form10-qforjune302011.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
     
 
FORM 10-Q
 
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended:    June 30, 2011
 
OR
 
[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina
(State or other jurisdiction of incorporation or organization)
 
000-27205
56-2132396
(Commission File No.)
(IRS Employer Identification No.)
 
518 West C Street, Newton, North Carolina
28658
(Address of principal executive offices)
(Zip Code)
 
(828) 464-5620
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes
X   No
 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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
X   No
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large Accelerate Filer
   
Accelerated Filer
   
Non-Accelerated Filer
   
 
Smaller Reporting Company
X
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2 of the Exchange Act).
 
Yes
      No
X
 
 
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
5,542,703 shares of common stock, outstanding at July 31, 2011.
 
 
 
 

 
 
 
INDEX
       
PART I.
FINANCIAL INFORMATION
PAGE(S)
       
Item 1.
 
Financial Statements
 
       
   
Consolidated Balance Sheets at June 30, 2011 (Unaudited) and December
 
   
31, 2010 (Audited)
3
       
   
Consolidated Statements of Earnings for the three and six months ended
 
   
June 30, 2011 and 2010 (Unaudited)
4
       
   
Consolidated Statements of Comprehensive Income for the three and six
 
   
months ended June 30, 2011 and 2010 (Unaudited)
5
       
   
Consolidated Statements of Cash Flows for the six months ended June 30,
 
   
2011 and 2010 (Unaudited)
6-7
       
   
Notes to Consolidated Financial Statements (Unaudited)
8-21
       
Item 2.
 
Management's Discussion  and Analysis of Financial Condition
 
   
and Results of Operations
22-34
       
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
35
       
Item 4T.
 
Controls and Procedures
36
       
PART II.
OTHER INFORMATION
 
       
Item 1.
 
Legal Proceedings
37
Item 1A.
 
Risk Factors
37
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
37
Item 3.
 
Defaults upon Senior Securities
37
Item 5.
 
Other Information
37
Item 6.
 
Exhibits
37-40
Signatures
   
41
Certifications
   
42-44
 
 

Statements made in this Form 10-Q, other than those concerning historical information, should be considered forward-looking statements pursuant to the safe harbor provisions of the Securities Exchange Act of 1934 and the Private Securities Litigation Act of 1995.  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management and on the information available to management at the time that this Form 10-Q was prepared.  These statements can be identified by the use of words like “expect,”  “anticipate,” “estimate,” and “believe,” variations of these words and other similar expressions.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environments and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in other filings with the Securities and Exchange Commission, including but not limited to those described in Peoples Bancorp of North Carolina, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
 
 
 
2

 
 
 
PART I.
FINANCIAL INFORMATION
 
Item 1.
Financial Statements
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
           
Consolidated Balance Sheets
           
(Dollars in thousands)
           
 
June 30,
   
December 31,
 
                                       Assets
2011
   
2010
 
 
(Unaudited)
   
(Audited)
 
           
Cash and due from banks, including reserve requirements
$ 38,792     22,521  
Interest bearing deposits
  2,843     1,456  
Cash and cash equivalents
  41,635     23,977  
             
Certificates of deposit
  735     735  
             
Investment securities available for sale
  297,606     272,449  
Other investments
  5,840     5,761  
Total investment securities
  303,446     278,210  
             
Mortgage loans held for sale
  1,967     3,814  
             
Loans
  692,813     726,160  
Less allowance for loan losses
  (15,984 )   (15,493 )
Net loans
  676,829     710,667  
             
Premises and equipment, net
  17,513     17,334  
Cash surrender value of life insurance
  7,660     7,539  
Other real estate      7,115     6.673  
Accrued interest receivable and other assets
  16,067     18,703  
Total assets
$ 1,072,967     1,067,652  
             
  Liabilities and Shareholders' Equity
           
             
Deposits:
           
Non-interest bearing demand
$ 132,288     114,792  
NOW, MMDA & savings
  346,808     332,511  
Time, $100,000 or more
  212,440     241,366  
Other time
  138,874     150,043  
Total deposits
  830,410     838,712  
             
Demand notes payable to U.S. Treasury
  1,252     1,600  
Securities sold under agreement to repurchase
  44,512     34,094  
FHLB borrowings
  70,000     70,000  
Junior subordinated debentures
  20,619     20,619  
Accrued interest payable and other liabilities
  5,641     5,769  
Total liabilities
  972,434     970,794  
             
Commitments            
             
Shareholders' equity:
           
             
Series A preferred stock, $1,000 stated value; authorized
           
5,000,000 shares; issued and outstanding
           
25,054 shares in 2011 and 2010
  24,687     24,617  
Common stock, no par value; authorized
           
20,000,000 shares; issued and outstanding
           
5,542,703 shares in 2011 and 5,541,413 shares in 2010
  48,289     48,281  
Retained earnings
  24,644     23,573  
Accumulated other comprehensive income
  2,913     387  
Total shareholders' equity
  100,533     96,858  
             
Total liabilities and shareholders' equity
$ 1,072,967     1,067,652  
             
See accompanying notes to consolidated financial statements.
           
 
 
 
3

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
                       
Consolidated Statements of Earnings
                       
(Dollars in thousands, except per share amounts)
                       
 
Three months ended
   
Six months ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
Interest income:
                     
Interest and fees on loans
$ 9,159     10,162     18,774     20,253  
Interest on investment securities:
                       
U.S. Government sponsored enterprises
  1,413     1,196     2,494     2,601  
States and political subdivisions
  790     460     1,595     862  
Other
  60     61     116     93  
Total interest income
  11,422     11,879     22,979     23,809  
                         
Interest expense:
                       
NOW, MMDA & savings deposits
  601     911     1,319     1,777  
Time deposits
  1,277     1,746     2,681     3,622  
FHLB borrowings
  753     813     1,497     1,702  
Junior subordinated debentures
  101     101     200     198  
Other
  77     111     156     208  
Total interest expense
  2,809     3,682     5,853     7,507  
                         
Net interest income
  8,613     8,197     17,126     16,302  
                         
Provision for loan losses
  3,368     3,179     6,318     5,561  
                         
Net interest income after provision for loan losses
  5,245     5,018     10,808     10,741  
                         
Non-interest income:
                       
Service charges
  1,316     1,441     2,572     2,760  
Other service charges and fees
  528     559     1,109     1,161  
Other than temporary impairment losses
  -        (100 )   -        (100 )
Gain on sale of securities
  181     246     1,256     268  
Mortgage banking income
  218     91     405     247  
Insurance and brokerage commissions
  121     93     229     191  
Miscellaneous
  372     800     738     1,213  
Total non-interest income
  2,736     3,130     6,309     5,740  
                         
Non-interest expense:
                       
Salaries and employee benefits
  3,673     3,433     7,340     6,953  
Occupancy
  1,331     1,301     2,696     2,652  
Other
  2,404     2,323     4,742     4,641  
Total non-interest expense
  7,408     7,057     14,778     14,246  
                         
Earnings before income taxes
  573     1,091     2,339     2,235  
                         
Income tax (benefit) expense
  (56 )   227     349     496  
                         
Net earnings
  629     864     1,990     1,739  
                         
Dividends and accretion on preferred stock
  348     349     697     697  
                         
Net earnings available to common shareholders
$ 281     515     1,293     1,042  
                         
Basic net earnings per common share
$ 0.05     0.09     0.23     0.19  
Diluted net earnings per common share
$ 0.05     0.09     0.23     0.19  
Cash dividends declared per common share
$ 0.02     0.02     0.04     0.04  
                         
See accompanying notes to consolidated financial statements.
                   
 
 
 
4

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
                       
Consolidated Statements of Comprehensive Income
                       
 (Dollars in thousands)
                       
 
Three months ended
   
Six months ended
 
 
June 30,
   
June 30,
 
 
2011
   
2010
   
2011
   
2010
 
 
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                       
Net earnings
$ 629     864     1,990     1,739  
                         
Other comprehensive income:
                       
Unrealized holding gains on securities
                       
available for sale
  5,568     1,739     6,041     2,662  
Reclassification adjustment for other than temporary
                       
impairment losses included in net earnings
  -        100     -        100  
Reclassification adjustment for gains on
                       
securities available for sale
                       
included in net earnings
  (181 )   (246 )   (1,256 )   (268 )
Unrealized holding losses on derivative
                       
financial instruments qualifying as cash flow
                       
hedges
  (264 )   (252 )   (648 )   (399 )
                         
Total other comprehensive income,
                       
before income taxes
  5,123     1,341     4,137     2,095  
                         
Income tax expense related to other
                       
comprehensive income:
                       
                         
Unrealized holding gains on securities
                       
available for sale
  2,168     677     2,353     1,037  
Reclassification adjustment for gains net of
                       
write downs of securities available for sale
                       
included in net earnings
  (70 )   (57 )   (489 )   (66 )
Unrealized holding losses on derivative
                       
financial instruments qualifying as cash flow
                       
hedges
  (103 )   (98 )   (253 )   (155 )
                         
Total income tax expense related to
                       
other comprehensive income
  1,995     522     1,611     816  
                         
Total other comprehensive income,
                       
net of tax
  3,128     819     2,526     1,279  
                         
Total comprehensive income
$ 3,757     1,683     4,516     3,018  
                         
See accompanying notes to consolidated financial statements.
                   
 
 
 
5

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
           
Consolidated Statements of Cash Flows
           
Six months ended June 30, 2011 and 2010
           
(Dollars in thousands)
           
 
2011
   
2010
 
 
(Unaudited)
   
(Unaudited)
 
Cash flows from operating activities:
         
Net earnings
$ 1,990     1,739  
Adjustments to reconcile net earnings to
           
net cash provided by operating activities:
           
Depreciation, amortization and accretion
  2,853     2,272  
Provision for loan losses
  6,318     5,561  
Gain on sale of investment securities
  (1,256 )   (268 )
Write-down of investment securities
  -        100  
Loss/(Gain) on sale of other real estate and repossessions
  143     (238 )
Write-down of other real estate and repossessions
  565     352  
Restricted stock expense
  7     5  
Change in:
           
Mortgage loans held for sale
  1,847     984  
Cash surrender value of life insurance
  (121 )   (128 )
Other assets
  394     (648 )
Other liabilities
  (135 )   514  
             
Net cash provided by operating activities
  12,605     10,245  
             
Cash flows from investing activities:
           
Net change in certificates of deposit
  -        1,938  
Purchases of investment securities available for sale
  (80,971 )   (102,354 )
Proceeds from calls, maturities and paydowns of investment securities
           
available for sale
  24,749     48,061  
Proceeds from sale of investment securities available for sale
  35,269     5,238  
Purchases of other investments
  (232 )   -     
Proceeds from sale of other investments
  153     -     
Net change in loans
  24,691     19,810  
Purchases of premises and equipment
  (1,214 )   (283 )
Proceeds from sale of other real estate and repossessions
  1,679     3,954  
             
Net cash provided (used) by investing activities
  4,124     (23,636 )
             
Cash flows from financing activities:
           
Net change in deposits
  (8,302 )   39,894  
Net change in demand notes payable to U.S. Treasury
  (348 )   (313 )
Net change in securities sold under agreement to repurchase
  10,418     4,027  
Proceeds from FHLB borrowings
  5,000     -     
Repayments of FHLB borrowings
  (5,000 )   (7,000 )
Restricted stock payout
  9     -     
Cash dividends paid on Series A preferred stock
  (626 )   (626 )
Cash dividends paid on common stock
  (222 )   (221 )
             
Net cash provided by financing activities
  929     35,761  
             
Net change in cash and cash equivalent
  17,658     22,370  
             
Cash and cash equivalents at beginning of period
  23,977     31,340  
             
Cash and cash equivalents at end of period
$ 41,635     53,710  
 
 
 
6

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
           
Consolidated Statements of Cash Flows, continued
           
Six months ended June 30, 2011 and 2010
           
(Dollars in thousands)
           
           
 
2011
   
2010
 
 
(Unaudited)
   
(Unaudited)
 
           
Supplemental disclosures of cash flow information:
         
Cash paid during the year for:
         
Interest
$ 5,924     7,584  
Income taxes
$ 112     834  
             
Noncash investing and financing activities:
           
Change in unrealized gain on investment securities
           
 available for sale, net
$ (2,921 )   (1,523 )
Change in unrealized gain on derivative financial
           
 instruments, net
$ 395     244  
Transfer of loans to other real estate and repossessions
$ 6,051     4,280  
Financed portion of sale of other real estate
$ 3,222     1,531  
Accretion of Series A preferred stock
$ 70     70  
             
             
See accompanying notes to consolidated financial statements.
           
 
 
 
7

 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1)
    Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly-owned subsidiaries, Peoples Bank (the “Bank”) and Community Bank Real Estate Solutions, LLC, along with the Bank’s wholly-owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.

The consolidated financial statements in this report are unaudited.  In the opinion of management, all adjustments (none of which were other than normal accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included.  Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles in the United States (“GAAP”).  Actual results could differ from those estimates.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of the specific accounting guidance.  A description of the Company’s significant accounting policies can be found in Note 1 of the notes to consolidated financial statements in the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Recently Issued Accounting Pronouncements
In April 2011, the Financial Accounting Standard Accounting Board (“FASB”) issued Accounting Standards Update (“ASU”)No. 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring This ASU provides additional guidance for determining what constitutes a troubled debt restructuring.  The ASU is effective for interim and annual periods ending after June 15, 2011.  The adoption of this guidance did not have a material impact on the Company's results of operations, financial position or disclosures.

In May 2011, the Financial Accounting Standard Accounting Board (“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 International Financial Reporting Standards (“IFRS”).  ASU No. 2011-04 is intended to result in convergence between U.S. GAAP and IFRS requirements for measurement of and disclosures about fair value. The amendments are not expected to have a significant impact on companies applying U.S. GAAP.  This ASU is effective for interim and annual periods beginning after December 15, 2011.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In June 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income.  ASU No. 2011-05 will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements.  It eliminates the option to present components of other comprehensive income as part of the statement of changes in shareholders' equity.  This ASU does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011.  Because ASU No. 2011-05 impacts presentation only, it will have no impact on the Company's results of operations or financial position.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's results of operations, financial position or disclosures.
 
 
8

 

 
(2)
    Investment Securities

Investment securities available for sale at June 30, 2011 and December 31, 2010 are as follows:
 
(Dollars in thousands)
             
 
June 30, 2011
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated Fair
Value
               
Mortgage-backed securities
$ 153,613   2,216   272   155,557
U.S. Government
               
sponsored enterprises
  49,821   830   103   50,548
State and political subdivisions
  87,125   2,214   392   88,947
Trust preferred securities
  1,250   -      -      1,250
Equity securities
  1,025   360   81   1,304
                 
Total
$ 292,834   5,620   848   297,606
                 
 
(Dollars in thousands)
             
 
December 31, 2010
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
 Losses
 
Estimated Fair
Value
               
Mortgage-backed securities
$ 137,811   2,119   569   139,361
U.S. Government
               
sponsored enterprises
  42,933   393   686   42,640
State and political subdivisions
  89,486   793   2,450   87,829
Trust preferred securities
  1,250   -      -      1,250
Equity securities
  982   387   -      1,369
                 
Total
$ 272,462   3,692   3,705   272,449
 
The current fair value and associated unrealized losses on investments in securities with unrealized losses at June 30, 2011 and December 31, 2010 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.

(Dollars in thousands)
                   
 
June 30, 2011
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
 Losses
                       
Mortgage-backed securities
$ 28,020   272   -      -      28,020   272
U.S. Government
                       
sponsored enterprises
  10,845   103   -      -      10,845   103
State and political subdivisions
  22,405   378   784   14   23,189   392
Equity securities   -       -       327   81   327   81
                         
Total
$ 61,270   753   1,111   95   62,381   848
 
(Dollars in thousands)
                   
 
December 31, 2010
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
                       
Mortgage-backed securities
$ 59,471   569   -      -      59,471   569
U.S. Government
                       
sponsored enterprises
  24,123   686   -      -      24,123   686
State and political subdivisions
  56,374   2,450   -      -      56,374   2,450
                         
Total
$ 139,968   3,705   -      -      139,968   3,705
 
 
 
9

 
 
At June 30, 2011, unrealized losses in the investment securities portfolio relating to debt securities totaled $767,000.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the June 30, 2011 tables above, 31 out of 151 securities issued by state and political subdivisions contained unrealized losses and 18 out of 106 securities issued by U.S. government sponsored enterprises, including mortgage-backed securities, contained unrealized losses.  These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.  The unrealized loss on one equity security was $81,000 as of June 30, 2011.  This unrealized loss is considered temporary based upon the entity’s strong capital position and growth potential.

The amortized cost and estimated fair value of investment securities available for sale at June 30, 2011, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
(Dollars in thousands)
     
 
Amortized
Cost
 
Estimated Fair
Value
Due within one year
$ 7,368   7,415
Due from one to five years
  41,668   42,452
Due from five to ten years
  70,375   71,596
Due after ten years
  18,785   19,282
Mortgage-backed securities
  153,613   155,557
Equity securities
  1,025   1,304
Total
$ 292,834   297,606
 
Proceeds from sales of securities available for sale during six months ended June 30, 2011 were $35.3 million and resulted in a gross gain of $1.3 million.  Proceeds from sales of securities available for sale during the six months ended June 30, 2010 were $5.2 million and resulted in a gross gain of $268,000.

Securities with a fair value of approximately $101.8 million and $75.5 million at June 30, 2011 and December 31, 2010, respectively, were pledged to secure public deposits and for other purposes as required by law.

(3)
    Loans

Major classifications of loans at June 30, 2011 and December 31, 2010 are summarized as follows:
 
(Dollars in thousands)
     
       
 
June 30, 2011
 
December 31, 2010
       
Real Estate Loans
     
     Construction and land development
$ 108,353   124,048
     Single-family residential
  276,452   287,307
     Commercial
  210,186   213,487
     Multifamily and farmland
  5,179   6,456
          Total real estate loans
  600,170   631,298
         
Commercial loans (not secured by real estate)
  56,575   60,994
Consumer loans (not secured by real estate)
  10,557   11,500
All other loans (not secured by real estate)
  25,511   22,368
         
     Total loans
  692,813   726,160
         
Less allowance for loan losses
  15,984   15,493
         
     Total net loans
$ 676,829   710,667
 
 
 
10

 

The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties of North Carolina.  Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following tables present an age analysis of past due loans, by loan type, as of June 30, 2011 and December 31, 2010:
 
June 30, 2011
                   
(Dollars in thousands)
                   
 
Loans 30-89
Days Past
Due
 
Loans 90 or
More Days
Past Due
 
Total Past
Due
Loans
 
Total
Current
Loans
 
Total Loans
 
Accruing
Loans 90 or
More Days
Past Due
Real Estate Loans
                     
     Construction and land development
$ 1,031   2,882   3,913   104,441   108,353   -   
     Single-family residential
  7,766   5,064   12,830   263,621   276,452   1,124
     Commercial
  1,340   1,191   2,531   207,655   210,186   -   
     Multifamily and farmland
  -      -      -      5,179   5,179   -   
          Total real estate loans
  10,137   9,137   19,274   580,896   600,170   1,124
                         
Commercial loans (not secured by real estate)
  340   92   432   56,143   56,575   -   
Consumer loans (not secured by real estate)
  20   31   51   10,506   10,557   -   
All other loans (not secured by real estate)
  -      -      -      25,511   25,511   -   
     Total loans
$ 10,497   9,260   19,757   673,056   692,813   1,124
 
December 31, 2010
                   
(Dollars in thousands)
                   
 
Loans 30-89
Days Past
Due
 
Loans 90 or
More Days
Past Due
 
Total Past
Due
Loans
 
Total
Current
Loans
 
Total Loans
 
Accruing
Loans 90 or
More Days
Past Due
Real Estate Loans
                     
     Construction and land development
$ 2,306   8,870   11,176   112,872   124,048   197
     Single-family residential
  19,377   5,936   25,313   261,994   287,307   -   
     Commercial
  382   1,482   1,864   211,623   213,487   -   
     Multifamily and Farmland
  -      -      -      6,456   6,456   -   
          Total real estate loans
  22,065   16,288   38,353   592,945   631,298   197
                         
Commercial loans (not secured by real estate)
  1,098   720   1,818   59,176   60,994   13
Consumer loans (not secured by real estate)
  98   13   111   11,389   11,500   -   
All other loans (not secured by real estate)
  -      -      -      22,368   22,368   -   
     Total loans
$ 23,261   17,021   40,282   685,878   726,160   210
 
 
 
11

 
 
The following table presents the Company’s non-accrual loans as of June 30, 2011 and December 31, 2010:
 
(Dollars in thousands)
     
 
June 30, 2011
 
December 31, 2010
Real Estate Loans
     
     Construction and land development
$ 19,256   22,916
     Single-family residential
  7,035   10,837
     Commercial
  3,922   5,351
     Multifamily and Farmland
  -      -   
          Total real estate loans
  30,213   39,104
         
Commercial loans (not secured by real estate)
  637   816
Consumer loans (not secured by real estate)
  147   142
All other loans (not secured by real estate)
  -      -   
     Total
$ 30,997   40,062
 
At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which is generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.  No interest income is recognized on impaired loans subsequent to their classification as impaired.

The following tables present the Company’s impaired loans as of June 30, 2011 and December 31, 2010:
 
June 30, 2011
                   
(Dollars in thousands)
                   
 
Unpaid Contractual Principal
Balance
 
Recorded Investment
With No Allowance
 
Recorded Investment
With
Allowance
 
Recorded Investment 
in Impaired
Loans
 
Related
Allowance
 
Average Outstanding Impaired
Loans
Real Estate Loans
                     
     Construction and land development
$ 28,266   19,256   -      19,256   -      21,086
     Single-family residential
  8,507   6,927   108   7,035   1,257   8,936
     Commercial
  4,686   2,667   1,255   3,922   98   4,636
     Multifamily and farmland
  -      -      -      -      -      -   
          Total impaired real estate loans
  41,459   28,850   1,363   30,213   1,355   34,658
                         
Commercial loans (not secured by real estate)
  686   313   324   637   113   727
Consumer loans (not secured by real estate)
  162   147   -      147   -      144
All other loans (not secured by real estate)
  -       -      -      -      -      -   
     Total impaired loans
$ 42,307   29,310   1,687   30,997   1,468   35,529
 
 
December 31, 2010
                   
(Dollars in thousands)
                   
 
Unpaid Contractual Principal
Balance
 
Recorded Investment
With No Allowance
 
Recorded Investment
With
Allowance
 
Recorded Investment
in Impaired
Loans
 
Related
Allowance
 
Average Outstanding Impaired
Loans
Real Estate Loans
                     
     Construction and land development
$ 31,346   20,787   2,130   22,916   1,055   18,767
     Single-family residential
  12,376   9,847   990   10,837   168   12,573
     Commercial
  6,018   4,991   359   5,351   148   4,769
     Multifamily and Farmland
  -      -      -      -      -      27
          Total impaired real estate loans
  49,740   35,625   3,479   39,104   1,371   36,136
                         
Commercial loans (not secured by real estate)
  1,243   811   5   816   5   1,479
Consumer loans (not secured by real estate)
  152   142   -      142   -      79
     Total impaired loans
$ 51,135   36,578   3,484   40,062   1,376   37,694
 
 
 
 
12

 
 
 Changes in the allowance for loan losses for the six months ended June 30, 2011 were as follows:
 
(Dollars in thousands)
                         
                                 
 
Real Estate Loans
                 
 
Construction
and Land Development
 
Single-
family Residential
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Consumer
 
Unallocated
 
Total
 
Allowance for loan losses:
                               
Beginning balance
$ 5,774   6,097   1,409   17   1,174   430   592   15,493  
Charge-offs
  (3,329 ) (1,698 ) (894 ) -   (118 ) (272 ) -   (6,311 )
Recoveries
  234   65   23   -   77   85   -   484  
Provision
  2,915   1,696   1,081   (3 ) (31 ) 11   649   6,318  
Ending balance
$ 5,594   6,160   1,619   14   1,102   254   1,241   15,984  
                                   
Ending balance: Individually
                                 
evaluated for impairment
$ -   1,257   98   -   113   -   -   1,468  
Ending balance: Collectively
                                 
 evaluated for impairment
  5,594   4,903   1,521   14   989   254   1,241   14,516  
Ending balance
$ 5,594   6,160   1,619   14   1,102   254   1,241   15,984  
 
 
The Company utilizes an internal risk grading matrix to assign a risk grade to each of its loans.  Loans are graded on a scale of 1 to 9.  A description of the general characteristics of the nine risk grades is as follows:

·  
Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists.  CD or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.
·  
Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company’s range of acceptability.  The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.
·  
Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company’s range of acceptability but higher than normal. This may be a new organization or an existing  organization in a transitional phase (e.g. expansion, acquisition, market change).
·  
Risk Grade 4 – Management Attention: These loans have very high risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends are evident.  These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.
·  
Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company’s position at some future date.  This frequently results from deviating from prudent lending practices, for instance over-advancing on collateral.
·  
Risk Grade 6 – Substandard: A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any).  There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
·  
Risk Grade 7 – Low Substandard: These loans have the general characteristics of a Grade 6 Substandard loan, with heightened potential concerns.  The exact amount of loss is not yet known because neither the liquidation value of the collateral nor the borrower’s predicted repayment ability is known with confidence.
·  
Risk Grade 8 – Doubtful: Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable.  Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.
·  
Risk Grade 9 – Loss: Loans classified Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future.  Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.

 
 
13

 
 
The following tables present the credit risk profile of each loan type based on internally assigned risk grade as of June 30, 2011 and December 31, 2010.
 
June 30, 2011
                       
(Dollars in thousands)
                       
 
Real Estate Loans
               
 
Construction
and land development
 
Single-
family residential
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Consumer
 
All other
 
Total
                               
1- Excellent Quality
$ 17   24,408   37   -   656   1,008   -   26,126
2- High Quality
$ 5,746   67,036   24,680   233   8,917   4,067   5,057   115,736
3- Good Quality
$ 28,518   110,855   129,385   3,630   36,834   4,862   20,446   334,530
4- Management Attention
$ 48,829   53,511   45,005   371   8,484   458   8   156,666
5- Watch
$ 3,515   7,639   1,863   730   455   11   -   14,213
6- Substandard
$ 21,728   13,003   9,216   215   1,229   151   -   45,542
7- Low Substandard
$ -   -   -   -   -   -   -   -
8- Doubtful
$ -   -   -   -   -   -   -   -
9- Loss
$ -   -   -   -   -   -   -   -
      Total
$ 108,353   276,452   210,186   5,179   56,575   10,557   25,511   692,813
 
December 31, 2010
                       
(Dollars in thousands)
                       
 
Real Estate Loans
               
 
Construction
and land development
 
Single-
family residential
 
Commercial
 
Multifamily and
Farmland
 
Commercial
 
Consumer
 
All other
 
Total
                               
1- Excellent Quality
$ 19   27,698   102   -   630   1,006   -   29,455
2- High Quality
$ 5,789   70,990   21,591   2,856   9,673   4,491   5,145   120,535
3- Good Quality
$ 33,991   109,800   129,530   2,256   39,248   5,360   17,223   337,408
4- Management Attention
$ 46,283   55,001   43,731   1,121   8,143   454       154,733
5- Watch
$ 8,076   7,959   5,569   -   1,590   38       23,232
6- Substandard
$ 29,502   15,022   12,605   223   1,678   145       59,175
7- Low Substandard
$ -   756   359   -   -   -       1,115
8- Doubtful
$ 388   81   -   -   17   -       486
9- Loss
$ -   -   -   -   15   6   -   21
      Total
$ 124,048   287,307   213,487   6,456   60,994   11,500   22,368   726,160
 
 
The following tables present weighted average risk grades and balances of the total loan portfolio, along with balances of classified loans, by loan type as of June 30, 2011 and December 31, 2010.  Classified loans include loans in risk grades 6, 7, 8 and 9.
 
June 30, 2011
             
(Dollars in thousands)
             
 
Weighted Average
Risk Grade of Loans Outstanding
 
Loans
Outstanding
 
Classified
Loans
   
Real Estate Loans
             
     Construction and land development
4.06   $ 108,353   21,728    
     Single-family residential
2.97     276,452   13,003    
     Commercial
3.25     210,186   9,216    
     Multifamily and farmland
3.43     5,179   215    
          Total real estate loans
      600,170   44,161    
                 
Commercial loans (not secured by real estate)
3.05     56,575   1,229    
Consumer loans (not secured by real estate)
2.47     10,557   151    
All other loans (not secured by real estate)
2.80     25,511   -       
     Total loans
    $ 692,813   45,542  
 (1)
                 
(1) Includes $36.2 million of TDR loans
               
 

 
14

 
 
 
December 31, 2010
             
(Dollars in thousands)
             
 
Weighted Average
Risk Grade of Loans Outstanding
  Loans Outstanding   Classified Loans    
Real Estate Loans
             
     Construction and land development
4.19   $ 124,048   29,890    
     Single-family residential
2.97     287,307   15,859    
     Commercial
3.33     213,487   12,964    
     Multifamily and Farmland
2.83     6,456   223    
          Total real estate loans
      631,298   58,936    
                 
Commercial loans (not secured by real estate)
3.09     60,994   1,710    
Consumer loans (not secured by real estate)
2.48     11,500   151    
All other loans (not secured by real estate)
2.77     22,368   -       
     Total loans
    $ 726,160   60,797  
 (1)
                 
(1) Includes $39.2 million of TDR loans
               
 
At June 30, 2011, troubled debt restructured (“TDR”) loans amounted to $51.2 million, including $16.5 million in performing TDR loans.  The terms of these loans have been renegotiated to provide a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  At December 31, 2010, TDR loans amounted to $56.7 million, including $10.0 million in performing TDR loans.

The following table presents an analysis of TDR loans by loan type as of June 30, 2011.
 
(Dollars in thousands)
         
 
Number of Contracts
 
Pre-Modification Outstanding Recorded
Investment
 
Post-Modification Outstanding
Recorded
Investment
Real Estate Loans
         
     Construction and land development
38   $ 25,644   19,480
     Single-family residential
239     27,249   25,236
     Commercial
15     8,086   4,336
     Multifamily and farmland
1     322   215
          Total real estate TDR loans
293     61,301   49,267
             
Commercial loans (not secured by real estate)
24     5,856   1,763
Consumer loans (not secured by real estate)
10     160   148
     Total TDR loans
327   $ 67,317   51,178
 
(4)
    Net Earnings Per Common Share
 
Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share.  The average market price during the year is used to compute equivalent shares.

The reconciliation of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the three and six months ended June 30, 2011 and 2010 is as follows:
 
 
 
15

 
 
 
For the three months ended June 30, 2011
         
 
Net Earnings Available to Common Shareholders (Dollars in thousands)
 
Common Shares
 
Per Share Amount
           
Basic earnings per common share
$ 281   5,542,703   $ 0.05
Effect of dilutive securities:
             
Stock options
  -      1,739      
Diluted earnings per common share
$ 281   5,544,442   $ 0.05
 
For the six months ended June 30, 2011
         
 
Net Earnings Available to Common Shareholders (Dollars in thousands)
 
Common Shares
 
Per Share Amount
           
Basic earnings per common share
$ 1,293   5,542,126   $ 0.23
Effect of dilutive securities:
             
Stock options
  -      1,646      
Diluted earnings per common share
$ 1,293   5,543,772   $ 0.23
 
For the three months ended June 30, 2010
         
 
Net Earnings Available to Common Shareholders (Dollars in thousands)
 
Common Shares
 
Per Share Amount
           
Basic earnings per common share
$ 515   5,539,056   $ 0.09
Effect of dilutive securities:
             
Stock options
  -      5,988      
Diluted earnings per common share
$ 515   5,545,044   $ 0.09

(5)
    Stock-Based Compensation
 
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “1999 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  The 1999 Plan expired on May 13, 2009.
 
 
 
16

 
 
Under the 1999 Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant.  The options granted in 1999 vested over a five-year period.  Options granted subsequent to 1999 vested over a three-year period.  All options expire ten years after issuance.  The Company did not grant any options during the six months ended June 30, 2011 and 2010.

The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock at a grant date fair value of $12.80 per share during the third quarter of 2008 and 2,000 shares of restricted stock at a fair value of $11.37 per share during the fourth quarter of 2008. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date).  The amount of expense recorded each period reflects the changes in the Company’s stock price during the period.  As of June 30, 2011, there was $2,000 of total unrecognized compensation cost related to restricted stock grants, which is expected to be recognized during 2011.

The Company also has an Omnibus Stock Ownership and Long Term Incentive Plan that was approved by shareholders’ on May 7, 2009 (the “2009 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  A total of 360,000 shares are currently reserved for possible issuance under the 2009 Plan.   All rights must be granted or awarded within ten years from the May 7, 2009 effective date of the 2009 Plan.  The Company has not granted any rights under the 2009 Plan.

(6)
Fair Value

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.

Cash and Cash Equivalents
For cash, due from banks and interest bearing deposits, the carrying amount is a reasonable estimate of fair value.

Certificates of Deposit
The carrying amount of certificates of deposit is a reasonable estimate of fair value.

Investment Securities Available for Sale
Fair values for investment securities are based on quoted market prices.

Other Investments
For other investments, the carrying value is a reasonable estimate of fair value.

Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at lower of aggregate cost or market value.  The cost of mortgage loans held for sale approximates the market value.

Loans
The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.

Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Derivative Instruments
For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.
 
 
17

 
 
Deposits and Demand Notes Payable to U.S. Treasury
The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to the U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Securities Sold Under Agreements to Repurchase
For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.

Federal Home Loan Bank (“FHLB”) Borrowings
The fair value of FHLB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.

Junior Subordinated Debentures
Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit
Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.

Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability.   The following tables present the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of June 30, 2011 and December 31, 2010.
 
 
(Dollars in thousands)
             
 
Fair Value
Measurements June
30, 2011
Level 1
Valuation
Level 2
Valuation
Level 3 Valuation
Mortgage-backed securities
$ 155,557   -   155,557   -
U.S. government
               
sponsored enterprises
$ 50,548   -   50,548   -
State and political subdivisions
$ 88,947   -   88,947   -
Trust preferred securities
$ 1,250   -   -   1,250
Equity securities
$ 1,304   1,304   -   -
Mortgage loans held for sale
$ 1,967   -   1,967   -
 
 
 
18

 
 
 
 
Fair Value
Measurements
December 31, 2010
Level 1
Valuation
Level 2
Valuation
Level 3 Valuation
Mortgage-backed securities
$ 139,361   -   139,361   -
U.S. government
               
sponsored enterprises
$ 42,640   -   42,640   -
State and political subdivisions
$ 87,829   -   87,829   -
Trust preferred securities
$ 1,250   -   -   1,250
Equity securities
$ 1,369   1,369   -   -
Mortgage loans held for sale
$ 3,814   -   3,814   -
Market value of derivatives (in other assets)
$ 648   -   648   -
 
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2011:
 
(Dollars in thousands)
 
 
Investment Securities Available for Sale
 
Level 3 Valuation
Balance, beginning of period
$ 1,250
Change in book value
  -
Change in gain/(loss) realized and unrealized
  -
Purchases/(sales)
  -
Transfers in and/or out of Level 3
  -
Balance, end of period
$ 1,250
     
Change in unrealized gain/(loss) for assets still held in Level 3
$ -
 
The Company’s June 30, 2011 and December 31, 2010 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:
 
(Dollars in thousands)
               
 
Fair Value Measurements
June 30, 2011
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
 
Total Gains/(Losses) for the
Six Months Ended June 30,
2011
Impaired loans
$ 30,997   -   21,274   9,723   (6,311)
Other real estate
$ 7,115   -   7,115   -   (708)
 
(Dollars in thousands)
               
 
Fair Value Measurements December 31, 2010
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
 
Total Gains/(Losses) for
the Year Ended December
31, 2010
Impaired loans
$ 40,062   -   26,798   13,264   (10,591)
Other Real Estate
$ 6,673   -   6,673   -   (340)
 
 
 
19

 
 
The carrying amount and estimated fair value of the Company’s financial instruments at June 30, 2011 and December 31, 2010 are as follows:
 
(Dollars in thousands)
             
 
June 30, 2011
 
December 31, 2010
 
Carrying Amount
 
Estimated
Fair Value
 
Carrying
Amount
 
Estimated
Fair Value
Assets:
             
Cash and cash equivalents
$ 41,635   41,635   23,977   23,977
Certificates of deposit
  735   735   735   735
Investment securities available for sale
  297,606   297,606   272,449   272,449
Other investments
  5,840   5,840   5,761   5,761
Mortgage loans held for sale
  1,967   1,967   3,814   3,814
Loans, net
  676,829   673,221   710,667   710,880
Cash surrender value of life insurance
  7,660   7,660   7,539   7,539
Derivative instruments
  -   -   648   648
                 
Liabilities:
               
Deposits and demand notes payable
$ 831,662   830,875   840,312   839,379
Securities sold under agreements
               
to repurchase
  44,512   44,512   34,094   34,094
FHLB borrowings
  70,000   80,035   70,000   79,950
Junior subordinated debentures
  20,619   20,619   20,619   20,619
 

 (7)
Derivative Instruments and Hedging Activities

Accounting Policy for Derivative Instruments and Hedging Activities
The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

Risk Management Objective of Using Derivatives
The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  The Company did not have any interest rate derivatives outstanding as of June 30, 2011.
 
 
20

 
 
Fair Values of Derivative Instruments on the Balance Sheet
The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of June 30, 2011 and December 31, 2010.
 
(Dollars in thousands)
             
 
Asset Derivatives
 
As of June 30, 2011
 
As of December 31, 2010
 
Balance Sheet
Location
  Fair Value  
Balance Sheet
Location
  Fair Value
Interest rate derivative contracts
Other assets
  $ -  
Other assets
  $ 648
 
Cash Flow Hedges of Interest Rate Risk
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floors designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.  The Company did not have any interest rate derivatives outstanding as of June 30, 2011.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  Such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets during 2011 and 2010.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company’s derivatives did not have any hedge ineffectiveness recognized in earnings during the six months ended June 30, 2011 and 2010.
 
Effect of Derivative Instruments on the Income Statement
The table below presents the effect of the Company’s derivative financial instruments on the income statement for the six months ended June 30, 2011 and 2010.
 
(Dollars in thousands)
                         
                           
                           
             
Location of Gain
 
Amount of Gain
 
Amount of Gain
 
(Loss) Reclassified
 
(Loss) Reclassified
 
(Loss) Recognized in
 
from Accumulated
 
from Accumulated
 
OCI on Derivatives
 
OCI into Income
 
OCI into Income
 
Six months ended
     
Six months ended
   June 30,        June 30, 
 
 
  2011  
 
  2010      
 
  2011  
 
  2010
Interest rate derivative contracts
 $  (20)    $  354  
Interest income
   $  628    $  753
 
Subsequent Events
The Company has reviewed and evaluated subsequent events and transactions for material subsequent events through the date the financial statements are issued.  Management has concluded that there were no material subsequent events.
 
 
 
 
21

 
 
Item 2.     Management's Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-30  through A-63 of the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc (“the Company”). The Company is the parent company of Peoples Bank (the “Bank”) and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview
Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Economic conditions in 2011 continue to have a negative impact on our financial condition and results of operations.  Unfavorable trends, such as increased unemployment, falling real estate prices, increased loan default and increased bankruptcy rates, have created the difficult business conditions that are affecting the general economy and therefore our operating results.  The unemployment rates in our primary market area continue to be higher than state and national averages.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. This new legislation makes extensive changes to the laws regulating financial products and services as well as firms and companies offering financial products and services. The Dodd-Frank Act also alters certain corporate governance matters affecting public companies. The legislation requires substantial rulemaking and mandates numerous additional studies, the results of which could impact future legislative and regulatory action. We are in the process of evaluating this new legislation and determining the extent to which it will impact our current and future operations. Among other things that could have an impact on our operations and activities, the Dodd-Frank Act (i) amends the manner for calculating the assessment base for deposit insurance premiums paid to the FDIC; (ii) requires the federal banking agencies to issue new rules to implement new minimum leverage and risk-based capital requirements for insured depository institutions; and (iii) requires the Securities and Exchange Commission to complete studies and develop rules or approve stock exchange rules regarding various investor protection issues, including shareholder access to the proxy process, and various matters pertaining to executive compensation and compensation committee oversight. Additionally, the Dodd-Frank Act establishes the Consumer Financial Protection Bureau (“Bureau”) as a new, independent federal agency, which will have broad rulemaking, supervisory and enforcement authority over financial institutions providing consumer financial products and services. Examples of such products and services include deposit products, residential mortgages, home-equity loans and credit cards. Under the Dodd-Frank Act, states are permitted to adopt more stringent consumer protection laws, and state attorneys general can enforce those laws as well as consumer protection rules issued by the Bureau.
 
 
22

 
 
While we are unable to determine all ramifications of the Dodd-Frank Act at this time, we expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years.  Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies, the full extent of the impact of such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business.  These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Federal Reserve has maintained the Federal Funds Rate at 0.25% since December 2008.  This historically low rate has had a negative impact on earnings and will continue to have a negative impact on our net interest income in future periods.  The negative impact of low interest rates has been partially offset by earnings realized on interest rate contracts utilized by the Company.  Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”

On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”).  Under  the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the UST’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”).  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield.  As of June 30, 2011, the Company has accreted a total of $337,000 of the discount related to the Series A preferred stock.  The Company has paid dividends of $626,000 on the Series A preferred stock during 2011for the period from November 16, 2010 through May 15, 2011.  Cumulative undeclared dividends at June 30, 2011 were $157,000 for the period from May 16, 2011 through June 30, 2011.

The Series A preferred stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends.  Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital.  However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000.  There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.
 
 
23

 
 
It is the intent of the Company to utilize CPP funds to provide capital to support making loans to qualified borrowers in our market area.  The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.  We are also working with our current builders and contractors to provide financing for potential buyers who may not be able to qualify for financing in the current mortgage market in order to help these customers sell existing single family homes.  The Company will also use the CPP capital infusion as additional Tier I capital to protect the Bank from potential losses that may be incurred during this current recessionary period.  It is the desire of the Company to repay the CPP funds without raising additional equity capital.  The Company anticipates being able to repay the CPP funds from future earnings and existing capital.  However, the funds will not be repaid until economic conditions improve and the Company achieves higher levels of earnings.

The Company continues to face challenges resulting from the impact of the current economy on the housing and real estate markets.  We continue to monitor and evaluate all significant loans in our portfolio, and will continue to manage our credit risk exposure with the expectation that stabilization of the real estate market will not occur within the next 18 to 24 months.  The CPP funds have enhanced our capital position as the Company infused the Bank with $8.0 million additional regulatory capital. The Company has $16.0 million available that can be infused into the Bank as additional capital if needed to maintain its position as a well capitalized bank.  We anticipate increased loan losses in the short run and have prepared for that expectation. We have experienced staff managing our past due loans and foreclosed properties to minimize our potential losses. As the economy recovers, we are positioned to take advantage of all opportunities that present themselves.  The amount and timing of any future Federal Reserve rate adjustment remains uncertain, and may further impact us if those adjustments are significant.

Summary of Significant Accounting Policies
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2010 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2011 Annual Meeting of Shareholders.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectibility of loans is reflected through the Company’s estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectibility.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company’s internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the Notes to the Consolidated Financial Statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards.  These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with generally accepted accounting principles in the United States ("GAAP").  For a more complete discussion of policies, see the Notes to the Consolidated Financial Statements.

The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
 
 
24

 

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  The Company did not have any interest rate derivatives outstanding as of June 30, 2011

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet as of June 30, 2011 and December 31, 2010.
 
(Dollars in thousands)
             
 
Asset Derivatives
 
As of June 30, 2011
 
As of December 31, 2010
 
Balance Sheet
Location
  Fair Value  
Balance Sheet
Location
  Fair Value
Interest rate derivative contracts
Other assets
  $ -  
Other assets
  $ 648
 
The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floor designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in “accumulated other comprehensive income” and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. Such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets during 2011 and 2010.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company’s derivatives did not have any hedge ineffectiveness recognized in earnings during the six months ended June 30, 2011 and 2010.

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the six months ended June 30, 2011 and 2010.
 
(Dollars in thousands)
                         
                           
                           
             
Location of Gain
 
Amount of Gain
 
Amount of Gain
 
(Loss) Reclassified
 
(Loss) Reclassified
 
(Loss) Recognized in
 
from Accumulated
 
from Accumulated
 
OCI on Derivatives
 
OCI into Income
 
OCI into Income
 
Six months ended
     
Six months ended
 
June 30,
     
June 30,
 
            2011
 
             2010
     
             2011
 
              2010
Interest rate derivative contracts
 $  (20)    $  354  
Interest income
   $  628    $  753
 
GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements.  There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability.   The tables below present the balance of securities available for sale, mortgage loans held for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of June 30, 2011 and December 31, 2010.
 
 
25

 
 
 
(Dollars in thousands)
             
 
Fair Value
Measurements June
30, 2011
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
Investment securities available for sale
$ 297,606   1,304   295,052   1,250
Mortgage loans held for sale
$ 1,967   -   1,967   -
 
(Dollars in thousands)
             
 
Fair Value
Measurements
December 31, 2010
 
Level 1 Valuation
 
Level 2 Valuation
 
Level 3 Valuation
Investment securities available for sale
$ 272,449   1,369   269,830   1,250
Mortgage loans held for sale
$ 3,814   -   3,814   -
Market value of derivatives (in other assets)
$ 648   -   648   -
 
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available.  If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.  Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2011:
 
(Dollars in thousands)
 
 
Investment Securities Available for Sale
 
Level 3 Valuation
Balance, beginning of period
$ 1,250
Change in book value
  -
Change in gain/(loss) realized and unrealized
  -
Purchases/(sales)
  -
Transfers in and/or out of Level 3
  -
Balance, end of period
$ 1,250
     
Change in unrealized gain/(loss) for assets still held in Level 3
$ -
 
The Company’s June 30, 2011 and December 31, 2010 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:
 
(Dollars in thousands)
               
 
Fair Value
Measurements June
30, 2011
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
 
Total Gains/(Losses) for the
Six Months Ended June 30,
2011
Impaired loans
$ 30,997   -   21,274   9,723   (6,311)
Other real estate
$ 7,115   -   7,115   -   (708)
 
(Dollars in thousands)
               
 
Fair Value
Measurements
December 31, 2010
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
 
Total Gains/(Losses) for the
Year Ended December 31,
2010
Impaired loans
$ 40,062   -   26,798   13,264   (10,591)
Other Real Estate
$ 6,673   -   6,673   -   (340)
 
 
 
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At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which are generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP.  Actual results could differ from those estimates.

Results of Operations
Summary.  Net earnings for the second quarter of 2011 were $629,000, or $0.11 basic and diluted net earnings per share before adjustment for preferred stock dividends and accretion as compared to $864,000, or $0.16 basic and diluted net earnings per share for the same period one year ago.  After adjusting for $348,000 in dividends and accretion on preferred stock, net earnings available to common shareholders for the three months ended June 30, 2011 were $281,000, or $0.05 basic and diluted net earnings per common share as compared to $515,000, or $0.09 basic and diluted net earnings per common share for the same period one year ago.  The decrease in second quarter earnings is attributable to increases in non-interest expense and the provision for loan losses combined with a decrease in non-interest income, which were partially offset by an increase in net interest income, as discussed below.

The annualized return on average assets was 0.24% for the three months ended June 30, 2011 compared to 0.32% for the same period in 2010, and annualized return on average shareholders’ equity was 2.52% for the three months ended June 30, 2011 compared to 3.42% for the same period in 2010.
 
Year-to-date net earnings as of June 30, 2011 were $2.0 million, or $0.36 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, as compared to $1.7 million, or $0.31 basic and diluted net earnings per share, for the same period one year ago.  After adjusting for dividends and accretion on preferred stock, net earnings available to common shareholders for the six months ended June 30, 2011 were $1.3 million or $0.23 basic and diluted net earnings per common share as compared to $1.0 million, or $0.19 basic and diluted net earnings per common share, for the same period one year ago.  The increase in year-to-date earnings is primarily attributable to aggregate increases in net interest income and non-interest income, which were partially offset by increases in the provision for loan losses and non-interest expense, as discussed below.

The annualized return on average assets was 0.38% for the six months ended June 30, 2011 compared to 0.33% for the same period in 2010, and annualized return on average shareholders’ equity was 4.08% for the six months ended June 30, 2011 compared to 3.46% for the same period in 2010.
 
Net Interest Income.  Net interest income, the major component of the Company’s net earnings, was $8.6 million for the three months ended June 30, 2011 compared to $8.2 million for the same period in 2010.  This increase is primarily attributable to a reduction in interest expense due to a decrease in deposit interest rates.

Interest income decreased $457,000 or 4% for the three months ended June 30, 2011 compared with the same period in 2010.  The decrease was primarily due to a reduction in average loans.  The average yield on earning assets for the quarters ended June 30, 2011 and 2010 was 4.70% and 4.92%, respectively.  During the quarter ended June 30, 2011, average loans decreased $57.2 million to $704.4 million from $761.6 million for the three months ended June 30, 2010.  During the quarter ended June 30, 2011, average investment securities available for sale increased $75.6 million to $285.2 million from $209.6 million for the three months ended June 30, 2010 primarily due to the investment of additional funds received from loan repayments outpacing new loans disbursed.

Interest expense decreased $873,000 or 24% for the three months ended June 30, 2011 compared with the same period in 2010 primarily due to lower cost of funds.  The average rate paid on interest-bearing checking and savings accounts was 0.70% for the three months ended June 30, 2011 as compared to 1.18% for the same period of 2010.  The average rate paid on certificates of deposits was 1.43% for the three months ended June 30, 2011 compared to 1.70% for the same period one year ago.

Net interest income increased to $17.1 million for the six months ended June 30, 2011 compared to $16.3 million for the same period in 2010.  This increase is primarily attributable to a reduction in interest expense due to a decrease in the cost of funds for time deposits.
 
 
27

 
 
Interest income decreased $830,000 or 3% for the six months ended June 30, 2011 compared with the same period in 2010.  The decrease was primarily due to a reduction in average loans.  The average yield on earning assets for the six months ended June 30, 2011 and 2010 was 4.75% and 4.99%, respectively.  During the six months ended June 30, 2011, average loans decreased $55.9 million to $713.0 million from $768.9 million for the six months ended June 30, 2010.  During the six months ended June 30, 2011, average investment securities available for sale increased $75.8 million to $276.3 million from $200.5 million for the six months ended June 30, 2010 primarily due to the investment of additional funds received from the decrease in loans.

Interest expense decreased $1.7 million or 22% for the six months ended June 30, 2011 compared with the same period in 2010 primarily due to lower cost of funds.  The average rate paid on interest-bearing checking and savings accounts was 0.79% for the six months ended June 30, 2011 as compared to 1.20% for the same period of 2010.  The average rate paid on certificates of deposits was 1.46% for the six months ended June 30, 2011 compared to 1.77% for the same period one year ago.

Provision for Loan Losses. For the three months ended June 30, 2011 a contribution of $3.4 million was made to the provision for loan losses compared to a $3.2 million contribution to the provision for loan losses for the three months ended June 30, 2010.

The provision for loan losses for the six months ended June 30, 2011 was $6.3 million as compared to $5.6 million for the same period one year ago, primarily attributable to a $1.8 million increase in net charge-offs during the six months ended June 30, 2011 compared to the same period last year.  Net charge-offs during the six months ended June 30, 2011 included $3.1 million on acquisition, development and construction (“AD&C”) loans, $2.5 million on mortgage loans and $228,000 on non-real estate loans.

Non-Interest Income.  Total non-interest income was $2.7 million for the second quarter of 2011 as compared to $3.1 million for the same period of 2010.  This decrease is primarily attributable to a $428,000 decrease in miscellaneous non-interest income due to a $450,000 increase in net losses and write-downs on foreclosed properties for the three months ended June 30, 2011, as compared to the same period one year ago.

Non-interest income increased 10% to $6.3 million for the six months ended June 30, 2011, as compared to $5.7 million for the same period one year ago.  This increase is primarily attributable to a $1.1 million increase in gains on the sale of securities, which was partially offset by a $475,000 decrease in miscellaneous non-interest income due to a $593,000 increase in net losses and write-downs on foreclosed properties for the six months ended June 30, 2011, as compared to the same period one year ago.

 Non-Interest Expense.  Total non-interest expense increased 5% to $7.4 million for the three months ended June 30, 2011, as compared to $7.1 million for the same period last year.  The increase in non-interest expense included: (1) an increase of $240,000 or 7% in salaries and benefits expense, (2) an increase of $30,000 or 2% in occupancy expense and (3) an increase of $81,000 or 4% in non-interest expenses other than salary, employee benefits and occupancy expenses.

Non-interest expense increased 4% to $14.8 million for the six months ended June 30, 2011, as compared to $14.2 million for the same period last year.  The increase in non-interest expense included: (1) an increase of $387,000 or 6% in salaries and benefits expense, (2) an increase of $44,000 or 2% in occupancy expense and (3) an increase of $101,000 or 2% in non-interest expenses other than salary, employee benefits and occupancy expenses.

Income Taxes.  The Company reported an income tax benefit of $56,000 and income tax expense of $227,000 for the three months ended June 30, 2011 and 2010, respectively.  The reduction in tax expense is primarily due to an increase in investment income exempt from income taxes combined with a decrease in earnings before taxes.

The Company reported income taxes of $349,000 and $496,000 for the six months ended June 30, 2011and 2010, respectively.  This represented an effective tax rate of 15% and 22% for the respective periods.  The decrease in the effective tax rate is primarily due to an increase in tax exempt investment income.

Analysis of Financial Condition
Investment Securities.  Available for sale securities amounted to $297.6 million at June 30, 2011 compared to $272.4 million at December 31, 2010.  Average investment securities available for sale for the six months ended June 30, 2011 amounted to $276.3 million compared to $219.8 million for the year ended December 31, 2010. This increase reflects the investment of additional funds received from loan repayments outpacing new loans disbursed.

Loans.  At June 30, 2011, loans amounted to $692.8 million compared to $726.2 million at December 31, 2010, a decrease of $33.4 million.  This decrease reflects a decline in loan originations combined with continuing payments on existing loans. Loans originated or renewed during the six months ended June 30, 2011, amounting to approximately $37.9 million, were offset by paydowns and payoffs of existing loans.  Average loans represented 70% and 76% of average earning assets for the six months ended June 30, 2011 and the year ended December 31, 2010, respectively.  The Company had $2.0 million and $3.8 million in mortgage loans held for sale as of June 30, 2011 and December 31, 2010, respectively.
 
 
28

 
 
Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Real estate mortgage loans include both commercial and residential mortgage loans.  At June 30, 2011, the Company had $121.7 million in residential mortgage loans, $95.6 million in home equity loans and $274.0 million in commercial mortgage loans, which include $214.5 million using commercial property as collateral and $59.5 million using residential property as collateral.   Residential mortgage loans include $66.3 million made to customers in the Company’s traditional banking offices and $55.4 million in mortgage loans originated in the Company’s Latino banking operations.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.

At June 30, 2011, the Company had $108.4 million in AD&C loans.  The following table presents a breakout of these loans.
 
(Dollars in thousands)
         
           
 
Number of Loans
 
Balance Outstanding
 
Non-accrual Balance
Land acquisition and development - commercial purposes
77   $ 22,494   $ 2,642
Land acquisition and development - residential purposes
351     74,858     16,614
1 to 4 family residential construction
31     9,433     -
Commercial construction
3     1,568     -
Total acquisition, development and construction
462   $ 108,353   $ 19,256
 
At June 30, 2011, troubled debt restructured (“TDR”) loans amounted to $51.2 million, including $16.5 million in performing TDR loans.  The terms of these loans have been renegotiated to provide a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  At December 31, 2010, TDR loans amounted to $56.7 million, including $10.0 million in performing TDR loans.

Allowance for Loan Losses.  The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  We periodically analyze the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·  
our loan loss experience;
·  
the amount of past due and non-performing loans;
·  
specific known risks;
·  
the status and amount of other past due and non-performing assets;
·  
underlying estimated values of collateral securing loans;
·  
current and anticipated economic conditions; and
·  
other factors which management believes affect the allowance for potential credit losses.

Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the originating loan officer evaluates the quality of the loan and assigns one of nine risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by our Credit Administration department. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the  Credit Administration department. Any issues regarding the risk assessments are addressed by our senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Credit Administration department.

As an additional measure, we engage an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million.  The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.

Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.
 
 
 
29

 

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment.  When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.  At June 30, 2011 and December 31, 2010, the recorded investment in loans that were considered to be impaired was approximately $31.0 million and $40.1 million, respectively, with related allowance for loan losses of approximately $1.5 million and $1.4 million, respectively.

The general allowance reflects reserves established for collective loan impairment.  These reserves are based upon historical net charge-offs using the last two years’ experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  We consider information derived from our loan risk ratings and external data related to industry and general economic trends.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with GAAP and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the six months ended June 30, 2011 as compared to the year ended December 31, 2010.  Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations.

The allowance for loan losses at June 30, 2011 amounted to $16.0 million or 2.31% of total loans compared to $15.5 million or 2.13% of total loans at December 31, 2010.  We believe we have established the allowance for credit losses pursuant to GAAP, and have taken into account the views of our regulators and the current economic environment.

The following table presents the percentage of loans assigned to each risk grade at June 30, 2011 and December 31, 2010.
 
LOAN RISK GRADE ANALYSIS:
   
 
Percentage of Loans
 
By Risk Grade*
Risk Grade
06/30/2011
12/31/2010
Risk Grade 1 (Excellent Quality)
3.30%
3.36%
Risk Grade 2 (High Quality)
16.71%
16.60%
Risk Grade 3 (Good Quality)
48.58%
47.00%
Risk Grade 4 (Management Attention)
22.52%
21.31%
Risk Grade 5 (Watch)
2.05%
2.84%
Risk Grade 6 (Substandard)
2.07%
3.09%
Risk Grade 7 (Low Substandard)
0.00%
0.00%
Risk Grade 8 (Doubtful)
0.00%
0.00%
Risk Grade 9 (Loss)
0.00%
0.00%
     
* Excludes non-accrual loans
   
 
 
 
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At June 30, 2011 there were four relationships exceeding $1.0 million (which totaled $5.7 million) in the Watch risk grade, three relationships exceeding $1.0 million (which totaled $6.9 million) in the Substandard risk grade and no relationships exceeding $1.0 million in the Low Substandard risk grade.  These customers continue to meet payment requirements in accordance with the terms of the promissory notes on these loans.

Non-performing Assets.  Non-performing assets totaled $39.2 million at June 30, 2011 or 3.66% of total assets, compared to $46.9 million at December 31, 2010, or 4.40% of total assets.  Non-accrual loans were $31.0 million at June 30, 2011 and $40.1 million at December 31, 2010.  As a percentage of total loans outstanding, non-accrual loans were 4.47% at June 30, 2011 compared to 5.52% at December 31, 2010. Non-performing loans include Non-performing loans include $19.3 million in AD&C loans, $12.1 million in commercial and residential mortgage loans and $784,000 in other loans at June 30, 2011 as compared to $23.1 million in AD&C loans, $16.2 million in commercial and residential mortgage loans and $1.0 million in other loans as of December 31, 2010.  The Bank had loans 90 days past due and still accruing totaling $1.1 million and $210,000 as of June 30, 2011 and December 31, 2010, respectively.  Other Real Estate Owned totaled $7.1 million as of June 30, 2011 as compared to $6.7 million at December 31, 2010. The Bank had no repossessed assets as of June 30, 2011 and December 31, 2010.

               Deposits.  Total deposits at June 30, 2011 were $830.4 million compared to $838.7 million at December 31, 2010. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposits of denominations less than $100,000, increased $22.4 million to $615.1 million at June 30, 2011 as compared to $592.7 million at December 31, 2010.  Certificates of deposit in amounts greater than $100,000 or more totaled $212.4 million at June 30, 2011 as compared to $241.4 million at December 31, 2010.  This decrease is primarily due to a $14.6 million decrease in certificates of deposit issued through the Certificate of Deposit Account Registry Service (“CDARS”) and a $7.7 million decrease in brokered certificates of deposit as of June 30, 2011 compared to December 31, 2010.  At June 30, 2011, brokered deposits amounted to $64.3 million as compared to $87.4 million at December 31, 2010.  Brokered deposits outstanding as of June 30, 2011 had a weighted average rate of 1.07% with a weighted average original term of 14 months as compared to brokered deposits outstanding at December 31, 2010, which had a weighted average rate of 1.20% with a weighted average original term of 13 months.

Borrowed Funds. Borrowings from the FHLB totaled $70.0 million at June 30, 2011 and December 31, 2010, respectively.  The average balance of FHLB borrowings for the six months ended June 30, 2011 was $70.1 million compared to $72.0 million for the year ended December 31, 2010.  At June 30, 2011, all of the Bank’s FHLB borrowings had maturities exceeding one year.  The FHLB has the option to convert $50.0 million of the total advances to a floating rate and, if converted, we may repay the advances without a prepayment fee.

Securities sold under agreements to repurchase were $44.5 million at June 30, 2011 compared to $34.1 million at December 31, 2010.

Junior Subordinated Debentures (related to Trust Preferred Securities).  In June 2006 the Company formed a wholly-owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Capital Trust I in December 2001 and for general corporate purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

Asset Liability and Interest Rate Risk Management.  The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities.  This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income.
 
 
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The Company manages its exposure to fluctuations in interest rates through policies established by our Asset/Liability Committee (“ALCO”).  ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company.  ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements.  The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year.  Rate sensitive assets therefore include both loans and available for sale securities.  Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds.  The Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market.  Because the majority of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits.  During periods of rising rates, this results in increased net interest income.  The opposite occurs during periods of declining rates.  Average rate sensitive assets for the six months ended June 30, 2011 totaled $1.0 billion, exceeding average rate sensitive liabilities of $839.6 million by $172.1 million.

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  The Company did not have any interest rate derivatives outstanding as of June 30, 2011

Included in the rate sensitive assets are $391.8 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”).  We utilize interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At June 30, 2011, we had $302.8 million in loans with interest rate floors.  The floors were in effect on $301.8 million of these loans pursuant to the terms of the promissory notes on these loans.   The weighted average rate on these loans is 1.13% higher than the indexed rate on the promissory notes without interest rate floors.

               Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements.  Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities.  In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit.  As of June 30, 2011 such unfunded commitments to extend credit were $131.1 million, while commitments in the form of standby letters of credit totaled $3.0 million.

The Company uses several sources to meet its liquidity requirements.  The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships.  As of June 30, 2011, the Company’s core deposits totaled $615.1 million, or 74% of total deposits.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings.  The Bank is also able to borrow from the Federal Reserve Bank (“FRB”) on a short-term basis.  Our policies include the ability to access wholesale funding up to 40% of total assets.  Our wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina.  The Company’s ratio of wholesale funding to total assets was 12.71% as of June 30, 2011.

At June 30, 2011, we had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $64.3 million, which have an average maturity of 14 months.  The cost of these deposits is more susceptible to changes in the interest rate environment than other deposits.  Access to the brokered deposit market could be restricted if the Bank were to fall below the well capitalized level.

 
 
32

 
 
The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $70.0 million at June 30, 2011 and December 31, 2010.  At June 30, 2011, the carrying value of loans pledged as collateral to the FHLB totaled $159.6 million compared to $153.8 million at December 31, 2010.  As additional collateral, the Bank has pledged securities to FHLB.  At June 30, 2011, the market value of securities pledged to FHLB totaled $37.4 million compared to $10.0 million at December 31, 2010.  The remaining availability at the FHLB was $47.5 million at June 30, 2011 compared to $7.2 million at December 31, 2010.  The Bank had no borrowings from the FRB at June 30, 2011 and December 31, 2010.  FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At June 30, 2011, the carrying value of loans pledged as collateral to the FRB totaled $336.4 million compared to $348.9 million at December 31, 2010.

The Bank also had the ability to borrow up to $47.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of June 30, 2011.

The liquidity ratio for the Bank, which is defined as net cash, interest bearing deposits with banks, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 28.82% at June 30, 2011 and 25.87% at December 31, 2010.  The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 10%.

Contractual Obligations and Off-Balance Sheet Arrangements.  The Company’s contractual obligations and other commitments as of June 30, 2011 and December 31, 2010 are summarized in the table below.  The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements.  Other commitments include commitments to extend credit.  Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
 
(Dollars in thousands)
     
 
June 30, 2011
 
December 31, 2010
Contractual Cash Obligations:
     
Long-term borrowings
$ 70,000   70,000
Junior subordinated debentures
  20,619   20,619
Operating lease obligations
  2,911   3,220
Total
$ 93,530   93,839
Other Commitments:
       
Commitments to extend credit
$ 131,059   137,015
Standby letters of credit and financial guarantees written
  2,983   3,590
Total
$ 134,042   140,605
 
The Company enters into derivative contracts to manage various financial risks.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date.  Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk.  Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management”.

Capital Resources.  Shareholders’ equity at June 30, 2011 was $100.5 million compared to $96.9 million at December 31, 2010.  Annualized return on average equity for the six months ended June 30, 2011 was 4.08% compared to 1.81% for the year ended December 31, 2010.  Total cash dividends paid on common stock amounted to $222,000 and $221,000 for the six months ended June 30, 2011 and 2010, respectively.

The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.

On December 23, 2008, the Company entered into a Purchase Agreement with the UST.  Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the CPP under the TARP.  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  Additional discussion of the Company’s participation in the CPP can be found on page 21.  The Board of Directors does not currently anticipate issuing any additional series of preferred stock.

 
 
33

 
 
Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater.  Tier 1 capital is generally defined as shareholders’ equity and trust preferred securities less all intangible assets and goodwill.  Tier 1 capital at June 30, 2011 and December 31, 2010 includes $20.0 million in trust preferred securities.  The Company’s Tier 1 capital ratio was 15.03% and 14.24% at June 30, 2011 and December 31, 2010, espectively.  Total risk-based capital is defined as Tier 1 capital plus supplementary capital.  Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets.  The Company’s total risk-based capital ratio was 16.30% and 15.51% at June 30, 2011 and December 31, 2010, respectively.  In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater.  The Company’s Tier 1 leverage capital ratio was 11.00% and 10.70% at June 30, 2011 and December 31, 2010, respectively.

The Bank’s Tier 1 risk-based capital ratio was 12.67% and 11.87% at June 30, 2011 and December 31, 2010, respectively.  The total risk-based capital ratio for the Bank was 13.95% and 13.15% at June 30, 2011 and December 31, 2010, respectively.   The Bank’s Tier 1 leverage capital ratio was 9.27% and 8.91% at June 30, 2011 and December 31, 2010, respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be "well capitalized" at June 30, 2011.
 
 
 
 
34

 
 
Item 3.     Quantitative and Qualitative Disclosures About Market Risk

Not required for smaller reporting companies.

 
 
 
 
 
35

 
 
Item 4T.    Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report.  Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 
 
 
 
 
 
36

 
 
 
PART II.
OTHER INFORMATION
 
Item 1.
Legal Proceedings
 
 
In the opinion of management, the Company is not involved in any material pending legal proceedings other than routine proceedings
 
occurring in the ordinary course of business.
 
Item 1A.
Risk Factors
   
 
Not required for smaller reporting companies.
   
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
  ISSUER PURCHASES OF EQUITY SECURITIES
           
                     
               Period  
Total
Number of
Shares
Purchased
     
Average
Price Paid
per Share
 
Total
Number of
Shares
Purchased as
Part of
Publicly
Announced
Plans or
Programs
 
Maximum
Number of
Shares that
May Yet Be Purchased
Under the Plans
or Programs
                     
 April 1 - 30, 2011
  -           $ -       -       -     
                       
 May 1 - 31, 2011
  2,640         6.56   -       -     
                       
 June 1 - 30, 2011
  -            -      -       -     
                       
 Total
  2,640   (1)   $ 6.56   -        
                       
(1) The Company purchased 2,640 shares on the open market in the three months ended June 30, 2011 for its deferred compensation plan. All purchases were funded by participant contributions to the plan. The Purchase Agreement with the UST under the CPP program permits the Company to purchase its common stock on the open market pursuant to benefit plans.
 
 
Item 3.
Defaults Upon Senior Securities
   
 
Not applicable
 
Item 5.
Other Information
   
 
Not applicable
 
 
Item 6.
Exhibits
 
     
 
Exhibit (3)(1)
Articles of Amendment dated December 19, 2008, regarding the Series A
   
Preferred Stock, incorporated by reference to Exhibit (3)(1) to the Form 8-K filed
   
with the Securities and Exchange Commission on December 29, 2008
     
 
Exhibit (3)(2)
Articles of Amendment dated February 26, 2010, incorporated by reference to
   
Exhibit (3)(2) to the Form 10-K filed with the Securities and Exchange
   
Commission on March 25, 2010
     
 
Exhibit (3)(i)
Articles of Incorporation of Peoples Bancorp of North Carolina, Inc.,
   
incorporated by reference to Exhibit (3)(i) to the Form 8-A filed with the
   
Securities and Exchange Commission on September 2, 1999
 
 
 
37

 
 
 
 
Exhibit (3)(ii)
Amended and Restated Bylaws of Peoples Bancorp of North Carolina, Inc.,
   
incorporated by reference to Exhibit (3)(ii) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 25, 2010
     
 
Exhibit (4)
Specimen Stock Certificate, incorporated by reference to Exhibit (4) to the Form
   
8-A filed with the Securities and Exchange Commission on September 2, 1999
     
 
Exhibit (4)(1)
Form of Certificate for the Series A Preferred Stock, incorporated by reference to
   
Exhibit (4)(1) to the Form 8-K filed with the Securities and Exchange
   
Commission on December 29, 2008
     
 
Exhibit (4)(2)
Warrant dated December 23, 2008, for the purchase of shares of Common Stock,
   
incorporated by reference to Exhibit (4)(2) to the Form 8-K filed with the
   
Securities and Exchange Commission on December 29, 2008
     
 
Exhibit (10)(1)
Letter Agreement dated December 23, 2008 between the Registrant and the
   
United States Department of the Treasury, incorporated by reference to Exhibit
   
(10)(1) to the Form 8-K filed with the Securities and Exchange Commission on
   
December 29, 2008
     
 
Exhibit (10)(a)(i)
Employment Letter Agreement dated December 23, 2008 between Peoples
   
Bancorp of North Carolina, Inc. and Tony W. Wolfe, incorporated by reference
   
to Exhibit (10)(a)(i) to the Form 8-K filed with the Securities and Exchange
   
Commission on December 29, 2008
     
 
Exhibit (10)(a)(ii)
Amendment to Employment Agreement between Peoples Bank and Tony W.
   
Wolfe dated December 18, 2008, incorporated by reference to Exhibit (10)(a)(ii)
   
to the Form 8-K filed with the Securities and Exchange Commission on
   
December 29, 2008
     
 
Exhibit (10)(a)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Tony W. Wolfe dated December 18, 2008, incorporated by
   
reference to Exhibit (10)(a)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(b)(i)
Employment Letter Agreement dated December 23, 2008 between Peoples
   
Bancorp of North Carolina, Inc. and Joseph F. Beaman, Jr., incorporated by
   
reference to Exhibit (10)(b)(i) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(b)(ii)
Amendment to Employment Agreement between Peoples Bank and Joseph F.
   
Beaman, Jr. dated December 18, 2008, incorporated by reference to Exhibit
   
(10)(b)(ii) to the Form 8-K filed with the Securities and Exchange Commission
   
on December 29, 2008
     
 
Exhibit (10)(b)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Joseph F. Beaman, Jr. dated December 18, 2008, incorporated
   
by reference to Exhibit (10)(b)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(c)(i)
Employment Letter Agreement dated December 23, 2008 between Peoples
   
Bancorp of North Carolina, Inc. and William D. Cable, Sr., incorporated by
   
reference to Exhibit (10)(c)(i) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(c)(ii)
Amendment to Employment Agreement between Peoples Bank and William D.
   
Cable, Sr. dated December 18, 2008, incorporated by reference to Exhibit
   
(10)(c)(ii) to the Form 8-K filed with the Securities and Exchange Commission
   
on December 29, 2008
 
 
 
38

 
 
 
 
Exhibit (10)(c)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and William D. Cable, Sr. dated December 18, 2008, incorporated
   
by reference to Exhibit (10)(c)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(d)(i)
Employment Letter Agreement dated December 23, 2008 between Peoples
   
Bancorp of North Carolina, Inc. and Lance A. Sellers, incorporated by reference
   
to Exhibit (10)(d)(i) to the Form 8-K filed with the Securities and Exchange
   
Commission on December 29, 2008
     
 
Exhibit (10)(d)(ii)
Amendment to Employment Agreement between Peoples Bank and Lance A.
   
Sellers dated December 18, 2008, incorporated by reference to Exhibit (10)(d)(ii)
   
to the Form 8-K filed with the Securities and Exchange Commission on
   
December 29, 2008
     
 
Exhibit (10)(d)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Lance A. Sellers dated December 18, 2008, incorporated by
   
reference to Exhibit (10)(d)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(e)
Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership and Long
   
Term Incentive Plan incorporated by reference to Exhibit (10)(f) to the Form 10-
   
K filed with the Securities and Exchange Commission on March 30, 2000
     
 
Exhibit (10)(e)(i)
Amendment No. 1 to the Peoples Bancorp of North Carolina, Inc. Omnibus Stock
   
Ownership and Long Term Incentive Plan incorporated by reference to Exhibit
   
(10)(e)(i) to the Form 10-K filed with the Securities and Exchange Commission
   
on March 15, 2007
     
 
Exhibit (10)(f)(i)
Employment Letter Agreement dated December 23, 2008 between Peoples
   
Bancorp of North Carolina, Inc. and A. Joseph Lampron, incorporated by
   
reference to Exhibit (10)(f)(i) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(f)(ii)
Amendment to Employment Agreement between Peoples Bank and A. Joseph
   
Lampron dated March 18, 2010, incorporated by reference to Exhibit (10)(f)(ii)
   
to the Form 10-K filed with the Securities  and Exchange Commission on March
   
25, 2010
     
 
Exhibit (10)(f)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and A. Joseph Lampron dated December 18, 2008, incorporated by
   
reference to Exhibit (10)(f)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(g)
Peoples Bank Directors' and Officers' Deferral Plan, incorporated by reference to
   
Exhibit (10)(h) to the Form 10-K filed with the Securities and Exchange
   
Commission on March 28, 2002
     
 
Exhibit (10)(h)
Rabbi Trust for the Peoples Bank Directors' and Officers' Deferral Plan,
   
incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 28, 2002
     
 
Exhibit (10)(i)
Description of Service Recognition Program maintained by Peoples Bank,
   
incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 27, 2003
     
 
Exhibit (10)(j)
Capital Securities Purchase Agreement dated as of June 26, 2006, by and among
   
Peoples Bancorp of North Carolina, Inc., PEBK Capital Trust II and Bear, Sterns
   
Securities Corp., incorporated by reference to Exhibit (10)(j) to the Form 10-Q
   
filed with the Securities and Exchange Commission on November 13, 2006
 
 
 
39

 
 
 
 
Exhibit (10)(k)
Amended and Restated Trust Agreement of PEBK Capital Trust II, dated as of
   
June 28, 2006 incorporated by reference to Exhibit (10)(k) to the Form 10-Q filed
   
with the Securities and Exchange Commission on November 13, 2006
     
 
Exhibit (10)(l)
Guarantee Agreement of Peoples Bancorp of North Carolina, Inc. dated as of
   
June 28, 2006 incorporated by reference to Exhibit (10)(l) to the Form 10-Q filed
   
with the Securities and Exchange Commission on November 13, 2006
     
 
Exhibit (10)(m)
Indenture, dated as of June 28, 2006, by and between Peoples Bancorp of North
   
Carolina, Inc. and LaSalle Bank National Association, as Trustee, relating to
   
Junior Subordinated Debt Securities Due September 15, 2036, incorporated by
   
reference to Exhibit (10)(m) to the Form 10-Q filed with the Securities and
   
Exchange Commission on November 13, 2006
     
 
Exhibit (10)(n)
Form of Amended and Restated Director Supplemental Retirement Agreement
   
between Peoples Bank and Directors Robert C. Abernethy, James S. Abernethy,
   
Douglas S. Howard, John W. Lineberger, Jr., Gary E. Matthews, Dr. Billy L.
   
Price, Jr., Larry E. Robinson, W. Gregory Terry, Dan Ray Timmerman, Sr. and
   
Benjamin I. Zachary, incorporated by reference to Exhibit (10)(n) to the Form 8-
   
K filed with the Securities and Exchange Commission on December 29, 2008
     
 
Exhibit (10)(o)
2009 Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership and
   
Long Term Incentive Plan incorporated by reference to Exhibit (10)(o) to the
   
Form 10-K filed with the Securities and Exchange Commission on March 20,
   
2009
     
 
Exhibit (14)
Code of Business Conduct and Ethics of Peoples Bancorp of North Carolina,
   
Inc., incorporated by reference to Exhibit (14) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 25, 2005
     
 
Exhibit (31)(a)
Certification of principal executive officer pursuant to section 302 of the
   
Sarbanes-Oxley Act of 2002
     
 
Exhibit (31)(b)
Certification of principal financial officer pursuant to section 302 of the
   
Sarbanes-Oxley Act of 2002
     
 
Exhibit (32)
Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
   
906 of the Sarbanes-Oxley Act of 2002
     
  Exhibit (101) The following materials from the Company's 10-Q Report for the quarterly
    period ended June 30, 2011, formatted in XBRL: (i) the Condensed Consolidated
    Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the
    Condensed Consolidated Statements of Changes in Shareholders' Equity, (iv) the
    Condensed Consolidated Statements of Cash Flows, and (v) the Notes to the
    Condensed Consolidated Financial Statements, tagged as blocks of text.*
     
    *Furnished, not filed.
 
 
 
 
40

 
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
   
Peoples Bancorp of North Carolina, Inc.
     
     
     
  August 12,  2011
 
 /s/ Tony W. Wolfe
Date
 
Tony W. Wolfe
   
President and Chief Executive Officer
   
(Principal Executive Officer)
     
     
     
  August 12,  2011
 
 /s/ A. Joseph Lampron, Jr.
Date
 
A. Joseph Lampron, Jr.
   
Executive Vice President and Chief Financial Officer
   
(Principal Financial and Principal Accounting Officer)

 
 
 
 
 
 
 
 
 
 
 
41