SCMF Southern Community Financial Corp. (MM)

U.S. Securities and Exchange Commission

Washington, D.C. 20549

 

Form 10-K

 

x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the fiscal year ended December 31, 2011

 

¨ Transition Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from ____________ to ____________

 

Commission file number 000-33227

 

Southern Community Financial Corporation

(Exact name of registrant as specified in its charter)

 

North Carolina		56-2270620
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)
4605 Country Club Road
Winston-Salem, North Carolina		27104
(Address of principal executive offices)		(Zip Code)

 

Registrant's telephone number, including area code (336) 768-8500

 

Securities Registered Pursuant to Section 12(b) of the Exchange Act:

 

Title of each class		Exchange on which registered
Common Stock, No Par Value		NASDAQ Global Select Market
7.95% Cumulative Trust Preferred Securities		NASDAQ Global Select Market
7.95% Junior Subordinated Debentures		NASDAQ Global Select Market
Guarantee with respect to 7.95% Cumulative Trust Preferred Securities		NASDAQ Global Select Market

 

Securities Registered Pursuant to Section 12(g) of the Exchange Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes. ¨ No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter periods 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, a non-accelerated filer, or a smaller reporting company. See definitions of “accelerated and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨

Accelerated filer ¨

Non-accelerated filer ¨

Smaller reporting company x

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $17.2 million.

 

As of February 29, 2012, the registrant had outstanding 16,827,075 shares of Common Stock, no par value.

 

Documents Incorporated By Reference

 

Document		Where Incorporated
Proxy Statement for the Annual Meeting of Shareholders to be held May 23, 2012 to be mailed to shareholders within 120 days of December 31, 2011.		Part III

 

 

Form 10-K Table of Contents

 

Index				PAGE
PART I
	Item 1.	Business		3
	Item 1A.	Risk Factors		16
	Item 1B.	Unresolved Staff Comments		24
	Item 2.	Properties		25
	Item 3.	Legal Proceedings		26
	Item 4.	Mine Safety Disclosures		26
PART II
	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
		Purchases of Equity Securities		27
	Item 6	Selected Financial Data		29
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		31
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		68
	Item 8.	Financial Statements and Supplementary Data		68
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		132
	Item 9A.	Controls and Procedures		132
	Item 9B.	Other Information		132
PART III
	Item 10.	Directors, Executive Officers and Corporate Governance		133
	Item 11.	Executive Compensation		133
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related
		Stockholder Matters		133
	Item 13.	Certain Relationships and Related Transactions, and Director Independence		133
	Item 14.	Principal Accountant Fees and Services		133
PART IV
	Item 15.	Exhibits and Financial Statement Schedules		134

 

 

 

PART I

 

Item 1. Business

 

Who We Are

 

Southern Community Financial Corporation (“we,” “our,” “us,” Southern Community” or the “Company”) is the holding company for Southern Community Bank and Trust (the “Bank”), a community bank with twenty-two banking offices operating in nine counties throughout central and western North Carolina. The Bank commenced operations on November 18, 1996 and effective October 1, 2001 became a wholly-owned subsidiary of the Company. Our banking offices are located in the Piedmont Triad area (including Winston-Salem (our headquarters), Greensboro, High Point and surrounding areas), Mooresville (the Charlotte area), Raleigh and Asheville.

 

At December 31, 2011, the Company had total assets of $1.5 billion, net loans of $925.9 million, deposits of $1.2 billion and shareholders’ equity of $97.6 million. The Company had net income (loss) available to common shareholders of $520 thousand, ($25.7) million and ($65.7) million and diluted earnings (loss) per common share of $0.03, ($1.53) and ($3.91) for the years ended December 31, 2011, 2010 and 2009, respectively.

 

The Company has been, and intends to remain, a community-focused financial institution offering a full range of financial services to individuals, businesses and nonprofit organizations in the communities we serve. Our banking services include checking and savings accounts; commercial, installment, mortgage and personal loans; trust and investment services; safe deposit boxes and other associated services to satisfy the needs of our customers.

 

Over our fifteen years of existence, the Company has:

 

·

Established a reputation for superior service to our customers and the communities in which we operate;

·

Developed a full service financial institution operating in four of the fastest growing markets in North Carolina; and

·

Grown to fourth position in deposit market share in our home base of Forsyth County and seventh position in the aggregate in markets where we have a presence.

 

The website for the Bank is www.smallenoughtocare.com. Our periodic reports on Forms 10-Q and 10-K are available on our website under “Investor Relations.” In March 2011, the Company changed its status to a bank holding company. See “Supervision and Regulation” below. The Company and the Bank are organized under the laws of North Carolina. The Federal Deposit Insurance Corporation insures the Bank’s deposits up to applicable limits. The address of our principal executive office is 4605 Country Club Road, Winston-Salem, North Carolina 27104 and our telephone number is (336) 768-8500. Our common stock and one of our trust preferred security issues are traded on the NASDAQ Global Select Market System under the symbols “SCMF” and “SCMFO,” respectively.

 

Our Market Area

 

The Company’s primary market areas are the Piedmont Triad area of North Carolina, Mooresville (the Charlotte area), Asheville (Western Mountains of North Carolina) and Raleigh (in the Research Triangle region of the eastern Piedmont of North Carolina). The Piedmont Triad is a twelve county region located in north central North Carolina. The three largest cities in the region are: Winston-Salem (where our headquarters is located), Greensboro and High Point. The US Census Bureau showed North Carolina had a population growth of 18.5% for the decade concluding with the 2010 census. The US Census has projected that North Carolina will become the seventh most populous state by 2030 with over 12.2 million residents. As of July 2010, Winston-Salem is the largest city in Forsyth County and the fourth largest city in North Carolina according to the NC State Data Center. Greensboro is the largest city in Guilford County and the third largest city in North Carolina; while High Point is the second largest city in Guilford County and the ninth largest city in North Carolina according to the estimates of the NC Data Center. They estimated the July 2010 population of Forsyth County as 351,798 and the population of Guilford County as 490,371. The populations of Forsyth County and Guilford County are projected to grow to 475 thousand and 632 thousand, respectively, by 2030.

 

The Piedmont Triad is the economic hub of northwest North Carolina. For fiscal year 2012, the US Department of Housing and Urban Development estimated that the median family income ranged from a low of $48,900 in the Surry County area to a high of $62,000 in the Forsyth County area. Over 99% of the work force is employed in nonagricultural wage and salary positions. According to the NC Employment Security Commission, the major employment sectors for the year of 2010 were manufacturing (18.4%), healthcare (14.9%), government (13.8%), trade (13.1%), financial (6.8%) and construction (4.3%). According to the NC Employment Security Commission, the labor force in the Piedmont Triad exceeded 801 thousand in November 2011 and the unemployment rate through November 2011 varied from a low of 9.6% in November to a high of 10.8% in August.

 

 

The Raleigh-Cary metropolitan statistical area is the fastest growing metropolitan statistical area (MSA) in North Carolina. The 2010 census indicated that the population of Wake County is 900,993. The Wake County population is projected to grow to 1.47 million by 2030. The US Department of Housing and Urban Development estimated the area’s fiscal year 2012 median family income to be $79,900. According to the NC Employment Security Commission, the major employment sectors in the year of 2010 were government (18.2%), trade (13.4%), healthcare (10.5%), manufacturing (8.0%), financial (5.6%) and construction (5.4%). According to the NC Employment Security Commission, the labor force in the Raleigh-Cary MSA exceeded 566 thousand in November 2011 and the unemployment rate through November 2011 varied from a low of 7.8% in March and November to a high of 8.8% in August.

 

The Charlotte MSA is the third fastest growing MSA in North Carolina. The 2010 census indicated that the population of Mecklenburg County 919,628. The Mecklenburg County population is projected to grow to over 1.2 million by 2030. The US Department of Housing and Urban Development estimated the area’s fiscal year 2012 median family income to be $68,500. According to the NC Employment Security Commission, the major employment sectors in the year of 2010 were financial (13.9%), government (13.4%), trade (12.9%), healthcare (12.1%), manufacturing (8.8%) and construction (4.5%). According to the NC Employment Security Commission, the area’s labor force exceeded 842 thousand in November 2011 and the unemployment rate through November 2011 varied from a low of 10.0% in November to a high of 11.3% in June, July and August. Mooresville is located in the Lake Norman area, north of Charlotte.

 

Asheville is the largest city in Western North Carolina and the eleventh largest city in North Carolina. The 2010 census indicated that the population of Asheville is 83,393. The US Department of Housing and Urban Development estimated the median family income in the area to be $58,400 for fiscal year 2012. The Asheville MSA has a balanced and diversified economy. According to the US Bureau of Labor Statistics, the major employment sectors in the year of 2010 were education and health services (32.6%), government (19.5%), manufacturing (15.0%), retail (9.3%), leisure and hospitality (6.4%) and construction (4.6%). According to the NC Employment Security Commission, the Asheville MSA’s labor force exceeded 208 thousand in November 2011 and the unemployment rate through November 2011 varied from a low of 7.5% in November to a high of 8.9% in January.

 

The Bank serves our market areas through twenty-two full service banking offices. Our television and radio advertising has extended into our market areas for several years, providing the Bank name recognition. The Bank’s customers may access various banking services through over one hundred and fifty-five ATMs owned or leased by the Bank, through debit cards, and through the Bank’s automated telephone and Internet electronic banking products. These products allow the Bank’s customers to apply for loans, access account information and conduct various transactions from their telephones and computers.

 

Business Strategy

 

The Company’s overall long term objective is to continue to be a vital, long-standing community bank in our markets with a reputation for quality customer service provided by a financially sound organization. Our business strategy is to operate as a well capitalized institution that is strong in asset quality, profitable, independent, customer-oriented and connected to our community.

 

Southern Community Bank, along with others in our industry and our community, has been adversely impacted by the current and challenging economic cycle. During the past four years, we have concentrated our efforts on managing our problem assets. Our strategy during this economic downturn has been to focus on promptly identifying and resolving nonperforming loans and reducing our inventory of foreclosed real estate. Many of our borrowers were significantly affected by a weak economy, and we have been working closely with them during this economic downturn to achieve acceptable solutions.

 

 

 

Regardless of the impact of the economic cycle, a commitment to customer service remains the foundation of our approach. Our commitment is to put our customers first and we believe it differentiates us from our competitors. We intend to leverage the core relationships we build by providing a variety of services to our customers. With that focus, we target:

 

·

Small and medium sized businesses, and the owners and managers of these entities;

·

Professional and middle managers of locally based companies; and

·

Individual consumers.

 

Until the economy recovers more fully, we intend to concentrate on developing our existing markets. We will consider branching or acquisitions which make strategic and economic sense.

 

We have also diversified our revenue in order to generate non-interest income. These efforts include mortgage banking, wealth management and investment in Small Business Investment Company (SBIC) activities through Salem Capital Partners. Southern Community Advisors, our wealth management group, offers investment advisory, brokerage, trust and insurance services. For more information on the Company’s SBIC activities, see below under the heading “SUBSIDIARIES”. We believe that the profitability of these added businesses and services, not just the revenue generated, is critical to our long term success.

 

Key aspects of our strategy and mission include:

 

·

To maintain solid asset quality and remain well capitalized;

·

To provide community-oriented banking services by delivering a broad range of financial services to our customers through responsive service and communication;

·

To form a partnership with our customers whereby our decision making and product offerings are geared toward their best long-term interests;

·

To be recognized in our community as a long-term player with employees, stockholders and directors committed to that effort; and

·

To be progressive in our adoption of new technology so that we can provide our customers access to products and services that meet their needs for convenience and efficiency.

 

Our belief is that our way of doing business will continue to support a profitable corporation and grow shareholder value. We want to consistently reward our shareholders for their investment and trust in us.

 

Subsidiaries

 

In addition to those financial services offered by the Bank, the Company has two subsidiaries, Southern Community Capital Trust II (“Trust II”) and Southern Community Capital Trust III (“Trust III”), formed to issue trust preferred securities. Each subsidiary is described below.

 

In November 2003, Southern Community Capital Trust II publicly issued 3,450,000 shares of Trust Preferred Securities (“Trust II Securities”), generating gross total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase junior subordinated debentures from the Company under the same terms and conditions as the Trust II Securities. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital and to support the growth and operations of our subsidiary bank. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extends beyond the stated maturities of the debentures. Such deferral of interest payments by the Company results in a deferral of distribution payments on the related Trust II Securities. The Company has deferred the payment of interest on these securities since March 2011 and will continue to defer these quarterly payments until reestablished by management. Due to the non-payment of interest on the debentures, the Company is precluded from the payment of cash dividends to shareholders.

 

 

 

In June 2007, $10.0 million of trust preferred securities were placed through Southern Community Capital Trust III, a newly formed subsidiary of the Company, as part of a pooled trust preferred security. The Trust issuer invested the total proceeds from the sale of the trust preferred securities (the “Trust III Securities”) in junior subordinated deferrable interest debentures (the “Junior Subordinated Debentures”) issued by the Company. The terms of the trust preferred securities require payment of cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to LIBOR plus 1.43%. During 2008, the Company entered into an interest rate swap derivative contract with a counterparty that shifted this debt service from a variable rate to a fixed rate of 4.7% per annum. The payment of interest for these securities has also been deferred with the same provisions described above for Trust II securities. While interest to shareholders is deferred, required interest payments for the derivative contract has been, and will continue to be, paid. Despite the deferral of the quarterly payments on these Trust II and Trust III securities, the Company continues to accrue the cost of these obligations, which is recorded as interest expense. The Trust III Securities are redeemable in 30 years with a five year call provision. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The principal use of the net proceeds from the sale of the debentures was to provide additional capital into the Company to fund its operations and continued expansion, and to maintain the Company’s and the Bank’s status as “well capitalized” under regulatory guidelines.

 

The amount of the proceeds generated from the above offerings of trust preferred securities was $44.5 million. The amount of proceeds that qualify as Tier 1 capital cannot comprise more than 25% of our core capital elements. For us, this Tier 1 limit was $32.2 million at December 31, 2011. The $12.3 million in excess of that 25% limitation qualifies as Tier 2 supplementary capital on our books.

 

The Bank has interests in two unconsolidated entities (VCS Management LLC and SCP Advisor LLC) to house its investment in its SBIC activities. VCS Management, LLC was formed in March 2000 as the managing general partner of what is now known as Salem Capital Partners, L.P. (“SCP I”), a small business investment company (SBIC) licensed by the Small Business Administration. The Bank has invested $1.7 million in SCP I, which has a total of $9.2 million of invested capital from various private investors including the Bank. The partnership can also borrow funds on a non-recourse basis from the Small Business Administration to increase its funds available for investment. The partnership makes investments generally in the form of subordinated debt and earns revenue through interest received on its investments and potentially through gains realized from warrants that it receives in conjunction with its debt investments. The Bank shares in any earnings of the partnership through its investment in the partnership. During 2006, Salem Capital Partners II, L.P., now Salem Halifax Capital Partners, LP (“SHCP”), was formed and licensed by the Small Business Administration, with a purpose and operations similar to SCP I. Through December 31, 2011, the Bank has contributed 60%, or $1.2 million, of its $2.0 million capital commitment to SHCP. As of January 2012, SCP II has received $21.0 million, or 60%, of the total capital commitments of $35.0 million from various private investors, including the Bank. In connection with the formation of SHCP, a new entity, SCP Advisor LLC, was formed as the management company for both SCP I and SHCP with the Bank having 15% ownership. VCS Management, LLC is currently dormant and only receives the Bank’s portion of any carried interest from SCP I. For the year ended December 31, 2011, the Company had a net loss of $88 thousand from its SBIC activities, including income from the investments in SCP I and SCHP and SBIC management fees. The revenue stream from SBIC activities has been irregular over the past three years due to the impact of economic conditions on certain portfolio companies compared with substantial gains from the exit of certain portfolio investments during 2007.

 

Competition

 

The activities in which the Bank engages are highly competitive. Commercial banking in North Carolina is extremely competitive due to early adoption of state laws which permitted statewide branching. Consequently, many commercial banks have branches located in several communities. One of the largest regional commercial banks in North Carolina and one savings institution also have their headquarters in Winston-Salem. Currently, we operate branches in Buncombe, Forsyth, Guilford, Iredell, Rockingham, Stokes, Surry, Wake and Yadkin Counties, North Carolina. In June 2011, there were 737 branches operated by fifty banks and eleven savings institutions in these nine counties with approximately $56.2 billion in deposits. On that date, deposits of the Bank were $1.3 billion for a 2.23% market share. The top three deposit market share leaders in this market area account for 51.7% of deposits. Many of these competing banks have capital resources and legal lending limits substantially in excess of those available to the Bank. Therefore, in our market area, the Bank has significant competition for deposits and loans from other depository institutions.

 

 

 

Other financial institutions such as credit unions, consumer finance companies, insurance companies, brokerage companies, small loan companies and other financial institutions with varying degrees of regulatory restrictions compete vigorously for a share of the financial services market. Credit unions have been permitted to expand their membership criteria and expand their loan services to include such traditional bank services as commercial lending. These entities pose an ever increasing challenge to our efforts to serve the markets traditionally served by banks. We expect competition to continue to be significant.

 

Employees

 

During 2011, all employees of the Company were compensated by the Bank. At December 31, 2011, the Bank employed 290 full-time equivalent persons (including our executive officers). None of the employees are represented by any unions or similar groups, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be good and extremely important to our long-term success. The Board and management continually seek ways to enhance employee benefits and the well being of employees.

 

SUPERVISION AND REGULATION

 

On March 3, 2011, the Company applied with the Board of Governors of the Federal Reserve System (“Federal Reserve”) to change its status from a financial holding company to a bank holding company because it was no longer eligible to be a financial holding company due to the regulatory condition of the Bank. The Company had not utilized any of the powers to operate financial holding company non-bank subsidiaries. The Federal Reserve approved the Company’s change in status to a bank holding company on March 14, 2011. The Bank is a North Carolina chartered banking corporation which is not a member of the Federal Reserve. Banking is a complex, highly regulated industry. The primary goals of bank regulations are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The descriptions of and references to the statutes and regulations below are brief summaries and do not purport to be complete.

 

Southern Community Financial Corporation

 

As a bank holding company under the Bank Holding Company Act of 1956, as amended, we are registered with and subject to regulation by the Federal Reserve. We are required to file annual and other reports with, and furnish information to, the Federal Reserve. The Federal Reserve may conduct periodic examinations of the parent holding company and may examine any of its subsidiaries, including the Bank.

 

The Bank Holding Company Act provides that a bank holding company must obtain the prior approval of the Federal Reserve for the acquisition of more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. In addition, the Bank Holding Company Act restricts the extension of credit to any bank holding company by its subsidiary bank. The Bank Holding Company Act also provides that, with certain exceptions, a bank holding company may not engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries or own or control more than five percent of the voting shares of any company that is not a bank. The Federal Reserve has deemed limited activities to be closely related to banking and therefore permissible for a bank holding company.

 

Subject to various limitations, federal banking law generally permits a bank holding company to elect to become a “financial holding company.” A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are “financial in nature.” Among the activities that are deemed “financial in nature” are, in addition to traditional lending activities, securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, certain merchant banking activities as well as activities that the Federal Reserve considers to be closely related to banking.

 

 

A bank holding company may become a financial holding company if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. Formerly, Southern Community Financial Corporation elected, and was authorized by the Federal Reserve, to be a financial holding company until its recent application to cease its financial holding company status and become a bank holding company.

 

The Federal Reserve serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies are generally regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators and insurance activities by insurance regulators. Federal law imposes certain restrictions and disclosure requirements regarding private information collected by financial institutions.

 

Enforcement Authority . We will be required to obtain the approval of the Federal Reserve prior to engaging in or, with certain exceptions, acquiring control of more than 5% of the voting shares of a company engaged in any new activity. Prior to granting such approval, the Federal Reserve must weigh the expected benefits of any such new activity to the public (such as greater convenience, increased competition, or gains in efficiency) against the risk of possible adverse effects of such activity (such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices). The Federal Reserve has cease-and-desist powers over bank holding companies and their nonbanking subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. The Federal Reserve also has authority to regulate debt obligations (other than commercial paper) issued by bank holding companies. This authority includes the power to impose interest ceilings and reserve requirements on such debt obligations. A bank holding company and its subsidiaries are also prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

 

In connection with the Consent Order executed on February 25, 2011 with the FDIC and the North Carolina Commissioner of Banks (NCCOB), the Federal Reserve notified the Company’s management and Board of Directors in January 2011 that all dividends, common and preferred, and interest payments on trust preferred securities require prior approval of the Federal Reserve. On February 14, 2011, the Company announced that it had notified the US Department of the Treasury that it was suspending the payment of regular quarterly cash dividends on the preferred stock issued to the US Treasury. Additionally, the Company elected to defer the payment of regularly scheduled interest payments on both issues of junior subordinated debentures, relating to its outstanding trust preferred securities. Furthermore, on June 23, 2011, the Company entered into a Written Agreement with the Federal Reserve under which the Company has agreed to:

 

·

Act as a source of strength for the Bank;

·

Not declare or pay dividends on its, common and preferred, stock or make any distributions of interest or principal on trust preferred securities without the prior approval of the Federal Reserve;

·

Formulate and implement a written plan to maintain sufficient capital at the Company on a consolidated basis;

·

Not, directly or indirectly, incur, increase or guarantee any debt without the prior approval of the Federal Reserve; and

·

Not, directly or indirectly, purchase or redeem any shares of its stock without the prior approval of the Federal Reserve.

 

The Company has undertaken the following actions to comply with the Written Agreement:

 

·

In June 2011, the Company submitted its Capital Plan to maintain sufficient capital on a consolidated basis. As of December 31, 2011, the Company had consistently maintained regulatory capital ratios in excess of the submitted Capital Plan’s minimum level.

·

During the first quarter of 2011 and during the subsequent quarters, the Company suspended its regularly scheduled quarterly payments of interest on both issues of trust preferred securities and cash dividends on its preferred stock issued to the US Treasury.

 

 

 

Interstate Acquisitions . Federal banking law generally provides that a bank holding company may acquire or establish banks in any state of the United States, subject to certain deposit concentration limits. In addition, North Carolina banking laws permit a bank holding company that owns stock of a bank located outside North Carolina to acquire a bank or bank holding company located in North Carolina. In any event, federal banking law will not permit a bank holding company to own or control banks in North Carolina if the acquisition would exceed 20% of the total deposits of all federally-insured deposits in North Carolina.

 

Capital Adequacy . The Federal Reserve has promulgated capital adequacy regulations for all bank holding companies with assets in excess of $150.0 million. The Federal Reserve’s capital adequacy regulations are based upon a risk based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on- and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

 

The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.

 

Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies and a minimum leverage ratio of at least 4.0% for all other banks. As of December 31, 2011, the Company’s leverage capital ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.47%, 11.75% and 14.26%, respectively.

 

The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 2011, the Federal Reserve had not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable to us.

 

The Company’s trust preferred securities from Trust II, which are accounted for as debt under generally accepted accounting principles, presently qualify as Tier 1 regulatory capital to the limit of 25% of all core capital elements and are reported in Federal Reserve regulatory reports as minority interest in our consolidated subsidiaries. As of December 31, 2011, $32.2 million of the total $44.5 million in trust preferred securities counted as Tier 1 capital and the remaining $12.3 million as Tier 2 supplementary capital.

 

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company without restriction as the first three years of this agreement has passed. Effective February 14, 2011, the Company elected, and has continued, to defer the payment of these quarterly dividends to the United States Department of the Treasury. As of December 31, 2011, the Company owes the US Treasury $2.6 million in cumulative dividends. Once the Company has deferred payment of the quarterly preferred stock dividends for six or more quarters, the US Treasury may appoint up to two directors to the Company’s Board of Directors.

 

 

 

Source of Strength for Subsidiaries . Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

 

Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary bank. Our primary source of income is dividends paid by the Bank. We must pay all of our operating expenses from funds we receive from the Bank. North Carolina banking law requires that dividends be paid out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC. Therefore, shareholders may receive dividends from us only to the extent that funds are available at the holding company or from our subsidiary bank. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. The Federal Reserve may impose restrictions on the Company’s payment of cash dividends since we are required to maintain adequate regulatory capital of our own and are expected to serve as a source of financial strength and to commit resources to our subsidiary bank. As a condition of the issuance of Cumulative Perpetual Preferred Stock to the United States Treasury under the CPP, the Company must obtain the consent of the United States Treasury Department to increase the cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. On March 24, 2009, Southern Community Financial Corporation announced that its Board of Directors voted to suspend payment of a quarterly dividend to common shareholders. In January 2011, the Federal Reserve notified the Company that payment of all dividends and interest payments on trust preferred securities require prior approval of the Federal Reserve. The Board will determine when the payment of a quarterly cash dividend may be appropriate.

 

Change of Control. State and federal banking law restrict the amount of voting stock of the company that a person may acquire without the prior approval of banking regulators. The Bank Holding Company Act requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank, acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire us by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, our shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies .

 

Treasury Regulations. In June 2009, the United States Treasury Department adopted new rules to implement the requirements of the American Recovery and Reinvestment Act of 2009 which added a number of obligations to institutions that hold investments under the CPP, such as the Company, that are in addition to those agreed to by the Company at the time of the Treasury investment. Among other things, these rules require that the Compensation Committee of the Board meet at least every six months and undertake various reviews of the risks presented to the Company by its compensation practices ; increase the number of employees subject to clawback of incentive compensation in the event of inaccurate financial statements by the Company; prohibit the Company from paying any severance compensation to certain executives even where the Company has a contractual obligation to make those payments; limits the amount of incentive compensation payments to certain executives and only permits those payments in the form of restricted stock; requires the Company to permit a non-binding shareholder vote on the Company’s executive compensation; requires the Company to adopt an excessive or luxury expenditures policy; prohibits the Company from paying any tax gross-ups on compensation for certain executives; and requires the Company to identify a number of its most highly compensated employees.

 

 

 

The Bank

 

The Bank is subject to various requirements and restrictions under the laws of the United States and the State of North Carolina. As a North Carolina bank, our subsidiary bank is subject to regulation, supervision and regular examination by the NCCOB. The Bank is also subject to regulation, supervision and regular examination by the FDIC. The FDIC and the NCCOB have the power to enforce compliance with applicable banking statutes and regulations. These requirements and restrictions include requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and restrictions relating to investments and other activities of the Bank.

 

On February 25, 2011, the Bank entered into a Consent Order with the FDIC and the NCCOB. Under the terms of the Consent Order, the Bank agreed to develop and submit for approval written plans to: (1) strengthen Board oversight of the management and operations of the Bank; (2) comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital; (3) strengthen credit risk management practices; (4) reduce over a two-year period the Bank’s risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination; (5) reduce any undue concentration of credit in the Bank’s loan portfolio; (6) provide for improved management of the Bank’s funds management practices; and (7) identify and develop the Bank’s long-term strategic plan for asset growth, market focus, earnings projections, capital needs, and liquidity position.

 

In addition, the Bank agreed to: (1) notify the FDIC and NCCOB in writing when it proposes to make changes to the Bank’s directors or senior executive officers; (2) not make any distributions of interest or principal on subordinated debentures or declare or pay any dividends or bonuses without the prior written approval of the FDIC and NCCOB; (3) not undertake asset growth in excess of 10% or more per year or other material changes in asset and liability composition without prior notice to the FDIC and NCCOB; (4) not extend additional credit to or for the benefit of borrowers who have a loan that has been charged-off or adversely classified, in whole or in part, and is uncollected, except under certain circumstances and with the prior approval of a majority of the Board of Directors or a Board committee; (5) eliminate all assets classified as “loss” and 50% of those assets classified as “doubtful” in the Bank’s June 30, 2010 Report of Examination; (6) not accept, renew or rollover any brokered deposits without obtaining a waiver from the FDIC; (7) provide for the maintenance of an adequate allowance for loan losses; (8) strengthen lending and collection policies and provide for the ongoing internal loan review and grading of the Bank’s loan portfolio; and (9) eliminate or correct all deficiencies noted in the June 30, 2010 Report of Examination and ensure future compliance with applicable laws and regulations.

 

Under the Consent Order, the Board of Directors of the Bank must also retain an independent consultant to conduct an analysis and assessment of the Bank’s Board, management, key staff performance and related staffing needs. Following receipt of the consultant’s report, the Board was required to submit a management plan to the FDIC and the NCCOB that addresses the findings and recommendations in the report. Following its approval by the FDIC and NCCOB, the Board is required to implement and follow the management plan.

 

The foregoing description of the Consent Order is a summary of its material terms and does not purport to be a complete description of all of its terms.

 

In connection with the Consent Order executed with the FDIC and the NCCOB, the Federal Reserve notified the Company’s management and Board of Directors that all dividends, common and preferred, and interest payments on trust preferred securities require prior approval of the Federal Reserve. On February 14, 2011, the Company announced that it had notified the US Department of the Treasury that it was suspending the payment of regular quarterly cash dividends on the preferred stock issued to the US Treasury. Additionally, the Company elected to defer the payment of regularly scheduled interest payments on both issues of junior subordinated debentures, relating to its outstanding trust preferred securities.

 

The Bank has undertaken the following additional actions, among other things, to comply with the Consent Order:

 

·

The Bank has exceeded all minimum capital requirements of the Consent Order.

·

As of December 31, 2011, the Bank had reduced its risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination by an amount (42%) exceeding its scheduled reduction of 35% at its second measurement point (by the one year anniversary of the Consent Order, February 25, 2012).

 

 

 

·

The Bank retained an independent consultant who prepared a management plan, which was approved by the Board. The plan was submitted to, and approved by, the FDIC and the NCCOB.

·

By December 31, 2011, the Bank had eliminated all assets classified as “loss” and the appropriate portions of those assets classified as “doubtful” in the Bank’s June 30, 2010 Report of Examination.

·

The Bank approved and submitted a revised 2011 budget, its 2012 budget, its 2011 – 2013 Strategic Plan and the latest version of the Bank’s Credit Policy, incorporating revisions in response to Consent Order provisions.

·

Throughout the second half of 2010 and into 2011, the Bank has taken a number of measures to strengthen its credit risk management, including the staffing of a Special Assets Group to resolve problem credits and formal Board oversight of the internal loan review function.

·

The Board of Directors formulated a plan to address the findings and recommendations contained in the management assessment report prepared by an independent consultant. After the plan’s approval by the regulators, the Board has implemented many of the elements of the plan and some elements of the plan are in process of being implemented.

 

To date, management believes that the Company’s compliance efforts with the Consent Order have been satisfactory and within the scheduled time frames. Compliance efforts remain ongoing.

 

Transactions with Affiliates . The Bank may not engage in specified transactions (including, for example, loans) with its affiliates unless the terms and conditions of those transactions are substantially the same or at least as favorable to the Bank as those prevailing at the time for comparable transactions with or involving other nonaffiliated entities. In the absence of comparable transactions, any transaction between the Bank and its affiliates must be on terms and under circumstances, including credit standards, which in good faith would be offered or would apply to nonaffiliated companies. In addition, transactions referred to as “covered transactions” between the Bank and its affiliates may not exceed 10% of the Bank’s capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. The Bank also is prohibited from purchasing low quality assets from an affiliate. Every company under common control with the Bank, including the Company and Southern Community Capital Trust II and Trust III, is deemed to be an affiliate of the Bank.

 

Loans to Insiders . Federal law also constrains the types and amounts of loans that the Bank may make to its executive officers, directors and principal shareholders. Among other things, these loans are limited in amount, must be approved by the Bank’s board of directors in advance, and must be on terms and conditions as favorable to the Bank as those available to an unrelated person.

 

Regulation of Lending Activities . Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies to the borrower or consumer and penalties to the Bank are provided if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.

 

Branch Banking . All banks located in North Carolina are authorized to branch statewide. Accordingly, a bank located anywhere in North Carolina has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within our market area. If other banks were to establish branch facilities near our facilities, it is uncertain whether these branch facilities would have a material adverse effect on our business.

 

Federal law provides for nationwide interstate banking and branching, subject to certain deposit concentration limits that may be imposed under applicable state laws. Applicable North Carolina statutes permit regulatory authorities to approve de novo branching in North Carolina by institutions located in states that would permit North Carolina institutions to branch on a de novo basis into those states. Federal regulations prohibit an out-of-state bank from using interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to ensure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the host state communities served by the out-of-state bank.

 

 

 

Reserve Requirements. Pursuant to regulations of the Federal Reserve, the bank must maintain average daily reserves against its transaction accounts. Beginning in October 2008, the Federal Reserve paid interest on balances in excess of a financial institution’s reserve requirement. During 2011, no reserves were required to be maintained on the first $10.7 million of transaction accounts, but reserves equal to 3.0% were required on the aggregate balances of those accounts between $10.7 million and $58.8 million, and additional reserves were required on aggregate balances in excess of $58.8 million in an amount equal to 10.0% of the excess. These percentages are subject to annual adjustment by the Federal Reserve, which has advised that for 2012, no reserves will be required to be maintained on the first $11.5 million of transaction accounts, but reserves equal to 3.0% will be required on the aggregate balances of those accounts between $11.5 million and $71.0 million, and additional reserves are required on aggregate balances in excess of $71.0 million in an amount equal to 10.0% of the excess. Because required reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets and interest income. As of December 31, 2011, the Bank met its reserve requirements.

 

Community Reinvestment . Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the Bank’s records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The Bank received a “satisfactory” rating in its most recent CRA examination.

 

Governmental Monetary Policies . The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates are some of the monetary policies available to the Federal Reserve. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid for deposits.

 

The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.

 

Dividends . All dividends paid by the Bank are paid to the Company, the sole shareholder of the Bank. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving our applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the Board of Directors of the Bank and will depend upon such factors as future earnings, growth, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements (including those in the Consent Order) and general business conditions. In connection with the Board’s March 24, 2009 decision to suspend the Company’s quarterly cash dividends to common shareholders, the Board suspended the Bank’s quarterly cash dividends to the Company. In lieu of Bank dividends, the Company utilized some of its cash resources obtained from its issuance of preferred stock through the Treasury’s CPP to fund its expenses and debt obligations.

 

As well as the restriction on the payment of dividends contained in the recent Consent Order discussed above, the ability of the Bank to pay dividends is restricted under applicable law and regulations. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

 

 

 

The exact amount of future dividends paid to the Company by the Bank will be conditioned upon the Consent Order and its restrictions being lifted and thereafter will be a function of the profitability of the Bank in general and applicable tax rates in effect from year to year. The satisfaction and lifting of the current regulatory restrictions and the restoration of sufficient future Bank profitability cannot be accurately estimated or assured.

 

Capital Adequacy . At December 31, 2011, the Company’s consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.47%, 11.75% and 14.26%, respectively, which exceeded the minimum requirements for a “well-capitalized” bank holding company. As of December 31, 2011, the Bank’s leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 9.07%, 12.59% and 13.85%, respectively. The Consent Order, as set forth above, requires the Bank to achieve and maintain minimum capital requirements of 8% Tier 1 (leverage) capital and 11% total risk-based capital. Our capital position has been consistently in excess of our regulatory capital requirements pursuant to the Consent Order. In addition to utilizing balance sheet shrinkage through net loan run-off and the reduction in brokered deposits and ways to improve Bank profitability, the Company is currently considering various strategies such as: asset sales, plans for capital injections, and taking action to restructure the risk weighting of assets in order to maintain compliance with the terms of the Consent Order. As of December 31, 2011, the parent holding company had $5.6 million in cash available to be invested into the Bank to bolster capital levels. The ability to accomplish some of these goals is significantly constricted by the current economic environment. As has been widely publicized, access to capital markets is extremely limited in the current economic environment, and there can be no assurances that the Company will be able to access any such capital or sell assets.

 

Given the current regulatory environment and recent legislation such as the Dodd-Frank Act, our regulatory burden could increase. Such actions could result in a material impact on the Company and could include requirements for higher regulatory capital levels and various other restrictions.

 

Changes in Management. Any depository institution that has been chartered less than two years, is not in compliance with the minimum capital requirements of its primary federal banking regulator, or is otherwise in a troubled condition must notify its primary federal banking regulator of the proposed addition of any person to the Board of Directors or the employment of any person as a senior executive officer of the institution at least 30 days before such addition or employment becomes effective. During this 30-day period, the applicable federal banking regulatory agency may disapprove of the addition of such director or employment of such officer. As a provision of the Consent Order discussed above, the Bank is subject to these requirements.

 

Enforcement Authority . The federal banking laws also contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse affect on the institution, who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. As disclosed above, the Consent Order contains provisions, among others, that restrict the Bank’s growth and require reductions in the Bank’s adversely classified assets as shown in the Bank’s Report of Examination as of June 30, 2010.

 

Prompt Corrective Action. Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital. Under these regulations, a bank is deemed to be “well capitalized” if it has a total risk-based capital ratio of ten percent or more, a core capital ratio of six percent or more and a leverage ratio of five percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level, as is the case with the Bank. Under these regulations, a bank is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of eight percent or more, a core capital ratio of four percent or more and a leverage ratio of four percent or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of three percent or more). Under these regulations, a bank is deemed to be “undercapitalized” if it has a total risk-based capital ratio of less than eight percent, a core capital ratio of less than four percent or a leverage ratio of less than three percent. Under these regulations, a bank is deemed to be “significantly undercapitalized” if it has a risk-based capital ratio of less than six percent, a core capital ratio of less than three percent and a leverage ratio of less than three percent. Under such regulations, a bank is deemed to be “critically undercapitalized” if it has a leverage ratio of less than or equal to two percent. In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (but not to “critically undercapitalized”) based on other considerations even if the bank meets the capital guidelines.

 

 

If a state bank, such as the Bank, is classified as undercapitalized, the bank is required to submit a capital restoration plan to the FDIC. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the FDIC of a capital restoration plan for the bank.

 

If a state bank were classified as undercapitalized, the FDIC may take certain actions to correct the capital position of the bank. If a state bank is classified as significantly undercapitalized, the FDIC would be required to take one or more prompt corrective actions. These actions would include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. If a bank is classified as critically undercapitalized, the bank must be placed into conservatorship or receivership within 90 days, unless the Federal Deposit Insurance Corporation determines otherwise.

 

The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank. The FDIC is required to conduct a full-scope, on-site examination of every member bank on a periodic basis.

 

Banks also may be restricted in their ability to accept brokered deposits, depending on their capital classification. “Well capitalized” banks are permitted to accept brokered deposits, but all banks that are not well capitalized are not permitted to accept such deposits. The FDIC may, on a case-by-case basis, permit member banks that are adequately capitalized to accept brokered deposits if the FDIC determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank. As disclosed above, under the terms of the Consent Order, the Bank will not accept, renew or rollover any brokered deposit without a waiver from the FDIC. As of December 31, 2011, the Bank has $147.6 million of brokered certificates of deposit or 12.5% of total deposits.

 

Deposit Insurance. FDIC-insured banks are required to pay deposit insurance premium assessments to the FDIC . The FDIC has adopted a risk-based assessment system whereby FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. The FDIC recently raised assessment rates to increase funding for the DIF to restore the DIF to target levels.

 

The Dodd-Frank Act makes permanent the general $250,000 deposit insurance limit for insured deposits. In addition, federal deposit insurance for the full net amount of deposits in noninterest-bearing transaction accounts was extended to January 1, 2013 for all insured banks.

 

The Dodd-Frank Act changes the deposit insurance assessment framework, primarily by basing assessments on an institution’s total assets less tangible equity rather than domestic deposits, which is expected to shift a greater portion of the aggregate assessments to large banks, as described in detail below. The Dodd-Frank Act also eliminates the upper limit for the reserve ratio designated by the FDIC each year, increases the minimum designated reserve ratio of the Deposit Insurance Fund (“DIF”) from 1.15% to 1.35% of the estimated amount of total insured deposits by September 30, 2020 and eliminates the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds.

 

 

 

The Dodd-Frank Act requires the DIF to reach a reserve ratio of 1.35% of insured deposits by September 30, 2020. On December 20, 2010, the FDIC raised the minimum designated reserve ratio of DIF to 2%. The ratio is higher than the minimum reserve ratio of 1.35% as set by the Dodd-Frank Act. Under the Dodd-Frank Act, the FDIC is required to offset the effect of the higher reserve ratio on insured depository institutions with consolidated assets of less than $10 billion.

 

On February 7, 2011, the FDIC adopted a revised approach to the assessment of deposit insurance premiums. The final rule, mandated by the Dodd-Frank Act, changes the deposit insurance assessment system from one that is based on domestic deposits to one that is based on average consolidated total assets minus average tangible equity. Because the new assessment base under the Dodd-Frank Act is larger than the current assessment base, the final rule’s assessment rates are lower than the current rates, which achieves the FDIC’s goal of not significantly altering the total amount of revenue collected from the industry. In addition, the final rule suspends dividend payments if the DIF reserve ratio exceeds 1.5% but provides for decreasing assessment rates when the DIF reserve ratio reaches certain thresholds. The final rule also determines how the effect of the higher reserve ratio will be offset for institutions with less than $10 billion of consolidated assets.

 

Annual Disclosure Statement

 

This statement has not been reviewed for accuracy or relevance by the Federal Deposit Insurance Corporation.

 

Item 1A. Risk Factors

 

An investment in our common stock involves risk. Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-K and information incorporated by reference in this Form 10-K, including our consolidated financial statements and related notes. If any of the following risks or other risks which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. This could cause the price of our stock to decline and shareholders could lose part or all of their investment. This Form 10-K contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions and expectations. Many factors, including those described below, could cause actual results to differ materially from those discussed in our forward-looking statements.

 

Risks Related to Holding Southern Community Common Stock

 

If we fail to comply with regulatory orders effectively, it would negatively affect our financial condition and results of operations.

 

We intend to continue to address the issues raised by our regulators in connection with the Consent Order we executed with the FDIC and the NCCOB on February 25, 2011. The Consent Order requires us to report to the regulators at least quarterly on our efforts to address, among other things, the management and oversight of the Bank, a reduction in the Bank’s classified assets and concentrations of credit, and an improvement in the Bank’s earnings. We have substantially complied with the Consent Order provisions over the past year, including:

 

·

Maintaining capital in excess of regulatory imposed minimum levels;

·

Reduced classified assets (as contained in the June 30, 2010 Report of Examination) in the aggregate in excess of the benchmarks set in the Consent Order;

·

Significantly reduced our reliance on brokered deposits to 12.5% of total deposits at December 31, 2011 (and expect our brokered deposits to be less than 10% of total deposits by March 31, 2012);

·

Improving Bank profitability; and

·

Formulated a plan to address the recommendations in the management assessment report prepared by an independent consultant. After being approved by the FDIC/NCCOB, this plan is in process of being implemented.

 

 

 

While the provisions of the Consent Order remain in effect, our prospects to continue to comply and have these regulatory restrictions lifted must be evaluated in light of the continued risks, expenses and difficulties in addressing these issues.

 

Our ability to achieve the goal of lifting the Consent Order will depend on a variety of factors including the continued availability of desirable and profitable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our responses to these issues. Failure to comply with the requirements of the Consent Order could result in further adverse regulatory action and restrictions on our activities which could have a material adverse effect on our business, future prospects, financial condition or results of operations.

 

Given the current depressed market value of our common stock, if we were required to raise additional capital, it could have a dilutive effect on the existing holders of our common stock and adversely affect the market price of our common stock.

 

As of December 31, 2011, we had 13,172,925 shares of additional authorized common stock available for issuance, and 957,250 shares of additional authorized preferred shares available for issuance. We are not restricted from issuing additional authorized shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, our common stock. We, as well as our banking regulators, continue to regularly perform a variety of capital analyses, including the preparation of stress case scenarios, taking into account our regulatory capital ratios, financial condition, and other relevant considerations. If it becomes appropriate in order to maintain or increase our capital levels, we may opportunistically issue in public or private transactions additional shares of common stock or other securities that are convertible into, or exchangeable for, or that represent the right to receive, our common stock. There could also be market perceptions that we need to raise additional capital, and regardless of the outcome of any stress test or other stress case analysis, such perceptions could have an adverse effect on the price of our common stock. Shareholders of our common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series. Therefore, the issuance of any additional shares of common stock or securities convertible into or exchangeable for common stock or that represent the right to receive common stock, or the exercise of such securities, could be substantially dilutive to existing common shareholders. The market price of our common stock could also decline as a result of sales or in anticipation of such sales.

 

Failure to maintain adequate capital could have a material adverse effect on our operations.

 

Given current economic conditions, capital resources may not be available at all or on terms acceptable to the Company if it becomes necessary in order to maintain our capital levels at or above the minimum level specified in the Consent Order (see “Supervision and Regulation”). If the Bank fails to comply with the minimum capital levels in the Consent Order, the Bank may be subject to further restrictions. An undercapitalized bank is subject to various restrictions depending on the extent of the lack of capital. A bank may be prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the FDIC of a capital restoration plan for the bank. Therefore, failure to maintain adequate capital could have a material adverse effect on our operations.

 

Continued slow economic growth in our market area could adversely affect our financial condition and results of operations .

 

Economic growth and migration into our market areas in North Carolina has slowed significantly and our real estate markets have been subject to a significant decline in value. In prior years, these markets experienced substantial growth in population, new business formation, and residential real estate sales activity. A significant amount of our growth was based upon our loans to residential builders. Current economic conditions have resulted in a decrease in residential real estate sales activity in our markets, which has limited our lending opportunities and negatively affected our loan portfolio and earnings. We do not anticipate that the housing market will improve significantly in the near term, and accordingly, this could lead to additional valuation adjustments on our loan portfolio. A prolonged period of slow economic growth could have a further material adverse effect on our business, results of operations and financial condition.

 

 

 

Failure to effectively manage our credit risk may adversely affect our financial condition or results of operation.

 

There are risks inherent in making any loan, including risks with respect to the period of time over which the loan may be repaid, risks resulting from changes in economic and industry conditions, risks inherent in dealing with individual borrowers and risks resulting from uncertainties as to the future value of collateral. The risk on non-payment of loans is inherent in commercial banking. We cannot assure you that our credit approval procedures and loan monitoring procedures will adequately reduce these lending risks. We cannot assure you that our credit administration personnel, policies and procedures will adequately adapt to changes in economic or any other conditions affecting our customers or the quality of our loan portfolio. Declines in the net worth of our borrowers or the value of their loan collateral could have a continued material adverse effect on our results of operations and financial condition.

 

Further declines in the value of commercial and residential real estate may adversely affect our financial condition or results of operation.

 

Our real estate lending activities, and the exposure to fluctuations in commercial and residential real estate values, are significant. At December 31, 2011, approximately 85.4% of the Bank’s loans had real estate as a primary or secondary component of collateral. The market value of real estate can fluctuate significantly in a relatively short period of time as a result of market conditions in the geographic area in which the real estate is located. We have been adversely impacted by the decline in real estate values in our market during 2011. These declines in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions that have relatively lower concentrations of real estate secured loan portfolios. If the value of the real estate serving as collateral for our loan portfolio continues to decline materially, a significant part of our loan portfolio could become under-collateralized and we may not be able to realize the amount of security that we anticipated at the time of originating the loan. The inability of purchasers of real estate, including residential real estate, to obtain financing may weaken the financial condition of our borrowers dependent on the sale or refinancing of the property. If we restructure loans to improve the prospects of collectability, such actions may require loans to be treated as troubled debt restructurings, or non-performing loans which could adversely affect the adequacy of our allowance for loan losses and our capital. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Foreclosed real estate may decline in value and we may be required to liquidate such assets at discounts to their appraised values. Declines in the value of commercial and residential real estate in our markets could continue to have a material adverse effect on our results of operations and financial condition.

 

Our construction loans are subject to additional lending risks that could adversely affect earnings.

 

As of December 31, 2011, approximately 15.0% of our total loan portfolio was comprised of construction, acquisition and development loans. In the event of a continuing general economic slowdown, these loans may have additional risk due to the borrower’s inability to repay on a timely basis. In addition to the normal repayment risk and potential decreases in real estate values, construction lending may pose additional risks that affect repayment and the value and marketability of real estate collateral, such as:

 

·

Developers, builders or owners may fail to complete or develop projects;

·

Developers, builders, or owners may experience a decline in liquidity and secondary sources of repayment;

·

Municipalities may place moratoriums on building, utility connections or required certifications;

·

Developers may fail to sell the improved real estate;

·

There may be construction delays and cost overruns;

·

Loans with rising variable rates may experience increases in the borrower’s payments on the loan at a time when the borrower’s income is under stress;

·

Collateral may prove insufficient;

·

Permanent financing may not be obtained in a timely manner; or

·

Economic conditions may negatively impact demand for our borrower’s product.

 

Any of these conditions could negatively affect collectability, our net income and our financial condition.

 

 

 

Our financial condition or results of operation may be adversely affected if we experience higher loan losses that we have provided for in our allowance for loan losses.

 

Our reliance on historic loan loss experience and other assumptions related to our assessment of the adequacy of our allowance for loan losses may not be warranted under the current economic situation. Approximately 69.4% of our loan portfolio is composed of construction, commercial mortgage and commercial loans. Repayment of such loans is generally considered subject to greater credit risk than residential mortgage loans. Historic loan losses may not be a sufficient guide given the current economic environment. Losses may be experienced as a result of various factors beyond our control, including, among other things, overall economic conditions, changes in market conditions affecting the value of our loan collateral and problems affecting the credit of our borrowers. If our loan losses are more than what we have provided for in our loan loss assumptions, those losses could negatively affect our earnings.

 

Our financial condition or results of operation may be adversely affected if our controls and procedures fail or are circumvented.

 

Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure to circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations or financial condition.

 

If Southern Community loses key employees with significant business contacts in its market area, its business may suffer.

 

Southern Community’s success is dependent on the personal contacts of its officers and employees in its market area. If Southern Community lost key employees temporarily or permanently, its business could be hurt. Southern Community could be particularly hurt if its key employees went to work for competitors. Southern Community’s future success depends on the continued contributions of its existing senior management personnel, particularly on the efforts of F. Scott Bauer and Jeff T. Clark, each of whom has significant local experience and contacts in its market area. While we have entered into employment agreements with certain key employees, we cannot assure you that we will be successful in retaining those or other key employees.

 

Due to recent regulatory restrictions on us, we may be unable to pay future cash dividends or other obligations of the Company, which may have a material adverse effect on our stock price.

 

Our Board of Directors discontinued cash dividends on our common stock during 2009 in order to conserve our capital. Our ability to pay cash dividends is limited by regulatory restrictions and the need to maintain sufficient capital. In connection with the Consent Order (see “Supervision and Regulation”), the Company is restricted from paying any dividends, common and preferred, and interest payments on trust preferred securities without Federal Reserve approval. Since the parent company has no operations, we are dependent upon our bank subsidiary as the operating company as a source of funds to pay future cash dividends. Under the provisions of the Consent Order with the FDIC and the NCCOB (see “Supervision and Regulation”), the Bank shall not declare or pay dividends without prior regulatory approval. As announced on February 17, 2011, the Company has suspended the payment of quarterly cash dividends on the preferred stock issued to the US Treasury and has deferred its quarterly interest payments on trust preferred securities to preserve cash resources at the holding company level. However, after the deferral of six quarterly payments to the US Treasury, we are subject to the contractual imposition of conditions by the US Treasury, including the election of two new board members by the US Treasury. The inability to pay cash dividends or the imposition of conditions by the US Treasury for failure to pay preferred stock dividends could have a material adverse effect on our stock price.

 

Our trading volume has been low compared with larger bank holding companies which may cause the market price of our stock to be more volatile.

 

The average daily trading volume of our shares on the NASDAQ Global Select Market for the three months ended February 29, 2012 was approximately 19,862 shares. Lightly traded stock can be more volatile than stock trading in an active public market like that for larger bank holding companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of a significant number of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. In recent years, the stock market has experienced a high level of price and volume volatility and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance. Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

 

 

 

Our financial condition or results of operation may be adversely affected if we are required to pay significantly higher FDIC deposit insurance premiums and assessments in the future.

 

Recent insured depository institution failures, as well as deterioration in banking and economic conditions, have significantly increased the loss provisions of the FDIC, resulting in a decline in the designated reserve ratio of the Deposit Insurance Fund to historical lows. The FDIC expects a higher rate of insured depository institution failures in the next few years compared to recent years. Therefore, the reserve ratio may continue to decline. In addition, the deposit insurance limit on FDIC deposit insurance coverage generally has increased to $250,000, which may result in even larger losses to the Deposit Insurance Fund. These developments have caused an increase to our FDIC insurance premium assessments, and the FDIC may be required to make additional increases to the assessment rates or to levy additional special assessments on us. As a result of the Consent Order, our FDIC insurance premium assessment has increased significantly (See “Supervision and Regulation”). Higher insurance premiums and assessments increase our costs and limit our ability to pursue certain business opportunities. We are unable to predict the impact in future periods, including whether and when additional special assessments will occur. Significant additional FDIC insurance premium assessments could have a material adverse effect on our results of operations or financial condition.

 

Failure to realize our deferred tax asset could have a material adverse effect on our capital.

 

We calculate income taxes in accordance with accounting principles generally accepted in the United States (“US GAAP”), which requires the use of the asset and liability method. The largest component of our net deferred tax asset at December 31, 2011 was related to the activity in our allowance for loan losses. In accordance with US GAAP, we regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered. Based upon our analysis of our tax position, including taxes paid in prior years available through carryback and the use of tax planning strategies, we maintained a valuation allowance of $14.4 million as of December 31, 2011 to properly state our ability to realize our deferred tax assets. Realization of a deferred tax asset requires us to apply significant judgment and is inherently speculative because it may require the future occurrence of circumstances that cannot be predicted with certainty. The realizability of the net deferred tax asset of $2.1 million at December 31, 2011 is substantially based on the offset of deferred tax liabilities and tax planning strategies.

 

We face strong competition in our market areas, which may limit our asset growth and profitability.

 

The banking business in our primary market areas, in North Carolina, is very competitive. We experience competition in both lending and attracting funds from other banks and nonbank financial institutions located within our market areas. Some of our banking competitors are significantly larger, well-established institutions. Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, securities firms, money market funds, life insurance companies and the mutual funds. For loans, we encounter competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts and securities firms. We face a competitive disadvantage as a result of our smaller size, lack of multi-state geographic diversification and inability to spread our marketing costs across a broader market. This competition may limit our asset growth and profitability. The Consent Order restricts our asset growth without prior regulatory approval.

 

 

 

In addition to regulatory restrictions on the payment of dividends, government regulations may prevent or impair our ability to engage in acquisitions or operate in other ways.

 

We are subject to supervision and periodic examination by the Federal Reserve Board and the North Carolina Commissioner of Banks. Our principal bank subsidiary, Southern Community Bank and Trust, as a state chartered commercial bank, also receives regulatory scrutiny from the North Carolina Commissioner of Banks and the FDIC. In addition to the regulatory restrictions contained in the terms of the Consent Order (see “Supervision and Regulation”), banking regulations, designed primarily for the protection of depositors, may limit the return to you as an investor, by restricting our activities, such as:

 

·

Desired investments;

·

Loans we can make;

·

The possible expansion of branch offices; and

·

Possible transactions with or acquisitions by other institutions.

 

We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our business. The cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.

 

The US Treasury has the right to elect two directors to the Board if we defer more than six quarterly cash dividends on the preferred stock held by the US Treasury.

 

On February 14, 2011, the Company announced that it had notified the US Department of the Treasury that it was suspending the payment of regular quarterly cash dividends on the preferred stock issued to the US Treasury. If we defer more than six quarterly payments to the US Treasury, then the US Treasury will have the right to elect two new board members. Directors elected by the US Treasury may not have the same interests as other shareholders and may desire the Company to take certain actions not supported by other shareholders. We can give no assurances that directors elected to represent the US Treasury would be supportive of our management’s business plans or the interests of other shareholders. Therefore, the election of directors to represent the US Treasury could have a material adverse effect on our business or the direction of its future prospects.

 

Our Articles of Incorporation include anti-takeover provisions that may prevent shareholders from receiving a premium for their shares or effecting a transaction favored by a majority of shareholders.

 

Our Articles of Incorporation include certain anti-takeover provisions, such as being subject to the Shareholder Protection Act and Control Share Acquisition Act under North Carolina law and a provision allowing our Board of Directors to consider the social and economic effects of a proposed merger, which may discourage a change of control of the Company by allowing minority shareholders to prevent a transaction favored by a majority of the shareholders. The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our Company. These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director. These provisions may have the effect of preventing shareholders from receiving a premium for their shares of common stock in a change of control transaction.

 

Holders of our trust preferred securities have rights that are senior to those of our common shareholders.

 

We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures. At December 31, 2011, we had outstanding trust preferred securities and accompanying junior subordinated debentures totaling $44.5 million. Payments of the principal and interest on the trust preferred securities of this special purpose trust are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures we issued to the special purpose trust are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. In February 2011, the Company elected to defer regularly scheduled interest payments on both issues of junior subordinated debentures, related to our outstanding trust preferred securities. We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock.

 

 

 

Our common stock is not FDIC insured.

 

Our common stock is not a savings or deposit account or other obligation of any bank and is not insured by the Federal Deposit Insurance Corporation, the Deposit Insurance Fund or any other governmental agency and is subject to investment risk, including the possible loss of principal.

 

Risks Related to an Investment in the Trust II and Trust III Securities

 

If we do not make interest payments under the debentures, the trust will be unable to pay distributions and liquidation amounts. The guarantee would not apply because the guarantee covers payments only if the trust has funds available.

 

Trust II will depend solely on our payments on the debentures to pay amounts due to holders of the Trust II Securities on the debentures. Without these payments, the trust will not have sufficient funds to pay distributions or the liquidation amount on the Trust II and Trust III Securities. In that case, holders of these securities will not be able to rely on the guarantee for payment of these amounts because the guarantee only applies if the trust has sufficient funds to make distributions or to pay the liquidation amount. Instead, holders of these securities or the property trustee will have to institute a direct action against us to enforce the property trustee’s rights under the indenture relating to the debentures.

 

Under the terms of the Consent Order, we are not allowed to pay dividends from our bank subsidiary to our holding company to fund interest payments on the debentures to the trust.

 

Prior to the issuance of the Consent Order (see “Supervision and Regulation”), ability to make payments on the debentures when due depended primarily on dividends received from our bank subsidiary because we are a holding company and substantially all of our assets are held by our bank subsidiary. In addition, the holding company has utilized some of the proceeds from the Treasury’s preferred stock investment to make interest payments under the debentures during periods when the bank subsidiary has been restricted from paying dividends to the holding company due to reduced profitability. The ability of our bank subsidiary to pay dividends is currently subject to regulatory restrictions. If these regulatory restrictions are lifted or waived, the bank subsidiary’s ability to pay dividends will be subject to the Bank’s profitability, financial condition, capital adequacy and cash flow requirements. The Company is required to obtain prior approval from regulatory bodies to borrow additional funds, issue debt instruments, issue and sell shares of preferred stock or engage in other types of financing activities at the holding company level.

 

Our obligation to make interest payments to the trust on the debentures is subordinated to existing liabilities or additional debt we may incur.

 

Our obligations under the debentures and the guarantee are unsecured and will rank junior in priority of payment to our existing liabilities and any future senior and subordinated indebtedness. Also, because we are a holding company, the creditors of our bank subsidiary, including depositors, also will have priority over holders of the Trust II Securities in any distribution of our subsidiaries’ assets in liquidation, reorganization or otherwise. Accordingly, the debentures and the guarantee will be effectively subordinated to all existing and future liabilities of our subsidiaries, and holders of the Trust II and Trust III Securities should look only to our assets for payments on these obligations of the Company .

 

We have the option to defer interest payments on the debentures for substantial periods.

 

As we announced in February 2011, we have elected to defer interest payments on the debentures. As long as we are not in default under the indenture relating to the debentures, we may, at one or more times, defer interest payments on the debentures for up to 20 consecutive quarters. If we defer interest payments on the debentures, the trust will defer distributions on the Trust II and Trust III Securities during any deferral period.

 

 

As we defer interest payments, holders of the Trust II and Trust III Securities will still be required to recognize the deferred interest amounts as income.

 

During a deferral period, holders of the Trust II and Trust III Securities will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on their proportionate share of the debentures, held by the trust in the tax year in which that interest accrues, even though holders of these securities will not receive these amounts until a later date if they hold these securities until the deferred interest is paid.

 

If holders of the Trust II and Trust III Securities sell their securities during a deferral period, they will forfeit the deferred interest amount and only have a capital loss.

 

Holders of the Trust II and III Securities will not receive the cash related to any accrued and unpaid interest from the trust if they sell these securities before the end of any deferral period. During a deferral period, accrued but unpaid distributions will increase their tax basis in these securities. If holders of these securities sell the securities during a deferral period, their increased tax basis will decrease the amount of any capital gain or increase the amount of any capital loss that they may have otherwise realized on the sale. A capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income. As a result, deferral of distributions could result in ordinary income and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain.

 

Deferrals of interest payments may increase the volatility of the market price of the Trust II and Trust III Securities .

 

As we defer interest payments, the market price of the Trust II and Trust III Securities will likely be adversely affected. The Trust II and Trust III Securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the debentures. If holders of these securities sell the securities during a deferral period, they may not receive the same return on investment as someone who continues to hold these securities. Because of our right to defer interest payments, the market price of these securities may be more volatile than the market prices of other securities without a deferral feature.

 

There are no financial covenants in the indenture and the trust agreement.

 

The indenture governing the debentures and the trust agreement governing the trust do not require us to maintain any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity. The instruments do not protect holders of the debentures or the Trust II and Trust III Securities in the event we experience significant adverse changes in our financial condition or results of operations. In addition, neither the indenture nor the trust agreement limits our ability or the ability of any subsidiary to incur additional indebtedness. Therefore, holders of these securities should not consider the provisions of these governing instruments as a significant factor in evaluating whether we will be able to comply with our obligations under the debentures or the guarantee.

 

We may not redeem the Trust II or the Trust III Securities without the consent of the US Treasury until we redeem the preferred stock we sold to the Treasury or the Treasury transfers ownership of the preferred stock.

 

The Company has issued Cumulative Perpetual Preferred Stock, Series A, to the US Treasury. As a condition of this sale to the US Treasury, the Company agreed that it may not repurchase or redeem any of its trust preferred securities, including the Trust II and Trust III Securities, without the consent of the US Treasury, prior to the date upon which we either redeem the Series A preferred shares or the Treasury transfers ownership of the Series A preferred shares to a third party. Therefore, holders of these securities should have no expectation that we will redeem until, at the earliest, such conditional event transpires.

 

We may redeem some or all of the debentures and reduce the period during which holders of the Trust II and Trust III Securities will receive distributions .

 

We have the option to redeem any or all of the outstanding debentures without the payment of any premium upon satisfaction of the conditions to our sale of preferred stock to the US Treasury. Upon early redemption, holders of the Trust II and Trust III Securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on these securities.

 

We may redeem all of the debentures after December 6, 2011 upon the occurrence of certain events.

 

We may redeem all of the debentures before their stated maturity without payment of premium within 90 days after certain occurrences. These occurrences include adverse tax, investment company or bank regulatory developments. Upon early redemption (in compliance with the conditions of our sale of preferred stock to the US Treasury), holders of the Trust II and Trust III Securities may be required to reinvest their principal at a time when they may not be able to earn a return that is as high as they were earning on these securities.

 

 

 

We can distribute the debentures to holders of the Trust II and Trust III Securities, which may have adverse tax consequences for holders of the Trust II and Trust III Securities and could also adversely affect the market price of the Trust II and Trust III Securities.

 

The trustees may dissolve the trust before maturity of the debentures and distribute the debentures to holders of the Trust II and Trust III Securities under the terms of the trust agreement. Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the debentures to holders of these securities upon the dissolution of the trust would not be a taxable event. Nevertheless, if the trust is classified for United States income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the debentures would be a taxable event to holders of these securities. In addition, if there is a change in law, a distribution of the debentures upon the dissolution of the trust could be a taxable event to holders of these securities. Also, the debentures that holders of these securities may receive if the trust is liquidated may trade at a discount to the price that was paid to purchase these securities.

 

Holders of the Trust II and Trust III Securities must rely on the property trustee to enforce their rights if there is an event of default under the indenture.

 

Holders of the Trust II and Trust III Securities may not be able to directly enforce their rights against us under the indenture if an event of default occurs. If an event of default occurs under the indenture, holders of these securities must rely on the enforcement by the property trustee of its rights as holder of the debentures against us. The holders of a majority in liquidation amount of these securities will have the right to direct the property trustee to enforce its rights. If the property trustee does not enforce its rights following an event of default and there is no request by the record holders of the debentures to do so, any record holder may, to the extent permitted by applicable law, take action directly against us to enforce the property trustee’s rights. If an event of default occurs that is attributable to our failure to pay interest or principal on the debentures, or if we default under the guarantee, holders of these securities may proceed directly against us. Holders of these securities will not be able to exercise directly any other remedies available to the holders of the debentures, unless the property trustee fails to do so.

 

Holders of Trust II and Trust III Securities have limited voting rights to replace the property trustee and the Delaware trustee.

 

Holders of Trust II and Trust III Securities only have voting rights that pertain primarily to certain amendments to the trust agreement. In general, only we can replace or remove any of the trustees. The holders of at least a majority in aggregate liquidation amount of these securities may replace the property trustee and the Delaware trustee only if an event of default under the trust agreement occurs and is continuing.

 

The subordinated debentures and the Trust II and Trust III Securities do not represent deposit accounts and are not insured.

 

The subordinated debentures and the Trust II and Trust III Securities do not represent bank deposit accounts and they are not obligations issued or guaranteed by the Federal Deposit Insurance Corporation or by any other governmental agency and are subject to investment risk, including the possible loss of principal.

 

Item 1B. Unresolved Staff Comments

 

None.

 

 

Item 2. Properties

 

As of December 31, 2011, we operated out of twenty-two banking offices, and seven operations/administrative offices. All banking offices have ATMs. A summary of our offices is as follows:

 

Approximate

Year

Square

Established

Owned or

Footage

or Acquired

Leased

Banking Offices :

Asheville, North Carolina

1751 Hendersonville Road

9,821

2009

Owned

Clemmons, North Carolina

6290 Towncenter Drive

3,800

2004

Owned

Dobson, North Carolina

201 West Kapp Street

2,800

1995

Owned

Greensboro, North Carolina

1505 Highwoods Blvd.

9,800

2005

Owned

High Point, North Carolina

2541 Eastchester Drive

3,000

2003

Owned

Jonesville, North Carolina

503 Winston Road

2,500

1995

Owned

Kernersville, North Carolina

1207 South Main Street

8,300

2002

Owned

King, North Carolina

105 Post Office Street

4,000

2004

Owned

Madison, North Carolina

619 Ayersville Road

2,000

1990

Owned

Mooresville, North Carolina

210 Knob Hill Road

8,800

2006

Owned

Mount Airy, North Carolina

255 East Independence Blvd.

10,345

1999

Owned

2010 Community Drive

3,500

1988

Owned

Pilot Mountain, North Carolina

616 South Key Street

8,300

1987

Owned

Raleigh, North Carolina

3100 Edwards Mill Road

10,740

2009

Owned

Sandy Ridge, North Carolina

4928 Highway 704 West

1,250

1989

Owned

Union Grove, North Carolina

1439 W. Memorial Highway

2,300

1990

Owned

Walnut Cove, North Carolina

1072 North Main Street

1,700

1999

Leased

 

 

 

 

		Approximate				Year
		Square				Established				Owned or
		Footage				or Acquired				Leased
Banking Offices (continued) :
Winston Salem, North Carolina
4701 Country Club Road			4,300				1996				Leased
225 Hanes Mill Road			2,800				2001				Owned
3151 Peters Creek Parkway			2,500				1998				Leased
500 South Stratford Road			5,980				2008				Owned
Yadkinville, North Carolina
532 East Main Street			7,800				1998				Owned
Operations and Administrative Offices :
Winston Salem, North Carolina
465 Shepherd Street			47,114				2006				Owned
100 Cambridge Plaza	(1)		7,028				2006				Owned
104 Cambridge Plaza	(1)		7,028				2006				Owned
108 Cambridge Plaza	(1)		7,028				2006				Owned
112 Cambridge Plaza	(1)		7,988				2006				Owned
4605 Country Club Road - Corporate			27,000				2003				Owned
4625 Country Club Road	(1)		4,700				1998				Owned

 

(1) Approximately 79% of these properties are leased to tenants.

 

In addition to the above locations, the Bank has approximately 130 outsourced ATM cash dispensing machines throughout North Carolina.

 

All of our properties, including land, buildings and improvements, furniture, equipment and vehicles, had a net book value at December 31, 2011 of $38.3 million. See further information presented in Note 6 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.

 

Additional banking offices may be opened at later dates if deemed appropriate by the Board of Directors and if regulatory approval can then be obtained. The Company may acquire property in which a director, directly or indirectly, has an interest. In such event, the acquisition of such facilities shall be approved by a majority of the Board of Directors, excluding any individual who may have such an interest in the property.

 

Item 3. Legal Proceedings

 

The Company is a party to legal proceedings arising in the normal conduct of business. Our management believes that this litigation is not material to the Company’s financial position or results of its operations or the operations of the Bank.

 

Item 4. Mine Safety Disclosures

 

 

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Price Range of Common Stock and Dividends

 

Our common stock and Trust II Securities are listed on the NASDAQ Global Select Market under the symbols “SCMF” and “SCMFO,” respectively. The following table sets forth the high and low sales prices per share of our common stock and our preferred securities (“SCMFO”), based on published financial sources. In March 2009, the Board suspended the payment of cash dividends on the common stock.

 

						Price
							SCMF								SCMFO
Year			Quarterly Period				High				Low				High				Low
2010			First Quarter			$	2.85			$	2.09			$	8.00			$	6.18
			Second Quarter				3.19				2.10				8.45				6.60
			Third Quarter				2.23				1.50				8.07				6.35
			Fourth Quarter				1.93				1.00				7.48				4.02
2011			First Quarter			$	2.55			$	1.05			$	6.98			$	3.25
			Second Quarter				2.14				1.02				4.50				3.00
			Third Quarter				1.87				1.15				5.45				3.12
			Fourth Quarter				1.30				1.00				5.30				3.35
2012			First Quarter			$	2.27			$	1.03			$	5.90			$	4.15
			(through February 29, 2012)

  

At February 29, 2012, there were approximately 6,657 holders of record of our common stock.

 

Effective February 2011, the Company and the Bank became subject to the following restrictions imposed by their regulators relating to cash dividends and cash payments on debt service. (See “Supervision and Regulation” for a complete summary of these regulatory restrictions.)

 

·

The Company is required to obtain the prior written approval of the Federal Reserve for the payment of all dividends, common and preferred, and for interest payments on trust preferred securities; and

·

Under a Consent Order with the FDIC and the NCCOB, the Bank agreed not to make any distributions of interest or principal on subordinated debentures or declare or pay any dividends without the prior written approval of the FDIC and the NCCOB.

 

Absent these restrictions, holders of our common stock will be entitled to receive any cash dividends the Board of Directors may declare. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our Board of Directors and will depend upon our earnings and financial condition, regulatory conditions and considerations and such other factors as our Board of Directors may deem relevant. As a holding company, Southern Community Financial Corporation is ultimately dependent upon its bank subsidiary to provide funding for its operating expenses, debt service (including the interest payments on the preferred securities issued by our remaining trust subsidiary), and dividends. Our primary sources of income are dividends paid by the Bank. The Company must pay all of its operating expenses from funds received from the Bank. Various banking laws applicable to our bank subsidiary limit the payment of dividends, management fees and other distributions by the Bank to the Company and may therefore limit the Company’s ability to make dividend payments. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if payment of the dividend would cause the Bank’s surplus to be less than 50% of its paid-in capital. Under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation. As a condition of the issuance of Cumulative Perpetual Preferred Stock to the United States Treasury under its Capital Purchase Program, the Company must obtain the consent of the United States Treasury Department to increase the cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share.

 

 

 

In the future, any declaration and payment of cash dividends will be subject to the waiver or permanent lifting of the above regulatory restrictions, the Board of Directors’ evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, tax and other relevant considerations. There is no assurance that, in the future, these regulatory restrictions will be waived or lifted; we will have funds available to pay cash dividends; or, even if funds are available, that we will pay dividends in any particular amount or at any particular time; or that we will pay dividends at all.

 

Share Repurchases

 

Through July 2006, the Company authorized the repurchase up to 1.9 million shares of its common stock. Through December 5, 2008 (the date of our participation in the Treasury’s Capital Purchase Plan), the Company had repurchased 1,858,073 shares at an average price of $6.99 per share under the three plans. No shares were repurchased during 2011 or 2010.

 

As a condition of the issuance of its Cumulative Perpetual Preferred Stock to the United States Treasury under its CPP, the Company must obtain the consent of the United States Treasury Department to repurchase any of its common stock.

 

Total Number of

Shares Purchased as

Maximum Number of

Total Number

Part of Publicly

Shares That May Yet

of Shares

Average Price

Announced

Be Purchased Under

Period

Purchased

Paid per Share

Programs

the Programs

October 1, 2011 to December 31, 2011

None

41,927

Total for quarter

-

$

-

-

Total repurchases under all programs

1,858,073

$

6.99

 

 

 

Item 6. Selected Financial Data

 

SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

 

The following tables set forth selected consolidated financial information and other data. The information set forth below does not purport to be complete and should be read in conjunction with our consolidated financial statements appearing elsewhere in this annual report.

 

		At or For the Years Ended December 31,
		2011				2010				2009				2008				2007
		(Amounts in thousands, except share and per share data)
Operating Data:
Interest income		$	70,736			$	80,638			$	89,473			$	96,742			$	98,908
Interest expense			21,892				28,279				37,726				49,282				55,141
Net interest income			48,844				52,359				51,747				47,460				43,767
Provision for loan losses			15,150				39,000				34,000				8,165				2,775
Net interest income after
provision for loan losses			33,694				13,359				17,747				39,295				40,992
Non-interest income			14,040				15,606				12,906				11,341				11,329
Non-interest expense			44,660				47,768				100,498				42,148				40,898
Income (loss) before income taxes			3,074				(18,803	)			(69,845	)			8,488				11,423
Provision for income taxes (benefit)			-				4,318				(6,686	)			2,634				3,869
Net income (loss)			3,074				(23,121	)			(63,159	)			5,854				7,554
Effective dividends on preferred stock			2,554				2,531				2,508				185				-
Net income (loss) available to common
shareholders		$	520			$	(25,652	)		$	(65,667	)		$	5,669			$	7,554
Securities gains (losses) included in
non-interest income		$	3,989			$	3,531			$	1,236			$	98			$	-
Per Common Share Data:
Net income (loss)
Basic		$	0.03			$	(1.53	)		$	(3.91	)		$	0.33			$	0.43
Diluted			0.03				(1.53	)			(3.91	)			0.33				0.43
Cash dividends			-				-				0.040				0.160				0.155
Book value			3.29				2.99				4.77				8.77				8.18
Weighted average shares
Basic			16,827,684				16,811,439				16,787,938				17,363,395				17,559,352
Diluted			16,891,910				16,811,439				16,787,938				17,398,318				17,624,399
Balance Sheet Data:
Total assets			1,502,356				1,653,398				1,728,608				1,803,778				1,569,182
Loans			950,022				1,130,076				1,230,275				1,314,811				1,188,438
Allowance for loan losses			24,165				29,580				29,638				18,851				14,258
Deposits			1,183,172				1,348,419				1,314,070				1,233,112				1,045,237
Short-term borrowings			33,629				22,098				85,477				145,197				117,772
Long-term borrowings			177,514				182,686				199,103				228,016				254,633
Stockholders’ equity			97,635				92,341				121,997				187,710				142,339
Capital Ratios:
Total risk-based capital			14.26	%			11.75	%			12.92	%			13.80	%			11.44	%
Tier 1 risk-based capital			11.75	%			9.35	%			11.34	%			12.46	%			10.28	%
Leverage ratio			8.47	%			7.42	%			9.14	%			10.57	%			8.96	%
Equity to assets ratio			6.50	%			5.58	%			7.06	%			10.41	%			9.07	%

 

 

 

 

 

		At or For the Years Ended December 31,
		2011				2010				2009				2008				2007
		(Amounts in thousands, except share and per share data)
Selected Performance Ratios:
Return on average assets			0.20	%			-1.38	%			-3.57	%			0.34	%			0.50	%
Return on average equity			3.25	%			NM				NM				4.02	%			5.45	%
Net interest spread (1)			3.20	%			3.19	%			2.95	%			2.75	%			2.81	%
Net interest margin (2)			3.34	%			3.35	%			3.16	%			2.99	%			3.19	%
Non-interest income as a
percentage of total
revenue (3)			22.33	%			22.96	%			19.96	%			19.21	%			20.57	%
Non-interest income as a
percentage of average
assets			0.89	%			0.93	%			0.73	%			0.65	%			0.75	%
Non-interest expense to
average assets  (6)			2.84	%			2.84	%			5.69	%			2.42	%			2.70	%
Efficiency ratio (4) (6)			71.02	%			70.28	%			155.44	%			71.65	%			74.23	%
Dividend payout ratio			NA				NA				NA				48.48	%			36.05	%
Asset Quality Ratios:
Nonperforming loans to
period-end loans			7.13	%			8.08	%			3.07	%			1.10	%			0.17	%
Allowance for loan losses
to period-end loans			2.53	%			2.60	%			2.41	%			1.43	%			1.20	%
Allowance for loan losses
to nonperforming loans			0.36	X			0.32	X			0.79	X			1.31	X			6.95	X
Nonperforming assets
to total assets (5)			5.85	%			6.60	%			3.32	%			1.12	%			0.18	%
Net loan charge-offs
to average loans outstanding			1.98	%			3.25	%			1.82	%			0.28	%			0.14	%
Other Data:
Number of banking offices			22				22				22				22				22
Number of full-time
equivalent employees			290				301				331				337				337

 

 

(1) Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(2) Net interest margin is net interest income divided by average interest-earning assets.

(3) Total revenue consists of net interest income and non-interest income.

(4) Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.

(5) Nonperforming assets consist of non-accrual loans, restructured loans and real estate owned, where applicable.

(6) Excluding the $49.5 million goodwill impairment charge in 2009, the ratio of non-interest expenses to average assets and the efficiency ratio would be 2.89% and 78.88%, respectively.

NM – Not meaningful

NA – Not applicable

 

 

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following presents management’s discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of our operations.

 

CRITICAL ACCOUNTING POLICIES

 

The Company’s accounting policies are in accordance with accounting principles generally accepted in the United States and with general practices within the banking industry. Management makes a number of estimates and assumptions relating to reported amounts of assets, liabilities, revenues and expenses in the preparation of the financial statements and disclosures. Estimates and assumptions that are most significant to the Company are related to the determination of the allowance for loan losses, goodwill and other intangible assets and income taxes.

 

Allowance for Loan Losses

 

The allowance for loan losses represents management’s estimate of probable losses inherent in the loan portfolio. Determining the appropriate level of the allowance is one of the most critical and complex accounting estimates for any financial institution. Management’s judgments include those involved in risk grading the loan portfolio, determining specific allowances for loans considered impaired, and evaluating the impact of current economic conditions on the levels of the allowance. Loans are considered impaired when it is probable that all amounts due will not be collected in accordance with the contractual terms of the loan agreement. While management believes that the allowance for loan losses is appropriate and adequate to cover probable losses inherent in the portfolio, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. For further discussion, see “Nonperforming Assets” and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”

 

Goodwill and Other Intangibles

 

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Prior to March 31, 2009, goodwill impairment testing was performed annually or more frequently if events or circumstances indicate possible impairment. The evaluation of goodwill for impairment included both the income and market approaches to value the Company. The income approach consisted of discounting projected long-term future cash flows, which were derived from internal forecasts and economic expectations for the Company. The significant inputs to the income approach include the long-term target tangible equity to tangible assets ratio and the discount rate, which was determined utilizing the Company’s cost of capital adjusted for a company-specific risk factor. The company-specific risk factor was used to address the uncertainty of growth estimates and earnings projections of management. Under the market approach, a value was calculated from an analysis of comparable acquisition transactions based on earnings, book value, assets and deposit premium multiples from the sale of similar financial institutions. Another market valuation approach utilized the current stock price adjusted by an appropriate control premium as an indicator of fair market value. Given the substantial declines in our common stock price, declining operating results, asset quality trends, market comparables and the economic outlook for our industry, the Company’s fair value at March 31, 2009 had decreased significantly compared with previous assessments. Our goodwill testing for the first quarter of 2009 indicated that the Company’s fair value did not support the goodwill recorded at the time of the acquisition of The Community Bank in January 2004; therefore, the Company recorded a $49.5 million goodwill impairment charge to write off the entire amount of goodwill as of March 31, 2009. This non-cash goodwill impairment charge to earnings was one of the primary reasons for the Company’s $63.2 million net loss for 2009.

 

 

 

Income Taxes

 

Accrued taxes represent the estimated amount payable to or receivable from taxing jurisdictions, either currently or in the future, and are reported, on a net basis, as a component of “other assets” in the consolidated balance sheets. The calculation of the Company’s income tax expense is complex and requires the use of many estimates and judgments in its determination.

 

Management’s determination of the realization of the net deferred tax asset is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income and the implementation of various tax plans to maximize realization of the deferred tax asset. As of December 31, 2011, a $14.4 million valuation allowance has been established primarily due to the possibility that all of the deferred tax asset associated with the allowance for loan losses may not be realized. See Note 14 Income Taxes in the footnotes to the audited financial statements for further disclosure on this matter.

 

From time to time, management bases the estimates of related tax liabilities on its belief that future events will validate management’s current assumptions regarding the ultimate outcome of tax-related exposures. While the Company has obtained the opinion of advisors that the anticipated tax treatment of these transactions should prevail and has assessed the relative merits and risks of the appropriate tax treatment, examination of the Company’s income tax returns, changes in tax law and regulatory guidance may impact the treatment of these transactions and resulting provisions for income taxes.

 

Other than Temporary Impairment of Investment Securities

 

In evaluating investment securities for “other than temporary impairment” losses, management considers, among other things, (i) the length of time and the extent to which the investment is in an unrealized loss position, (ii) the financial condition and near term prospects of the issuer, and (iii) the intent and ability of the Company to retain its investment in the issuer for a sufficient period of time to allow for any anticipated recovery of unrealized loss.

 

Valuation of Foreclosed Assets

 

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less estimated cost to sell at the date of foreclosure, establishing a new cost basis. Principal and interest losses existing at the time of acquisition of such assets are charged against the allowance for loan losses and interest income, respectively. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. Revenue and expenses from operations, the impact of any subsequent changes in the carrying value and any gain or loss on the sale of the foreclosed property are included in other expenses.

 

OVERVIEW

 

Southern Community’s founders recognized an opportunity to fulfill the financial service needs of individuals and organizations left underserved by consolidation within the financial services industry. To fill a part of this void, the founders began in 1995 the process by which Southern Community Bank and Trust was created, and began operations on November 18, 1996. From inception, Southern Community has strived to serve the financial needs of small to medium-sized businesses, individuals, residential homebuilders and others in and around our markets in North Carolina. We offer a broad array of banking and other financial products; many of which are similar to those offered by our larger competitors, but we deliver them with an emphasis on superior customer service. We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $1.5 billion in total assets in just over fifteen years of operations.

 

The Company began operations in November 1996 with $11.0 million in capital, a single branch facility and thirteen employees. Through December 31, 2011, Southern Community Financial Corporation has grown to a total of twenty-two full-service banking offices with $1.2 billion in deposit accounts. In support of this growth, the Company has generated additional capital through issuing common and preferred stock and retaining operating earnings. At December 31, 2011, the Company had $97.6 million in total stockholders’ equity. Through our banking subsidiary we offer traditional banking products as well as a full array of financial services. In October 2001, Southern Community Financial Corporation became the parent company of Southern Community Bank and Trust. On January 12, 2004, we acquired The Community Bank, a $240.0 million asset community bank with 10 banking offices in contiguous markets. The Company created Southern Community Advisors, our wealth management division, and has developed and acquired mortgage banking operations. While these operations are currently not significant to our results of operations, we intend to pursue growth in these businesses to enhance our non-interest income.

 

 

Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, comprise the majority of our loan portfolio, with the balance of our loans consisting of commercial and industrial loans and loans to individuals. We originate residential mortgages, at both fixed and variable rates, earning fees for loans originated and additional income for loans sold to others. It has been our strategy to recruit skilled banking professionals who are well trained and highly knowledgeable about our market area, enabling us to develop and maintain a loan portfolio of sound credit quality.

 

Management recognizes that current market conditions expose the Company to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality. The Company has developed critical functions such as Credit Administration, Training, Audit and Compliance to assist in managing and monitoring these and other risks. We are committed to creating and maintaining a solid and diversified financial services organization with a focus on customer service. It is management’s firm belief that this foundation will continue building our loyal customer base while attracting new clients.

 

Financial Condition at December 31, 2011 and 2010

 

During the year ended December 31, 2011, our total assets decreased to $1.50 billion from $1.65 billion at the prior year end. The most significant factor contributing to this decrease was the continued decline in our loan portfolio which decreased $180.1 million. Total loans decreased at the end of all four quarters of 2011 due largely to weak loan demand, customer deleveraging and problem loan remediation. The continued weak economic environment caused net charge-offs to remain a significant factor although improved from the preceding two years. The Company’s liquidity improved during the year as investment securities increased $51.9 million or 14.4%. Total deposits were $1.2 billion at December 31, 2011, a decrease of $165.2 million or 12.3% from the year ago period. Time deposits decreased $83.6 million while Money market, savings and NOW accounts decreased $107.0 million and demand accounts increased $25.3 million. The decrease in time, money market, NOW and savings deposits was the result of rate sensitive customers moving to other investment opportunities. The decrease in deposits was offset by a greater decrease in loans allowing the Company to maintain adequate liquidity.

 

The loan portfolio, excluding loans held for sale, declined $180.1 million in 2011 due to a slowdown in loan demand, payoffs and the workout of nonperforming loans. The decline in loans was very pronounced in commercial real estate and residential construction loans which decreased $68.4 million and $35.7 million, respectively, as new loan closings did not keep pace with payoffs and foreclosures. Other commercial loans decreased $27.1 million while other consumer loans decreased $48.9 million. Foreclosure of real estate loans of $20.5 million was offset by sales of foreclosed properties of $15.2 million and writedowns in the carrying value of foreclosed properties of $2.8 million, resulting in an increase of $2.5 million in foreclosed assets by year end.

 

Our total liquid assets, defined as cash and due from banks, federal funds sold, interest-bearing deposits and investment securities, increased by $32.3 million during the year to $460.1 million at December 31, 2011. Liquid assets represented 30.6% of total assets at December 31, 2011 as compared to 25.9% at the beginning of the year. Investment securities increased $51.9 million while cash equivalents and federal funds sold decreased $19.6 million. The majority of securities that were called, matured, or sold during the year were reinvested in mortgage pools and other asset backed securities that had the best available yield. As of year-end, we believe our liquidity is adequate to fund future loan demand and manage deposit and borrowing outflows.

 

Customer deposits have traditionally been our primary funding source supplemented by wholesale funding. Total deposits totaled $1.18 billion, a decrease of $165.2 million or 12.3% from year-end 2010. A major factor in this decrease was the reduction in brokered deposits of $87.0 million as the Company focused on reducing the level of brokered deposits as required by the Consent Order. Another major decrease in deposits during 2011 was in money market and NOW accounts which decreased $88.8 million as customers utilized their liquidity to deleverage and seek reinvestment focused on the best available yield. Savings accounts decreased $18.1 million year-over-year, including our Ready Saver savings account which is available only on the internet. Demand deposits increased $25.3 million while customer certificates of deposits increased $3.5 million. Management will continue to focus on growing the local core deposit base; however, we will continue to monitor the costs of our various funding alternatives. Our funding mix may change from time to time as a result.

 

 

 

Total borrowings aggregated $211.1 million at December 31, 2011, and included $76.6 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), junior subordinated debentures with a carrying value of $45.9 million and securities sold under agreements to repurchase of $88.6 million. At December 31, 2011, we had funding of $80.0 million in the form of term repurchase agreements with $20.0 million maturing within one year and $60.0 million with maturities from one to seven years. Management will use FHLB advances and other funding sources as necessary to support balance sheet management. However, management expects that our branch network will produce a larger volume of our core deposits and become an increasingly larger portion of our funding mix, which over time should contribute to a reduction in our overall funding cost.

 

The Company’s capital position remains strong with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At December 31, 2011, our stockholders’ equity totaled $97.6 million, a increase of $5.3 million from the December 31, 2010 balance. This net change includes $3.1 million of net income, $97 thousand of stock-based compensation and $2.1 million in other comprehensive income due primarily to unrealized gain in fair value on available for sale investment securities.

 

NET INTEREST INCOME

 

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume and changes in interest rates earned and paid. By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities. During the years ended December 31, 2011, 2010 and 2009, our average interest-earning assets were $1.46 billion, $1.56 billion and $1.64 billion, respectively. During these same years, our net interest margins were 3.34%, 3.35% and 3.16%, respectively.

 

During 2011, the Federal Reserve maintained the federal funds target rate consistent with year-end 2010 at a range of zero to 0.25%. The federal funds rate is currently at a historical low surpassing the previous low of 1.00% in June 2003. These low rates are expected to continue through the end of 2014 based on guidance issued by the Federal Reserve. There is a 300 basis point spread between the federal funds rate and the prime rate which remained at 3.25% throughout 2011. While it is management’s goal to remain relatively interest rate neutral, the Bank’s interest rate sensitivity has remained slightly asset sensitive during 2011, as the funding mix has remained relatively stable. Net interest income totaled $48.8 million, a decrease of $3.5 million or 6.7% over the $52.4 million for the same period in 2010. The main factor in this decrease was the year-over-year reduction in average outstanding loan balances described above. Net interest income benefited from a slight improvement in net interest spread year-over-year as the Bank’s asset yields decreased at a slower pace (0.32% from 5.16% to 4.84%) than cost of funds (0.33% from 1.97% to 1.64%), leading to a flat net interest margin of 3.34% from 3.35% in 2010. The total cost of funds decreased $6.4 million while the interest income from interest earning assets decreased $9.9 million. The decrease in the year-over-year interest income from interest-earning assets was attributable to the aforementioned reduction in average loan balances and an earning asset mix shift from higher yielding loans to lower yielding investment securities and overnight funds. The continued use of interest rate floors on the majority of our variable rate loans helped to stabilize and moderate the pace of decline in the overall yield on loans. The improvement in the cost of funds was attributed to decreased rates on money market deposits and customers renewing their certificates of deposit at a lower rate.

 

 

 

Average Balances and Average Rates Earned and Paid . The following table sets forth, for the years 2009 through 2011, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Average loans include nonaccruing loans, the effect of which is to lower the average yield.

 

		For the Years Ended December 31,
		2011												2010												2009
		Average balance				Interest earned/paid				Average yield/cost				Average balance				Interest earned/paid				Average yield/cost				Average balance				Interest earned/paid				Average yield/cost
		(Amounts in thousands)
Interest-earning assets:
Loans (1)		$	1,039,531			$	58,373				5.62	%		$	1,200,609			$	68,384				5.70	%		$	1,272,087			$	74,548				5.86	%
Investment securities
available for sale			328,648				9,916				3.02	%			311,850				11,303				3.62	%			327,487				14,035				4.29	%
Investment securities
held to maturity			46,945				2,281				4.86	%			17,911				886				4.95	%			18,751				877				4.68	%
Federal funds sold and
overnight deposits			46,892				166				0.35	%			32,023				65				0.20	%			19,846				13				0.07	%
Total interest-earning assets			1,462,016				70,736				4.84	%			1,562,393				80,638				5.16	%			1,638,171				89,473				5.46	%
Other assets			108,757												118,675												128,876
Total assets		$	1,570,773											$	1,681,068											$	1,767,047
Interest-bearing liabilities:
Deposits:
NOW and money market		$	499,265			$	2,800				0.56	%		$	601,122			$	5,718				0.95	%		$	466,667			$	6,787				1.45	%
Time deposits greater
than $100,000			217,325				2,329				1.07	%			178,288				2,714				1.52	%			193,505				4,833				2.50	%
Other time deposits			402,144				7,720				1.92	%			403,694				10,067				2.49	%			486,721				14,798				3.04	%
Borrowings			215,102				9,043				4.20	%			253,339				9,780				3.86	%			354,812				11,308				3.19	%
Total interest-bearing
liabilities			1,333,836				21,892				1.64	%			1,436,443				28,279				1.97	%			1,501,705				37,726				2.51	%
Demand deposits			132,469												119,418												107,461
Other liabilities			10,013												9,245												10,229
Stockholders' equity			94,455												115,962												147,652
Total liabilities and
stockholders' equity		$	1,570,773											$	1,681,068											$	1,767,047
Net interest income and
net interest spread						$	48,844				3.20	%						$	52,359				3.19	%						$	51,747				2.95	%
Net interest margin											3.34	%											3.35	%											3.16	%
Ratio of average interest-earning
assets to average interest-bearing
liabilities							109.61	%											108.77	%											109.09	%

 

(1) Non-accrual notes are included in the loan amounts.

 

RATE/VOLUME ANALYSIS

 

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

 

		December 31, 2011 vs. 2010												December 31, 2010 vs. 2009
		Increase (Decrease) Due to												Increase (Decrease) Due to
		Volume				Rate				Total				Volume				Rate				Total
		(Amounts in thousands)
Interest income:
Loans		$	(9,110	)		$	(901	)		$	(10,011	)		$	(4,130	)		$	(2,034	)		$	(6,164	)
Investment securities available
for sale			558				(1,945	)			(1,387	)			(618	)			(2,114	)			(2,732	)
Investment securities held
to maturity			1,423				(28	)			1,395				(40	)			49				9
Federal funds sold			41				60				101				18				34				52
Total interest income			(7,088	)			(2,814	)			(9,902	)			(4,770	)			(4,065	)			(8,835	)
Interest expense:
Deposits:
NOW and money market			(770	)			(2,148	)			(2,918	)			1,617				(2,686	)			(1,069	)
Time deposits greater
than $100,000			506				(891	)			(385	)			(306	)			(1,813	)			(2,119	)
Other time deposits			(34	)			(2,313	)			(2,347	)			(2,297	)			(2,434	)			(4,731	)
Borrowings			(1,542	)			805				(737	)			(3,578	)			2,050				(1,528	)
Total interest expense			(1,840	)			(4,547	)			(6,387	)			(4,564	)			(4,883	)			(9,447	)
Net interest income increase
(decrease)		$	(5,248	)		$	1,733			$	(3,515	)		$	(206	)		$	818			$	612

 

RESULTS OF OPERATIONS

Years Ended December 31, 2011 and 2010

 

Net Income (Loss). Our net income for 2011 was $3.1 million, an increase of $26.2 million from net loss of $23.1 million recorded in 2010. Net income available to common shareholders was $520 thousand for the year ended December 31, 2011 and net loss available to common shareholders was ($25.7) million for 2010. Net income (loss) per share available to common shareholders was $0.03 basic and diluted for the year ended December 31, 2011 and ($1.53) basic and diluted for 2010. Net interest income for 2011 was $48.8 million, down $3.5 million or 6.7%, compared with 2010, due primarily to a $161.1 million decrease in the average balance of loans outstanding year-over-year. The most significant factor of the improved earnings was the decreased level of asset quality costs, including a provision for loan losses of $15.2 million compared to $39.0 million for the prior year. Non-interest income for 2011 was $14.0 million which represents a decrease of $1.6 million, or 10.0%, from non-interest income of $15.6 million reported for 2010. The largest decrease in non-interest income was from mortgage banking activities which decreased $908 thousand, while the largest increase was from gain on sale of investment securities which increased $458 thousand for the year. Non-interest expense decreased $3.1 million, or 6.5%, compared with the previous year. The largest decrease in non-interest expense resulted from salaries and employee benefits including decreases of $1.9 million in salaries and commissions and $899 thousand in employee benefits. The largest increase was the FDIC insurance premium which increased $1.6 million. During 2011, average earning assets decreased $100.4 million or 6.9% to $1.46 billion, and average interest bearing liabilities decreased $102.6 million or 7.7%. A total unfavorable volume variance of $5.2 million resulted in the decline in the net interest income more than offsetting the favorable rate variance of $1.7 million.

 

 

 

Net Interest Income. During 2011, our net interest income decreased $3.5 million, or 6.7%, to $48.8 million. Interest income decreased due to (i) a decrease in average loan balances resulting from customer deleveraging, weak loan demand and problem loan remediation, (ii) declining market asset yields and (iii) the reversal of interest from loans being reclassified into a non-accrual status as well as other factors. Average total interest-earning assets decreased $100.4 million, or 6.9%, during 2011 as the average loan balances decreased $161.1 million, the average investment securities portfolio increased $45.8 million and federal funds sold increased $14.9 million. Our average total interest-bearing liabilities decreased by $102.6 million, or 7.7%. Approximately 54% of the loan portfolio is composed of fixed rate loans while 46% have a variable interest rate which generally adjusts immediately when index rates, such as our prime rate, change. During 2011, the Company continued its emphasis of interest rate floors on a majority of its variable rate loans which slowed the decline in its loan yields in 2011. Although we maintained loan pricing discipline when possible through the continued use of interest rate floors on variable rate loans during this period of low market interest rates, the yield on loans decreased eight basis points. In addition to the impact of declining market interest rates on asset yields, the interest foregone for loans in a non-accrual status for 2011 was $3.8 million.

 

During 2011, the Federal Reserve maintained the federal funds target rate consistent with year-end 2010 at a range of zero to 0.25%. Although the federal funds rate did not change during the year, the yield on earning assets decreased 32 basis points while our funding costs decreased 33 basis points. Interest income on investment securities decreased due to lower yields on new purchases of investment securities as the yields on available for sale investment securities and held to maturity investment securities dropped 60 and nine basis points, respectively.

 

Management reduced pricing on all deposit categories, particularly in transaction, money market and time deposits, during 2011, achieving significant improvements in our cost of funds as the cost of interest-bearing liabilities fell 33 basis points from 1.97% for 2010 to 1.64% for 2011.

 

We will continue to evaluate ways to improve our net interest margin. We expect competition for loan production during this time of weak loan demand to keep pressure on loan yields; while competition for deposits and the related deposit costs will not be as intense as in some prior years. We will also have an opportunity to reprice downward higher rate, maturing certificates of deposit. This should assist us in the challenge of stabilizing our major revenue source and improving our net interest margin in 2012.

 

Provision for Loan Losses. We recorded a $15.2 million provision for loan losses for the year 2011 representing a decrease of $23.8 million from the $39.0 million provision for the full year 2010. The level of provisions is reflective of the trends in the loan portfolio, including levels of nonperforming loans and other loan portfolio quality measures, and analyses of impaired loans. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” The provision for loan losses was 1.46% and 3.25% of average loans in 2011 and 2010, respectively. Our percentage of net loan charge-offs to average loans outstanding was 1.98% for the year ended December 31, 2011, compared with 3.25% for the year ended December 31, 2010. Nonperforming loans totaled $68.0 million, or 7.13% of total loans, at December 31, 2011 compared with $91.8 million, or 8.08% of total loans, at December 31, 2010. Nonperforming loans and net charge-offs have been predominantly related to residential construction and development lending in prior years. As of December 31, 2011, the mix of nonperforming loans has become distributed throughout the entire loan portfolio with $26.5 million in commercial real estate, $5.0 million in other commercial loans, $13.0 million in construction $12.1 in residential lots and $11.5 million in consumer loans. The allowance for loan losses at December 31, 2011 of $24.2 million represents 2.53% of total loans and 36% of nonperforming loans. The allowance for loan losses at December 31, 2010 of $29.6 million was 2.60% of total loans outstanding and 32% of nonperforming loans at that date.

 

Non-Interest Income. For the year ended December 31, 2011, non-interest income decreased $1.6 million, or 10.0%. Mortgage banking income decreased $908 thousand as refinance activity slowed and new purchase loan volume was weak due to the continued economic environment. Income from the investment in SBIC activities decreased $719 thousand with a loss of $88 thousand in 2011 compared to income of $631 thousand in 2010. The decline in SBIC income resulted from realized charge offs of investments in smaller companies who were not able to survive the current economic weakness. Service charges decreased $594 thousand, or 9.1%, of which $716 thousand was due to reduced NSF transaction volume and $86 thousand due to decreased service charges on deposit accounts. These decreases were partially offset by an increase in debit card income of $208 thousand. Income from investment brokerage and trust fees decreased from the prior year by $466 thousand to $1.0 million. Gains on the sale of investment securities increased $458 thousand and other sources of non-interest income increased $75 thousand. Decreased losses on economic hedges and other than temporary impairment charges of $403 thousand and $186 thousand, respectively, had a positive effect on non-interest income.

 

 

Non-Interest Expense. N on-interest expense decreased $3.1 million year over year due to cost reduction initiatives established in prior years and continued during 2011. These cost reductions included salary reductions for executive management, a salary freeze for all employees and eliminating the 401(k) employer match. The result of these actions was a reduction in salaries and commissions of $1.7 million and reduced employee benefit cost of $899 thousand, including a decrease of $328 thousand in the 401(k) match, a $302 thousand decrease in a Supplementary Executive Retirement Plan, a reduction of $128 thousand in payroll taxes and a $98 thousand reduction in employee insurance costs. Foreclosed asset related expenses decreased by $1.1 million as writedowns in the carrying values of foreclosed assets decreased $321 thousand, or 11.6%, and expenses to maintain foreclosed property, net of gains on sales of foreclosed assets, decreased $762 thousand, or 71.9%. Gains on sales of foreclosed assets increased $260 thousand on higher volume of sales ($15.9 million in 2011 versus $11.4 million in 2010). Occupancy and equipment expense decreased $260 thousand, or 3.5%, primarily due to decreases in depreciation on furniture and equipment of $164 thousand and in depreciation on information technology equipment of $71 thousand. The FDIC deposit insurance assessment for 2011 totaled $3.8 million, an increase of $1.6 million compared to 2010 due to increased premiums charged in connection with the previously announced Consent Order. Included in the decrease in other expenses of $754 thousand, was a $413 thousand decrease due to the discontinuance of a buyer incentive promotion in the second half of 2010 and throughout 2011.

 

Provision for Income Taxes. The Company recorded no income tax or benefit for the year ending December 31, 2011 compared to income tax expense of $4.3 million for 2010. The Company has now used all available net operating loss (NOL) carrybacks and now has a federal NOL carryforward of $4.7 million. No income tax expense or benefit is expected until future earnings utilize the NOL carryforward or the valuation allowance is partially or fully recaptured. The $14.6 million deferred tax asset valuation allowance recorded as of December 31, 2010 was reduced to $14.4 million at December 31, 2011. The $4.3 million income tax expense for 2010 reflected the impact of tax exempt interest income, income from bank owned life insurance for the period and a $8.6 million increase in the valuation allowance related to our ability to realize net deferred tax assets. See Note 14 Income Taxes in the footnotes to the audited financial statements for further disclosure on this matter.

 

RESULTS OF OPERATIONS

Years Ended December 31, 2010 and 2009

 

Net Income (Loss). Our net loss for 2010 was $23.1 million, a decrease of $40.1 million from net loss of $63.2 million recorded in 2009. Net income (loss) available to common shareholders was ($25.7) million and ($65.7) million for 2010 and 2009, respectively. Net income (loss) per share available to common shareholders was ($1.53) basic and diluted for the year ended December 31, 2010 and ($3.91) basic and diluted for 2009. Net interest income for 2010 was $52.4 million, up $612 thousand or 1.2%, compared with 2009, due to improvement in the net interest margin. The net interest margin of 3.35% improved 19 basis points from 2009. One significant factor for the loss for the year was the elevated level of asset quality costs, including a provision for loan losses of $39.0 million for the year. Non-interest income for 2010 was $15.6 million which represents an increase of $2.7 million, or 20.9%, from non-interest income of $12.9 million reported for 2009. The largest increase in non-interest income was from gain on sale of investment securities which increased $2.3 million, while losses on derivative activity decreased non-interest income $766 thousand for the year. Non-interest expense decreased $52.7 million, or 52.5%, compared with the previous year. The largest increase in non-interest expense resulted from asset quality costs including increases of $939 thousand in expenses in acquiring and maintaining foreclosed property and $599 thousand in writedowns of the carrying values of foreclosed properties. The largest decrease was related to recognizing a non-recurring goodwill impairment charge of $49.5 million during the first quarter of 2009. During 2010, average earning assets decreased $75.8 million or 4.6% to $1.56 billion, and average interest bearing liabilities decreased $65.3 million or 4.4%. A total favorable rate variance of $818 thousand resulted in the improvement in the net interest margin more than offsetting the unfavorable volume variance of $206 thousand.

 

 

 

Net Interest Income. During 2010, our net interest income increased $612 thousand, or 1.2%, to $52.4 million. Interest income decreased due to the reversal of interest from loans being reclassified into a non-accrual status, weak loan demand and declining market asset yields. Interest income was affected by non-accrual loans totaling $91.8 million at year end which increased $54.0 million, for 143.25%, during the year. Our cost of funds decreased to a greater extent due to decreased volume of average deposits, the more favorable repricing of deposits and reduced levels of higher cost borrowings. Average total interest-earning assets decreased $75.8 million, or 4.6%, during 2010 as the average loan balances decreased $71.5 million, the average investment securities portfolio decreased $16.5 million and federal funds sold increased $12.2 million. Our average total interest-bearing liabilities decreased by $65.3 million, or 4.3%. Approximately 49% of the loan portfolio is composed of fixed rate loans while 51% have a variable interest rate which generally adjusts immediately when index rates, such as our prime rate, changes. During 2010, the Company continued its emphasis of interest rate floors on a majority of its variable rate loans which slowed the decline in its loan yields in 2010. In addition to the impact of declining market interest rates on asset yields, the interest foregone for loans in a non-accrual status for 2010 was $2.9 million. Transaction deposit accounts including NOW and money market accounts also have variable interest rates; although changes are determined by management and are not based on a specific index such as prime. Our certificates of deposit and certain borrowings have rates that are fixed until maturity. While repricing of fixed rate certificates of deposit and borrowings are delayed until renewal, our floating rate borrowings are primarily LIBOR-based, and changes in LIBOR rates more closely match changes in market interest rates than changes in the prime rate.

 

During 2010, the Federal Reserve maintained the federal funds target rate consistent with year-end 2009 at a range of zero to 0.25%. The federal funds rate is currently at a historical low, surpassing the previous low of 1.00% in June of 2003. Although the federal funds rate did not change during the year, the yield on earning assets decreased 30 basis points while our funding costs decreased 54 basis points. Net interest income increased on downward repricing on deposits, particularly on renewed certificates of deposit, declining borrowing balances and maintaining loan pricing discipline through the increased use of interest rate floors on variable rate loans during this period of low market interest rates.

 

We will continue to evaluate ways to improve our net interest margin. We expect competition for loan production during this time of weak loan demand to keep pressure on loan yields; while competition for deposits and the related deposit costs will not be as intense as in some prior years. We will also have an opportunity to reprice downward higher rate, maturing certificates of deposit. This should assist us in improving our net interest margin in 2012.

 

Provision for Loan Losses. We recorded a $39.0 million provision for loan losses for the year 2010 representing an increase of $5.0 million from the $34.0 million provision for the full year 2009. The level of provisions is reflective of the trends in the loan portfolio, including levels of nonperforming loans and other loan portfolio quality measures, and analyses of impaired loans. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” The provision for loan losses was 3.25% and 2.67% of average loans in 2010 and 2009, respectively. Our percentage of net loan charge-offs to average loans outstanding was 3.25% for the year ended December 31, 2010, compared with 1.82% for the year ended December 31, 2009. Nonperforming loans totaled $91.8 million, or 8.08%, of total loans at December 31, 2010 compared with $37.7 million, or 3.07%, of total loans at December 31, 2009. Nonperforming loans and increased net charge-offs continue to be predominantly related to residential construction and development lending although we are now beginning to see stress in other segments of the loan portfolio as the weak economy persists. The allowance for loan losses at December 31, 2010 of $29.6 million represents 2.60% of total loans and 32% of nonperforming loans. The allowance for loan losses at December 31, 2009 of $29.6 million was 2.41% of total loans outstanding and 79% of nonperforming loans at that date.

 

Non-Interest Income. For the year ended December 31, 2010, non-interest income increased $2.7 million, or 20.9%. Gains on sales of investment securities increased $2.3 million. Income from the investment in SBIC activities increased $483 thousand with income of $631 thousand in 2010 compared to $148 thousand in 2009. The improved SBIC income resulted from realized gains from the harvest of certain investments while recognizing smaller write-downs in other investments in small companies who were not able to survive the current economic weakness. Income from investment brokerage and trust fees increased from the prior year by $315 thousand to $1.5 million. Service charges on deposit accounts increased $287 thousand, or 4.6%, of which $121 thousand was due to increased fees and growth of new deposit accounts, a $537 thousand increase in debit card income and a decrease of $371 thousand in NSF fees. Mortgage banking income increased $78 thousand due to improved pricing strategies and maintaining strong origination volume heavily refinance laden. Losses on economic hedges for 2010 were $532 thousand, a decrease of $766 thousand compared to a gain of $234 thousand in the prior year.

 

 

 

Non-Interest Expense. The significant decrease of $52.7 million in non-interest expense in 2010 was due primarily to recognizing a non-recurring $49.5 million goodwill impairment charge during 2009 which was related to the goodwill generated by the merger with The Community Bank in January 2004. Excluding the goodwill impairment charge, non-interest expense decreased $3.2 million due to cost reduction initiatives established during late 2009 and continuing during 2010. These cost reductions included salary reductions for executive management, a salary freeze for all employees and reducing the 401(k) employer match from 100% to 50%. The result of these actions was a reduction in salaries of $1.1 million and reduced employee benefit cost of $509 thousand, including a decrease of $347 thousand in the 401(k) match and a reduction of $77 thousand in payroll taxes. The FDIC deposit insurance assessment for 2010 totaled $2.2 million, a decrease of $901 thousand compared to 2009 when a special assessment of $789 thousand was charged. FDIC assessments for 2011 and following years will continue at increased premium rates to rebuild the Deposit Insurance Fund that has been stressed during the recent economic downturn and the Bank’s regulatory condition. Non-interest expense related to problem loans increased sharply as writedowns in the carrying values of foreclosed assets increased $599 thousand, or 24.0%, and expenses to maintain foreclosed property increased $939 thousand, or 106.3%. Gains on sales of foreclosed assets increased $233 thousand on slightly higher volume of sales ($11.4 million in 2010 versus $10.7 million in 2009). The Company began a buyer incentive program near the end of 2008 to assist contractors in the sales of speculative houses financed by the Bank. Under this program, the Bank paid up to $10 thousand to home buyers that purchased certain bank-financed speculative houses. The expense for this program during 2010 was $413 thousand compared to $1.3 million during 2009 as the program was discontinued at the end of the second quarter of 2010. Occupancy and equipment expense decreased $475 thousand, or 6.0% primarily due to decreases in depreciation on software of $248 thousand and in depreciation on information technology equipment of $105 thousand. Other non-interest expense included increases in professional expenses of $758 thousand and real estate appraisal fees of $224 thousand, partially offset by a decrease in advertising of $178 thousand. Professional expenses increased due to higher legal and collection costs largely driven by the increased volume of problem loans in 2010. Management reduced our advertising expenses during 2010 by selectively cutting back on product promotional opportunities in print media.

 

Provision for Income Taxes. The Company recorded an income tax expense of $4.3 million for the year ending December 31, 2010 compared to income tax benefit of $6.7 million for 2009. The tax expense was primarily the result of increasing the deferred tax asset valuation allowance by $12.6 million to properly state the realizability of the Company’s deferred tax asset. The Company will recapture all available prior year taxes paid and generate a net operating loss carryforward when filing the current year return. See Note 14 Income Taxes in the footnotes to the audited financial statements for further disclosure on this matter.

 

LIQUIDITY

 

Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources.

 

The term “liquidity” refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.

 

Sources of liquidity include cash and cash equivalents, (net of federal requirements to maintain reserves against deposit liabilities), investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits and borrowings. The primary sources of borrowed funds are from the Federal Home Loan Bank, under the Federal Reserve’s discount window, and from correspondent banks under overnight federal funds credit lines and revolving lines of credit. In addition to managing deposit and borrowing outflows, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.

 

 

 

We have maintained a sufficient level of liquidity in the form of federal funds sold, overnight deposits and investment securities. These liquid assets aggregated $405.4 million at December 31, 2011, compared to $373.9 million and $353.8 million at December 31, 2010 and 2009, respectively. The increase in 2011 resulted from increased investment securities funded by loan payoffs which exceeded decreases in deposits, reduced federal funds sold and interest bearing accounts and new borrowings. Supplementing customer deposits as a source of funding, we had an available line of credit from a correspondent bank to purchase federal funds on a short-term basis of approximately $15.0 million at December 31, 2011. As a result of the Bank’s February 2011 Consent Order, we let some federal funds lines expire rather than secure them with collateral. As of December 31, 2011, the Bank has the credit capacity to borrow up to $374.9 million, from the Federal Home Loan Bank of Atlanta, with $76.6 million outstanding as of that date. The Bank’s ability to borrow at the FHLB is a function of its lendable collateral available for pledging. At December 31, 2011, the Bank had $118.1 million in lendable collateral (loans and investment securities) value pledged at the FHLB. Excluding the $76.6 million in borrowings outstanding with the FHLB, pledged collateral at the FHLB would support $41.5 million in additional borrowings absent the pledging of any additional collateral. At December 31, 2011, we had funding of $60.0 million in the form of long term repurchase agreements with maturities from one to seven years. We also had short-term repurchase agreements with total outstanding balances of $28.6 million and $4.8 million at December 31, 2011 and 2010, respectively, $8.6 million of which were done as accommodations for our deposit customers. Securities sold under agreements to repurchase are collateralized by US government agency obligations. As of December 31, 2011, the Bank had repurchase lines of credit aggregating $145.0 million from various institutions. The repurchases must be adequately collateralized.

 

During the first twelve years of our fifteen year history, our loan demand typically exceeded our growth in core deposits. We therefore relied heavily on certificates of deposit as a source of funds. While the majority of these funds are generally from our local market area, the Bank has utilized brokered and out-of-market certificates of deposit to diversify and supplement our deposit base. Certificates of deposit represented 48.3% of our total deposits at December 31, 2011, virtually unchanged from 48.6% at December 31, 2010 although the volume of these time deposits decreased $83.6 million during the year. Brokered and out-of-market certificates of deposit totaled $147.6 million at year-end 2011 and $234.6 million at year-end 2010, which comprised 12.5% and 17.4% of total deposits, respectively. This $87.0 million reduction in brokered deposits is in compliance with our Consent Order which states that we may not accept, renew or rollover any brokered or out-of-market certificates of deposit. Further, the Bank intends to reduce these deposits to 10% of total deposits or less during 2012. Certificates of deposit of $100 thousand or more represented 18.4% of our total deposits at December 31, 2011 and 15.4% at December 31, 2010. A portion of these deposits come from customers with long-standing relationships with our management. Based upon the nature of these relationships, management does not believe we are subject to significant liquidity risk related to these deposits. Large certificates of deposit are generally considered rate sensitive.

 

At December 31, 2011, our outstanding commitments to extend credit consisted of loan commitments of $227.1 million, including amounts available under home equity credit lines and letters of credit of $89.4 million and $6.9 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand, deposit and borrowings maturities and deposit withdrawals in the near term.

 

 

CONTRACTUAL OBLIGATIONS AND COMMITMENTS

 

In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, which may or may not require future cash outflows. The following table reflects contractual obligations of the Company outstanding as of December 31, 2011.

 

		Payments Due by Period
						On Demand
						or Within												After
Contractual Obligations		Total				1 Year				2 - 3 Years				4 - 5 Years				5 Years
		(Amounts in thousands)
Short-term borrowings		$	33,629			$	33,629			$	-			$	-			$	-
Long-term borrowings			177,514				-				30,000				65,000				82,514
Operating leases			5,374				810				1,397				679				2,488
Total contractual cash obligations
excluding deposits			216,517				34,439				31,397				65,679				85,002
Deposits			1,183,172				902,913				200,871				16,588				62,800
Total contractual cash obligations		$	1,399,689			$	937,352			$	232,268			$	82,267			$	147,802

 

The following table reflects other commitments of the Company outstanding as of December 31, 2011.

 

		Amount of Commitment Expiration Per Period
						Within												After
Other Commitments		Total				1 Year				2 - 3 Years				4 - 5 Years				5 Years
		(Amounts in thousands)
Undisbursed portion of home equity
credit lines collateralized primarily
by junior liens on 1-4 family properties		$	89,387			$	2,151			$	5,080			$	5,656			$	76,500
Other commitments and credit lines			102,648				87,271				5,314				1,390				8,673
Undisbursed portion of construction loans			28,123				17,109				2,646				6,176				2,192
Mortgage loan commitments			6,911				6,911				-				-				-
Total other commitments		$	227,069			$	113,442			$	13,040			$	13,222			$	87,365

 

OFF-BALANCE SHEET ARRANGEMENTS

 

Information about the Company’s off-balance sheet risk exposure is presented in Note 18 to the accompanying consolidated financial statements. As part of its ongoing business, the Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (SPEs), which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2011, Southern Community Capital Trust II, the subsidiary that issued 3,450,000 shares of Trust Preferred Securities in November 2003 and Southern Community Capital Trust III, which issued $10.0 million in Trust Preferred Securities in June 2007, represented the Company’s only SPE activity. The Trust Preferred Securities are backed by junior subordinated debentures issued by the Company, which are included in long-term borrowings on the balance sheet.

 

CAPITAL RESOURCES

 

Stockholders’ equity at December 31, 2011 was $97.6 million. At that date, the Company’s capital to asset ratio was 6.50% and all of our regulatory capital ratios exceeded the minimums established for a well capitalized bank holding company.

 

The Bank and the Company are subject to minimum capital requirements. See “Supervision and Regulation.” As the following table indicates, at December 31, 2011, the Company exceeded its regulatory capital requirements.

 

		At December 31, 2011
			Bank				Company				Minimum Requirement				Well Capitalized Requirements
Total risk-based capital ratio			13.85	%			14.26	%			8.00	%*			10.00	%
Tier 1 risk-based capital ratio			12.59	%			11.75	%			4.00	%			6.00	%
Leverage ratio			9.07	%			8.47	%			4.00	%*			5.00	%

 

* Under the terms of the Consent Order into which the Bank entered on February 25, 2011 (see “Supervision and Regulation”), the Bank agreed to comply with increased minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital.

 

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval. On February 14, 2011, the Company announced the suspension of the payment of regular quarterly cash dividends on the Company’s preferred stock issued to the US Treasury. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. Interest on the past due payments is now also being accrued. As of December 31, 2011, the total amount of cumulative dividends owed to the US Treasury was $2.6 million.

 

As a condition of the CPP, the Company must obtain approval from the United States Department of the Treasury to repurchase its common stock or to increase its cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. The Company agreed to certain restrictions on executive compensation, including limitations on amounts payable to certain executives under severance arrangements and change in control provisions of employment contracts and clawback provisions in compensation plans, as part of the CPP. During 2009, Congress and the United States Treasury Department imposed additional restrictions on executive compensation, including a prohibition on severance arrangements with certain executive officers, limitations on incentive compensation and various corporate governance requirements that are applicable to participants in the CPP.

 

On March 24, 2009, Southern Community Financial Corporation announced that its Board of Directors had voted to suspend payment of a quarterly cash dividend to common shareholders. If and when the Consent Order is removed, the Board will continue to evaluate a payment of a quarterly cash dividend on a periodic basis.

 

The Company’s dividend policy is subject to the discretion of our Board of Directors and will depend upon such factors as future earnings, growth, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions. Our ability to pay dividends in the future will directly depend on future profitability, which cannot be accurately estimated or assured. In light of the current economic environment, the FDIC has encouraged banks to consider reducing their dividends to preserve capital. We cannot guarantee if or when we will resume paying quarterly cash dividends to shareholders in the future.

 

Through July 2006, the Company authorized the repurchase of up to 1.9 million shares of its common stock. Through December 5, 2008 (the date of our participation in the Treasury’s Capital Purchase Plan), the Company had repurchased 1,858,073 shares at an average price of $6.99 per share under the three plans. No shares were repurchased during 2010 or 2011.

 

The Company’s trust preferred securities presently qualify as Tier 1 regulatory capital to the limit of 25% of all core capital elements and are reported in Federal Reserve regulatory reports as a minority interest in our consolidated subsidiaries. Amounts in excess of the 25% limitation count as Tier 2 supplementary capital for regulatory purposes. At December 31, 2011, $32.2 million of the total $44.5 million in trust preferred securities counted as Tier 1 capital and the remaining $12.3 million as Tier 2 supplementary capital.

 

 

 

In June 2007, $10.0 million of trust preferred securities were placed through Southern Community Capital Trust III (“Trust III”), as part of a pooled trust preferred security. The Trust III issuer invested the total proceeds from the sale of the trust preferred securities in junior subordinated deferrable interest debentures (the “Junior Subordinated Debentures”) issued by the Company. The terms of the trust preferred securities require payment of cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to LIBOR plus 1.43%. During 2008, the Company entered into an interest rate swap derivative contract with a counterparty that shifted this debt service from a variable rate to a fixed rate of 4.7% per annum. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities are redeemable in 30 years with a five year call provision. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The principal use of the net proceeds from the sale of the debentures was to provide additional capital to the Company to fund its operations and continued expansion, and to maintain the Company’s and the Bank’s status as “well capitalized” under regulatory guidelines.

 

In November of 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 shares of Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase junior subordinated debentures from the Company under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extends beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Because we have deferred the payment of interest on the debentures, the Company is precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank.

 

In February 2011, the Company elected to defer the regularly scheduled interest payments on both issues of junior subordinated debentures related to our outstanding trust preferred securities. As of December 31, 2011, the total amount of suspended interest payments on trust preferred securities was $2.9 million.

 

ASSET/LIABILITY MANAGEMENT

 

Our results of operations depend substantially on net interest income. Like most financial institutions, our interest income and cost of funds are affected by general economic conditions and by competition in the market place. The purpose of asset/liability management is to provide stable net interest income growth by protecting earnings from undue interest rate risk, which arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk and capital adequacy. We adhere to a Board-approved asset/liability management policy that provides guidelines for controlling, monitoring and reporting exposure to interest rate risk. Our policy is to manage the Company’s net interest income exposure by measuring the impact of changing interest rate environments and adjusting the mix of assets and liabilities to provide an acceptable return within established risk limits. Net interest income simulation and gap reports in conjunction with other tools are utilized to measure and monitor interest rate risk.

 

When suitable lending opportunities are not sufficient to utilize available funds, we have generally invested such funds in securities, primarily securities issued by governmental agencies and asset-backed securities. The securities portfolio contributes to increased profitability and plays an important part in our overall interest rate risk management. However, management of the securities portfolio alone cannot balance overall interest rate risk. The securities portfolio must be used in combination with other asset/liability techniques to actively manage the balance sheet. The primary objectives in the overall management of the securities portfolio are safety, liquidity, yield, asset/liability management (interest rate risk), and investing in securities that can be pledged for public deposits or for borrowings.

 

In reviewing the needs of our Bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including net interest income simulations and gap analyses. A net interest income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Based on the results of the income simulation model as of December 31, 2011, if interest rates increase instantaneously by two percentage points, our net interest income over a one-year time frame could increase by approximately 15.7%, or $6.2 million. As of December 31, 2011, if interest rates decrease instantaneously by two percentage points, our net interest income over a one-year time frame could decrease by approximately 20.9% or $8.3 million. Given that many market interest rates were less than 1% as of December 31, 2011, we do not expect that rates would decrease by 2% from year end 2011 levels.

 

The analysis of interest rate gap (the difference between the amount of interest-earning assets and interest-bearing liabilities repricing or maturing during a given period of time) is another standard tool we use to measure exposure to interest rate risk. We believe that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.

 

Our balance sheet, based on gap measurements, was liability-sensitive at December 31, 2011 in the less than one-year horizon and asset-sensitive beyond one year. An asset-sensitive position means that there are more assets than liabilities subject to repricing in that period as market rates change, and conversely with a liability-sensitive position. As a result, in a falling rate environment, our earnings position could improve initially followed by a reduction in net interest income, with the opposite expectation in a rising rate environment, depending on the correlation of rate changes in these categories.

The following table presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2011 will either mature or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. Included in interest-bearing liabilities subject to rate changes within 90 days, there is 100% of the money market, NOW and savings deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators. As simplifying assumptions concerning repricing behavior, all money market, NOW and savings deposits are assumed to reprice immediately and fixed rate loans and mortgage-backed securities are assumed to reprice at their contractual maturity.

 

		At December 31, 2011
		3 Months or Less				Over 3 Months to 12 Months				Total Within 12 Months				Over 12 Months				Total
		(Amounts in thousands)
Interest-earning assets
Loans		$	124,935			$	182,913			$	307,848			$	642,174			$	950,022
Investment securities available for sale			-				850				850				361,448				362,298
Investment securities held to maturity			-				171				171				44,232				44,403
Federal funds sold and other interest-
bearing deposits			23,198				-				23,198				-				23,198
Total interest-earning assets		$	148,133			$	183,934			$	332,067			$	1,047,854			$	1,379,921
Interest-bearing liabilities
Deposits:
Money market, NOW and savings deposits		$	475,900			$	-			$	475,900			$	-			$	475,900
Time deposits greater than $100,000			5,737				115,808				121,545				95,591				217,136
Other time deposits			43,211				126,824				170,035				184,667				354,702
Borrowings			33,629				-				33,629				177,514				211,143
Total interest-bearing liabilities		$	558,477			$	242,632			$	801,109			$	457,772			$	1,258,881
Interest sensitivity gap per period		$	(410,344	)		$	(58,698	)		$	(469,042	)		$	590,082			$	121,040
Cumulative gap		$	(410,344	)		$	(469,042	)		$	(469,042	)		$	121,040			$	121,040
Cumulative ratio of interest-sensitive
assets to interest-sensitive liabilities			26.52	%			41.45	%			41.45	%			109.61	%			109.61	%

  

 

MARKET RISK

 

Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the Bank’s asset/liability management function, which is discussed in “Asset/Liability Management” above. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments that are considered market risk sensitive at December 31, 2011.

 

		Expected Maturities of Market Sensitive Instruments Held
		at December 31, 2011 Occurring in the Indicated Year
		(Amounts in thousands)																												Average				Estimated
																							Beyond								Interest				Fair
			2012				2013				2014				2015				2016				Five Years				Total				Rate				Value
FINANCIAL ASSETS
Federal funds sold		$	23,198			$	-			$	-			$	-			$	-			$	-			$	23,198				0.35	%		$	23,198
Investment securities (1) (2)			1,424				11,109				821				568				1,592				391,187				406,701				2.64	%			407,812
Loans (3)
Fixed rate			86,526				90,041				63,947				87,459				84,785				100,089				512,847				5.96	%			488,166
Variable rate			184,795				59,772				23,337				16,698				29,529				123,044				437,175				3.72	%			416,136
Total		$	295,943			$	160,922			$	88,105			$	104,725			$	115,906			$	614,320			$	1,379,921				4.18	%		$	1,335,312
FINANCIAL LIABILITIES
Money market, NOW and
savings deposits		$	475,900			$	-			$	-			$	-			$	-			$	-			$	475,900				0.36	%		$	475,900
Time deposits			291,579				146,435				54,436				14,813				1,775				62,800				571,838				1.79	%			701,173
Short-term borrowings			33,629				-				-				-				-				-				33,629				3.44	%			35,334
Long-term borrowings			-				30,000				-				10,000				55,000				82,514				177,514				4.17	%			161,888
Total		$	801,108			$	176,435			$	54,436			$	24,813			$	56,775			$	145,314			$	1,258,881				1.63	%		$	1,374,295

 

(1)

Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using federal and state tax rates of 34% and 6.9%, respectively, less estimated disallowed interest expense.

(2)

Callable securities and borrowings with favorable market rates at December 31, 2011 are assumed to mature at their call dates for purposes of this table.

(3)

Includes non-accrual loans but not the allowance for loan losses.

QUARTERLY FINANCIAL INFORMATION

 

The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period.

 

		Year Ended December 31, 2011																Year Ended December 31, 2010
		Fourth				Third				Second				First				Fourth				Third				Second				First
		Quarter				Quarter				Quarter				Quarter				Quarter				Quarter				Quarter				Quarter
		(Amounts in thousands, except per share data and common stock price)
Interest income		$	16,602			$	17,287			$	18,148			$	18,699			$	19,164			$	20,049			$	20,439			$	20,986
Interest expense			5,111				5,335				5,578				5,868				6,759				6,773				7,007				7,739
Net interest income			11,491				11,952				12,570				12,831				12,405				13,276				13,432				13,247
Provision for loan losses			3,400				3,950				3,700				4,100				6,500				17,000				5,500				10,000
Net interest income  (loss)
after provision for
loan losses			8,091				8,002				8,870				8,731				5,905				(3,724	)			7,932				3,247
Non-interest income			4,403				3,200				3,534				2,903				4,200				3,060				4,392				3,953
Non-interest expense			11,497				10,425				11,255				11,483				12,608				10,984				12,333				11,843
Income (loss) before income
taxes			997				777				1,149				151				(2,503	)			(11,648	)			(9	)			(4,643	)
Income taxes			-				-				-				-				8,318				(3,698	)			(270	)			(32	)
Net income (loss)			997				777				1,149				151				(10,821	)			(7,950	)			261				(4,611	)
Effective dividend on
preferred stock			638				639				638				639				633				633				632				633
Net income (loss) available
to common shareholders		$	359			$	138			$	511			$	(488	)		$	(11,454	)		$	(8,583	)		$	(371	)		$	(5,244	)
Per common share data:
Net income (loss):
Basic		$	0.02			$	0.01			$	0.03			$	(0.03	)		$	(0.68	)		$	(0.51	)		$	(0.02	)		$	(0.31	)
Diluted			0.02				0.01				0.03				(0.03	)			(0.68	)			(0.51	)			(0.02	)			(0.31	)
Common stock price:
High		$	1.30			$	1.87			$	2.14			$	2.55			$	1.93			$	2.23			$	3.19			$	2.85
Low			1.00				1.15				1.02				1.05				1.00				1.50				2.10				2.09

 

 

 

LENDING ACTIVITIES

 

General. We provide to our customers residential, commercial and construction loans secured by real estate, as well as a full range of short- to medium-term commercial and industrial, Small Business Administration guaranteed and personal loans, both secured and unsecured. We have implemented loan policies and procedures that establish the basic guidelines governing our lending operations. Generally, those guidelines address the types of loans that we seek, our target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to us, including the indebtedness of any guarantor. The policies are reviewed and approved at least annually by our Board of Directors. We supplement our supervision of the loan underwriting and approval process with periodic loan audits by internal loan examiners. We have focused our lending activities on the types of loans that we believe will be most in demand by our target customers, as presented in the loan portfolio composition tables below.

 

 

 

		At December 31,
		2011								2010
						Percent								Percent
		Amount				of Total				Amount				of Total
		(Amounts in thousands)
Commercial real estate		$	387,275				40.8	%		$	455,705				40.3	%
Commercial
Commercial and industrial			85,321				9.0	%			92,307				8.2	%
Commercial line of credit			44,574				4.7	%			64,660				5.7	%
Residential real estate
Residential construction			101,945				10.7	%			137,644				12.2	%
Residential lots			45,164				4.8	%			62,552				5.5	%
Raw land			17,488				1.8	%			20,171				1.8	%
Home equity lines			95,136				10.0	%			104,833				9.3	%
Consumer			173,119				18.2	%			192,204				17.0	%
Subtotal			950,022				100	%			1,130,076				100	%
Less: Allowance for loan losses			(24,165	)			.0				(29,580	)			.0
Net Loans		$	925,857							$	1,100,496

 

		At December 31,
		2009								2008								2007
						Percent								Percent								Percent
		Amount				of Total				Amount				of Total				Amount				of Total
										(Amounts in thousands)
Residential mortgage loans		$	395,586				32.2	%		$	393,360				29.9	%		$	318,038				26.8	%
Commercial mortgage loans			455,268				37.0	%			419,212				31.9	%			390,948				32.9	%
Construction loans			178,239				14.5	%			260,549				19.8	%			259,740				21.9	%
Commercial and industrial loans			183,319				14.9	%			221,231				16.8	%			197,851				16.6	%
Loans to individuals			17,863				1.4	%			20,459				1.6	%			21,861				1.8	%
Subtotal			1,230,275				100	%			1,314,811				100	%			1,188,438				100	%
Less: Allowance for loan losses			(29,638	)							(18,851	)							(14,258	)
Net loans		$	1,200,637							$	1,295,960							$	1,174,180

 

   

The following table presents at December 31, 2011 the aggregate maturities of loans in the named categories of our loan portfolio which mature during the periods indicated.

 

		At December 31, 2011
		Due within								Due after one year								Due after
		one year								but within five years								five years								Total
		Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield
														(Amounts in thousands)
Commercial real estate		$	81,380				6.24	%		$	232,513				6.08	%		$	47,305				5.82	%		$	361,198				6.08	%
Commercial
Commercial and industrial			30,925				4.86	%			38,493				5.95	%			12,354				4.96	%			81,772				5.39	%
Commercial line of credit			36,784				5.66	%			6,169				5.24	%			191				6.58	%			43,144				5.60	%
Residential real estate
Residential construction			46,253				5.78	%			42,274				5.33	%			1,926				6.66	%			90,453				5.59	%
Residential lots			17,448				5.22	%			14,590				5.80	%			1,029				7.27	%			33,067				5.54	%
Raw land			5,164				6.82	%			3,836				6.43	%			7,005				4.33	%			16,005				5.63	%
Home equity lines			25,049				3.57	%			2,105				5.72	%			65,345				5.25	%			92,499				4.81	%
Consumer			32,084				6.54	%			68,844				6.48	%			62,908				5.96	%			163,836				6.29	%
Total			275,087				5.67	%			408,824				6.04	%			198,063				5.59	%			881,974				5.82	%
Nonaccrual loans			32,761								30,001								5,286								68,048
Loans, gross		$	307,848							$	438,825							$	203,349							$	950,022

 

The above table is based on contractual scheduled maturities. Early repayments of loans or renewals at maturity are not considered in this table.

 

Commercial Mortgage Loans. Our commercial mortgage loans totaled $387.3 million at December 31, 2011. These loans are secured principally by commercial buildings for office, retail, manufacturing, storage and warehouse properties. Generally, in underwriting commercial mortgage loans, we require the personal guaranty of borrowers and a demonstrated cash flow capability sufficient to service the debt. Loans secured by commercial real estate may be in greater amount and involve a greater degree of risk than one-to-four family residential mortgage loans, and payments on such loans are often dependent on successful operation or management of the properties and the underlying businesses. We make commercial mortgage loans at both fixed and variable rates for payment terms with amortizations periods of up to 20 years.

 

Commercial Loans. Commercial business lending is a primary focus of our lending activities. At December 31, 2011, our commercial and industrial loan portfolio equaled $129.9 million or 13.7% of total loans. Commercial loans include both secured and unsecured loans for working capital, expansion and other business purposes. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment. The Bank also makes term commercial loans secured by equipment and real estate. Lending decisions are based on an evaluation of the financial strength, management and credit history of the borrower and the quality of the collateral securing the loan. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment.

 

Commercial loans generally provide greater yields and reprice more frequently than other types of loans, such as real estate loans. More frequent repricing means that the yields on our commercial loans adjust with changes in market interest rates.

 

Real Estate Loans. Loans secured by real estate represent our greatest concentration of loans and are divided into three categories: residential mortgage, commercial mortgage and construction loans. We make real estate loans for purchasing, constructing and refinancing one-to-four family residential, five or more family residential and commercial properties. We also make loans secured by real estate to commercial and individual borrowers who use the loan proceeds for other purposes. Our real estate loans totaled $805.6 million at December 31, 2011, representing 84.8% of our total loans outstanding. Our loan policy generally requires an appraisal prior to funding a real estate loan, particularly if the loan amount equals or exceeds $250,000. It is the Bank’s policy to generally obtain a new appraisal on loan renewals depending on the complexity of the real estate, the amount of new credit being extended and the loan-to-value ratio. A new appraisal will generally be obtained if the value of the property in question appears to have changed significantly based on local real estate market conditions since last appraisal or if local real estate valuations have changed substantially since the property’s last appraisal.

 

 

 

We pursue an aggressive policy of evaluation and monitoring on any real estate loan that becomes troubled, including reappraisal when appropriate. We recognize and reserve for potential exposures as soon as we identify them. However, the pace of absorption of real properties is affected by each property’s individual nature and characteristics, the status of the real estate market at the time, general economic conditions and other factors that could adversely affect our volume of non-performing real estate loans and our ability to dispose of foreclosed properties without loss.

 

Residential Mortgage Loans. We provide our customers access to long-term conventional real estate loans through the origination of Federal National Mortgage Association-conforming loans. Many of the fixed-rate one-to-four family owner occupied residential mortgage loans that we originate are for sale in the secondary market and have been pre-sold for the account of third parties. As it relates to loans sold to third party investors, the Bank has no repurchase obligation on sold loans generally as long as: the investor underwriting guidelines were followed; there was no false representations or fraud involved; and the underlying borrowers make their first mortgage payment when due. Residential mortgage loans held for sale totaled $4.5 million at December 31, 2011.

 

Residential loans are generated through our in-house staff as well as the Bank’s existing customer base, referrals from real estate agents and builders and local marketing efforts. Our lending efforts include the origination of loans secured by first mortgages on one–to-four family residences or unimproved residential parcels of land and on home equity credit lines. Our residential mortgage loans totaled $316.4 million at December 31, 2011 including $158.6 million in one-to-four family permanent mortgage loans, $95.1 million in outstanding advances under home equity credit lines, $45.2 in residential lots and $17.5 in raw land. Substantially our entire residential mortgage loans are secured by properties located within our market area, although we will make loans secured by properties outside our market area to qualifying existing customers. We believe that the amount of risk associated with this group of residential mortgage loans is mitigated in part due to the type of loans involved. Historically, the amount of losses suffered on this type of loan has been significantly less than those loans collateralized by other types of properties. Declining real estate values have increased risk of loss in this sector in recent periods.

 

Our one-to-four family residential loans generally have maturities ranging from 1 to 30 years. These loans are either fully amortizing with monthly payments sufficient to repay the total amount of the loan or amortizing with a balloon feature, typically due in fifteen years or less. We review information concerning the income, financial condition, employment history and credit history when evaluating the creditworthiness of an applicant for a residential mortgage loan.

 

Consumer Loans. Consumer l oans include $158.6 million in 1-4 family residential mortgage loans discussed above and $14.5 million in loans to individuals totaling $173.1 million. Loans to individuals include automobile loans, boat and recreational vehicle financing and miscellaneous secured and unsecured personal loans. Consumer loans generally can carry significantly greater risks than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Repossessed collateral securing a defaulted consumer loan may not provide an adequate source of repayment of the loan. We attempt to manage the risks inherent in consumer lending by following established credit guidelines and underwriting practices designed to minimize risk of loss.

 

Construction Loans. We originate one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower or the home is presold), and we provide construction financing to builders including acquisition, development and “spec” home financing. We have a staff of lending professionals and assistants who service only our construction loan portfolio. We generally receive a pre-arranged permanent financing commitment from an outside banking entity prior to financing the construction of pre-sold homes. We lend to builders who have demonstrated a favorable record of performance and profitable operations within our market area. We also make commercial real estate construction loans on properties as noted in the preceding paragraph. We endeavor to limit our construction lending risk through adherence to established underwriting procedures. Also, we generally require documentation of all draw requests and utilize loan officers to inspect the project prior to funding any draw requests from the builder. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment on construction loans. Construction loans aggregated $101.9 million at December 31, 2011.

 

Loan Approvals. Our loan policies and procedures establish the basic guidelines governing our lending operations. Generally, the guidelines address the type of loans that we seek, our target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to us, including the indebtedness of any guarantor. The policies are reviewed and approved at least annually. We supplement our supervision of the loan underwriting and approval process with periodic internal loan audits.

 

Individual lending authorities are established by the Board of Directors as periodically requested by management. All individual lending authorities are reviewed and approved at least annually by the Board of Directors.

 

The Board Loan Committee consists of the CEO, Chief Commercial Banking Officer, Chief Credit Officer and five outside Directors as appointed by the Board of Directors. This Committee meets on a monthly basis to review for approval all loan requests from borrowers with aggregate exposure in excess of a specified limit. During November 2011, the Board of Directors revised the committee and individual lending authorities. While the Bank’s legal lending limit at December 31, 2011 was approximately $22.7 million, the Board Loan Committee must review for approval all loan requests from borrowers with aggregate exposure in excess of $5.0 million; this approval limit was previously $9.0 million. The Bank also has an internal bank loan committee comprised of seven members who review all loan requests with aggregate exposure between $4.0 million and $5.0 million; their previous approval authority was for aggregate exposure between $6.0 million and $9.0 million.

 

ASSET QUALITY

 

We consider asset quality to be of primary importance. We employ a formal internal loan review process to ensure adherence to the Lending Policy as approved by the Board of Directors. It is the responsibility of each lending officer to assign an appropriate risk grade to every loan originated. Credit Administration, through the loan review process, validates the accuracy of the initial and any revised risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, it is the loan officer’s responsibility to change the borrower’s risk grade accordingly. Our policy in regard to past due loans normally requires a charge-off to the allowance for loan losses within a reasonable period after collection efforts and a thorough review have been completed. Further collection efforts are then pursued through various means including legal remedies. Loans carried in a nonaccrual status and probable losses are considered in the determination of the allowance for loan losses.

 

Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on loans, unless we place a loan on nonaccrual basis. We account for loans on a nonaccrual basis when we have serious doubts about the collectability of principal or interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. If a borrower brings their loan current, our general policy is to keep this loan in a nonaccrual status until this loan has remained current for six months. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. We record interest on restructured loans at the restructured rates, as collected, when we anticipate that no loss of original principal will occur. Management also considers potential problem loans in the evaluation of the adequacy of the Bank’s allowance for loan losses. Potential problem loans are loans which are currently performing and are not included in nonaccrual or restructured loans as shown below, but about which we have doubts as to the borrower’s ability to comply with present repayment terms. Because these loans are at a heightened risk of becoming past due, reaching nonaccrual status or being restructured, they are being monitored closely.

 

Nonperforming Assets

 

The table sets forth, for the period indicated, information about our nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), and total nonperforming assets.

 

		At December 31,
		2011				2010				2009				2008				2007
						(Amounts in thousands)
Nonaccrual loans		$	38,715			$	63,168			$	35,535			$	14,433			$	2,052
Restructured loans - nonaccruing			29,333				28,609				2,197				-				-
Total nonperforming loans			68,048				91,777				37,732				14,433				2,052
Foreclosed assets			19,812				17,314				19,634				5,745				775
Total nonperforming assets		$	87,860			$	109,091			$	57,366			$	20,178			$	2,827
Accruing loans past due
90 days or more		$	-			$	-			$	-			$	-			$	8
Allowance for loan losses			24,165				29,580				29,638				18,851				14,258
Nonperforming loans to period end loans			7.13	%			8.08	%			3.07	%			1.10	%			0.17	%
Allowance for loan losses to period end loans			2.53	%			2.60	%			2.41	%			1.43	%			1.20	%
Allowance for loan losses to
nonperforming loans			36	%			32	%			79	%			131	%			695	%
Nonperforming assets to total assets			5.85	%			6.60	%			3.32	%			1.12	%			0.18	%
Restructured loans in accrual status not included
above		$	24,202			$	12,117			$	-			$	-			$	-

 

Nonperforming loans decreased to $68.0 million, or 7.13% of total loans, at December 31, 2011 compared to $91.8 million, or 8.08% of loans, at December 31, 2010.

 

The following table sets forth a breakdown of nonperforming loans as of the dates shown, by loan class.

 

		At December 31,
Nonperforming loans		2011				2010				2009
		(Amounts in thousands)
Construction		$	12,975			$	26,256			$	11,789
Commercial real estate			26,484				22,086				11,922
Commercial and industrial			4,977				10,642				3,586
Residential lots			12,096				19,192				7,643
Consumer			11,516				13,601				2,792
Total nonperforming loans		$	68,048			$	91,777			$	37,732

 

 

 

The following table sets forth a breakdown, by loan class, of impaired loans that were individually evaluated for loss impairment at December 31, 2011. This table further shows, within each loan class, the evaluation results for those loans requiring a specific valuation allowance and those which did not.

 

 

		With Specific Allowance												No Specific Allowance
		Unpaid												Unpaid								Total				Net
		Principal				Recorded				Specific				Principal				Recorded				Recorded				of Specific
		Balance				Investment				Allowance				Balance				Investment				Investment				Allowance
										(Amounts in thousands)
Commercial real estate		$	10,710			$	10,380			$	655			$	36,251			$	28,917			$	39,297			$	38,642
Commercial
Commercial and industrial			498				498				114				4,742				3,401				3,899				3,785
Commercial line of credit			99				99				99				957				905				1,004				905
Residential real estate
Residential construction			1,348				1,188				102				17,874				15,431				16,619				16,517
Residential lot loans			9,080				8,045				161				6,853				4,050				12,095				11,934
Raw land			-				-				-				3,808				1,484				1,484				1,484
Home equity lines			1,033				1,033				387				954				922				1,955				1,568
Consumer loans			1,839				1,753				90				10,501				9,000				10,753				10,663
Total		$	24,607			$	22,996			$	1,608			$	81,940			$	64,110			$	87,106			$	85,498

 

The recorded investment in loans that were considered individually impaired at December 31, 2011 totaled $87.1 million including all non-accrual loans and accruing troubled debt restructured loans. At that time, the largest non-accrual balance of any one borrower was $5.2 million, with the average balance for the two hundred twenty-one non-accrual loans being $308 thousand. At December 31, 2011, the recorded investment in impaired loans requiring a valuation allowance based on individual analysis were $23.0 million, with a corresponding valuation allowance of $1.6 million. In the above table for these impaired loans individually evaluated for loss impairment, the unpaid principal balance represents the amount borrowers owe the Bank; while, the recorded investment represents the amount of loans shown on the Bank’s books which are net of amounts charged off to date. For these impaired loans as of December 31, 2011, amounts charged off to date were $19.4 million or 18.2% of the unpaid principal balances.

 

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The Company has a small residential mortgage portfolio without the need to utilize government sponsored loan modification programs. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

 

As illustrated in one of the tables in Note 4 to the financial statements, during the twelve months ended December 31, 2011, the following concessions were made on 117 loans for $47.9 million (measured as a percentage of TDR loan balances):

 

·

Reduced interest rate for 36.8% (24 loans for $17.6 million);

·

Extension of payment terms for 57.2% (90 loans for $27.4 million);

·

Forgiveness of principal for 4.0% (1 loan for $1.9 million); and

·

Other for 2.0% (2 loans for $938 thousand).

 

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

 

Of the total of 117 loans for $47.9 million which were modified as TDRs during the twelve months ended December 31, 2011, there were payment defaults (where the modified loan was past due thirty days or more) of $7.0 million, or 14.7% of the total, during the twelve months ended December 31, 2011.

 

On these TDRs (117 loans for $47.9 million) during the twelve months ended December 31, 2011, the following represents the success or failure of these concessions during the past year:

 

·

63.1% are paying as restructured;

·

24.9% have been reclassified to nonaccrual;

·

6.8% have defaulted and/or been foreclosed upon; and

·

5.2% have paid in full.

 

For a further breakdown of the successes and failures of each type of concession/modification, see the table in Note 4 to the financial statements.

 

In addition to nonperforming loans, there were $98.5 million of loans at December 31, 2011, for which management has concerns regarding the ability of the borrowers to meet existing repayment terms, compared with $118.4 million at December 31, 2010. See “Credit Quality Indicators” below for a more detailed disclosure and discussion on the Bank’s distribution of credit risk grade classifications. Potential problem loans are primarily classified as substandard for regulatory purposes and reflect the distinct possibility, but not the probability, that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Although these loans have been identified as potential problem loans, they may never become delinquent, nonperforming or impaired. Additionally, these loans are generally secured by residential real estate or other assets, thus reducing the potential for loss should they become nonperforming. Potential problem loans are considered in the determination of the adequacy of the allowance for loan losses.

 

The following table sets forth a breakdown of foreclosed assets as of the dates shown, by loan class.

 

		At December 31,
Foreclosed assets		2011				2010				2009
		(Amounts in thousands)
Residential construction, land development
and other land		$	9,854			$	13,719			$	11,101
Commercial construction			1,196				1,196				2,206
1 - 4 family residential properties			1,990				991				4,272
Nonfarm nonresidential properties			6,772				1,353				1,670
Multi family properties			-				50				160
Repossessed equipment			-				5				225
Total foreclosed assets		$	19,812			$	17,314			$	19,634

 

Foreclosed assets consist of real estate acquired through foreclosure, repossessed assets and idled properties. At December 31, 2011 foreclosed assets totaled $19.8 million, or 1.32%, of total assets, and consisted of seventy seven properties. The largest dollar value of a foreclosed property at December 31, 2011 was $2.0 million. During the course of 2011, the Company acquired $20.5 million of property through foreclosure or repossession, collected $15.9 million in proceeds on asset dispositions, realized approximately $689 thousand in net gains on those dispositions and recorded $2.8 million in foreclosed asset valuation write-downs. The majority of these foreclosed assets at December 31, 2011 are located in North Carolina (88%) with the remainder located mostly in Florida (8%) and South Carolina (4%). We have reviewed recent appraisals of these properties and believe that the fair values, less estimated costs to sell, equal or exceed their carrying value.

 

 

Credit Quality Indicators

 

We monitor credit risk migration and delinquency trends in the ongoing evaluation and assessment of credit risk exposure in the overall loan portfolio. The following table presents trends in loan delinquencies, in loans classified substandard or doubtful and in nonperforming loans.

 

		At December 31,
		2011								2010								2009
										(Amounts in millions)
		$				% of Total				$				% of Total				$				% of Total
Loans delinquencies
30 - 89 days past due		$	5.2				0.55	%		$	5.5				0.48	%		$	7.2				0.58	%
Loans classified substandard or
doubtful		$	185.7				19.46	%		$	219.9				19.36	%		$	83.6				6.80	%
Nonperforming loans		$	68.0				7.13	%		$	91.8				8.08	%		$	37.7				3.07	%

 

As delinquency is viewed as one of the leading indicators for credit quality, the dollar amount of the Company’s 30-89 day delinquencies has declined year-over-year and sequentially compared with the last seven quarter end statistics since March 31, 2010. The percentage of total statistic has increased year-over-year due to the significant decrease in the Company’s loan portfolio. The improvement in loan delinquencies is attributable to a continued strong involvement of commercial loan officers and their management in monthly collection efforts.

 

Another key indicator of credit quality is the distribution of credit risk grade classifications in the loan portfolio and the trends in the movement or migration of these risk grades or classifications. See Note 5 in the financial statements for a description of the Bank’s credit risk grade classifications. The Substandard (Grade 7) and Doubtful (Grade 8) classifications denote adversely classified loans; while the Special Mention (Grade 6) classification may provide an early warning indicator of deterioration in the credit quality of a loan portfolio. The following table is a summary of certain classified loans in our loan portfolio at the dates indicated.

 

		December 31,								December 31,								December 31,
		2011								2010								2009
										(Amounts in millions)
		$				% of Total				$				% of Total				$				% of Total
Special Mention		$	96.1				10.1	%		$	139.0				12.3	%		$	119.7				9.8	%
Substandard and Doubtful			185.7				19.6	%			219.9				19.5	%			83.6				6.8	%
		$	281.8				29.7	%		$	358.9				31.8	%		$	203.3				16.6	%

 

The $34.2 million, or 16%, decrease in adversely classified loans from December 31, 2010 to December 31, 2011 was primarily due to the remediation of these loans, including the $20.5 million through foreclosure during 2011. The $42.9 million, or 21%, year-over-year decline in loans classified Special Mention demonstrates the improvement in the credit quality of the loan portfolio.

 

The following table is a further breakdown of the certain classified loans by loan class at December 31, 2011 along with an indicator of the overall credit quality of each loan class denoted by the weighted average risk grade.

 

		Weighted
		Average				Special				Substandard and
		Risk Grade				Mention				Doubtful
						(Amounts in thousands)
Commercial real estate			4.98			$	49,179			$	76,809
Commercial
Commercial and industrial			4.86				10,804				16,953
Commercial line of credit			4.49				2,796				3,895
Residential real estate
Residential construction			5.09				11,212				28,351
Residential lots			6.17				5,612				29,101
Raw land			5.35				976				4,705
Home equity lines			3.66				2,362				5,449
Consumer			4.21				13,147				20,480
						$	96,088			$	185,743

 

The following table is a further breakdown of the certain classified loans by loan class at December 31, 2010 along with an indicator of the overall credit quality of each loan class denoted by the weighted average risk grade.

 

		Weighted
		Average				Special				Substandard and
		Risk Grade				Mention				Doubtful
						(Amounts in thousands)
Commercial real estate			4.88			$	54,923			$	91,567
Commercial
Commercial and industrial			4.80				13,294				14,650
Commercial line of credit			4.52				4,000				6,384
Residential real estate
Residential construction			5.40				35,543				39,572
Residential lots			6.06				10,503				35,924
Raw land			5.01				209				6,824
Home equity lines			3.55				3,024				4,905
Consumer			4.15				17,489				20,087
						$	138,985			$	219,914

 

In addition to the financial strength of each borrower and cash flow characteristics of each project, the repayment of construction and development loans are particularly dependent on the value of the real estate collateral. Repayment of such loans is generally considered subject to greater credit risk than residential mortgage loans. Regardless of the underwriting criteria the Company utilizes, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of the real estate collateral and problems affecting the credit of our borrowers.

 

Furthermore, we monitor certain performance and credit metrics related to these higher risk loan categories, including the aging of the underlying loans in these categories. As of December 31, 2011, speculative construction loans on our books more than twelve months amounted to $12.6 million, or 37.9%, of the total speculative residential construction loan portfolio, a decrease from $19.3 million, or 50.5%, of total speculative residential construction loans as of December 31, 2010. Land acquisition and development loans on our books for more than twenty-four months at December 31, 2011 amounted to $35.7 million, or 77.8%, of that portfolio, a decrease from $40.2 million, or 67.7%, of that portfolio as of December 31, 2010.

 

Analysis of Allowance for Loan Losses

 

Our allowance for loan losses (“ALLL”) is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off and we reduce our allowance by loans charged off. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors derived from our history of operations. Management is continuing to closely monitor the value of real estate serving as collateral for our loans, especially lots and land under development, due to continued concern that the low level of real estate sales activity will continue to have a negative impact on the value of real estate collateral. In addition, depressed market conditions have adversely impacted, and may continue to adversely impact, the financial condition and liquidity position of certain of our borrowers. Additionally, the value of commercial real estate collateral may come under further pressure from weak economic conditions and prevailing unemployment levels. The methodology and assumptions used to determine the allowance are continually reviewed as to their appropriateness given the most recent losses realized and other factors that influence the estimation process. The model assumptions and resulting allowance level are adjusted accordingly as these factors change.

 

The ALLL consists of two major components: specific valuation allowances and a general valuation allowance. The Bank’s format for the calculation of ALLL begins with the evaluation of individual loans considered impaired. For the purpose of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be considered for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. Because the significant portion of the Company’s impaired loans are collaterally dependent, the fair value of collateral method is most often used. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Once a loan is considered individually impaired, it is not included in other troubled loan analysis, even if no specific allowance is considered necessary.

 

In addition to the evaluation of loans for impairment, we calculate the loan loss exposure on the remaining loans (not evaluated for impairment) by applying the applicable historical loan loss experience of the loan portfolio to provide for probable losses in the loan portfolio through the general valuation allowance. These loss factors are based on an appropriate loss history for each major loan segment more heavily weighted for the most recent twelve months historical loss experience to reflect current market conditions. In addition, we assign additional general allowance requirements utilizing qualitative risk factors related to economic trends (such as the unemployment rate and changes in real estate values) and portfolio trends (such as delinquencies and concentration levels among others) that are pertinent to the underlying risks in each major loan segment in estimating the general valuation allowance. This methodology allows us to focus on the relative risk and the pertinent factors for the major loan segments of the Company. The Company incorporates certain refinements and improvements to its allowance for loan losses methodology from time to time. During 2011, these refinements had a minimal effect on the total allowance for loan losses.

 

As discussed herein, management has undertaken various initiatives, particularly since September 30, 2010, in response to the challenging economic environment, increased nonperforming loans, weakened collateral positions, and increased foreclosed asset levels, including but not limited to:

 

·

Restructuring interest only loan payment terms to require principal repayments;

·

Refining the allowance for loan losses methodology to weight current period loss experience more heavily;

·

Downgrading renewed and other higher risk loans to a substandard classification;

·

Enhancing the internal controls surrounding troubled debt restructured (TDR) loan identification and monitoring;

·

Charging off weakened credits;

 

 

·

Increasing the staffing resources of our Credit Administration function, including problem asset management and loan review;

·

Enhancing our internal and external loan review protocol; and

·

Increasing the general valuation allowance component of our allowance for loan losses.

 

The following table shows, by loan segment, an analysis of the allowance for loan losses.

 

 

		At December 31,
		2011				2010
Allowance for credit losses:		(Amounts in thousands)
Beginning balance		$	29,580			$	29,638
Chargeoffs:
Commercial real estate			(7,988	)			(8,200	)
Commercial			(3,400	)			(5,610	)
Residential real estate			(8,132	)			(23,944	)
HELOC			(977	)			(1,799	)
Consumer			(4,388	)			(2,935	)
Total charge-offs			(24,885	)			(42,488	)
Recoveries
Commercial real estate			1,259				310
Commercial			525				1,165
Residential real estate			1,816				1,609
HELOC			147				172
Consumer			573				174
Total recoveries			4,320				3,430
Net charge-offs			(20,565	)			(39,058	)
Provision for loan losses
Commercial real estate			9,102				5,237
Commercial			1,757				5,520
Residential real estate			40				22,597
HELOC			749				1,933
Consumer			3,502				3,713
Total provision			15,150				39,000
Balance at end of period		$	24,165			$	29,580
Loans outstanding		$	950,022			$	1,130,076
Loans held for sale			4,559				5,991
Total Loans			954,581				1,136,067
Average loans outstanding		$	1,039,531			$	1,200,609
Allowance for loan losses to
loans outstanding			2.53	%			2.60	%
Ratio of net loan charge-offs to
average loans outstanding			1.98	%			3.25	%

 

In disaggregating the loan portfolio as of December 31, 2010, the Company revised the loan classes to be more closely aligned with the risk profile of the loan portfolio. We have not applied these revisions retroactively to prior year data and therefore we are disclosing the allocation of the allowance for loan losses for the dates indicated under both the new revised loan classes and the previous loan categories for comparability purposes.

 

An analysis of the allowance for loan losses and a breakdown of the specific and general valuation components of the ALLL are as follows:

 

		At December 31,
		2009				2008				2007
		(Amounts in thousands)
Balance at beginning of period		$	18,851			$	14,258			$	13,040
Charge-offs:
Residential mortgage loans			8,161				921				974
Commercial mortgage loans			1,753				165				-
Construction loans			7,757				1,452				140
Commercial and industrial loans			5,719				702				239
Loans to individuals			1,243				594				541
Total charge-offs			24,633				3,834				1,894
Recoveries:
Residential mortgage loans			131				113				86
Commercial mortgage loans			1				-				-
Construction loans			182				4				7
Commercial and industrial loans			971				28				63
Loans to individuals			135				117				181
Total recoveries			1,420				262				337
Net charge-offs			(23,213	)			(3,572	)			(1,557	)
Provision for loan losses			34,000				8,165				2,775
Balance at end of period		$	29,638			$	18,851			$	14,258
Loans outstanding		$	1,230,275			$	1,314,811			$	1,188,438
Loans held for sale			3,025				316				1,929
Total loans		$	1,233,300			$	1,315,127			$	1,190,367
Average loans outstanding		$	1,272,087			$	1,279,041			$	1,114,677
Allowance for loan losses to
loans outstanding			2.40	%			1.43	%			1.20	%
Ratio of net loan charge-offs to
average loans outstanding			2.33	%			1.47	%			1.28	%

 

		At December 31,
		2011								2010								2009								2008
		(Amounts in thousands)
		$				%				$				%				$				%				$				%
ALLL components:
Specific		$	1,608				7	%		$	5,129				17	%		$	9,792				33	%		$	2,792				15	%
General			22,557				93	%			24,451				83	%			19,846				67	%			16,059				85	%
Total		$	24,165				100	%		$	29,580				100	%		$	29,638				100	%		$	18,851				100	%

 

 

The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur. In disaggregating the loan portfolio as of December 31, 2010, the Company revised the loan classes to be more closely aligned with the risk profile of the loan portfolio. We have not applied these revisions retroactively to prior year data and therefore we are disclosing the allocation of the allowance for loan losses for the dates indicated under both the new revised loan classes and the previous loan categories for comparability purposes.

 

 

		At December 31,
		2011								2010
						% of Total								% of Total
By Loan Class		Amount				Loans (1)				Amount				Loans (1)
						(Amounts in thousands)
Commercial real estate		$	9,076				37.6	%		$	6,703				22.7	%
Commercial
Commercial and industrial			1,865				7.7	%			2,226				7.5	%
Commercial line of credit			1,171				4.8	%			1,928				6.5	%
Residential real estate
Residential Construction			4,564				18.9	%			7,451				25.2	%
Residential lots			2,595				10.7	%			5,576				18.9	%
Raw land			99				0.5	%			507				1.7	%
Home equity lines			1,412				5.8	%			1,493				5.0	%
Consumer			3,383				14.0	%			3,696				12.5	%
		$	24,165				100.0	%		$	29,580				100.0	%

 

		At December 31,
		2009								2008								2007
		Amount				% of Total Loans (1)				Amount				% of Total Loans (1)				Amount				% of Total Loans (1)
		(Amounts in thousands)
Residential mortgage loans		$	9,503				32.2	%		$	5,221				29.9	%		$	4,046				26.9	%
Commercial mortgage loans			5,782				37.0	%			3,670				31.9	%			2,975				32.8	%
Construction loans			8,629				14.5	%			4,428				19.8	%			3,225				21.8	%
Commercial and
industrial loans			5,203				14.9	%			3,524				16.9	%			2,854				16.6	%
Loans to individuals			421				1.4	%			1,058				1.5	%			1,158				1.9	%
Other (2)			100				-	%			950				-	%			-				-	%
Total		$	29,638				100.0	%		$	18,851				100.0	%		$	14,258				100.0	%

  

(1)

Represents total of all outstanding loans in each category as a percentage of total loans outstanding.

(2)

During 2007, the ALLL methodology was revised to comply with the Interagency Policy Statement on the ALLL. As a result the unallocated portion of the allowance decreased due to the methodology enhancements. During 2008, an unallocated segment was re-established as an additional qualitative factor due to the current economic environment presenting potential loss exposures in excess of our historical loss rates.

 

 

INVESTMENT ACTIVITIES

 

Our investment portfolio plays a primary role in the management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. The securities portfolio generates approximately 17% of our interest income and serves as a necessary source of liquidity.

 

Management attempts to deploy investable funds into instruments that are expected to increase the overall return of the portfolio given the current assessment of economic and financial conditions, while maintaining acceptable levels of capital, and interest rate and liquidity risk.

 

The following table summarizes the amortized cost, gross unrealized gains and losses and the resulting fair value of securities at the dates indicated.

 

						Gross				Gross
		Amortized				Unrealized				Unrealized
		Cost				Gains				Losses				Fair Value
						(Amounts in thousands)
December 31, 2011
Securities available for sale:
US Government agencies		$	34,660			$	69			$	-			$	34,729
Asset-backed securities
Residential mortgage-backed securities			185,838				1,713				245				187,306
Collateralized mortgage obligations			28,089				450				1,447				27,092
Small Business Administration loan pools			67,507				637				76				68,068
Student loan pools			8,903				-				1				8,902
Municipals			26,981				2,239				-				29,220
Trust preferred securities			3,250				-				929				2,321
Corporate bonds			4,213				-				554				3,659
Other			1,000				1				-				1,001
		$	360,441			$	5,109			$	3,252			$	362,298
Securities held to maturity:
Asset-backed securities
Residential mortgage-backed securities		$	474			$	34			$	-			$	508
Small Business Administration loan pools			4,928				230				-				5,158
Municipals			33,214				1,904				1				35,117
Corporate bonds			5,787				-				1,056				4,731
		$	44,403			$	2,168			$	1,057			$	45,514

 

 

						Gross				Gross
		Amortized				Unrealized				Unrealized
		Cost				Gains				Losses				Fair Value
		(Amounts in thousands)
December 31, 2010
Securities available for sale:
US Government agencies		$	100,101			$	198			$	2,059			$	98,240
Asset-backed securities
Residential mortgage-backed securities			65,452				2,001				130				67,323
Collateralized mortgage obligations			42,379				274				422				42,231
Small Business Administration loan pools			40,453				74				305				40,222
Municipals			55,901				404				741				55,564
Trust preferred securities			4,252				21				1,179				3,094
Common stocks and mutual funds			2,650				353				-				3,003
Other			1,000				-				24				976
		$	312,188			$	3,325			$	4,860			$	310,653
Securities held to maturity:
Asset-backed securities
Residential mortgage-backed securities		$	804			$	48			$	-			$	852
Municipals			31,416				104				1,631				29,889
Corporate bonds			10,000				-				560				9,440
		$	42,220			$	152			$	2,191			$	40,181
December 31, 2009
Securities available for sale:
US Government agencies		$	57,441			$	407			$	560			$	57,288
Asset-backed securities
Residential mortgage-backed securities			106,412				4,460				256				110,616
Collateralized mortgage obligations			70,131				1,353				-				71,484
Municipals			64,797				1,564				102				66,259
Trust preferred securities			4,252				-				1,376				2,876
Common stocks and mutual funds			3,418				141				295				3,264
Other			1,000				-				7				993
		$	307,451			$	7,925			$	2,596			$	312,780
Securities held to maturity:
US Government agencies		$	2,500			$	35			$	-			$	2,535
Asset-backed securities
Residential mortgage-backed securities			1,175				44				-				1,219
Municipals			7,244				185				3				7,426
		$	10,919			$	264			$	3			$	11,180

 

 

 

 

The following table presents the carrying values, fair values, intervals of maturities or repricings and weighted average yields of our investment portfolio at December 31, 2011.

 

 

		Amortized Cost				Fair Value				Weighted Average Yield
		(Amount in thousands)								(1)
Securities available for sale:
US Government agencies
Due after one but within five years		$	11,000			$	11,005				0.51	%
Due after five but within ten years			1,319				1,333				3.36	%
Due after ten years			22,341				22,391				3.56	%
			34,660				34,729				2.58	%
Asset-backed securities
Due after one but within five years			1,048				1,044				1.03	%
Due after five but within ten years			22,479				23,176				2.70	%
Due after ten years			266,810				267,148				2.04	%
			290,337				291,368				2.08	%
Municipals
Due within one year			850				850				1.40	%
Due after one but within five years			445				449				3.35	%
Due after five but within ten years			457				474				4.20	%
Due after ten years			25,229				27,447				4.56	%
			26,981				29,220				4.44	%
Trust preferred securities
Due after ten years			3,250				2,321				3.19	%
			3,250				2,321
Corporate Bonds
Due after ten years			4,213				3,659				7.00	%
			4,213				3,659
Other
Due after five but within ten years			1,000				1,001				1.17	%
			1,000				1,001
Total securities available for sale
Due within one year			850				850				1.40	%
Due after one but within five years			12,493				12,498				0.61	%
Due after five but within ten years			25,255				25,984				3.39	%
Due after ten years			321,843				322,966				2.36	%
		$	360,441			$	362,298				2.37	%
Securities held to maturity:
Asset-backed securities
Due within one year		$	6			$	6				6.47	%
Due after one but within five years			275				293				4.64	%
Due after ten years			5,122				5,367				3.96	%
			5,403				5,666				4.00	%
Municipals
Due within one year			165				166				4.25	%
Due after one but within five years			1,722				1,808				3.74	%
Due after five but within ten years			4,215				4,416				4.21	%
Due after ten years			27,111				28,727				4.82	%
			33,213				35,117				4.68	%
Corporate bonds
Due after one but within five years			5,787				4,731				6.00	%
			5,787				4,731
Total securities held to maturity
Due within one year			171				172				4.32	%
Due after one but within five years			7,784				6,832				3.86	%
Due after five but within ten years			4,215				4,416				5.25	%
Due after ten years			32,233				34,094				4.68	%
		$	44,403			$	45,514				4.77	%

____________

(1) Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using federal and state tax rates of 34% and 6.9%, respectively, less estimated disallowed interest expense.

 

 

At December 31, 2011, there were no securities of any issuer (other than US Government agencies) that exceeded 10% of the Company’s stockholders’ equity.

 

Derivative Financial Instruments

 

A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or reference rate. These instruments primarily consist of interest rate swaps, caps, floors, financial forward and futures contracts and options written or purchased. Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties and do not represent amounts to be exchanged between parties and are not a measure of financial risks. Credit risk arises when amounts receivable from counterparties exceed amounts payable. We control our risk of loss on derivative contracts by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit.

 

We have used interest rate swaps, caps and floors in the management of interest rate risk. Interest rate swaps are contractual agreements between two parties to exchange a series of cash flows representing interest payments. A swap allows both parties to alter the re-pricing characteristics of assets or liabilities without affecting the underlying principal positions. Through the use of a swap, assets and liabilities may be transformed from fixed to floating rates, from floating rates to fixed rates, or from one type of floating rate to another. At December 31, 2011, interest rate swap arrangements with total notional amounts of $85.0 million, with terms ranging up to thirty years, were outstanding. In addition, we had $12.5 million notional of interest rate caps with up to twenty-six months remaining until maturity at year end. These instruments help protect the Company from changes in interest rates by allowing us to receive payments from the counterparty on these contracts when the referenced rate falls outside the level specified in the agreement.

 

The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect any counterparties to fail their obligations.

 

A discussion of derivatives is presented in Note 17 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.

 

Sources of Funds

 

Deposit Activities

 

We provide a range of deposit services, including non-interest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and our desire to increase or decrease certain types or maturities of deposits. We have used brokered deposits and out-of-market deposits as funding sources. As of December 31, 2011, we have $147.6 million of brokered certificates of deposits or 12.5% of total deposits. Under the Consent Order, the Bank agreed that it will not accept, renew or rollover any brokered deposits without obtaining a waiver from the FDIC. We strive to establish customer relationships to attract core deposits in non-interest-bearing and other transactional accounts and thus to reduce our costs of funds.

 

 

The following table sets forth for the periods indicated the average balances outstanding and average interest rates for each of our major categories of deposits:

 

		For the Years Ended December 31,
		2011								2010								2009
		Average				Average				Average				Average				Average				Average
		Amount				Rate				Amount				Rate				Amount				Rate
		(Amounts in thousands)
Interest-bearing NOW and money market accounts		$	499,265				0.56	%		$	601,122				0.95	%		$	466,667				1.45	%
Time deposits $100,000 or more			217,325				1.07	%			178,288				1.52	%			193,505				2.50	%
Other time deposits			402,144				1.92	%			403,694				2.49	%			486,721				3.04	%
Total interest-bearing deposits			1,118,734				1.15	%			1,183,104				1.56	%			1,146,893				2.30	%
Demand and other non-interest-bearing deposits			132,469								119,418								107,461
Total average deposits		$	1,251,203				1.03	%		$	1,302,522				1.42	%		$	1,254,354				2.11	%

 

The following table presents the amounts and maturities of our certificates of deposit with balances of $100,000 or more and brokered certificates of deposit at the dates indicated:

 

		At December 31, 2011
		CDs > $100,000				Brokered CDs
		(Amounts in thousands)
Remaining Maturity
Less than three months		$	5,737			$	20,000
Three to six months			53,569				15,005
Six to twelve months			62,239				12,973
Over twelve months			95,591				99,581
Total		$	217,136			$	147,559

 

Borrowings

 

To supplement deposits, our primary source of funding, the Company utilizes borrowings for loan growth and other liquidity needs. The following is a summary of our borrowings at the indicated dates:

 

		At December 31,
		2011				2010
		(Amounts in thousands)
Short-term borrowings
FHLB advances		$	5,000			$	16,250
Repurchase agreements			28,629				4,808
Other borrowed funds			-				1,040
		$	33,629			$	22,098
Long-term borrowings
FHLB advances		$	71,637			$	56,809
Term repurchase agreements			60,000				80,000
Junior subordinated debentures			45,877				45,877
		$	177,514			$	182,686

 

Short term advances from the FHLB are collateralized as described below and are scheduled to be repaid within one year based on the terms of the individual borrowing. Securities sold under agreements to repurchase are scheduled to be repaid within one year based on the terms of the individual borrowing and are provided solely as an accommodation to our customers. Customer repurchase agreements are collateralized by US government agency obligations and generally mature within ninety days from the transaction date. The Company purchases federal funds through unsecured lines of credit aggregating $15.0 million. Federal funds purchased are subject to restrictions limiting the frequency and term of advances, are payable on demand and bear interest based upon the daily federal funds rate.

 

 

 

As an additional source of funding, the Company has long term borrowings including long term advances from the FHLB, term repurchase agreements from other commercial and investment banks and debt associated with the issuance of trust preferred securities. Total FHLB advances outstanding of $76.6 million at December 31, 2011 are collateralized by loans with a carrying amount of $73.9 million, which approximates market value, and investment securities with a market value of $44.2 million. The Company also has long-term repurchase agreements outstanding of $60.0 million from various institutions that are collateralized by investment securities having a carrying value of $97.5 million at December 31, 2011. Certain of these agreements contain embedded interest rate or call options that may be exercised by us or the counterparty. The following table presents the maturities for long term FHLB advances and term repurchase agreements.

 

Long term borrowings		At December 31, 2011
		FHLB Advances								Term Repo
Years of maturity		Interest Rate				Amount				Interest Rate				Amount
		(Amounts in thousands)
2013			1.83	%		$	30,000				-			$	-
2015			2.97	%			10,000				-				-
2016			3.02	%			25,000				3.70	%			30,000
Thereafter			3.54	%			6,637				3.74	%			30,000
						$	71,637							$	60,000

 

In November 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the Company, issued 3,450,000 shares of Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The Company is amortizing the issuance costs of these securities over their contractual life of thirty years. The unamortized balance of these issuance costs at December 31, 2008 was $1.3 million. The proceeds from the Trust II Securities were utilized to purchase junior subordinated debentures from the Company under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extends beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Because we have deferred the payment of interest on the debentures, the Company is precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank.

 

In June 2007, $10.0 million of trust preferred securities were placed through Southern Community Capital Trust III (“Trust III”), as part of a pooled trust preferred security. The Trust issuer invested the total proceeds from the sale of the trust preferred securities in junior subordinated deferrable interest debentures (the “Junior Subordinated Debentures”) issued by the Company. The terms of the trust preferred securities require payment of cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to LIBOR plus 1.43%. During 2008, the Company entered into an interest rate swap derivative contract with a counterparty that shifted this debt service from a variable rate to a fixed rate of 4.7% per annum. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities are redeemable in 30 years with a five year call provision. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The principal use of the net proceeds from the sale of the debentures was to provide additional capital into the Company to fund its operations and continued expansion, and to maintain the Company’s and the Bank’s status as “well capitalized” under regulatory guidelines.

 

The amount of the proceeds generated from the above offerings of trust preferred securities was $44.5 million. The amount of proceeds we count as Tier 1 capital cannot comprise more than 25% of our core capital elements. For us, this Tier 1 limit was $32.2 million at December 31, 2011. The $12.3 million in excess of that 25% limitation counts as Tier 2 supplementary capital on our books.

 

The carrying value of the junior subordinated debentures in connection with the two issues of trust preferred securities described above was $45.9 million at December 31, 2011.

 

In February 2011, the Company elected to defer the regularly scheduled interest payments on both issues of junior subordinated debentures related to our outstanding trust preferred securities.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

A discussion of recent accounting pronouncements is presented in Note 1 to our consolidated financial statements, which are presented under Item 8 in this Form 10-K.

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Statements contained in this annual report, which are not historical facts, are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Amounts herein could vary as a result of market and other factors. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Such forward-looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to the financial condition, expected or anticipated revenue, results of operations and business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory and technological factors affecting the Company's operations, pricing, products and services.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

See “MARKET RISK” under Item 7.

 

Item 8. Financial Statements and Supplementary Data

 

The information required by this item is filed herewith.

 

 

 

Report of Independent Registered Public Accounting Firm

 

To the Stockholders and the Board of Directors

Southern Community Financial Corporation and Subsidiary

Winston-Salem, North Carolina

 

We have audited the accompanying c onsolidated statements of financial condition of Southern Community Financial Corporation and Subsidiary as of December 31, 2011 and 2010, and the related c onsolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the c onsolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Community Financial Corporation and Subsidiary at December 31, 2011 and 2010 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Dixon Hughes Goodman LLP

 

Raleigh, North Carolina

March 23, 2012

 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
Consolidated STATEMENTS OF FINANCIAL CONDITION
December 31, 2011 and 2010

---

 

		2011				2010
		(Amounts in thousands, except share data)
Assets
Cash and due from banks		$	23,356			$	16,584
Federal funds sold and overnight deposits			23,198				49,587
Investment securities (Note 3)
Available for sale, at fair value			362,298				310,653
Held to maturity, (fair value of $45,514 and $40,181 at December 31, 2011 and 2010, respectively)			44,403				42,220
Federal Home Loan Bank stock (Note 3)			6,842				8,750
Loans held for sale			4,459				5,991
Loans (Note 4)			950,022				1,130,076
Allowance for loan losses (Note 5)			(24,165	)			(29,580	)
Net Loans			925,857				1,100,496
Premises and equipment (Note 6)			38,315				40,550
Foreclosed assets			19,812				17,314
Other assets (Notes 7 and 14)			54,038				61,253
Total Assets		$	1,502,578			$	1,653,398
Liabilities and Stockholders’ Equity
Deposits
Demand		$	135,434			$	110,114
Money market and NOW			453,114				541,949
Savings			22,786				40,929
Time (Note 8)			571,838				655,427
Total Deposits			1,183,172				1,348,419
Short-term borrowings (Note 9)			33,629				22,098
Long-term borrowings (Notes 9 and 10)			177,514				182,686
Other liabilities (Note 12 and 17)			10,628				7,854
Total Liabilities			1,404,943				1,561,057
Stockholders’ Equity (Notes 10, 11, 12 and 16)
Senior Cumulative Perpetual Preferred Stock (Series A),
no par value, 1,000,000 shares authorized; 42,750 shares
issued and outstanding at December 31, 2011 and 2010			41,870				41,453
Common stock, no par value, 30,000,000 shares authorized;
issued and outstanding 16,827,075 shares and 16,812,625
shares at December 31, 2011 and 2010, respectively			119,505				119,408
Retained earnings (accumulated deficit)			(64,425	)			(67,082	)
Accumulated other comprehensive income (loss)			685				(1,438	)
Total Stockholders’ Equity			97,635				92,341
Commitments and contingencies (Notes 13 and 18)
Total Liabilities and Stockholders’ Equity		$	1,502,578			$	1,653,398

 

See accompanying notes.

 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
Consolidated STATEMENTS OF OPERATIONS
Years Ended December 31, 2011, 2010 and 2009

---

 

		2011				2010				2009
		(Amounts in thousands, except
		share and per share data)
Interest Income
Loans		$	58,373			$	68,384			$	74,548
Investment securities available for sale			9,916				11,303				14,035
Investment securities held to maturity			2,281				886				877
Federal funds sold and overnight deposits			166				65				13
Total Interest Income			70,736				80,638				89,473
Interest Expense
Money market, savings, and NOW deposits			2,800				5,718				6,787
Time deposits			10,049				12,781				19,631
Short-term borrowings			397				1,108				1,701
Long-term borrowings			8,646				8,672				9,607
Total Interest Expense			21,892				28,279				37,726
Net Interest Income			48,844				52,359				51,747
Provision for Loan Losses (Note 5)			15,150				39,000				34,000
Net Interest Income After
Provision for Loan Losses			33,694				13,359				17,747
Non-Interest Income
Service charges and fees on deposit accounts			5,939				6,533				6,246
Income from mortgage banking activities			1,274				2,182				2,104
Investment brokerage and trust fees			1,008				1,474				1,159
Gain on sale of investment securities			3,989				3,531				1,236
Net impairment loss recognized in earnings			-				(186	)			(404	)
Other (Note 15)			1,830				2,072				2,565
Total Non-Interest Income			14,040				15,606				12,906
Non-Interest Expense
Salaries and employee benefits			18,308				20,926				22,502
Occupancy and equipment			7,168				7,428				7,903
FDIC deposit insurance			3,803				2,197				3,098
Foreclosed asset related			3,832				4,914				3,376
Goodwill impairment			-				-				49,501
Other (Note 15)			11,549				12,303				14,118
Total Non-Interest Expense			44,660				47,768				100,498
Income (Loss) Before Income Taxes			3,074				(18,803	)			(69,845	)
Income Tax Expense (Benefit) (Note 14)			-				4,318				(6,686	)
Net Income (loss)			3,074				(23,121	)			(63,159	)
Effective dividends on preferred stock (Note 11)			2,554				2,531				2,508
Net income (loss) available to common shareholders		$	520			$	(25,652	)		$	(65,667	)
Net Income (loss) Per Common Share
Basic		$	0.03			$	(1.53	)		$	(3.91	)
Diluted			0.03				(1.53	)			(3.91	)
Weighted Average Common Shares Outstanding
Basic			16,829,391				16,811,439				16,787,938
Diluted			16,896,692				16,811,439				16,787,938

 

See accompanying notes.

 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
Consolidated STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Years Ended December 31, 2011, 2010 and 2009

---

 

		2011				2010				2009
		(Amounts in thousands)
Net income (loss)		$	3,074			$	(23,121	)		$	(63,159	)
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding gains (loss) on available for sale securities			7,381				(3,519	)			1,012
Tax effect			(2,846	)			1,357				(390	)
Reclassification of gains recognized in net income			(3,989	)			(3,531	)			(1,236	)
Tax effect			1,538				1,361				476
Reclassification of impairment on equity securities			-				186				-
Tax effect			-				(72	)			-
Net of tax amount			2,084				(4,218	)			(138	)
Cash flow hedging activities:
Unrealized holding gains (losses) on cash flow hedging activities			(342	)			(738	)			354
Tax effect			132				284				(137	)
Reclassification of gains recognized in net income (loss), net
Reclassified into income			684				297				233
Tax effect			(264	)			(115	)			(90	)
Other			-				(14	)			(315	)
Tax effect			-				6				121
Net of tax amount			210				(280	)			166
Net postretirement benefit plans adjustment			(279	)			(40	)			(14	)
Tax effect			108				15				6
Net of tax amount			(171	)			(25	)			(8	)
Total other comprehensive income (loss)			2,123				(4,523	)			20
Comprehensive income (loss)		$	5,197			$	(27,644	)		$	(63,139	)

 

See accompanying notes.

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
Consolidated STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31, 2011, 2010 and 2009

---

   

																						Accumulated
																		Retained				Other				Total
		Preferred Stock								Common Stock								Earnings				Comprehensive				Stockholders'
		Shares				Amount				Shares				Amount				(Deficit)				Income (Loss)				Equity
										(Amounts in thousands, except share data)
Balance at December 31, 2008			42,750			$	40,690				16,769,675			$	119,054			$	24,901			$	3,065			$	187,710
Net income (loss)			-				-				-				-				(63,159	)			-				(63,159	)
Other comprehensive income, net of tax			-				-				-				-				-				20				20
Restricted stock issued			-				-				18,000				63				-				-				63
Stock-based compensation			-				-				-				165				-				-				165
Cash dividends of $0.04 per share			-				-				-				-				(664	)			-				(664	)
Preferred stock transaction:
Preferred stock dividends			-				-				-				-				(2,138	)			-				(2,138	)
Preferred stock accretion of discount			-				370				-				-				(370	)			-				-
Balance at December 31, 2009			42,750				41,060				16,787,675				119,282				(41,430	)			3,085				121,997
Net income (loss)			-				-				-				-				(23,121	)			-				(23,121	)
Other comprehensive income (loss), net of tax			-				-				-				-				-				(4,523	)			(4,523	)
Stock options exercised including income tax benefit of $0			-				-				200				-				-				-				-
Restricted stock issued			-				-				24,750				74				-				-				74
Stock-based compensation			-				-				-				52				-				-				52
Preferred stock transaction:
Preferred stock dividends			-				-				-				-				(2,138	)			-				(2,138	)
Preferred stock accretion of discount			-				393				-				-				(393	)			-				-
Balance at December 31, 2010			42,750				41,453				16,812,625				119,408				(67,082	)			(1,438	)			92,341
Net income			-				-				-				-				3,074				-				3,074
Other comprehensive income net of tax			-				-				-				-				-				2,123				2,123
Stock options exercised including
income tax benefit of $0			-				-				200				-				-				-				-
Restricted stock issued			-				-				14,250				71				-				-				71
Stock-based compensation			-				-				-				26				-				-				26
Cash dividends of $0.00 per share			-				-				-				-				-				-				-
Preferred stock transaction:
Preferred stock accretion of discount			-				417				-				-				(417	)			-				-
Balance at December 31, 2011			42,750			$	41,870				16,827,075			$	119,505			$	(64,425	)		$	685			$	97,635

 

See accompanying notes.

 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2011, 2010 and 2009

---

 

		2011				2010				2009
		(Amounts in thousands)
Cash Flows from Operating Activities
Net income (loss)		$	3,074			$	(23,121	)		$	(63,159	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization			4,617				4,389				4,131
Provision for loan losses			15,150				39,000				34,000
Net proceeds from sales of loans held for sale			60,846				105,113				175,887
Originations of loans held for sale			(58,040	)			(105,897	)			(176,492	)
Gain from mortgage banking			(1,274	)			(2,182	)			(2,104	)
Stock-based compensation			97				126				228
Net increase in cash surrender value of life insurance			(1,103	)			1,079				1,116
Realized gain on sales of available for sale securities			(3,989	)			(3,531	)			(1,236	)
Realized loss on impairment of investment securities available for sale			-				186				-
Realized loss of equity investment in Silverton Bank			-				-				404
Realized (gain) loss on sale of premises and equipment			54				24				(57	)
Loss on economic hedges			129				532				826
Deferred income taxes			(869	)			9,710				(5,836	)
Realized (gains) loss on sale of foreclosed assets			(689	)			(429	)			(196	)
OREO writedown			2,772				3,092				2,493
Goodwill impairment			-				-				49,501
Change in assets and liabilities:
(Increase) decrease in other assets			7,923				(1,964	)			(12,886	)
Increase (decrease) in other liabilities			2,422				(638	)			(2,608	)
Total Adjustments			28,046				48,610				67,171
Net Cash Provided by Operating Activities			31,120				25,489				4,012
Cash Flows from Investing Activities
(Increase) decrease in federal funds sold			26,389				(18,318	)			(29,089	)
Purchases of:
Available for sale investment securities			(360,488	)			(278,934	)			(215,169	)
Held to maturity investment securities			(7,829	)			(36,632	)			-
Proceeds from maturities and calls of:
Available for sale investment securities			44,496				143,570				122,115
Held to maturity investment securities			1,071				5,320				24,309
Proceeds from sale of:
Available for sale investment securities			274,785				132,930				69,846
Purchase of Federal Home Loan Bank stock			-				-				(421	)
Proceeds from sales of Federal Home Loan Bank stock			1,908				1,044				384
Net (increase) decrease in loans			139,167				49,280				35,421
OREO capitalized cost			(269	)			(103	)			(758	)
Purchases of premises and equipment			(827	)			(1,154	)			(5,962	)
Proceeds from disposal of premises and equipment			127				92				59
Proceeds from sale of foreclosed assets			16,010				11,401				10,699
Net Cash Provided by (Used in) Investing Activities			134,540				8,496				11,434

 

See accompanying notes.

 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARY
Consolidated STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2011, 2010 and 2009

---

 

		2011				2010				2009
		(Amounts in thousands)
Cash Flows from Financing Activities
Net increase (decrease) in demand deposits and transaction accounts			(81,658	)			(4,407	)			119,579
Net increase (decrease) in time deposits			(83,589	)			38,756				(38,621	)
Net increase (decrease) in short-term borrowings			(13,469	)			(63,379	)			(59,720	)
Proceeds from long-term borrowings			45,000				-				16,250
Repayment of long-term borrowings			(25,172	)			(16,417	)			(45,163	)
Preferred dividends paid			-				(2,138	)			(2,138	)
Cash dividends paid			-				-				(664	)
Net Cash Provided by (Used in) Financing Activities			(158,888	)			(47,585	)			(10,477	)
Net Increase (decrease) in Cash and Cash Equivalents			6,772				(13,600	)			4,969
Cash and Cash Equivalents, Beginning of Year			16,584				30,184				25,215
Cash and Cash Equivalents, End of Year		$	23,356			$	16,584			$	30,184

 

 

		2011				2010				2009
		(Amounts in thousands)
Supplemental Disclosures of Cash Flow Information
Interest paid on deposits and borrowed funds		$	19,452			$	28,818			$	40,835
Income taxes paid			-				945				754
Supplemental Schedule of Noncash Investing and Financing Activities
Transfer of loans to foreclosed assets		$	20,322			$	11,861			$	25,902
Transfer of investments from HTM to AFS			4,463				-				-
Increase (decrease) in fair value of securities available for sale, net of tax			2,084				(4,218	)			(138	)
Increase (decrease) in fair value of cash flow hedges, net of tax			210				(280	)			166
Unrealized gain (loss) on fair value hedges			266				(379	)			161

 

See accompanying notes.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

The consolidated financial statements include the accounts of Southern Community Financial Corporation and its wholly-owned subsidiary, Southern Community Bank and Trust. All material intercompany transactions and balances have been eliminated in consolidation. Southern Community Financial Corporation and its subsidiary are collectively referred to herein as the “Company.”

 

Nature of Operations

 

Southern Community Bank and Trust (the “Bank”) was incorporated November 14, 1996 and began banking operations on November 18, 1996. The Bank is engaged in general commercial and retail banking principally in Central and Western North Carolina, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation. In October 2001, Southern Community Financial Corporation (the “Company”) was formed as a financial holding company for the Bank, and is subject to the rules and regulations of the Federal Reserve System. On March 3, 2011, the Company applied to the Federal Reserve to modify its status from a financial holding company to a bank holding company. This was approved by the Federal Reserve Bank on March 14, 2011. The Bank and the Company undergo periodic examinations by those regulatory authorities.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the carrying value of foreclosed assets and the valuation allowance on deferred tax assets.

 

Cash and Cash Equivalents

 

For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption “Cash and due from banks,” which include cash on hand and amounts due from banks.

 

Federal regulations require institutions to set aside specified amounts of cash as reserves against transaction and time deposits. As of December 31, 2011, the daily average gross reserve requirement was $6.4 million.

 

Investment Securities

 

Available for sale securities are carried at fair value and consist of bonds, asset-backed securities and municipal securities not classified as trading securities or as held to maturity securities. The cost of debt securities available for sale is adjusted for amortization of premiums and accretion of discounts to maturity. Amortization of premiums, accretion of discounts, interest and dividend income are included in investment income. Unrealized holding gains and losses on available for sale securities are reported as a net amount in accumulated other comprehensive income, net of income taxes. Gains and losses on the sale of available for sale securities are determined using the specific identification method. Bonds and asset-backed securities for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using a method that approximates the interest method over the period to maturity. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in a permanent write down of the individual securities to their fair value if they are credit related. Such write-downs would be included in earnings as realized losses. Declines in fair value of individual debt securities that are not credit related including securities with below market interest rates are included in other comprehensive income. If the Company intends to sell a security or cannot assert that it is more likely than not to have to sell the security the loss must be included as a realized loss regardless of the reason for impairment. The classification of securities is generally determined at the date of purchase.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Federal Home Loan Bank Stock

 

The Company has an investment in the Federal Home Loan Bank of Atlanta which does not have readily determinable fair value and we do not exercise significant influence on them. The Company carries its investment in FHLB at its cost which is the par value of the stock.

 

Loans Held for Sale

The Company originates single family, residential first mortgage loans on a pre-sold basis. Loans held for sale are carried at the lower of cost or fair value in the aggregate as determined by outstanding commitments from investors. Upon closing, these loans, together with their servicing rights, are sold to mortgage loan investors under prearranged terms. The Company recognizes certain origination and service release fees upon the sale, which are included in non-interest income in the consolidated statement of operations . The Company does not hold nonmortgage loans for sale and did not reclassify any financing receivables to held for sale during the year.

 

The Company is exposed to certain risks relating to its ongoing mortgage origination business. The Company enters into interest rate lock commitments and commitments to sell mortgages. The primary risks are related to these interest rate lock commitments and forward-loan-sale commitments, which the Company executes on a “best efforts” basis rather than on a mandatory commitment basis. Under best efforts commitments, the Company is not obligated to deliver the loan for sale if the loan does not close. Using best efforts commitments to sell its mortgage loans, the Company can substantially mitigate the interest rate risk in its mortgage origination business.

 

Loans

 

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment to yield over the life of the related loan. Interest on loans is recorded based on the principal amount outstanding. For all classes, loans are considered delinquent and past due when payment has not been received for a period of 30 days after a scheduled payment due date. The accrual of interest on impaired loans is discontinued when loans are 90 days or more past due or, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Interest income is subsequently recognized only to the extent cash payments are received. Loans are written down or charged off when management has determined the loan to be uncollectible in part or in total. Loans are returned to an accrual status when the borrower makes timely principal and interest payments for a period of six months and has the ability to continue making scheduled payments until the loan is repaid in full. See Note 4 for further discussion of lending practices by loan class. Loans are primarily made in the Bank’s market areas of North Carolina. Real estate loans can be affected by the condition of the local real estate market. Commercial and installment loans can be affected by the local economic conditions. The Company’s off balance sheet credit exposure is limited to unused lines of credit. An allowance for loan loss has not been established for this exposure. The Company did not enter into any significant purchases or sales of financing receivables during 2011 or 2010.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Allowance for Loan Losses

 

The provision for loan losses is based upon management’s estimate of the amount needed to maintain the allowance for loan losses at a level believed adequate to absorb probable losses inherent in the loan portfolio. The Bank’s format for the calculation of ALLL begins with the evaluation of loans under impairment guidelines. For the purposes of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be considered for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. Once a loan is considered impaired, it is not included in the determination of the general loss component of the allowance, even if no specific allowance is considered necessary. In addition to the evaluation of individual loans for impairment, the Bank calculates the loan loss exposure on the remaining loans (not individually evaluated for impairment) by applying the applicable historical loan loss experience factors to each major loan segment.

 

The Bank also utilizes various other qualitative and quantitative factors to further evaluate the portfolio for risk. The other factors utilized include economic trends (such as the unemployment rate and changes in real estate values) and portfolio trends (such as delinquencies and concentration levels among others) that are pertinent to the underlying risks in each major loan segment. Based on the subjective evaluation of the impact of these qualitative and quantitative other factors, we assign additional general allowance requirements. The appropriate combined factor (historical loss experience adjusted for the qualitative and quantitative factors is applied to only those loans not individually evaluated for impairment. The ALLL calculation for specific loss and general loss exposure are aggregated to arrive at the approximate allowance level for our loan portfolio. While management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while the Company believes the allowance for loan losses has been established in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the loan portfolio, will not require adjustments to the allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect the Company’s financial condition and results of operations.

 

Premises and Equipment

 

Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets which are 11 to 30 years for buildings and 3 to 7 years for furniture and equipment. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are charged to operations as incurred and additions and improvements to premises and equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable.

 

Foreclosed Assets

 

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less estimated cost to sell at the date of foreclosure, establishing a new cost basis. Principal and interest losses existing at the time of acquisition of such assets are charged against the allowance for loan losses and interest income, respectively. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. Revenue and expenses from operations and the impact of any subsequent changes in the carrying value are included in other expenses.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Goodwill and Other Intangibles

 

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill impairment testing is performed annually or more frequently if events or circumstances indicate possible impairment. An impairment loss is recorded to the extent that the carrying value of goodwill exceeds its implied fair value.

 

Intangible assets with finite lives include core deposits and other intangibles. Intangible assets other than goodwill are subject to impairment testing whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Core deposit intangibles are amortized on the straight-line method over a period not to exceed 10 years. Note 7 contains additional information regarding goodwill and other intangible assets.

 

Income Taxes

 

Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. These temporary differences consist primarily of the allowance for loan losses, differences in the financial statement and income tax basis in premises and equipment and differences in financial statement and income tax basis in accrued liabilities. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be fully realized.

 

Derivative Instruments

 

The Company utilizes stand-alone derivative financial instruments, primarily in the form of interest rate swap and option agreements, in its asset/liability management program. These transactions involve both credit and market risk. The Company uses derivative instruments to mitigate exposure to adverse changes in fair value or cash flows of certain assets and liabilities which are required to be carried at fair value. Derivative instruments designated in a hedge relationship to mitigate 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. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

 

Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense on the hedged asset or liability. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in accumulated other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods the hedged transaction affects earnings. Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement.

 

The Company does not enter into derivative financial instruments for speculative or trading purposes. For derivatives that are economic hedges, but are not designated as hedging instruments or otherwise do not qualify for hedge accounting treatment, all changes in fair value are recognized in non-interest income during the period of change. The net cash settlement on these derivatives is included in non-interest income.

 

The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures and agreements that specify collateral levels to be maintained by the Company and the counterparties. These collateral levels are based on the credit rating of the counterparties.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

The Company currently has nine derivative instrument contracts consisting of one interest rate cap, six interest rate swaps and two foreign exchange contracts. The primary objective for each of these contracts is to minimize risk, interest rate risk being the primary risk for the interest rate caps and swaps; while foreign exchange risk is the primary risk for the foreign exchange contracts. The Company’s strategy is to use derivative contracts to stabilize and improve net interest margin and net interest income currently and in future periods. In order to acquire low cost, long term fixed rate funding without incurring currency risk, the Company entered into the foreign exchange contract to convert foreign currency denominated certificates of deposit into long term dollar denominated time deposits. The interest rate on the underlying $10.0 million certificates of deposit is based on a proprietary index (Barclays Intelligent Carry Index USD ER) managed by the counterparty (Barclays Bank). The currency swap is also based on this proprietary index. Note 17 contains additional information regarding derivative financial instruments.

 

Per Share Data

 

Basic net income (loss) per common share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during each period. Diluted net income (loss) per common share reflects the potential dilution that could occur if stock options or warrants were exercised resulting in the issuance of common stock that would then share in the net income of the Company. Diluted earnings (loss) per common share is computed by dividing net income (loss) available to common shareholders by the weighted average number of shares of common stock, common stock equivalents and other potentially dilutive securities using the treasury stock method.

 

Basic and diluted net income (loss) per common share have been computed based upon net income (loss) available to common shareholders as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:

 

		2011				2010				2009
Weighted average number of common shares used in computing basic net income per common share			16,829,391				16,811,439				16,787,938
Effect of  restricted stock			67,301				-				-
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per common share			16,896,692				16,811,439				16,787,938

 

 

For the years ended December 31, 2011, 2010 and 2009, net income (loss) for determining earnings per common share was reported net income (loss) less the effective dividends on preferred stock. For the years ended December 31, 2011, 2010 and 2009, there were 531,850, 598,006 and 657,100 exercisable options, respectively. In 2011, 531,850 options were antidilutive since the exercise price exceeded the average market price for the year. In 2010 and 2009, all options were antidilutive due to reported net losses. The outstanding warrants to purchase 1,623,418 shares provided to the US Treasury were antidilutive since the exercise price exceeded the average market price for the year. These antidilutive common stock equivalents have been omitted from the calculation of diluted earnings per common share for their respective years.

 

Stock-Based Compensation

 

The Company has certain stock-based employee compensation plans, described more fully in Note 12. Effective January 1, 2006, the Company adopted the modified prospective application method for expensing the value of options and accordingly did not restate prior period amounts. Generally accepted accounting principles require recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (usually the vesting period). Compensation cost for all awards granted after the date of adoption and any unvested awards that remained outstanding as of the date of adoption are required to be measured based on the fair value of the award on the grant date.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Comprehensive Income

 

Comprehensive income (loss) is defined as the change in equity during a period for non-owner transactions and comprises net income and other comprehensive income (loss). Other comprehensive income (loss) includes revenues, expenses, gains and losses that are excluded from earnings under current accounting standards. Components of other comprehensive income (loss) for the Company consist of the unrealized gains and losses, net of taxes, in the Company’s available for sale securities portfolio, unrealized gains and losses, net of taxes, in the Company’s cash flow hedge instruments, and the components of changes in net benefit plan liabilities that are not recognized as benefit costs.

 

Accumulated other comprehensive income at December 31, 2011 and 2010 consists of the following:

 

		2011				2010
		(Amounts in thousands)
Unrealized holding gain  - investment securities available for sale		$	1,857			$	(1,535	)
Deferred income taxes			(715	)			592
Net unrealized holding gain - investment securities available for sale			1,142				(943	)
Unrealized holding gain (loss) - cash flow hedge instruments			9				(333	)
Deferred income taxes			(4	)			128
Net unrealized holding gain (loss) - cash flow hedge instruments			5				(205	)
Postretirement benefit plans adjustment			(751	)			(473	)
Deferred income taxes			289				183
Net postretirement benefit plans adjustment			(462	)			(290	)
Total accumulated other comprehensive income		$	685			$	(1,438	)

 

Segment Reporting

 

Management is required to report selected financial and descriptive information about reportable operating segments. Related disclosures about products and services, geographic areas and major customers are also required. Generally, disclosures are required for segments internally identified to evaluate performance and resource allocation. In all material respects, the Company’s operations are entirely within the commercial banking segment, and the consolidated financial statements presented herein reflect the results of that segment. Also, the Company has no foreign operations or customers.

 

Risk and Uncertainties

 

In the normal course of its business, the Company encounters two significant types of risk: economic and regulatory. The two primary components of economic risk to the Company are credit risk and market risk. Credit risk is the risk of default on the Bank’s loan portfolio that results from borrowers’ failure to make contractually required payments. Market risk arises principally from interest rate risk inherent in our lending, investing, deposit and borrowing activities.

 

The Company is subject to the regulations of various government agencies. These regulations may change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances or operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examination.

 

Effective February 25, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation and the State of North Carolina Office of the Commissioner of Banks with certain requirements, including reducing adversely classified loans and maintaining regulatory capital above specified minimum levels. On June 23, 2011, the Company entered into a Written Agreement with the Federal Reserve with certain restrictions including not paying any distributions of interest or principal on trust preferred securities without prior approval. See Note 2 for further discussion concerning the provisions of the Consent Order and Written Agreement.

 

 

(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Reclassifications

 

Certain amounts reported in prior years have been reclassified to conform to current year presentation. Such reclassifications had no effect on income or equity.

 

Recent Accounting Pronouncements

 

The Company has adopted Accounting Standards Update No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses . This standard requires additional disclosures related to the allowance for loan loss with the objective of providing financial statement users with greater transparency about an entity’s loan loss reserves and overall credit quality disaggregated by portfolio segment and class of financing receivable. Additional disclosures include showing on a disaggregated basis the aging of receivables, credit quality indicators, and troubled debt restructurings with their effect on the allowance for loan loss. The provisions of this standard are effective for interim and annual periods ending on or after December 15, 2010. The disclosures about activity during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. This standard was adopted as of December 31, 2010 and during the quarter ended March 31, 2011 through additional disclosures in the notes to the consolidated financial statements.

 

In April 2011, the FASB has issued Accounting Standards Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring . The new standard provides additional guidance on a creditor’s evaluation of when a concession on a loan has been granted and whether a debtor is experiencing financial difficulties. A creditor must conclude that both of these conditions exist for the loan to be considered a troubled debt restructuring. This guidance is effective for interim and annual reporting periods beginning after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The Company adopted the update of this standard during the quarter ending September 30, 2011. The adoption did not have a material impact on the consolidated financial statements.

 

In May 2011, the FASB has issued Accounting Standards Update No. 2011-04, Fair Value Measurement . The purpose of the standard is to clarify and combine fair value measurements and disclosure requirements for accounting principles generally accepted in the United States (“US GAAP”) and international financial reporting standards (IFRS). The new standard provides amendments and wording changes used to describe certain requirements for measuring fair value and for disclosing information about fair value measurements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied prospectively to the beginning of the annual period of adoption. The Company adopted this statement during the quarter ended March 31, 2011 and its adoption did not have a material impact on the consolidated financial statements.

 

In June 2011, the FASB has issued Accounting Standards Update No. 2011-05, Comprehensive Income . The new standard provides guidance and new formats for reporting components and total net income and comprehensive income. The guidance allows the presentation of net income and comprehensive income to be in a single continuous statement or two separate but consecutive statements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The Company adopted this statement in 2011 and continued to use the two consecutive statement formats which is allowed by the pronouncement.

 

From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements and SEC Staff Accounting Bulletins on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.

 

 

(2)  REGULATORY MATTERS

 

Regulatory Actions

 

On February 25, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation “and the North Carolina Commission of Banks. Under the terms of the Consent Order among other things, the Bank agreed to:

 

	·	Strengthen Board oversight of the management and operations of the Bank;
	·	Comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital;
	·	Formulate and implement a plan to reduce the Bank’s risk exposure in assets classified “Substandard or Doubtful” in the FDIC’s most recent report of examination by 15% in 180 days, 35% in 360 days, 60% in 540 days and 75% in 720 days;
	·	Within 90 days, implement effective lending and collection policies;
	·	Not pay cash dividends without the prior written approval of the FDIC and the Commissioner; and
	·	Neither renew, rollover or accept any brokered deposits without obtaining a waiver from the FDIC.

 

In connection with the Consent Order executed with the FDIC and the NCCOB, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond (the “Federal Reserve”) on June 23, 2011. Under the terms of the Written Agreement, among other things, the Company agreed to:

 

	·	Act as a source of strength for the Bank;
	·	Not declare or pay dividends on its, common and preferred, stock or make any distributions of interest or principal on trust preferred securities without the prior approval of the Federal Reserve;
	·	Formulate and implement a written plan to maintain sufficient capital at the Company on a consolidated basis;
	·	Not, directly or indirectly, incur, increase or guarantee any debt without the prior approval of the Federal Reserve; and
	·	Not, directly or indirectly, purchase or redeem any shares of its stock without the prior approval of the Federal Reserve.

 

In February 2011, the Company suspended the payment of regular quarterly cash dividends on the preferred stock issued to the US Treasury. As of December 31, 2011, the total amount of cumulative dividends owed to the US Treasury was $2.6 million. In addition, the Company elected to defer the payment of regularly scheduled interest payments on both issues of junior subordinated debentures related to its outstanding trust preferred securities. As of December 31, 2011, the total cumulative interest payments due on the trust preferred securities were $2.9 million. The Company continues to account for the cumulative amounts due on the subordinated debentures and preferred stock. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature.

 

The Consent Order and the Written Agreement each specify certain time frames for meeting these requirements. The Company and the Bank must furnish periodic progress reports to the pertinent supervisory authority regarding its compliance with the Consent Order or Written Agreement. The Consent Order and the Written Agreement will remain in effect until modified or terminated by the pertinent supervisory authority.

 

 

(2)  REGULATORY MATTERS (Continued)

 

Management’s Plans and Compliance Efforts

 

As of December 31, 2011, the Bank has undertaken the necessary actions to comply with the Consent Order, including the following:

 

	·	The Bank has exceeded all minimum capital requirements of the Consent Order.  With respect to the Bank’s regulatory capital ratios as of December 31, 2011, the Tier 1 leverage capital ratio and the total risk-based capital ratios were 9.07% and 13.85%, respectively, compared to requirements of the Consent Order of 8% and 11%, respectively.
	·	As of December 31, 2011, the Bank reduced its risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination by 42% which exceeds its scheduled reduction at its second measurement point (35% reduction by the February 25, 2012).
	·	The Bank retained an independent consultant who prepared a management plan which was approved by the Board.  The plan was submitted to, and approved by, the FDIC and the NCCOB.
	·	The Bank has reduced its reliance on brokered deposits which amounted to 12.5% of total deposits at December 31, 2011 and has complied with the applicable restrictions on brokered deposits as stipulated in the Consent Order.

 

In addition to utilizing balance sheet shrinkage through net loan run-off and reduction of brokered deposits and undertaking various ways to improve Bank profitability, the Company is continuing to evaluate various strategies such as asset sales and plans for capital injections in order to maintain compliance with the minimum regulatory capital ratios required under the Consent Order provisions. As of December 31, 2011, the parent holding company had $5.6 million in cash available to be invested into the Bank to bolster capital levels. The ability to accomplish some of these goals is significantly constricted by the current economic environment. As has been widely publicized, access to capital markets is extremely limited in the current economic environment, and there can be no assurances that the Company will be able to access any such capital or sell assets.

 

Failure by the Bank to comply with the requirements set forth in the Consent Order may result in further adverse regulatory actions, sanctions, and restrictions on the Bank’s activities, which could have a material adverse effect on the business, future prospects, financial condition or results of operations of the Bank and the Company.

 

 

(3) INVESTMENT SECURITIES

 

The following is a summary of the securities portfolio by major classification at December 31, 2011 and 2010:

  

		2011
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(Amount in thousands)
Securities available for sale:
US Government agencies		$	34,660			$	69			$	-			$	34,729
Asset-backed securities
Residential mortgage-backed securities			185,838				1,713				245				187,306
Collateralized mortgage obligations			28,089				450				1,447				27,092
Small Business Administration loan pools			67,507				637				76				68,068
Student loan pools			8,903				-				1				8,902
Municipals			26,981				2,239				-				29,220
Trust preferred securities			3,250				-				929				2,321
Corporate Bonds			4,213				-				554				3,659
Other			1,000				1				-				1,001
		$	360,441			$	5,109			$	3,252			$	362,298
Securities held to maturity:
Asset-backed securities
Residential mortgage-backed securities		$	474			$	34			$	-			$	508
Small Business Administration loan pools			4,928				230				-				5,158
Municipals			33,214				1,904				1				35,117
Corporate Bonds			5,787				-				1,056				4,731
		$	44,403			$	2,168			$	1,057			$	45,514

 

		2010
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(Amount in thousands)
Securities available for sale:
US Government agencies		$	100,101			$	198			$	2,059			$	98,240
Asset-backed securities
Residential mortgage-backed securities			65,452				2,001				130				67,323
Collateralized mortgage obligations			42,379				274				422				42,231
Small Business Administration loan pools			40,453				74				305				40,222
Municipals			55,901				404				741				55,564
Trust preferred securities			4,252				21				1,179				3,094
Common stocks and mutual funds			2,650				353				-				3,003
Other			1,000				-				24				976
		$	312,188			$	3,325			$	4,860			$	310,653
Securities held to maturity:
Mortgage-backed securities
Residential mortgage-backed securities		$	804			$	48			$	-			$	852
Municipals			31,416				104				1,631				29,889
Corporate bonds			10,000				-				560				9,440
		$	42,220			$	152			$	2,191			$	40,181

 

 

(3) INVESTMENT SECURITIES (Continued)

 

Residential mortgage-backed securities and collateralized mortgage obligations are primarily government sponsored (GSE) agency issued whose underlying collateral are prime residential mortgage loans. The Company’s municipal securities are composed of geographic concentrations of 94.0% North Carolina, 3.0% of Texas independent school districts and less than 3.0% in other states. As the Company’s investment policy limits the purchase of municipal securities to “A” rated or better, the municipal investment portfolio segment has 98.4% of this portfolio rated “A” or better.

 

Proceeds from sales of available for sale securities during 2011, 2010 and 2009 were $274.8 million, $132.9 million and $69.8 million respectively, at an aggregate gain of $4.0 million, $3.5 million and $1.2 million respectively. These sales were part of the Company’s asset liability management.

 

On May 1, 2009, the Office of the Comptroller of the Currency closed Silverton Bank, N.A. and appointed the FDIC as the receiver to conduct an orderly liquidation of Silverton through the use of a bridge bank. The Company recorded a loss of $404 thousand in the first quarter of 2009 to write-off its equity investment in Silverton which was classified as other securities available for sale. The impairment loss on the Company’s equity investment in Silverton Bank was recorded as a component of non-interest income on the consolidated statements of operations for the period ended December 31, 2009. The Company determined one marketable equitable security was “other-than-temporarily” impaired during the first quarter of 2010 and recognized a $186 thousand write-down on the investment. The investment was sold during the fourth quarter of 2010 and the loss on the sale is included in securities gains and losses.

 

The following tables show the gross unrealized losses and fair values for our investments aggregated by category and length of time that the individual securities have been in a continuous unrealized loss position as of December 31, 2011 and December 31, 2010. For available for sale securities, the unrealized losses relate to thirty-one issues of residential mortgage backed securities, one issue of student loan pools, two municipal issues and three issues of other securities. For held to maturity securities, the unrealized losses relate to one municipal security issue and one corporate bond. All investment securities with unrealized losses are considered by management to be temporarily impaired given the credit ratings on these investment securities and management’s intent and ability to hold these securities until recovery. Should the Company decide in the future to sell securities in an unrealized loss position, or determine that impairment of any securities is other than temporary, irrespective of a decision to sell, an impairment loss would be recognized in the period such determination is made.

 

 

(3) INVESTMENT SECURITIES (Continued)

 

During the second half of 2011, management determined that (while possessing an A-credit rating as of December 31, 2011) the issuer’s creditworthiness appeared to be weakening, its intentions related to holding a specific corporate bond to maturity had changed. Based on this, management transferred this issue of corporate bonds from the held-to-maturity classification to available-for-sale. The pre-transfer carrying amount of this security was $4.2 million amortized cost and its post-transfer carrying value was $4.0 million at the date of the transfer, resulting in a $241 thousand unrealized loss.

 

		2011
		Less than 12 Months								12 Months or More								Total
		Fair Value				Unrealized losses				Fair Value				Unrealized losses				Fair Value				Unrealized losses
		(Amount in thousands)
Securities available for sale:
Asset-backed securities
Residential mortgage-backed securities		$	54,446			$	245			$	-			$	-			$	54,446			$	245
Collateralized mortgage obligations			12,248				1,447				-				-				12,248				1,447
Small Business Administration loan pools			12,309				74				686				2				12,995				76
Student loan pools			8,902				1				-				-				8,902				1
Municipals			6				-				-				-				6				-
Trust preferred securities			-				-				2,321				929				2,321				929
Corporate bonds			-				-				3,659				554				3,659				554
Total temporarily impaired
securities		$	87,911			$	1,767			$	6,666			$	1,485			$	94,577			$	3,252
Securities held to maturity:
Municipals		$	-			$	-			$	967			$	1			$	967			$	1
Corporate bonds			-				-				4,731				1,056				4,731				1,056
Total temporarily impaired
securities		$	-			$	-			$	5,698			$	1,057			$	5,698			$	1,057

 

		2010
		Less than 12 Months								12 Months or More								Total
		Fair Value				Unrealized losses				Fair Value				Unrealized losses				Fair Value				Unrealized losses
		(Amount in thousands)
Securities available for sale:
US Government agencies		$	75,252			$	2,059			$	-			$	-			$	75,252			$	2,059
Asset-backed securities
Residential mortgage-backed securities			29,315				130				-				-				29,315				130
Collateralized mortgage obligations			15,055				422				-				-				15,055				422
Small Business Administration loan pools			25,680				305				-				-				25,680				305
Municipals			31,513				737				719				4				32,232				741
Trust preferred securities			-				-				2,192				1,179				2,192				1,179
Common stocks and mutual funds																			-				-
Other			976				24				-				-				976				24
Total temporarily impaired
securities		$	177,791			$	3,677			$	2,911			$	1,183			$	180,702			$	4,860
Securities held to maturity:
Municipals		$	22,507			$	1,631			$	-			$	-			$	22,507			$	1,631
Corporate bonds			9,440				560				-				-				9,440				560
Total temporarily impaired
securities		$	31,947			$	2,191			$	-			$	-			$	31,947			$	2,191

 

 

(3) INVESTMENT SECURITIES (Continued)

 

In evaluating investment securities for “other than temporary impairment” losses, management considers, among other things, (i) the length of time and the extent to which the investment is in an unrealized loss position, (ii) the financial condition and near term prospects of the issuer, and (iii) the intent and ability of the Company to retain its investment in the issuer for a sufficient period of time to allow for any anticipated recovery of unrealized loss. At December 31, 2011, there were six investment securities with aggregate fair values of $12.4 million in an unrealized loss position for at least twelve months. Based on the nature of these securities, we believe the decline in value to be solely due to changes in interest rates and the general economic conditions and not deterioration in their credit quality. Of the securities in an unrealized loss position for at least twelve months at December 31, 2011, two issues of corporate bonds amounted to $8.4 million in fair value (of the total $12.4 million in fair value) with unrealized loss positions of $1.6 million (of the total $2.5 million). The trust preferred securities had two issues in an unrealized loss position for 12 months or more due to changes in the level of market interest rates and a less active market in these securities. One of these securities has a variable rate based on LIBOR which has remained low throughout 2011. Based on the nature of these securities, we believe the decline in value to be solely due to changes in interest rates and the general economic conditions and not deterioration in their credit quality. We have the intention and ability to hold these securities for a period of time sufficient to allow for their recovery in value or maturity. The unrealized losses are reflected in other comprehensive income.

 

The amortized cost and fair values of securities available for sale and held to maturity at December 31, 2011 by contractual maturity are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligation.

 

		Securities Available for Sale								Securities Held to Maturity
		Amortized Cost				Fair Value				Amortized Cost				Fair Value
		(Amount in thousands)
US Government Agencies
Due after one but through five years		$	11,000			$	11,005			$	-			$	-
Due after five but through ten years			1,319				1,333				-				-
Due after ten years			22,341				22,391				-				-
Municipals
Due within one year			850				850				568				577
Due after one but through five years			445				449				1,319				1,397
Due after five but through ten years			457				474				4,215				4,416
Due after ten years			25,229				27,447				27,112				28,727
Trust preferred securities
Due after ten years			3,250				2,321				-				-
Corporate bonds
Due after ten years			4,213				3,659				5,787				4,731
Other
Due after five but through ten years			1,000				1,001				-				-
Asset-backed securities
Residential mortgage-backed securities			185,838				187,306				474				508
Collateralized mortgage obligations			28,089				27,092				-				-
Small Business Administration loan pools			67,507				68,068				4,928				5,158
Student loan pools			8,903				8,902				-				-
		$	360,441			$	362,298			$	44,403			$	45,514

 

Securities with carrying values of $76.8 million and $81.6 million and fair values of $80.5 million and $80.5 million at December 31, 2011 and 2010, respectively, were pledged to secure public deposits as required by law. Additionally, at December 31, 2011, securities with carrying values and fair values of $48.6 million and $49.1 million were pledged to secure the Company’s borrowings from the FHLB. Securities with carrying values of $113.9 million and fair values of $115.5 million were pledged for other purposes, primarily to secure repurchase agreements and derivative positions.

 

For the years ended December 31, 2011, 2010 and 2009, income from taxable and nontaxable securities were $10.1 million and $2.1 million, $9.6 million and $2.6 million, and $31.1 million and $1.8 million, respectively.

 

(3) INVESTMENT SECURITIES (Continued)

 

Federal Home Loan Bank Stock

 

As disclosed separately on our statements of financial condition, the Company has an investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock of $6.8 million at December 31, 2011 and $8.8 million at December 31, 2010. The Company carries its investment in FHLB at its cost which is the par value of the stock. In prior years, member institutions of the FHLB system have been able to redeem shares in excess of their required investment level at par on a voluntary basis daily. On March 6, 2009, FHLB announced changes in the calculation of member stock requirements (that had the impact of requiring increased member stock ownership) and changes in its policy toward the repurchase of excess stock held by members. These steps were taken as capital preservation measures reflecting a conservative financial management approach in the face of continued volatility in the financial markets and regulatory pressures. Prior to the announcement, the FHLB automatically repurchased excess stock on a daily basis. During 2011, the Company received a total of $1.9 million as its portion of repurchases of excess stock. The FHLB paid a quarterly cash dividend to its members since the second quarter of 2009. Management believes that our investment in FHLB stock was not impaired as of December 31, 2011 or December 31, 2010.

 

(4) LOANS

 

Following is a summary of loans by loan class:

 

		At December 31,
		2011								2010
						Percent								Percent
		Amount				of Total				Amount				of Total
		(Amounts in thousands)
Commercial real estate		$	387,275				40.8	%		$	455,705				40.3	%
Commercial
Commercial and industrial			85,321				9.0	%			92,307				8.2	%
Commercial line of credit			44,574				4.7	%			64,660				5.7	%
Residential real estate
Residential construction			101,945				10.7	%			137,644				12.2	%
Residential lots			45,164				4.8	%			62,552				5.5	%
Raw land			17,488				1.8	%			20,171				1.8	%
Home equity lines			95,136				10.0	%			104,833				9.3	%
Consumer			173,119				18.2	%			192,204				17.0	%
Subtotal			950,022				100	%			1,130,076				100	%
Less: Allowance for loan losses			(24,165	)							(29,580	)
Net Loans		$	925,857							$	1,100,496

 

Construction loans are non-revolving extensions of credit secured by real property, the proceeds of which will be used to a) finance the preparation of land for construction of industrial, commercial, residential, or farm buildings; or b) finance the on-site construction of such buildings. Construction loans are approved based on a set of projections regarding cost, time to completion, time to stabilization or sale, and availability of permanent financing. Any one of these projections may vary from actual results. Therefore, construction loans are considered based not only on the expected merits of the project itself, but also on secondary and tertiary repayment sources of the project sponsor, project sponsor expertise and experience and independent evaluation of project viability. Personal guarantees are typically required. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections to ensure that loan commitments remain in-balance with work completed to date and that adequate funds remain available to ensure completion.

 

 

(4) LOANS (Continued)

 

Commercial real estate loans are underwritten by evaluating and understanding the borrower’s ability to generate adequate cash flow to repay the subject debt within reasonable terms. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan amounts relative to equity sources of capitalization and higher debt service requirements relative to available cash flow. This heightened degree of financial and operating leverage can expose commercial real estate loans to increased sensitivity to changes in market and economic conditions. Repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Management monitors and evaluates commercial real estate loans based on collateral, geography, and secondary/tertiary sources of repayment of the property sponsors. Management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. Loans secured by owner-occupied properties are generally considered to be less sensitive to real estate market conditions, since the profitability and cash flow of the occupying business are aligned via common ownership.

 

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to generate positive cash flow, operate profitably and prudently expand its business. Underwriting standards are designed to promote relationships to include a full range of loan, deposit, and cash management services. Underwriting processes include thorough examination of the borrower’s market, operating environment, and business model, to assess whether current and projected cash flows can reasonably be expected to present an acceptable source of repayment. Such repayments are generally sensitized with variances of growth/decline, profitability, and operating cycle changes. Secondary repayment sources, including collateral, are assessed. The level of control and monitoring over such secondary repayment sources may be impacted by the strength of the primary repayment source and the financial position of the borrower.

 

Residential lot loans are extensions of credit secured by developed tracts of land with appropriate entitlements to support construction of single family or multifamily residential buildings. Such loans were historically structured as time or term loans to finance the holding of the lot for future construction. Because the property is neither generating current income nor providing shelter, these loans have proven to be subject to a higher-than-average risk of abandonment. Extensions of credit for acquisition of finished lots are generally assessed based on the outside repayment sources readily available to the borrower in the current underwriting for such loans.

 

Consumer loans are originated utilizing a centralized approval process staffed by experienced consumer loan administration personnel. Policies and procedures are developed and maintained to ensure compliance with the Company’s risk management objectives and regulatory compliance requirements. This activity, coupled with relatively small loan amounts spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a periodic basis, along with periodic review activity of particular regions and individual lenders. Loans are concentrated in home equity lines of credit and term loans secured by first or second liens on owner-occupied residential real estate.

 

Home Equity loans are consumer-purpose revolving or term loans secured by 1 ^st or 2 ^nd liens on owner-occupied residential real estate. Such loans are underwritten and approved on the same centralized basis as other consumer loans. Appropriate risk management and compliance practices are exercised to ensure that loan-to-value, lien perfection, and compliance risks are addressed and managed within the Bank’s established tolerances. The degree of utilization of revolving commitments within this asset class is reviewed monthly to identify changes in the behavior of this borrowing group.

 

Commercial lines of credit are underwritten according to the same standards applied to other commercial and industrial loans; with particular focus on the cash flow impact of the borrower’s operating cycle. Based on the risk profile of each borrower, an appropriate level of monitoring and servicing can be applied, such that higher risk categories involve more frequent monitoring and more involved control over the cash proceeds of asset conversion. Lower risk profiles may involve less restrictive controls and lighter servicing intensity.

 

Raw land loans are those secured by tracts of undeveloped raw land held for personal use or investment. Such properties are expected to be held for a period of not less than twenty-four months with no active development plan. Given the raw nature of the land, these loans are underwritten based on the ability of the borrower to service the indebtedness with sources of income unrelated to the property. Higher cash down payment and lower loan-to-value expectations are applied to such loans.

 

 

(4) LOANS (Continued)

 

Loan origination fees and certain direct origination are capitalized and recognized as an adjustment to yield over the life of the related loan. Net unamortized deferred fees less related cost included in the above were $136 thousand and $128 thousand for 2011 and 2010.

 

Loans are placed in a nonaccrual status for all classes of loans when, in management’s opinion, the borrower may be unable to meet payments as they become due or 90 days past due. Loans are returned to an accrual status when the borrower makes timely principal and interest payments for a period of six months and has the ability to continue making scheduled payments until the loan is repaid in full. The following is a summary of nonperforming loans and nonperforming assets at December 31, 2011 and 2010:

 

		2011				2010
		(Amounts in thousands)
Nonaccrual loans		$	38,715			$	63,178
Restructured loans - nonaccruing			29,333				28,599
Total nonperforming loans			68,048				91,777
Foreclosed assets			19,812				17,314
Total nonperforming assets		$	87,860			$	109,091
Restructured loans in accrual status not included above		$	24,202			$	12,117

 

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The Company has a small residential mortgage portfolio without the need to utilize government sponsored loan modification programs. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

 

Loans on nonaccrual status at the date of modification are initially classified as nonaccrual TDRs. Loans on accruing status at the date of concession are initially classified as accruing TDRs if the loan is reasonably assured of repayment and performance is expected in accordance with its modified terms. Such loans may be designated as nonaccrual loans subsequent to the concession date if reasonable doubt exists as to the collection of interest or principal under the restructuring agreement. TDRs are returned to accruing status when there is economic substance to the restructuring, there is documented credit evaluation of the borrower’s financial condition, the remaining balance is reasonably assured of repayment in accordance with its modified terms, and the borrower has demonstrated sustained repayment performance in accordance with the modified terms for a reasonable period of time (generally a minimum of six months).

 

As illustrated in the table below, during the year ended December 31, 2011, the following concessions were made on 117 loans for $47.9 million (measured as a percentage of loan balances on TDRs):

 

	·	Reduced interest rate for 37% (24 loans for $17.7 million);
	·	Extension of payment terms for 57% (90 loans for $27.4 million);
	·	Forgiveness of principal for 4% (1 loan for $1.9 million); and
	·	Other for 2% (2 loans for $938 thousand).

 

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

 

 

(4) LOANS (Continued)

 

The following table presents a breakdown of the types of concessions made by loan class for the twelve months ended December 31, 2011.

 

 

		Twelve Months ended December 31, 2011
						Pre-Modification				Post-Modification
						Outstanding				Outstanding
		Number of				Recorded				Recorded
Amounts in $ thousands		Loans				Investment				Investment
Below market interest rate
Commercial real estate			5			$	6,303			$	6,303
Commercial and industrial			1				68				68
Commercial line of credit			2				247				247
Residential construction			3				6,331				6,331
Residential lots			10				4,578				4,578
Raw land			-				-				-
Consumer			3				117				117
Subtotals			24				17,644				17,644
Extended payment terms
Commercial real estate			26				13,397				13,397
Commercial and industrial			15				2,071				2,071
Commercial line of credit			3				296				296
Residential construction			5				2,682				2,682
Home equity lines			3				393				393
Residential lots			4				384				384
Raw land			2				59				59
Consumer			32				8,134				8,134
Subtotals			90				27,416				27,416
Forgiveness of principal
Commercial real estate			1				1,931				1,391
Subtotals			1				1,931				1,391
Other
Residential lots			1				910				1,113
Consumer			1				28				28
Subtotals			2				938				1,141
Grand Totals			117			$	47,929			$	47,592

 

The twenty-four loans for which an interest rate concession was granted during 2011 were collateral dependent. These loans are evaluated individually for impairment using the fair value of collateral method. Prior to the modifications shown above, these loans had partial charge-offs of $ 1.4 million. Because this recorded investment of these loans had already been charged down to the fair value of their collateral prior to the date of the modification, the recorded investment of these loans has not changed post-modification. The largest loan modification for $910 thousand in the other category involved the Bank advancing additional funds to further develop lots; such funds would not generally be advanced given the borrower’s financial condition. At December 31, 2011, this loan was adequately collateralized and no specific reserve was recorded.

 

 

(4) LOANS (Continued)

 

During the twelve months ended December 31, 2011, the Company modified 117 loans in the amount of $47.9 million. Of this total, there were payment defaults (where the modified loan was past due thirty days or more) of $7.0 million, or 14.7%, respectively, during the twelve months ended December 31, 2011.

 

The following table presents loans that were modified as troubled debt restructurings within the previous 12 months and for which there was a payment default during the three and twelve months ended December 31, 2011.

 

		Year ended December 31, 2011
		Number of				Recorded
Amounts in $ thousands		Loans				Investment
Below market interest rate
Commercial real estate			-			$	-
Residential construction			1				942
Home equity lines			-				-
Residential lots			-				-
Consumer			-				-
Subtotals			1				942
Extended payment terms
Commercial real estate			7				3,170
Commercial and industrial			5				555
Commercial line of credit			1				38
Residential construction			2				244
Home equity lines			2				392
Residential lots			1				43
Consumer			10				1,655
Subtotals			28				6,097
Forgiveness of principal
Commercial real estate			-				-
Consumer			-				-
Subtotals			-				-
Other
Consumer			-				-
Subtotals			-				-
Grand Totals			29			$	7,039

 

 

Of the total of 117 loans for $47.9 million which were modified during the twelve months ended December 31, 2011, the following represents their success or failure during the year ended December 31, 2011:

 

	·	63.1% are paying as restructured;
	·	24.9% have been reclassified to nonaccrual;
	·	6.8% have defaulted and/or foreclosed upon; and
	·	5.2% have paid in full.

 

The following table presents the successes and failures of the types of modifications within the previous 12 months as of December 31, 2011.

   

		Paid in full								Paying as restructured								Converted to non-accrual								Foreclosure/Default
		Number				Recorded				Number				Recorded				Number				Recorded				Number				Recorded
Amounts in $ thousands		of Loans				Investment				of Loans				Investment				of Loans				Investment				of Loans				Investment
Below market interest rate			1			$	942				12			$	6,778				11			$	9,924				-			$	-
Extended payment terms			5				1,550				69				20,612				7				1,989				9				3,265
Forgiveness of principal			-				-				1				1,931				-				-
Other			-				-				2				938				-				-				-				-
Total			6			$	2,492				84			$	30,259				18			$	11,913				9			$	3,265

 

 

(4) LOANS (Continued)

 

The following is a summary of the recorded investment in nonaccrual loans and impaired loans segregated by class of loans:

 

		December 31, 2011								December 31, 2010
		Nonaccrual Loans				Impaired Loans				Nonaccrual Loans				Impaired Loans
		(Amounts in thousands)
Commercial real estate		$	26,484			$	39,297			$	22,085			$	21,251
Commercial and industrial			3,548				3,899				7,324				6,359
Commercial line of credit			1,429				1,004				3,381				3,233
Residential construction			11,491				16,619				26,257				25,676
Home equity lines			2,637				1,955				1,031				433
Residential lots			12,096				12,095				19,192				19,336
Raw land			1,484				1,484				1,963				1,962
Consumer			8,879				10,753				10,544				8,872
Total		$	68,048			$	87,106			$	91,777			$	87,122

 

The Company evaluates “impaired” loans, which includes nonperforming loans and accruing troubled debt restructured loans, having risk characteristics that are unique to an individual borrower on a loan-by-loan basis with balances above a specified level. For smaller loans, the allowance is calculated based on historical loss experience and other qualitative factors. Included in the table below, $65.1 million out of the total of $68.0 million of nonperforming loans and $22.0 million out of the total of $24.2 million of accruing troubled debt restructured loans were individually evaluated which required a reserve of $1.2 million and $392 thousand, respectively, for a total specific ALLL of $1.6 million. The impaired loans with smaller balances ($2.9 million in nonperforming loans and $2.2 million in accruing troubled debt restructured loans) were collectively evaluated for impairment.

 

The following is a summary of loans individually or collectively evaluated for impairment, by segment, at December 31, 2011:

 

		Commercial								Residential
		Real								Real
		Estate				Commercial				Estate				HELOC				Consumer				Total
		(Amounts in thousands)
Ending balance: nonperforming
loans individually
evaluated for impairment		$	24,822			$	3,889			$	27,238			$	1,955			$	7,209			$	65,113
Accruing troubled debt
restructured loans
individually evaluated
for impairment			14,475				1,014				2,960				-				3,544				21,993
Ending balance: total impaired
loans individually evaluated
for impairment			39,297				4,903				30,198				1,955				10,753				87,106
Ending balance: collectively
evaluated for impairment			347,978				124,993				134,399				93,180				162,366				862,916
Ending Balance		$	387,275			$	129,896			$	164,597			$	95,135			$	173,119			$	950,022

 

 

(4) LOANS (Continued)

 

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at December 31, 2011:

  

																		Year to Date				Year to Date
		Unpaid				Partial												Average				Interest
		Principal				Charge Offs				Recorded				Related				Recorded				Income
		Balance				To Date				Investment				Allowance				Investment				Recognized
With no related		(Amounts in thousands)
allowance recorded:
Commercial real estate		$	36,251			$	(7,334	)		$	28,917			$	-			$	26,846			$	358
Commercial
Commercial and industrial			4,742				(1,341	)			3,401				-				2,998				76
Commercial line of credit			957				(52	)			905				-				1,427				-
Residential real estate
Residential construction			17,874				(2,443	)			15,431				-				15,241				190
Residential lots			6,853				(2,803	)			4,050				-				10,387				17
Raw land			3,808				(2,324	)			1,484				-				1,467				-
Home equity lines			954				(32	)			922				-				655				-
Consumer			10,501				(1,501	)			9,000				-				5,211				81
Subtotal			81,940				(17,830	)			64,110				-				64,232				722
With an allowance recorded:
Commercial real estate			10,710				(330	)			10,380				655				8,346				420
Commercial
Commercial and industrial			498				-				498				114				1,067				14
Commercial line of credit			99				-				99				99				482				-
Residential real estate
Residential construction			1,348				(160	)			1,188				102				2,602				17
Residential lots			9,080				(1,035	)			8,045				161				3,843				32
Raw land			-				-				-				-				144				-
Home equity lines			1,033				-				1,033				387				1,027				-
Consumer			1,839				(86	)			1,753				90				2,921				80
Subtotal			24,607				(1,611	)			22,996				1,608				20,432				563
Summary
Commercial real estate			46,961				(7,664	)			39,297				655				35,192				778
Commercial			6,296				(1,393	)			4,903				213				5,974				90
Residential real estate			38,963				(8,765	)			30,198				263				33,684				256
Home equity lines			1,987				(32	)			1,955				387				1,682				-
Consumer			12,340				(1,587	)			10,753				90				8,132				161
Grand Totals		$	106,547			$	(19,441	)		$	87,106			$	1,608			$	84,664			$	1,285

    

As shown in the above table, the Company has previously taken partial charge-offs of $19.4 million on the $87.1 million in loans individually evaluated for impairment. In addition, the Company has set aside $1.6 million in specific allowance for these $23.0 million in loans.

 

 

(4) LOANS (Continued)

 

The following is a summary of loans by segment at December 31, 2010:

 

		Commercial								Residential
		Real								Real
		Estate				Commercial				Estate				HELOC				Consumer				Total
		(Amounts in thousands)
Ending balance: individually
evaluated for impairment		$	21,252			$	9,592			$	46,974			$	432			$	8,872			$	87,122
Ending balance: collectively
evaluated for impairment			437,186				147,375				173,393				104,401				180,599				1,042,954
Ending Balance		$	458,438			$	156,967			$	220,367			$	104,833			$	189,471			$	1,130,076

 

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at December 31, 2010:

 

		Unpaid				Partial												Average
		Principal				Charge Offs				Recorded				Related				Recorded
		Balance				To Date				Investment				Allowance				Investment
With no related allowance recorded:		(Amounts in thousands)
Commercial real estate		$	23,114			$	(5,761	)		$	17,353			$	-			$	12,065
Commercial
Commercial and industrial			7,398				(1,923	)			5,475				-				5,593
Commercial line of credit			2,530				(105	)			2,425				-				1,620
Residential real estate
Residential construction			23,230				(4,554	)			18,676				-				14,254
Residential lots			15,449				(6,511	)			8,938				-				8,621
Raw land			3,989				(2,277	)			1,712				-				1,450
Home equity lines			457				(123	)			334				-				208
Consumer			5,904				(1,524	)			4,380				-				2,992
Subtotal			82,071				(22,778	)			59,293				-				46,803
With an allowance recorded:
Commercial real estate			3,958				(60	)			3,898				775				9,041
Commercial
Commercial and industrial			990				(106	)			884				510				1,583
Commercial line of credit			834				(26	)			808				583				2,084
Residential real estate
Residential construction			7,114				(114	)			7,000				860				15,352
Residential lots			10,484				(86	)			10,398				841				11,251
Raw land			251				(1	)			250				53				251
Home equity lines			100				(1	)			99				91				83
Consumer			4,516				(24	)			4,492				1,417				1,755
Subtotal			28,247				(418	)			27,829				5,130				41,400
Summary
Commercial real estate			27,072				(5,821	)			21,251				775				21,106
Commercial			11,752				(2,160	)			9,592				1,093				10,880
Residential real estate			60,517				(13,543	)			46,974				1,754				51,179
Home equity lines			557				(124	)			433				91				291
Consumer			10,420				(1,548	)			8,872				1,417				4,747
Grand Totals		$	110,318			$	(23,196	)		$	87,122			$	5,130			$	88,203

 

The amount of interest income recognized on impaired loans during the portion of the year they were considered impaired for 2010 and 2009 was $59 thousand and $312 thousand, respectively. The interest income foregone for loans in a non-accrual status for 2010 and 2009 was $2.9 million and $1.2 million, respectively.

 

 

(4) LOANS (Continued

 

The recorded investment in loans that were considered and collectively evaluated for impairment at December 31, 2011 and 2010 totaled $862.9 million and $1.04 billion, respectively. The recorded investment in loans that were considered individually impaired at December 31, 2011 and 2010 totaled $87.1 million and $87.1 million, respectively. At December 31, 2011 and 2010, the recorded investment in impaired loans requiring a valuation allowance based on individual analysis were $23.0 million and $27.8 million, respectively, with a corresponding valuation allowance of $1.6 million and $5.1 million. No valuation allowance for the other impaired loans was considered necessary. No loans with deteriorated credit quality were acquired during the years ended December 31, 2011 or 2010.

 

The average recorded investment in impaired loans for the years ended December 31, 2011, 2010, and 2009 was approximately $84.7 million, $88.2 million and $26.8 million, respectively. The amount of interest income recognized on impaired loans during the portion of the year they were considered impaired for 2011, 2010 and 2009 was $1.3 million, $723 thousand and $312 thousand, respectively. The interest income foregone for loans in a non-accrual status for 2011, 2010 and 2009 was $3.8 million, $2.9 million and $1.2 million, respectively.

 

The following is an age analysis of past due financing receivables by class at December 31, 2011:

 

		30-59 Days Past Due				60-89 Days Past Due				Greater than 90 Days (1)				Total Past Due				Current				Total Financing Receivables				Recorded Investment 90 Days or more and Accruing
		(Amounts in thousands)
Commercial real estate		$	376			$	265			$	26,484			$	27,125			$	360,150			$	387,275			$	-
Commercial and industrial			308				7				3,548				3,863				81,458				85,321				-
Commercial line of credit			50				35				1,429				1,514				43,060				44,574				-
Residential construction			-				-				11,491				11,491				90,454				101,945				-
Home equity lines			248				171				2,637				3,056				92,080				95,136				-
Residential lots			-				-				12,096				12,096				33,068				45,164				-
Raw land			-				-				1,484				1,484				16,004				17,488				-
Consumer			2,839				932				8,879				12,650				160,469				173,119				-
Total		$	3,821			$	1,410			$	68,048			$	73,279			$	876,743			$	950,022			$	-
Percentage of total loans			0.40	%			0.15	%			7.16	%			7.71	%			92.29	%

 

The following is an age analysis of past due financing receivables by class at December 31, 2010:

 

		30-59 Days Past Due				60-89 Days Past Due				Greater than 90 Days (1)				Total Past Due				Current				Total Financing Receivables				Recorded Investment 90 Days or more and Accruing
		(Amounts in thousands)
Commercial real estate		$	43			$	114			$	22,085			$	22,242			$	433,463			$	455,705			$	-
Commercial and industrial			53				2				7,324				7,379				84,928				92,307				-
Commercial line of credit			103				19				3,381				3,503				61,157				64,660				-
Residential construction			92				721				26,257				27,070				110,574				137,644				-
Home equity lines			415				222				1,031				1,668				103,165				104,833				-
Residential lots			34				-				19,192				19,226				43,326				62,552				-
Raw land			24				-				1,963				1,987				18,184				20,171				-
Consumer			3,165				468				10,544				14,177				178,027				192,204				-
Total		$	3,929			$	1,546			$	91,777			$	97,252			$	1,032,824			$	1,130,076			$	-
Percentage of total loans			0.35	%			0.14	%			8.12	%			8.61	%			91.39	%

 

(1) As the Company has no loans past due 90 or more days and still accruing, this category only includes nonaccrual loans.

  

  

(4) LOANS (Continued)

 

The Company has granted loans to certain directors and executive officers of the Company and their related interests. Such loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other borrowers and, in management’s opinion, do not involve more than the normal risk of collectability. All loans to directors and executive officers or their interests are submitted to the Board of Directors for approval. A summary of loans to directors and their interests follows:

  

		2011				2010				2009
		(Amounts in thousands)
Balance at beginning of year		$	21,961			$	24,433			$	25,585
Disbursements			9,093				11,032				13,110
Repayments			(14,623	)			(13,504	)			(14,262	)
Other increases (decreases) in exposure due to:
Other			(170	)			-				-
Balance at end of year		$	16,261			$	21,961			$	24,433

  

At December 31, 2011, the Company had pre-approved but unused lines of credit totaling $2.7 million to executive officers, directors and their affiliates.

 

(5)  ALLOWANCE FOR LOAN LOSSES

 

An analysis of the allowance for loan losses follows:

 

		2011				2010				2009
		(Amounts in thousands)
Balance at beginning of year		$	29,580			$	29,638			$	18,851
Provision for loan losses			15,150				39,000				34,000
Charge-offs			(24,885	)			(42,489	)			(24,633	)
Recoveries			4,320				3,431				1,420
Net charge-offs			(20,565	)			(39,058	)			(23,213	)
Balance at end of year		$	24,165			$	29,580			$	29,638

  

The following table shows, by loan segment, an analysis of the allowance for loan losses at December 31, 2011.

 

		Commercial								Residential
		Real								Real
		Estate				Commercial				Estate				HELOC				Consumer				Total
		(Amounts in thousands)
Allowance for credit losses:
Beginning balance		$	6,703			$	4,154			$	13,534			$	1,493			$	3,696			$	29,580
Provision			9,102				1,757				40				749				3,502				15,150
Charge-offs			(7,988	)			(3,400	)			(8,132	)			(977	)			(4,388	)			(24,885	)
Recoveries			1,259				525				1,816				147				573				4,320
Ending balance		$	9,076			$	3,036			$	7,258			$	1,412			$	3,383			$	24,165
For nonperforming loans
requiring specific ALLL		$	309			$	213			$	262			$	387			$	45			$	1,216
For accruing troubled debt
restructured loans
requiring specific ALLL			346				-				1				-				45				392
Ending balance: requiring
specific ALLL		$	655			$	213			$	263			$	387			$	90			$	1,608
Ending balance: general
ALLL		$	8,421			$	2,823			$	6,995			$	1,025			$	3,293			$	22,557

 

 

(5)  ALLOWANCE FOR LOAN LOSSES (Continued)

 

The following table shows, by loan segment, an analysis of the allowance for loan losses at December 31, 2010.

  

		Commercial								Residential
		Real								Real
		Estate				Commercial				Estate				HELOC				Consumer				Total
		(Amounts in thousands)
Allowance for credit losses:
Beginning balance		$	9,356			$	3,079			$	13,272			$	1,187			$	2,744			$	29,638
Provision			5,237				5,520				22,597				1,933				3,713				39,000
Charge-offs			(8,200	)			(5,610	)			(23,944	)			(1,799	)			(2,935	)			(42,488	)
Recoveries			310				1,165				1,609				172				174				3,430
Ending balance		$	6,703			$	4,154			$	13,534			$	1,493			$	3,696			$	29,580
Ending balance: requiring
specific ALLL		$	775			$	1,093			$	1,754			$	91			$	1,417			$	5,130
Ending balance: general
ALLL		$	5,928			$	3,061			$	11,780			$	1,402			$	2,279			$	24,450

  

Credit Quality Indicators . As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) nonperforming loans (see details above) and (v) the general economic conditions in its market areas.

The Company utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the 9 risk grades is as follows: 

 

	·	Grades 1, 2 and 3 – Better Than Average Risk – Borrowers assigned any one of these ratings would generally be characterized as representing better than average risk. Access to alternate sources of traditional bank financing is evident; secondary repayment sources are sufficient to protect against the risk of principal or income loss.
	·	Grade 4 – Average Risk – Borrowers assigned this rating would generally be characterized as representing average risk. Access to alternate sources of traditional bank financing is evident; secondary repayment sources are sufficient to protect against the risk of principal or income loss. Or, the risk attributable to a marginally sufficient primary repayment source is mitigated by liquid collateral in amounts which, discounted for normal fluctuations in market value, are sufficient to protect against the risk of principal or income loss.
	·	Grade 5 – Acceptable Risk/Watch – Loans where the borrower’s ability to repay from primary (intended) repayment source is not clearly sufficient to ensure performance as contracted; however, the loan is performing as contracted, secondary repayment sources are clearly sufficient to protect against the risk of principal or income loss, and the Bank can reasonably expect that the circumstances causing the repayment concern will be resolved. Access to alternate financing sources exists, but may be limited to institutions specializing in higher risk financing.
	·	Grade 6 – Special Mention – This would include “Other Assets Especially Mentioned” (OAEM). OAEM are currently protected but potentially weak, they are characterized by: undue and unwarranted credit risk but not to the point of justifying a classification of substandard. Potential weakness may weaken the asset or inadequately protect the Bank’s credit position at some future date if not corrected. Evidence that the risk is increasing beyond that at which the loan originally would have been granted. Loans, where adverse economic conditions that develop subsequent to the loan origination that do not jeopardize liquidation of the debt but do increase the level of risk, may also warrant this rating.

 

 

(5)  ALLOWANCE FOR LOAN LOSSES (Continued)

 

	·	Grade 7 – Substandard – A substandard loan is inadequately protected by the current net worth and paying capacity of the obligor or by the value of the collateral pledged, if any. There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. Examples include high debt to worth ratios, declining or negative earnings trends, declining or inadequate liquidity, improper loan structure and questionable repayment sources. Near term improvement is questionable.
	·	Grade 8 – 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. Some loss of principal is expected, however, the amount of such loss cannot be fully determined at this time. Factors such as equity injection, alternative financing, liquidation of assets or the pledging of additional collateral can impact the loan. All loans in this category are immediately placed on non-accrual with all payments applied to principal until such time as the potential loss exposure is eliminated.
	·	Grade 9 – Loss – Loans classified as loss are considered uncollectable and of such little value that there 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 affected in the future.

 

Loan grades for all commercial loans are established at the origination of the loan. Non-commercial loans are graded as a 4 at origination date as these loans are determined to be “pass graded” loans. These non-commercial loans may subsequently require a different risk grade if the credit department has evaluated the credit and determined it necessary to reclassify the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes public. Credit improvements are evidenced by known factors regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a grade of 1 to 5 are believed to have some inherent losses in the portfolios, but to a lesser extent than the other loan grades. The special mention or OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential losses. However, the likelihood of loss is greater than Watch grade because there has been measurable credit deterioration. Loans with a substandard grade are generally loans the Company has individually analyzed for potential impairment. The Doubtful graded loans and the Loss graded loans are to a point that the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off.

The Company’s allowance for loan losses (“ALLL”) is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off and we reduce our allowance by loans charged off. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors derived from our history of operations. Management is continuing to closely monitor the value of real estate serving as collateral for our loans, especially lots and land under development, due to continued concern that the low level of real estate sales activity will continue to have a negative impact on the value of real estate collateral. In addition, depressed market conditions have adversely impacted, and may continue to adversely impact, the financial condition and liquidity position of certain of our borrowers. Additionally, the value of commercial real estate collateral may come under further pressure from weak economic conditions and prevailing unemployment levels. The methodology and assumptions used to determine the allowance are continually reviewed as to their appropriateness given the most recent losses realized and other factors that influence the estimation process. The model assumptions and resulting allowance level are adjusted accordingly as these factors change. The Company incorporates certain refinements and improvements to its allowance for loan losses methodology from time to time. During 2011, the Company made the following refinements in its allowance methodology. First, the Company individually evaluated accruing TDR loans for impairment which at December 31, 2011 amounted to $22.0 million in accruing TDR loans requiring a specific allowance of $392 thousand. Second, the use of a loan migration factor by risk grade as an increment to historical loss experience was discontinued in the general (FAS 5) loss allowance calculation because of the lack of statistically meaningful supporting data. Third, we enhanced the use of qualitative and quantitative factors to further evaluate the portfolio risk. Except for the impact of the first refinement noted above, the effects of these refinements were offsetting and minimally affected the total allowance.

 

(5)  ALLOWANCE FOR LOAN LOSSES (Continued)

 

The ALLL consists of two major components: specific valuation allowances and a general valuation allowance. The Bank’s format for the calculation of ALLL begins with the evaluation of individual loans considered impaired. For the purpose of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be considered for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Once a loan is considered individually impaired, it is not included in the population of loans collectively evaluated for impairment, even if no specific allowance is considered necessary.

In addition to the evaluation of loans for impairment, the Company calculates loan loss exposure on the remaining loans (not evaluated for impairment) by applying the applicable historical loan loss experience of the loan portfolio to provide for probable losses in the loan portfolio through the general valuation allowance. These loss factors are based on an appropriate loss history for each major loan segment more heavily weighted for the most recent twelve months historical loss experience to reflect current market conditions. In addition, the Company assigns additional general allowance requirements utilizing qualitative risk factors related to economic and portfolio trends that are pertinent to the underlying risks in each major loan segment in estimating the general valuation allowance. This methodology allows the Company to focus on the relative risk and the pertinent factors for the major loan segments of the Company. 

 

   

(5) ALLOWANCE FOR LOAN LOSSES (Continued)

  

The following is a summary of credit exposure segregated by credit risk profile by internally assigned grade by class at December 31, 2011 and December 31, 2010:

 

	Commercial Real Estate						Commercial and Industrial						Commercial Lines of Credit
	December 31,			December 31,			December 31,			December 31,			December 31,			December 31,
	2011			2010			2011			2010			2011			2010
	(Amounts in thousands)
Acceptable Risk or Better	$	261,287		$	309,215		$	57,563		$	64,362		$	37,883		$	54,276
Special Mention		49,179			54,923			10,804			13,295			2,796			4,000
Substandard		76,701			89,355			16,526			13,656			3,765			4,592
Doubtful		108			2,212			428			994			130			1,792
Total	$	387,275		$	455,705		$	85,321		$	92,307		$	44,574		$	64,660

 

	Residential Construction						Home Equity Lines						Consumer
	December 31,			December 31,			December 31,			December 31,			December 31,			December 31,
	2011			2010			2011			2010			2011			2010
	(Amounts in thousands)
Acceptable Risk or Better	$	62,382		$	62,529		$	87,325		$	96,904		$	139,491		$	154,628
Special Mention		11,212			35,543			2,362			3,024			13,147			17,489
Substandard		28,351			39,572			5,449			4,905			20,481			20,087
Total	$	101,945		$	137,644		$	95,136		$	104,833		$	173,119		$	192,204

 

	Residential Lots						Raw Land
	December 31,			December 31,			December 31,			December 31,
	2011			2010			2011			2010
	(Amounts in thousands)
Acceptable Risk or Better	$	10,451		$	16,125		$	11,807		$	13,138
Special Mention		5,612			10,503			976			209
Substandard		29,101			35,924			4,705			6,824
Total	$	45,164		$	62,552		$	17,488		$	20,171

 

(6) PREMISES AND EQUIPMENT

 

Following is a summary of premises and equipment at December 31, 2011 and 2010:

 

	2011			2010
	(Amounts in thousands)
Land	$	10,409		$	10,590
Buildings and leasehold improvements		35,560			35,545
Furniture and equipment		18,512			17,832
		64,481			63,967
Less accumulated depreciation		(26,166	)		(23,417	)
Total	$	38,315		$	40,550

 

Depreciation and amortization amounting to $2.9 million in 2011, $3.1 million in 2010 and $3.4 million in 2009, is included in occupancy and equipment expense.

 

 

(7) GOODWILL AND OTHER INTANGIBLES

 

The following is a summary of goodwill and other intangible assets at December 31, 2011 and 2010. Other intangible assets are included in other assets in the consolidated balance sheet.

 

	2011			2010
	(Amounts in thousands)
Core deposit intangibles - gross	$	2,177		$	2,177
Less accumulated amortization		1,724			1,506
Core deposit intangibles - net	$	453		$	671

 

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Goodwill impairment testing is performed annually or more frequently if events or circumstances indicate possible impairment. An impairment loss is recorded to the extent that the carrying value of goodwill exceeds its implied fair value.

 

In performing the first step (“Step 1”) of the goodwill impairment testing and measurement process to identify possible impairment, the estimated fair value of the reporting unit (determined to be Company-level) was developed using both the income and market approaches to value the Company. The income approach consists of discounting projected long-term future cash flows, which are derived from internal forecasts and economic expectations for the Company. The significant inputs to the income approach include the long-term target tangible equity to tangible assets ratio and the discount rate, which is determined utilizing the Company’s cost of capital adjusted for a company-specific risk factor. The company-specific risk factor is used to address the uncertainty of growth estimates and earnings projections of management. Under one market approach, a value is calculated from an analysis of comparable acquisition transactions based on earnings, book value, assets and deposit premium multiples from the sale of similar financial institutions. Another market valuation approach utilizes the current stock price adjusted by an appropriate control premium as an indicator of fair market value. Our annual goodwill testing in May 2008, which was updated as of December 31, 2008, indicated that the goodwill booked at the time of the acquisition of The Community Bank continued to properly value the acquired company and had not been impaired as of December 31, 2008. No impairment was recorded as a result of goodwill testing performed during 2008.

 

We updated our Step 1 goodwill impairment testing as of March 31, 2009. Given the substantial declines in our common stock price, declining operating results, asset quality trends, market comparables and the economic outlook for our industry, the results of this Step 1 process indicated that the Company’s estimated fair value was less than book value, thus requiring a second step (“Step 2”) of the goodwill impairment test. Based on the Step 2 analysis, it was determined that the Company’s fair value did not support the goodwill recorded at the time of the acquisition of The Community Bank in January 2004; therefore, the Company recorded a $49.5 million goodwill impairment charge to write-off the entire amount of goodwill as of March 31, 2009. This non-cash goodwill impairment charge to earnings was recorded as a component of non-interest expense on the consolidated statement of operations.

 

Amortization expense associated with acquired intangibles amounted to $218 thousand for 2011 and 2010 and $265 thousand for 2009. The following table presents estimated future amortization expense for other intangibles.

 

	Estimated Amortization Expense
	(Amounts in thousands)
For the Years Ended December 31:
2012	$	218
2013		218
2014		17
	$	453

 

 

(8) DEPOSITS

 

Time deposits in denominations of $100,000 or more were approximately $217.1 million and $207.1 million at December 31, 2011 and 2010, respectively. At December 31, 2011, the scheduled maturities of certificates of deposit are as follows:

  

	$ 100,000			Under
		and Over		$ 100,000				Total
		(Amounts in thousands)
2012	$	121,545		$	170,034		$	291,579
2013		65,951			80,484			146,435
2014		20,984			33,452			54,436
2015		7,545			7,268			14,813
2016		1,111			664			1,775
Thereafter		-			62,800			62,800
Total	$	217,136		$	354,702		$	571,838

  

 

Under the Consent Order, the Bank agreed that it will not accept, renew or rollover any brokered deposits without obtaining a waiver from the FDIC.

 

The following table presents the amounts and maturities of brokered deposits at December 31, 2011:

 

	At December 31, 2011
	Brokered CDs
	(Amounts in thousands)
Remaining Maturity
Less than three months	$	20,000
Three to six months		15,005
Six to twelve months		12,973
Over twelve months		99,581
Total	$	147,559

 

(9) BORROWINGS

 

The following is a summary of the Company’s borrowings at December 31, 2011 and 2010:

 

	2011			2010
	(Amounts in thousands)
Short-term borrowings
FHLB advances	$	5,000		$	16,250
Repurchase agreements		28,629			4,808
Other borrowed funds		-			1,040
	$	33,629		$	22,098
Long-term borrowings
FHLB advances	$	71,637		$	56,809
Term repurchase agreements		60,000			80,000
Junior subordinated debentures		45,877			45,877
	$	177,514		$	182,686

 

See Note 2 for discussion on deferral of interest payments on subordinated debentures.

 

 

(9) BORROWINGS (Continued)

 

At December 31, 2011, the interest rates on the Federal Home Loan Bank advances ranged from 0.00% to 4.60% with a weighted average rate of 2.64%. At the prior year end, the rates ranged from 0.00% to 4.63% with a weighted average rate of 3.24%. The Company has an available line of credit of $309.2 million with the Federal Home Loan Bank of Atlanta for advances. These advances are secured by both loans with a carrying value of $73.9 million and pledged investment securities with a market value of $45.6 million and lendable collateral value of $44.2 million.

 

The Company has also entered into long-term financing through term repurchase agreements with various parties. At December 31, 2011, the interest rates on these term repurchase agreements, which are variable rate agreements based upon LIBOR, range from 2.9% to 4.5%.

 

Certain of the FHLB advances and the term repurchase agreements contain embedded interest rate options. Some of the options are exercisable by the holder and relate to converting a floating rate to a fixed rate. Other options are held by the Bank and relate to reducing the interest rate charged should the reference rate fall below a rate specified in the agreement. Several of the FHLB advances and term repurchase agreements contain options which allow them to be called prior to their contractual maturity.

 

Under the caption “Other borrowed funds,” the Company has entered into overnight unsecured borrowing arrangements with various parties at an interest rate slightly higher than repurchase agreements. These arrangements are the obligations of the parent holding company, not the Bank, and are not FDIC insured.

 

The contractual maturities of the Federal Home Loan Bank advances and term repurchase agreements at December 31, 2011 are as follows:

 

	FHLB			Term Repurchase
	Advances			Agreements
	(Amounts in thousands)
Due in 2012	$	5,000		$	20,000
Due in 2013		30,000			-
Due in 2015		10,000			-
Due in 2016		25,000			30,000
Thereafter		6,637			30,000
	$	76,637		$	80,000

  

In addition to the above advances and term repurchase agreements, the Company also had repurchase agreements with outstanding balances of $8.6 million and $4.8 million at December 31, 2011 and 2010, respectively, which were for customer accommodations. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by US Government Agency obligations. The Company has repurchase lines of credit of $120.0 million from various institutions, which must be adequately collateralized.

 

As of December 31, 2011, the Company also had a line of credit of $15.0 million from a correspondent bank to purchase federal funds on a short-term basis. As a result of the Bank’s February 25, 2011 Consent Order, we have let some federal funds lines expire rather than secure them with collateral. The Company had no outstanding balances of federal funds purchased as of December 31, 2011.

 

 

(10) JUNIOR SUBORDINATED DEBENTURES

 

In November of 2003, Southern Community Capital Trust II (“Trust II”), wholly owned by the Company, issued 3,450,000 shares of Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The Company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase junior subordinated debentures from the Company under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extends beyond the stated maturities of the debentures. Such deferral of interest payments by the Company will result in a deferral of distribution payments on the related Trust II Securities. Whenever we defer the payment of interest on the debentures, the Company will be precluded from the payment of cash dividends to shareholders. The principal uses of the net proceeds from the sale of the debentures were to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank.

 

At December 31, 2011 and 2010, the Company had outstanding 3.45 million shares of the trust preferred securities from Trust II used to purchase related junior subordinated debentures from the Bank, with a carrying amount of $35.1 million at both year ends.

 

In June 2007, $10.0 million of trust preferred securities were placed through Southern Community Capital Trust III (“Trust III”), as part of a pooled trust preferred security. The Trust issuer invested the total proceeds from the sale of the trust preferred securities in junior subordinated deferrable interest debentures (the “Junior Subordinated Debentures”) issued by the Company. The terms of the trust preferred securities require payment of cumulative cash distributions quarterly at an annual rate, reset quarterly, equal to LIBOR plus 1.43%. During 2008, the Company entered into an interest rate swap derivative contract with a counterparty that shifted this debt service from a variable rate to a fixed rate of 4.7% per annum. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities are redeemable in 30 years with a five year call provision. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company. The principal use of the net proceeds from the sale of the debentures was to provide additional capital into the Company to fund its operations and continued expansion, and to maintain the Company’s and the Bank’s regulatory capital status.

 

The amount of the proceeds generated from the above offerings of trust preferred securities was $44.5 million. The amount of proceeds the company counts as Tier 1 capital cannot comprise more than 25% of our core capital elements. For the Company, this Tier 1 limit was $32.2 million at December 31, 2011. The $12.3 million in excess of that 25% limitation qualifies as Tier 2 supplementary capital for regulatory reporting.

 

In February 2011, the Company elected to defer the regularly scheduled interest payments on both issues of junior subordinated debentures to our outstanding trust preferred securities. As of December 31, 2011, the total amount of suspended interest payments on trust preferred securities was $2.9 million.

 

 

(11) CUMULATIVE PERPETUAL PREFERRED STOCK

 

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval.

 

On February 14, 2011, the Company announced that it had notified the US Department of the Treasury that it was suspending the payment of regular quarterly cash dividends on the preferred stock issued to the US Treasury. As of December 31, 2011, the total amount of cumulative dividends suspended in payment to the US Treasury was $2.6 million. If the Company defers more than six quarterly payments to the US Treasury, then the US Treasury will have the right to elect two new board members. Directors elected by the US Treasury may not have the same interests as other shareholders and may desire the Company to take certain actions not supported by other shareholders. There can be no assurances that directors elected to represent the US Treasury would be supportive of our management’s business plans or the interests of other shareholders. Therefore, the election of directors to represent the US Treasury could have a material adverse effect on our business or the direction of its future prospects.

 

As a condition of the CPP, the Company must obtain approval from the United States Department of the Treasury to repurchase its common stock or to increase its cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. Furthermore, the Company has agreed to certain restrictions on executive compensation. Under the American Recovery and Reinvestment Act of 2009, the Company is limited to using restricted stock as a form of payment to the top five highest compensated executives under any incentive compensation programs.

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS

 

401(k) Retirement Plan

 

The Company maintains a qualified profit sharing 401(k) Plan for employees of age 21 years or over with at least three months of service. Under the plan, employees may contribute up to an annual maximum as determined under the Internal Revenue Code. Through July 2009, the Bank matched 100% of employee contributions not exceeding 6% of the participants’ compensation. Beginning August of 2009, the match was decreased to 50% and has been further reduced to zero effective January 1, 2011 as a cost reduction measure. The Board of Directors can authorize discretionary contributions to the plan. The plan provides that employees’ contributions are 100% vested at all times and the Company’s contributions vest at 20% each year of participation in the plan. The expense related to this plan for the years ended December 31, 2011, 2010 and 2009 totaled approximately none, $373 thousand and $716 thousand, respectively.

 

Deferred Compensation

 

The Company during 2007 implemented a non-qualifying deferred compensation plan for certain key executive and senior officers whose participation in the Company’s 401(k) plan is limited by Internal Revenue Service regulations. Under the plan, participants are entitled to elect to defer from 1% to 25% of current compensation until their normal retirement date. Through July 1, 2009, the Bank matched 100% of such contributions not exceeding 6% of the participants’ compensation. Beginning August 2009, the employer match was decreased to 50% and has been further reduced to zero effective January 1, 2011 as a cost reduction measure. The plan provides that employees’ contributions are 100% vested at all times and the Company’s contributions vest at 20% for each year of service. The expense related to this plan totaled approximately none, $4 thousand and $6 thousand for the years ended December 31, 2011, 2010 and 2009, respectively.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Employment Agreements

 

The Company has entered into employment agreements with its chief executive officer and certain other executive officers to ensure a stable and competent management base. The agreements provide for a two or three-year term, but the agreements may annually be extended for an additional year. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officers’ rights to receive certain vested benefits, including compensation. In the event of a change in control of the Company, as outlined in the agreements, the acquirer will be bound by the terms of the contracts. As a condition to the purchase of the Company’s preferred stock by the United States Treasury Department under the CPP, the Company agreed to certain restrictions on executive compensation, including limitations on amounts payable to certain executives under severance arrangements and change in control provisions of employment contracts and clawback provisions in compensation plans. During 2009, Congress and the United States Treasury Department imposed additional restrictions on executive compensation paid by participants in the CPP, including a prohibition on severance arrangements with certain executive officers and limitations on incentive compensation.

 

Termination Agreements

 

Prior to 2005, the Company entered into termination agreements with substantially all other employees, which provide for severance pay benefits in the event of a change in control of the Company which results in the termination of such employee or diminished compensation, duties or benefits. As of December 31, 2011, approximately 30% of the Company’s employees were covered under such agreements. As a condition of the Company’s participation in the United States Treasury’s Capital Purchase Program, the Company agreed to modify these agreements for the five senior executive officers (SEOs) to restrict the severance pay benefit the SEOs would receive in the event of a change in control while the Treasury maintains a preferred stock investment in the Company. During 2009, Congress and the United States Treasury Department imposed additional restrictions on executive compensation paid by participants in the CPP, including a prohibition on severance arrangements with certain executive officers.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Defined Benefit Pension Plan

 

The Company also has a non-contributory Defined Benefit Pension Plan covering substantially all employees of an acquired bank, The Community Bank. This plan was assumed as part of the purchase of The Community Bank in January 2004. Benefits under the plan are based on length of service and qualifying compensation during the final years of employment. Contributions to the plan are based upon the projected unit credit actuarial funding method to comply with the funding requirements of the Employee Retirement Income Security Act. The plan was frozen effective May 1, 2004. No contribution was required for the years ended December 31, 2011, 2010 or 2009. The changes in benefit obligations and plan assets, as well as the funded status, actuarial assumptions and components of net periodic pension cost of the plan at December 31 were:

 

	2011			2010			2009
	(Amounts in thousands)
Change in Benefit Obligation
Beginning of year	$	1,045		$	987		$	890
Actuarial loss		156			47			85
Service cost		-			-			-
Interest cost		58			56			56
Settlement		-			-			-
Benefits paid		(44	)		(45	)		(44	)
End of year - Benefit obligations	$	1,215		$	1,045		$	987
Change in Fair Value of Plan Assets
Beginning of year	$	1,053		$	997		$	873
Benefits paid		(44	)		(45	)		(44	)
Return on assets		(16	)		101			168
End of year - Fair value	$	993		$	1,053		$	997
Amounts recognized in the consolidated statement of financial condition consist of:
Noncurrent Asset	$	-		$	8		$	10
Noncurrent Liability		222			-			-
Funded status	$	(222	)	$	8		$	10

 

Because the total unrecognized net gain or loss exceeds the greater of 10 percent of the projected benefit obligation or 10 percent of the pension plan assets, the excess will be amortized over the average expected future working life of active plan participants. As of January 1, 2011, the average expected future working life of active plan participants was 12.2 years. The components of accumulated other comprehensive income relating to pension adjustments are entirely comprised of actuarial losses, which amount to $584 thousand, excluding income taxes.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Defined Benefit Pension Plan (Continued)

 

Actuarial assumptions used in accounting for net periodic pension cost were:

  

	2011			2010			2009
	(Amounts in thousands)
Weighted average discount rate		4.70	%		5.40	%		5.80	%
Weighted average rate of increase in compensation level		N/A			N/A			N/A
Weighted average expected long-term rate of return on plan assets		7.50	%		7.50	%		7.50	%
Components of Net Periodic Pension Cost (Benefit)
Service cost	$	-		$	-		$	-
Interest cost		58			56			56
Expected return on plan assets		(77	)		(73	)		(64	)
Loss		-			-			-
Amortization of prior service cost		-			-			-
Amortiztion of net (gain) loss		24			19			24
Net periodic pension cost (benefit)	$	5		$	2		$	16

   

The measurement date used for the plan was December 31, 2011. As of that date, the pension plan had a funded status with the fair value of plan assets of $993 thousand compared to an accumulated projected benefit obligation of $1.21 million. The actual minimum required contribution for the 2012 plan year has not yet been determined, but no employer contribution is expected to be made during 2012.

 

The overall expected long-term rate of return on assets assumption is based on: (1) the target asset allocation for plan assets, (2) long-term capital markets forecasts for asset classes employed and (3) active management excess return expectations to the extent asset classes are actively managed.

 

Plan assets are invested using allocation guidelines as established by the Plan. The primary objective is to provide long-term capital appreciation through investments in equities and fixed income securities. These guidelines ensure risk control by maintaining minimum and maximum exposure in equity and fixed income/cash equivalents portfolios. The minimum equity and fixed income/cash equivalents investment exposure is 35% and 25%, respectively. The maximum equity and fixed income/cash equivalents investment exposure is 75% and 65%, respectively. The current asset allocation is 62% equity securities and 38% fixed income securities/cash equivalents, which meets the criteria established by the Plan.

 

The fair values and allocations of pension plan assets at December 31, 2011 and 2010 are as follows:

  

	2011						2010
				Percent						Percent
	Market			of Plan			Market			of Plan
	Value			Assets			Value			Assets
	(Amounts in thousands)
Cash and equivalents	$	2			-		$	2			-
Fixed income:
Bond Funds		379			38	%		398			38	%
Equity Securities:
Mutual Funds		612			62	%		653			62	%
Total	$	993			100	%	$	1,053			100	%

  

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Defined Benefit Pension Plan (Continued)

 

All plan assets, except the money market account, are traded on the open market. At December 31, 2011 market values were determined using quoted prices and current shares owned. Bond funds currently held in the plan include long-duration and high yield bond funds and emerging market debt funds. Equity securities include large, medium and small sized companies and equity securities of foreign companies. The value of all assets are considered level 1 within the fair value hierarchy as they are valued with quoted prices for identical assets. The highest percentage of any one investment at year end 2011 was 10.5% which does not represent a concentration of risk.

 

Allowable investment types include both US and international equity and fixed income funds. The equity component is composed of common stocks, convertible notes and bonds, convertible preferred stocks and ADRs of non-US companies as well as various mutual funds, including government and corporate bonds, large to mid-cap value, growth and world/international equity funds and index funds. The fixed income/cash equivalents component is composed of money market funds, commercial paper, certificates of deposit, US Government and agency securities, corporate notes and bonds, preferred stock and fixed income securities of foreign governments and corporations.

 

The plan's weighted-average asset allocations at December 31, 2011, by asset category are as follows.

 

U.S. equity		57	%
International blend		5
Fixed income and cash equivalents		38

 

Estimated future benefits payments are shown below (in thousands):

 

Year			Pension Benefits
	2012		44
	2013		46
	2014		55
	2015		56
	2016		56
	2017 - 2012		317

   

Supplemental Retirement

 

The Company during 2001 implemented a non-qualifying supplemental retirement plan for certain key executive and senior officers. The Company has purchased life insurance policies on the participating officers in order to provide future funding of benefit payments. Benefits under the plan are intended to provide the executive officers with approximately 60% of final base pay when combined with Social Security benefits and 401(k) Plan deferral payments. Such benefits will continue to accrue and be paid throughout each participant’s life. The plan also provides for payment of death or disability benefits in the event a participating officer becomes permanently disabled or dies prior to attainment of retirement age. Provisions of $115 thousand, $426 thousand and $446 thousand in 2011, 2010 and 2009, respectively, were expensed for future benefits to be provided under this plan. The accrued liability related to this plan was approximately $2.5 million and $2.5 million as of December 31, 2011 and 2010, respectively. Payouts for this plan were $50 thousand and $62 thousand for years ended December 31, 2011 and 2010 respectively.

 

Effective January 1, 2011, the Company elected to freeze the accrued liability related to currently employed executive and senior officers at the December 31, 2010 level for the foreseeable future. This annual cost savings is estimated to be $350 thousand.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Supplemental Retirement (Continued)

 

During 1994, The Community Bank had established an unfunded Supplemental Executive Retirement Plan, which is a nonqualified plan that provides additional retirement benefits to certain key management personnel. The accrued liability related to this plan was approximately $789 thousand and $786 thousand at December 31, 2011 and 2010, respectively. Total expense for this plan aggregated $44 thousand for the year ended December 31, 2011 and $44 thousand for the year ended 2010 and $46 thousand for the year ended 2009. Payouts for this plan were $95 thousand for years ended December 31, 2011 and 2010 and are expected to continue at this level until the plan is terminated.

 

Employee Stock Purchase Plan

 

On December 19, 2002, the Board approved the creation of, and on February 20, 2003 the Board adopted, the 2002 Employee Stock Purchase Plan (the “2002 ESPP”). An aggregate of 1,000,000 shares of common stock of the Company has been reserved for issuance by the Company upon exercise of options to be granted from time to time under the 2002 ESPP. The purpose of the 2002 ESPP is to provide employees of the Company with an opportunity to purchase shares of the common stock of the Company in order to encourage employee participation in the ownership and economic success of the Company.

 

The 2002 ESPP as originally adopted provides employees of the Company the right to purchase, annually, shares of the Company’s common stock at 95% of fair market value. The plan was amended during 2009 to allow employees the right to purchase these shares monthly. The number of shares that can be purchased in any calendar year by any individual is limited to the lesser of: (1) shares with a fair market value of $25 thousand or (2) shares with a fair market value of 20% of the individual’s annual compensation. Shares purchased through the 2002 ESPP must be held by the employee for one year, after which time the employee is free to dispose of the stock.

 

For the years ended December 31, 2011, 2010 and 2009, employees of the Company purchased 24,500, 32,379 and 47,942 shares, respectively, under the ESPP. During 2011, the shares purchased for the ESPP were purchased on the open market.

 

Stock Option Plans

 

During 1997 the Company adopted, with stockholder approval, the 1997 Incentive Stock Option Plan and the 1997 Nonstatutory Stock Option Plan. Both plans were amended in 2000 and in 2001, with stockholder approval, to increase the number of shares available for grant. Each of these plans makes available options to purchase 875,253 shares of the Company’s common stock. Both of these plans have now terminated by their terms. During 2002 the Company adopted, with stockholder approval in 2003, the 2002 Incentive Stock Option Plan with 350,000 options available and the 2002 Nonstatutory Stock Option Plan with 150,000 options available. During 2006 the Company adopted, with shareholder approval, the 2006 Nonstatutory Stock Option Plan with 150,000 options available. The exercise price of all options granted to date is the fair value of the Company’s common shares on the date of grant.

 

All options had an initial vesting period of five years. During the first quarter 2005, the Company vested all unvested stock options. As a result of this decision 623,725 non-vested options were accelerated from their established vesting over a five-year period from date of grant to being fully vested. Stock options granted after December 31, 2005 and stock options granted to advisory board members generally vest over a five-year period. All unexercised options expire ten years after the date of grant.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Stock Option Plans (Continued)

 

A summary of the Company’s option plans as of and for the year ended December 31, 2011 is as follows:

 

				Outstanding Options						Exercisable Options
	Shares Available for Future Grants			Number Outstanding			Weighted Average Exercise Price			Number Outstanding			Weighted Average Exercise Price
At December 31, 2010		612,605			619,606		$	9.57			598,006		$	9.71
Options authorized		-			-			-			-			-
Options granted/vested		-			-			-			-			-
Options exercised		-			(200	)		2.67			(200	)		2.67
Options forfeited		28,500			(28,500	)		10.04			(16,700	)		10.04
Options expired		49,256			(49,256	)		6.46			(49,256	)		6.46
At December 31, 2011		690,361			541,650		$	9.57			531,850		$	9.71

 

The weighted average remaining life of options outstanding and options exercisable at December 31, 2011 and 2010 is 2.80 years and 3.50 years, respectively. Information pertaining to options outstanding at December 31, 2011 is as follows:

 

		Number of			Number of
Range of Exercise Prices		Options Outstanding			Options Exercisable
$2.67 - $7.15			93,600			83,800
$7.16 - $10.10			181,050			181,050
$10.11 - $12.00			267,000			267,000
Outstanding at end of year			541,650			531,850

 

The estimated average per share fair value of options granted, using the Black-Scholes methodology, together with the assumptions used in estimating those fair values, are displayed below. Because no options were granted in 2011, this is not applicable for 2011.

  

	2011			2010			2009
Estimated fair value of options granted		N/A			N/A		$	0.97
Assumptions in estimating average option values:
Risk-free interest rate		N/A			N/A		2.28		%
Dividend yield		N/A			N/A		1.76		%
Volatility		N/A			N/A		36		%
Expected life		N/A			N/A		5 years

  

As there were a minor number of options exercised in 2011 and 2010, the total intrinsic value of options exercised during the years ended December 31, 2011, and 2010 was none. The aggregate intrinsic value of options outstanding and options exercisable at December 31, 2011 and 2010 were zero. As of December 31, 2011, there was $9 thousand of unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted average period of 1.41 years.

 

 

(12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

 

Stock Option Plans (Continued)

 

Cash received from option exercises under all share-based payment arrangements for the years ended December 31, 2011, 2010 and 2009 was $1 thousand, $1 thousand and none, respectively. The tax benefit realized for tax deductions from option exercise of the share-based payment arrangements for the years ended December 31, 2011, 2010 and 2009 were none, respectively. Under this plan, the Company expensed $26 thousand, $52 thousand and $165 thousand for the years ended December 31, 2011, 2010 and 2009, respectively.

 

Restricted Stock

 

During 2007 the Company adopted the Southern Community Financial Corporation Restricted Stock Plan. The plan initially made 300,000 shares available to be issued as restricted stock. The plan is administered by the Compensation Committee of the Board of Directors who may authorize the grant of restricted stock to certain current directors, officers and employees of the Corporation. The shares vest over a five year period and are taxable to the recipient at their option either when received or after the vesting period at the current fair market value. The recipient must be employed with the Company at the end of the five year period or the shares are forfeited. For the year ended December 31, 2011, 26,750 shares were granted and 12,500 shares were forfeited. During the period from the inception of the plan through December 31, 2011, a total of 128,750 shares have now been issued and 25,250 shares have been forfeited, leaving 196,500 shares available for future grants. Under this plan, the Company expensed $71 thousand, $74 thousand and $63 thousand for the years ended December 31, 2011, 2010 and 2009, respectively.

 

(13) LEASES

 

The Company leases office space and equipment under non-cancelable operating leases. Future minimum lease payments under these leases for the years ending December 31 are as follows (amounts in thousands):

 

2012	$	810
2013		774
2014		623
2015		353
2016		326
Thereafter		2,488
	$	5,374

 

Total rental expense for office space and equipment under operating leases are as follows:

 

	2011			2010			2009
	(Amounts in thousands)
Office Space	$	620		$	620		$	730
Equipment		223			365			444
	$	843		$	985		$	1,174

 

 

(14) INCOME TAXES

 

The significant components of the provision for income taxes for the years ended December 31, 2011, 2010 and 2009 are as follows:

 

	2011			2010			2009
	(Amounts in thousands)
Current tax provision (benefit)
Federal	$	869		$	(5,380	)	$	(693	)
State		-			(12	)		(157	)
		869			(5,392	)		(850	)
Deferred tax provision (benefit)
Federal		(1,290	)		8,497			(4,760	)
State		421			1,213			(1,076	)
		(869	)		9,710			(5,836	)
Net provision (benefit) for income taxes	$	-		$	4,318		$	(6,686	)

 

The difference between the provision for income taxes and the amounts computed by applying the statutory federal income tax rate of 34% to income before income taxes is summarized below:

 

	2011			2010			2009
	(Amounts in thousands)
Tax computed at the statutory federal rate	$	1,045		$	(6,393	)	$	(23,747	)
Increase (decrease) resulting from:
Goodwill impairment		-			-			16,830
Valuation allowance on deferred tax assets		(218	)		12,600			2,000
State income taxes, net of federal benefit		278			793			(814	)
Tax exempt income		(1,153	)		(1,275	)		(1,071	)
Other permanent differences		48			(1,407	)		116
		(1,045	)		10,711			17,061
Provision (benefit) for income taxes	$	-		$	4,318		$	(6,686	)

 

 

(14) INCOME TAXES (Continued)

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred taxes at December 31, 2011 and 2010 are as follows:

 

	2011			2010
	(Amounts in thousands)
Deferred tax assets relating to:
Allowance for loan losses	$	9,317		$	11,404
Net operating loss carry forward		4,669			2,994
Deferred compensation		1,560			1,613
OREO writedowns		1,830			1,228
Accumulated other comprehensive income		-			903
Other		800			721
Gross deferred tax assets		18,176			18,863
Valuation allowance		(14,382	)		(14,600	)
Net total deferred tax assets		3,794			4,263
Deferred tax liabilities relating to:
Property and equipment		(2	)		(333	)
Loan fees and costs		(639	)		(633	)
Core deposit intangible		(175	)		(259	)
Prepaid expenses		(365	)		(390	)
Other		(63	)		(65	)
Accumulated other comprehensive income		(430	)		-
Total deferred tax liabilities		(1,674	)		(1,680	)
Net recorded deferred tax asset	$	2,120		$	2,583

 

We calculate income taxes in accordance with US GAAP, which requires the use of the asset and liability method. The largest component of our net deferred tax asset at December 31, 2011 was related to the activity in our allowance for loan losses. In accordance with US GAAP, we regularly assess available positive and negative evidence to determine whether it is more likely than not that our deferred tax asset balances will be recovered. Based upon our analysis of our tax position, including taxes paid in prior years available through carryback and the use of tax planning strategies, we maintained the valuation allowance of $14.4 million at December 31, 2011 to properly state our ability to realize this deferred tax asset. The total valuation allowance resulted in a net deferred tax asset of $2.1 million. Our analysis of our tax position included future taxable earnings based on current earnings for 2011. Realization of a deferred tax asset requires us to apply significant judgment and is inherently speculative because it may require the future occurrence of circumstances that cannot be predicted with certainty. The realizability of the net deferred tax asset of $2.1 million at December 31, 2011 is based on the offset of deferred tax liabilities, tax planning strategies and future operating earnings.

 

As a result of the net operating loss carry forward of $3.0 million expiring in 2020 and $1.7 million expiring in 2021 at December 31, 2011 and the $14.4 million deferred tax asset valuation allowance, the Company will not record tax expense or tax benefit until positive operating earnings utilize all existing tax loss carry forwards and support the partial or full reinstatement of deferred tax assets.

 

The Company classifies interest and penalties related to income tax assessments, if any, in income tax expense in the consolidated statements of operations. Most recent tax year examined by Internal Revenue Service was 2009, leaving 2010 and subsequent years subject to IRS examination. The Company has approximately $32 thousand accrued for payment of interest and penalties as of December 31, 2011.

 

 

(14) INCOME TAXES (Continued)

 

A reconciliation of the beginning and ending balance of unrecognized tax benefit is as follows:

 

	2011			2010
	(Amounts in thousands)
Balance at January 1, 2011	$	153		$	162
Additions based on tax positions related to the current year		27			38
Additions for tax positions of prior years		-			-
Reductions for tax positions of prior years		(17	)		(47	)
Settlements		-			-
Balance at December 31, 2011	$	163		$	153

 

(15) NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE

 

The major components of non-interest income for the years ended December 31, 2011, 2010 and 2009 are as follows:

 

	2011			2010			2009
	(Amounts in thousands)
SBIC income (loss) and management fees	$	(88	)	$	631		$	148
Increase in cash surrender value of life insurance		1,103			1,079			1,116
Gain (loss) and net cash settlement on economic hedges		(129	)		(532	)		234
Other		944			894			1,067
Total	$	1,830		$	2,072		$	2,565

 

The major components of other non-interest expense for the years ended December 31, 2011, 2010 and 2009 are as follows:

 

	2011			2010			2009
	(Amounts in thousands)
Postage, printing and office supplies	$	658		$	753		$	921
Telephone and communication		881			880			927
Advertising and promotion		871			925			1,103
Data processing and other outsourced services		750			857			746
Professional services		2,959			2,972			2,215
Debit card expense		934			917			780
Buyer incentive plan		-			413			1,320
Loss on early extinguishment of debt		-			-			472
Gain on sales of foreclosed assets		(689	)		(429	)		(196	)
Other		5,185			5,015			5,830
Total	$	11,549		$	12,303		$	14,118

 

 

(16) REGULATORY CAPITAL

 

The Bank, as a North Carolina banking corporation, may pay cash dividends to the Company only out of retained earnings as determined pursuant to North Carolina banking laws. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such limitation is in the public interest and is necessary to ensure financial soundness of the bank. The Consent Order restricts the Bank from paying cash dividends without prior regulatory approval. The Bank is subject to various regulatory capital requirements administered by federal and state banking agencies. On February 25, 2011, the Bank entered into a Consent Order with the FDIC and the NCCOB. Under the terms of the Consent Order, the Bank has agreed, among other things, to comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital. See Note 2 for a discussion of management’s compliance with these minimum capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as prescribed by regulations, of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Information regarding the Bank’s capital and capital ratios is set forth below:

 

	Actual						Minimum For Capital Adequacy Purposes						Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount			Ratio			Amount			Ratio			Amount			Ratio
	(Amounts in thousands)
As of December 31, 2011
Total Capital (to Risk-Weighted Assets)	$	151,336			13.85	%	$	87,400			8.00	%	$	109,200			10.00	%
Tier 1 Capital (to Risk-Weighted Assets)		137,552			12.59	%		43,700			4.00	%		65,500			6.00	%
Tier 1 Capital (to Average Assets)		137,552			9.07	%		43,700			4.00	%		75,900			5.00	%
As of December 31, 2010
Total Capital (to Risk-Weighted Assets)	$	147,983			11.14	%	$	107,000			8.00	%	$	133,700			10.00	%
Tier 1 Capital (to Risk-Weighted Assets)		131,217			9.88	%		53,500			4.00	%		80,200			6.00	%
Tier 1 Capital (to Average Assets)		131,217			7.83	%		67,000			4.00	%		83,800			5.00	%

 

As a bank holding company subject to regulation by the Federal Reserve, the Company must comply with the above mentioned regulatory capital requirements. Information regarding the Company’s capital and capital ratios is set forth below:

 

	At December 31, 2011						At December 31, 2010
	Actual						Actual
	Amount			Ratio			Amount			Ratio
	(Amounts in thousands)
Total risk-based capital ratio	$	156,186			14.26	%	$	156,503			11.75	%
Tier 1 risk-based capital ratio		128,661			11.75	%		124,615			9.35	%
Leverage ratio		128,661			8.47	%		124,615			7.42	%

 

 

(17) DERIVATIVES

 

Derivative Financial Instruments

 

The Company utilizes stand-alone derivative financial instruments, primarily in the form of interest rate swap and option agreements, in its asset/liability management program. These transactions involve both credit and market risk. The Company uses derivative instruments to mitigate exposure to adverse changes in fair value or cash flows of certain assets and liabilities. Derivative instruments designated in a hedge relationship to mitigate 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. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

 

Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense on the hedged asset or liability. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in accumulated other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods the hedged transaction affects earnings. Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement.

 

The Company does not enter into derivative financial instruments for speculative or trading purposes. For derivatives that are economic hedges, but are not designated as hedging instruments or otherwise do not qualify for hedge accounting treatment, all changes in fair value are recognized in non-interest income during the period of change. The net cash settlement on these derivatives is included in non-interest income.

 

The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures and agreements that specify collateral levels to be maintained by the Company and the counterparties. These collateral levels are based on the credit rating of the counterparties and the value of the derivatives.

 

The Company currently has nine derivative instrument contracts consisting of six interest rate swaps, one interest rate cap and two foreign exchange contracts. The primary objective for each of these contracts is to minimize risk, interest rate risk being the primary risk for the interest rate caps and swaps while foreign exchange risk is the primary risk for the foreign exchange contracts. The Company’s strategy is to use derivative contracts to stabilize and improve net interest margin and net interest income currently and in future periods. In order to acquire low cost, long term fixed rate funding without incurring currency risk, the Company entered into the foreign exchange contract to convert foreign currency denominated certificates of deposit into long term dollar denominated time deposits. The interest rate on the underlying $10.0 million certificates of deposit is based on a proprietary index (Barclays Intelligent Carry Index USD ER) managed by the counterparty (Barclays Bank). The currency swap is also based on this proprietary index.

 

 

(17) DERIVATIVES (Continued)

 

Risk Management Policies - Hedging Instruments

 

The primary focus of the Company’s asset/liability management program is to monitor the sensitivity of the Company’s net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Company simulates the net portfolio value and net income expected to be earned for a period following the date of simulation. The simulation is based on a projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Company considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Company evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates.

 

The fair value of the Company’s derivative assets and liabilities and their related notional amounts is summarized below.

  

	December 31, 2011						December 31, 2010
	Fair Value			Notional Amount			Fair Value			Notional Amount
	(Amounts in thousands)
Fair value hedges
Interest rate swaps associated with deposit  activities: Certificate of Deposit contracts	$	436		$	65,000		$	392		$	75,000
Currency Exchange contracts		(457	)		10,000			(679	)		10,000
Cash flow hedges
Interest rate swaps associated with borrowing activities: Trust Preferred contracts		(202	)		10,000			(468	)		10,000
Interest rate cap contracts		9			12,500			113			12,500
	$	(214	)	$	97,500		$	(642	)	$	107,500

  

See Note 20 for additional information on fair values of net derivatives.

 

Certain derivative liabilities were collateralized by securities, which are held by the counterparty or in safekeeping by third parties. The fair value of these securities at December 31, 2011 was $7.3 million.

 

 

(17) DERIVATIVES (Continued)

 

The following table further breaks down the derivative positions of the Company:

  

		For the Year Ended December 31, 2011
		Asset Derivatives					Liability Derivatives
		2011					2011
		Balance Sheet					Balance Sheet
		Location		Fair Value			Location		Fair Value
		(Amounts in thousands)
Derivatives designated as hedging instruments
Interest rate cap contracts		Other Assets		$	9
Interest rate swap contracts		Other Assets			436		Other Liabilities		$	202
Derivatives not designated as hedging instruments
Interest rate swap contracts		Other Assets			-		Other Liabilities			457
Total derivatives				$	445				$	659
Net Derivative Asset (Liability)									$	(214	)

 

  

		For the Year Ended December 31, 2010
		Asset Derivatives					Liability Derivatives
		2010					2010
		Balance Sheet					Balance Sheet
		Location		Fair Value			Location		Fair Value
		(Amounts in thousands)
Derivatives designated as hedging instruments
Interest rate cap contracts		Other Assets		$	113
Interest rate swap contracts		Other Assets			392		Other Liabilities		$	468
Derivatives not designated as hedging instruments
Interest rate swap contracts		Other Assets			-		Other Liabilities			679
Total derivatives				$	505				$	1,147
Net Derivative Asset (Liability)									$	(642	)

   

The tables below illustrate the effective portion of the gains (losses) recognized in other comprehensive income and the gains (losses) reclassified from accumulated other comprehensive income into earnings for the years ended December 31, 2011 and 2010.

 

For the Year Ended December 31, 2011
					Location of Gain or		Amount of Gain or (Loss)
		Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
		Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging		Derivative (Effective			into Income		Income (Effective
Relationships		Portion)			(Effective Portion)		Portion)
		(Amounts in thousands)
Interest rate contracts		$	(104)		Interest expense		$	-
		Ineffective Portion					Ineffective Portion
		$	264				$	300

 

  

 

(17) DERIVATIVES (Continued)

 

In prior years, no gain or loss has been recognized in the income statement due to any ineffective portion of any cash flow hedging relationship. In February 2011, the payment of interest on the trust preferred securities was suspended which resulted in the swap changing its status from effective to ineffective. The change to an ineffective status disqualified the instrument from hedge accounting and required mark to market adjustments to be included in the income statement instead of other comprehensive income as previously recorded. Upon recognizing this ineffective status in the first quarter of 2011, the Company recorded a $384 thousand mark to market loss in the income statement on this interest rate swap relating to trust preferred securities. The Company recorded a $264 thousand gain on this swap into non-interest income during the year ended December 31, 2011.

  

For the Year Ended December 31, 2010
					Location of Gain or		Amount of Gain or (Loss)
		Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
		Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging		Derivative (Effective			into Income		Income (Effective
Relationships		Portion)			(Effective Portion)		Portion)
		(Amounts in thousands)
Interest rate contracts		$	(738	)	Interest expense		$	(283	)

   

There was no gain or loss recognized in the income statement due to any ineffective portion of any cash flow hedging relationship for the year ended December 31, 2010.

  

For the Year Ended December 31, 2009
					Location of Gain or		Amount of Gain or (Loss)
		Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
		Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging		Derivative (Effective			into Income		Income (Effective
Relationships		Portion)			(Effective Portion)		Portion)
		(Amounts in thousands)
Interest rate contracts		$	354		Interest expense		$	(233	)

   

There was no gain or loss recognized in the income statement due to any ineffective portion of any cash flow hedging relationship for the year ended December 31, 2009.

 

 

(17) DERIVATIVES (Continued)

 

The tables below show the location and amount of gains (losses) recognized in earnings for fair value hedges and other economic hedges for the years ended December 31, 2011 and 2010.

 

For the Year Ended December 31, 2011
		Location of Gain or			Amount of Gain or (Loss)
		(Loss) Recognized in			Recognized in Income on
Description		Income on Derivative			Derivative
					(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other income (expense)		$	(129	)
Interest Rate Contracts - Fair value hedging relationships		Interest income/(expense)		$	1,766

  

For the Year Ended December 31, 2010
		Location of Gain or			Amount of Gain or (Loss)
		(Loss) Recognized in			Recognized in Income on
Description		Income on Derivative			Derivative
					(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other income (expense)		$	(532	)
Interest Rate Contracts - Fair value hedging relationships		Interest income/(expense)		$	1,954

 

 

For the Year Ended December 31, 2009
		Location of Gain or			Amount of Gain or (Loss)
		(Loss) Recognized in			Recognized in Income on
Description		Income on Derivative			Derivative
					(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other income (expense)		$	234
Interest Rate Contracts - Fair value hedging relationships		Interest income/(expense)		$	1,499

 

The interest rate swap with borrowing activities on trust preferred securities has a maturity of September 6, 2012. The maturity date for the interest rate cap contract is February 18, 2014. The currency exchange contracts have maturity dates of November 29, 2013 and December 30, 2013. The interest rate swaps with deposit taking activities on certificates of deposit have maturity dates of July 28, 2025, August 27, 2030, September 30, 2030, October 12, 2040 and December 17, 2040. The interest rate swaps on certificates of deposit have original call dates of July 28, 2011, May 27, 2011, September 30, 2011, October 12, 2014 and November 28, 2014 and quarterly thereafter. All of these swaps have the ability to be called by the counterparty prior to their maturity date. No new derivative contracts were entered into during 2011.

 

Certain derivative liabilities were collateralized by securities, which are held by the counterparty or in safekeeping by third parties. The fair value of these securities was $7.3 million and $9.7 million at December 31, 2011 and December 31, 2010, respectively. Collateral calls can be required at any time that the market value exposure of the contracts is less than the collateral pledged. The degree of overcollateralization is dependent on the derivative contracts to which the Company is a party.

 

As part of our banking activities, the Company originates certain residential loans and commits these loans for sale. The commitments to originate residential loans and the sales commitments are freestanding derivative instruments and are generally funded within 90 days. The fair value of these commitments was not significant at December 31, 2011.

 

 

(17) DERIVATIVES (Continued)

 

In January 2012, the Company entered into $35.0 million notional forward starting interest rate swaps. The purpose of these swaps is to lock in currently low fixed rate funding costs for intermediate term FHLB advances maturing from July 2012 through November 2013.

 

Interest Rate Risk Management - Cash Flow Hedging Instruments

 

To mitigate exposure to variability in expected future cash flows resulting from changes in interest rates, management may enter into interest rate swap and option agreements. At December 31, 2011 and 2010, the Company had an interest rate swap agreement related to a variable-rate obligation that provides for the Company to pay fixed and receive floating payments related to the variable rate Trust Preferred Securities (the Trust III Securities). The Company also had an interest rate option agreement that provides payments to the Company in the event interest rates increase or decrease above or below levels provided in the agreements. The gains and losses from such hedges not designated as cash flow hedges are recognized in non-interest income in the line item net cash settlement and change in fair value of economic hedges.

 

Interest Rate Risk Management – Fair Value Hedging Instruments

 

As part of interest rate risk management, the Company from time to time has entered into interest rate swap agreements to convert certain fixed-rate obligations to floating rates. At December 31, 2011 and 2010, the Company had interest rate swap agreements related to fixed-rate obligations that provide for the Company to pay floating and receive fixed interest payments, certain of which had been designated as fair value hedges, others of which were not designated as fair value hedges. The gains (losses) from such interest rate swaps that were not designated as accounting hedges are recognized in non-interest income in the line item net cash settlement and change in fair value of economic hedges. Prior to designation as fair value hedges, the change in the fair value of the interest rate swap agreements were included in noninterest income. Subsequent to the designation as fair value hedges, the changes in the fair value of the interest rate swap and the changes to the fair value of the hedged CD are included in noninterest income. The difference between the changes in the fair values of the interest rate swaps and the related CDs represents hedge ineffectiveness. The Company currently has no fair value hedges for which hedge effectiveness is evaluated using the “short-cut” method.

 

(18) OFF-BALANCE SHEET RISK, COMMITMENTS AND CONTINGENCIES

 

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis.

 

The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds and certificates of deposit.

 

 

(18) OFF-BALANCE SHEET RISK, COMMITMENTS AND CONTINGENCIES (Continued)

 

A summary of the contract amount of the Company’s exposure to off-balance sheet risk as of December 31, 2011 and 2010 is as follows:

 

 

	2011			2010
	(Amounts in thousands)
Financial instruments whose contract amounts represent credit risk:
Loan commitments and undisbursed lines of credit	$	192,036		$	188,549
Undisbursed standby letters of credit		6,910			8,280
Undisbursed portion of construction loans		28,123			27,321
	$	227,069		$	224,150

 

The Company is a party to legal proceedings and potential claims arising in the normal conduct of business. Management believes that this litigation is not material to the financial position or results of operations of the Company.

 

(19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS

 

Financial instruments include cash and due from banks, federal funds sold, investment securities, loans, bank-owned life insurance, deposit accounts and other borrowings, accrued interest and derivatives. Fair value estimates are made at a specific moment 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 active market readily exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. 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.

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

 

Cash and due from banks, federal funds sold and other interest-bearing deposits

 

The carrying amounts for cash and due from banks, federal funds sold and other interest-bearing deposits approximate fair value because of the short maturities of those instruments.

 

Investment securities

 

Fair value for investment securities equals quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The Company utilizes a third party pricing service to provide valuations on its securities portfolio. Most of these securities are US government agency debt obligations and agency mortgage-backed securities traded in active markets. The third party valuations are determined based on the characteristics of each security (such as maturity, duration, rating, etc.) and in reference to similar or comparable securities. Due to the nature and methodology of these valuations, the Company considers these fair value measurements as Level 2.

 

Loans

 

For certain homogeneous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of 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 and for the same remaining maturities.

 

 

(19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

 

Investment in bank-owned life insurance

 

The carrying value of bank-owned life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.

 

Deposits

 

The fair value of demand deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated based on discounting expected cash flows using the rates currently offered for deposits of similar remaining maturities.

 

Borrowings

 

The fair values are based on discounting expected cash flows at the current interest rate for debt with the same or similar remaining maturities and collateral requirements. As it relates to the Company’s subordinated debentures, the fair values are calculated by reference to the market price of the publicly traded trust preferred securities as an indication of the Company’s credit risk.

 

Accrued interest

 

The carrying amounts of accrued interest approximate fair value.

 

Derivative financial instruments

 

Fair values for interest rate swap and option agreements are based upon the amounts required to settle the contracts. Fair values for commitments to originate loans held for sale are based on fees currently charged to enter into similar agreements. Fair values for fixed-rate commitments also consider the difference between current levels of interest rates and the committed rates.

 

Financial instruments with off-balance sheet risk

 

With regard to financial instruments with off-balance sheet risk discussed in Note 18, it is not practicable to estimate the fair value of future financing commitments.

 

 

(19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

 

The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, are as follows at December 31, 2011 and 2010:

 

	2011						2010
	Carrying amount			Estimated fair value			Carrying amount			Estimated fair value
	(Amounts in thousands)
Financial assets:
Cash and due from banks	$	23,356		$	23,356		$	16,584		$	16,584
Federal funds sold and overnight deposits		23,198			23,198			49,587			49,587
Investment securities available for sale		362,298			362,298			310,653			310,653
Investment securities held to maturity		44,403			45,514			42,220			40,181
Loans		925,857			904,302			1,100,496			1,119,189
Market risk/liquidity adjustment		-			(41,323	)		-			(50,272	)
Net loans		925,857			862,979			1,100,496			1,068,917
Investment in life insurance		30,919			30,919			29,831			29,831
Accrued interest receivable		5,843			5,843			6,782			6,782
Financial liabilities:
Deposits		1,183,172			1,177,073			1,348,419			1,349,501
Short-term borrowings		33,629			35,334			22,098			22,098
Long-term borrowings		177,514			161,888			182,686			155,967
Accrued interest payable		5,219			5,219			2,779			2,779
On-balance sheet derivative financial instruments:
Interest rate swap and option agreements:
(Assets) Liabilities, net		214			214			642			642

 

(20) FAIR VALUES OF ASSETS AND LIABILITIES

 

Accounting standards establish a framework for measuring fair value according to generally accepted accounting principles and expands disclosures about fair value measurements. Under these standards, there is a three level fair value hierarchy that is fully described below. The Company reports fair value on a recurring basis for certain financial instruments, most notably for available for sale investment securities and certain derivative instruments. The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis. These include assets that are measured at the lower of cost or market that were recognized at fair value which was below cost at the end of the period. Assets subject to nonrecurring use of fair value measurements could include loans held for sale, goodwill, impaired loans and foreclosed assets. At December 31, 2011 and December 31, 2010, the Company had certain impaired loans that are measured at fair value on a nonrecurring basis.

 

The Company groups financial assets and financial liabilities measured 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 – Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. There were no investments held with level 1 valuations.

 

 

(20) FAIR VALUES OF ASSETS AND LIABILITIES (Continued)

 

·

Level 2 – Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 securities include asset-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Valuations are obtained from third party services for similar or comparable assets or liabilities.

 

·

Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or brokered traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

 

There were no transfers between any of the levels during 2011. The table below presents the balances of assets and liabilities measured at fair value on a recurring basis.

 

	December 31, 2011
	Total			Level 1			Level 2			Level 3
	(Amounts in thousands)
Securities available for sale:
US government agencies	$	34,729		$	-		$	34,729		$	-
Asset-backed securities		291,368			-			291,368			-
Municipals		29,220			-			29,220			-
Trust preferred securities		2,321			-			2,321			-
Corporate bonds		3,659			-			3,659			-
Other		1,001			-			1,001			-
Net Derivatives		(214	)		-			243			(457	)

 

	December 31, 2010
	Total			Level 1			Level 2			Level 3
	(Amounts in thousands)
Securities available for sale:
US government agencies	$	98,240		$	-		$	98,240		$	-
Asset-backed securities		149,776			-			149,776			-
Municipals		55,564			-			55,564			-
Trust preferred securities		3,094			-			3,094			-
Corporate bonds		3,003			-			-			3,003
Other		976			-			976			-
Net Derivatives		(642	)		-			37			(679	)

 

There were no transfers between any levels during 2010. The table below presents reconciliation for the period of January 1, 2011 to December 31, 2011, for all level 3 assets and liabilities that are measured at fair value on a recurring basis.

 

	Fair Value Measurements Using Significant Unobservable Inputs
	Securities
	Available for sale			Net Derivatives
	(Amounts in thousands)
Beginning Balance January 1, 2011	$	3,003		$	(679	)
Total realized and unrealized gains or losses:
Included in earnings		537			222
Included in other comprehensive income		-			-
Purchases, issuances and settlements		(3,540	)		-
Transfers in and/or out of Level 3		-			-
Ending Balance	$	-		$	(457	)

 

During 2011, the Company sold the available for sale securities which were measured for fair value as level 3 assets.

 

 

(20) FAIR VALUES OF ASSETS AND LIABILITIES (Continued)

 

The Company utilizes a third party pricing service to provide valuations on its securities portfolio. Most of these securities are US Government agency debt obligations and agency asset-backed securities traded in active markets. The third party valuations are determined based on the characteristics of each security (such as maturity, duration, rating, etc.) and in reference to similar or comparable securities. Due to the nature and methodology of these valuations, the Company considers these fair value measurements as level 2.

 

The fair value reporting standards allows an entity to make an irrevocable election to measure certain financial instruments at fair value. The changes in fair value from one reporting period to the next period must be reported in the income statement with additional disclosures to identify the effect on net income. The Company continued to account for securities available for sale at fair value as reported in prior years. Derivative activity is also reported at fair value. Securities available for sale and derivative activity are reported on a recurring basis. Upon adoption of the fair value reporting standard, no additional financial assets or liabilities were reported at fair value and there was no material effect on earnings.

 

The Company records loans in the ordinary course of business and does not record loans at fair value on a recurring basis. Loans are considered impaired when it is determined to be probable that all amounts due under the contractual terms of the loan will not be collected when due. Loans considered individually impaired are evaluated and a specific allowance is established if required based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. A specific allowance is required if the fair value of the expected repayments or the collateral is less than the recorded investment in the loan. At December 31, 2011, loans with a book value of $87.1 million were evaluated for impairment. Of this total, $23.0 million required a specific allowance totaling $1.6 million for a net fair value of $21.4 million. At December 31, 2010, loans with a book value of $87.1 million were evaluated for impairment. Of this total, $27.8 million required a specific allowance totaling $5.1 million for a net fair value of $22.7 million. The methods used to determine the fair value of these loans were generally either the present value of expected future cash flows or fair value of collateral and were considered level 3.

 

The table below presents the balances of assets and liabilities measured at fair value on a nonrecurring basis.

 

	December 31, 2011
	Total			Level 1			Level 2			Level 3
	(Amounts in thousands)
Impaired loans	$	21,388		$	-		$	-		$	21,388
Foreclosed assets		19,812			-			-			19,812

 

	December 31, 2010
	Total			Level 1			Level 2			Level 3
	(Amounts in thousands)
Impaired loans	$	22,699		$	-		$	-		$	22,699
Foreclosed assets		17,314			-			-			17,314

 

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less estimated cost to sell on the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management or outside appraisers and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. These valuations generally are based on market comparable sales data for similar type of properties. The range of discounts in these valuations is specific to the nature, type, location, condition and market demand for each property. The methods used to determine the fair value of these foreclosed assets were considered level 3.

 

 

(21) PARENT COMPANY FINANCIAL DATA

 

Southern Community Financial Corporation's condensed balance sheets as of December 31, 2011 and 2010 and its related condensed statements of operations and cash flows for each of the years in the three-year period ended December 31, 2011 are as follows:

 

Condensed Balance Sheets

December 31, 2011 and 2010

 

	2011			2010
	(Amounts in thousands)
Assets:
Cash and due from banks	$	5,602		$	5,559
Investment in subsidiary		140,068			131,610
Investment securities available for sale		-			1,352
Other assets		1,244			1,035
Total assets	$	146,914		$	139,556
Liabilities:
Junior subordinated debentures	$	45,877		$	45,877
Other liabilities		3,402			1,338
Total liabilities		49,279			47,215
Stockholders' equity
Preferred stock		41,870			41,453
Common stock		119,505			119,408
Retained earnings (accumulated deficit)		(64,425	)		(67,082	)
Accumulated other comprehensive income (loss)		685			(1,438	)
Total stockholders' equity		97,635			92,341
Total liablilites and stockholders' equity	$	146,914		$	139,556

 

Condensed Statements of Operations

Years Ended December 31, 2011, 2010 and 2009

 

	2011			2010			2009
	(Amounts in thousands)
Equity in income (loss) of subsidiaries	$	6,022		$	(20,530	)	$	(60,729	)
Interest income		110			301			433
Other income		540			(220	)		104
Interest expense		(3,513	)		(3,559	)		(3,723	)
Other expense		(85	)		(435	)		(485	)
Income tax benefit		-			1,322			1,241
Net income (loss)		3,074			(23,121	)		(63,159	)
Effective dividend on preferred stock		2,554			2,531			2,508
Net income (loss) available to common shareholders	$	520		$	(25,652	)	$	(65,667	)

 

 

(21) PARENT COMPANY FINANCIAL DATA (Continued)

 

Condensed Statements of Cash Flows

Years Ended December 31, 2011, 2010 and 2009

 

 

	2011			2010			2009
	(Amounts in thousands)
Operating activities:
Net income (loss)	$	3,074		$	(23,121	)	$	(63,159	)
Equity in (income) loss of subsidiaries		(6,022	)		20,530			60,729
Amortization of debt issuance costs		51			443			421
Amortization of preferred stock warrants		-			(393	)		(370	)
Realized (gain) loss on sale of available  for sale securities		(537	)		35			-
Realized loss on impairment of  investment  securities available for sale		-			186			-
(Increase) decrease in other assets		(122	)		10			(1	)
Increase (decrease) in other liabilities		2,062			-			(2,307	)
Net cash provided (used) by operating activities		(1,494	)		(2,310	)		(4,687	)
Investing activities:
Investment in bank subsidiary		-			(6,000	)		(9,000	)
Proceeds from sale of available for sale investment securities		1,537			48			-
Net cash provided (used) by investing activities		1,537			(5,952	)		(9,000	)
Financing activities:
Increase (decrease) in short term debt		-			(38,327	)		39,366
Dividends paid preferred stock		-			(2,138	)		(2,138	)
Dividends paid common shareholders		-			-			(664	)
Net cash provided (used) by financing activities		-			(40,465	)		36,564
Net increase (decrease) in cash		43			(48,727	)		22,877
Cash, beginning of year		5,559			54,286			31,409
Cash, end of year	$	5,602		$	5,559		$	54,286

 

(22) SUBSEQUENT EVENTS

 

Management has evaluated subsequent events through the date the financial statements were issued and there have been no material subsequent events.

 

 

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None.

 

Item 9A. Controls and Procedures

 

Southern Community Financial Corporation’s management, with the participation of its Chief Executive Officer and its Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of December 31, 2011. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2011.

 

Management’s Report On Internal Control Over Financial Reporting

 

Management of Southern Community Financial Corporation and Subsidiary (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with US generally accepted accounting principles.

 

Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting, including controls over the preparation of financial statements, based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control – Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting as of December 31, 2011.

 

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. As previously discussed in this document, the Bank, by and through its Board of Directors, executed on February 25, 2011 a Stipulation to the Issuance of a Consent Order whereby the Bank consented, without admitting or denying any charges of unsafe or unsound banking practices or violations of law or regulation, to the issuance of a Consent Order by the FDIC and the NCCOB. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws during the year ended December 31, 2011.

 

Changes in Internal Controls over Financial Reporting

 

The Company assesses the adequacy of its internal control over financial reporting quarterly and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. No such control enhancements during the quarter ended December 31, 2011 have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Item 9B. Other Information 

 

None.

 

 

 

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance

 

Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2012.

 

Item 11. Executive Compensation

 

Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2012.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management

 

Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2012.

 

The following table sets forth equity compensation plan information at December 31, 2011.

 

Equity Compensation Plan Information
Plan Category	Number of securities to be issued upon exercise of outstanding options warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights	Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
	(a)	(b)	(c)
Equity compensation plans approved by security holders
Stock Option Plans	541,650	$9.77	690,361
Employee Stock Purchase Plan	N/A	N/A	799,170
Restricted Stock Plan	N/A	N/A	196,500
Equity compensation plans not approved by security holders	N/A	N/A	N/A
None
Total	541,650	$9.77	1,686,031

  

Item 13. Certain Relationships and Related Transactions, and Director Independence

 

Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2012.

 

Item 14. Principal Accountant Fees and Services

 

Incorporated by reference from the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 23, 2012.

PART IV

 

Item 15. Exhibits, Financial Statement Schedules

 

(a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8 of this report.

 

Financial Statements	Form 10-K Page
Report of Independent Registered Public Accounting Firm	69
Consolidated Statements of Financial Condition as of December 31, 2011 and 2010	70
Consolidated Statements of Operations for the years ended
December 31, 2011, 2010 and 2009	71
Consolidated Statements of Comprehensive Income (Loss) for the years ended
December 31, 2011, 2010 and 2009	72
Consolidated Statements of Changes in Stockholders’ Equity for the years ended
December 31, 2011, 2010 and 2009	73
Consolidated Statements of Cash Flows for the years ended
December 31, 2011, 2010 and 2009	74-75
Notes to Consolidated Financial Statements	76-131

 

Exhibit No.		Description
Exhibit 3.1:		Articles of Incorporation (incorporated by reference from Exhibit 3(i) to the Current Report on Form 8-K dated October 1, 2001)
Exhibit 3.2:		Bylaws (incorporated by reference from Exhibit 3.2 to the Quarterly Report on Form 10-Q for the quarter ended September 30, 2009)
Exhibit 3.3:		Amendment to Articles of Incorporation (incorporated by reference from Exhibit 3.3 to the Annual Report on Form 10-K for the year ended December 31, 2001 (“2001 Annual Report”))
Exhibit 4.1:		Specimen certificate for Common Stock of Southern Community Financial Corporation (incorporated by reference from Exhibit 4 to the Current Report on Form 8-K dated October 1, 2001)
Exhibit 4.2:		Form of 7.95% Junior Subordinated Debenture (incorporated by reference from Exhibit 4.2 to the Registration Statement on Form S-3 dated September 26, 2003, Registration No. 333-109167 (the “S-3 Registration Statement”))
Exhibit 4.3:		Form of Certificate for 7.95% Trust Preferred Security of Southern Community Capital Trust II (incorporated by reference from Exhibit 4.6 to the S-3 Registration Statement)
Exhibit 10.1:		1997 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 10.1 to Amendment Number One to the Registration Statement on Form S-2 dated January 10, 2002, Registration Number 333-74084 (the “Amended S-2 Registration Statement”))
Exhibit 10.2:		1997 Non-Statutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 10.2 to the Amended S-2 Registration Statement)
Exhibit 10.3:		2002 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 10.7 to the Annual Report on Form 10-K for the year ended December 31, 2003 (“2003 Annual Report”))
Exhibit 10.4:		2002 Non-Statutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 10.8 to the 2003 Annual Report)
Exhibit 10.5:		Indenture with respect to the Company’s 7.95% Junior Subordinated Debentures (incorporated by reference from Exhibit 10.9 to the 2003 Annual Report)
Exhibit 10.6:		Amended and Restated Trust Agreement of Southern Community Capital Trust II (incorporated by reference from Exhibit 10.10 to the 2003 Annual Report)

 

 

 

Exhibit 10.7:		Guarantee Agreement for Southern Community Capital Trust II (incorporated by reference from Exhibit 10.11 to the 2003 Annual Report)
Exhibit 10.8:		Agreement as to Expenses and Liabilities with respect to Southern Community Capital Trust II (incorporated by reference from Exhibit 10.12 to the 2003 Annual Report)
Exhibit 10.9:		2002 Employee Stock Purchase Plan (incorporated by reference from Exhibit 10.13 to the 2003 Annual Report)
Exhibit 10.10:		The Community Bank Amended and Restated Stock Option Plan for Key Employees (incorporated by reference from Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114997)
Exhibit 10.11:		2001 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114993)
Exhibit 10.12:		2001 Stock Option Plan for Directors of Southern Community Financial Corporation (incorporated by reference from Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114991)
Exhibit 10.13:		2006 Nonstatutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference from Exhibit 4.2 to the Registration Statement on Form S-8 dated November 11, 2006, Registration Number 333-138601)
Exhibit 10.14:		Employment Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2006 (“2006 First Quarter Form 10-Q”))
Exhibit 10.15:		Employment Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.2 to the 2006 First Quarter Form 10-Q)
Exhibit 10.16:		Amended & Restated Salary Continuation Agreement of F. Scott Bauer (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 (“2007 First Quarter Form 10-Q”))
Exhibit 10.17:		Amended & Restated Salary Continuation Agreement of Jeff T. Clark (incorporated by reference from Exhibit 10.2 to the 2007 First Quarter Form 10-Q)
Exhibit 10.18:		Employment Agreement with James C. Monroe, Jr. (incorporated by reference to the Annual Report of Form 10-K for the year ended December 31, 2007)
Exhibit 10.19:		Amendment Number One to Employment Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.1 to the Quarterly Report on Form 10-Q for the quarter ended September 30, 2007 (“2007 Third Quarter Form 10-Q”))
Exhibit 10.20:		Amendment Number One to Employment Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.2 to the 2007 Third Quarter Form 10-Q)
Exhibit 10.21:		Amendment Number One to Employment agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.3 to the 2007 Third Quarter Form 10-Q)
Exhibit 10.22:		Salary Continuation Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.22 to the Annual Report on Form 10-K for the year ended December 31, 2007)
Exhibit 10.23:		Amendment Number One to Salary Continuation Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.23 to the Annual Report on Form 10-K for the year ended December 31, 2007)
Exhibit 10.24:		Addendum A to Split Dollar Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.24 to the Annual Report on Form 10-K for the year ended December 31, 2007)
Exhibit 10.25:		Addendum A to Split Dollar Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.25 to the Annual Report on Form 10-K for the year ended December 31, 2007)
Exhibit 10.26:		Employment Agreement with James Hastings (incorporated by reference from Exhibit 10.1 to the Current report on Form 8-K dated June 17, 2008)
Exhibit 10.27:		Salary Continuation Agreement with James Hastings (incorporated by reference from Exhibit 10.2 to the Current report on Form 8-K dated June 17, 2008)

 

 

 

Exhibit 10.28:		Waiver Agreement and Acknowledgement with F. Scott Bauer (incorporated by reference from Exhibit 10.28 to the Annual Report on Form 10-K for the year ended December 31, 2008 the “2008 Annual Report”)
Exhibit 10.29		Waiver Agreement and Acknowledgement with Jeffrey T. Clark (incorporated by reference from Exhibit 10.29 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.30		Waiver Agreement and Acknowledgement with Robert L. Davis, Jr. (incorporated by reference from Exhibit 10.30 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.31		Waiver Agreement and Acknowledgement with James Hastings (incorporated by reference from Exhibit 10.31 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.32		Waiver Agreement and Acknowledgement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.32 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.33:		Amendment Number Two to Employment Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.33 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.34:		Amendment Number One to Amended and Restated Salary Continuation Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.34 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.35:		Amendment Number One to Amended and Restated Salary Continuation Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.35 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.36:		Amendment Number One to Salary Continuation Agreement with James Hastings (incorporated by reference from Exhibit 10.36 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.37:		Amendment Number One to Employment Agreement with James Hastings (incorporated by reference from Exhibit 10.37 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.38:		Amendment Number Two to Employment Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.38 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.39:		Amendment Number Two to Employment Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.39 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.40:		Amendment Number One to Salary Continuation Agreement with Robert L. Davis (incorporated by reference from Exhibit 10.40 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.41:		Amendment Number Two to Employment Agreement with Robert L. Davis (incorporated by reference from Exhibit 10.41 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.42:		Amendment Number Two to Salary Continuation Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.42 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.43:		Amendment Number Three to Employment Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.43 to the 2008 Annual Report on Form 10-K for the year ended December 31, 2008)
Exhibit 10.44:		Amendment Number Two to the Amended & Restated Salary Continuation Agreement with F. Scott Bauer (incorporated by reference from Exhibit 10.44 to the 2010 Annual Report on Form 10-K for the year ended December 31, 2010)
Exhibit 10.45:		Amendment Number Two to the Amended & Restated Salary Continuation Agreement with Jeff T. Clark (incorporated by reference from Exhibit 10.45 to the 2010 Annual Report on Form 10-K for the year ended December 31, 2010)

 

 

 

Exhibit 10.46:		Amendment Number Two to the Salary Continuation Agreement with James Hastings (incorporated by reference from Exhibit 10.46 to the 2010 Annual Report on Form 10-K for the year ended December 31, 2010)
Exhibit 10.47:		Amendment Number Three to the Salary Continuation Agreement with James C. Monroe, Jr. (incorporated by reference from Exhibit 10.47 to the 2010 Annual Report on Form 10-K for the year ended December 31, 2010)
Exhibit 10.48:		Amendment Number Two to the Salary Continuation Agreement with Robert L. Davis (incorporated by reference from Exhibit 10.48 to the 2010 Annual Report on Form 10-K for the year ended December 31, 2010)
Exhibit 10.49:		Stipulation to the Issuance of a Consent Order Dated February 16, 2011 by and between Southern Community Bank and Trust, the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks (incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed February 17, 2011)
Exhibit 10.50:		Consent Order dated February 16, 2011 by and between Southern Community Bank and Trust, the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks (incorporated by reference from Exhibit 10.2 to the Current Report on Form 8-K filed February 17, 2011)
Exhibit 10.51:		Written Agreement dated June 23, 2011 by and between Southern Community Financial Corporation and the Federal Reserve Bank (incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K dated June 23, 2011)
Exhibit 10.52:		Employment Agreement with Merle B. Andrews
Exhibit 10.53:		Amendment Number One to Employment Agreement with Merle B. Andrews
Exhibit 10.54:		Salary Continuation Agreement with Merle B. Andrews
Exhibit 10.55:		Amendment Number One to Salary Continuation Agreement with Merle B. Andrews
Exhibit 21:		Subsidiaries of the Registrant
Exhibit 23:		Consent of Dixon Hughes PLLC
Exhibit 31.1:		Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer
Exhibit 31.2:		Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer
Exhibit 32:		Section 1350 Certifications
Exhibit 99.1		TARP Certification by Chief Executive Officer
Exhibit 99.2		TARP Certification by Chief Financial Officer

 

 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.

 

	SOUTHERN COMMUNITY
	FINANCIAL CORPORATION
Date: March 23, 2012	By:	/s/ F, Scott Bauer
		F. Scott Bauer
		President and Chief Executive Officer
		(principal executive officer)

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

SIGNATURE		TITLE	DATE
/s/ F. Scott Bauer		President and Chief Executive
F. Scott Bauer		Officer (principal executive officer)	March 23, 2012
/s/ James Hastings		Executive Vice President and Chief
James Hastings		Financial Officer (principal financial
		and accounting officer)	March 23, 2012
/s/ Edward T. Brown		Director
Edward T. Brown			March 23, 2012
/s/ James G. Chrysson		Director
James G. Chrysson			March 23, 2012
/s/ James O. Frye		Director
James O. Frye			March 23, 2012
/s/ Matthew G. Gallins		Director
Matthew G. Gallins			March 23, 2012

 

 

SIGNATURE		TITLE	DATE
/s/ Lynn L. Lane		Director
Lynn L. Lane			March 23, 2012
/s/ H. Lee Merritt, Jr.		Director
H. Lee Merritt, Jr.			March 23, 2012
/s/ Stephen L. Robertson		Director
Stephen L. Robertson			March 23, 2012
/s/ W. Samuel Smoak		Director
W. Samuel Smoak			March 23, 2012
/s/ William G. Ward, Sr., M.D.		Chairman of the Board	March 23, 2012
William G. Ward, Sr., M.D.		and Director