Edgar Filing: AUBURN NATIONAL BANCORPORATION, INC

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FORM 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended June 30, 2011

¨	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period to

Commission File Number: 0-26486

Auburn National Bancorporation, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

63-0885779

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

100 N. Gay Street

Auburn, Alabama 36830

(334) 821-9200

(Address and telephone number of principal executive offices)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class		Outstanding at July 31, 2011
Common Stock, $0.01 par value per share		3,642,738 shares

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

INDEX


PART I. FINANCIAL INFORMATION		PAGE

Item 1	Financial Statements

	Condensed Consolidated Balance Sheets (Unaudited) as of June 30, 2011 and December 31, 2010	3

	Condensed Consolidated Statements of Earnings (Unaudited) for the quarter and six months ended June 30, 2011 and 2010	4

	Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Unaudited) for the six months ended June 30, 2011 and 2010	5

	Condensed Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2011 and 2010	6

	Notes to Condensed Consolidated Financial Statements (Unaudited)	7

Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	29

	Table 1 – Explanation of Non-GAAP Financial Measures	46

	Table 2 – Selected Quarterly Financial Data	47

	Table 3 – Selected Financial Data	48

	Table 4 – Average Balances and Net Interest Income Analysis – for the quarter ended June 30, 2011 and 2010	49

	Table 5 – Average Balances and Net Interest Income Analysis – for the six months ended June 30, 2011 and 2010	50

	Table 6 – Loan Portfolio Composition	51

	Table 7 – Allowance for Loan Losses and Nonperforming Assets	52

	Table 8 – Allocation of Allowance for Loan Losses	53

	Table 9 – CDs and Other Time Deposits of $100,000 or more	54

Item 3	Quantitative and Qualitative Disclosures About Market Risk	55

Item 4	Controls and Procedures	55

PART II. OTHER INFORMATION

Item 1	Legal Proceedings	55

Item 1A	Risk Factors	55

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	55

Item 3	Defaults Upon Senior Securities	56

Item 4	Removed and Reserved	56

Item 5	Other Information	56

Item 6	Exhibits	56

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(Unaudited)


(Dollars in thousands, except share data)	June 30, 2011			December 31, 2010

Assets:
Cash and due from banks	$	15,654		$	11,432
Federal funds sold		40,835			7,500
Interest bearing bank deposits		1,091			2,492

Cash and cash equivalents		57,580			21,424

Securities available-for-sale		296,443			315,220
Loans held for sale		2,278			4,281
Loans, net of unearned income		373,795			374,215
Allowance for loan losses		(7,746	)		(7,676	)

Loans, net		366,049			366,539

Premises and equipment, net		8,237			8,105
Bank-owned life insurance		16,385			16,171
Other real estate owned		9,361			8,125
Other assets		23,392			23,964

Total assets	$	779,725		$	763,829


Liabilities:
Deposits:
Noninterest-bearing	$	96,888		$	87,660
Interest-bearing		531,081			519,467

Total deposits		627,969			607,127
Federal funds purchased and securities sold under agreements to repurchase		2,314			2,685
Long-term debt		85,322			93,331
Accrued expenses and other liabilities		3,020			4,318

Total liabilities		718,625			707,461


Stockholders’ equity:
Preferred stock of $.01 par value; authorized 200,000 shares; no issued shares		—			—
Common stock of $.01 par value; authorized 8,500,000 shares; issued 3,957,135 shares		39			39
Additional paid-in capital		3,753			3,752
Retained earnings		62,970			61,421
Accumulated other comprehensive income (loss), net		981			(2,201	)
Less treasury stock, at cost - 314,397 shares and 314,417 shares at June 30, 2011 and December 31, 2010, respectively		(6,643	)		(6,643	)

Total stockholders’ equity		61,100			56,368

Total liabilities and stockholders’ equity	$	779,725		$	763,829

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Earnings

(Unaudited)


	Quarter ended June 30,						Six months ended June 30,
(Dollars in thousands, except share and per share data)	2011			2010			2011			2010

Interest income:
Loans, including fees	$	5,371		$	5,492		$	10,658		$	10,925
Securities		2,613			2,959			5,151			6,178
Federal funds sold and interest bearing bank deposits		14			10			23			17

Total interest income		7,998			8,461			15,832			17,120


Interest expense:
Deposits		2,092			2,615			4,262			5,255
Short-term borrowings		3			3			6			14
Long-term debt		846			1,155			1,693			2,332

Total interest expense		2,941			3,773			5,961			7,601


Net interest income		5,057			4,688			9,871			9,519
Provision for loan losses		600			750			1,200			2,200

Net interest income after provision for loan losses		4,457			3,938			8,671			7,319


Noninterest income:
Service charges on deposit accounts		290			334			581			648
Mortgage lending		439			625			879			1,107
Bank-owned life insurance		107			106			214			232
Affordable housing investment losses		(230	)		(57	)		(230	)		(114	)
Other		355			353			708			734
Securities gains, net:
Realized gains, net		445			1,431			450			2,531
Total other-than-temporary impairments		(51	)		(20	)		(312	)		(260	)
Non-credit portion of other-than-temporary impairments recognized in other comprehensive income		—			20			210			210

Total securities gains, net		394			1,431			348			2,481

Total noninterest income		1,355			2,792			2,500			5,088


Noninterest expense:
Salaries and benefits		2,068			1,939			4,054			3,844
Net occupancy and equipment		328			364			674			748
Professional fees		189			191			360			367
FDIC and other regulatory assessments		199			286			481			562
Other real estate owned, net		718			911			701			972
Prepayment penalty on long-term debt		—			298			—			298
Other		861			820			1,743			1,654

Total noninterest expense		4,363			4,809			8,013			8,445


Earnings before income taxes		1,449			1,921			3,158			3,962
Income tax (benefit) expense		(8	)		314			152			738


Net earnings	$	1,457		$	1,607		$	3,006		$	3,224


Net earnings per share:
Basic and diluted	$	0.40		$	0.44		$	0.83		$	0.88


Weighted average shares outstanding:
Basic and diluted		3,642,738			3,642,877			3,642,733			3,642,996

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income

(Unaudited)


					Additional paid-in capital		Retained earnings			Accumulated other comprehensive income (loss)			Treasury stock			Total
	Common Stock
(Dollars in thousands, except share data)	Shares		Amount

Balance, December 31, 2009		3,957,135	$	39	$	3,751	$	58,917		$	111			$(6,635	)	$	56,183
Comprehensive income:
Net earnings		—		—		—		3,224			—			—			3,224
Other comprehensive loss due to change in other-than-temporary impairment losses related to factors other than credit on available-for- sale, net		—		—		—		—			(133	)		—			(133	)
Other comprehensive income due to change in all other unrealized gains (losses) on securities available-for- sale, net		—		—		—		—			1,196			—			1,196

Total comprehensive income		—		—		—		3,224			1,063			—			4,287

Cash dividends paid ($0.39 per share)		—		—		—		(1,421	)		—			—			(1,421	)
Stock repurchases (484 shares)		—		—		—		—			—			(8	)		(8	)
Sale of treasury stock (60 shares)		—		—		1		—			—			—			1

Balance, June 30, 2010		3,957,135	$	39	$	3,752	$	60,720		$	1,174		$	(6,643	)	$	59,042


Balance, December 31, 2010		3,957,135	$	39	$	3,752	$	61,421		$	(2,201	)	$	(6,643	)	$	56,368
Comprehensive income:
Net earnings		—		—		—		3,006			—			—			3,006
Other comprehensive loss due to change in other-than-temporary impairment losses related to factors other than credit on available-for- sale, net		—		—		—		—			(133	)		—			(133	)
Other comprehensive income due to change in all other unrealized gains (losses) on securities available-for- sale, net		—		—		—		—			3,315			—			3,315

Total comprehensive income		—		—		—		3,006			3,182			—			6,188

Cash dividends paid ($0.40 per share)		—		—		—		(1,457	)		—			—			(1,457	)
Sale of treasury stock (20 shares)		—		—		1		—			—			—			1

Balance, June 30, 2011		3,957,135	$	39	$	3,753	$	62,970		$	981		$	(6,643	)	$	61,100

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)


	Six months ended June 30,
(In thousands)	2011			2010

Cash flows from operating activities:
Net earnings	$	3,006		$	3,224
Adjustments to reconcile net earnings to net cash provided by operating activities:
Provision for loan losses		1,200			2,200
Depreciation and amortization		309			273
Premium amortization and discount accretion, net		1,074			916
Net gain on securities		(348	)		(2,481	)
Net gain on sale of loans held for sale		(683	)		(927	)
Net loss on other real estate owned		741			857
Loss on prepayment of long-term debt		—			298
Loans originated for sale		(22,317	)		(38,702	)
Proceeds from sale of loans		24,851			40,130
Increase in cash surrender value of bank owned life insurance		(214	)		(232	)
Net increase in other assets		(1,706	)		(1,087	)
Net (decrease) increase in accrued expenses and other liabilities		(1,298	)		355

Net cash provided by operating activities		4,615			4,824


Cash flows from investing activities:
Proceeds from sales of securities available-for-sale		97,407			120,083
Proceeds from maturities of securities available-for-sale		44,834			71,029
Purchase of securities available-for-sale		(119,147	)		(186,208	)
Net increase in loans		(3,268	)		(3,113	)
Net purchases of premises and equipment		(295	)		(75	)
Decrease in FHLB stock		423			—
Proceeds from sale of other real estate owned		581			571

Net cash provided by investing activities		20,535			2,287


Cash flows from financing activities:
Net increase in noninterest-bearing deposits		9,228			10,012
Net increase in interest-bearing deposits		11,614			16,334
Net decrease in federal funds purchased and securities sold under agreements to repurchase		(371	)		(13,809	)
Repayments or retirement of long-term debt		(8,009	)		(5,307	)
Proceeds from sale of treasury stock		1			1
Stock repurchases		—			(8	)
Dividends paid		(1,457	)		(1,421	)

Net cash provided by financing activities		11,006			5,802


Net change in cash and cash equivalents		36,156			12,913
Cash and cash equivalents at beginning of period		21,424			12,395

Cash and cash equivalents at end of period	$	57,580		$	25,308



Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	6,108		$	7,770
Income taxes		332			843
Supplemental disclosure of non-cash transactions:
Real estate acquired through foreclosure		2,558			477

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

General

Auburn National Bancorporation, Inc. (the “Company”) provides a full range of banking services to individual and corporate customers in Lee County, Alabama and surrounding counties through its wholly owned subsidiary, AuburnBank (the “Bank”). The Company does not have any segments other than banking that are considered material.

Basis of Presentation and Use of Estimates

The unaudited condensed consolidated financial statements in this report have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information. Accordingly, these financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. The unaudited condensed consolidated financial statements include, in the opinion of management, all adjustments necessary to present a fair statement of the financial position and the results of operations for all periods presented. All such adjustments are of a normal recurring nature. The results of operations in the interim statements are not necessarily indicative of the results of operations that the Company and its subsidiaries may achieve for future interim periods or the entire year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2010.

Reclassifications

Certain amounts reported in prior periods have been reclassified to conform to the current-period presentation. These reclassifications had no effect on the Company’s previously reported net earnings or total stockholders’ equity.

Subsequent Events

The Company has evaluated the effects of events or transactions through the date of this filing that have occurred subsequent to June 30, 2011. The Company does not believe there are any material subsequent events that would require further recognition or disclosure.

Accounting Developments

No new guidance was adopted by the Company during the second quarter of 2011. In the first quarter of 2011 the Company adopted new guidance related to the following Codification topic:

•

Accounting Standards Update (“ASU”) 2010-06, Improving Disclosures about Fair Value Measurements.

Information about this pronouncement is described in more detail below.

ASU 2010-06, Improving Disclosures about Fair Value Measurements, amends the disclosure requirements for fair value measurements. Companies are required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy. The ASU also clarifies that fair value measurement disclosures should be presented for each asset and liability class, which is generally a subset of a line item in the statement of financial position. In the rollforward of Level 3 activity, companies must present information on purchases, sales, issuances, and settlements on a gross basis rather than on a net basis. Companies should also provide information about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring instruments classified as either Level 2 or Level 3. In the first quarter of 2011, the Company adopted the requirement for gross presentation in the Level 3 rollforward with prospective application. The remaining provisions were effective for the Company in the first quarter of 2010. Adoption of the ASU did not have a significant impact on the consolidated financial statements of the Company since it amends only the disclosure requirements for fair value measurements.

NOTE 2: BASIC AND DILUTED EARNINGS PER SHARE

Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the quarter and six months ended June 30, 2011 and 2010, respectively. Diluted net earnings per share reflect the potential dilution that could occur if the Company’s potential common stock was issued. At June 30, 2011 and 2010, respectively, the Company had no options issued or outstanding, and therefore, no dilutive effect to consider for the diluted earnings per share calculation.

A reconciliation of the numerator and denominator of the basic and diluted earnings per share computation for the quarter and six months ended June 30, 2011 and 2010 is presented below.


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands, except share and per share data)		2011		2010		2011		2010
Basic and diluted:
Net earnings	$	1,457	$	1,607	$	3,006	$	3,224
Weighted average common shares outstanding		3,642,738		3,642,877		3,642,733		3,642,996
Earnings per share	$	0.40	$	0.44	$	0.83	$	0.88

NOTE 3: COMPREHENSIVE INCOME

Comprehensive income is defined as the change in equity from all transactions other than those with shareholders, and it includes net earnings and other comprehensive income (loss). Comprehensive income for the quarter and six months ended June 30, 2011 and 2010 is presented below.


	Quarter ended June 30,					Six months ended June 30,
(In thousands)		2011		2010			2011			2010
Comprehensive income:
Net earnings	$	1,457	$	1,607		$	3,006		$	3,224
Other comprehensive income (loss):
Due to change in other-than-temporary impairment losses related to factors other than credit on securities available-for-sale, net of tax		—		(13	)		(133	)		(133	)
Due to change in all other unrealized gains on securities available-for-sale, net of tax		2,571		387			3,315			1,196
Total comprehensive income	$	4,028	$	1,981		$	6,188		$	4,287

NOTE 4: VARIABLE INTEREST ENTITIES

The Company is involved in various entities that are considered to be variable interest entities (“VIEs”), as defined by authoritative accounting literature. Generally, a VIE is a corporation, partnership, trust or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities.

At June 30, 2011, the Company did not have any consolidated VIEs to disclose but did have certain nonconsolidated VIEs, discussed below.

Trust Preferred Securities

The Company owns the common stock of a subsidiary business trust, Auburn National Bancorporation Capital Trust I, which issued mandatorily redeemable preferred capital securities (“trust preferred securities”) in the aggregate of approximately $7.0 million at the time of issuance. This trust meets the definition of a VIE of which the Company is not the primary beneficiary; the trust’s only assets are junior subordinated debentures issued by the Company, which were acquired by the trust using the proceeds from the issuance of the trust preferred securities and common stock. The junior subordinated debentures of approximately $7.2 million are included in long-term debt and the Company’s equity interest in

the business trust is included in other assets. Interest expense on the junior subordinated debentures is reported in interest expense on long-term debt. For regulatory reporting and capital adequacy purposes, the Federal Reserve Board has indicated that such trust preferred securities will continue to constitute Tier 1 Capital until further notice.

Affordable Housing Investments

Periodically, the Company may invest in various limited partnerships that sponsor affordable housing projects in its primary markets and surrounding areas as a means of supporting local communities. These investments are designed to generate a return primarily through the realization of federal tax credits. These projects are funded through a combination of debt and equity and the partnerships meet the definition of a VIE. While the Company’s investment as a limited partner in a single entity may at times exceed 50% of the outstanding equity interests, the Company does not consolidate the partnerships due to the nature of the management activities of the general partner and the performance guaranties provided by the project sponsors. The Company typically provides financing during the construction and development of the properties; however, permanent financing is generally obtained from independent parties upon completion of a project.

At June 30, 2011 and December 31, 2010, the Company had limited partnership investments of $5.6 million and $3.4 million, respectively, related to these projects, which are included in other assets on the Condensed Consolidated Balance Sheets. At June 30, 2011 and December 31, 2010, the Company had unfunded commitments related to affordable housing investments of $0.5 million and $1.9 million, respectively, included in accrued expenses and other liabilities on the Condensed Consolidated Balance Sheets.

Additionally, the Company had outstanding loan commitments with certain of the partnerships totaling $4.1 million and $11.4 million at June 30, 2011 and December 31, 2010, respectively. The funded portion of these loans was approximately $3.0 and $8.9 million at June 30, 2011 and December 31, 2010, respectively. The funded portions of these loans are included in loans, net of unearned income on the Condensed Consolidated Balance Sheets.

The following table summarizes VIEs that are not consolidated by the Company as of June 30, 2011.

(Dollars in thousands)

Maximum
Loss
Exposure

Liability
Recognized

Classification

Type:

Affordable housing investments (a)

5,647

458

Other assets

Trust preferred issuances

N/A

7,217

Long-term debt

(a)	Maximum loss exposure represents the Company’s current investment of $5.6 million included in other assets. The current investment of $5.6 million includes $0.5 million of unfunded commitments related to affordable housing investments included in accrued expenses and other liabilities.

NOTE 5: SECURITIES

At June 30, 2011 and December 31, 2010, respectively, all securities within the scope of FASB ASC 320, Investments – Debt and Equity Securities were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity at June 30, 2011 and December 31, 2010, respectively, are presented below.


	June 30, 2011
	1 year		1 to 5		5 to 10		After 10		Fair		Gross Unrealized				Amortized
(Dollars in thousands)	or less		years		years		years		Value		Gains		Losses		Cost
Available-for-sale:
Agency obligations (a)	$	—		—		23,899		26,860		50,759		29		424	$	51,154
Agency RMBS (a)		—		—		14,255		146,103		160,358		1,254		532		159,636
State and political subdivisions		20		932		15,389		66,734		83,075		1,737		353		81,691
Trust preferred securities:
Pooled		—		—		—		20		20		—		210		230
Individual issuer		—		—		—		2,231		2,231		186		134		2,179
Total available-for-sale	$	20		932		53,543		241,948		296,443		3,206		1,653	$	294,890

(a)	Includes securities issued by U.S. government agencies or government sponsored entities.


	December 31, 2010
	1 year		1 to 5		5 to 10		After 10		Fair		Gross Unrealized				Amortized
(Dollars in thousands)	or less		years		years		years		Value		Gains		Losses		Cost
Available-for-sale:
Agency obligations (a)	$	—		—		37,821		52,650		90,471		95		1,017	$	91,393
Agency RMBS (a)		—		—		9,976		133,168		143,144		1,566		1,441		143,019
State and political subdivisions		21		856		13,547		62,342		76,766		472		2,801		79,095
Trust preferred securities:
Pooled		—		—		—		20		20		—		210		230
Individual issuer		—		—		—		2,129		2,129		—		153		2,282
Corporate debt		—		2,690		—		—		2,690		—		—		2,690
Total available-for-sale	$	21		3,546		61,344		250,309		315,220		2,133		5,622	$	318,709

(a)	Includes securities issued by U.S. government agencies or government sponsored entities.

Securities with aggregate fair values of $186.5 million and $171.1 million at June 30, 2011 and December 31, 2010, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes required or permitted by law.

Included in other assets on the Condensed Consolidated Balance Sheets are cost-method investments. The carrying amounts of cost-method investments were $5.4 and $5.8 million at June 30, 2011 and December 31, 2010, respectively. Cost-method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock.

Gross Unrealized Losses and Fair Value

The fair values and gross unrealized losses on securities at June 30, 2011 and December 31, 2010, respectively, segregated by those securities that have been in an unrealized loss position for less than twelve months and twelve months or more are presented below.


	Less than 12 Months				12 Months or Longer				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(Dollars in thousands)	Value		Losses		Value		Losses		Value		Losses
June 30, 2011:
Agency obligations	$	27,704		424		—		—		27,704	$	424
Agency RMBS		65,363		532		—		—		65,363		532
State and political subdivisions		10,604		193		3,459		160		14,063		353
Trust preferred securities:
Pooled		—		—		20		210		20		210
Individual issuer		—		—		866		134		866		134
Total	$	103,671		1,149		4,345		504		108,016	$	1,653

December 31, 2010:
Agency obligations	$	45,351		1,017		—		—		45,351	$	1,017
Agency RMBS		89,840		1,441		—		—		89,840		1,441
State and political subdivisions		49,176		2,323		3,207		478		52,383		2,801
Trust preferred securities:
Pooled		—		—		20		210		20		210
Individual issuer		—		—		847		153		847		153
Total	$	184,367		4,781		4,074		841		188,441	$	5,622

The applicable date for determining when securities are in an unrealized loss position is June 30, 2011. As such, it is possible that a security in an unrealized loss position at June 30, 2011 had a market value that exceeded its amortized cost on other days during the past twelve-month period.

For the securities in the previous table, the Company does not have the intent to sell and has determined it is not more likely than not that the Company will be required to sell the security before recovery of the amortized cost basis, which may be maturity. The Company has assessed each security for credit impairment. For debt securities, the Company evaluates, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. For cost-method investments, the Company evaluates whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment.

In determining whether a loss is temporary, the Company considers all relevant information including:

•

the length of time and the extent to which the fair value has been less than the amortized cost basis;

•

adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors, including changes in technology or the discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security or changes in the quality of the credit enhancement);

•

the historical and implied volatility of the fair value of the security;

•

the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future;

•

failure of the issuer of the security to make scheduled interest or principal payments;

•

any changes to the rating of the security by a rating agency;

•

and recoveries or additional declines in fair value subsequent to the balance sheet date.

To the extent the Company estimates future expected cash flows, the Company considered all available information in developing those expected cash flows. For asset-backed securities such as pooled trust preferred securities, such information generally included:

•

remaining payment terms of the security (including as applicable, terms that require underlying obligor payments to increase in the future);

•

current delinquencies and nonperforming assets of underlying collateral;

•

expected future default rates; and

•

subordination levels or other credit enhancements.

Agency obligations

The unrealized losses associated with agency obligations are primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities are issued by U.S. government agencies or government-sponsored entities and do not have any credit losses given the explicit or implicit government guarantee.

Agency residential mortgage-backed securities (“RMBS”)

The unrealized losses associated with Agency RMBS are primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities are issued by U.S. government agencies or government-sponsored entities and do not have any credit losses given the explicit or implicit government guarantee.

Securities of U.S. states and political subdivisions

The unrealized losses associated with securities of U.S. states and political subdivisions are primarily driven by changes in interest rates and are not due to the credit quality of the securities. These securities will continue to be monitored as part of the Company’s quarterly impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. As a result, the Company expects to recover the entire amortized cost basis of these securities.

Pooled trust preferred securities

The unrealized losses associated with pooled trust preferred securities are primarily driven by higher projected collateral losses and wider credit spreads. Pooled trust preferred securities primarily consist of securities issued by community banks and thrifts. The Company assesses impairment for these securities using a cash flow model. The key assumptions include default probabilities of the underlying collateral and recoveries on collateral defaults. Based upon the Company’s assessment of the expected credit losses for these securities, and given the performance of the underlying collateral compared to the Company’s credit enhancement, the Company expects to recover the remaining amortized cost basis of these securities.

Individual issuer trust preferred securities

The unrealized losses associated with individual issuer trust preferred securities are primarily related to securities backed by individual issuer community banks. For individual issuers, management evaluates the financial performance of the issuer on a quarterly basis to determine if it is probable that the issuer can make all contractual principal and interest payments. Based upon its evaluation, the Company expects to recover the remaining amortized cost basis of these securities.

Cost-method investments

At June 30, 2011, cost-method investments with an aggregate cost of $5.4 million were not evaluated for impairment because the Company did not identify any events or changes in circumstances that may have a significant adverse effect on the fair value of these cost-method investments.

The carrying values of the Company’s investment securities could decline in the future if the underlying performance of the collateral for pooled trust preferred securities, the financial condition of individual issuers of trust preferred securities, or the credit quality of other securities deteriorate and the Company determines it is probable that it will not recover the entire amortized cost basis for the security. As a result, there is a risk that significant other-than-temporary impairment charges may occur in the future.

The following tables show the applicable credit ratings, fair values, gross unrealized losses, and life-to-date impairment charges for pooled and individual issuer trust preferred securities at June 30, 2011 and December 31, 2010, respectively, segregated by those securities that have been in an unrealized loss position for less than twelve months and twelve months or more.

Trust Preferred Securities as of June 30, 2011


							Unrealized Losses						Life-to-date Impairment Charges
	Credit Rating				Fair Value		Less than 12 months		12 months or Longer		Total
(Dollars in thousands)	Moody’s		Fitch		Fair Value		Less than 12 months		12 months or Longer		Total
Pooled:
ALESCO Preferred Funding XVII Ltd (a)		C		CC	$	20		—		210		210	$	1,770
Individual issuer (b):
Carolina Financial Capital Trust I		n/a		n/a		260		—		—		—		190
Main Street Bank Statutory Trust I (c)		n/a		n/a		459		—		41		41		—
MNB Capital Trust I		n/a		n/a		143		—		—		—		362
PrimeSouth Capital Trust I		n/a		n/a		161		—		—		—		339
TCB Trust		n/a		n/a		407		—		93		93		—
United Community Capital Trust		n/a		n/a		801		—		—		—		379

Total individual issuer						2,231		—		134		134		1,270

Total trust preferred securities					$	2,251		—		344		344	$	3,040

n/a – not applicable securities not rated.

(a)	Class B Deferrable Third Priority Secured Floating Rate Notes. The underlying collateral is primarily composed of trust preferred securities issued by community banks and thrifts.

(b)	144A Floating Rate Capital Securities. Underlying issuer is a community bank holding company. Securities have no excess subordination or overcollateralization.

(c)	Now an obligation of BB&T Corporation.

Trust Preferred Securities as of December 31, 2010


							Unrealized Losses						Life-to-date Impairment Charges
	Credit Rating				Fair Value		Less than 12 months		12 months or Longer		Total
(Dollars in thousands)	Moody’s		Fitch		Fair Value		Less than 12 months		12 months or Longer		Total
Pooled:
ALESCO Preferred Funding XVII Ltd (a)		Ca		C	$	20		—		210		210	$	1770
Individual issuer (b):
Carolina Financial Capital Trust I		n/a		n/a		312		—		—		—		138
Main Street Bank Statutory Trust I (c)		n/a		n/a		438		—		62		62		—
MNB Capital Trust I		n/a		n/a		152		—		—		—		348
PrimeSouth Capital Trust I		n/a		n/a		197		—		—		—		303
TCB Trust		n/a		n/a		409		—		91		91		—
United Community Capital Trust		n/a		n/a		621		—		—		—		379

Total individual issuer						2,129		—		153		153		1,168

Total trust preferred securities					$	2,149		—		363		363	$	2,938

n/a - not applicable securities not rated.

(a)	Class B Deferrable Third Priority Secured Floating Rate Notes. The underlying collateral is primarily composed of trust preferred securities issued by community banks and thrifts.

(b)	144A Floating Rate Capital Securities. Underlying issuer is a community bank holding company. Securities have no excess subordination or overcollateralization.

(c)	Now an obligation of BB&T Corporation.

For pooled trust preferred securities, the Company estimated expected future cash flows of the security by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which consider default probabilities derived from issuer credit ratings for the underlying collateral). The probability-weighted expected future cash flows of the security are then discounted at the interest rate used to recognize income on the security to arrive at a present value amount.

Excess subordination is defined as the amount of performing collateral that is in excess of what is needed to pay-off a specified class of securities and all classes senior to the specified class. Performing collateral is defined as total collateral minus all collateral that is currently deferring or currently in default. This definition assumes that all collateral that is currently deferring will default with a zero recovery rate. The underlying issuers can cure the deferral, or some portion greater than zero could be recovered on default of an underlying issuer. Excess subordination, as defined previously, does not consider any excess interest spread that is built into the structure of the security, which provides another source of repayment for the bonds.

At June 30, 2011 and December 31, 2010, respectively, there was no excess subordination for the Class B notes of ALESCO Preferred Funding XVII, Ltd.

Other-Than-Temporarily Impaired Securities

On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For equity securities with an unrealized loss, the Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; and recent events specific to the issuer or industry. Equity securities on which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses), net.

For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more-likely-than-not that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings, as a realized loss in securities gains (losses), and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes.

The following table presents a roll-forward of the credit loss component of the amortized cost of debt securities that the Company has written down for other-than-temporary impairment and the credit component of the loss is recognized in earnings (referred to as “credit-impaired” debt securities). Other-than-temporary impairments recognized in earnings for the quarters and six months ended June 30, 2011 and 2010 for credit-impaired debt securities are presented as additions in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). The credit loss component is reduced if the Company sells, intends to sell or believes it will be required to sell previously credit-impaired debt securities. Additionally, the credit loss component is reduced if the Company receives cash flows in excess of what it expected to receive over the remaining life of the credit-impaired debt security, the security matures or is fully written-down and deemed worthless. Changes in the credit loss component of credit-impaired debt securities were:


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands)	2011		2010		2011		2010
Balance, beginning of period	$	2,989	$	4,620	$	2,938	$	4,570
Additions:
Subsequent credit impairments		51		—		102		50
Reductions:
Securities sold		—		—		—		—
Due to change in intent or requirement to sell		—		—		—		—
Securities fully written down and deemed worthless		—		—		—		—
Increases in expected cash flows		—		—		—		—

Balance, end of period	$	3,040	$	4,620	$	3,040	$	4,620

Other-Than-Temporary Impairment

The following table presents details of the other-than-temporary impairment related to securities, including equity securities carried at cost, for the six months ended June 30, 2011 and 2010.


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands)	2011		2010		2011		2010
Other-than-temporary impairment charges (included in earnings):
Debt securities:
Pooled trust preferred securities	$	—	$	—	$	—	$	50
Individual issuer trust preferred securities		51		—		102		—

Total debt securities		51		—		102		50
Cost-method investments		—		—		—		—

Total other-than-temporary impairment charges	$	51	$	—	$	102	$	50

Other-than-temporary impairment on debt securities:
Recorded as part of gross realized losses:
Credit-related	$	51		—	$	102	$	50
Securities with intent to sell		—		—		—		—
Recorded directly to other comprehensive income for non-credit related impairment		—		20		210		210

Total other-than-temporary impairment on debt securities	$	51	$	20	$	312	$	260

Realized Gains and Losses

The following table presents the gross realized gains and losses on securities, including cost-method investments. Realized losses include other-than-temporary impairment charges.


	Quarter ended June 30,					Six months ended June 30,
(Dollars in thousands)	2011			2010		2011			2010
Gross realized gains	$	877		$	1,431	$	905		$	2,570
Gross realized losses		(483	)		—		(557	)		(89	)

Realized gains, net	$	394		$	1,431	$	348		$	2,481

NOTE 6: LOANS AND ALLOWANCE FOR LOAN LOSSES


(In thousands)	June 30, 2011			December 31, 2010
Commercial and industrial	$	52,027		$	53,288
Construction and land development		43,864			47,850
Commercial real estate:
Owner occupied		74,928			76,252
Other		91,344			89,989

Total commercial real estate		166,272			166,241
Residential real estate:
Consumer mortgage		58,816			57,562
Investment property		41,680			38,679

Total residential real estate		100,496			96,241
Consumer installment		11,248			10,676

Total loans		373,907			374,296
Less: unearned income		(112	)		(81	)

Loans, net of unearned income	$	373,795		$	374,215

Loans secured by real estate were approximately 83.1% of the total loan portfolio at June 30, 2011. Due to declines in economic indicators and real estate values, loans secured by real estate may have a greater risk of non-collection than other loans. At June 30, 2011, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama and surrounding areas.

In accordance with ASC 310, a portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for loan losses. The Company’s loan portfolio is disaggregated into the following portfolio segments: commercial and industrial, construction and land development, commercial real estate, residential real estate and consumer installment. The Company’s loan portfolio segments were determined based on collateral type. Where appropriate, the Company’s loan portfolio segments are further disaggregated into classes. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity’s method for monitoring and determining credit risk.

The following describe the risk characteristics relevant to each of the portfolio segments.

Commercial and industrial (“C&I”) — includes loans to finance business operations, equipment purchases, or other needs for small and medium-sized commercial customers. Also included in this category are loans to finance agricultural production. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower.

Construction and land development (“C&D”) — includes both loans and credit lines for the purpose of purchasing, carrying and developing land into commercial developments or residential subdivisions. Also included are loans and lines for construction of residential, multi-family and commercial buildings. Generally the primary source of repayment is dependent upon the sale or refinance of the real estate collateral.

Commercial real estate (“CRE”) — includes loans disaggregated into two classes: (1) owner occupied and (2) other.

•

Owner occupied – includes loans secured by business facilities to finance business operations, equipment and owner-occupied facilities primarily for small and medium-sized commercial customers. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower, who owns the property.

•

Other – primarily includes loans to finance income-producing commercial and multi-family properties. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, single retail stores, industrial buildings, warehouses and apartments leased generally to local businesses and residents. Generally the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates as well as the financial health of the borrower.

Residential real estate (“RRE”) — includes loans disaggregated into two classes: (1) consumer mortgage and (2) investment property.

•

Consumer mortgage – primarily includes first or second lien mortgages and home equity lines to consumers that are secured by a primary residence or second home. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history and property value.

•

Investment property – primarily includes loans to finance income-producing 1-4 family residential properties. Generally the primary source of repayment is dependent upon income generated from leasing the property securing the loan. The underwriting of these loans takes into consideration the rental rates as well as the financial health of the borrower.

Consumer installment — includes loans to individuals both secured by personal property and unsecured. Loans include personal lines of credit, automobile loans, and other retail loans. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and if applicable, property value.

The following is a summary of current, accruing past due and nonaccrual loans by portfolio class as of June 30, 2011, and December 31, 2010


(In thousands)	Current		Accruing 30-89 Days Past Due		Accruing Greater than 90 days		Total Accruing Loans		Non- Accrual		Total Loans
June 30, 2011:
Commercial and industrial	$	51,885		94		—		51,979		48	$	52,027
Construction and land development		41,020		—		—		41,020		2,844		43,864
Commercial real estate:
Owner occupied		73,483		255		—		73,738		1,190		74,928
Other		88,465		201		—		88,666		2,678		91,344

Total commercial real estate		161,948		456		—		162,404		3,868		166,272
Residential real estate:
Consumer mortgage		57,791		—		11		57,802		1,014		58,816
Investment property		41,089		360		—		41,449		231		41,680

Total residential real estate		98,880		360		11		99,251		1,245		100,496
Consumer installment		11,087		15		—		11,102		146		11,248

Total	$	364,820		925		11		365,756		8,151	$	373,907

December 31, 2010:
Commercial and industrial	$	52,643		124		—		52,767		521	$	53,288
Construction and land development		43,547		201		—		43,748		4,102		47,850
Commercial real estate:
Owner occupied		73,419		—		—		73,419		2,833		76,252
Other		88,087		—		—		88,087		1,902		89,989

Total commercial real estate		161,506		—		—		161,506		4,735		166,241
Residential real estate:
Consumer mortgage		53,225		2,219		—		55,444		2,118		57,562
Investment property		37,556		767		—		38,323		356		38,679

Total residential real estate		90,781		2,986		—		93,767		2,474		96,241
Consumer installment		10,646		29		—		10,675		1		10,676

Total	$	359,123		3,340		—		362,463		11,833	$	374,296

At June 30, 2011 and December 31, 2010, nonaccrual loans amounted to $8.2 and $11.8 million, respectively. At June 30, 2011, there was $11,000 in loans 90 days past due and still accruing interest. At December 31, 2010, there were no loans 90 days past due and still accruing interest.

Allowance for Loan Losses

The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolios, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loan losses are charged off when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. Allocation of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, is deemed to be uncollectible.

The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement.

An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs. The Company believes it follows appropriate accounting and regulatory guidance in determining impairment and accrual status of impaired loans.

The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

In assessing the adequacy of the allowance, the Company also considers the results of its ongoing independent loan review process. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that we will be able to collect all amounts due according to the contractual terms of a loan.

As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial loans, construction and land development loans, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment.

The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. Consistent with prior periods, at June 30, 2011 and December 31, 2010, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups.

The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors.

The Company maintains an unallocated amount for inherent factors that cannot be practically assigned to individual loan segments or categories. An example is the imprecision in the overall measurement process.

The following table presents an analysis of the allowance for loan losses by portfolio segment as of June 30, 2011 and December 31, 2010. The total allowance for loan losses is then disaggregated to show the amounts derived through individual evaluation and the amounts calculated through collective evaluation.


	Six months ended June 30, 2011
(In thousands)	Commercial and industrial			Construction and land development			Commercial real estate			Residential real estate			Consumer installment			Unallocated		Total
Allowance for loan losses:
Beginning balance	$	972			2,223			2,893			1,336			141			111	$	7,676
Charge-offs		(362	)		(145	)		(339	)		(446	)		(3	)		—		(1,295	)
Recoveries		23			1			—			135			6			—		165
Net (charge-offs) recoveries		(339	)		(144	)		(339	)		(311	)		3			—		(1,130	)
Provision		134			680			168			79			46			93		1,200
Ending balance	$	767			2,759			2,722			1,104			190			204	$	7,746

Individually evaluated		—			282			385			94			—			—		761
Collectively evaluated		767			2,477			2,337			1,010			190			204		6,985
Total loans:	$	52,027			43,864			166,272			100,496			11,248				$	373,907

Individually evaluated		233			2,844			4,319			949			—					8,345
Collectively evaluated		51,794			41,020			161,953			99,547			11,248					365,562

	December 31, 2010
(In thousands)	Commercial and industrial			Construction and land development			Commercial real estate			Residential real estate			Consumer installment			Unallocated		Total
Allowance for loan losses:	$	972			2,223			2,893			1,336			141			111	$	7,676

Individually evaluated		277			123			765			144			—			—		1,309
Collectively evaluated		695			2,100			2,128			1,192			141			111		6,367
Total loans:	$	53,288			47,850			166,241			96,241			10,676				$	374,296

Individually evaluated		521			4,102			4,630			2,418			—					11,671
Collectively evaluated		52,767			43,748			161,611			93,823			10,676					362,625

Credit Quality Indicators

The credit quality of the loan portfolio is summarized no less frequently than quarterly using categories similar to the standard asset classification system used by the federal banking agencies. The following table presents credit quality indicators for the loan portfolio segments and classes. These categories are utilized to develop the associated allowance for loan losses using historical losses adjusted for current economic conditions and are defined as follows:

•

Pass – loans which are well protected by the current net worth and paying capacity of the obligor (or guarantors, if any) or by the fair value, less cost to acquire and sell, of any underlying collateral.

•

Special Mention – loans with potential weakness that may, if not reversed or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans are not adversely classified and do not expose an institution to sufficient risk to warrant an adverse classification.

•

Substandard Accruing – loans that exhibit a well-defined weakness which presently jeopardizes debt repayment, even though they are currently performing. These loans are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected;

•

Nonaccrual – includes loans where management has determined that full payment of principal and interest is in doubt.


	June 30, 2011
(In thousands)	Pass		Special Mention		Substandard Accruing		Nonaccrual		Total loans
Commercial and industrial	$	48,984		2,004		991		48	$	52,027
Construction and land development		35,898		106		5,016		2,844		43,864
Commercial real estate:
Owner occupied		67,161		4,814		1,763		1,190		74,928
Other		80,916		204		7,546		2,678		91,344
Total commercial real estate		148,077		5,018		9,309		3,868		166,272
Residential real estate:
Consumer mortgage		51,067		2,822		3,913		1,014		58,816
Investment property		37,695		2,280		1,474		231		41,680
Total residential real estate		88,762		5,102		5,387		1,245		100,496
Consumer installment		10,893		100		109		146		11,248
Total	$	332,614		12,330		20,812		8,151	$	373,907


	December 31, 2010
(In thousands)	Pass		Special Mention		Substandard Accruing		Nonaccrual		Total loans
Commercial and industrial	$	51,632		722		413		521	$	53,288
Construction and land development		38,301		4,372		1,075		4,102		47,850
Commercial real estate:
Owner occupied		67,702		716		5,001		2,833		76,252
Other		84,354		3,718		15		1,902		89,989

Total commercial real estate		152,056		4,434		5,016		4,735		166,241
Residential real estate:
Consumer mortgage		48,620		2,700		4,124		2,118		57,562
Investment property		34,221		1,626		2,476		356		38,679

Total residential real estate		82,841		4,326		6,600		2,474		96,241
Consumer installment		10,426		133		116		1		10,676

Total	$	335,256		13,987		13,220		11,833	$	374,296

Impaired loans

The following table presents details related to the Company’s impaired loans. Loans which have been fully charged-off do not appear in the following table. The related allowance generally represents the following components which correspond to impaired loans:

•

Individually evaluated impaired loans equal to or greater than $500,000 secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate loans).

•

Individually evaluated impaired loans equal to or greater than $250,000 not secured by real estate (nonaccrual commercial and industrial and consumer loans).

The following table sets forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at June 30, 2011 and December 31, 2010.


										Six months ended
	June 30, 2011									June 30, 2011
(In thousands)	Unpaid principal balance (1)		Charge-offs and payments applied (2)			Recorded investment (3)		Related allowance		Average recorded investment		Interest income recognized (4)
With no allowance recorded:
Commercial and industrial	$	233		—			233			$	395	$	2
Construction and land development		—		—			—				1,390		—
Commercial real estate:
Owner occupied		811		(5	)		806				764		6
Other		1,580		(102	)		1,478				1,508		—

Total commercial real estate		2,391		(107	)		2,284				2,272		6
Residential real estate:
Consumer mortgages		—		—			—				58		—
Investment property		—		—			—				51		—

Total residential real estate		—		—			—				109		—
Consumer installment		—		—			—				—		—

Total	$	2,624		(107	)		2,517			$	4,166	$	8

With allowance recorded:
Commercial and industrial	$	—		—			—	$	—	$	—	$	—
Construction and land development		2,959		(115	)		2,844		282		2,562		—
Commercial real estate:
Owner occupied		848		(14	)		834		159		956		—
Other		1,229		(28	)		1,201		226		1,229		—

Total commercial real estate		2,077		(42	)		2,035		385		2,185		—
Residential real estate:
Consumer mortgages		1,010		(61	)		949		94		1,704		—
Investment property		—		—			—		—		—		—

Total residential real estate		1,010		(61	)		949		94		1,704		—
Consumer installment		—		—			—		—		—		—

Total	$	6,046		(218	)		5,828	$	761	$	6,451	$	—

Total impaired loans	$	8,670		(325	)		8,345	$	761	$	10,617	$	8

(1)	Unpaid principal balance represents the contractual obligation due from the customer.

(2)	Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance.

(3)	Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.

(4)	Represents interest income related to accruing TDRs, which are considered impaired.


	December 31, 2010
(In thousands)	Unpaid principal balance (1)		Charge-offs and payments applied (2)			Recorded investment (3)		Related allowance
With no allowance recorded:
Commercial and industrial	$	—		—			—
Construction and land development		2,538		(54	)		2,484
Commercial real estate:
Owner occupied		—		—			—
Other		1,592		(51	)		1,541

Total commercial real estate		1,592		(51	)		1,541
Residential real estate:
Consumer mortgages		1,072		(27	)		1,045
Investment property		356		—			356

Total residential real estate		1,428		(27	)		1,401
Consumer installment		—		—			—

Total	$	5,558		(132	)		5,426

With allowance recorded:
Commercial and industrial	$	528		(7	)		521	$	277
Construction and land development		1,618		—			1,618		123
Commercial real estate:
Owner occupied		3,124		(35	)		3,089		765
Other		—		—			—		—

Total commercial real estate		3,124		(35	)		3,089		765
Residential real estate:
Consumer mortgages		1,073		(56	)		1,017		144
Investment property		—		—			—		—

Total residential real estate		1,073		(56	)		1,017		144
Consumer installment		—		—			—		—

Total	$	6,343		(98	)		6,245	$	1,309

Total impaired loans	$	11,901		(230	)		11,671	$	1,309

⁽¹⁾	Unpaid principal balance represents the contractual obligation due from the customer.

⁽²⁾	Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance.

⁽³⁾	Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses.

At June 30, 2011 and December 31, 2010, the Company had impaired loans classified as troubled debt restructurings (“TDRs”) of $7.4 million and $7.6 million, respectively. At June 30, 2011 the Company had $0.7 million in accruing TDRs. The Company had no accruing TDRs at December 31, 2010. For impaired loans classified as TDRs, the related allowance for loan losses was approximately $0.7 million and $1.0 million at June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured.

NOTE 7: MORTGAGE SERVICING RIGHTS, NET

Mortgage servicing rights (“MSRs”) are recognized based on the fair value of the servicing rights on the date the corresponding mortgage loans are sold. An estimate of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income.

The Company has recorded MSRs related to loans sold without recourse to Fannie Mae. The Company generally sells conforming, fixed-rate, closed-end, residential mortgages to Fannie Mae. MSRs are included in other assets on the accompanying Consolidated Balance Sheets.

The change in amortized MSRs and the related valuation allowance for the quarters and six months ended June 30, 2011 and 2010 are presented below.


	Quarter ended June 30,						Six months ended June 30,
(Dollars in thousands)	2011			2010			2011			2010
Beginning balance	$	1,226		$	851		$	1,189		$	834
Additions, net		65			62			152			111
Amortization expense		(52	)		(36	)		(102	)		(68	)

Ending balance	$	1,239		$	877		$	1,239		$	877

Fair value of amortized MSRs:
Beginning of period	$	1,491		$	1,030		$	1,335		$	978
End of period		1,422			1,023			1,422			1,023

The Company periodically evaluates mortgage servicing rights for impairment. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation reserve is established. At June 30, 2011 and 2010 there was no valuation allowance recorded for MSRs.

NOTE 8: FAIR VALUE DISCLOSURES

“Fair value” is defined by FASB ASC 820, Fair Value Measurements and Disclosures, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the inputs market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1—inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2—inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3—inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The Company’s assets and liabilities recorded at fair value have been categorized based upon a fair value hierarchy in accordance with FASB ASC 820.

Securities – Securities available-for-sale are recorded at fair value on a recurring basis. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government securities such as U.S. Treasuries and exchange-traded equity securities.

When instruments are traded in secondary markets and quoted market prices are not available, the Company generally relies on prices obtained from independent vendors. Vendors compile prices from various sources and often apply matrix pricing for similar securities when no price is observable. Securities measured with these valuation techniques are generally classified within Level 2 of the valuation hierarchy and often involve using quoted market prices for similar securities, pricing models or discounted cash flow analyses using inputs observable in the market where available. Examples include U.S. government agency securities and residential mortgage-backed securities.

Security fair value measurements using significant inputs that are unobservable in the market due to limited activity or a less liquid market are classified within Level 3 of the valuation hierarchy. Such measurements include securities valued using models or a combination of valuation techniques such as weighting of models and vendor or broker pricing, where the unobservable inputs are significant to the overall fair value measurement. Securities classified as Level 3 include pooled and individual issuer trust preferred securities.

Loans held for sale – Loans held for sale are carried at the lower of cost or estimated fair value and are subjected to nonrecurring fair value adjustments. Estimated fair value is determined on the basis of the current market value of similar loans. All of the Company’s loans held for sale are classified within Level 2 of the valuation hierarchy.

Loans, net – Loans considered impaired under FASB ASC 310-10-35, Receivables, are loans for which, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are subject to nonrecurring fair value adjustments to reflect (1) partial write-downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value. All of the Company’s impaired loans are classified within Level 3 of the valuation hierarchy.

Other real estate – Other real estate, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less costs to sell upon transfer of the loans to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value less costs to sell. Fair value is generally determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. All of the Company’s other real estate is classified within Level 3 of the valuation hierarchy.

Other assets – The Company has certain financial assets carried at fair value on a recurring basis, including interest rate swap agreements. The carrying amount of interest rate swap agreements is based on information obtained from a third party bank. The Company classified these derivative assets within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments. The Company had no derivative contracts to assist in managing interest rate sensitivity at June 30, 2011 or December 31, 2010.

Mortgage servicing rights, net, included in other assets on the accompanying consolidated balance sheets, are carried at the lower of cost or estimated fair value and are subjected to nonrecurring fair value adjustments. MSRs do not trade in an active market with readily observable prices. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Because the valuation of MSRs requires the use of significant unobservable inputs, all of the Company’s MSRs are classified within Level 3 of the valuation hierarchy.

Other liabilities – The Company has certain financial liabilities carried at fair value on a recurring basis, including interest rate swap agreements. The carrying amount of interest rate swap agreements is based on information obtained from a third party bank. The Company classified these derivative liabilities within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments. The Company had no derivative contracts to assist in managing interest rate sensitivity at June 30, 2011 or December 31, 2010.

Assets and liabilities measured at fair value on a recurring basis

The following table presents the balances of the assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010, respectively, by caption, on the Condensed Consolidated Balance Sheets by FASB ASC 820 valuation hierarchy (as described above).


(Dollars in thousands)	Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2011:
Securities available-for-sale:
Agency obligations	$	50,759		—		50,759		—
Agency RMBS		160,358		—		160,358		—
State and political subdivisions		83,075		—		83,075		—
Trust preferred securities:
Pooled		20		—		—		20
Individual issuer		2,231		—		—		2,231

Total securities available-for-sale		296,443		—		294,192		2,251
Other assets ⁽¹⁾		1,090		—		1,090		—

Total assets at fair value	$	297,533		—		295,282		2,251


Other liabilities⁽¹⁾		1,090		—		1,090		—

Total liabilities at fair value	$	1,090		—		1,090		—

December 31, 2010:
Securities available-for-sale:
Agency obligations	$	90,471		—		90,471		—
Agency RMBS		143,144		—		143,144		—
State and political subdivisions		76,766		—		76,766		—
Trust preferred securities:
Pooled		20		—		—		20
Individual issuer		2,129		—		—		2,129
Corporate debt		2,690		2,690		—		—

Total securities available-for-sale		315,220		2,690		310,381		2,149
Other assets ⁽¹⁾		1,101		—		1,101		—

Total assets at fair value	$	316,321		2,690		311,482		2,149


Other liabilities⁽¹⁾		1,101		—		1,101		—

Total liabilities at fair value	$	1,101		—		1,101		—

⁽¹⁾	Represents the fair value of interest rate swap agreements

Level changes in fair value measurements

Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Corporation’s monthly and/or quarterly valuation process. The Company monitors the valuation techniques utilized for each category of financial assets and liabilities to ascertain when transfers between levels have been affected. The nature of the Company’s financial assets and liabilities generally is such that transfers in and out of any level are expected to be rare. For the six months ended June 30, 2011, there were no transfers between levels.

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements for trust preferred securities recognized in the accompanying Condensed Consolidated Balance Sheets using Level 3 inputs:


	Six months ended June 30,
(Dollars in thousands)	2011			2010
Beginning balance	$	2,149		$	1,463
Total realized and unrealized gains and (losses):
Included in net earnings		(102	)		(50	)
Included in other comprehensive income		204			187
Purchases		—			—
Issuances		—			—
Settlements		—			—
Transfers in and/or (out) of Level 3		—			—

Ending balance	$	2,251		$	1,600

Assets and liabilities measured at fair value on a nonrecurring basis

The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of June 30, 2011 and December 31, 2010, respectively, by caption, on the Condensed Consolidated Balance Sheets and by FASB ASC 820 valuation hierarchy (as described above):


(Dollars in thousands)	Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2011:
Loans held for sale	$	2,278		—		2,278		—
Loans, net⁽¹⁾		7,584		—		—		7,584
Other real estate owned		9,361		—		—		9,361
Other assets ⁽²⁾		1,239		—		—		1,239

Total assets at fair value	$	20,462		—		2,278		18,184


December 31, 2010:
Loans held for sale	$	4,281		—		4,281		—
Loans, net⁽¹⁾		10,362		—		—		10,362
Other real estate owned		8,125		—		—		8,125
Other assets ⁽²⁾		1,189		—		—		1,189

Total assets at fair value	$	23,957		—		4,281		19,676

⁽¹⁾	Loans considered impaired under FASB ASC 310-10-35 Receivables. This amount reflects the recorded investment in impaired loans, net of any related allowance for loan losses.

⁽²⁾	Represents the carrying value of mortgage servicing rights, net.

NOTE 9: FAIR VALUE OF FINANCIAL INSTRUMENTS

FASB ASC 825, Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow and other valuation techniques. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather a good–faith estimate of the fair value of financial instruments held by the Company. FASB ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

Cash and cash equivalents

Due to their short-term nature, the carrying amounts reported in the balance sheet are assumed to approximate fair value for these assets. For purposes of disclosure, cash equivalents include federal funds sold and other interest bearing bank deposits.

Securities available-for-sale

Fair value measurement is based upon quoted prices if available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments. See Note 5 for additional disclosure related to fair value measurements for securities.

Loans held for sale

Loans held for sale are carried at the lower of cost or estimated fair value and are subjected to nonrecurring fair value adjustments. Estimated fair value is determined on the basis of the current market value of similar loans.

Loans, net

The fair value of loans is calculated using discounted cash flows. The discount rates used to determine the present value of the loan portfolio are estimated market discount rates that reflect the credit and interest rate risk inherent in the loan portfolio. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by FASB ASC 820 and generally produces a higher value than an exit-price approach. The estimated maturities are based on the Company’s historical experience with repayments adjusted to estimate the effect of current market conditions.

Deposits

Under FASB ASC 825, the fair value of deposits with no stated maturity, such as noninterest bearing demand deposits, interest bearing demand deposits and savings and certain types of money market accounts, is equal to the amount payable on demand at the reporting date (i.e., their carrying amount). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using discounted cash flows. The discount rates used are based on estimated market rates for deposits of similar remaining maturities.

Short-term borrowings

The fair value of federal funds purchased, securities sold under agreements to repurchase, and other short–term borrowings approximate their carrying value.

Long-term debt

The fair value of the Company’s fixed rate long-term debt is estimated using discounted cash flows based on estimated current market rates for similar types of borrowing arrangements. The carrying amount of the Company’s variable rate long-term debt approximates its fair value.

Derivative Instruments

From time to time, the Company enters into interest rate swaps to meet the financing, interest rate and equity risk management needs of its customers. The carrying amounts of these derivative instruments represent their fair value. Generally, the fair value of these instruments is based on an observable market price.

Off-balance sheet Instruments

The fair values of the Company’s off-balance-sheet financial instruments are based on fees charged to enter into similar agreements. However, commitments to extend credit do not represent a significant value to the Company until such commitments are funded. The Company has determined that the estimated fair value of commitments to extend credit approximates the carrying amount and is immaterial to the financial statements.

The carrying value and related estimated fair value of the Company’s financial instruments at June 30, 2011 and December 31, 2010 are presented below.


	June 30, 2011				December 31, 2010
(Dollars in thousands)	Carrying amount		Estimated fair value		Carrying amount		Estimated fair value
Financial Assets:
Cash and cash equivalents	$	57,580	$	57,580	$	21,424	$	21,424
Securities available-for-sale		296,443		296,443		315,220		315,220
Loans held for sale		2,278		2,278		4,281		4,281
Loans, net		366,049		372,040		366,539		372,869
Derivative assets		1,090		1,090		1,101		1,101
Financial Liabilities:
Deposits	$	627,969	$	635,519	$	607,127	$	615,300
Short-term borrowings		2,314		2,314		2,685		2,685
Long-term debt		85,322		92,329		93,331		99,505
Derivative liabilities		1,090		1,090		1,101		1,101

NOTE 10: DERIVATIVE INSTRUMENTS

Financial derivatives are reported at fair value in other assets or other liabilities. The accounting for changes in the fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship. For derivatives not designated as part of a hedging relationship, the gain or loss is recognized in current earnings. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. Upon entering into these instruments to meet customer needs, the Company enters into offsetting positions in order to minimize the risk to the Company. These swaps qualify as derivatives, but are not designated as hedging instruments. At June 30, 2011, the Company had no derivative contracts to assist in managing its interest rate sensitivity.

Interest rate swap contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument contract is negative, the Company owes the customer or counterparty and therefore, has no credit risk.

A summary of the Company’s interest rate swaps as of and for the six months ended June 30, 2011 is presented below.


			Other Assets		Other Liabilities		Other noninterest income
(Dollars in thousands)	Notional		Estimated Fair Value		Estimated Fair Value		Gains (Losses)
Interest rate swap agreements:
Pay fixed / receive variable	$	5,892		—		1,090	$	11
Pay variable / receive fixed		5,892		1,090		—		(11	)

Total interest rate swap agreements	$	11,784		1,090		1,090	$	—

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of the Auburn National Bancorporation, Inc. (the “Company”) and its wholly owned subsidiary, AuburnBank (the “Bank”). This discussion is intended to supplement and highlight information contained in the accompanying unaudited condensed consolidated financial statements and related notes for the quarters and six months ended June 30, 2011 and 2010, as well as the information contained in our annual report on Form 10-K for the year ended December 31, 2010 and our quarterly report on Form 10-Q for the quarter ended March 31, 2011.

Certain of the statements made herein under the caption “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” and elsewhere, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning of, and subject to, the protections of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “desired,” “indicate,” “would,” “believe,” “deem,” “contemplate,” “expect,” “seek,” “estimate,” “evaluate,” “continue,” “plan,” “point to,” “project,” “predict,” “could,” “intend,” “target,” “potential,” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

•

the effects of future economic, business and market conditions and changes, domestic and foreign, including seasonality;

•

governmental monetary and fiscal policies;

•

legislative and regulatory changes, including changes in banking, securities and tax laws, regulations and rules and their application by our regulators, and changes in the scope and cost of FDIC insurance and other coverage;

•

changes in accounting policies, rules and practices;

•

the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities, and the risks and uncertainty of the amounts realizable and the timing of dispositions of assets by the FDIC where we may have a participation or other interest;

•

changes in borrower credit risks and payment behaviors;

•

changes in the availability and cost of credit and capital in the financial markets, and the types of instruments that may be included as capital for regulatory purposes;

•

changes in the prices, values and sales volumes of residential and commercial real estate;

•

the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services;

•

the failure of assumptions and estimates underlying the establishment of reserves for possible loan losses and other estimates, including estimates of potential losses due to claims from purchases of mortgages that we originated;

•

the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;

•

changes in technology or products that may be more difficult, costly, or less effective than anticipated;

•

the effects of war or other conflicts, acts of terrorism or other catastrophic events, such as the recent oil spill in the Gulf of Mexico, that may affect general economic conditions;

•

the failure of assumptions and estimates, as well as differences in, and changes to, economic, market and credit conditions, including changes in borrowers’ credit risks and payment behaviors from those used in our loan portfolio stress test;

•

the risks that our deferred tax assets could be reduced if estimates of future taxable income from our operations and tax planning strategies are less than currently estimated, and sales of our capital stock could trigger a reduction in the amount of net operating loss carry-forwards that we may be able to utilize for income tax purposes; and

•

other factors and information in this report and other filings that we make with the SEC under the Exchange Act, including our annual report on Form 10-K for the year ended December 31, 2010 and subsequent quarterly and current reports. See Part II, Item 1A, “RISK FACTORS.”

All written or oral forward-looking statements that are made by or attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

Business

The Company was incorporated in 1990 under the laws of the State of Delaware and became a bank holding company after it acquired its Alabama predecessor, which was a bank holding company established in 1984. The Bank, the Company’s principal subsidiary, is an Alabama state-chartered bank that is a member of the Federal Reserve System and has operated continuously since 1907. Both the Company and the Bank are headquartered in Auburn, Alabama. The Bank conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank operates full-service branches in Auburn, Opelika, Hurtsboro and Notasulga, Alabama. In addition, the Bank will be opening a new full-service branch in Valley, Alabama during the fourth quarter of 2011. In-store branches are located in the Auburn and Opelika Kroger stores, as well as Wal-Mart SuperCenter stores in Auburn, Opelika and Phenix City, Alabama. Mortgage loan offices are located in Phenix City, Valley, and Mountain Brook, Alabama.

Summary of Results of Operations


	Quarter ended June 30,					Six months ended June 30,
(Dollars in thousands, except per share amounts)	2011			2010		2011		2010
Net interest income (a)	$	5,497		$	5,126	$	10,746	$	10,394
Less: tax-equivalent adjustment		440			438		875		875

Net interest income (GAAP)		5,057			4,688		9,871		9,519
Noninterest income		1,355			2,792		2,500		5,088

Total revenue		6,412			7,480		12,371		14,607
Provision for loan losses		600			750		1,200		2,200
Noninterest expense		4,363			4,809		8,013		8,445
Income tax (benefit) expense		(8	)		314		152		738

Net earnings	$	1,457		$	1,607	$	3,006	$	3,224

Basic and diluted earnings per share	$	0.40		$	0.44	$	0.83	$	0.88

(a)	Tax-equivalent. See “Table 1 - Explanation of Non-GAAP Financial Measures.”

Financial Summary

The Company’s net earnings were $3.0 million for the first six months of 2011, compared to $ 3.2 million for the first six months of 2010. Basic and diluted earnings per share were $0.83 per share for the first six months of 2011, compared to $0.88 per share for the first six months of 2010.

Net interest income was $9.9 million for the first six months of 2011, compared to 9.5 million for the first six months of 2010. Average loans were $373.8 million in the first six months of 2011, a decrease of $5.0 million, or 1%, from the first six months of 2010. Average deposits were $624.3 million in the first six months of 2011, an increase of $21.8 million, or 4%, from the first six months of 2010.

The provision for loan losses during the first six months of 2011 was $1.2 million, compared to $2.2 million in the first six months of 2010. The Company’s annualized net charge-off ratio was 0.60% in the first six months of 2011, compared to 1.12% in the first six months of 2010.

Noninterest income was $2.5 million for the first six months of 2011, compared to noninterest income of $5.1 million in the first six months of 2010. The decrease in noninterest income was primarily due to a decrease in net securities gains of $2.1 million.

Noninterest expense was $8.0 million during the first six months of 2011, compared to noninterest expense of $8.4 million in the first six months of 2010. The decrease in noninterest expense was primarily due to decreases in net expenses related to other real estate owned and prepayment penalties on long-term debt, which were partially offset by an increase in salaries and benefits expense.

Income tax expense was approximately $0.2 million in the first six months of 2011, compared to $0.7 million in the first six months of 2010. The Company’s effective tax rate in the first six months of 2011 was approximately 4.81%, compared to 18.63% in the first six months of 2010. The decrease in the Company’s effective tax rate during the first six months of 2011 when compared to the first six months of 2010 was due to a decline in the level of earnings before taxes and an increase in federal tax credits related to the Company’s investments in affordable housing limited partnerships, which increased in 2011.

In the first six months of 2011, the Company paid cash dividends of $1.5 million, or $0.40 per share. The Company’s balance sheet remains strong and well capitalized under current regulatory guidelines with a total risk-based capital ratio of 16.20% and a Tier 1 leverage ratio of 8.65% at June 30, 2011.

CRITICAL ACCOUNTING POLICIES

The accounting and financial reporting policies of the Company conform with U.S. generally accepted accounting principles and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, our assessment of other-than-temporary impairment, recurring and non-recurring fair value measurements, the valuation of other real estate owned, and the valuation of deferred tax assets, were critical to the determination of our financial position and results of operations. Other policies also require subjective judgment and assumptions and may accordingly impact our financial position and results of operations.

Allowance for Loan Losses

Assessment for Other-Than-Temporary Impairment of Securities

On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For equity securities with an unrealized loss, the Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; and recent events specific to the issuer or industry. Equity securities for which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses).

For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the entity will be required to sell the debt security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings, as a realized loss in securities gains (losses), and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes.

The Company assesses impairment for pooled trust preferred securities using a cash flow model. The key assumptions include default probabilities of the underlying collateral and recoveries on collateral defaults. These assumptions may have a significant effect on the determination of the present value of expected future cash flows and the resulting amount of other-than-temporary impairment. As such, the use of different models and assumptions, as well as changes in market conditions, could result in materially different net earnings and retained earnings results.

Fair Value Determination

GAAP requires management to value and disclose certain of the Company’s assets and liabilities at fair value, including investments classified as available-for-sale and derivatives. FASB ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value in accordance with U.S. generally accepted accounting principles and expands disclosures about fair value measurements. For more information regarding fair value measurements and disclosures, please refer to Note 7 of the Condensed Consolidated Financial Statements.

Fair values are based on active market prices of identical assets or liabilities when available. Comparable assets or liabilities or a composite of comparable assets in active markets are used when identical assets or liabilities do not have readily available active market pricing. However, some of the Company’s assets or liabilities lack an available or comparable trading market characterized by frequent transactions between willing buyers and sellers. In these cases, fair value is estimated using pricing models that use discounted cash flows and other pricing techniques. Pricing models and their underlying assumptions are based upon management’s best estimates for appropriate discount rates, default rates, prepayments, market volatility and other factors, taking into account current observable market data and experience.

These assumptions may have a significant effect on the reported fair values of assets and liabilities and the related income and expense. As such, the use of different models and assumptions, as well as changes in market conditions, could result in materially different net earnings and retained earnings results.

Other Real Estate Owned

Other real estate owned (“OREO”), consists of properties obtained through foreclosure or in satisfaction of loans and is reported at the lower of cost or fair value, less estimated costs to sell at the date acquired with any loss recognized as a charge-off through the allowance for loan losses. Additional OREO losses for subsequent valuation adjustments are determined on a specific property basis and are included as a component of other noninterest expense along with holding costs. Any gains or losses on disposal realized at the time of disposal are also reflected in noninterest expense. Significant judgments and complex estimates are required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility, as experienced during 2011 and 2010. As a result, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other OREO.

Deferred Tax Asset Valuation

A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the historical level of taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more-likely-than-not that the Company will realize the benefits of these deductible differences at June 30, 2011. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during future periods are reduced.

RESULTS OF OPERATIONS

Average Balance Sheet and Interest Rates


	Six months ended June 30,
	2011					2010
(Dollars in thousands)	Average Balance		Yield/ Rate			Average Balance		Yield/ Rate
Loans and loans held for sale	$	375,550		5.72	%	$	381,694		5.77	%
Securities - taxable		232,353		3.00	%		248,210		3.64	%
Securities - tax-exempt		80,486		6.45	%		80,603		6.44	%

Total securities		312,839		3.88	%		328,813		4.33	%
Federal funds sold		24,174		0.18	%		16,195		0.21	%
Interest bearing bank deposits		1,834		0.11	%		829		0.00	%

Total interest-earning assets		714,397		4.72	%		727,531		4.99	%

Deposits:
NOW		92,951		0.67	%		93,174		0.74	%
Savings and money market		139,721		0.73	%		109,012		1.15	%
Certificates of deposits less than $100,000		114,998		2.03	%		113,595		2.56	%
Certificates of deposits and other time deposits of $100,000 or more		186,722		2.47	%		202,835		2.83	%

Total interest-bearing deposits		534,392		1.61	%		518,616		2.04	%
Short-term borrowings		2,409		0.50	%		4,230		0.67	%
Long-term debt		88,508		3.86	%		116,604		4.03	%

Total interest-bearing liabilities		625,309		1.92	%		639,450		2.40	%

Net interest income and margin	$	10,746		3.03	%	$	10,394		2.88	%

Net Interest Income and Margin

Net interest income (tax-equivalent) was $10.7 million in the first six months of 2011, compared to $10.4 million for the first six months of 2010 as net interest margin improvement offset a decline in average interest-earnings assets of 2%. Net interest margin (tax-equivalent) was 3.03% for the first six months of 2011, compared to 2.88% for the first six months of 2010.

The tax-equivalent yield on total interest-earning assets decreased 27 basis points in the first six months of 2011 from the first six months of 2010 to 4.72%. This decrease was primarily driven by a 45 basis points decrease in the tax-equivalent yield on total securities to 3.88%.

The cost of total interest-bearing liabilities decreased 48 basis points in the first six months of 2011 from the first six months of 2010 to 1.92%.

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