Edgar Filing: AUBURN NATIONAL BANCORPORATION, INC

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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 September 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 October 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 September 30, 2011 and December 31, 2010	3

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

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

	Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 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	31

	Table 1 – Explanation of Non-GAAP Financial Measures	48

	Table 2 – Selected Quarterly Financial Data	49

	Table 3 – Selected Financial Data	50

	Table 4 – Average Balances and Net Interest Income Analysis – for the quarter ended September 30, 2011 and 2010	51

	Table 5 – Average Balances and Net Interest Income Analysis – for the nine months ended September 30, 2011 and 2010	52

	Table 6 – Loan Portfolio Composition	53

	Table 7 – Allowance for Loan Losses and Nonperforming Assets	54

	Table 8 – Allocation of Allowance for Loan Losses	55

	Table 9 – CDs and Other Time Deposits of $100,000 or more	56

Item 3	Quantitative and Qualitative Disclosures About Market Risk	57

Item 4	Controls and Procedures	57

PART II. OTHER INFORMATION

Item 1	Legal Proceedings	57

Item 1A	Risk Factors	57

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	57

Item 3	Defaults Upon Senior Securities	58

Item 4	Removed and Reserved	58

Item 5	Other Information	58

Item 6	Exhibits	58

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)	September 30, 2011			December 31, 2010

Assets:
Cash and due from banks	$	13,165		$	11,432
Federal funds sold		40,664			7,500
Interest bearing bank deposits		1,816			2,492

Cash and cash equivalents		55,645			21,424

Securities available-for-sale		283,070			315,220
Loans held for sale		2,906			4,281
Loans, net of unearned income		374,788			374,215
Allowance for loan losses		(6,340	)		(7,676	)

Loans, net		368,448			366,539

Premises and equipment, net		8,672			8,105
Bank-owned life insurance		16,512			16,171
Other real estate owned		7,770			8,125
Other assets		21,614			23,964

Total assets	$	764,637		$	763,829


Liabilities:
Deposits:
Noninterest-bearing	$	99,148		$	87,660
Interest-bearing		509,922			519,467

Total deposits		609,070			607,127

Federal funds purchased and securities sold under agreements to repurchase		2,613			2,685
Long-term debt		85,317			93,331
Accrued expenses and other liabilities		3,215			4,318

Total liabilities		700,215			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		63,608			61,421
Accumulated other comprehensive income (loss), net		3,665			(2,201	)
Less treasury stock, at cost - 314,397 shares and 314,417 shares at September 30, 2011 and December 31, 2010, respectively		(6,643	)		(6,643	)

Total stockholders’ equity		64,422			56,368

Total liabilities and stockholders’ equity	$	764,637		$	763,829

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Earnings

(Unaudited)


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

Interest income:
Loans, including fees	$	5,393		$	5,442		$	16,051		$	16,367
Securities		2,253			2,922			7,404			9,100
Federal funds sold and interest bearing bank deposits		14			6			37			23

Total interest income		7,660			8,370			23,492			25,490


Interest expense:
Deposits		1,958			2,479			6,220			7,734
Short-term borrowings		3			5			9			19
Long-term debt		854			1,148			2,547			3,480

Total interest expense		2,815			3,632			8,776			11,233


Net interest income		4,845			4,738			14,716			14,257
Provision for loan losses		600			730			1,800			2,930

Net interest income after provision for loan losses		4,245			4,008			12,916			11,327


Noninterest income:
Service charges on deposit accounts		301			328			882			976
Mortgage lending		637			1,007			1,516			2,114
Bank-owned life insurance		127			118			341			350
Affordable housing investment losses		(231	)		(57	)		(461	)		(171	)
Other		349			332			1,057			1,066
Securities gains, net:
Realized gains, net		451			469			901			3,000
Total other-than-temporary impairments		(156	)		(340	)		(468	)		(600	)
Non-credit portion of other-than-temporary impairments (transferred from) recognized in other comprehensive income		(80	)		—			130			210

Total securities gains, net		215			129			563			2,610

Total noninterest income		1,398			1,857			3,898			6,945


Noninterest expense:
Salaries and benefits		2,218			2,051			6,272			5,895
Net occupancy and equipment		364			359			1,038			1,107
Professional fees		190			164			550			531
FDIC and other regulatory assessments		178			277			659			839
Other real estate owned, net		506			268			1,207			1,240
Prepayment penalty on long-term debt		—			381			—			679
Other		883			866			2,626			2,520

Total noninterest expense		4,339			4,366			12,352			12,811


Earnings before income taxes		1,304			1,499			4,462			5,461
Income tax (benefit) expense		(63	)		255			89			993


Net earnings	$	1,367		$	1,244		$	4,373		$	4,468


Net earnings per share:
Basic and diluted	$	0.38		$	0.34		$	1.20		$	1.23


Weighted average shares outstanding:
Basic and diluted		3,642,738			3,642,701			3,642,735			3,642,896

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		—		—		—		4,468			—			—			4,468
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		—		—		—		—			2,558			—			2,558

Total comprehensive income		—		—		—		4,468			2,425			—			6,893

Cash dividends paid ($0.585 per share)		—		—		—		(2,132	)		—			—			(2,132	)
Stock repurchases (484 shares)		—		—		—		—			—			(8	)		(8	)
Sale of treasury stock (85 shares)		—		—		1		—			—			—			1

Balance, September 30, 2010		3,957,135	$	39	$	3,752	$	61,253		$	2,536		$	(6,643	)	$	60,937


Balance, December 31, 2010		3,957,135	$	39	$	3,752	$	61,421		$	(2,201	)	$	(6,643	)	$	56,368
Comprehensive income:
Net earnings		—		—		—		4,373			—			—			4,373
Other comprehensive loss due to change in other-than-temporary impairment losses related to factors other than credit on available-for- sale, net		—		—		—		—			(82	)		—			(82	)
Other comprehensive income due to change in all other unrealized gains (losses) on securities available-for- sale, net		—		—		—		—			5,948			—			5,948

Total comprehensive income		—		—		—		4,373			5,866			—			10,239

Cash dividends paid ($0.60 per share)		—		—		—		(2,186	)		—			—			(2,186	)
Sale of treasury stock (20 shares)		—		—		1		—			—			—			1

Balance, September 30, 2011		3,957,135	$	39	$	3,753	$	63,608		$	3,665		$	(6,643	)	$	64,422

See accompanying notes to condensed consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(Unaudited)


	Nine months ended September 30,
(In thousands)	2011			2010

Cash flows from operating activities:
Net earnings	$	4,373		$	4,468
Adjustments to reconcile net earnings to net cash provided by operating activities:
Provision for loan losses		1,800			2,930
Depreciation and amortization		496			419
Premium amortization and discount accretion, net		1,634			1,380
Net gain on securities		(563	)		(2,610	)
Net gain on sale of loans held for sale		(1,253	)		(1,847	)
Net loss on other real estate owned		1,233			1,118
Loss on prepayment of long-term debt		—			679
Loans originated for sale		(44,028	)		(73,521	)
Proceeds from sale of loans		46,425			74,068
Increase in cash surrender value of bank owned life insurance		(341	)		(350	)
Loss on affordable housing partnership investments		461			171
Net decrease in other assets		315			365
Net increase (decrease) in accrued expenses and other liabilities		458			(104	)

Net cash provided by operating activities		11,010			7,166


Cash flows from investing activities:
Proceeds from sales of securities available-for-sale		113,841			147,828
Proceeds from maturities of securities available-for-sale		73,989			152,320
Purchase of securities available-for-sale		(147,455	)		(282,433	)
Net increase in loans		(6,364	)		(3,824	)
Net purchases of premises and equipment		(811	)		(75	)
Decrease in FHLB stock		631			—
Capital contributions to affordable housing limited partnerships		(4,069	)		(1,500	)
Proceeds from sale of other real estate owned		1,777			596

Net cash provided by investing activities		31,539			12,912


Cash flows from financing activities:
Net increase in noninterest-bearing deposits		11,488			15,811
Net (decrease) increase in interest-bearing deposits		(9,545	)		7,288
Net decrease in federal funds purchased and securities sold under agreements to repurchase		(72	)		(13,271	)
Repayments or retirement of long-term debt		(8,014	)		(10,693	)
Proceeds from sale of treasury stock		1			1
Stock repurchases		—			(8	)
Dividends paid		(2,186	)		(2,132	)

Net cash used in financing activities		(8,328	)		(3,004	)


Net change in cash and cash equivalents		34,221			17,074
Cash and cash equivalents at beginning of period		21,424			12,395

Cash and cash equivalents at end of period	$	55,645		$	29,469



Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	9,122		$	11,698
Income taxes		347			1,490
Supplemental disclosure of non-cash transactions:
Real estate acquired through foreclosure		2,655			2,585

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.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts or revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include other-than-temporary impairment on investment securities, the determination of the allowance for loan losses, fair value of financial instruments, income taxes, and the valuation of deferred tax assets and other real estate owned.

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 September 30, 2011. The Company does not believe there are any material subsequent events that would require further recognition or disclosure.

Accounting Developments

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.

In the third quarter of 2011, the Company adopted new guidance related to the following Codification topic:

•

ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.

Information about these pronouncements 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 roll-forward 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 roll-forward 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.

ASU 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, provides guidance clarifying under what circumstances a creditor should classify a restructured loan as a troubled debt restructuring or “TDR”. A loan is a TDR if both of the following exist: (1) a creditor has granted a concession to the debtor, and (2) the debtor is experiencing financial difficulties. The ASU clarifies that a creditor should consider all aspects of a restructuring when evaluating whether it has granted a concession, which include determining whether a debtor can obtain funds from another source at market rates and assessing the value of additional collateral and guarantees obtained at the time of restructuring. The ASU provides factors a creditor should consider when determining if a debtor is experiencing financial difficulties, such as probability of payment default and bankruptcy declarations. The Company adopted the new guidance in the third quarter of 2011 with retrospective application to January 1, 2011. Adoption of the ASU required expansion of the Company’s disclosures surrounding TDRs. See Note 6.

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 nine months ended September 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 September 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 nine months ended September 30, 2011 and 2010 is presented below.


	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands, except share and per share data)		2011		2010		2011		2010
Basic and diluted:
Net earnings	$	1,367	$	1,244	$	4,373	$	4,468
Weighted average common shares outstanding		3,642,738		3,642,701		3,642,735		3,642,896
Earnings per share	$	0.38	$	0.34	$	1.20	$	1.23

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 nine months ended September 30, 2011 and 2010 is presented below.


	Quarter ended September 30,				Nine months ended September 30,
(In thousands)		2011		2010		2011			2010
Comprehensive income:
Net earnings	$	1,367	$	1,244	$	4,373		$	4,468
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		51		—		(82	)		(133	)
Due to change in all other unrealized gains on securities available-for-sale, net of tax		2,633		1,361		5,948			2,558
Total comprehensive income	$	4,051	$	2,605	$	10,239		$	6,893

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 September 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 included 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 September 30, 2011 and December 31, 2010, the Company had limited partnership investments of $5.4 million and $3.4 million, respectively, related to these projects, which are included in other assets. At September 30, 2011 and December 31, 2010, the Company had unfunded commitments related to affordable housing investments of $0.3 million and $1.9 million, respectively, included in accrued expenses and other liabilities.

Additionally, the Company had no outstanding loan commitments or funded loans outstanding with any of the partnerships at September 30, 2011. The Company had outstanding loan commitments with certain of the partnerships totaling $11.4 million at December 31, 2010. The funded portion of these loans was approximately $8.9 million at December 31, 2010. The funded portion of these loans is included in loans, net of unearned income.

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


(Dollars in thousands)	Maximum Loss Exposure		Liability Recognized		Classification
Type:
Affordable housing investments (a)	$	5,417		308	Other assets/other liabilities
Trust preferred issuances		N/A		7,217	Long-term debt

(a)	Maximum loss exposure represents the Company’s current net investment of $5.4 million included in other assets. The net current investment of $5.4 million includes $0.3 million of unfunded commitments related to affordable housing investments included in accrued expenses and other liabilities.

NOTE 5: SECURITIES

At September 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 September 30, 2011 and December 31, 2010, respectively, are presented below.


	September 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)	$	—		—		9,034		32,225		41,259		184		5	$	41,080
Agency RMBS (a)		—		—		10,039		147,021		157,060		2,507		38		154,591
State and political subdivisions		20		507		15,257		67,016		82,800		3,443		61		79,418
Trust preferred securities:
Pooled		—		—		—		100		100		—		130		230
Individual issuer		—		—		—		1,851		1,851		162		255		1,944
Total available-for-sale	$	20		507		34,330		248,213		283,070		6,296		489	$	277,263


(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 $172.0 million and $171.1 million at September 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 are cost-method investments. The carrying amounts of cost-method investments were $5.2 and $5.8 million at September 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 September 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
September 30, 2011:
Agency obligations	$	12,100		5		—		—		12,100	$	5
Agency RMBS		4,849		38		—		—		4,849		38
State and political subdivisions		1,415		21		714		40		2,129		61
Trust preferred securities:
Pooled		—		—		100		130		100		130
Individual issuer		—		—		745		255		745		255
Total	$	18,364		64		1,559		425		19,923	$	489

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 September 30, 2011. As such, it is possible that a security in an unrealized loss position at September 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 assesses 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 considers all available information in developing those expected cash flows. For asset-backed securities such as pooled trust preferred securities, such information generally includes:

•

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 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 September 30, 2011, cost-method investments with an aggregate cost of $5.2 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 September 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 September 30, 2011


							Unrealized Losses						Life-to-date Impairment Charges
	Credit Rating				Fair Value		Less than		12 months
(Dollars in thousands)	Moody’s		Fitch		Fair Value		12 months		or Longer		Total
Pooled:
ALESCO Preferred Funding XVII Ltd (a)		C		CC	$	100		—		130		130	$	1,770
Individual issuer (b):
Carolina Financial Capital Trust I		n/a		n/a		193		—		—		—		257
Main Street Bank Statutory Trust I (c)		n/a		n/a		383		—		117		117		—
MNB Capital Trust I		n/a		n/a		55		—		—		—		445
PrimeSouth Capital Trust I		n/a		n/a		75		—		—		—		425
TCB Trust		n/a		n/a		362		—		138		138		—
United Community Capital Trust		n/a		n/a		783		—		—		—		379

Total individual issuer						1,851		—		255		255		1,506

Total trust preferred securities					$	1,951		—		385		385	$	3,276

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
(Dollars in thousands)	Moody’s		Fitch		Fair Value		12 months		or Longer		Total
Pooled:
ALESCO Preferred Funding XVII Ltd (a)		Ca		C	$	20		—		210		210	$	1,770
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 estimates 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 September 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 nine months ended September 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:

		$3,040		$3,040		$3,040		$3,040
	Quarter ended September 30,				Nine months ended September 30,
(Dollars in thousands)	2011		2010		2011		2010
Balance, beginning of period	$	3,040	$	4,620	$	2,938	$	4,570
Additions:
Initial credit impairments		—		340		—		340
Subsequent credit impairments		236		—		338		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	$	3,276	$	4,960	$	3,276	$	4,960

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 nine months ended September 30, 2011 and 2010.

		$3,040			$3,040		$3,040		$3,040
	Quarter ended September 30,					Nine months ended September 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		236			340		338		340

Total debt securities		236			340		338		390
Cost-method investments		—			—		—		—

Total other-than-temporary impairment charges	$	236		$	340	$	338	$	390

Other-than-temporary impairment on debt securities:
Recorded as part of gross realized losses:
Credit-related	$	236			340	$	338	$	340
Securities with intent to sell		—			—		—		50
(Transferred from) recorded directly to other comprehensive income for non-credit related impairment		(80	)		—		130		210

Total other-than-temporary impairment on debt securities	$	156		$	340	$	468	$	600

Realized Gains and Losses

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

		$3,040			$3,040			$3,040			$3,040
	Quarter ended September 30,						Nine months ended September 30,
(Dollars in thousands)	2011			2010			2011			2010
Gross realized gains	$	474		$	475		$	1,379		$	3,045
Gross realized losses		(23	)		(6	)		(478	)		(45	)
Other-than-temporary impairment charges		(236	)		(340	)		(338	)		(390	)

Realized gains, net	$	215		$	129		$	563		$	2,610

NOTE 6: LOANS AND ALLOWANCE FOR LOAN LOSSES


(In thousands)	September 30, 2011			December 31, 2010
Commercial and industrial	$	53,888		$	53,288
Construction and land development		40,781			47,850
Commercial real estate:
Owner occupied		71,247			76,252
Other		94,812			89,989

Total commercial real estate		166,059			166,241
Residential real estate:
Consumer mortgage		58,935			57,562
Investment property		43,095			38,679

Total residential real estate		102,030			96,241
Consumer installment		12,105			10,676

Total loans		374,863			374,296
Less: unearned income		(75	)		(81	)

Loans, net of unearned income	$	374,788		$	374,215

Loans secured by real estate were approximately 82.4% of the total loan portfolio at September 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 September 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 September 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
September 30, 2011:
Commercial and industrial	$	53,603		253		—		53,856		32	$	53,888
Construction and land development		35,452		173		—		35,625		5,156		40,781
Commercial real estate:
Owner occupied		69,652		—		—		69,652		1,595		71,247
Other		92,791		—		—		92,791		2,021		94,812

Total commercial real estate		162,443		—		—		162,443		3,616		166,059
Residential real estate:
Consumer mortgage		57,532		471		—		58,003		932		58,935
Investment property		41,845		623		—		42,468		627		43,095

Total residential real estate		99,377		1,094		—		100,471		1,559		102,030
Consumer installment		11,937		25		—		11,962		143		12,105

Total	$	362,812		1,545		—		364,357		10,506	$	374,863

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 September 30, 2011 and December 31, 2010, nonaccrual loans amounted to $10.5 and $11.8 million, respectively. At September 30, 2011 and 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 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 September 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 that is needed due to the imprecision in the overall measurement process.

The following table details the changes in the allowance for loan losses by portfolio segment for the quarter and nine months ended September 30, 2011.


	September 30, 2011
(In thousands)	Commercial and industrial			Construction and land development			Commercial real estate			Residential real estate			Consumer installment			Unallocated		Total
Quarter ended:
Beginning balance	$	767			2,759			2,722			1,104			190			204	$	7,746
Charge-offs		(298	)		(1,572	)		(79	)		(73	)		(7	)		—		(2,029	)
Recoveries		5			1			—			14			3			—		23

Net (charge-offs) recoveries		(293	)		(1,571	)		(79	)		(59	)		(4	)		—		(2,006	)
Provision		288			(50	)		—			359			(8	)		11		600

Ending balance	$	762			1,138			2,643			1,404			178			215	$	6,340

Nine months ended:
Beginning balance	$	972			2,223			2,893			1,336			141			111	$	7,676
Charge-offs		(659	)		(1,717	)		(419	)		(519	)		(11	)		—		(3,325	)
Recoveries		28			2			—			149			10			—		189

Net (charge-offs) recoveries		(631	)		(1,715	)		(419	)		(370	)		(1	)		—		(3,136	)
Provision		421			630			169			438			38			104		1,800

Ending balance	$	762			1,138			2,643			1,404			178			215	$	6,340

The following table presents an analysis of the allowance for loan losses and recorded investment in loans by portfolio segment and impairment methodology as of September 30, 2011 and December 31, 2010.


	Collectively evaluated (1)				Individually evaluated (2)				Total
(In thousands)	Allowance for loan losses		Recorded investment in loans		Allowance for loan losses		Recorded investment in loans		Allowance for loan losses		Recorded investment in loans
September 30, 2011:
Commercial and industrial	$	762		53,661		—		227		762		53,888
Construction and land development		929		35,625		209		5,156		1,138		40,781
Commercial real estate		2,221		162,374		422		3,685		2,643		166,059
Residential real estate		1,163		100,713		241		1,317		1,404		102,030
Consumer installment		178		12,105		—		—		178		12,105
Unallocated		215		—		—		—		215		—

Total	$	5,468		364,478		872		10,385		6,340		374,863

December 31, 2010:
Commercial and industrial	$	695		52,767		277		521		972		53,288
Construction and land development		2,100		43,748		123		4,102		2,223		47,850
Commercial real estate		2,128		161,611		765		4,630		2,893		166,241
Residential real estate		1,192		93,823		144		2,418		1,336		96,241
Consumer installment		141		10,676		—		—		141		10,676
Unallocated		111		—		—		—		111		—

Total	$	6,367		362,625		1,309		11,671		7,676		374,296

(1)	Represents loans collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for unimpaired loans.

(2)	Represents loans individually evaluated for impairment in accordance with ASC 310-30, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans.

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.


	September 30, 2011
(In thousands)	Pass		Special Mention		Substandard Accruing		Nonaccrual		Total loans
Commercial and industrial	$	51,602		1,460		794		32	$	53,888
Construction and land development		34,233		279		1,113		5,156		40,781
Commercial real estate:
Owner occupied		63,149		4,996		1,507		1,595		71,247
Other		83,956		627		8,208		2,021		94,812

Total commercial real estate		147,105		5,623		9,715		3,616		166,059
Residential real estate:
Consumer mortgage		50,977		2,335		4,691		932		58,935
Investment property		38,675		2,246		1,547		627		43,095

Total residential real estate		89,652		4,581		6,238		1,559		102,030
Consumer installment		11,741		115		106		143		12,105

Total	$	334,333		12,058		17,966		10,506	$	374,863


	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 tables present 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 tables set forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at September 30, 2011 and December 31, 2010.


	September 30, 2011
(In thousands)	Unpaid principal balance (1)		Charge-offs and payments applied (2)			Recorded investment (3)		Related allowance
With no allowance recorded:
Commercial and industrial	$	227		—			227
Construction and land development		3,958		(1,572	)		2,386
Commercial real estate:
Owner occupied		811		(11	)		800
Other		655		(44	)		611

Total commercial real estate		1,466		(55	)		1,411
Residential real estate:
Consumer mortgages		—		—			—
Investment property		—		—			—

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

Total	$	5,651		(1,627	)		4,024

With allowance recorded:
Commercial and industrial	$	—		—			—	$	—
Construction and land development		2,913		(143	)		2,770		209
Commercial real estate:
Owner occupied		1,104		(24	)		1,080		204
Other		1,240		(46	)		1,194		218

Total commercial real estate		2,344		(70	)		2,274		422
Residential real estate:
Consumer mortgages		1,005		(79	)		926		71
Investment property		391		—			391		170

Total residential real estate		1,396		(79	)		1,317		241
Consumer installment		—		—			—		—

Total	$	6,653		(292	)		6,361	$	872

Total impaired loans	$	12,304		(1,919	)		10,385	$	872

(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.


	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.

The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class.


	Quarter ended September 30, 2011				Nine months ended September 30, 2011
(In thousands)	Average recorded investment		Total interest income recognized		Average recorded investment		Total interest income recognized
Impaired loans:
Commercial and industrial	$	229		3		345		5
Construction and land development		3,589		—		3,843		—
Commercial real estate:						—		—
Owner occupied		1,886		10		1,769		17
Other		2,096		—		2,545		—

Total commercial real estate		3,982		10		4,314		17
Residential real estate:
Consumer mortgages		934		—		1,514		—
Investment property		130		—		75		—

Total residential real estate		1,064		—		1,589		—
Consumer installment		—		—		—		—

Total	$	8,864		13		10,091		22

Troubled Debt Restructurings

Impaired loans also included TDRs. In the normal course of business, management grants concessions to borrowers, which would not otherwise be considered where the borrowers are experiencing financial difficulty. A concession may include, but is not limited to, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date or reduction of the face amount or maturity amount of the debt. A concession has been granted when, as a result of the restructuring, the Bank does not expect to collect all amounts due, including interest at the original stated rate. A concession may have also been granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. The Company’s determination of whether a loan modification is a TDR considers the individual facts and circumstances surrounding each modification. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructure.

Similar to other impaired loans, TDRs are measured for impairment based on the present value of expected payments using the loan’s original effective interest rate as the discount rate, or the fair value of the collateral, less selling costs if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, impairment is recognized by establishing a valuation allowance as part of the allowance for loan losses or a charge-off to the allowance for loan losses. In periods subsequent to the modification, all TDRs are evaluated, including those that have payment defaults, for possible impairment.

At September 30, 2011 and December 31, 2010, the Company had impaired loans classified as TDRs of $9.5 million and $7.6 million, respectively. At September 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 $0.8 million and $1.0 million at September 30, 2011 and December 31, 2010, respectively. At September 30, 2011, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured.

Effective July 1, 2011, the Company adopted ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. See Note 1. As such, the Company reassessed all restructurings that occurred on or after January 1, 2011 for identification and disclosure as TDRs.

The following table summarizes the recorded investment in loans modified in a TDR both before and after their modification during the respective period.


	Quarter ended September 30, 2011						Nine months ended September 30, 2011
($ in thousands)	Number of contracts		Pre- modification outstanding recorded investment		Post - modification outstanding recorded investment		Number of contracts		Pre- modification outstanding recorded investment		Post - modification outstanding recorded investment
TDRs:
Commercial and industrial		1	$	283		283		2	$	791		523
Construction and land development		2		4,432		4,419		3		4,925		4,894
Commercial real estate:
Owner occupied		1		256		256		4		2,202		1,915
Other		—		—		—		1		1,229		1,229

Total commercial real estate		1		256		256		5		3,431		3,144
Residential real estate:
Consumer mortgages		—		—		—		—		—		—
Investment property		1		391		391		1		391		391

Total residential real estate		1		391		391		1		391		391
Consumer installment		—		—		—		—				—

Total		5	$	5,362		5,349		11	$	9,538		8,952

The majority of the loans modified in a TDR during the quarter and nine months ended September 30, 2011 included delays in required payments of principal and/or interest or where the only concession granted by the Company was that the interest rate at renewal was not considered to be a market rate. Only two modifications during the nine months ended September 30, 2011 were A/B note restructurings, where the B note was charged off. Total charge-offs related to B notes during the nine months ended September 30, 2011 were approximately $0.6 million.

As of September 30, 2011, there were no loans modified in a TDR within the previous 12 months for which there was a payment default (defined as more than 90 days past due) and an outstanding loan balance.

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 nine months ended September 30, 2011 and 2010 are presented below.


	Quarter ended September 30,						Nine months ended September 30,
(Dollars in thousands)	2011			2010			2011			2010
Beginning balance	$	1,239		$	877		$	1,189		$	834
Additions, net		79			149			231			260
Amortization expense		(61	)		(44	)		(163	)		(112	)
Change in valuation allowance		(20	)		—			(20	)		—

Ending balance	$	1,237		$	982		$	1,237		$	982

Fair value of amortized MSRs:
Beginning of period	$	1,422		$	1,023		$	1,335		$	978
End of period		1,237			1,024			1,237			1,024

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 September 30, 2011, the Company recorded a valuation allowance of $20,000 and at December 31, 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 for a security. 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 certain 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 — A loan is considered impaired when it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent. If the recorded investment in the impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan losses or the expense is recognized as a charge-off. Impaired loans are classified within Level 3 of the valuation hierarchy.

Other real estate owned — Other real estate owned, 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 September 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 September 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 September 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)
September 30, 2011:
Securities available-for-sale:
Agency obligations	$	41,259		—		41,259		—
Agency RMBS		157,060		—		157,060		—
State and political subdivisions		82,800		—		82,800		—
Trust preferred securities:
Pooled		100		—		—		100
Individual issuer		1,851		—		—		1,851

Total securities available-for-sale		283,070		—		281,119		1,951
Other assets ⁽¹⁾		1,334		—		1,334		—

Total assets at fair value	$	284,404		—		282,453		1,951


Other liabilities⁽¹⁾		1,334		—		1,334		—

Total liabilities at fair value	$	1,334		—		1,334		—

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 nine months ended September 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:


	Nine months ended September 30,
(Dollars in thousands)	2011			2010
Beginning balance	$	2,149		$	1,463
Total realized and unrealized gains and (losses):
Included in net earnings		(338	)		(390	)
Included in other comprehensive income		140			1,327
Purchases		—			—
Issuances		—			—
Settlements		—			—
Transfers in and/or (out) of Level 3		—			—

Ending balance	$	1,951		$	2,400

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 September 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)
September 30, 2011:
Loans held for sale	$	2,906		—		2,906		—
Loans, net⁽¹⁾		9,513		—		—		9,513
Other real estate owned		7,770		—		—		7,770
Other assets ⁽²⁾		1,237		—		—		1,237

Total assets at fair value	$	21,426		—		2,906		18,520


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 MSRs, 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

The carrying amounts of derivative instruments approximate their fair value.

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 September 30, 2011 and December 31, 2010 are presented below.


	September 30, 2011				December 31, 2010
(Dollars in thousands)	Carrying amount		Estimated fair value		Carrying amount		Estimated fair value
Financial Assets:
Cash and cash equivalents	$	55,645	$	55,645	$	21,424	$	21,424
Securities available-for-sale		283,070		283,070		315,220		315,220
Loans held for sale		2,906		2,906		4,281		4,281
Loans, net		368,448		377,683		366,539		372,869
Derivative assets		1,334		1,334		1,101		1,101
Financial Liabilities:
Deposits	$	609,070	$	615,518	$	607,127	$	615,300
Short-term borrowings		2,613		2,613		2,685		2,685
Long-term debt		85,317		93,833		93,331		99,505
Derivative liabilities		1,334		1,334		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 September 30, 2011, the Company had no derivative contracts to assist in managing its interest rate sensitivity.

Interest rate swap agreements involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument 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 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 nine months ended September 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	$	5,804		—		1,334	$	(233	)
Pay variable / receive fixed		5,804		1,334		—		233

Total interest rate swap agreements	$	11,608		1,334		1,334	$	—

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 nine months ended September 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 reports on Form 10-Q for the quarters ended March 31, 2011 and June 30, 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-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 September 30,				Nine months ended September 30,
(Dollars in thousands, except per share amounts)	2011		2010		2011		2010
Net interest income (a)	$	5,274	$	5,187	$	16,020	$	15,581
Less: tax-equivalent adjustment		429		449		1,304		1,324

Net interest income (GAAP)		4,845		4,738		14,716		14,257
Noninterest income		1,398		1,857		3,898		6,945

Total revenue		6,243		6,595		18,614

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