $ 68,871,000     $ 62,594,000  
 
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.  Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee.  Historically, many commitments expire without being drawn upon; therefore, the total commitment amounts shown in the above table are not necessarily indicative of future cash requirements.  The Company evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, as deemed necessary by the Company upon extension of credit is based on management’s credit evaluation of the customer.  Collateral held varies but may include personal or income-producing commercial real estate, accounts receivable, inventory and equipment.

Concentrations of credit risk – All of the Company’s loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area.  Although the Company is building a diversified loan portfolio, a substantial portion of its clients’ ability to honor contracts is reliant upon the economic stability of the Richmond, Virginia area, including the real estate markets in the area.  The concentrations of credit by type of loan are set forth in Note 5.  The distribution of commitments to extend credit approximates the distribution of loans outstanding.

Consent Order – In February 2012, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (“Consent Agreement”) with the Federal Deposit Insurance Corporation and the Virginia Bureau of Financial Institutions (the “Supervisory Authorities”), and the Supervisory Authorities have issued the related Consent Order (the “Order”) effective February 3, 2012.  The description of the Consent Agreement and the Order is set forth below:

Management. The Order requires that the Bank have and retain qualified management, including at a minimum a chief executive officer, senior lending officer and chief operating officer, with qualifications and experience commensurate with their assigned duties and responsibilities within 90 days from the effective date of the order.  Within 30 days of the effective date of the Order, the Bank must retain a bank consultant to develop a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management for the Bank.  Within 30 days from receipt of the consultant’s management report, the Bank must formulate a written management plan that
 
 
30

 
incorporates the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a timeframe for completing each action.

Capital Requirements. Within 90 days from the effective date of the Order and during the life of the Order, the Bank must have Tier 1 capital equal to or greater than 8 percent of its total assets, and total risk-based capital equal to or greater than 11 percent of the Bank’s total risk-weighted assets.  Within 90 days from the effective date of the Order, the Bank must submit a written capital plan to the Supervisory Authorities.  The capital plan must include a contingency plan in the event that the Bank fails to maintain the minimum capital ratios required in the Order, submit a capital plan that is acceptable to the Supervisory Authorities, or implement or adhere to the capital plan.

Charge-offs. The Order requires the Bank to eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” and 50 percent of those classified “Doubtful”.  If an asset is classified “Doubtful”, the Bank may, in the alternative, charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment.  The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, “loss” or “doubtful” and is uncollected.  The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.”  These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.

Asset Growth. While the Order is in effect, the Bank must notify the Supervisory Authorities at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition.  The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from the Supervisory Authorities.

Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of the Supervisory Authorities.  In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior written approval of the Supervisory Authorities.

Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits.  These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area. An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.

Written Plans and Other Material Terms. Under the terms of the Order, the Bank is required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:
 
 
31

 
     
 
·Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management
     
 
·Plan to reduce assets of $250,000 or greater classified “doubtful” and “substandard”
     
 
·Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions

     
·Effective internal loan review and grading system
 
     
·Policy for managing the Bank’s other real estate
 
     
·Business/strategic plan covering the overall operation of the Bank
 
     
·Plan and comprehensive budget for all categories of income and expense for the year 2011
 
     
·Policy and procedures for managing interest rate risk
 
     
·Assessment of the Bank’s information technology function
 
Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities. The Bank must also establish a board committee to monitor and coordinate compliance with the Order.

The Order will remain in effect until modified or terminated by the Supervisory Authorities.

While subject to the Consent Order, we expect that our management and board of directors will be required to focus considerable time and attention on taking corrective actions to comply with the terms.  In addition, certain provisions of the Consent Order described above could adversely impact the Company’s businesses and results of operations.

Written Agreement – In June 2012, the Company entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (“Reserve Bank”).  Under the terms of the Written Agreement, the Company has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans to maintain sufficient capital and correct any violations of section 23A of the Federal Reserve Act and Regulation W.  In addition, the Company will submit a written statement of its planned sources and uses of cash for debt service, operation expenses, and other purposes.

The Company also has agreed that it will not, without prior regulatory approval:
 
·
pay or declare any dividends;
 
·
take any other form of payment representing a reduction in Bank’s capital;
 
·
make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities;
 
·
incur, increase or guarantee any debt;
 
·
purchase or deem any shares of its stock.

In June 2012 the Treasury asked to allow an observer at the Company’s meetings of its board
 
 
32

 
of directors.  The observer will start attending board meetings commencing in August 2012.  The Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth missed dividend payment.  The Company has deferred five dividend payments as of June 30, 2012 and expects to defer its sixth dividend payment due August 15, 2012.

Note 12 – Income Taxes

The net deferred tax asset is included in other assets on the balance sheet.  Accounting Standards Codification Topic 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  Management considers both positive and negative evidence and analyzes changes in near-term market conditions as well as other factors which may impact future operating results.  In making such judgments, significant weight is given to evidence that can be objectively verified.  The deferred tax assets are analyzed quarterly for changes affecting realization.  Management determined that as of June 30, 2012, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance for all of the net deferred tax asset of approximately $10,210,000.

Note 13 – Recent accounting pronouncements

In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The Company adopted ASU 2011-04, which generally aligns the principles of fair value measurements with International Financial Reporting Standards (IFRSs), in its consolidated financial statements in the first quarter 2012. The provisions of ASU 2011-04 clarify the application of existing fair value measurement requirements, and expand the disclosure requirements for fair value measurements. The increased provisions of ASU 2011-04 did not have a material effect on the Company’s financial condition and results of operations.

In June 2011, The FASB issued ASU No. 2011-05, Presentation of Comprehensive Income, Topic 220. This ASU eliminates the option of presenting the components of other comprehensive income (OCI) as part of the statement of changes in stockholders’ equity.  The ASU instead permits an entity to present the total of comprehensive income, the components of net income, and the components of OCI either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  With either format, the entity is required to present each component of net income along with total net income, each component of OCI along with the total for OCI, and a total amount for comprehensive income.  Also, the ASU requires entities to present, for either format, reclassification adjustments for items that are reclassified from OCI to net income in the statement(s) where the components of net income and the components of OCI are presented.  This ASU is to be applied retrospectively.  The Company adopted ASU-2011-05 in the first quarter of 2012.   The provisions of ASU 22011-05 did not have a material effect on the Company’s financial condition and results of operations.

 
33

 

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Caution about forward-looking statements

In addition to historical information, this report may contain forward-looking statements.  For this purpose, any statement, that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy and financial and other goals.  Forward-looking statements often use words such as “believes,” “expects,” “plans,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends” or other words of similar meaning.  You can also identify them by the fact that they do not relate strictly to historical or current facts.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to:

 
·
the inability of the Bank to comply with the requirements of agreements with its regulators;
 
·
the inability to reduce nonperforming assets consisting of nonaccrual loans and foreclosed real estate;
 
·
our inability to improve our regulatory capital position;
 
·
the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;
 
·
changes in assumptions underlying the establishment of allowances for loan losses, and other estimates;
 
·
changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;
 
·
risks inherent in making loans such as repayment risks and fluctuating collateral values;
 
·
changes in operations of Village Bank Mortgage Corporation as a result of the activity in the residential real estate market;
 
·
legislative and regulatory changes, including the Dodd-Frank Act Wall Street Reform and Consumer Protection Act and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;
 
·
exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;
 
·
the effects of future economic, business and market conditions;
 
·
governmental monetary and fiscal policies;
 
·
changes in accounting policies, rules and practices;
 
·
maintaining capital levels adequate to remain well capitalized;
 
·
reliance on our management team, including our ability to attract and retain key personnel;
 
·
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
 
·
demand, development and acceptance of new products and services;
 
·
problems with technology utilized by us;
 
 
 
34

 
 
·
changing trends in customer profiles and behavior; and
 
·
other factors described from time to time in our reports filed with the SEC.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements.  Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made.  In addition, past results of operations are not necessarily indicative of future results.

General

The Company’s primary source of earnings is net interest income, and its principal market risk exposure is interest rate risk.  The Company is not able to predict market interest rate fluctuations and its asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on the Company’s results of operations and financial condition.

Although we endeavor to minimize the credit risk inherent in the Company’s loan portfolio, we must necessarily make various assumptions and judgments about the collectability of the loan portfolio based on our experience and evaluation of economic conditions.  If such assumptions or judgments prove to be incorrect, the current allowance for loan losses may not be sufficient to cover loan losses and additions to the allowance may be necessary, which would have a negative impact on net income.  Over the last three years, the Company has recorded record provisions for loan losses due primarily to deteriorating quality of loans collateralized by real estate located in its principal market area.

There is intense competition in all areas in which the Company conducts its business. The Company competes with banks and other financial institutions, including savings and loan associations, savings banks, finance companies, and credit unions.  Many of these competitors have substantially greater resources and lending limits and provide a wider array of banking services.  To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies.  Competition is based on a number of factors, including prices, interest rates, services, availability of products and geographic location.

Given current economic uncertainty as well as stress on our capital ratios resulting from operating losses, the Company has adopted a balance sheet reduction plan that focuses on the reduction of nonperforming assets and higher risk-weighted assets that will help increase capital ratios in three ways.  First, the lower overall asset size affords the Company's capital reserves to support a smaller balance sheet.  Second, the reduced risk profile of the Company's ensuing loan portfolio requires less capital support during times of economic stress.  Third, a reduced infrastructure reduces general and administrative expenses, which in turn reduces the need for additional capital.

Given the asset growth restriction in the Consent Order, as well as the Company's current weakened financial position, the Company does not anticipate undertaking growth via acquisition or de novo branching during the foreseeable future.

The Company's objective is to continue decreasing assets by loan and deposit attrition.

 
35

 
Results of operations

The following represents management’s discussion and analysis of the financial condition of the Company at June 30, 2012 and December 31, 2011 and the results of operations for the Company for the three and six months ended June 30, 2012 and 2011.  This discussion should be read in conjunction with the Company’s condensed consolidated financial statements and the notes thereto appearing elsewhere in this Quarterly report.

Income Statement Analysis

Summary

For the three months ended June 30, 2012, the Company had a net loss of $(9,736,000) and net loss available to common shareholders of $(9,922,000), or $(2.33) per fully diluted share, compared to net income of $257,000 and net income available to common shareholders of $37,000, or $0.01 per fully diluted share, for the same period in 2011.  For the six months ended June 30, 2012, the Company had a net loss totaling $(11,137,000) and a net loss available to common shareholders of $(11,543,000), or $(2.72) per fully diluted share, compared to net income totaling $340,000 and a net loss available to common shareholders of $(99,000), or $(0.02) per share on a fully diluted share, for the same period in 2011.  This represents decreases in net income before payment of dividends of $(9,993,000) and $(11,476,000), for the three and six month periods, respectively.

The components of these decreases in net income before payment of dividends are presented following:

   
Three Months
   
Six Months
 
   
Ended
   
Ended
 
   
June 30, 2012
   
June 30, 2012
 
             
Decrease in net interest income
  $ (586,000 )   $ (1,204,000 )
Increase in provision for loan losses
    (5,760,000 )     (6,492,000 )
Increase in noninterest income
    729,000       1,415,000  
Increase in noninterest expense
    (626,000 )     (1,555,000 )
Increase in tax expense
    (3,750,000 )     (3,640,000 )
                 
    $ (9,993,000 )   $ (11,476,000 )


Our profitability continues to be negatively affected by the continued stress on our borrowers and real estate values from the recessionary economy.  As a result, asset quality continues to be a concern and management is devoting substantial resources to problem asset resolution.  The increase in the provision for loan losses is discussed further under Asset quality and provision for loan losses.

Our cost of deposits declined from 1.74% for the second quarter of 2011 to 1.31% for the second quarter of 2012.  This decline in cost of deposits is a result of the repricing of higher cost certificates of deposit during low interest rate environment that has existed for the last three years as well as an effort to change our deposit mix so that we are not so dependent on higher cost deposits.  Our mortgage company’s profit increased in the first six months of 2012 compared to the same period of 2011 by $805,000 due to the mortgage company closing $140,359,000 in mortgage loans for the first two quarters of 2012 compared to $104,077,000 for the same period in 2011.

 
36

 
Net interest income

Net interest income, which represents the difference between interest earned on interest-earning assets and interest incurred on interest-bearing liabilities, is the Company’s primary source of earnings.  Net interest income can be affected by changes in market interest rates as well as the level and composition of assets, liabilities and shareholder’s equity.  Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.  The net yield on interest-earning assets (“net interest margin”) is calculated by dividing tax equivalent net interest income by average interest-earning assets.  Generally, the net interest margin will exceed the net interest spread because a portion of interest earning assets are funded by various noninterest-bearing sources, principally noninterest-bearing deposits and shareholders’ equity.

Net interest income for the second quarter of $4,351,000 represents a decrease of $(586,000), or 12%, compared to the second quarter of 2011, and a decrease of $70,000, or 2%, compared to the first quarter of 2012.

Compared to the second quarter of 2011, average interest-earning assets for the second quarter of 2012 decreased by $54,559,000 or 10%.  The decrease in interest-earning assets was due primarily to decreases in portfolio loans of $34,106,000, investment securities of $19,655,000 and federal funds sold of $6,144,000, offset by increases in loans held for sale of $5,347,000.  The primary reason for the decline in our portfolio loans that are interest-earning was loan charge-offs as well as loans placed on nonaccrual status.  In addition to the decline in interest-earning assets, the average yield on interest-earning assets decreased to 4.89% for the second quarter of 2012 compared to 5.37% for the second quarter of 2011.  These declines resulted in a decline in interest income from the second quarter of 2011 to the second quarter of 2012 of $3,588,000, or 18%.

Average interest-bearing liabilities for the second quarter of 2012 decreased by $58,175,000 or 12%, compared to the second quarter of 2011.  The decrease in interest-bearing liabilities was due primarily to declines in average deposits of $57,207,000.  The average cost of interest-bearing liabilities decreased to 1.41% for the six months ended 2012 from 1.80% for the six months ended 2011.  The principal reason for the decrease in liability costs was the maintenance of short-term interest rates by the Federal Reserve.  The continuing low interest rates have allowed us to reduce our cost of funds as certificates of deposit and borrowings mature.  See our discussion of interest rate sensitivity below for more information.

The Company’s net interest margin is not a measurement under accounting principles generally accepted in the United States, but it is a common measure used by the financial services industry to determine how profitably earning assets are funded.  Our net interest margin over the last several quarters is provided in the following table:

 
37

 
   
Net
 
   
Interest
 
Quarter Ended
 
Margin
 
       
June 30, 2011
    3.65 %
September 30, 2011
    3.63 %
December 31, 2011
    3.38 %
March 31, 2012
    3.53 %
June 30, 2012
    3.65 %


The net interest margin declined during 2011, primarily as a result of increasing nonaccrual loans.  Additionally our margin was compressed as our deposits generally do not reprice as quickly as our loans.  The improvement in net interest margin for the second quarter of 2012 compared to the first quarter of 2012 is a result of utilizing lower interest-earning assets, primarily federal funds sold, to fund a decrease in interest-bearing liabilities of $22,234,000.  As a result higher yielding loans represented 85% of total interest-bearing assets as compared to 83% for the first quarter of 2012.  However, given the continued depressed economy and the potential impact on interest income from new nonaccrual loans, no assurance can be provided that increases in the net interest margin will continue to occur.

The following table illustrates average balances of total interest-earning assets and total interest-bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, shareholders' equity and related income, expense and corresponding weighted-average yields and rates.  The average balances used in these tables and other statistical data were calculated using daily average balances.  We had no tax exempt assets for the periods presented.


 
38

 

Average Balance Sheets
 
(in thousands)
 
                                     
   
Three Months Ended June 30, 2012
   
Three Months Ended June 30, 2011
 
         
Interest
   
Annualized
         
Interest
   
Annualized
 
   
Average
   
Income/
   
Yield
   
Average
   
Income/
   
Yield
 
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
                                     
                                     
Loans net of deferred fees
  $ 405,173     $ 5,448       5.39 %   $ 443,722     $ 6,648       6.01 %
Loans held for sale
    16,122       166       4.13 %     9,728       119       4.91 %
Investment securities
    36,243       215       2.38 %     51,464       353       2.75 %
Federal funds and other
    20,060       12       0.24 %     37,527       20       0.21 %
Total interest earning assets
    477,598       5,841       4.91 %     542,441       7,140       5.28 %
                                                 
Allowance for loan losses and deferred fees
    (14,161 )                     (7,709 )                
Cash and due from banks
    13,796                       13,577                  
Premises and equipment, net
    26,428                       27,386                  
Other assets
    37,444                       32,547                  
                                                 
Total assets
  $ 541,105                     $ 608,242                  
                                                 
Interest bearing deposits
                                               
Interest checking
  $ 42,711     $ 36       0.34 %   $ 37,513     $ 69       0.74 %
Money market
    68,860       70       0.41 %     89,978       167       0.74 %
Savings
    17,752       22       0.50 %     12,073       22       0.73 %
Certificates
    262,106       1,118       1.71 %     317,615       1,647       2.08 %
Total
    391,429       1,246       1.28 %     457,179       1,905       1.67 %
Borrowings
    44,941       244       2.18 %     52,499       297       2.27 %
Total interest bearing liabilities
    436,370       1,490       1.37 %     509,678       2,202       1.73 %
Noninterest bearing deposits
    64,405                       46,130                  
Other liabilities
    5,295                       3,501                  
Total liabilities
    506,070                       559,309                  
Equity capital
    35,034                       48,933                  
Total liabilities and capital
  $ 541,104                     $ 608,242                  
                                                 
Net interest income before provision for loan losses
    $ 4,351                     $ 4,938          
                                                 
Interest spread - average yield on interest
                                               
earning assets, less average rate on
                                               
interest bearing liabilities
                    3.54 %                     3.55 %
                                                 
Annualized net interest margin (net
                                               
interest income expressed as
                                               
percentage of average earning assets)
                    3.65 %                     3.65 %
                                                 


 
39

 
Average Balance Sheets
 
(in thousands)
 
                                     
   
Six Months Ended June 30, 2012
   
Six Months Ended June 30, 2011
 
         
Interest
   
Annualized
         
Interest
   
Annualized
 
   
Average
   
Income/
   
Yield
   
Average
   
Income/
   
Yield
 
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
                                     
                                     
Loans net of deferred fees
  $ 412,503     $ 11,217       5.47 %   $ 446,609     $ 13,567       6.13 %
Loans held for sale
    14,616.52       297       4.08 %     9,270       241       5.24 %
Investment securities
    33,775       366       2.18 %     53,430       653       2.47 %
Federal funds and other
    29,358       32       0.22 %     35,502       39       0.22 %
Total interest earning assets
    490,253       11,912       4.89 %     544,811       14,500       5.37 %
                                                 
Allowance for loan losses and deferred fees
    (13,020.42 )                     (7,510 )                
Cash and due from banks
    14,553                       6,826                  
Premises and equipment, net
    26,569                       27,420                  
Other assets
    35,348                       32,516                  
                                                 
Total assets
  $ 553,703                     $ 604,063                  
                                                 
Interest bearing deposits
                                               
Interest checking
  $ 42,439     $ 76       0.36 %   $ 35,469     $ 133       0.75 %
Money market
    71,141       146       0.41 %     91,479       371       0.82 %
Savings
    16,969       43       0.51 %     11,658       41       0.71 %
Certificates
    269,564       2,339       1.74 %     318,714       3,400       2.15 %
Total
    400,114       2,604       1.31 %     457,321       3,944       1.74 %
Borrowings
    47,180       535       2.28 %     48,148       580       2.43 %
Total interest bearing liabilities
    447,294       3,139       1.41 %     505,469       4,524       1.80 %
Noninterest bearing deposits
    63,808                       45,187                  
Other liabilities
    4,423                       5,174                  
Total liabilities
    515,525                       555,830                  
Equity capital
    38,177                       48,234                  
Total liabilities and capital
  $ 553,703                     $ 604,064                  
                                                 
Net interest income before provision for loan losses
    $ 8,773                     $ 9,976          
                                                 
Interest spread - average yield on interest
                                               
earning assets, less average rate on
                                               
interest bearing liabilities
                    3.48 %                     3.57 %



 
40

 

Provision for loan losses

The provision for loan losses for the three months ended June 30, 2012 amounted to $6,660,000 compared to $900,000 for the three months ended June 30, 2011.  The provision for loan losses for the six months ended June 30, 2012 was $8,395,000 compared to $1,903,000 for the six months ended June 30, 2011.  These increases reflect the continued stress on our borrowers from the recessionary economy as well as recognition of declines in real estate values evidenced by current appraisals.  Asset quality continues to be a concern as there continues to be uncertainty in the economy.

Additionally, a significant portion of the provision for loan losses is based upon loan charge-off history over the last two years.  As charge-offs increased significantly during this period, the provision for loan losses based upon this history has significantly increased.

Noninterest income

Noninterest income increased from $2,406,000 for the three months ended June 30, 2011 to $3,135,000 for the three months ended June 30, 2012, an increase of $729,000, or 30%.  The increase in noninterest income is primarily a result of increases in gain on sale of loans of $555,000 and a gain on sale of securities of $99,000.  Noninterest income also increased from $4,443,000 for the first six months of 2011 to $5,858,000 for the first six months of 2012, an increase of $1,415,000, or 32%.  The increase in noninterest income is primarily a result of higher gains on sale of loans of $933,000 and gain on sale of securities of $201,000.

Noninterest expense

Noninterest expense for the three months ended June 30, 2012 was $6,681,000 compared to $6,055,000 for the three months ended June 30, 2011, an increase of $626,000, or 10%.  The more significant increases in noninterest expense occurred in expenses related to foreclosed real estate of $316,000 and salaries and benefits of $111,000.

Noninterest expense for the six months ended June 30, 2012 totaled $13,491,000, an increase of $1,555,000, or 13%, from $11,935,000 for the six months ended June 30, 2011.  Expenses related to foreclosed real estate increased by $972,000, salaries and benefits increased by $159,000, occupancy expense increased by $166,000 and loan underwriting expense increased by $170,000.

Income taxes

Certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit.  Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.

The net deferred tax asset is included in other assets on the balance sheet.  Accounting Standards Codification Topic 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  Management considers both positive and negative evidence and analyzes changes in near-term market conditions as well as other factors which may impact future operating results.  In making such judgments, significant weight is given to evidence that can be objectively verified.  The deferred tax assets are analyzed quarterly for
 
 
41

 
changes affecting realization.  Management determined that as of December 31, 2011, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance on its net deferred tax asset of approximately $3,900,000.  At June 30, 2012, management continues to believe that the objective negative evidence represented by the Company’s continued losses in the second quarter outweighed the more subjective positive evidence and, as a result, recognized an addition to the valuation allowance on its net deferred tax asset of approximately $5,871,000.  The net operating losses available to offset future taxable income amounted to $11,600,000 at June 30, 2012 and expire through 2030.

Commercial banking organizations conducting business in Virginia are not subject to Virginia income taxes.  Instead, they are subject to a franchise tax based on bank capital.  The Company recorded a franchise tax expense of $82,000 and $169,000 for the six months ended June 30, 2012 and 2011, respectively.

Balance Sheet Analysis

Our total assets decreased to $524,462,000 at June 30, 2012 from $581,704,000 at December 31, 2011, a decrease of $57,242,000, or 10%.  During the second quarter of 2012, liquid assets (cash and due from banks, federal funds sold and investment securities available for sale) decreased by $29,147,000, loans held for sale increased by $3,561,000, net portfolio loans decreased by $33,646,000, and other real estate owned increased by $8,500,000.

Loans

A management objective is to maintain the quality of the loan portfolio.  The Company seeks to achieve this objective by maintaining rigorous underwriting standards coupled with regular evaluation of the creditworthiness of and the designation of lending limits for each borrower.  The portfolio strategies include seeking industry and loan size diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar.

The Company’s real estate loan portfolios, which represent approximately 73% of all loans, are secured by mortgages on real property located principally in the Commonwealth of Virginia.  Sources of repayment are from the borrower’s operating profits, cash flows and liquidation of pledged collateral.  The Company’s commercial loan portfolio represents approximately 9% of all loans.  Loans in this category are typically made to individuals, small and medium-sized businesses and range between $250,000 and $2.5 million.  Based on underwriting standards, commercial and industrial loans may be secured in whole or in part by collateral such as liquid assets, accounts receivable, equipment, inventory, and real property.  The collateral securing any loan may depend on the type of loan and may vary in value based on market conditions.  The remainder of our loan portfolio is in consumer loans which represent .9% of the total.

The following table presents the composition of our loan portfolio (excluding mortgage loans held for sale) at the dates indicated.

 
42

 
Loan Portfolio, Net
 
(In thousands)
 
             
   
June 30, 2012
   
December 31, 2012
 
   
Amount
   
%
   
Amount
   
%
 
Construction and land development:
                       
Residential
  $ 7,442       1.89 %   $ 7,906       1.85 %
Commercial
    55,828       14.20 %     72,621       16.97 %
    Total construction and land development
    63,270       16.09 %     80,527       18.82 %
Commercial real estate:
                               
Farmland
    2,447       0.62 %     2,465       0.58 %
Commercial real estate - owner occupied
    100,149       25.48 %     105,592       24.68 %
Commercial real estate - non-owner occupied
    55,891       14.22 %     54,059       12.63 %
Multifamily
    6,960       1.77 %     6,680       1.56 %
    Total commercial real estate
    165,447       42.09 %     168,796       39.45 %
Consumer real estate:
                               
Home equity lines
    28,365       7.22 %     30,687       7.17 %
Secured by 1-4 family residential, secured by first deeds of trust
    84,775       21.58 %     93,219       21.79 %
Secured by 1-4 family residential, secured by second deeds of trust
    10,095       2.57 %     12,042       2.81 %
   Total consumer real estate
    123,235       31.37 %     135,947       31.77 %
Commercial and industrial loans (except those secured by real estate)
    37,529       9.55 %     37,734       8.82 %
Consumer and other
    3,554       0.90 %     4,865       1.14 %
                                 
Total Loans
    393,035       100.0 %     427,869       100.0 %
Deferred loan cost (unearned income), net
    752               768          
Less:  Allowance for loan losses
    (14,866 )             (16,071 )        
                                 
    $ 378,921             $ 412,566          
 
The decline in our total loan portfolio is part of management’s strategy to decrease our level of assets to improve our regulatory capital ratios as well as reduce our overhead expenses.  In addition, loans totaling $12,098,000 were foreclosed on and $9,772,000 were charged-off.

The Company assigns risk rating classifications to its loans.  These risk ratings are divided into the following groups:

 
·
Risk rated 1 to 4 loans are considered of sufficient quality to preclude an adverse rating.  1-4 assets generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral;
 
·
Risk rated 5 loans are defined as having potential weaknesses that deserve management’s close attention;
 
·
Risk rated 6 loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any, and;
 
·
Risk rated 7 loans have all the weaknesses inherent in substandard loans, with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Loans are considered impaired when, based on current information and events it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments.  Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans.  If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.  Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 
43

 
Allowance for loan losses

We monitor and maintain an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  We maintain policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The allowance reflects management’s best estimate of probable losses within the existing loan portfolio and of the risk inherent in various components of the loan portfolio, including loans identified as impaired as required by FASB Codification Topic 310: Receivables.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.

Loans are grouped by similar characteristics, including the type of loan, the assigned loan classification and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon historical net charge-off rates, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans is adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to our allowance for loan losses as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  We recognize the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the financial statements.

The allowance for loan losses at June 30, 2012 was $14,866,000, compared to $16,071,000 at December 31, 2011.  The ratio of the allowance for loan losses to gross portfolio loans (net of unearned income and excluding mortgage loans held for sale) at June 30, 2012 and December 31, 2011 was 3.78% and 3.75%, respectively.  The decrease in the allowance for loan losses for the first six months of 2012 was primarily a result of significant charge-offs recognized during the quarter for which specific provisions for loan losses had been previously provided.  We believe the amount of the allowance for loan losses at June 30, 2012 is adequate to absorb the losses that can reasonably be anticipated from the loan portfolio at that date.
 
 
44

 

The following table presents an analysis of the changes in the allowance for loan losses for the periods indicated (in thousands).

   
Six Months Ended
 
   
June 30,
 
   
2012
   
2011
 
             
Beginning balance
  $ 16,071     $ 7,312  
Provision for loan losses
    8,395       1,903  
Charge-offs
               
Construction and land development
               
Residential
    (795 )     -  
Commercial
    (3,773 )     -  
Commercial real estate
               
Commercial real estate - owner occupied
    (309 )        
Commercial real estate - non-owner occupied
    (313 )     (244 )
Multifamily
            (83 )
Consumer real estate
               
Home equity lines
    (292 )     (924 )
Secured by 1-4 family residential, secured by first deeds of trust
    (2,589 )        
Secured by 1-4 family residential, secured by second deeds of trust
    (197 )     (35 )
Commercial and industrial loans (except those secured by real estate)
    (1,156 )     (593 )
Consumer and other
    (402 )     (93 )
      (9,827 )     (1,972 )
Recoveries
               
Construction and land development
               
Residential
    1          
Commercial
    1       10  
Consumer real estate
               
Home equity lines
    1       1  
Secured by 1-4 family residential, secured by first deeds of trust
    81          
Secured by 1-4 family residential, secured by second deeds of trust
    5          
Commercial and industrial loans (except those secured by real estate)
    134       2  
Consumer and other
    3       -  
      226       13  
Net charge-offs
    (9,601 )     (1,959 )
                 
Ending balance
  $ 14,866     $ 7,256  
                 
Loans outstanding at end of period(1)
  $ 393,787     $ 443,710  
Ratio of allowance for loan losses as
               
a percent of loans outstanding at
               
end of period
    3.78 %     1.64 %
                 
Average loans outstanding for the year(1)
  $ 405,173     $ 446,609  
Ratio of net charge-offs to average loans
               
outstanding for the period
    2.37 %     0.44 %
                 
(1) Loans are net of unearned income.
               
 
The allowance for loan losses as a percentage of net loans increased from 1.64% at June 30, 2011 to 3.78% at June 30, 2012 primarily as a result of a decline in asset quality caused by the continued recessionary economy.

 
45

 
Asset quality

The following table summarizes asset quality information at the dates indicated (dollars in thousands).

   
June 30,
   
December 31,
   
June 30,
 
   
2012
   
2011
   
2011
 
                   
Nonaccrual loans
  $ 56,632     $ 48,097     $ 17,901  
Foreclosed properties
    17,677       9,177       11,982  
Total nonperforming assets
  $ 74,309     $ 57,274     $ 29,883  
                         
Restructured loans still accruing
  $ 12,655     $ 16,411     $ 25,130  
                         
Loans past due 90 days and still accruing
                       
(not included in nonaccrual loans above)
  $ 199     $ 1,172     $ 843  
                         
Nonperforming assets to loans at end of period(1)
    18.9 %     13.4 %     6.7 %
                         
Nonperforming assets to total assets
    14.1 %     9.8 %     4.9 %
                         
Allowance for loan losses to nonaccrual loans
    26.3 %     33.4 %     40.5 %
                         
(1) Loans are net of deferred fees and costs.
                       


The following table presents an analysis of the changes in nonperforming assets for the six months ended June 30, 2012 (dollars in thousands).

   
Nonaccrual
             
   
Loans
   
OREO
   
Total
 
                   
Balance December 31, 2011
  $ 48,097     $ 9,177     $ 57,274  
Additions, net
    34,133       -       34,133  
Transfers to OREO
    (12,098 )     12,098       -  
Repayments
    (3,728 )     -       (3,728 )
Charge-offs
    (9,772 )     (2,417 )     (12,189 )
Sales
    -       (1,181 )     (1,181 )
                         
Balance June 30, 2012
  $ 56,632     $ 17,677     $ 74,309  


The significant increase in nonaccrual loans during the first quarter of 2012 was a result of defaults and restructuring of larger real estate loans related to acquisition, construction, land development and commercial real estate.  Until a nonperforming restructured loan has performed in accordance with its restructured terms for a minimum of six months, it will remain on nonaccrual status.

Interest is accrued on outstanding loan principal balances, unless the Company considers collection to be doubtful.  Commercial and unsecured consumer loans are designated as non-accrual when the Company considers collection of expected principal and interest doubtful.  Mortgage loans and most other types of consumer loans past due 90 days or more may remain on accrual status if management determines that concern over our ability to collect principal and
 
 
46

 
interest is not significant.  When loans are placed in non-accrual status, previously accrued and unpaid interest is reversed against interest income in the current period and interest is subsequently recognized only to the extent cash is received.  Interest accruals are resumed on such loans only when in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

Of the total nonaccrual loans of $56,632,000 at June 30, 2012 that were considered impaired, 48 loans totaling $21,890,000 had specific allowances for loan losses totaling $6,106,000.  This compares to $48,097,000 in nonaccrual loans at December 31, 2011 of which 47 loans totaling $30,034,000 had specific allowances for loan losses of $5,034,000.

Cumulative interest income that would have been recorded had nonaccrual loans been performing would have been approximately $2,018,000 and $2,015,000 for the six months ended June 30, 2012 and 2011, respectively.

Deposits

Deposits as of June 30, 2012 and December 31, 2011 were as follows:

   
June 30, 2012
   
December 31, 2011
 
   
Amount
   
%
   
Amount
   
%
 
                         
Noninterest bearing demand
  $ 64,348,408       14.29 %   $ 66,534,956       13.70 %
Interest checking accounts
    43,542,588       9.67 %     40,237,146       8.29 %
Money market accounts
    65,933,468       14.64 %     75,487,907       15.55 %
Savings accounts
    18,688,852       4.15 %     15,166,012       3.12 %
Time deposits of $100,000 and over
    117,110,398       26.00 %     129,436,270       26.66 %
Other time deposits
    140,796,194       31.25 %     158,658,761       32.68 %
                                 
Total
  $ 450,419,908       100.00 %   $ 485,521,052       100.00 %


Total deposits decreased by $35,101,000, or 7.2%, from $485,521,000 at December 31, 2011 to $450,410,000 at June 30, 2012, as compared to an increase of $6,965,000, or 1.4%, during the first six months of 2011.  Checking and savings accounts increased by $4,642,000, money market accounts decreased by $9,554,000 and time deposits decreased by $30,188,000.  The decline in time deposits was a direct result of repricing maturing time deposits at rates below market for noncore depositors.  The cost of our interest-bearing deposits declined to 1.31% for the first six months of 2012 compared to 1.74% for the first six months of 2011.

While the mix of our deposits continues to be weighted toward time deposits, such deposits represent only 57% of total deposits at June 30, 2012 and 59% at December 31, 2011.  As our branch network has increased and is more convenient to a larger segment of our targeted customer base, we have experienced a move to a higher percentage of our deposits in checking accounts.

The variety of deposit accounts that we offer has allowed us to be competitive in obtaining funds and has allowed us to respond with flexibility to, although not to eliminate, the threat of disintermediation (the flow of funds away from depository institutions such as banking institutions into direct investment vehicles such as government and corporate securities).  Our ability to attract and retain deposits, and our cost of funds, has been, and is expected to continue to be, significantly affected by money market conditions.

 
47

 
Borrowings

We utilize borrowings to supplement deposits when they are available at a lower overall cost to us or they can be invested at a positive rate of return.

As a member of the Federal Home Loan Bank of Atlanta (“FHLB”), the Bank is required to own capital stock in the FHLB and is authorized to apply for borrowings from the FHLB.  Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities.  The FHLB may prescribe the acceptable uses to which the advances may be put, as well as on the size of the advances and repayment provisions.  Borrowings from the FHLB were $29,000,000 and $37,750,000 at June 30, 2012 and December 31, 2011 respectively.  The FHLB advances are secured by the pledge of residential mortgage loans, investment securities and our FHLB stock.

Capital resources

Stockholders’ equity at June 30, 2012 was $25,054,000, compared to $36,248,000 at December 31, 2011.  On May 1, 2009, the Company received a $14,738,000 investment by the United States Department of the Treasury under its Capital Purchase Program (the TARP Program).  The TARP Program is a voluntary program designed to provide capital for healthy banks to improve the flow of funds from banks to their customers.  Under the TARP Program, the Company issued to the Treasury $14,738,000 of preferred stock and warrants to purchase 499,030 shares of the Company’s common stock at a purchase price of $4.43 per share. The preferred stock issued by the Company under the TARP Capital Purchase Program carries a 5% dividend for each of the first 5 years of the investment, and 9% thereafter, unless the shares are redeemed by the Company.  The $(7,312,000) decrease in equity during the first six months of 2012 was primarily due to the net loss of $(7,255,000).

During the first quarter of 2005, the Company issued $5.2 million in Trust Preferred Capital Notes to increase its regulatory capital and to help fund its expected growth in 2005.  During the third quarter of 2007, the Company issued $3.6 million in Trust Preferred Capital Notes to partially fund the construction of an 80,000 square foot building completed in 2008.  The Trust Preferred Capital Notes may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion.

The Company is currently prohibited by its Written Agreement with the Reserve Bank from making dividend or interest payments on the TARP program preferred stock or trust preferred capital notes without prior regulatory approval.  In addition, the Consent Order with the FDIC and BFI provides that the Bank will not pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction in capital, without regulatory approval.  At June 30, 2012, the Company’s total accrued but deferred payment on TARP dividend payments was $982,533 and interest payments on trust preferred capital notes was $449,376.

In June 2012 as a result of the unpaid dividends, Treasury requested that an observer appointed by Treasury be allowed to attend the Company’s meetings of its board of directors.  The observer will start attending board meetings commencing in August 2012.  Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth deferred dividend payment.  The Company has deferred five dividend payments as of June 30, 2012 and expects to defer its sixth dividend payment due August 15, 2012.  However, Treasury has not indicated at this time it will nominate two directors to our
 
 
48

 
board if we missed the sixth dividend payment date.

The following table presents the composition of regulatory capital and the capital ratios for the Company at the dates indicated (dollars in thousands).

   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
Tier 1 capital
           
Preferred stock
  $ 59     $ 59  
Common stock
    17,007       16,974  
Additional paid-in capital
    40,704       40,732  
Retained earnings (deficit)
    (33,438 )     (21,896 )
Warrant Surplus
    732       732  
Discount on preferred stock
    (273 )     (346 )
Qualifying trust preferred securities
    8,764       8,764  
Less intangible assets
    (442 )     (491 )
Disallowed Deferred tax asset
    (186 )     (2,125 )
Total equity
    32,927       42,403  
Total Tier 1 capital
    32,927       42,403  
                 
Tier 2 capital
               
Allowance for loan losses
    5,375       5,629  
Total Tier 2 capital
    5,375       5,629  
                 
Total risk-based capital
    38,302       48,032  
                 
Risk-weighted assets
  $ 420,480     $ 439,873  
                 
Average assets
  $ 535,938     $ 578,330  
                 
Capital ratios
               
Leverage ratio (Tier 1 capital to
               
average assets)
    6.14 %     7.33 %
Tier 1 capital to risk-weighted assets
    7.83 %     9.64 %
Total capital to risk-weighted assets
    9.11 %     10.92 %
Equity to total assets
    4.78 %     6.23 %


The following table presents the composition of regulatory capital and the capital ratios for the Bank at the dates indicated (dollars in thousands).

 
49

 
   
June 30,
   
December 31,
 
   
2012
   
2011
 
             
Tier 1 capital
           
Common stock
    6,849       6,849  
Additional paid-in capital
    53,905       53,899  
Retained earnings (deficit)
    (29,954 )     (20,436 )
Less intangible assets
    (442 )     (491 )
Disallowed Deferred tax asset
    -       (846 )
Total equity
    30,358       38,975  
Total Tier 1 capital
    30,358       38,975  
                 
Tier 2 capital
               
Allowance for loan losses
    5,351       5,555  
Total Tier 2 capital
    5,351       5,555  
                 
Total risk-based capital
    35,709       44,530  
                 
Risk-weighted assets
  $ 418,540     $ 433,892  
                 
Average assets
  $ 532,850     $ 603,758  
                 
Capital ratios
               
Leverage ratio (Tier 1 capital to
               
average assets)
    5.70 %     6.46 %
Tier 1 capital to risk-weighted assets
    7.25 %     8.98 %
Total capital to risk-weighted assets
    8.53 %     10.26 %


Federal regulatory agencies are required by law to adopt regulations defining five capital tiers: well capitalized, adequately capitalized, under capitalized, significantly under capitalized, and critically under capitalized.  The Bank met the criteria to be categorized as an “adequately capitalized” institution as of June 30, 2012 and “well capitalized” as of December 31, 2011.  However, due to the minimum capital ratios required by the Consent Order, the Bank currently is considered “adequately capitalized”.  The Consent Order requires the Bank to maintain a leverage ratio of at least 8% and a total capital to risk-weighted assets ratio of at least 11%.  At June 30, 2012, the Bank’s leverage ratio was 5.70% and the total capital to risk weighted assets ratio was 8.53%.  As required by the Consent Order, the Bank has provided a capital plan to the FDIC and BFI that demonstrates how the Bank will come into compliance with the required minimum capital ratios set forth in the Consent Order.  When capital falls below the “well capitalized” requirement, consequences can include: new branch approval could be withheld; more frequent examinations by the FDIC; brokered deposits cannot be renewed without a waiver from the FDIC; and other potential limitations as described in FDIC Rules and Regulations sections 337.6 and 303, and FDIC Act section 29.  In addition, the FDIC insurance assessment increases when an institution falls below the “well capitalized” classification.

Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities.  Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day
 
 
50

 
cash flow requirements while maximizing profits.  Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made.  However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

At June 30, 2012, our liquid assets, consisting of cash, cash equivalents and investment securities available for sale totaled $63,802,000, or 12% of total assets.  Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.  However, approximately $5,553,000 of these securities are pledged against retail sweep accounts.  Therefore, the related borrowings would need to be repaid prior to the securities being sold in order for these securities to be converted to cash.  Liquid assets declined by approximately $29,147,000 during the six months ended June 30, 2012 primarily as a result of the decline in deposits discussed previously.

Our holdings of liquid assets plus the ability to maintain and expand our deposit base and borrowing capabilities serve as our principal sources of liquidity.  We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, and from additional borrowings.  In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities.  We maintain two federal funds lines of credit with correspondent banks totaling $22 million for which there were no borrowings against the lines at June 30, 2012.

At June 30, 2012, we had commitments to originate $68,871,000 of loans.  Fixed commitments to incur capital expenditures were less than $25,000 at June 30, 2012.  Certificates of deposit scheduled to mature in the 12-month period ending June 30, 2013 totaled $114,048,000.  We believe that a significant portion of such deposits will remain with us. We further believe that deposit growth, loan repayments and other sources of funds will be adequate to meet our foreseeable short-term and long-term liquidity needs.

Interest rate sensitivity

An important element of asset/liability management is the monitoring of our sensitivity to interest rate movements.  In order to measure the effects of interest rates on our net interest income, management takes into consideration the expected cash flows from the securities and loan portfolios and the expected magnitude of the repricing of specific asset and liability categories.  We evaluate interest sensitivity risk and then formulate guidelines to manage this risk based on management’s outlook regarding the economy, forecasted interest rate movements and other business factors.  Our goal is to maximize and stabilize the net interest margin by limiting exposure to interest rate changes.

Contractual principal repayments of loans do not necessarily reflect the actual term of our loan portfolio.  The average lives of mortgage loans are substantially less than their contractual terms because of loan prepayments and because of enforcement of due-on-sale clauses, which gives us the right to declare a loan immediately due and payable in the event, among other things, the borrower sells the real property subject to the mortgage and the loan is not repaid.  In addition, certain borrowers increase their equity in the security property by making payments in excess of those required under the terms of the mortgage.

The sale of fixed rate loans is intended to protect us from precipitous changes in the general level of interest rates. The valuation of adjustable rate mortgage loans is not as directly
 
 
51

 
dependent on the level of interest rates as is the value of fixed rate loans.  As with other investments, we regularly monitor the appropriateness of the level of adjustable rate mortgage loans in our portfolio and may decide from time to time to sell such loans and reinvest the proceeds in other adjustable rate investments.

The data in the following table reflects repricing or expected maturities of various assets and liabilities at June 30, 2012.  The gap analysis represents the difference between interest-sensitive assets and liabilities in a specific time interval.  Interest sensitivity gap analysis presents a position that existed at one particular point in time, and assumes that assets and liabilities with similar repricing characteristics will reprice at the same time and to the same degree.


Village Bank and Trust Financial Corp.
 
Interest Rate Sensitivity GAP Analysis
 
June 30, 2012
 
(In thousands)
 
                                     
                                     
   
Within 3
   
3 to 6
   
6 to 12
   
13 to 36
   
More than
       
   
Months
   
Months
   
Months
   
Months
   
36 Months
   
Total
 
Interest Rate Sensitive Assets
                                   
Loans (1)
                                   
Fixed rate
  $ 20,998     $ 11,810     $ 11,613     $ 30,277     $ 82,176     $ 156,874  
Variable rate
    79,103       7,171       17,620       32,825       99,442       236,161  
Investment securities
    -       3               -       36,693       36,696  
Loans held for sale
    19,730       -       -       -       -       19,730  
Federal funds sold
    3,835       -       -       -       -       3,835  
                                                 
Total rate sensitive assets
    123,666       18,984       29,233       63,102       218,311       453,296  
Cumulative rate sensitive assets
    123,666       142,650       171,883       234,985       453,296          
                                                 
Interest Rate Sensitive Liabilities
                                               
Interest checking (2)
    -       -       -       43,543       -       43,543  
Money market accounts
    65,933       -       -       -       -       65,933  
Savings (2)
    -       -       -       18,689       -       18,689  
Certificates of deposit
    23,913       53,193       36,942       82,454       61,405       257,907  
FHLB advances
    1,000       -       5,000       20,000       3,000       29,000  
Trust Preferred Securities
    -       -       -               8,764       8,764  
Other borrowings
    5,062       -       -       -       -       5,062  
                                                 
Total rate sensitive liabilities
    95,908       53,193       41,942       164,686       73,169       428,898  
Cumulative rate sensitive liabilities
    95,908       149,101       191,043       355,729       428,898          
                                                 
Rate sensitivity gap for period
  $ 27,758     $ (34,209 )   $ (12,709 )   $ (101,584 )   $ 145,142     $ 24,398  
Cumulative rate sensitivity gap
  $ 27,758     $ (6,451 )   $ (19,160 )   $ (120,744 )   $ 24,398          
                                                 
Ratio of cumulative gap to total assets
    5.3 %     (1.2 )%     (3.7 )%     (23.0 )%     4.7 %        
Ratio of cumulative rate sensitive
                                               
assets to cumulative rate sensitive
                                               
liabilities
    128.9 %     95.7 %     90.0 %     66.1 %     105.7 %        
Ratio of cumulative gap to cumulative
                                               
rate sensitive assets
    22.4 %     (4.5 )%     (11.1 )%     (51.4 )%     5.4 %        
                                                 
                                                 
                                                 
(1) Includes nonaccrual loans of approximately $56,632,000, which are spread throughout the categories.
           
(2) Management believes that interest checking and savings accounts are generally not sensitive to changes in interest
 
rates and therefore has placed such deposits in the "13 to 36 months" category.
 
 
At June 30, 2012, our balance sheet is asset sensitive for the first three months, meaning that our assets reprice more quickly than our liabilities during that period, and liability sensitive
 
 
52

 
 
for the next thirty-three months, meaning that our liabilities will reprice more quickly than our assets during that period, with a ratio of cumulative gap to total assets ranging from a positive gap of 5.3% for the first three months to a negative gap of (23.0)% for thirteen to thirty six month period.  A negative gap can adversely affect earnings in periods of increasing interest rates.  Given the Federal Reserve’s recent announcement that it will maintain short-term interest rates at current levels until the end of 2014, we do not expect interest rates to increase in the foreseeable future.  However, we believe our balance sheet should be asset sensitive and, accordingly, we have adopted pricing policies to lengthen the maturities/repricing of our liabilities relative to the maturities/pricing of our assets.

Critical accounting policies

The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry.  The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities, and amounts reported for revenues, expenses and related disclosures.  Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.

The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, real estate acquired in settlement of loans, goodwill and income taxes.  The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations.  Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 of the Notes to Consolidated Financial Statements.

The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions, and judgments.

Allowance for loan losses

We monitor and maintain an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  We maintain policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The allowance reflects management’s best estimate of probable losses within the existing loan portfolio and of the risk inherent in various components of the loan portfolio, including loans identified as impaired as required by FASB Codification Topic 310: Receivables.   Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.

Loans are grouped by similar characteristics, including the type of loan, the assigned loan classification and the general collateral type.  A loss rate reflecting the expected loss inherent in
 
 
53

 
a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans is adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to our allowance for loan losses as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  We recognize the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the financial statements.

Troubled debt restructurings

A loan is accounted for as a troubled debt restructuring if we, for economic or legal reasons, grant a concession to a borrower considered to be experiencing financial difficulties that we would not otherwise consider.  A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or balance of the loan, a reduction of accrued interest, an extension of the maturity date or renewal of the loan at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions.  Troubled debt restructurings can be in either accrual or nonaccrual status.  Nonaccrual troubled debt restructurings are included in nonperforming loans.  Accruing troubled debt restructurings are generally excluded from nonperforming loans as it is considered probable that all contractual principal and interest due under the restructured terms will be collected.  Troubled debt restructurings generally remain categorized as nonperforming loans and leases until a six-month payment history has been maintained.

In accordance with current accounting guidance, loans modified as troubled debt restructurings are, by definition, considered to be impaired loans.  Impairment for these loans is measured on a loan-by-loan basis similar to other impaired loans as described above under Allowance for loan losses.  Certain loans modified as troubled debt restructurings may have been previously measured for impairment under a general allowance methodology (i.e., pooling), thus at the time the loan is modified as a troubled debt restructuring the allowance will be impacted by the difference between the results of these two measurement methodologies.  Loans modified as troubled debt restructurings that subsequently default are factored into the determination of the allowance in the same manner as other defaulted loans.
 
 
54

 
 
Real estate acquired in settlement of loans

Real estate acquired in settlement of loans represent properties acquired through foreclosure or physical possession.  Write-downs to fair value less cost to sell of foreclosed assets at the time of transfer are charged to allowance for loan losses.  Subsequent to foreclosure, the Company periodically evaluates the value of foreclosed assets held for sale and records an impairment charge for any subsequent declines in fair value less selling costs.  Subsequent declines in value are charged to operations.  Fair value is based on an assessment of information available at the end of a reporting period and depends upon a number of factors, including historical experience, economic conditions, and issues specific to individual properties.  The evaluation of these factors involves subjective estimates and judgments that may change.

Income taxes

The Company uses the asset and liability method of accounting for income taxes.  Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance may be established.  Management considers the determination of this valuation allowance to be a critical accounting policy due to the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income.  These judgments and estimates are reviewed on a continual basis as regulatory and business factors change.  A valuation allowance for deferred tax assets may be required if the amounts of taxes recoverable through loss carry backs decline, or if management projects lower levels of future taxable income.  Management determined that as of December 31, 2011 and June 30, 2012, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance of $3,929,000 and $10,277,000 on its net deferred tax asset respectively.

New accounting standards

In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The Company adopted ASU 2011-04, which generally aligns the principles of fair value measurements with International Financial Reporting Standards (IFRSs), in its consolidated financial statements in the first quarter 2012. The provisions of ASU 2011-04 clarify the application of existing fair value measurement requirements, and expand the disclosure requirements for fair value measurements. The increased provisions of ASU 2011-04 did not have a material effect on the Company’s financial condition and results of operations.

In June 2011, The FASB issued ASU No. 2011-05, Presentation of Comprehensive Income, Topic 220. This ASU eliminates the option of presenting the components of other comprehensive income (OCI) as part of the statement of changes in stockholders’ equity.  The ASU instead permits an entity to present the total of comprehensive income, the components of net income, and the components of OCI either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  With either format, the entity is required to present each component of net income along with total net income, each component of OCI along with the total for OCI, and a total amount for comprehensive income.  Also, the ASU requires entities to present, for either format, reclassification adjustments for items that are reclassified from OCI to net income in the statement(s) where the components of net income and the components of OCI are presented.  This ASU is to be applied retrospectively.  The Company adopted ASU-2011-05 in the first quarter of 2012.   The provisions of ASU 22011-05 did not have a material effect on the Company’s financial condition and results of operations.

Impact of inflation and changing prices

The Company’s consolidated financial statements included herein have been prepared in accordance with generally accepted accounting principles in the United States, which require the Company to measure financial position and operating results primarily in terms of historical dollars.  Changes in the relative value of money due to inflation or recession are generally not considered.  The primary effect of inflation on the operations of the Company is reflected in increased operating costs.  In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate.  While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate.  Interest rates are highly sensitive to many factors that are beyond the control of the Company, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.



 
55

 

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable.


ITEM 4 – CONTROLS AND PROCEDURES

The Company’s Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of June 30, 2012.  Based on that evaluation, management concluded that the Company’s disclosure controls and procedures were not effective as of June 30, 2012 due to insufficient time to test the policies and procedures described below which were implemented during the quarter to remediate the material weakness disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.

As disclosed in its Annual Report on Form 10-K for the year ended December 31, 2011, the Company’s internal control over financial reporting was not effective as of December 31, 2011 as a result of a material weakness related to the Company’s allowance for loan and lease losses.
 
During the first quarter of 2012, the Company implemented certain changes in its internal controls to address the material weakness. Specifically, during the first quarter of 2012, management took the following steps to remediate the material weakness:
 
 
1.
Replaced the Chief Lending Officer with an individual who has substantial experience with assessing a borrowers’ ability to repay their obligations to the Company.
 
 
2.
Hired a new senior vice president with substantial experience to direct the disposition of problem loans and foreclosed real estate.
 
 
3.
Established a Special Assets committee including management and outside members of the board of directors to meet two times a month to address the resolution of problem loans and foreclosed real estate.
 
 
4.
Reorganized the credit department to ensure appropriate separation of duties and developed expanded training for the Bank’s lenders.
 
 
5.
Changed the Bank’s credit policy to require identification of concentrations of risk, analysis of our customer’s global cash flows, reappraisal and re-evaluation of collateral, more accurate and timely credit-risk rating procedures and improved underwriting processes and standards.
 
 
6.
Engaged qualified outside consultants to assist in re-evaluating our methodology for assessing the adequacy of the allowance for loan and lease losses.
 
 
7.
Improved the processes for identifying problem loans and the determination of the amount of impairment.
 
 
56

 
 
The Company’s management believes the control enhancements described above are sufficient to remediate the material weakness identified. However, as noted above, insufficient time to test the remediation has not yet occurred and therefore management is unable to conclude they are effective at June 30, 2012. Other than the remedial measures noted above, there were no changes in internal control over financial reporting during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.


 
57

 

PART II – OTHER INFORMATION


ITEM 1 – LEGAL PROCEEDINGS

Not applicable.
 
ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.
 
ITEM 3 – DEFAULTS UPON SENIOR SECURITIES

In consideration of our agreements with our regulators, which require regulatory approval to make dividend payments on our preferred stock, the Company notified the U.S. Treasury in May 2011 that the Company was going to defer the payment of the quarterly cash dividend of $184,225 due on May 16, 2011, and subsequent quarterly payments, on the Preferred Stock.  The total arrearage on such preferred stock as of June 30, 2012 was $982,533.

ITEM 4 – MINE SAFETY DISCOLOSURES

None

ITEM 5 – OTHER INFORMATION

Not applicable.
 
ITEM 6 – EXHIBITS
 
 
10.1
 
Written Agreement by and between Village Bank and Trust Financial Corp. and the Federal Reserve Bank of Richmond, dated June 26, 2012 (attached as Exhibit 10.1 to the Company’s current report on Form 8-K filed July 2, 2012 and incorporated by reference herein).
 
 
31.1
 
Certification of Chief Executive Officer
       
 
31.2
 
Certification of Chief Financial Officer
       
 
32.1
 
Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
       
 
101
 
The following materials from the Village Bank and Trust Financial Corp. Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Stockholders' Equity, (iv) Consolidated Statements of Cash Flows, and (v) Notes to Condensed Consolidated Financial Statements.
 
 
58

 

SIGNATURES

In accordance with 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.


     
VILLAGE BANK AND TRUST FINANCIAL CORP.
     
(Registrant)
           
           
Date:
August 14, 2012
 
By:
/s/ Thomas W. Winfree
 
       
Thomas W. Winfree
 
       
President and
 
       
Chief Executive Officer
           
           
Date:
August 14, 2012
 
By:
/s/ C. Harril Whitehurst, Jr.
 
       
C. Harril Whitehurst, Jr.
 
       
Senior Vice President and
 
       
Chief Financial Officer



 
59

 

Exhibit Index

Exhibit
Number
 
Document
   
10.1 Written Agreement by and between Village Bank and Trust Financial Corp. and the Federal Reserve Bank of Richmond, dated June 26, 2012 (attached as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed July 2, 2012 and incorporated by reference herein).
   
31.1
Certification of Chief Executive Officer
   
31.2
Certification of Chief Financial Officer
   
32.1
Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
   
101
The following materials from the Village Bank and Trust Financial Corp. Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Stockholders' Equity, (iv) Consolidated Statements of Cash Flows, and (v) Notes to Condensed Consolidated Financial Statements.