form10qforjun302014.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, 2014
 
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.
5,617,125 shares of common stock, outstanding at July 31, 2014.
 
 
 
 

 
 
 
INDEX
       
PART I.
FINANCIAL INFORMATION
PAGE(S)
       
Item 1.
 
Financial Statements
 
       
   
Consolidated Balance Sheets at June 30, 2014 (Unaudited) and December
 
   
31, 2013 (Audited)
3
       
   
Consolidated Statements of Earnings for the three and six months ended
 
   
June 30, 2014 and 2013 (Unaudited)
4
       
   
Consolidated Statements of Comprehensive Income for the three and six
 
   
months ended June 30, 2014 and 2013 (Unaudited)
5
       
   
Consolidated Statements of Cash Flows for the three and six months ended
 
   
June 30, 2014 and 2013 (Unaudited)
6-7
       
   
Notes to Consolidated Financial Statements (Unaudited)
8-23
       
Item 2.
 
Management's Discussion  and Analysis of Financial Condition
 
   
and Results of Operations
24-38
       
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
39
       
Item 4T.
 
Controls and Procedures
40
       
PART II.
OTHER INFORMATION
 
       
Item 1.
 
Legal Proceedings
41
Item 1A.
 
Risk Factors
41
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
41
Item 3.
 
Defaults upon Senior Securities
41
Item 5.
 
Other Information
41
Item 6.
 
Exhibits
41-44
Signatures
45
Certifications
46-48
 
 
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, 2013.
 
 
 
2

 
 
 
PART I.
FINANCIAL INFORMATION
   
Item I.
Financial Statements
 
 PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
 
Consolidated Balance Sheets
           
June 30, 2014 and December 31, 2013
           
(Dollars in thousands)
 
June 30,
   
December 31,
 
Assets
2014
   
2013
 
 
(Unaudited)
   
(Audited)
 
           
Cash and due from banks, including reserve requirements
$ 54,522     49,902  
of $10,561 and $11,472, respectively
           
Interest-bearing deposits
  20,546     26,871  
Cash and cash equivalents
  75,068     76,773  
             
Investment securities available for sale
  297,165     297,890  
Other investments
  4,706     4,990  
Total securities
  301,871     302,880  
             
Mortgage loans held for sale
  2,048     497  
             
Loans
  633,336     620,960  
Less allowance for loan losses
  (12,675 )   (13,501 )
Net loans
  620,661     607,459  
             
Premises and equipment, net
  16,762     16,358  
Cash surrender value of life insurance
  13,914     13,706  
Other real estate
  3,532     1,679  
Accrued interest receivable and other assets
  13,996     15,332  
Total assets
$ 1,047,852     1,034,684  
             
  Liabilities and Shareholders' Equity
           
             
Deposits:
           
Noninterest-bearing demand
$ 206,655     195,265  
NOW, MMDA & savings
  397,305     386,893  
Time, $100,000 or more
  112,201     115,268  
Other time
  95,318     101,935  
Total deposits
  811,479     799,361  
             
Securities sold under agreements to repurchase
  46,764     45,396  
FHLB borrowings
  65,000     65,000  
Junior subordinated debentures
  20,619     20,619  
Accrued interest payable and other liabilities
  10,943     20,589  
Total liabilities
  954,805     950,965  
             
Commitments
           
             
Shareholders' equity:
           
Common stock, no par value; authorized
           
20,000,000 shares; issued and outstanding
           
5,617,125 and 5,613,495 shares, respectively
  48,170     48,133  
Retained earnings
  41,433     36,758  
Accumulated other comprehensive income (loss)
  3,444     (1,172 )
Total shareholders' equity
  93,047     83,719  
             
Total liabilities and shareholders' equity
$ 1,047,852     1,034,684  
             
See accompanying Notes to Consolidated Financial Statements.
           
 
 
 
3

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
                 
Consolidated Statements of Earnings
                 
Three and Six Months Ended June 30, 2014 and 2013
                 
(Dollars in thousands, except per share amounts)
                 
 
Three months ended
 
Six months ended
 
 
June 30,
 
June 30,
 
 
2014
 
2013
 
2014
 
2013
 
 
(Unaudited)
 
(Unaudited)
 
(Unaudited)
 
(Unaudited)
 
Interest income:
               
Interest and fees on loans
$ 7,491   7,439   14,893   15,079  
Interest on due from banks
  12   28   24   40  
Interest on investment securities:
                 
U.S. Government sponsored enterprises
  804   286   1,651   664  
States and political subdivisions
  1,169   1,069   2,346   2,053  
Other
  100   87   207   176  
Total interest income
  9,576   8,909   19,121   18,012  
                   
Interest expense:
                 
NOW, MMDA & savings deposits
  125   200   251   418  
Time deposits
  303   422   637   889  
FHLB borrowings
  549   635   1,094   1,296  
Junior subordinated debentures
  97   100   193   199  
Other
  11   15   21   32  
Total interest expense
  1,085   1,372   2,196   2,834  
                   
Net interest income
  8,491   7,537   16,925   15,178  
                   
Provision for loan losses
  67   773   (282 ) 1,827  
                   
Net interest income after provision for loan losses
  8,424   6,764   17,207   13,351  
                   
Non-interest income:
                 
Service charges
  1,223   1,104   2,352   2,143  
Other service charges and fees
  260   268   679   642  
Gain on sale of securities
  -     352   26   614  
Mortgage banking income
  188   315   292   699  
Insurance and brokerage commissions
  162   178   361   317  
Gain/(loss) on sale and write-down of
                 
 other real estate
  12   (184   (150 ) (173 )
Miscellaneous
  1,265   1,276   2,392   2,494  
Total non-interest income
  3,110   3,309   5,952   6,736  
                   
Non-interest expense:
                 
Salaries and employee benefits
  4,207   4,240   8,483   8,430  
Occupancy
  1,466   1,320   2,988   2,632  
Other
  2,394   2,419   4,720   4,655  
Total non-interest expense
  8,067   7,979   16,191   15,717  
                   
Earnings before income taxes
  3,467   2,094   6,968   4,370  
                   
Income tax expense
  916   461   1,838   979  
                   
Net earnings
  2,551   1,633   5,130   3,391  
                   
Dividends and accretion on preferred stock
  -     156   -     313  
                   
Net earnings available to common shareholders
$ 2,551   1,477   5,130   3,078  
                   
Basic and diluted net earnings per common share
$ 0.45   0.26   0.91   0.55  
Cash dividends declared per common share
$ 0.04   0.03   0.08   0.06  
                   
See accompanying Notes to Consolidated Financial Statements.
             
 
 
 
4

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
                 
Consolidated Statements of Comprehensive (Loss) Income
                 
Three and Six Months Ended June 30, 2014 and 2013
                 
 (Dollars in thousands)
                 
 
Three months ended
 
Six months ended
 
 
June 30,
 
June 30,
 
 
2014
 
2013
 
2014
 
2013
 
 
(Unaudited)
 
(Unaudited)
 
(Unaudited)
 
(Unaudited)
 
                 
Net earnings
$ 2,551   1,633   5,130   3,391  
                   
Other comprehensive income (loss):
                 
Unrealized holding gains (losses) on securities
                 
available for sale
  3,726   (6,583 ) 7,586   (7,798 )
Reclassification adjustment for gains on
                 
securities available for sale
                 
included in net earnings
  -     (352 ) (26)   (614 )
                   
Total other comprehensive income (loss),
                 
before income taxes
  3,726   (6,935 ) 7,560   (8,412 )
                   
Income tax (benefit) expense related to other
                 
comprehensive (loss) income:
                 
                   
Unrealized holding gains (losses) on securities
                 
available for sale
  1,451   (2,564 ) 2,954   (3,038 )
Reclassification adjustment for gains
                 
on securities available for sale
                 
included in net earnings
  -     (137 ) (10)   (239 )
                   
Total income tax expense (benefit) related to
                 
other comprehensive income (loss)
  1,451   (2,701 ) 2,944   (3,277 )
                   
Total other comprehensive income (loss),
                 
net of tax
  2,275   (4,234 ) 4,616   (5,135 )
                   
Total comprehensive income (loss)
$ 4,826   (2,601 ) 9,746   (1,744 )
                   
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, 2014 and 2013
         
(Dollars in thousands)
         
 
2014
2013
 
(Unaudited)
(Unaudited)
         
Cash flows from operating activities:
       
Net earnings
$ 5,130   3,391  
Adjustments to reconcile net earnings to
         
net cash (used) provided by operating activities:
         
Depreciation, amortization and accretion
  3,258   4,438  
Provision for loan losses
  (282 ) 1,827  
Gain on sale of investment securities
  (26 ) (614 )
Gain on sale of other real estate
  (2 ) (86 )
Write-down of other real estate
  152   259  
Restricted stock expense
  167   70  
Change in:
         
Mortgage loans held for sale
  (1,552 ) 920  
Cash surrender value of life insurance
  (208 ) (214 )
Other assets
  (2,274 ) 2,217  
Other liabilities
  2,877   (1,381 )
           
Net cash provided by operating activities
  7,240   10,827  
           
Cash flows from investing activities:
         
Purchases of investment securities available for sale
  (13,070 ) (59,154 )
Proceeds from calls, maturities and paydowns of investment securities
         
available for sale
  18,415   35,031  
Proceeds from sales of investment securities available for sale
  677   17,463  
FHLB stock redemption
  284   384  
Net change in loans
  (15,978 ) 7,718  
Purchases of premises and equipment
  (1,372 ) (1,666 )
Proceeds from sales of other real estate and repossessions
  1,554   3,619  
           
Net cash (used) provided by investing activities
  (9,490 ) 3,395  
           
Cash flows from financing activities:
         
Net change in deposits
  12,118   6,908  
Net change in securities sold under agreements to repurchase
  1,368   11,393  
Proceeds from FHLB borrowings
  -     15,000  
Repayments of FHLB borrowings
  -     (15,000 )
    Preferred stock repurchase   (12,524 )    
Proceeds from stock options exercised
  37   -    
Cash dividends paid on preferred stock
  -     (313 )
Cash dividends paid on common stock
  (454 ) (337 )
           
Net cash provided by financing activities
  545   17,651  
           
Net change in cash and cash equivalent
  (1,705 ) 31,873  
           
Cash and cash equivalents at beginning of period
  76,773   48,843  
           
Cash and cash equivalents at end of period
$ 75,068   80,716  
 
 
 
6

 
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
         
Consolidated Statements of Cash Flows, continued
         
Six Months Ended June 30, 2014 and 2013
         
(Dollars in thousands)
         
         
 
2014
2013
 
(Unaudited)
(Unaudited)
         
Supplemental disclosures of cash flow information:
       
Cash paid during the period for:
       
Interest
$ 2,217   2,889  
Income taxes
$ 837   1,112  
           
Noncash investing and financing activities:
         
Change in unrealized gain on investment securities
         
 available for sale, net
$ 4,616   (5,135 )
Transfers of loans to other real estate and repossessions
$ 3,288   2,003  
Financed portion of sales of other real estate
$ 230   40  
           
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. (“REAS”) (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.

The consolidated financial statements in this report (other than the Consolidated Balance Sheet at December 31, 2013) 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 the 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 2013 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2014 Annual Meeting of Shareholders.

Recently Issued Accounting Pronouncements
In January 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-04, (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.  ASU No. 2014-04 provides additional guidance to clarify when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan should be derecognized and the real estate property recognized.  ASU No. 2014-04 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014.  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 May 2014, the FASB issued ASU No. 2014-09, (Topic 606):  Revenue from Contracts with Customers.  ASU No. 2014-09 provides guidance on the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive.  ASU No. 2014-09 is effective for reporting periods beginning after December 15, 2016.  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 2014, the FASB issued ASU No. 2014-11, (Subtopic 860-10): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.  ASU No. 2014-11 makes limited amendments to the guidance in FASB Accounting Standards Codification ("ASC") 860, Transfers and Servicing, on accounting for certain repurchase agreements (repos). ASU No. 2014-1 (1) requires entities to account for repurchase-to-maturity transactions as secured borrowings (rather than as sales with forward repurchase agreements), (2) eliminates accounting guidance on linked repurchase financing transactions, and (3) expands disclosure requirements related to certain transfers of financial assets that are accounted for as sales and certain transfers (specifically, repos, securities lending transactions, and repurchase-to-maturity transactions) accounted for as secured borrowings. ASU 2014-11 also amends FASB ASC 860 to clarify that repos and securities lending transactions that do not meet all of the derecognition criteria should be accounted for as secured borrowings. In addition, ASU No. 2014-11provides examples of repurchase and securities lending arrangements that illustrate whether a transferor has maintained effective control over the transferred financial assets.  ASU No. 2014-11 is effective for reporting periods beginning the first interim or annual period after December 15, 2014.  The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
 
 
8

 

Other accounting standards that have been issued or proposed by 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.

(2)
   Investment Securities

Investment securities available for sale at June 30, 2014 and December 31, 2013 are as follows:
 
(Dollars in thousands)
             
 
June 30, 2014
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair Value
Mortgage-backed securities
$ 115,747   1,937   170   117,514
U.S. Government
               
sponsored enterprises
  25,211   107   217   25,101
State and political subdivisions
  145,573   4,398   1,342   148,629
Corporate bonds
  3,495   14   22   3,487
Trust preferred securities
  750   -     -     750
Equity securities
  748   936   -     1,684
Total
$ 291,524   7,392   1,751   297,165
                 
(Dollars in thousands)
               
 
December 31, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
 Fair Value
Mortgage-backed securities
$ 123,706   1,040   769   123,977
U.S. Government
               
sponsored enterprises
  22,115   97   69   22,143
State and political subdivisions
  148,468   1,987   5,087   145,368
Corporate bonds
  3,522   11   70   3,463
Trust preferred securities
  1,250   -     -     1,250
Equity securities
  748   941   -     1,689
Total
$ 299,809   4,076   5,995   297,890

The current fair value and associated unrealized losses on investments in securities with unrealized losses at June 30, 2014 and December 31, 2013 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, 2014
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
 Losses
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
Losses
Mortgage-backed securities
$ 8,550   6   18,386   164   26,936   170
U.S. Government
                       
sponsored enterprises
  16,483   217   -     -     16,483   217
State and political subdivisions
  12,495   40   38,905   1,302   51,400   1,342
Corporate bonds
  1,000   -     533   22   1,533   22
Total
$ 38,528   263   57,824   1,488   96,352   1,751
 
 
 
9

 
 
 
(Dollars in thousands)
                     
 
December 31, 2013
 
Less than 12 Months
 
12 Months or More
 
Total
 
Fair Value
 
Unrealized
Losses
 
Fair Value
 
Unrealized
 Losses
 
Fair Value
 
Unrealized
Losses
Mortgage-backed securities
$ 40,857   691   10,128   78   50,985   769
U.S. Government
                       
sponsored enterprises
  9,714   69   -     -     9,714   69
State and political subdivisions
  77,187   4,863   1,824   224   79,011   5,087
Corporate bonds
  1,984   16   511   54   2,495   70
Total
$ 129,742   5,639   12,463   356   142,205   5,995
 
At June 30, 2014, unrealized losses in the investment securities portfolio relating to debt securities totaled $1.8 million.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the June 30, 2014 tables above, 50 out of 175 securities issued by state and political subdivisions contained unrealized losses, 17 out of 95 securities issued by U.S. Government sponsored enterprises, including mortgage-backed securities, contained unrealized losses, and two out of five securities issued by corporations contained unrealized losses.  These unrealized losses are considered temporary because of acceptable financial condition and results of operations on each security and the repayment sources of principal and interest on U.S. Government sponsored enterprises, including mortgage-backed securities, are government backed.

The amortized cost and estimated fair value of investment securities available for sale at June 30, 2014, 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.
 
June 30, 2014
     
(Dollars in thousands)
     
 
Amortized
Cost
 
Estimated
Fair Value
Due within one year
$ 4,392   4,401
Due from one to five years
  37,594   38,956
Due from five to ten years
  114,940   116,246
Due after ten years
  18,103   18,364
Mortgage-backed securities
  115,747   117,514
Equity securities
  748   1,684
Total
$ 291,524   297,165
 
Proceeds from sales of securities available for sale during the six months ended June 30, 2014 were $677,000 and resulted in gross gains of $26,000.  Proceeds from sales of securities available for sale during the six months ended June 30, 2013 were $17.5 million and resulted in gross gains of $738,000 and gross losses of $124,000.

Securities with a fair value of approximately $83.9 million and $86.0 million at June 30, 2014 and December 31, 2013, respectively, were pledged to secure public deposits and for other purposes as required by law.
 
 
10

 

 
(3)
    Loans

Major classifications of loans at June 30, 2014 and December 31, 2013 are summarized as follows:
 
(Dollars in thousands)
     
 
June 30, 2014
 
December 31, 2013
Real estate loans
     
Construction and land development
$ 59,843   63,742
Single-family residential
  196,192   195,975
Single-family residential -
       
Banco de la Gente stated income
  48,165   49,463
Commercial
  214,378   209,287
Multifamily and farmland
  11,821   11,801
Total real estate loans
  530,399   530,268
         
Loans not secured by real estate
       
Commercial loans
  78,056   68,047
Farm loans
  93   19
Consumer loans
  10,143   9,593
All other loans
  14,645   13,033
         
Total loans
  633,336   620,960
         
Less allowance for loan losses
  12,675   13,501
         
Total net loans
$ 620,661   607,459
 
The Bank 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.  Risk characteristics of the major components of the Bank’s loan portfolio are discussed below:

·  
Construction and land development loans – The risk of loss is largely dependent on the initial estimate of whether the property’s value at completion equals or exceeds the cost of property construction and the availability of take-out financing.  During the construction phase, a number of factors can result in delays or cost overruns.  If the estimate is inaccurate or if actual construction costs exceed estimates, the value of the property securing the loan may be insufficient to ensure full repayment when completed through a permanent loan, sale of the property, or by seizure of collateral.  As of June 30, 2014, construction and land development loans comprised approximately 9% of the Bank’s total loan portfolio.
 
·  
Single-family residential loans – Declining home sales volumes, decreased real estate values and higher than normal levels of unemployment could contribute to losses on these loans.  As of June 30, 2014, single-family residential loans comprised approximately 39% of the Bank’s total loan portfolio, and include Banco de la Gente single-family residential stated income loans, which were approximately 8% of the Bank’s total loan portfolio.

·  
Commercial real estate loans – Repayment is dependent on income being generated in amounts sufficient to cover operating expenses and debt service.  These loans also involve greater risk because they are generally not fully amortizing over a loan period, but rather have a balloon payment due at maturity.  A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property.  As of June 30, 2014, commercial real estate loans comprised approximately 34% of the Bank’s total loan portfolio.

·  
Commercial loans – Repayment is generally dependent upon the successful operation of the borrower’s business.   In addition, the collateral securing the loans may depreciate over time, be difficult to appraise, be illiquid, or fluctuate in value based on the success of the business.  As of June 30, 2014, commercial loans comprised approximately 12% of the Bank’s total loan portfolio.
 
 
 
11

 
 
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, 2014 and December 31, 2013:

June 30, 2014
                     
(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
$ 830   4,862   5,692   54,151   59,843   -  
Single-family residential
  1,453   667   2,120   194,072   196,192   392
Single-family residential -
                       
Banco de la Gente stated income
  1,874   719   2,593   45,572   48,165   -  
Commercial
  1,652   289   1,941   212,437   214,378   -  
Multifamily and farmland
  169   -     169   11,652   11,821   -  
Total real estate loans
  5,978   6,537   12,515   517,884   530,399   392
                         
Loans not secured by real estate
                       
Commercial loans
  1,001   49   1,050   77,006   78,056   -  
Farm loans
  -     -     -     93   93   -  
Consumer loans
  129   -     129   10,014   10,143   -  
All other loans
  -     -     -     14,645   14,645   -  
Total loans
$ 7,108   6,586   13,694   619,642   633,336   392
                         
                         
December 31, 2013
                       
(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
$ 3,416   5,426   8,842   54,900   63,742   -  
Single-family residential
  4,518   1,555   6,073   189,902   195,975   -  
Single-family residential -
                       
Banco de la Gente stated income
  9,833   1,952   11,785   37,678   49,463   881
Commercial
  1,643   486   2,129   207,158   209,287   -  
Multifamily and farmland
  177   -     177   11,624   11,801   -  
Total real estate loans
  19,587   9,419   29,006   501,262   530,268   881
                         
Loans not secured by real estate
                       
Commercial loans
  424   29   453   67,594   68,047   -  
Farm loans
  -     -     -     19   19   -  
Consumer loans
  181   3   184   9,409   9,593   1
All other loans
  -     -     -     13,033   13,033   -  
Total loans
$ 20,192   9,451   29,643   591,317   620,960   882
 
 
 
12

 
 
The following table presents the Company’s non-accrual loans as of June 30, 2014 and December 31, 2013:

(Dollars in thousands)
     
 
June 30, 2014
 
December 31, 2013
Real estate loans
     
Construction and land development
$ 5,216   6,546
Single-family residential
  1,563   2,980
Single-family residential -
       
Banco de la Gente stated income
  1,780   1,990
Commercial
  1,804   2,043
Total real estate loans
  10,363   13,559
         
Loans not secured by real estate
       
Commercial loans
  511   250
Consumer loans
  47   27
Total
$ 10,921   13,836
 
At each reporting period, the Bank determines which loans are impaired.  Accordingly, the Bank’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank.  REAS is staffed by certified appraisers that also perform appraisals for other companies.  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.  An allowance for each impaired loan that is non-collateral dependent is calculated based on the present value of projected cash flows.  If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses.  Impaired loans under $250,000 are not individually evaluated for impairment, with the exception of the Bank’s troubled debt restructured (“TDR”) loans in the residential mortgage loan portfolio, which are individually evaluated for impairment.  Accruing impaired loans were $27.7 million, $27.6 million and $26.2 million at June 30, 2014, December 31, 2013 and June 30, 2013, respectively.  Interest income recognized on accruing impaired loans was $681,000, $579,000 and $1.3 million for the six months ended June 30, 2014, the six months ended June 30, 2013 and the year ended December 31, 2013, respectively.  Interest income recognized on accruing impaired loans was $325,000 and $286,000 for the three months ended June 30, 2014 and 2013, respectively.  No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.

The following tables present the Company’s impaired loans as of June 30, 2014 and December 31, 2013:

June 30, 2014
                     
(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
$ 6,963   3,784   2,355   6,139   56   6,502
Single-family residential
  5,972   947   4,827   5,774   132   7,507
Single-family residential -
                       
Banco de la Gente stated income
  21,758   -     21,129   21,129   1,217   20,303
Commercial
  4,665   2,251   2,145   4,396   256   4,463
Multifamily and farmland
  169   -     169   169   1   172
Total impaired real estate loans
  39,527   6,982   30,625   37,607   1,662   38,947
                         
Loans not secured by real estate
                       
Commercial loans
  849   -     755   755   16   895
Consumer loans
  303   249   51   300   1   305
Total impaired loans
$ 40,679   7,231   31,431   38,662   1,679   40,147
 
 
 
13

 
 
 
December 31, 2013
                     
(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
$ 9,861   6,293   868   7,161   53   8,289
Single-family residential
  7,853   1,428   5,633   7,061   123   7,859
Single-family residential -
                       
Banco de la Gente stated income
  22,034   -     21,242   21,242   1,300   21,242
Commercial
  5,079   3,045   1,489   4,534   182   4,171
Multifamily and farmland
  177   -     177   177   1   184
Total impaired real estate loans
  45,004   10,766   29,409   40,175   1,659   41,745
                         
Loans not secured by real estate
                       
Commercial loans
  999   257   724   981   15   826
Consumer loans
  302   264   35   299   1   247
Total impaired loans
$ 46,305   11,287   30,168   41,455   1,675   42,818
 
Changes in the allowance for loan losses for the three and six months ended June 30, 2014 and 2013 were as follows:
 
(Dollars in thousands)
                                 
 
Real Estate Loans
                     
 
Construction
and Land
Development
 
Single-
Family
Residential
 
Single-
Family
Residential -
Banco de la
Gente
Stated
 Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
and All
Other
 
Unallocated
 
Total
 
Six months ended June 30, 2014
                                     
Allowance for loan losses:
                                       
Beginning balance
$ 3,218   3,123   1,863   2,219   37   1,069   -   245   1,727   13,501  
Charge-offs
  (260 ) (194 ) (140 ) (131 ) -   (193 ) -   (254 ) -   (1,172 )
Recoveries
  282   60   17   161   -   26   -   82   -   628  
Provision
  147   (141 ) (32 ) (410 ) (30 ) 179   -   180   (175 ) (282 )
Ending balance
$ 3,387   2,848   1,708   1,839   7   1,081   -   253   1,552   12,675  
                                           
Three months ended June 30, 2014
                                     
Allowance for loan losses:
                                         
Beginning balance
$ 3,133   3,132   1,767   2,196   36   945   -   230   1,539   12,978  
Charge-offs
  -   (171 ) (108 ) (20 ) -   (181 ) -   (117 ) -   (597 )
Recoveries
  3   52   5   101   -   21   -   45   -   227  
Provision
  251   (165 ) 44   (438 ) (29 ) 296   -   95   13   67  
Ending balance
$ 3,387   2,848   1,708   1,839   7   1,081   -   253   1,552   12,675  
                                           
Allowance for loan losses June 30, 2014:
                                     
Ending balance: individually
                                         
evaluated for impairment
$ -   67   1,175   -   -   242   -   -   -   1,484  
Ending balance: collectively
                                         
evaluated for impairment
  3,387   2,781   533   1,839   7   839   -   253   1,552   11,191  
Ending balance
$ 3,387   2,848   1,708   1,839   7   1,081   -   253   1,552   12,675  
                                           
Loans June 30, 2014:
                                         
Ending balance
$ 59,843   196,192   48,165   214,378   11,821   78,056   93   24,788   -   633,336  
                                           
Ending balance: individually
                                         
evaluated for impairment
$ 5,297   2,325   19,287       -   3,307   -   250   -   30,466  
Ending balance: collectively
                                         
evaluated for impairment
$ 54,546   193,867   28,878   214,378   11,821   74,749   93   24,538   -   602,870  
 
 
 
14

 
 
 
(Dollars in thousands)
                                 
 
Real Estate Loans
                     
 
Construction
and Land
Development
 
Single-
Family
Residential
 
Single-
Family
Residential -
Banco de la
Gente
Stated
 Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
and All
Other
 
Unallocated
 
Total
 
Six months ended June 30, 2013
                                     
Allowance for loan losses:
                                       
Beginning balance
$ 4,399   3,231   1,998   2,049   28   1,088   -   245   1,385   14,423  
Charge-offs
  (715 ) (636 ) (224 ) (275 ) -   (382 ) -   (281 ) -   (2,513 )
Recoveries
  26   43   70   50   -   25   -   78   -   292  
Provision
  1,015   666   80   34   6   91   -   187   (252 ) 1,827  
Ending balance
$ 4,725   3,304   1,924   1,858   34   822   -   229   1,133   14,029  
                                           
Three months ended June 30, 2013
                                     
Allowance for loan losses:
                                         
Beginning balance
$ 4,785   3,182   1,976   1,811   30   1,209   -   232   1,187   14,412  
Charge-offs
  (218 ) (274 ) (72 ) (275 ) -   (361 ) -   (134 ) -   (1,334 )
Recoveries
  25   24   70   2   -   14   -   43   -   178  
Provision
  133   372   (50 ) 320   4   (40 ) -   88   (54 ) 773  
Ending balance
$ 4,725   3,304   1,924   1,858   34   822   -   229   1,133   14,029  
                                           
Allowance for loan losses June 30, 2013:
                                     
Ending balance: individually
                                         
evaluated for impairment
$ 6   343   1,234   -   -   -   -   -   -   1,583  
Ending balance: collectively
                                         
evaluated for impairment
  4,719   2,961   690   1,858   34   822   -   229   1,133   12,446  
Ending balance
$ 4,725   3,304   1,924   1,858   34   822   -   229   1,133   14,029  
                                           
Loans June 30, 2013:
                                         
Ending balance
$ 70,112   192,601   50,454   191,368   10,918   66,161   24   26,434   -   608,072  
                                           
Ending balance: individually
                                         
evaluated for impairment
$ 7,626   3,480   19,912   3,125   -   -   -   279   -   34,422  
Ending balance: collectively
                                         
evaluated for impairment
$ 62,486   189,121   30,542   188,243   10,918   66,161   24   26,155   -   573,650  
 
The provision for loan losses for the three months ended June 30, 2014 was $67,000, as compared to $773,000 for the same period one year ago.  The decrease in the provision for loan losses is primarily attributable to a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014 and a reduction in net charge-offs of $786,000 during the three months ended June 30, 2014, as compared to the same period one year ago.

The provision for loan losses for the six months ended June 30, 2014 was a credit of $282,000, as compared to an expense of $1.8 million for the same period one year ago.  The decrease in the provision for loan losses is primarily attributable to a $1.7 million decrease in net charge-offs during the six months ended June 30, 2014 compared to the same period one year ago and a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014.  The credit to provision for loan losses in the six months ended June 30, 2014 resulted from, and was considered appropriate as part of, management’s assessment and estimate of the risks in the total loan portfolio and determination of the total allowance for loan losses.  The primary factors contributing to the decrease in the allowance for loan losses at June 30, 2014 to $12.7 million from $13.5 million at December 31, 2013 were the continuing positive trends in indicators of potential losses on loans, primarily non-accrual loans and the reduction in net charge-offs.

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 8.  These risk grades are evaluated on an ongoing basis.  A description of the general characteristics of the eight 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 higher risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends is observed.  These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.
 
 
 
15

 
 

·  
Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there has been some recent past due history on repayment and there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company’s position at some future date.
·  
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 – Doubtful: Loans classified as 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 8 – Loss: Loans classified as 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.
 
The following tables present the credit risk profile of each loan type based on internally assigned risk grades as of June 30, 2014 and December 31, 2013:

June 30, 2014
                               
(Dollars in thousands)
                               
 
Real Estate Loans
                   
 
Construction
and Land Development
 
Single-
Family
Residential
 
Single-
Family
Residential -
Banco de la
Gente
Stated
 Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
 
All Other
 
Total
                                       
1- Excellent Quality
$ -   15,376   -   -   -   720   -   1,386   -   17,482
2- High Quality
  8,224   66,361   -   37,883   682   11,404   -   3,659   1,972   130,185
3- Good Quality
  23,249   71,086   21,528   129,951   6,621   51,697   93   4,424   10,439   319,088
4- Management Attention
  12,949   32,416   8,293   35,900   1,643   12,452   -   575   2,234   106,462
5- Watch
  7,355   5,914   7,040   6,661   2,706   944   -   20   -   30,640
6- Substandard
  8,066   5,039   11,304   3,983   169   770   -   77   -   29,408
7- Doubtful
  -   -   -   -   -   -   -   -   -   -
8- Loss
  -   -   -   -   -   69   -   2   -   71
Total
$ 59,843   196,192   48,165   214,378   11,821   78,056   93   10,143   14,645   633,336
                                         
                                         
December 31, 2013
                                 
(Dollars in thousands)
                                 
 
Real Estate Loans
                   
 
Construction
and Land Development
 
Single-
Family
Residential
 
Single-
Family
Residential -
Banco de la
Gente
Stated
Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
 
All Other
 
Total
                                         
1- Excellent Quality
$ 7   15,036   -   -   -   365   -   1,270   -   16,678
2- High Quality
  7,852   60,882   -   33,340   715   8,442   -   3,519   2,139   116,889
3- Good Quality
  22,899   73,118   22,255   123,604   7,882   44,353   19   4,061   8,565   306,756
4- Management Attention
  14,464   34,090   8,369   42,914   286   13,704   -   358   2,329   116,514
5- Watch
  8,163   6,806   8,113   5,190   2,741   320   -   50   -   31,383
6- Substandard
  10,357   6,043   10,726   4,239   177   863   -   330   -   32,735
7- Doubtful
  -   -   -   -   -   -   -   -   -   -
8- Loss
  -   -   -   -   -   -   -   5   -   5
Total
$ 63,742   195,975   49,463   209,287   11,801   68,047   19   9,593   13,033   620,960
 
Total TDR loans amounted to $11.7 million and $21.9 million at June 30, 2014 and December 31, 2013, respectively.  The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  There were $1.5 million and $335,000 in performing loans classified as TDR loans at June 30, 2014 and December 31, 2013, respectively.
 
 
16

 
 
The Bank did not enter into any new TDR loan modifications during the three months ended June 30, 2014.  The following table presents an analysis of loan modifications during the six months ended June 30, 2014:
 
Six months ended June 30, 2014
         
(Dollars in thousands)
         
 
Number of
Contracts
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
Investment
Real estate loans
         
Construction and land development
1   $ 316   316
Single-family residential
1     734   734
Single-family residential -
           
Banco de la Gente stated income
6     494   494
Total real estate TDR loans
8     1,544   1,544
             
Total TDR loans
8   $ 1,544   1,544
 
The following tables present an analysis of loan modifications during the three and six months ended June 30, 2013:
 
Three months ended June 30, 2013
         
(Dollars in thousands)
         
 
Number of
Contracts
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
 Investment
Real estate loans
         
Construction and land development
1   $ 724   712
Single-family residential
2     78   78
Single-family residential -
           
Banco de la Gente stated income
1     140   138
Total real estate TDR loans
4     942   928
             
Total TDR loans
4   $ 942   928
 
Six months ended June 30, 2013
         
(Dollars in thousands)
         
 
Number of
Contracts
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
Investment
Real estate loans
         
Construction and land development
2   $ 841   829
Single-family residential
2     78   78
Single-family residential -
           
Banco de la Gente stated income
4     472   469
Total real estate TDR loans
8     1,391   1,376
             
Total TDR loans
8   $ 1,391   1,376
 
(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, 2014 and 2013 is as follows:
 
 
17

 
 

For the three months ended June 30, 2014
         
 
Net Earnings
Available to
Common
Shareholders
 (Dollars in
 thousands)
 
Common Shares
 
Per Share
Amount
Basic earnings per common share
$ 2,551   5,616,008   $ 0.45
Effect of dilutive securities:
             
Stock options
  -     25,471      
Diluted earnings per common share
$ 2,551   5,641,479   $ 0.45
               
For the six months ended June 30, 2014
             
 
Net Earnings
Available to
Common
Shareholders
(Dollars in
thousands)
 
Common Shares
 
Per Share
Amount
Basic earnings per common share
$ 5,130   5,614,758   $ 0.91
Effect of dilutive securities:
             
Stock options
  -     22,432      
Diluted earnings per common share
$ 5,130   5,637,190   $ 0.91
 
For the three months ended June 30, 2013
         
 
Net Earnings
Available to
 Common
Shareholders
(Dollars in
thousands)
 
Common Shares
 
Per Share
Amount
Basic earnings per common share
$ 1,477   5,613,495   $ 0.26
Effect of dilutive securities:
             
Stock options
  -     5,589      
Diluted earnings per common share
$ 1,477   5,619,084   $ 0.26
               
For the six months ended June 30, 2013
             
 
Net Earnings
Available to
Common
Shareholders
 (Dollars in
 thousands)
 
Common Shares
 
Per Share
Amount
Basic earnings per common share
$ 3,078   5,613,495   $ 0.55
Effect of dilutive securities:
             
Stock options
  -     5,185      
Diluted earnings per common share
$ 3,078   5,618,680   $ 0.55
 
(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 and restricted stock units were granted to eligible directors and employees.  The 1999 Plan expired on May 13, 2009 but still governs the rights and obligations of the parties for grants made thereunder.

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.
 
 
18

 
 
In addition, under the 1999 Plan, the Company granted 3,000 restricted stock units in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 restricted stock units at a grant date fair value of $12.80 per share during the third quarter of 2008 and 2,000 restricted stock units at a grant date fair value of $11.37 per share during the fourth quarter of 2008. The Company recognizes compensation expense on the restricted stock units over the period of time the restrictions are in place (three years from the grant date for the grants of restricted stock units to date under the 1999 Plan).  The amount of expense recorded each period reflects the changes in the Company’s stock price during the period.  As of June 30, 2014, there was no unrecognized compensation expense related to the 2007 and 2008 restricted stock unit grants granted under the 1999 Plan.

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, restricted stock units, performance units, stock appreciation rights or book value shares, may be granted to eligible directors and employees.  A total of 282,635 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 granted 29,514 restricted stock units under the 2009 Plan at a grant date fair value of $7.90 per share during the first quarter of 2012.  5,355 restricted stock units were forfeited by the executive officers of the Company as required by the agreement with the U.S. Department of the Treasury (“UST”) in conjunction with the Company’s participation in the Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”).  In July 2012, the Company granted 5,355 restricted stock units at a grant date fair value of $8.25 per share. The Company granted 26,795 restricted stock units under the 2009 Plan at a grant date fair value of $11.90 per share during the second quarter of 2013.  The Company granted 21,056 restricted stock units under the 2009 Plan at a grant date fair value of $15.70 per share during the first quarter of 2014.  The Company recognizes compensation expense on the restricted stock units over the period of time the restrictions are in place (five years from the grant date for the 2012 grants, four years from the grant date for the 2013 grants and three years from the grant date for the 2014 grants).  The amount of expense recorded each period reflects the changes in the Company’s stock price during the period.  As of June 30, 2014, the total unrecognized compensation expense related to the restricted stock unit grants under the 2009 Plan was $840,000.

The Company recognized compensation expense for restricted stock awards granted under the 2009 Plan of $167,000 and $70,000 for the six months ended June 30, 2014 and 2013, respectively.

(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 the value of financial instruments held by the Company since purchase, origination or issuance.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

·  
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.
·  
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
·  
Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
 
 
 
19

 
 
Cash and Cash Equivalents
For cash, due from banks and interest-bearing deposits, the carrying amount is a reasonable estimate of fair value.  Cash and cash equivalents are reported in the Level 1 fair value category.

Investment Securities Available for Sale
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 for investment securities with quoted market prices are reported in the Level 1 fair value category.  Fair value measurements obtained from independent pricing services are reported in the Level 2 fair value category. All other fair value measurements are reported in the Level 3 fair value category.

Other Investments
For other investments, the carrying value is a reasonable estimate of fair value.  Other investments are reported in the Level 3 fair value category.

Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at the lower of aggregate cost or market value.  The cost of mortgage loans held for sale approximates the market value.  Mortgage loans held for sale are reported in the Level 3 fair value category.

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.  Loans are reported in the Level 3 fair value category, as the pricing of loans is more subjective than the pricing of other financial instruments.

Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.  Cash surrender value of life insurance is reported in the Level 2 fair value category.

Other Real Estate
The fair value of other real estate is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  Other real estate is reported in the Level 3 fair value category.

Deposits
The fair value of demand deposits, interest-bearing demand deposits and savings 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.  Deposits are reported in the Level 2 fair value category.

Securities Sold Under Agreements to Repurchase
For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.  Securities sold under agreements to repurchase are reported in the Level 2 fair value category.

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.  FHLB borrowings are reported in the Level 2 fair value category.

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.  Junior subordinated debentures are reported in the Level 2 fair value category.

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.
 
 
20

 
 
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 deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The table below presents the balance of securities available for sale, which are measured at fair value on a recurring basis by level within the fair value hierarchy, as of June 30, 2014 and December 31, 2013.

(Dollars in thousands)
             
 
June 30, 2014
 
Fair Value
Measurements
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
Mortgage-backed securities
$ 117,514   -   117,514   -
U.S. Government
               
sponsored enterprises
$ 25,101   -   25,101   -
State and political subdivisions
$ 148,629   -   148,629   -
Corporate bonds
$ 3,487   -   3,487   -
Trust preferred securities
$ 750   -   -   750
Equity securities
$ 1,684   1,684   -   -
 
(Dollars in thousands)
             
 
December 31, 2013
 
Fair Value
Measurements
 
Level 1
Valuation
 
Level 2
Valuation
 
Level 3
Valuation
Mortgage-backed securities
$ 123,977   -   123,977   -
U.S. Government
               
sponsored enterprises
$ 22,143   -   22,143   -
State and political subdivisions
$ 145,368   -   145,368   -
Corporate bonds
$ 3,463   -   3,463   -
Trust preferred securities
$ 1,250   -   -   1,250
Equity securities
$ 1,689   1,689   -   -
 
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, 2014.

(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 and calls)
  (500 )
Transfers in and/or (out) of Level 3
  -  
Balance, end of period
$ 750  
       
Change in unrealized gain/(loss) for assets still held in Level 3
$ -  
 
 
 
21

 
 
The fair value measurements for impaired loans and other real estate on a non-recurring basis at June 30, 2014 and December 31, 2013 are presented below.  The fair value measurement process uses certified appraisals and other market-based information; however, in many cases, it also requires significant input based on management’s knowledge of, and judgment about, current market conditions, specific issues relating to the collateral, and other matters.  As a result, all fair value measurements for impaired loans and other real estate are considered Level 3.

(Dollars in thousands)
                 
 
Fair Value
Measurements
June 30, 2014
Level 1
Valuation
Level 2
Valuation
Level 3
Valuation
Total Gains/(Losses) for
the Six Months Ended
June 30, 2014
Impaired loans
$ 36,983   -   -   36,983   (433 )
Other real estate
$ 3,532   -   -   3,532   (150 )
                       
(Dollars in thousands)
                 
 
Fair Value
Measurements
December 31, 2013
Level 1
Valuation
Level 2
Valuation
Level 3
 Valuation
Total Gains/(Losses) for
the Year Ended
December 31, 2013
Impaired loans
$ 39,780   -   -   39,780   (3,207 )
Other real estate
$ 1,679   -   -   1,679   (581 )
 
The carrying amount and estimated fair value of financial instruments at June 30, 2014 and December 31, 2013 are as follows:

(Dollars in thousands)
                 
     
Fair Value Measurements at June 30, 2014
 
Carrying
Amount
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
                 
Cash and cash equivalents
$ 75,068   75,068   -   -   75,068
Investment securities available for sale
  297,165   1,684   294,731   750   297,165
Other investments
  4,706   -   -   4,706   4,706
Mortgage loans held for sale
  2,048   -   -   2,048   2,048
Loans, net
  620,661   -   -   623,799   623,799
Cash surrender value of life insurance
  13,914   -   13,914   -   13,914
                     
Liabilities:
                   
Deposits
$ 811,479   -   810,415   -   810,415
Securities sold under agreements
                   
to repurchase
  46,764   -   46,764   -   46,764
FHLB borrowings
  65,000   -   65,984   -   65,984
Junior subordinated debentures
  20,619   -   20,619   -   20,619
 
 
 
22

 
 
 
(Dollars in thousands)
                 
 
 
 
Fair Value Measurements at December 31, 2013
 
Carrying
Amount
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
                   
Cash and cash equivalents
$ 76,773   76,773   -   -   76,773
Investment securities available for sale
  297,890   1,689   294,951   1,250   297,890
Other investments
  4,990   -   -   4,990   4,990
Mortgage loans held for sale
  497   -   -   497   497
Loans, net
  607,459   -   -   612,132   612,132
Cash surrender value of life insurance
  13,706   -   13,706   -   13,706
                     
Liabilities:
                   
Deposits
$ 799,361   -   798,460   -   798,460
Securities sold under agreements
                   
to repurchase
  45,396   -   45,396   -   45,396
FHLB borrowings
  65,000   -   65,891   -   65,891
Junior subordinated debentures
  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, 2014 or December 31, 2013.
 
(8)
    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.
 
 
23

 

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-28  through A-64 of the Company’s 2013 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2014 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 the Company. The Company is the parent company of 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 2014 continue to demonstrate signs of improvement.  While the general trends are positive, the lack of significant recoveries in the housing and job markets continue to stress various segments of our customer base and therefore limit the impact of the economic recovery to our financial condition and results of operations.  With the unemployment rate continuing to be higher than historical norms and home prices well below pre-crisis levels, the primary indicators of economic activity for our markets continue to point to challenging business conditions that have slowed our return to pre-crisis levels of earnings.  This is also reflected in our local markets, as the unemployment rate in our primary markets remains above the national and state unemployment rates.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. This legislation made 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 altered 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 continue to evaluate this legislation including its related rules and regulations, and we continue to assess the extent to which it will impact our current and future operations.

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.
 
 
24

 
 
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.  While we continue to focus our resources in and around our current footprint, we do consider other avenues of growth that could add shareholder value.

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 Bank.  Additional information regarding the Bank’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 U.S. Department of the Treasury (“UST”) pursuant to the Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”).  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 the Company’s common stock.  Proceeds from this issuance of Series A 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 Warrant.  The discount recorded on the Series A preferred stock that resulted from allocating a portion of the proceeds to the Warrant was being accreted directly to retained earnings over a five-year period applying a level yield.

The Series A preferred stock qualified as Tier 1 capital and paid cumulative dividends at a rate of 5% per annum for the first five years (i.e., through December 23, 2013) and 9% per annum thereafter.  The Series A preferred stock was redeemable 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 Series A 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 could redeem the Series A preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock was 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 UST sold all of its Series A preferred stock in a public auction in June 2012, and, as a result, the Company is no longer subject to the executive compensation and corporate governance standards imposed by TARP.  The Company purchased 12,530 shares of the 25,054 outstanding shares of Series A preferred stock from the UST.  The shares were purchased for $933.36 per share, for a total purchase price of $11,778,576, including $83,575 accrued and unpaid dividends on the Series A preferred stock.  The Company retired the 12,530 shares purchased.  The $834,999 difference between the $12,530,000 face value of the Series A preferred stock retired and the $11,695,001 purchase price of the Series A preferred stock retired was credited to retained earnings effective June 30, 2012.  Remaining Series A preferred shares were redeemable at any time at par.

During 2012, the Company completed its repurchase of the Warrant to purchase 357,234 shares of the Company’s common stock.  The Company repurchased the Warrant for a total price of $425,000.  The exercise price of the Warrant was $10.52 per common share and was exercisable at anytime on or before December 18, 2018.  The Company is no longer accreting the discount associated with the Warrant, as the discount remaining at the time of repurchase was included in the cost of the Warrant.  As of December 31, 2013, the Company had accreted a total of $478,000 of the discount related to the Series A preferred stock.

The Company received regulatory approval in December 2013 to repurchase and redeem the remaining 12,524 outstanding shares of its Series A preferred stock.  The repurchase and redemption was completed on January 17, 2014 and was reflected on the Company’s Consolidated Balance Sheets as of December 31, 2013.   “Accrued interest payable and other liabilities” at December 31, 2013 includes $12.6 million for the payment to preferred shareholders of principal and accrued dividends on January 17, 2014.
 
 
25

 
 
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 2013 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2014 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 this management’s discussion and analysis and the Notes to the Consolidated Financial Statements.
 
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 table below presents the balance of securities available for sale, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of June 30, 2014 and December 31, 2013.

(Dollars in thousands)
             
 
June 30, 2014
 
Fair Value
Measurements
 
Level 1
Valuation
Level 2
Valuation
Level 3
Valuation
Mortgage-backed securities
$ 117,514   -   117,514   -
U.S. Government
               
sponsored enterprises
$ 25,101   -   25,101   -
State and political subdivisions
$ 148,629   -   148,629   -
Corporate bonds
$ 3,487   -   3,487   -
Trust preferred securities
$ 750   -   -   750
Equity securities
$ 1,684   1,684   -   -
 
(Dollars in thousands)
             
 
December 31, 2013
 
Fair Value
Measurements
 
Level 1
Valuation
Level 2
Valuation
Level 3
Valuation
Mortgage-backed securities
$ 123,977   -   123,977   -
U.S. Government
               
sponsored enterprises
$ 22,143   -   22,143   -
State and political subdivisions
$ 145,368   -   145,368   -
Corporate bonds
$ 3,463   -   3,463   -
Trust preferred securities
$ 1,250   -   -   1,250
Equity securities
$ 1,689   1,689   -   -
 
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.
 
 
26

 
 
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, 2014:

(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 and calls)
  (500 )
Transfers in and/or (out) of Level 3
  -  
Balance, end of period
$ 750  
       
Change in unrealized gain/(loss) for assets still held in Level 3
$ -  
 
The Bank’s June 30, 2014 and December 31, 2013 fair value measurements for impaired loans and other real estate on a non-recurring basis are presented below.  The fair value measurement process uses certified appraisals and other market-based information; however, in many cases, it also requires significant input based on management’s knowledge of and judgment about current market conditions, specific issues relating to the collateral, and other matters.  As a result, all fair value measurements for impaired loans and other real estate are considered Level 3.

(Dollars in thousands)
                 
 
Fair Value
Measurements
 June 30, 2014
Level 1
Valuation
Level 2
Valuation
Level 3
Valuation
Total Gains/(Losses) for
the Six Months Ended
June 30, 2014
 
Impaired loans
$ 36,983   -   -   36,983   (433 )
Other real estate
$ 3,532   -   -   3,532   (150 )
                       
(Dollars in thousands)
                 
 
Fair Value
Measurements
December 31, 2013
Level 1
Valuation
Level 2
Valuation
Level 3
Valuation
Total Gains/(Losses) for
the Year Ended
December 31, 2013
 
Impaired loans
$ 39,780   -   -   39,780   (3,207 )
Other real estate
$ 1,679   -   -   1,679   (581 )
 
At each reporting period, the Bank determines which loans are impaired.  Accordingly, the Bank’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank.  REAS is staffed by certified appraisers that also perform appraisals for other companies.  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.  An allowance for each impaired loan that is non-collateral dependent is calculated based on the present value of projected cash flows.  If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses.  Impaired loans under $250,000 are not individually evaluated for impairment, with the exception of the Bank’s TDR loans in the residential mortgage loan portfolio, which are individually evaluated for impairment.  Accruing impaired loans were $27.7 million, $27.6 million and $26.2 million at June 30, 2014, December 31, 2013 and June 30, 2013, respectively.  Interest income recognized on accruing impaired loans was $681,000, $579,000 and $1.3 million for the six months ended June 30, 2014, the six months ended June 30, 2013 and the year ended December 31, 2013, respectively.  Interest income recognized on accruing impaired loans was $325,000 and $286,000 for the three months ended June 30, 2014 and 2013, respectively.  No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.
 
 
27

 
 
Results of Operations
Summary.  Net earnings were $2.6 million or $0.45 basic and diluted net earnings per share for the three months ended June 30, 2014, as compared to $1.6 million or $0.29 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, for the same period one year ago.  After adjusting for dividends and accretion on preferred stock, net earnings available to common shareholders were $2.6 million or $0.45 basic and diluted net earnings per common share for the three months ended June 30, 2014, as compared to $1.5 million or $0.26 basic and diluted net earnings per common share, for the same period one year ago.  The increase in second quarter earnings is attributable to a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by a decrease in non-interest income.

The annualized return on average assets was 1.00% for the three months ended June 30, 2014 compared to 0.64% for the same period one year ago, and annualized return on average shareholders’ equity was 11.08% for the three months ended June 30, 2014 compared to 6.55% for the same period one year ago.

Year-to-date net earnings as of June 30, 2014 were $5.1 million or $0.91 basic and diluted net earnings per share, as compared to $3.4 million or $0.60 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, 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, 2014 were $5.1 million or $0.91 basic and diluted net earnings per common share, as compared to $3.1 million or $0.55 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 a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by a decrease in non-interest income and an increase in non-interest expense, as discussed below.
 
The annualized return on average assets was 1.01% for the six months ended June 30, 2014 compared to 0.68% for the same period one year ago, and annualized return on average shareholders’ equity was 11.33% for the six months ended June 30, 2014 compared to 6.80% for the same period one year ago.

Net Interest Income.  Net interest income, the major component of the Company’s net earnings, was $8.5 million for the three months ended June 30, 2014, compared to $7.5 million for the same period one year ago.  This increase was primarily due to an increase in interest income due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities combined with a decrease in interest expense due to a reduction in the cost of funds.

Interest income increased $667,000 or 7% for the three months ended June 30, 2014 compared to the same period one year ago.  The increase was primarily due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities.  The average yield on investment securities available for sale for the quarters ended June 30, 2014 and 2013 was 3.55% and 2.67%, respectively.  The average yield on earning assets for the quarters ended June 30, 2014 and 2013 was 4.34% and 3.97%, respectively.  During the quarter ended June 30, 2014, average investment securities available for sale increased $4.2 million to $295.2 million from $291.0 million for the three months ended June 30, 2013.  During the quarter ended June 30, 2014, average loans increased $12.2 million to $619.7 million from $607.5 million for the three months ended June 30, 2013.

Interest expense decreased $287,000 or 21% for the three months ended June 30, 2014 compared with the same period one year ago due to lower cost of funds and a reduction in certificates of deposit.  The average rate paid on interest-bearing checking and savings accounts was 0.13% for the three months ended June 30, 2014 as compared to 0.21% for the same period one year ago.  The average rate paid on certificates of deposit was 0.58% for the three months ended June 30, 2014 compared to 0.73% for the same period one year ago.  During the quarter ended June 30, 2014, average certificates of deposit decreased $22.6 million to $210.3 million from $232.9 million for the three months ended June 30, 2013.

The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the three months ended June 30, 2014 and 2013. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate of 37.96% for securities that are both federal and state tax exempt and an effective tax rate of 31.96% for federal tax exempt securities.  Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.
 
 
28

 
 
 
 
Three months ended
 
Three months ended
 
June 30, 2014
 
June 30, 2013
(Dollars in thousands)
Average
Balance
Interest
Yield /
 Rate
Average
Balance
Interest
Yield /
Rate
Interest-earning assets:
                     
                       
Loans receivable
$ 619,675     7,491   4.85%   607,481   7,439   4.91%
Investments - taxable
  125,403     758   2.42%   139,546   225   0.65%
Investments - nontaxable*
  175,107     1,901   4.38%   157,283   1,747   4.46%
Other
  18,060     12   0.26%   48,588   28   0.23%
                           
Total interest-earning assets
  938,245     10,162   4.34%   952,898   9,439   3.97%
                           
Cash and due from banks
  47,399             28,002        
Other assets
  52,362             54,430        
Allowance for loan losses
  (13,018 )           (14,286 )      
                           
Total assets
$ 1,024,988             1,021,044        
                           
                           
Interest-bearing liabilities:
                         
                           
NOW, MMDA & savings deposits
$ 392,186     125   0.13%   374,531   200   0.21%
Time deposits
  210,251     303   0.58%   232,868   422   0.73%
FHLB borrowings
  65,000     549   3.39%   70,000   635   3.64%
Trust preferred securities
  20,619     97   1.89%   20,619   100   1.96%
Other
  45,597     11   0.09%   41,965   15   0.14%
                           
Total interest-bearing liabilities
  733,653     1,085   0.59%   739,983   1,372   0.74%
                           
Demand deposits
  195,383             176,974        
Other liabilities
  4,786             4,714        
Shareholders' equity
  92,388             100,054        
                           
Total liabilities and shareholder's equity
$ 1,026,210             1,021,725        
                           
Net interest spread
      $ 9,077   3.75%       8,067   3.23%
                           
Net yield on interest-earning assets
            3.88%           3.40%
                           
Taxable equivalent adjustment
                         
Investment securities
      $ 586           530    
                           
Net interest income
      $ 8,491           7,537    
                           
*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $25.4 million in 2014 and $19.3 million in 2013. Tax rates of 6.00% and 6.90% were used to calculate the tax equivalent yield on these securities in 2014 and 2013, respectively.
 
Year-to-date net interest income as of June 30, 2014 increased 11.5% to $16.9 million compared to $15.2 million for the same period one year ago.  This increase was primarily due to an increase in interest income due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities combined with a decrease in interest expense due to a reduction in the cost of funds.

Interest income increased $1.1 million or 6% for the six months ended June 30, 2014 compared with the same period in 2013.  This increase was primarily due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities.  The average yield on investment securities available for sale for the six months ended June 30, 2014 and 2013 was 3.56% and 2.66%, respectively.  The average yield on earning assets for the six months ended June 30, 2014 and 2013 was 4.35% and 4.06%, respectively.  During the six months ended June 30, 2014, average investment securities available for sale increased $8.3 million to $297.1 million from $288.8 million for the six months ended June 30, 2013.  During the six months ended June 30, 2014, average loans increased $4.3 million to $618.6 million from $614.3 million for the six months ended June 30, 2013.

Interest expense decreased $638,000 or 23% for the six months ended June 30, 2014 compared with the same period in 2013 primarily due to lower cost of funds and a reduction in certificates of deposit.  The average rate paid on interest-bearing checking and savings accounts was 0.13% for the six months ended June 30, 2014 as compared to 0.23% for the same period one year ago.  The average rate paid on certificates of deposits was 0.60% for the six months ended June 30, 2014 compared to 0.75% for the same period one year ago.  Average certificates of deposit decreased $22.8 million to $214.8 million for the six months ended June 30, 2014 from $237.6 million for the six months ended June 30, 2013.
 
 
29

 
 
The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the six months ended June 30, 2014 and 2013. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate of 37.96% for securities that are both federal and state tax exempt and an effective tax rate of 31.96% for federal tax exempt securities.  Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.

 
Six months ended
 
Six months ended
 
June 30, 2014
 
June 30, 2013
(Dollars in thousands)
Average
Balance
Interest
Yield /
Rate
Average
Balance
Interest
Yield /
Rate
Interest-earning assets:
                     
                       
Loans receivable
$ 618,574     14,893   4.86%   614,241   15,079   4.95%
Investments - taxable
  127,983     1,549   2.44%   144,278   567   0.79%
Investments - nontaxable*
  174,556     3,833   4.43%   150,499   3,342   4.48%
Other
  19,359     24   0.25%   35,885   40   0.22%
                           
Total interest-earning assets
  940,472     20,299   4.35%   944,903   19,028   4.06%
                           
Cash and due from banks
  45,403             26,884        
Other assets
  49,579             55,406        
Allowance for loan losses
  (13,307 )           (14,496 )      
                           
Total assets
$ 1,022,147             1,012,697        
                           
                           
Interest-bearing liabilities:
                         
                           
NOW, MMDA & savings deposits
$ 389,248     251   0.13%   371,502   418   0.23%
Time deposits
  214,825     637   0.60%   237,615   889   0.75%
FHLB borrowings
  65,000     1,094   3.40%   70,000   1,296   3.73%
Trust preferred securities
  20,619     193   1.89%   20,619   199   1.96%
Other
  44,582     21   0.10%   39,371   32   0.16%
                           
Total interest-bearing liabilities
  734,274     2,196   0.60%   739,107   2,834   0.77%
                           
Demand deposits
  193,985             169,921        
Other liabilities
  5,185             4,611        
Shareholders' equity
  91,331             100,532        
                           
Total liabilities and shareholder's equity
$ 1,024,775             1,014,171        
                           
Net interest spread
      $ 18,103   3.75%       16,194   3.29%
                           
Net yield on interest-earning assets
            3.88%           3.40%
                           
Taxable equivalent adjustment
                         
Investment securities
      $ 1,178           1,016    
                           
Net interest income
      $ 16,925           15,178    
                           
*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $24.1 million in 2014 and $19.2 million in 2013. Tax rates of 6.00% and 6.90% were used to calculate the tax equivalent yield on these securities in 2014 and 2013, respectively.
 
Changes in interest income and interest expense can result from variances in both volume and rates.  The following table presents the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated.  The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.
 
 
30

 
 

 
Three months ended June 30, 2014
compared to three months ended June
30, 2013
 
Six months ended June 30, 2014
compared to six months ended June 30,
2013
 
(Dollars in thousands)
Changes in
average
volume
Changes in
average
rates
Total
Increase
(Decrease)
 
Changes in
average
volume
Changes in
average
rates
Total
Increase
(Decrease)
 
Interest income:
                       
Loans: Net of unearned income
$ 148   (96 ) 52   105   (291 ) (186 )
Investments - taxable
  (54 ) 587   533   (131 ) 1,113   982  
Investments - nontaxable
  196   (42 ) 154   531   (40 ) 491  
Other
  (19 ) 3   (16 ) (20 ) 4   (16 )
Total interest income
  271   452   723   485   786   1,271  
                           
Interest expense:
                         
NOW, MMDA & savings deposits
  7   (82 ) (75 ) 16   (183 ) (167 )
Time deposits
  (37 ) (82 ) (119 ) (77 ) (175 ) (252 )
FHLB borrowings
  (44 ) (42 ) (86 ) (88 ) (114 ) (202 )
Trust preferred securities
  -   (3 ) (3 ) -   (6 ) (6 )
Other
  1   (5 ) (4 ) 3   (13 ) (10 )
Total interest expense
  (73 ) (214 ) (287 ) (146 ) (491 ) (637 )
Taxable equivalent net interest income
$ 344   666   1,010   631   1,277   1,908  
 
Provision for Loan Losses. The provision for loan losses for the three months ended June 30, 2014 was $67,000, as compared to $773,000 for the same period one year ago.  The decrease in the provision for loan losses is primarily attributable to a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014 and a reduction in net charge-offs of $786,000 during the three months ended June 30, 2014, as compared to the same period one year ago.

The provision for loan losses for the six months ended June 30, 2014 was a credit of $282,000, as compared to an expense of $1.8 million for the same period one year ago.  The decrease in the provision for loan losses is primarily attributable to a $1.7 million decrease in net charge-offs during the six months ended June 30, 2014 compared to the same period one year ago and a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014.  The credit to provision for loan losses in the six months ended June 30, 2014 resulted from, and was considered appropriate as part of, management’s assessment and estimate of the risks in the total loan portfolio and determination of the total allowance for loan losses.  The primary factors contributing to the decrease in the allowance for loan losses at June 30, 2014 to $12.7 million from $13.5 million at December 31, 2013 were the continuing positive trends in indicators of potential losses on loans, primarily non-accrual loans and the reduction in net charge-offs since 2010, as shown below:
 
 
31

 
 
 
(Dollars in thousands)
                                       
   
Net charge-offs
 
Net charge-offs as a percent of average loans outstanding
   
Six months ended
 June 30,
 
Years ended December 31,
 
Six months ended
June 30,
 
Years ended December 31,
   
2014
2013
 
2013
2012
2011
2010
 
2014
2013
 
2013
2012
2011
2010
Real estate loans
                                               
Construction and land development
  $ (22 ) 689   400   4,201   6,923   10,135   -0.04%   0.96%   0.58%   4.99%   6.40%   6.84%
Single-family residential
    134   593   1,613   814   2,049   2,853   0.07%   0.30%   0.82%   0.39%   0.91%   1.15%
Single-family residential -
                            0.00%   0.00%   0.00%   0.00%   0.00%   0.00%
Banco de la Gente stated income
    123   154   132   668   675   425   0.25%   0.30%   0.26%   1.25%   1.23%   0.98%
Commercial
    (30 ) 225   395   563   1,247   753   -0.01%   0.12%   0.20%   0.27%   0.59%   0.43%
Multifamily and farmland
    -   -   -   -   -   -   0.00%   0.00%   0.00%   0.00%   0.00%   0.00%
Total real estate loans
    205   1,661   2,540   6,246   10,894   14,166   0.04%   0.32%   0.48%   1.12%   1.80%   2.14%
      -   -   -   -   -   -                        
Loans not secured by real estate
                                                 
Commercial loans
    167   357   458   451   193   1,668   0.25%   0.59%   0.73%   0.75%   0.34%   3.41%
Farm loans
    -   -   -   -   -   -   0.00%   0.00%   0.00%   0.00%   0.00%   0.00%
Consumer loans (1)
    172   203   508   408   434   524   1.78%   2.12%   5.27%   4.00%   4.05%   4.73%
All other loans
    -   -   -   -   -   -   0.00%   0.00%   0.00%   0.00%   0.00%   0.00%
Total loans
  $ 544   2,221   3,506   7,105   11,521   16,358   0.09%   0.37%   0.57%   1.10%   1.65%   2.16%
                                                   
Provision for loan losses for the period
  $ (282 ) 1,827   2,584   4,924   12,632   16,438                        
                                                   
Allowance for loan losses at end of period
  $ 12,675   14,029   13,501   14,423   16,604   15,493                        
                                                   
Total loans at end of period
  $ 633,336   608,072   620,960   619,974   670,497   726,160                        
                                                   
Non-accrual loans at end of period
  $ 10,921   16,107   13,836   17,630   21,785   40,062                        
                                                   
Allowance for loan losses as a percent of
                                           
total loans outstanding at end of period
    2.00%   2.31%   2.17%   2.33%   2.48%   2.13%                        
                                                   
Non-accrual loans as a percent of
                                                 
total loans outstanding at end of period
    1.72%   2.65%   2.23%   2.84%   3.25%   5.52%                        
                                                   
(1) The loss ratio for Consumer loans is elevated because overdraft charge-offs related to DDA and NOW accounts are reported in Consumer Loan charge-offs and recoveries. The net overdraft charge-offs are not considered material and are therefore not shown separately.
 
  Another factor considered in taking a credit to provision expense in the six months ended June 30, 2014 was the continuing decline in the construction and land development portfolio.  This portfolio has experienced the highest percentage of loss since 2010 as shown in the table above.  The balance outstanding declined to $59.8 million at June 30, 2014 from $63.7 million at December 31, 2013, continuing the decline in this portfolio from the maximum balance of $213.7 million at December 31, 2008.   Also, the net losses in this portfolio declined to a credit in the six months ended June 30, 2014 of $22,000 as opposed to a net loss of $689,000 for the same period in 2013.

Non-Interest Income.  Total non-interest income was $3.1 million for the three months ended June 30, 2014, compared to $3.3 million for the same period one year ago.  This decrease is primarily attributable to a $352,000 decrease in gains on sale of securities and a $127,000 decrease in mortgage banking income due to a reduction in mortgage loan activity.  These decreases in non-interest income were partially offset by a $111,000 increase in service charges and fees primarily due to an increase in commercial checking service charge income and a $185,000 increase in miscellaneous non-interest income primarily due to a reduction in losses and write-downs on foreclosed properties for the three months ended June 30, 2014, as compared to the same period one year ago.

Non-interest income was $6.0 million for the six months ended June 30, 2014, compared to $6.7 million for the same period one year ago.  This decrease is primarily attributable to a $588,000 decrease in gains on sale of securities and a $407,000 decrease in mortgage banking income due to a reduction in mortgage loan activity.  These decreases in non-interest income were partially offset by a $246,000 increase in service charges and fees primarily due to an increase in commercial checking service charge income for the six months ended June 30, 2014, as compared to the same period one year ago.

Non-Interest Expense.  Total non-interest expense was $8.1 million for the three months ended June 30, 2014, compared to $8.0 million for the same period one year ago.  This increase is primarily due to a $146,000 increase in occupany expense primarily due to an increase in depreciation expense, which was due to a $145,000 increase in furniture and equipment depreciation expense during the three months ended June 30, 2014, as compared to the same period one year ago.

Non-interest expense was $16.2 million for the six months ended June 30, 2014, as compared to $15.7 million for the same period one year ago.  This increase is primarily due to a $356,000 increase in occupancy expense primarily due to an increase in depreciation expense, which was primarily due to a $257,000 increase in furniture and equipment depreciation expense during the six months ended June 30, 2014, as compared to the same period one year ago.

Income Taxes.  The Company reported income tax expense of $916,000 and $461,000 for the three months ended June 30, 2014 and 2013, respectively.  This represented an effective tax rate of 26% and 22% for the respective periods.
 
 
32

 
 
The Company reported income taxes of $1.8 million and $979,000 for the six months ended June 30, 2014 and 2013, respectively.  This represented an effective tax rate of 26% and 22% for the respective periods.   

Analysis of Financial Condition
Investment Securities.  Available for sale securities were $297.2 million at June 30, 2014 compared to $297.9 million at December 31, 2013.  Average investment securities available for sale for the six months ended June 30, 2014 were $295.2 million compared to $293.8 million for the year ended December 31, 2013.

Loans.  At June 30, 2014, loans were $633.3 million compared to $621.0 million at December 31, 2013.  Loans originated or renewed during the three months ended June 30, 2014, amounting to approximately $91.8 million, were offset by paydowns and payoffs of existing loans.  Average loans represented 66% and 65% of average earning assets for the six months ended June 30, 2014 and the year ended December 31, 2013, respectively.  The Company had $2.0 million and $497,000 in mortgage loans held for sale as of June 30, 2014 and December 31, 2013, respectively.

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, 2014, the Company had $104.7 million in residential mortgage loans, $84.0 million in home equity loans and $280.6 million in commercial mortgage loans, which include $224.7 million secured by commercial property and $55.9 million secured by residential property.   Residential mortgage loans include $56.6 million made to customers in the Company’s traditional banking offices and $48.2 million in mortgage loans originated in the Company’s Latino banking offices.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.

At June 30, 2014, the Company had $59.8 million in construction and land development 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
63   $ 14,078   $ 30
Land acquisition and development - residential purposes
273     36,028     5,186
1 to 4 family residential construction
41     6,153     -
Commercial construction
6     3,584     -
Total construction and land development
383   $ 59,843   $ 5,216
 
Total TDR loans amounted to $11.7 million and $21.9 million at June 30, 2014 and December 31, 2013, respectively.  The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  There were $1.5 million and $335,000 in performing loans classified as TDR loans at June 30, 2014 and December 31, 2013, respectively.

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.  The Bank periodically analyzes 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:

·  
the Bank’s 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.
 
 
 
33

 
 
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 collectability becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of eight 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 the Bank’s Credit Administration. 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 Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s 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 Bank’s Credit Administration.

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than $1.0 million, excluding loans in default, and loans in process of litigation or liquidation.  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.

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 Bank’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.

The general allowance reflects reserves established under GAAP for collective loan impairment.  These reserves are based upon historical net charge-offs using the greater of the last two, three, four or five years’ loss experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves.

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, the 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 Bank’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.

Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s 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.  Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment.

The allowance for loan losses at June 30, 2014 was $12.7 million or 2.00% of total loans compared to $13.5 million or 2.17% of total loans at December 31, 2013.  
 
 
34

 
 
The following table presents the percentage of loans assigned to each risk grade at June 30, 2014 and December 31, 2013.
 
 
Percentage of Loans
 
By Risk Grade
Risk Grade
6/30/2014
12/31/2013
Risk Grade 1 (Excellent Quality)
2.17%   2.40%  
Risk Grade 2 (High Quality)
20.56%   18.82%  
Risk Grade 3 (Good Quality)
50.74%   49.49%  
Risk Grade 4 (Management Attention)
16.75%   18.69%  
Risk Grade 5 (Watch)
4.84%   5.05%  
Risk Grade 6 (Substandard)
4.62%   5.25%  
Risk Grade 7 (Doubtful)
0.00%   0.00%  
Risk Grade 8 (Loss)
0.01%   0.00%  
 
At June 30, 2014, including non-accrual loans, there were six relationships exceeding $1.0 million in the Watch risk grade (which totaled $12.4 million) and four relationships exceeding $1.0 million in the Substandard risk grade (which totaled $9.8 million).

Non-performing Assets.  Non-performing assets totaled $14.8 million at June 30, 2014, or 1.42% of total assets, compared to $16.4 million at December 31, 2013, or 1.58% of total assets.  Non-accrual loans were $10.9 million at June 30, 2014 and $13.8 million at December 31, 2013.  As a percentage of total loans outstanding, non-accrual loans were 1.72% at June 30, 2014 compared to 2.23% at December 31, 2013.  Non-accrual loans include $5.2 million in construction and land development loans, $5.1 million in commercial and residential mortgage loans and $558,000 in other loans at June 30, 2014 as compared to $6.5 million in construction and land development loans, $7.0 million in commercial and residential mortgage loans and $277,000 in other loans at December 31, 2013.  The Bank had loans 90 days past due and still accruing totaling $392,000 and $882,000 as of June 30, 2014 and December 31, 2013, respectively. Other real estate totaled $3.5 million at June 30, 2014 as compared to $1.7 million at December 31, 2013.

           Deposits.  Total deposits at June 30, 2014 were $811.5 million compared to $799.4 million at December 31, 2013. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposit of denominations less than $100,000, were $699.1 million at June 30, 2014 as compared to $683.9 million at December 31, 2013.  Certificates of deposit in amounts of $100,000 or more totaled $112.2 million at June 30, 2014 as compared to $115.3 million at December 31, 2013.  At June 30, 2014, brokered deposits were $11.0 million as compared to $15.1 million at December 31, 2013. Brokered deposits outstanding as of June 30, 2014 had a weighted average rate of 0.13% with a weighted average original term of ten months as compared to brokered deposits outstanding at December 31, 2013, which had a weighted average rate of 0.14% with a weighted average original term of eight months.

Borrowed Funds. Borrowings from the FHLB totaled $65.0 million at June 30, 2014 and December 31, 2013.  The average balance of FHLB borrowings for the three months ended June 30, 2014 was $65.0 million compared to $69.7 million for the year ended December 31, 2013.  The FHLB borrowings outstanding at June 30, 2014 had interest rates ranging from 1.79% to 4.26% and maturity dates ranging from 2014 to 2019.

Securities sold under agreements to repurchase were $46.8 million at June 30, 2014 compared to $45.4 million at December 31, 2013.

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 in December 2001 by PEBK Capital Trust, a wholly owned Delaware statutory trust of the Company, and for general 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 does not have 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.
 
 
35

 
 
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, which right became effective on June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount plus 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.

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.  Average rate sensitive assets for the six months ended June 30, 2014 totaled $940.5 million, exceeding average rate sensitive liabilities of $734.3 million by $206.2 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, 2014.

Included in the rate sensitive assets are $281.2 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”).  The Company utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At June 30, 2014, the Company had $195.1 million in loans with interest rate floors.  The floors were in effect on $192.8 million of these loans pursuant to the terms of the promissory notes on these loans.   The weighted average rate on these loans is 1.01% 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, 2014, such unfunded commitments to extend credit were $165.3 million, while commitments in the form of standby letters of credit totaled $3.5 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 deposit 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, 2014, the Company’s core deposits totaled $699.1 million, or 86% 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 agreements to repurchase and FHLB borrowings.  The Bank is also able to borrow from the Federal Reserve Bank (“FRB”) on a short-term basis.  The Company’s policies include the ability to access wholesale funding of up to 40% of total assets.  The Company’s  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 7.29% as of June 30, 2014.
 
 
36

 
 
At June 30, 2014, the Bank had a significant amount of deposits in amounts greater than $100,000.  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.

The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $65.0 million at June 30, 2014 and December 31, 2013.  At June 30, 2014, the carrying value of loans pledged as collateral to the FHLB totaled $126.2 million compared to $132.9 million at December 31, 2013.  As additional collateral, the Bank has pledged securities to the FHLB.  At June 30, 2014, the market value of securities pledged to the FHLB totaled $14.7 million compared to $17.3 million at December 31, 2013.  The remaining availability under the line of credit with the FHLB was $23.4 million at June 30, 2014 compared to $21.6 million at December 31, 2013.  The Bank had no borrowings from the FRB at June 30, 2014 or December 31, 2013.  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, 2014, the carrying value of loans pledged as collateral to the FRB totaled $313.8 million compared to $315.2 million at December 31, 2013.

The Bank also had the ability to borrow up to $54.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of June 30, 2014.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 35.55% at June 30, 2014 and 35.65% at December 31, 2013.  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, 2014 and December 31, 2013 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, 2014
 
December 31, 2013
Contractual Cash Obligations
     
Long-term borrowings
$ 65,000   65,000
Junior subordinated debentures
  20,619   20,619
Operating lease obligations
  4,873   3,743
Total
$ 90,492   89,362
Other Commitments
       
Commitments to extend credit
$ 165,317   146,243
Standby letters of credit and financial guarantees written
  3,509   4,361
Total
$ 168,826   150,604
 
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 was $93.0 million, or 8.9% of total assets, as of June 30, 2014, compared to $83.7 million, or 8.1% of total assets, as of December 31, 2013.  This increase reflects an increase in retained earnings and an increase in accumulated other comprehensive income resulting from an increase in the unrealized gain on investment securities

During 2012, the Company purchased 12,530 shares of the Company’s 25,054 outstanding shares of Series A preferred stock from the UST.  The shares were purchased for $933.36 per share, for a total purchase price of $11,778,576, including $83,575 accrued and unpaid dividends on the Series A preferred stock.  The Company retired the 12,530 shares purchased.  The $834,999 difference between the $12,530,000 face value of the Series A preferred stock retired and the $11,695,001 purchase price of the Series A preferred stock retired was credited to retained earnings effective June 30, 2012.  Remaining Series A preferred shares were redeemable at any time at par.
 
 
37

 
 
During 2012, the Company completed its repurchase of the Warrant to purchase 357,234 shares of the Company’s common stock.  The Company repurchased the Warrant for a total price of $425,000.  The exercise price of the Warrant was $10.52 per common share and was exercisable at any time on or before December 18, 2018.  The Company is no longer accreting the discount associated with the Warrant, as the discount remaining at the time of repurchase was included in the cost of the Warrant.  As of December 31, 2013, the Company had accreted a total of $478,000 of the discount related to the Series A preferred stock.

The Company received regulatory approval in December 2013 to repurchase and redeem the remaining 12,524 outstanding shares of its Series A preferred stock.  The repurchase and redemption was completed on January 17, 2014 and was reflected on the Company’s Consolidated Balance Sheets as of December 31, 2013.   “Accrued interest payable and other liabilities” at December 31, 2013 includes $12.6 million for the payment to preferred shareholders of principal and accrued dividends on January 17, 2014.

Annualized return on average equity for the six months ended June 30, 2014 was 11.33% compared to 6.67% for the year ended December 31, 2013.  Total cash dividends paid on common stock were $454,000 and $337,000 for the six months ended June 30, 2014 and 2013, 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.  The Board of Directors does not currently anticipate issuing any additional series of preferred stock.

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, 2014 and December 31, 2013 includes $20.0 million in trust preferred securities.  The Company’s Tier 1 capital ratio was 14.80% and 14.83% at June 30, 2014 and December 31, 2013, respectively.  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 16.11% and 16.14% at June 30, 2014 and December 31, 2013, 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 10.69% and 10.08% at June 30, 2014 and December 31, 2013, respectively.
 
The Bank’s Tier 1 risk-based capital ratio was 14.13% and 14.43% at June 30, 2014 and December 31, 2013, respectively.  The total risk-based capital ratio for the Bank was 15.44% and 15.73% at June 30, 2014 and December 31, 2013, respectively.   The Bank’s Tier 1 leverage capital ratio was 10.20% and 9.79% at June 30, 2014 and December 31, 2013, 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 a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be “well capitalized” at June 30, 2014.

On July 2, 2013, the Federal Reserve Board approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations.  Capital levels at the Company and the Bank currently exceed the new capital requirements, which will be effective on January 1, 2015.
 
 
38

 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
Not required for smaller reporting companies.
 
 

 
39

 
 
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.

 

 
40

 
 
 
PART II.
OTHER INFORMATION
 
Item 1.
Legal Proceedings
   
 
On April 2, 2013, the Bank received notice that a lawsuit was filed against it in the General Court of Justice, Superior Court Division, Lincoln County, North Carolina. The complaint alleges (i) breach of contract and the covenants of good faith and fair dealing by the Bank, (ii) conversion, (iii) unjust enrichment and (iv) violations of the North Carolina Unfair and Deceptive Trade Practices Act in its assessment and collection of overdraft fees. It seeks the refund of overdraft fees, treble damages, attorneys’ fees and injunctive relief. The Plaintiff seeks to have the lawsuit certified as a class action.  On June 6, 2013, the Bank filed a motion for judgment on the pleadings, which was heard in the North Carolina Business Court on October 1, 2013.  On April 15, 2014, the North Carolina Business Court denied the Bank's motion for judgment on the pleadings.  The effect of the court's ruling, which is not a determination on the merits, is to allow the case to proceed to the next stages of the legal process, including discovery and determination as to whether class certification is appropriate or not.  The Bank continues to believe that the allegations in the complaint are without merit and intends to vigorously defend the lawsuit, including the request that the lawsuit be certified as a class action.
   
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
       
                   
              Total    
              Number of    
              Shares   Maximum
              Purchased as   Number of
              Part of   Shares that
    Total         Publicly   May Yet Be
    Number of     Average   Announced   Purchased
    Shares     Price Paid   Plans or   Under the Plans
 Period            Purchased     per Share   Programs   or Programs
                   
 April 1 - 30, 2014
  551     $ 17.50   -         -      
                     
 May 1 - 31, 2014
  321       17.48   -         -      
                     
 June 1 - 30, 2014
  382       17.00   -         -      
                     
 Total
  1,254   (1)   $ 17.34   -          
                     
(1) The Company purchased 1,254 shares on the open market in the three months ended June 30, 2014 for its deferred compensation plan. All purchases were funded by participant contributions to the plan.
 
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
 
 
 
41

 
 
 
 
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 the Registrant, incorporated by reference to
   
Exhibit (3)(i) to the Form 8-A filed with the Securities and Exchange
   
Commission on September 2, 1999
     
 
Exhibit (3)(ii)
Amended and Restated Bylaws of the Registrant, 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 (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 the Registrant
   
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 the Registrant
   
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
     
 
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 the Registrant
   
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
 
 
 
42

 
 
 
  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 the Registrant
   
and A. Joseph Lampron, Jr., 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, Jr. 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, Jr. 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
   
the Registrant, 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
     
 
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 the Registrant 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
 
 
 
43

 
 
 
  Exhibit (10)(m) Indenture, dated as of June 28, 2006, by and between the Registrant 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 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 (10)(p)
Underwriting Agreement with Merrill Lynch, Pierce, Fenner & Smith
   
Incorporated and Sandler O'Neill & Partners, L.P., as representatives of the
   
several underwriters listed on Schedule A thereto and the UST incorporated by
   
reference to Exhibit 1.1 to the Form 8-K filed with the Securities and Exchange
   
Commission on June 29, 2012
     
 
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, 2014, 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.
 
 
 
44

 
 
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 8, 2014
 
 /s/ Lance A. Sellers
Date
 
Lance A. Sellers
   
President and Chief Executive Officer
   
(Principal Executive Officer)
     
     
     
  August 8, 2014
 
 /s/ A. Joseph Lampron, Jr.
Date
 
A. Joseph Lampron, Jr.
   
Executive Vice President and Chief Financial Officer
   
(Principal Financial and Principal Accounting Officer)
 
 
 
 
 
45