Edgar Filing: AUBURN NATIONAL BANCORPORATION, INC

10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2013

[ ]

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):


Large Accelerated filer ¨	Accelerated filer ¨	Non-accelerated filer ¨	Smaller reporting company x
	(Do not check if a smaller reporting company)

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

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


Class		Outstanding at July 31, 2013
Common Stock, $0.01 par value per share		3,643,013 shares

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

INDEX


	PAGE
PART I. FINANCIAL INFORMATION

Item 1 Financial Statements

Consolidated Balance Sheets (Unaudited) as of June 30, 2013 and December 31, 2012		3

Consolidated Statements of Earnings (Unaudited) for the quarter and six months ended June 30, 2013 and 2012		4

Consolidated Statements of Comprehensive Income (Unaudited) for the quarter and six months ended June 30, 2013 and 2012		5

Consolidated Statements of Stockholders’ Equity (Unaudited) for the six months ended June 30, 2013 and 2012		6

Consolidated Statements of Cash Flows (Unaudited) for the six months ended June 30, 2013 and 2012		7

Notes to Consolidated Financial Statements (Unaudited)		8

Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations		32

Table 1 – Explanation of Non-GAAP Financial Measures		49

Table 2 – Selected Quarterly Financial Data		50

Table 3 – Selected Financial Data		51

Table 4 – Average Balances and Net Interest Income Analysis – for the quarter ended June 30, 2013 and 2012		52

Table 5 – Average Balances and Net Interest Income Analysis – for the six months ended June 30, 2013 and 2012		53

Table 6 – Loan Portfolio Composition		54

Table 7 – Allowance for Loan Losses and Nonperforming Assets		55

Table 8 – Allocation of Allowance for Loan Losses		56

Table 9 – CDs and Other Time Deposits of $100,000 or more		57

Item 3 Quantitative and Qualitative Disclosures About Market Risk		58

Item 4 Controls and Procedures		58

PART II. OTHER INFORMATION

Item 1 Legal Proceedings		58

Item 1A Risk Factors		58

Item 2 Unregistered Sales of Equity Securities and Use of Proceeds		58

Item 3 Defaults Upon Senior Securities		58

Item 4 Mine Safety Disclosures		59

Item 5 Other Information		59

Item 6 Exhibits		59

PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)


(Dollars in thousands, except share data)	June 30, 2013		December 31, 2012

Assets:
Cash and due from banks	$	17,015	$	18,762
Federal funds sold		38,710		42,682
Interest bearing bank deposits		6,813		505

Cash and cash equivalents		62,538		61,949

Securities available-for-sale		270,794		259,475
Loans held for sale		4,824		2,887
Loans, net of unearned income		390,726		398,193
Allowance for loan losses		(6,457)		(6,723)

Loans, net		384,269		391,470

Premises and equipment, net		10,790		10,528
Bank-owned life insurance		17,272		17,076
Other real estate owned		3,609		4,919
Other assets		13,651		11,529

Total assets	$	767,747	$	759,833

Liabilities:
Deposits:
Noninterest-bearing	$	127,189	$	118,014
Interest-bearing		539,301		518,803

Total deposits		666,490		636,817
Federal funds purchased and securities sold under agreements to repurchase		4,953		2,689
Long-term debt		27,217		47,217
Accrued expenses and other liabilities		3,876		2,961

Total liabilities		702,536		689,684

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		3,757		3,756
Retained earnings		69,887		67,821
Accumulated other comprehensive (loss) income, net		(1,831)		5,174
Less treasury stock, at cost—314,142 shares and 314,232 shares at June 30, 2013 and December 31, 2012, respectively		(6,641)		(6,641)

Total stockholders’ equity		65,211		70,149

Total liabilities and stockholders’ equity	$	767,747	$	759,833

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

(Unaudited)


	Quarters ended June 30,					Six months ended June 30,

(In thousands, except share and per share data)	2013		2012			2013		2012

Interest income:
Loans, including fees	$	5,224	$	5,490		$	10,552	$	10,755
Securities		1,607		1,860			3,223		3,829
Federal funds sold and interest bearing bank deposits		29		7			60		21

Total interest income		6,860		7,357			13,835		14,605

Interest expense:
Deposits		1,349		1,605			2,753		3,330
Short-term borrowings		3		5			7		9
Long-term debt		276		435			702		953

Total interest expense		1,628		2,045			3,462		4,292

Net interest income		5,232		5,312			10,373		10,313
Provision for loan losses		—		600			400		1,200

Net interest income after provision for loan losses		5,232		4,712			9,973		9,113

Noninterest income:
Service charges on deposit accounts		234		279			483		570
Mortgage lending		837		785			1,647		1,454
Bank-owned life insurance		101		113			196		212
Gain on sale of affordable housing investments		—		—			—		3,268
Other		381		386			721		744
Securities gains, net:
Realized gains, net		518		251			679		560
Total other-than-temporary impairments		—		—			—		(130)

Total securities gains, net		518		251			679		430

Total noninterest income		2,071		1,814			3,726		6,678

Noninterest expense:
Salaries and benefits		2,114		2,205			4,364		4,348
Net occupancy and equipment		333		336			664		674
Professional fees		209		188			385		375
FDIC and other regulatory assessments		143		185			337		368
Other real estate owned, net		20		(6	)		43		63
Prepayment penalty on long-term debt		1,046		12			1,471		3,720
Other		859		1,128			1,686		2,042

Total noninterest expense		4,724		4,048			8,950		11,590

Earnings before income taxes		2,579		2,478			4,749		4,201
Income tax expense		672		449			1,153		707

Net earnings	$	1,907	$	2,029		$	3,596	$	3,494

Net earnings per share:
Basic and diluted	$	0.52	$	0.56		$	0.99	$	0.96

Weighted average shares outstanding:
Basic and diluted		3,642,955		3,642,826			3,642,936		3,642,782

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited)


	Quarters ended June 30,						Six months ended June 30,

(Dollars in thousands)	2013			2012			2013			2012

Net earnings	$	1,907		$	2,029		$	3,596		$	3,494
Other comprehensive (loss) income, net of tax:
Unrealized net holding (loss) gain on securities		(5,821	)		1,195			(6,577	)		1,145
Reclassification adjustment for net gain on securities recognized in net earnings		(327	)		(158	)		(428	)		(271)

Other comprehensive (loss) income		(6,148	)		1,037			(7,005	)		874

Comprehensive (loss) income	$	(4,241	)	$	3,066		$	(3,409	)	$	4,368

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

(Unaudited)


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

Balance, December 31, 2011		3,957,135	$	39	$	3,753	$	64,045		$	4,222		$	(6,643	)	$	65,416
Net earnings		—		—		—		3,494			—			—			3,494
Other comprehensive income		—		—		—		—			874			—			874
Cash dividends paid ($0.41 per share)		—		—		—		(1,494	)		—			—			(1,494)
Sale of treasury stock (105 shares)		—		—		1		—			—			1			2

Balance, June 30, 2012		3,957,135	$	39	$	3,754	$	66,045		$	5,096		$	(6,642	)	$	68,292


Balance, December 31, 2012		3,957,135	$	39	$	3,756	$	67,821		$	5,174		$	(6,641	)	$	70,149
Net earnings		—		—		—		3,596			—			—			3,596
Other comprehensive loss		—		—		—		—			(7,005	)		—			(7,005)
Cash dividends paid ($0.42 per share)		—		—		—		(1,530	)		—			—			(1,530)
Sale of treasury stock (90 shares)		—		—		1		—			—			—			1

Balance, June 30, 2013		3,957,135	$	39	$	3,757	$	69,887		$	(1,831	)	$	(6,641	)	$	65,211

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)


	Six months ended June 30,
(In thousands)	2013			2012

Cash flows from operating activities:
Net earnings	$	3,596		$	3,494
Adjustments to reconcile net earnings to net cash provided by operating activities:
Provision for loan losses		400			1,200
Depreciation and amortization		448			403
Premium amortization and discount accretion, net		1,143			1,590
Net gain on securities available for sale		(679	)		(430	)
Net gain on sale of loans held for sale		(1,258	)		(1,416	)
Net (gain) loss on other real estate owned		(47	)		25
Loss on prepayment of long-term debt		1,471			3,720
Loans originated for sale		(61,382	)		(64,433	)
Proceeds from sale of loans		60,225			62,013
Increase in cash surrender value of bank owned life insurance		(196	)		(212	)
Gain on sale of affordable housing partnership investments		—			(3,268	)
Net decrease in other assets		1,061			300
Net increase (decrease) in accrued expenses and other liabilities		915			(22	)

Net cash provided by operating activities		5,697			2,964


Cash flows from investing activities:
Proceeds from sales of securities available-for-sale		37,859			39,344
Proceeds from maturities of securities available-for-sale		39,179			68,088
Purchase of securities available-for-sale		(99,923	)		(84,871	)
Decrease (increase) in loans, net		6,159			(31,046	)
Net purchases of premises and equipment		(471	)		(740	)
Decrease in FHLB stock		1,153			1,607
Proceeds from sale of affordable housing limited partnerships		—			8,499
Proceeds from sale of other real estate owned		1,999			3,039

Net cash (used in) provided by investing activities		(14,045	)		3,920


Cash flows from financing activities:
Net increase in noninterest-bearing deposits		9,175			7,201
Net increase in interest-bearing deposits		20,498			17,493
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		2,264			(20	)
Repayments or retirement of long-term debt		(21,471	)		(41,816	)
Proceeds from sale of treasury stock		1			2
Dividends paid		(1,530	)		(1,494	)

Net cash provided by (used in) financing activities		8,937			(18,634	)


Net change in cash and cash equivalents		589			(11,750	)
Cash and cash equivalents at beginning of period		61,949			55,428

Cash and cash equivalents at end of period	$	62,538		$	43,678

Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	3,548		$	4,507
Income taxes		254			667
Supplemental disclosure of non-cash transactions:
Real estate acquired through foreclosure		642			323

See accompanying notes to consolidated financial statements

AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

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 consolidated financial statements in this report have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, these financial statements do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The unaudited 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, 2012.

The unaudited consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Auburn National Bancorporation Capital Trust I is an affiliate of the Company and was included in these unaudited consolidated financial statements pursuant to the equity method of accounting. Significant intercompany transactions and accounts are eliminated in consolidation.

The preparation of financial statements in conformity with U.S. GAAP 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 of 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, and the valuation of deferred tax assets and other real estate owned.

Subsequent Events

The Company has evaluated the effects of events and transactions through the date of this filing that have occurred subsequent to June 30, 2013. The Company does not believe there were any material subsequent events during this period that would have required recognition or disclosure in the unaudited consolidated financial statements included in this report.

Accounting Developments

In the first quarter of 2013, the Company adopted new guidance related to the following Codification topics:

•

ASU 2011-11, Disclosures about Offsetting Assets and Liabilities;

•

ASU 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities; and

•

ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.

Information about these pronouncements are described in more detail below.

ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, expands the disclosure requirements for financial instruments and derivatives that may be offset in accordance with enforceable master netting agreements or similar arrangements. The disclosures are required regardless of whether the instruments have been offset (or netted) in the statement of financial position. Under ASU 2011-11, companies must describe the nature of offsetting arrangements and provide quantitative information about those agreements, including the gross and net amounts of financial instruments that are recognized in the statement of financial position. In January 2013, the FASB issued ASU 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, which clarifies the scope of the offsetting disclosures and addresses any unintended consequences due to feedback from stakeholders that standard commercial provisions of many contracts would equate to a master netting arrangement. These changes were effective for the Company in the first quarter of 2013 with retrospective application. Adoption of this ASU did not have a significant impact on the financial statements of the Company.

ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, seeks to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments in this Update will require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. These changes were effective for the Company in the first quarter of 2013 with retrospective application. This Update did not affect our consolidated financial results as it amends only the presentation of comprehensive income. See Consolidated Statements of Comprehensive Income.

NOTE 2: BASIC AND DILUTED EARNINGS PER SHARE

Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the quarter and six month periods ended June 30, 2013 and 2012, respectively. Diluted net earnings per share reflect the potential dilution that could occur upon exercise of securities or other rights for, or convertible into, shares of the Company’s common stock. At June 30, 2013 and 2012, respectively, the Company had no such securities or rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted earnings per share calculation.

The basic and diluted earnings per share computation for the quarter and six month periods ended June 30, 2013 and 2012 is presented below.


	Quarter ended June 30,				Six months ended June 30,
(In thousands, except share and per share data)	2013		2012		2013		2012

Basic and diluted:
Net earnings	$	1,907	$	2,029	$	3,596	$	3,494
Weighted average common shares outstanding		3,642,955		3,642,826		3,642,936		3,642,782

Earnings per share	$	0.52	$	0.56	$	0.99	$	0.96

NOTE 3: VARIABLE INTEREST ENTITIES

Generally, a variable interest entity (“VIE”) is a corporation, partnership, trust or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities.

At June 30, 2013, the Company did not have any consolidated VIEs to disclose but did have one nonconsolidated VIE, 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 of $0.2 million 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.

The following table summarizes VIEs that are not consolidated by the Company as of June 30, 2013.


(Dollars in thousands)	Maximum Loss Exposure		Liability Recognized		Classification

Type:
Trust preferred issuances		N/A		$ 7,217	Long-term debt

NOTE 4: SECURITIES

At June 30, 2013 and December 31, 2012, respectively, all securities within the scope of ASC 320, Investments – Debt and Equity Securities, were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity at June 30, 2013 and December 31, 2012, respectively, are presented below.


	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

June 30, 2013
Agency obligations (a)	$	—		—		24,001		22,614		46,615		22		2,480	$	49,073
Agency RMBS (a)		—		—		3,968		149,995		153,963		938		3,416		156,441
State and political subdivisions		—		1,846		20,149		47,527		69,522		2,341		309		67,490
Trust preferred securities		—		—		—		694		694		137		136		693

Total available-for-sale	$	—		1,846		48,118		220,830		270,794		3,438		6,341	$	273,697


December 31, 2012
Agency obligations (a)	$	—		—		20,065		19,460		39,525		187		19	$	39,357
Agency RMBS (a)		—		—		4,700		136,760		141,460		3,012		162		138,610
State and political subdivisions		111		1,830		21,006		54,891		77,838		5,222		—		72,616
Trust preferred securities		—		—		—		652		652		113		154		693

Total available-for-sale	$	111		1,830		45,771		211,763		259,475		8,534		335	$	251,276

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

Securities with aggregate fair values of $145.8 million and $134.0 million at June 30, 2013 and December 31, 2012, 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 $1.8 million and $3.0 million at June 30, 2013 and December 31, 2012, respectively. Cost-method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock.

Gross Unrealized Losses and Fair Value

The fair values and gross unrealized losses on securities at June 30, 2013 and December 31, 2012, respectively, segregated by those securities that have been in an unrealized loss position for less than 12 months and 12 months or longer, are presented below.


	Less than 12 Months				12 Months or Longer				Total
(Dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

June 30, 2013:
Agency obligations	$	41,593		2,480		—		—	$	41,593		2,480
Agency RMBS		108,049		3,416		—		—		108,049		3,416
State and political subdivisions		7,381		309		—		—		7,381		309
Trust preferred securities		—		—		364		136	$	364		136

Total	$	157,023		6,205		364		136	$	157,387		6,341

December 31, 2012:
Agency obligations	$	9,966		19		—		—	$	9,966		19
Agency RMBS		25,207		162		—		—		25,207		162
Trust preferred securities		—		—		346		154		346		154

Total	$	35,173		181		346		154	$	35,519		335

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. On a quarterly basis, 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.

Agency obligations

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

Agency residential mortgage-backed securities (“RMBS”)

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

Securities of U.S. states and political subdivisions

The unrealized losses associated with securities of U.S. states and political subdivisions were primarily driven by changes in interest rates and were not due to the credit quality of the securities. Some of these securities are guaranteed by a bond insurer, but management did not rely on the guarantee in making its investment decision. 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.

Trust preferred securities

The unrealized losses associated with individual issuer trust preferred securities were related to securities issued on behalf of individual community bank holding companies. Management evaluates the financial performance of individual community bank holding companies on a quarterly basis to determine if it is probable that such issuer can make all contractual principal and interest payments. Based upon its evaluation, the Company expects to recover the remaining amortized cost basis of these securities.

Cost-method investments

At June 30, 2013, cost-method investments with an aggregate cost of $1.8 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 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.

Other-Than-Temporarily Impaired Securities

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 has recognized the credit component of the loss in earnings (referred to as “credit-impaired” debt securities). Other-than-temporary impairments recognized in earnings 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 the security is fully written-down and deemed worthless. Changes in the credit loss component of credit-impaired debt securities for the quarters and six months ended June 30, 2013 and 2012 were as follows:


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands)	2013		2012		2013		2012

Balance, beginning of period	$	1,257	$	1,257	$	1,257	$	3,276
Additions:
Subsequent credit impairments		—		—		—		130
Reductions:
Securities sold		—		—		—		2,149
Securities fully written down and deemed worthless		500		—		500		—

Balance, end of period	$	757	$	1,257	$	757	$	1,257

Other-Than-Temporary Impairment

The following table presents details of the other-than-temporary impairment related to securities.


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands)	2013		2012		2013		2012

Other-than-temporary impairment charges (included in earnings):
Debt securities:
Individual issuer trust preferred securities	$	—	$	—	$	—	$	130

Total debt securities		—		—		—		130

Total other-than-temporary impairment charges	$	—	$	—	$	—	$	130

Other-than-temporary impairment on debt securities:
Recorded as part of gross realized losses:
Credit-related	$	—	$	—	$	—	$	130

Total other-than-temporary impairment on debt securities	$	—	$	—	$	—	$	130

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.


	Quarter ended June 30,					Six months ended June 30,
(Dollars in thousands)	2013			2012		2013			2012

Gross realized gains	$	524		$	251	$	685		$	724
Gross realized losses		(6	)		—		(6	)		(164)
Other-than-temporary impairment charges		—			—		—			(130)

Realized gains, net	$	518		$	251	$	679		$	430

NOTE 5: LOANS AND ALLOWANCE FOR LOAN LOSSES


	June 30,		December 31,
(In thousands)	2013		2012
Commercial and industrial	$	56,030	$	59,334
Construction and land development		45,886		37,631
Commercial real estate:
Owner occupied		60,140		64,368
Other		117,151		119,243

Total commercial real estate		177,291		183,611
Residential real estate:
Consumer mortgage		55,192		58,087
Investment property		43,829		47,544

Total residential real estate		99,021		105,631
Consumer installment		12,747		12,219

Total loans		390,975		398,426
Less: unearned income		(249)		(233)

Loans, net of unearned income	$	390,726	$	398,193

Loans secured by real estate were approximately 82.4% of the Company’s total loan portfolio at June 30, 2013. At June 30, 2013, 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. As part of the Company’s quarterly assessment of the allowance, the 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. 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 and classes.

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 that are not owner occupied. 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 of credit 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 and property value, 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 segment and class as of June 30, 2013, and December 31, 2012.


			Accruing 30-89 Days		Accruing Greater than		Total Accruing		Non-		Total
(In thousands)	Current		Past Due		90 days		Loans		Accrual		Loans

June 30, 2013:
Commercial and industrial	$	55,644		329		—		55,973		57	$	56,030
Construction and land development		44,285		—		—		44,285		1,601		45,886
Commercial real estate:
Owner occupied		59,035		50		—		59,085		1,055		60,140
Other		115,274		1,448		—		116,722		429		117,151
Total commercial real estate		174,309		1,498		—		175,807		1,484		177,291
Residential real estate:
Consumer mortgage		53,742		325		—		54,067		1,125		55,192
Investment property		43,258		176		—		43,434		395		43,829
Total residential real estate		97,000		501		—		97,501		1,520		99,021
Consumer installment		12,598		147		—		12,745		2		12,747
Total	$	383,836		2,475		—		386,311		4,664	$	390,975

December 31, 2012:
Commercial and industrial	$	59,101		173		—		59,274		60	$	59,334
Construction and land development		35,917		8		—		35,925		1,706		37,631
Commercial real estate:
Owner occupied		63,323		—		—		63,323		1,045		64,368
Other		113,344		230		—		113,574		5,669		119,243
Total commercial real estate		176,667		230		—		176,897		6,714		183,611
Residential real estate:
Consumer mortgage		55,521		1,202		58		56,781		1,306		58,087
Investment property		46,460		335		—		46,795		749		47,544
Total residential real estate		101,981		1,537		58		103,576		2,055		105,631
Consumer installment		12,157		62		—		12,219		—		12,219
Total	$	385,823		2,010		58		387,891		10,535	$	398,426

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 portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a 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. Loans are charged off, in whole or in part, 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.

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 internal and independent loan review processes. 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 it 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, construction and land development, 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. At June 30, 2013 and December 31, 2012, and for the periods then ended, 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.

economic conditions on the Company’s loan loss experience, the Company calculated average losses for all loan segments (except for the commercial real estate loan segment) using a rolling 8 quarter historical period for the quarter ended June 30, 2013. Based upon management’s review of charge-off trends for each loan segment, the Company continued to calculate average losses for the commercial real estate loan segment using a rolling 6 quarter historical period for the quarter ended June 30, 2013. If the Company continued to calculate average losses for all loan segments using a rolling 6 quarter historical period, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $1.1 million at June 30, 2013. Other than the changes discussed above, the Company has not made any changes to its calculation of historical loss periods that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings.

The following table details the changes in the allowance for loan losses by portfolio segment for the respective periods.


	June 30, 2013
(In thousands)	Commercial and industrial			Construction and land development			Commercial real estate			Residential real estate			Consumer installment			Total
Quarter ended:
Beginning balance	$	569			1,619			3,571			885			125		$	6,769
Charge-offs		—			—			(118	)		(189	)		(45	)		(352	)
Recoveries		5			2			—			28			5			40

Net (charge-offs) recoveries		5			2			(118	)		(161	)		(40	)		(312	)
Provision		101			(167	)		(342	)		401			7			—

Ending balance	$	675			1,454			3,111			1,125			92		$	6,457

Six months ended:
Beginning balance	$	812			1,545			3,137			1,126			103		$	6,723
Charge-offs		(68	)		(39	)		(118	)		(455	)		(62	)		(742	)
Recoveries		17			3			4			41			11			76

Net charge-offs		(51	)		(36	)		(114	)		(414	)		(51	)		(666	)
Provision		(86	)		(55	)		88			413			40			400

Ending balance	$	675			1,454			3,111			1,125			92		$	6,457


	June 30, 2012
(In thousands)	Commercial and industrial			Construction and land development			Commercial real estate			Residential real estate			Consumer installment			Total
Quarter ended:
Beginning balance	$	845			1,439			3,816			1,332			64			7,496
Charge-offs		(95	)		(231	)		(1,218	)		(78	)		(26	)	$	(1,648	)
Recoveries		5			1			—			45			4		$	55

Net charge-offs		(90	)		(230	)		(1,218	)		(33	)		(22	)		(1,593	)
Provision		(24	)		414			219			(21	)		12		$	600

Ending balance	$	731			1,623			2,817			1,278			54		$	6,503

Six months ended:
Beginning balance	$	948			1,470			3,009			1,363			129		$	6,919
Charge-offs		(95	)		(231	)		(1,218	)		(111	)		(32	)		(1,687	)
Recoveries		8			1			—			51			11			71

Net charge-offs		(87	)		(230	)		(1,218	)		(60	)		(21	)		(1,616	)
Provision		(130	)		383			1,026			(25	)		(54	)		1,200

Ending balance	$	731			1,623			2,817			1,278			54		$	6,503

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 June 30, 2013 and 2012.


	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
June 30, 2013:
Commercial and industrial	$	675		55,882		—		148		675		56,030
Construction and land development		1,347		44,285		107		1,601		1,454		45,886
Commercial real estate		2,991		174,922		120		2,369		3,111		177,291
Residential real estate		1,069		97,732		56		1,289		1,125		99,021
Consumer installment		92		12,747		—		—		92		12,747

Total	$	6,174		385,568		283		5,407		6,457		390,975

June 30, 2012:
Commercial and industrial	$	731		59,223		—		195		731		59,418
Construction and land development		1,257		35,110		366		3,858		1,623		38,968
Commercial real estate		2,666		182,817		151		3,029		2,817		185,846
Residential real estate		953		102,678		325		1,549		1,278		104,227
Consumer installment		54		11,133		—		—		54		11,133

Total	$	5,661		390,961		842		8,631		6,503		399,592

(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 qualitative and environmental factors 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.


(In thousands)	Pass		Special Mention		Substandard Accruing		Nonaccrual		Total loans
June 30, 2013:
Commercial and industrial	$	55,087		2		884		57	$	56,030
Construction and land development		42,710		374		1,201		1,601		45,886
Commercial real estate:
Owner occupied		56,834		760		1,491		1,055		60,140
Other		113,552		2,828		342		429		117,151
Total commercial real estate		170,386		3,588		1,833		1,484		177,291
Residential real estate:
Consumer mortgage		47,619		793		5,655		1,125		55,192
Investment property		40,384		933		2,117		395		43,829
Total residential real estate		88,003		1,726		7,772		1,520		99,021
Consumer installment		12,579		20		146		2		12,747
Total	$	368,765		5,710		11,836		4,664	$	390,975

December 31, 2012:
Commercial and industrial	$	58,487		224		563		60	$	59,334
Construction and land development		34,490		310		1,125		1,706		37,631
Commercial real estate:
Owner occupied		59,270		2,528		1,525		1,045		64,368
Other		111,719		653		1,202		5,669		119,243
Total commercial real estate		170,989		3,181		2,727		6,714		183,611
Residential real estate:
Consumer mortgage		49,462		1,544		5,775		1,306		58,087
Investment property		43,559		1,033		2,203		749		47,544
Total residential real estate		93,021		2,577		7,978		2,055		105,631
Consumer installment		11,850		155		214		—		12,219
Total	$	368,837		6,447		12,607		10,535	$	398,426

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 installment loans).

The following tables set forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at June 30, 2013 and December 31, 2012.


		June 30, 2013
(In thousands)		Unpaid principal balance (1)		Charge-offs and payments applied (2)			Recorded investment (3)		Related allowance

With no allowance recorded:
Commercial and industrial	$		148		—			148
Construction and land development			2,878		(1,681	)		1,197
Commercial real estate:
Owner occupied			350		(51	)		299
Other			515		(86	)		429

Total commercial real estate			865		(137	)		728
Residential real estate:
Consumer mortgages			960		(177	)		783
Investment property			210		(29	)		181

Total residential real estate			1,170		(206	)		964

Total	$		5,061		(2,024	)		3,037

With allowance recorded:
Construction and land development	$		461		(57	)		404	$	107
Commercial real estate:
Owner occupied			1,759		(118	)		1,641		120

Total commercial real estate			1,759		(118	)		1,641		120
Residential real estate:
Investment property			412		(87	)		325		56

Total residential real estate			412		(87	)		325		56

Total	$		2,632		(262	)		2,370	$	283

Total impaired loans	$		7,693		(2,286	)		5,407	$	283

(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 subsequent to the loans being placed on nonaccrual status.

(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, 2012
(In thousands)	Unpaid principal balance (1)		Charge-offs and payments applied (2)			Recorded investment (3)		Related allowance

With no allowance recorded:
Commercial and industrial	$	169		—			169
Construction and land development		2,879		(1,682	)		1,197
Commercial real estate:
Owner occupied		787		(212	)		575
Other		7,914		(1,862	)		6,052

Total commercial real estate		8,701		(2,074	)		6,627
Residential real estate:
Consumer mortgages		971		(152	)		819
Investment property		508		(110	)		398

Total residential real estate		1,479		(262	)		1,217

Total	$	13,228		(4,018	)		9,210

With allowance recorded:
Construction and land development	$	471		(45	)		426	$	129
Commercial real estate:
Owner occupied		899		—			899		134

Total commercial real estate		899		—			899		134

Total	$	1,370		(45	)		1,325	$	263

Total impaired loans	$	14,598		(4,063	)		10,535	$	263

(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 subsequent to the loans being placed on nonaccrual status.

(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 during the respective periods.


	Quarter ended June 30, 2013				Six months ended June 30, 2013
(In thousands)	Average recorded investment		Total interest income recognized		Average recorded investment		Total interest income recognized

Impaired loans:
Commercial and industrial	$	150		2		158		5
Construction and land development		1,607		—		1,614		—
Commercial real estate:
Owner occupied		1,984		14		2,019		29
Other		430		—		1,902		—

Total commercial real estate		2,414		14		3,921		29
Residential real estate:
Consumer mortgages		789		—		801		—
Investment property		348		—		323		—

Total residential real estate		1,137		—		1,124		—

Total	$	5,308		16		6,817		34


	Quarter ended June 30, 2012				Six months ended June 30, 2012
(In thousands)	Average recorded investment		Total interest income recognized		Average recorded investment		Total interest income recognized

Impaired loans:
Commercial and industrial	$	197		4		205		8
Construction and land development		4,185		—		4,595		—
Commercial real estate:
Owner occupied		2,561		18		2,566		35
Other		1,245		—		1,500		—

Total commercial real estate		3,806		18		4,066		35
Residential real estate:
Consumer mortgages		863		—		881		—
Investment property		695		—		562		—

Total residential real estate		1,558		—		1,443		—

Total	$	9,746		22		10,309		43

Troubled Debt Restructurings

Impaired loans also include troubled debt restructurings (“TDRs”). In the normal course of business, management may grant concessions to borrowers that are experiencing financial difficulty. A concession may include, but is not limited to, delays in required payments of principal and interest for a specified period, 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, the Company 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.

The following is a summary of accruing and nonaccrual TDRs, which are included in impaired loan totals, and the related allowance for loan losses, by portfolio segment and class as of June 30, 2013, and December 31, 2012.


	TDRs
(In thousands)	Accruing		Nonaccrual		Total		Related Allowance

June 30, 2013
Commercial and industrial	$	148		—		148	$	—
Construction and land development		—		1,601		1,601		107
Commercial real estate:
Owner occupied		885		299		1,184		120
Other		—		429		429		—

Total commercial real estate		885		728		1,613		120
Residential real estate:
Consumer mortgages		—		783		783		—
Investment property		—		225		225		—

Total residential real estate		—		1,008		1,008		—

Total	$	1,033		3,337		4,370	$	227

December 31, 2012
Commercial and industrial	$	169		—		169	$	—
Construction and land development		—		1,623		1,623		129
Commercial real estate:
Owner occupied		899		1,045		1,944		134
Other		—		432		432		—

Total commercial real estate		899		1,477		2,376		134
Residential real estate:
Consumer mortgages		—		819		819		—
Investment property		—		188		188		—

Total residential real estate		—		1,007		1,007		—

Total	$	1,068		4,107		5,175	$	263

At June 30, 2013, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured.

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


	Quarter ended June 30,						Six Months ended June 30,
(Dollars 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

2013:
Commercial real estate:
Other		—	$	—		—		1	$	431		431

Total commercial real estate		—		—		—		1		431		431
Residential real estate:
Consumer mortgages		—		—		—		1		131		131

Total residential real estate		—		—		—		1		131		131

Total		—	$	—		—		2	$	562		562

2012:
Construction and land development		—	$	—		—		2	$	2,842		1,753
Commercial real estate:
Owner occupied		3		2,349		1,406		4		3,167		2,225
Other		—		—		—		2		1,804		1,657

Total commercial real estate		3		2,349		1,406		6		4,971		3,882
Residential real estate:
Consumer mortgages		2		863		857		2		863		857

Total residential real estate		2		863		857		2		863		857

Total		5	$	3,212		2,263		10	$	8,676		6,492

The majority of the loans modified in a TDR during the quarters and six months ended June 30, 2013 and 2012, respectively, included permitting 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 considered to be less than a market rate.

For the quarter ended June 30, 2012, the decrease in the post modification outstanding recorded investment was primarily due to A/B note restructurings, where the B note was charged off. Total charge-offs related to B notes were $0.9 million for the quarter ended June 30, 2012.

For the six months ended June 30, 2012, the decrease in the post modification outstanding recorded investment was primarily due to principal payments made by borrowers at the date of modification for construction and land development loans and A/B note restructurings for two owner occupied commercial real estate loans. Total charge-offs related to B notes were $0.9 million for the six months ended June 30, 2012.

The following table summarizes the recorded investment in loans modified in a TDR within the previous 12 months for which there was a payment default (defined as 90 days or more past due) during the respective periods.


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands)	Number of Contracts		Recorded investment⁽¹⁾		Number of Contracts		Recorded investment⁽¹⁾

2013:
Construction and land development		—	$	—		1	$	1,197

Total		—	$	—		1	$	1,197

2012:
Construction and land development		—	$	—		1	$	2,386

Total		—	$	—		1	$	2,386

(1)	Amount as of applicable month end during the respective period for which there was a payment default.

NOTE 6: 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 Company periodically evaluates MSRs 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 allowance is established. The valuation allowance is adjusted as the fair value changes. Changes in the valuation allowance are recognized in earnings as a component of mortgage lending income.

The change in amortized MSRs and the related valuation allowance for the quarters and six months ended June 30, 2013 and 2012 are presented below.


	Quarters ended June 30,						Six months ended June 30,
(Dollars in thousands)	2013			2012			2013			2012

MSRs, net:
Beginning balance	$	1,728		$	1,260		$	1,526		$	1,245
Additions, net		218			198			478			366
Amortization expense		(102	)		(93	)		(226	)		(183)
Change in valuation allowance		135			(46	)		201			(109)

Ending balance	$	1,979		$	1,319		$	1,979		$	1,319

Valuation allowance included in MSRs, net:
Beginning of period	$	320		$	180		$	386		$	117
End of period		185			226			185			226

Fair value of amortized MSRs:
Beginning of period	$	1,994		$	1,260		$	1,526		$	1,245
End of period		2,453			1,319			2,453			1,319

NOTE 7: DERIVATIVE INSTRUMENTS

Financial derivatives are reported at fair value in other assets or other liabilities on the accompanying Consolidated Balance Sheets. 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 within other noninterest income on the accompanying Consolidated Statements of 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 swaps, the Company enters into offsetting positions in order to minimize the risk to the Company. These swaps qualify as derivatives, but are not designated as hedging instruments. At June 30, 2013, the Company had no derivative contracts designated as part of a hedging relationship 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 swap agreements at June 30, 2013 and December 31, 2012 is presented below.


			Other Assets		Other Liabilities
(Dollars in thousands)	Notional		Estimated Fair Value		Estimated Fair Value

June 30, 2013:
Pay fixed / receive variable	$	5,221		—		961
Pay variable / receive fixed		5,221		961		—

Total interest rate swap agreements	$	10,442		961		961

December 31, 2012:
Pay fixed / receive variable	$	5,367		—		1,210
Pay variable / receive fixed		5,367		1,210		—

Total interest rate swap agreements	$	10,734		1,210		1,210

NOTE 8: FAIR VALUE

Fair Value Hierarchy

“Fair value” is defined by 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 occurring in the principal market (or most advantageous market in the absence of a principal market) for an asset or liability at the measurement date. GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is 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, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable for the asset or liability, either directly or indirectly.

Level 3—inputs to the valuation methodology are unobservable and reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset or liability.

Level changes in fair value measurements

Transfers between levels of the fair value hierarchy are generally recognized at the end of the reporting period. 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 infrequent. For the six months ended June 30, 2013, there were no transfers between levels and no changes in valuation techniques for the Company’s financial assets and liabilities.

Assets and liabilities measured at fair value on a recurring basis

Securities available-for-sale

Fair values of securities available for sale were primarily measured using Level 2 inputs. For these securities, the Company obtains pricing from third party pricing services. These third party pricing services consider observable data that may include broker/dealer quotes, market spreads, cash flows, market consensus prepayment speeds, benchmark yields, reported trades, market consensus prepayment speeds, credit information and the securities’ terms and conditions. On a quarterly basis, management reviews the pricing received from the third party pricing services for reasonableness given current market conditions. As part of its review, management may obtain non-binding third party broker quotes to validate the fair value measurements. In addition, management will periodically submit pricing provided by the third party pricing services to another independent valuation firm on a sample basis. This independent valuation firm will compare the price provided by the third party pricing service with its own price and will review the significant assumptions and valuation methodologies used with management.

Fair values of individual issuer trust preferred securities were measured using Level 3 inputs. The valuation of individual issuer trust preferred securities requires significant management judgment due to the absence of observable quoted market prices, inherent lack of liquidity, and the long-term nature of such assets. In order to assist management in making its determination of fair value, the Company engages a third party firm who specializes in valuing illiquid securities. The third party firm utilizes a discounted cash flow model to estimate the fair value measurements for these securities. In making its final determination of fair value, management reviews the reasonableness of projected cash flows and the credit spread utilized in the discounted cash flow model after evaluating the financial performance of the individual community bank holding companies. The credit spread that is included in the discount rate applied to the projected future cash flows is an unobservable input that is significant to the overall fair value measurement for these securities. Significant increases (decreases) in the credit spread could result in a lower (higher) fair value measurement. Because these trust preferred securities were issued by individual community banks, the credit spread will generally increase when the financial performance of the issuer deteriorates and decrease as the financial performance of the issuer improves.

Interest rate swap agreements

The carrying amount of interest rate swap agreements was included in other assets and accrued expenses and other liabilities on the accompanying consolidated balance sheets. The fair value measurements for our interest rate swap agreements were based on information obtained from a third party bank. This information is periodically tested by the Company and validated against other third party valuations. If needed, other third party market participants may be utilized to corroborate the fair value measurements for our interest rate swap agreements. The Company classified these derivative assets and liabilities within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments.

The following table presents the balances of the assets and liabilities measured at fair value on a recurring basis as of June 30, 2013 and December 31, 2012, respectively, by caption, on the accompanying Consolidated Balance Sheets by ASC 820 valuation hierarchy (as described above).


(Dollars in thousands)	Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2013:
Securities available-for-sale:
Agency obligations	$	46,615		—		46,615		—
Agency RMBS		153,963		—		153,963		—
State and political subdivisions		69,522		—		69,522		—
Trust preferred securities		694		—		—		694

Total securities available-for-sale		270,794		—		270,100		694
Other assets ⁽¹⁾		961		—		961		—

Total assets at fair value	$	271,755		—		271,061		694

Other liabilities⁽¹⁾		961		—		961		—

Total liabilities at fair value	$	961		—		961		—


December 31, 2012:
Securities available-for-sale:
Agency obligations	$	39,525		—		39,525		—
Agency RMBS		141,460		—		141,460		—
State and political subdivisions		77,838		—		77,838		—
Trust preferred securities		652		—		—		652

Total securities available-for-sale		259,475		—		258,823		652
Other assets ⁽¹⁾		1,210		—		1,210		—

Total assets at fair value	$	260,685		—		260,033		652

Other liabilities⁽¹⁾		1,210		—		1,210		—

Total liabilities at fair value	$	1,210		—		1,210		—

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

Assets and liabilities measured at fair value on a nonrecurring basis

Loans held for sale

Loans held for sale are carried at the lower of cost or fair value. Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Loans held for sale are classified within Level 2 of the fair value hierarchy.

Impaired Loans

Loans considered impaired under ASC 310-10-35, Receivables, are loans for which, based on current information and events, it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be 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.

The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above.

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 values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, a loss is recognized in noninterest expense.

Mortgage servicing rights, net

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. 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. Periodically, the Company will review broker surveys and other market research to validate significant assumptions used in the model. The significant unobservable inputs include prepayment speeds or the constant prepayment rate (“CPR”) and the weighted average discount rate. 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.

The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of June 30, 2013 and December 31, 2012, respectively, by caption, on the accompanying Consolidated Balance Sheets and by FASB ASC 820 valuation hierarchy (as described above):


(Dollars in thousands)		Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2013:
Loans held for sale	$		4,824		—		4,824		—
Loans, net⁽¹⁾			5,124		—		—		5,124
Other real estate owned			3,609		—		—		3,609
Other assets ⁽²⁾			1,979		—		—		1,979
Total assets at fair value	$		15,536		—		4,824		10,712


December 31, 2012:
Loans held for sale	$		2,887		—		2,887		—
Loans, net⁽¹⁾			10,272		—		—		10,272
Other real estate owned			4,919		—		—		4,919
Other assets ⁽²⁾			1,526		—		—		1,526
Total assets at fair value	$		19,604		—		2,887		16,717

⁽¹⁾	Loans considered impaired under 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.

Quantitative Disclosures for Level 3 Fair Value Measurements

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


		Six months ended June 30,
(Dollars in thousands)		2013		2012
Beginning balance	$		652	$	1,986
Total realized and unrealized gains and (losses):
Included in net earnings			—		(6	)
Included in other comprehensive income			42		124
Sales			—		(974	)
Settlements			—		(500	)
Ending balance	$		694	$	630

For Level 3 assets measured at fair value on a recurring or non-recurring basis as of June 30, 2013, the significant unobservable inputs used in the fair value measurements are presented below.


(Dollars in thousands)	Carrying Amount		Valuation Technique	Significant Unobservable Input	Weighted Average of Input

Recurring:

Trust preferred securities	$	694	Discounted cash flow	Credit spread (basis points)	624 bp

Nonrecurring:

Impaired loans	$	5,124	Appraisal	Appraisal discounts (%)	13.9 %

Other real estate owned		3,609	Appraisal	Appraisal discounts (%)	9.2 %

Mortgage servicing rights, net		1,979	Discounted cash flow	Prepayment speed or CPR (%)	12.0 %

				Discount rate (%)	11.0 %

Fair Value of Financial Instruments

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 analyses. 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 are a good–faith estimate of the fair value of financial instruments held by the Company. 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:

Loans, net

Fair values for loans were calculated using discounted cash flows. The discount rates reflected current rates at which similar loans would be made for the same remaining maturities. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820 and generally produces a higher value than an exit-price approach. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

Time Deposits

Fair values for time deposits were estimated using discounted cash flows. The discount rates were based on rates currently offered for deposits with similar remaining maturities.

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.

The carrying value, related estimated fair value, and placement in the fair value hierarchy of the Company’s financial instruments at June 30, 2013 and December 31, 2012 are presented below. This table excludes financial instruments for which the carrying amount approximates fair value. Financial assets for which fair value approximates carrying value included cash and cash equivalents. Financial liabilities for which fair value approximates carrying value included noninterest-bearing demand, interest-bearing demand, and savings deposits due to these products having no stated maturity. In addition, financial liabilities for which fair value approximates carrying value included overnight borrowings such as federal funds purchased and securities sold under agreements to repurchase.


					Fair Value Hierarchy
(Dollars in thousands)	Carrying amount		Estimated fair value		Level 1 inputs		Level 2 inputs		Level 3 Inputs
June 30, 2013:
Financial Assets:
Loans, net (1)	$	384,269	$	393,855	$	—	$	—	$	393,855
Financial Liabilities:
Time Deposits	$	261,825	$	265,782	$	—	$	265,782	$	—
Long-term debt		27,217		29,324		—		29,324		—

December 31, 2012:
Financial Assets:
Loans, net (1)	$	391,470	$	399,533	$	—	$	—	$	399,533
Financial Liabilities:
Time Deposits	$	263,195	$	267,636	$	—	$	267,636	$	—
Long-term debt		47,217		51,752		—		51,752		—

(1)	Represents loans, net of unearned income and the allowance for loan losses.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

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 quarter and six month periods ended June 30, 2013 and 2012, as well as the information contained in our annual report on Form 10-K for the year ended December 31, 2012 and our quarterly report on Form 10-Q for the quarter ended March 31, 2013.

Special Notice Regarding Forward-Looking Statements

Certain of the statements made in this discussion and analysis 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 the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. You should not expect us to update any 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,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “further,” “plan,” “point to,” “project,” “could,” “intend,” “target” 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, including capital and liquidity requirements, 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;

•

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 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

•

the 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, 2012 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, Valley, 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 and Opelika. Loan production offices are located in Montgomery and Phenix City, Alabama.

Summary of Results of Operations


	Quarter ended June 30,				Six months ended June 30,
(Dollars in thousands, except per share amounts)	2013		2012		2013		2012

Net interest income (a)	$	5,597	$	5,728	$	11,120	$	11,143
Less: tax-equivalent adjustment		365		416		747		830

Net interest income (GAAP)		5,232		5,312		10,373		10,313
Noninterest income		2,071		1,814		3,726		6,678

Total revenue		7,303		7,126		14,099		16,991
Provision for loan losses		—		600		400		1,200
Noninterest expense		4,724		4,048		8,950		11,590
Income tax expense		672		449		1,153		707

Net earnings	$	1,907	$	2,029	$	3,596	$	3,494

Basic and diluted earnings per share	$	0.52	$	0.56	$	0.99	$	0.96

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

Financial Summary

The Company’s net earnings were $3.6 million for the first six months of 2013, compared to $3.5 million for the first six months of 2012. Basic and diluted earnings per share were $0.99 per share for the first six months of 2013, compared to $0.96 per share for the first six months of 2012.

Net interest income (tax-equivalent) was $11.1 million for the first six months of 2013 and 2012. Despite downward pressure on yields for earning assets, net interest income (tax-equivalent) was largely unchanged to due to continued improvement in the Company’s cost of funds. Average loans were $392.9 million in the first six months of 2013, an increase of $6.7 million, or 2%, from the first six months of 2012. Average deposits were $653.4 million in the first six months of 2013, an increase of $19.0 million, or 3%, from the first six months of 2012.

The provision for loan losses was $0.4 million and $1.2 million for the first six months of 2013 and 2012, respectively. The Company’s annualized net charge-off ratio was 0.34% in the first six months of 2013, compared to 0.84% in the first six months of 2012. The decrease in the provision for loan losses was primarily due to a decline in net charge-offs and an improvement in the overall credit quality of the loan portfolio, including lower levels of adversely classified and nonperforming loans.

Noninterest income was $3.7 million for the first six months of 2013, compared to $6.7 million in the first six months of 2012. The decrease was primarily due to a non-recurring gain of $3.3 million realized in the first six months of 2012 when the Company sold its interests in three affordable housing limited partnerships.

Noninterest expense was approximately $9.0 million in the first six months of 2013 compared to $11.6 million in the second quarter of 2012. The decrease was primarily due to a decrease in prepayment penalties on long-term debt. During the first six months of 2013, the Company repaid $20.0 million of FHLB advances with a weighted average interest rate of 3.38% and incurred prepayment penalties of $1.5 million. During the first six months of 2012, the Company repaid $38.0 million of FHLB advances with a weighted average interest rate of 4.26% and incurred prepayment penalties of $3.7 million.

Income tax expense was approximately $1.2 million for the first six months of 2013, compared to $0.7 million in the first six months of 2012. The Company’s effective tax rate for the first six months of 2013 was 24.28%, compared to 16.83% in the first six months of 2012. The Company’s effective tax rate increased during the first six months of 2013 when compared to the first six months of 2012 primarily due to an increase in the level of earnings before taxes and the Company’s annualized effective tax rate for 2012 was reduced by the reversal of a deferred tax valuation allowance of $0.5 million related to capital loss carry-forwards.

In the first six months of 2013, the Company paid cash dividends of $1.5 million, or $0.42 per share. The Company’s balance sheet remains “well capitalized” under current regulatory guidelines with a total risk-based capital ratio of 17.70% and a Tier 1 leverage ratio of 9.76% at June 30, 2013.

CRITICAL ACCOUNTING POLICIES

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

Except as discussed below, there have been no material changes to the Company’s critical accounting policies, estimates, and assumptions, or the judgments affecting the application of these estimates and assumptions in 2013.

The Company regularly re-evaluates its practices in determining the allowance for loan losses. During the quarter ended June 30, 2013, the Company implemented certain refinements to its allowance for loan losses methodology, specifically the way that historical loss factors are calculated. Prior to June 30, 2013, the Company calculated average losses for all loan segments using a rolling 6 quarter historical period. In order to better capture the effect of current economic conditions on the Company’s loan loss experience, the Company calculated average losses for all loan segments (except for the commercial real estate loan segment) using a rolling 8 quarter historical period for the quarter ended June 30, 2013. Based upon management’s review of charge-off trends for each loan segment, the Company continued to

calculate average losses for the commercial real estate loan segment using a rolling 6 quarter historical period for the quarter ended June 30, 2013. If the Company continued to calculate average losses for all loan segments using a rolling 6 quarter historical period, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $1.1 million at June 30, 2013. Other than the changes discussed above, the Company has not made any changes to its calculation of historical loss periods that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings.

Allowance for Loan Losses

An impairment allowance is recognized if the fair value of the loan is less than the recor

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