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UNITED SECURITY BANCSHARES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 13, 2014

DESCRIPTION OF THE BUSINESS

United Security Bancshares, Inc., a Delaware corporation ("USBI"), is a bank holding company with its principal offices in Thomasville, Alabama. USBI operates one commercial banking subsidiary, First United Security Bank (the "Bank" or "FUSB"). As of June 30, 2014, the Bank operated and served its customers through nineteen banking offices located in Brent, Bucksville, Butler, Calera, Centreville, Coffeeville, Columbiana, Fulton, Gilbertown, Grove Hill, Harpersville, Jackson, Thomasville, Tuscaloosa and Woodstock, Alabama. The Bank owns all of the stock of Acceptance Loan Company, Inc. ("ALC"), an Alabama corporation. ALC is a finance company organized for the purpose of making and purchasing consumer loans. ALC operates twenty-three finance company offices located in Alabama and southeast Mississippi. The headquarters of ALC is located in Jackson, Alabama. The Bank is the funding source for ALC.



The Bank provides a wide range of commercial banking services to small and medium-sized businesses, property managers, business executives, professionals and other individuals, while ALC's business is consumer oriented.

FUSB Reinsurance, Inc. ("FUSB Reinsurance"), an Arizona corporation and a wholly-owned subsidiary of the Bank, reinsures or "underwrites" credit life and credit accident and health insurance policies sold to the Bank's and ALC's consumer loan customers. FUSB Reinsurance is responsible for the first level of risk on these policies up to a specified maximum amount, and a primary third-party insurer retains the remaining risk. The third-party insurer is also responsible for performing most of the administrative functions of FUSB Reinsurance on a contract basis. Delivery of the best possible financial services to customers remains an overall operational focus of USBI and its subsidiaries (collectively, the "Company"). We recognize that attention to details and responsiveness to customers' desires are critical to customer satisfaction. The Company continues to upgrade technology, both in its financial services and in the training of its 293 full-time equivalent employees, to ensure customer satisfaction and convenience. The accounting principles and reporting policies of the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America ("GAAP") and with general practices within the financial services industry. Critical accounting policies relate to securities, loans, allowance for loan losses, derivatives and hedging. A description of these estimates, which significantly affect the determination of consolidated financial position, results of operations and cash flows, is set forth in Note 2, "Summary of Significant Accounting Policies," of the Notes to Consolidated Financial Statements in USBI's Annual Report on Form 10-K for the year ended December 31, 2013. 35



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The emphasis of this discussion is a comparison of assets, liabilities and shareholders' equity as of June 30, 2014 to December 31, 2013, while comparing income and expense for the three- and six-month periods ended June 30, 2014 and 2013.



All yields and ratios presented and discussed herein are based on the accrual basis and not on the tax-equivalent basis, unless otherwise indicated.

This information should be read in conjunction with the Company's unaudited consolidated financial statements and related notes appearing elsewhere in this report and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing in USBI's Annual Report on Form 10-K for the year ended December 31, 2013. EXECUTIVE OVERVIEW For both the three-month periods ended June 30, 2014 and 2013, net income of the Company was $1.2 million, or $0.20 per common share. For the six-month period ended June 30, 2014, net income of the Company was $2.0 million, or $0.33 per common share, compared to $2.1 million, or $0.34 per common share, for the six-month period ended June 30, 2013. The computation of net income per common share was the same on both a basic and diluted basis for all periods presented. The second quarter of 2014 represented the Company's eighth consecutive quarter of positive net income and the seventh consecutive quarter of reduction in nonperforming assets. However, the Bank's loan portfolio decreased during the first six-months of 2014, partially offset by an increase in consumer loans at ALC. Although the national economy has continued to show modest signs of improvement, primarily based on metrics related to unemployment, the demand for new loans in the geographical locations served by the Bank remains weak, and the lending environment is fiercely competitive. Management has remained vigilant to ensure that new loan production at the Bank is thoroughly evaluated in accordance with the Company's established credit policies and procedures. During the first six months of 2014, Bank management's primary focus has continued to be the work out of nonperforming assets. Consolidated nonperforming assets as a percentage of net loans and OREO have declined from 6.74% as of December 31, 2013 to 5.72% as of June 30, 2014. We are encouraged by the modest increase in the loan portfolio at ALC during the first six months of 2014; however, we remain similarly vigilant at ALC in the evaluation of credit quality, particularly with respect to lending on real estate. ALC management continues to implement a strategy focused on shifting the mix of loans away from real estate lending and into consumer lending. We believe that this shift will result in a portfolio of higher credit quality. As of June 30, 2014, consumer loans represented 69.0% of ALC's loan portfolio, compared with 64.8% as of December 31, 2013. As a result of the reduction in the consolidated loan portfolio, management has supplemented interest income by increasing investment in the securities portfolio. The securities portfolio increased $39.0 million comparing June 30, 2014 to December 31, 2013. As a result, interest income on investment securities increased $0.7 million, or 50.4%, comparing the six-months ended June 30, 2014 to the six-months ended June 30, 2013. Management remains focused on ensuring that the duration of the investment portfolio will remain within established guidelines to ensure that appropriate cash flows are available to fund future loan growth. As of June 30, 2014, the average duration of the investment portfolio was 3.2 years. Management continues to maintain excess funding capacity to provide adequate liquidity for ongoing operations. We benefit from a strong deposit base, a highly liquid investment portfolio and access to funding from a variety of external sources, such as federal funds lines, Federal Home Loan Bank ("FHLB") advances and brokered deposits.



Other financial results as of and for the six-month period ended June 30, 2014, compared with the six-month period ended June 30, 2013, included the following:

Total assets for the Company increased 0.2% to $570.7 million as of June 30, 2014, compared with $569.8 million as of December 31, 2013. Loans, net of unearned interest and fees, decreased 9.9% for the Company



to $279.8 million as of June 30, 2014, compared with $310.3 million as of

December 31, 2013. At the Bank, loans, net of unearned interest and fees,

decreased $31.1 million to $208.6 million as of June 30, 2014, compared

with $239.7 million as of December 31, 2013. The decrease at the Bank was

partially offset by an increase in loans, net of unearned interest and

fees, at ALC to $71.1 million as of June 30, 2014, from $70.6 million as

of December 31, 2013. 36



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The Company's allowance for loan losses decreased $1.7 million, or 18.3%,

to $7.7 million as of June 30, 2014, compared with $9.4 million as of

December 31, 2013. The total decrease included a decrease at the Bank of

$1.2 million and a decrease at ALC of $0.5 million. The Company's investment securities portfolio (combining



available-for-sale and held-to-maturity investments) increased 22.9% to

$209.9 million as of June 30, 2014, compared with $170.8 million as of December 31, 2013. Total deposits at the Company decreased 0.2% to $483.3 million as of June 30, 2014, compared with $484.3 million as of December 31, 2013. As of June 30, 2014, the Company's ratio of loans, net of unearned

interest and fees, to deposits was 57.9%, compared with 64.1% as of December 31, 2013.



As of June 30, 2014, the Company's total risk-based capital was 21.3%,

significantly above the minimum requirement of 10% to achieve the highest

regulatory rating of "well-capitalized." Net interest income was $14.5 million for the six-months ended June 30,



2014, compared with $15.5 million for the same period in 2013, a decrease

of 6.4%. The Company's provision for loan losses totaled $0.2 million for the six-months ended June 30, 2014, compared with $0.6 million for the same period in 2013, a decrease of 73.2%. The amount for the six-months ended



June 30, 2014 was comprised of a charge of $0.7 million at ALC, partially

offset by a credit of $0.5 million at the Bank. Non-interest income for the Company totaled $2.6 million for the

six-months ended June 30, 2014, compared with $2.9 million for the same period in 2013, a decrease of 7.7%.



Non-interest expense for the Company totaled $14.1 million for the

six-months ended June 30, 2014, compared with $14.9 million for the same

period in 2013, a decrease of 5.1%. The Company's provision for income taxes totaled approximately $0.9



million for both six-month periods ended June 30, 2014 and June 30, 2013.

Shareholders' equity for the Company totaled $73.2 million, or book value

of $12.15 per outstanding common share, as of June 30, 2014, compared with

$70.1 million, or book value of $11.63 per outstanding common share, as of

December 31, 2013. The Company's return on average assets for the six-months ended June 30, 2014 was 0.71%, compared with 0.74% for the same period in 2013. The Company's return on average common shareholders' equity for the six-months ended June 30, 2014 was 6.79%, compared with 6.04% for the same period in 2013. RESULTS OF OPERATIONS Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 (Dollars in Thousands) Interest income $ 7,930$ 8,432$ 15,776$ 17,026 Interest expense 630 737 1,275 1,526 Net interest income 7,300 7,695 14,501 15,500 Provision (reduction in reserve) for loan losses (264 ) 53 150 559 Net interest income after provision (reduction in reserve) for loan losses 7,564 7,642 14,351 14,941 Non-interest income 1,485 1,228 2,632 2,851 Non-interest expense 7,223 7,176 14,107 14,868 Income before income taxes 1,826 1,694 2,876 2,924 Provision for income taxes 608 512 884 856 Net income $ 1,218$ 1,182$ 1,992$ 2,068 37



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Net Interest Income

Net interest income is comprised of the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in interest rates, as well as volume and mix changes in earning assets and interest-bearing liabilities, can materially impact net interest income. The Company's earning assets are comprised of loans, taxable and nontaxable investments and federal funds sold. Interest-bearing liabilities are comprised of interest-bearing demand deposits, savings and time deposits, as well as short-term borrowings and long-term debt. Net interest income decreased $0.4 million, or 5.1%, for the second quarter of 2014, and decreased $1.0 million, or 6.5%, for the six-months ended June 30, 2014, compared to the same periods in 2013. Interest income in the second quarter of 2014 decreased $0.5 million, or 6.0%, compared to the second quarter of 2013. For the six-months ended June 30, 2014, interest income decreased $1.3 million, or 7.3%, compared with the same period in 2013. The yield on average interest earning assets declined to 6.06% for the second quarter of 2014, compared with 6.49% for the second quarter of 2013. For the six-months ended June 30, 2014, yield on average interest earning assets declined to 6.03% from 6.07% for the same period in 2013. Although average interest-earning assets have remained relatively stable in total, the decline in interest income resulted primarily from a shift in the mix of earning assets. As a result of declining loan balances, the Company has continued to invest available funds in investment securities, which generally provide lower yields than loans. Loans, net of the allowance for loan losses, declined to $272.1 million as of June 30, 2014, compared with $300.9 million as of December 31, 2013. Investment securities (including both the available-for-sale and held-to-maturity portfolios) have increased to $209.9 million as of June 30, 2014, from $170.8 million as of December 31, 2013. Interest expense decreased $0.1 million, or 14.5%, comparing the second quarter of 2014 to the second quarter of 2013. For the six-months ended June 30, 2014, interest expense decreased $0.3 million, or 16.5%, compared to the same period of 2013. Average interest-bearing liabilities totaled $426.2 million and $421.7 million for the quarters ended June 30, 2014 and 2013, respectively. For the six-months ended June 30, 2014, average interest-bearing liabilities totaled $426.2 million, compared to $425.7 million for the six-months ended June 30, 2013. The average funding rate declined to 0.59% from 0.69% comparing the second quarter of 2014 to the second quarter of 2013, and to 0.60% from 0.73% comparing the six-months ended June 30, 2014 and 2013, respectively. The decrease resulted primarily from a mix-shift away from higher cost time deposits to demand deposits, as well as repricing of longer-term time deposits at lower rates. Management is continuing to focus efforts on generating quality loans and the deployment of asset/liability management strategies to manage risks associated with interest rate fluctuations. However, net interest income could continue to experience downward pressure due to increased competition for quality loan opportunities, lower reinvestment yields in the securities portfolio, and fewer opportunities to reduce future funding costs.



Provision for Loan Losses

The provision for loan losses is an expense used to establish the allowance for loan losses. Actual loan losses, net of recoveries, are charged directly to the allowance for loan losses. The expense recorded each reporting period is a reflection of actual net losses experienced during the period and management's judgment as to the adequacy of the allowance to absorb losses inherent in the portfolio. The Company's provision for loan losses was a credit of $0.3 million for the quarter ended June 30, 2014, compared to a charge of $0.1 million for the quarter ended June 30, 2013. For the six-months ended June 30, 2014, the Company's provision for loan losses was a charge of $0.2 million, compared to a charge of $0.6 million for the six-months ended June 30, 2013. Net charge-offs for the Company totaled $0.6 million and $1.9 million for the three- and six-month periods ended June 30, 2014, respectively, compared with $5.2 million and $8.2 million, respectively, for the same periods in 2013. Net charge-offs at the Bank were $0.2 million for the second quarter of 2014 and $0.7 million for the six-months ended June 30, 2014, compared to $4.7 million for the second quarter of 2013 and $7.0 million for the six-months ended June 30, 2013. At ALC, net charge-offs were $0.5 million for the second quarter of 2014 and $1.1 million for the six-months ended June 30, 2014, compared to $0.6 million for the second quarter of 2013 and $1.2 million for the six-months ended June 30, 2013. The decreases in net charge-offs and reductions in the provision for loan losses for both the second quarter and the first six months of 2014 as compared with 2013 resulted primarily from increases in the amount of recoveries on loans previously charged off, as well as an overall improvement in the credit quality and other inherent risks of the loan portfolio at both the Bank and ALC. 38



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Based on our evaluation of the portfolio, management believes that the allowance for loan losses is adequate to absorb losses inherent in the loan portfolio as of June 30, 2014. While we believe that the methodologies and calculations we use for estimating the allowance for loan losses are adequate, our conclusions are based on estimates and judgments and are therefore approximate and imprecise. Factors beyond our control, such as changes in economic conditions impacting the national economy or the local markets in which we operate, may negatively and materially affect asset quality and the adequacy of the allowance for loan losses, as well as the resulting provision for loan losses.



Non-Interest Income

Non-interest income represents fees and income derived from sources other than interest-earning assets. Total non-interest income increased $0.3 million, or 20.9%, for the second quarter of 2014, compared to the second quarter of 2013. For the six-month period ended June 30, 2014, total non-interest income decreased $0.2 million, or 7.7%, compared to the same period in 2013. The following table presents the major components of non-interest income for the periods indicated. Expanded discussion of certain significant non-interest income items and fluctuations is provided below the table. Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 (Dollars in Thousands) Service charges and other fees on deposit accounts $ 491$ 558$ 991$ 1,148 Credit insurance commissions and fees 93 169 233 279 Bank-owned life insurance 105 110 209 221 Other income 796 391 1,199 1,203 Total non-interest income $ 1,485$ 1,228$ 2,632$ 2,851



Service Charges and Other Fees on Deposit Accounts

Service charges and fees on deposit accounts decreased $0.1 million, or 12.1%, for the quarter ended June 30, 2014, and decreased $0.2 million, or 13.7%, for the six-months ended June 30, 2014, compared with the same periods in 2013. These decreases were primarily due to decreased fees generated from customer overdrafts and non-sufficient funds charges. Revenues from these sources have generally declined in recent years. Management continues to search for new sources of fee income from new financial services and products; however, income from non-interest sources is expected to continue to decline as a percentage of total revenue for the foreseeable future.



Credit Insurance Commissions and Fees

Credit insurance commissions and fees are generated from credit life and credit accident and health insurance policies sold to the Bank's and ALC's consumer loan customers through FUSB Reinsurance. Commission and fee income declined 45.0% during the second quarter of 2014, compared with the second quarter of 2013, and by 16.5% comparing the six-months ended June 30, 2014 to the six-months ended June 30, 2013. These declines resulted from the Company's shift in focus in the consumer lending portfolio, primarily at ALC, to lending strategies and customers that are less reliant on credit insurance. Management continues to search for new sources of non-interest income; however, income from credit insurance commissions and fees is not expected to increase at a significant level for the foreseeable future.



Other Income

Other non-interest income primarily consists of fee income generated by the Bank for ancillary services, such as letters of credit, ATMs, debit and credit cards and wire transfers, as well as realized gains on sale of investment securities. In addition, other income is generated at ALC for services including ALC's auto club program and certain real estate rental. 39



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Other income increased $0.4 million comparing the quarter ended June 30, 2014 to the quarter ended June 30, 2013. A portion of this increase resulted from the dissolution of one of the Bank's limited partnership investments that was previously carried on the balance sheet as a cost method investment. Upon dissolution of the partnership, the Bank received payment of an amount representing its residual interest in the partnership upon dissolution. The difference between the residual interest received and the carrying amount ($0.2 million) was recorded as other non-interest income. In addition, during the second quarter of 2014, the Company received approximately $0.2 million in reimbursement from a vendor related to non-interest income that had previously been remunerated to customers related to a product that was discontinued. Given the nature of these fees, there is uncertainty as to the level of revenue that will be sustained from these sources in the future.



Non-Interest Expense

Non-interest expense increased by less than $0.1 million during the second quarter of 2014, compared with the second quarter of 2013. For the six-months ended June 30, 2014, non-interest expense decreased $0.8 million, or 5.1%, compared to the six-months ended June 30, 2013. The following table presents the major components of non-interest expense for the periods indicated. Expanded discussion of certain significant non-interest expense items and fluctuations is provided below the table. Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 (Dollars in Thousands) Salaries and employee benefits $ 4,141$ 3,965$ 8,223$ 7,977 Occupancy 467 500 967 961 Furniture and equipment 308 281 623 564 Other real estate/foreclosure expense: Write-downs, net of gain or loss on sale 183 424 148 1,067 Carrying costs 142 108 277 372 Total other real estate/foreclosure expense 325 532 425 1,439 FDIC insurance assessments 189 170 367 365 Other 1,793 1,728 3,502 3,562 Total non-interest expense $ 7,223$ 7,176$ 14,107$ 14,868



Salaries and Employee Benefits

Salaries and employee benefits expense, the largest category of non-interest expense, increased $0.2 million, or 4.4%, and $0.2 million, or 3.1%, for the three- and six-month periods ended June 30, 2014, respectively, compared to the same periods in 2013. At both the Bank and ALC, these increases were primarily due to general merit increases. Salaries and employee benefits expenses at the Bank totaled $2.6 million and $5.1 million for the three- and six-month periods ended June 30, 2014, respectively, compared with $2.5 million and $5.1 million for the same periods in 2013. At ALC, salaries and benefits expenses totaled $1.5 million and $3.0 million for the three- and six-month periods ended June 30, 2014, respectively, compared with $1.5 million and $2.8 million for the same periods in 2013. This category of expenses also includes deferred fees paid by USBI to members of Company's board of directors. The total of these fees for all periods presented was less than $0.1 million.



Other Real Estate / Foreclosure Expense

Other real estate / foreclosure expense decreased $0.2 million in the second quarter of 2014, compared with the second quarter of 2013, and decreased $1.0 million for the six-months ended June 30, 2014, compared with the same period in 2013. These expenses include both the cost of carrying OREO and write-downs on OREO. Cost of carrying OREO includes property taxes, attorney fees, maintenance, security and the cost of obtaining independent property appraisals. Write-downs include impairments recorded on existing OREO properties in order to carry the property at the lower of cost or fair value, less estimated cost to sell. The table above presents write-downs netted with gains or losses recorded upon the sale of OREO properties. 40



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The decrease in other real estate / foreclosure expense for the six-months ended June 30, 2014, compared with the same period in 2013, resulted primarily from a decrease in net losses on sale of other real estate totaling $0.6 million and $0.2 million at ALC and the Bank, respectively. Cost of carrying was reduced $0.1 million at the Bank comparing the six-months ended June 30, 2014 with the same period in 2013. The reduction in write-downs at both the Bank and ALC resulted from management's ongoing efforts to sell OREO, along with stabilizing real estate values in certain service areas as compared with the prior year. Although management continues efforts to work through problem assets and to sell OREO, there continues to be uncertainty with respect to economic conditions and real estate values in certain of the service areas in which both the Bank and ALC operate. If the national or local economy weakens, or if real estate values decline further in our primary service areas, additional write-downs of existing OREO could be required, and the level of acquisition of properties into OREO could increase, resulting in increased carrying cost.



Provision for Income Taxes

Income tax expense was $0.6 million for the second quarter of 2014, compared with $0.5 million for the second quarter of 2013. For both six-month periods ended June 30, 2014 and 2013, respectively, income tax expense was $0.9 million. The effective tax rate was 33.3% for the second quarter of 2014, compared with 30.2% for the second quarter of 2013. For the six-month period ended June 30, 2014, the effective tax rate was 30.7%, compared with 29.3% for the six-months ended June 30, 2013. The increase in the effective tax rates for both the three- and six-month periods in 2014 compared with 2013 was primarily due to decreases in tax exempt interest income as the Company's holdings of municipal bonds have declined. BALANCE SHEET ANALYSIS Investment Securities The investment securities portfolio is used by management to generate interest income, to provide liquidity and for use as collateral for public deposits and wholesale funding. Risk and return can be adjusted by altering duration, composition and/or balance of the portfolio. The estimated average maturity of the investment portfolio was 3.2 years and 3.5 years as of June 30, 2014 and December 31, 2013, respectively. Available-for-sale securities are recorded at estimated fair value, with unrealized gains or losses recognized, net of taxes, in accumulated other comprehensive income, a separate component of shareholders' equity. At June 30, 2014, available-for-sale securities totaled $169.1 million, or 80.5% of the total investment portfolio, compared to $135.8 million, or 79.1% of the total portfolio, as of December 31, 2013. As of June 30, 2014, available-for-sale securities consisted of residential and commercial mortgage-backed securities, U.S. Treasury securities, obligations of U.S. government sponsored agencies and obligations of state and political subdivisions. Held-to-maturity securities are recorded at amortized cost and represent securities that the Company both intends and has the ability to hold to maturity. As of June 30, 2014, held-to-maturity securities totaled $40.8 million, or 19.5% of the total investment portfolio, compared to $35.1 million, or 20.4% of the total investment portfolio, as of December 31, 2013. As of June 30, 2014, held-to-maturity securities consisted of commercial mortgage-backed securities, obligations of U.S. government sponsored agencies, and obligations of states and political subdivisions.



Loans and Allowance for Loan Losses

Total loans outstanding, net of unearned income, decreased $30.5 million, from $310.3 million as of December 31, 2013, to $279.8 million as of June 30, 2014. Loans outstanding at the Bank totaled $208.6 million at June 30, 2014, compared with $239.7 million at December 31, 2013, a decrease of $31.1 million. This decrease resulted primarily from significant loan payoffs during the first six months of 2014, as well as the migration of nonperforming loans to OREO. In addition, the lending environment remains fiercely competitive in the Bank's primary locations, which has impeded new loan production. Loans outstanding at ALC totaled $71.1 million at June 30, 2014, compared with $70.6 million at December 31, 2013, an increase of $0.6 million. Although loan growth is a major focus of management at both the Bank and ALC for the coming years, quality loan growth will remain a challenge. The Company's allowance for loan losses totaled $7.7 million, or 2.74% of loans net of unearned income, as of June 30, 2014, compared with $9.4 million, or 3.03% of loans net of unearned income, as of December 31, 2013. At the Bank, the allowance for loan losses was reduced from $6.3 million to $5.0 million during the six-months ended June 30, 2014. At ALC, the allowance for loan losses was reduced from $3.1 million to $2.6 million during the six- 41



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months ended June 30, 2014. The decreases at both the Bank and ALC resulted from continued problem asset resolution by management during the first six months of 2014, and overall improvement in the credit quality of the loan portfolio, including lower levels of non-accrual loans. We believe that growing the loan portfolio at the Bank and ALC with quality customers, along with continued efforts to reduce non-performing loans, should result in continued reduction in the allowance for loan losses as a percentage of loans. The allowance for loan losses is maintained at a level that, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the portfolio and change in its risk profile, credit concentrations, historical trends and economic conditions. Though management believes that the allowance for loan losses is adequate, taking into consideration the current economic environment and the amount of subjective judgment involved in the calculation, there can be no assurance that the allowance for loan losses is sufficient, and ultimate losses may vary from estimates. Factors beyond management's control (such as conditions in the national economy, local real estate markets or industry conditions) may have a material adverse effect on our asset quality and the adequacy of the allowance for loan losses. Estimates are reviewed periodically. As adjustments become necessary, they are reported in earnings in the period in which they become known. Non-Performing Assets



Non-performing assets as of June 30, 2014, December 31, 2013 and June 30, 2013 were as follows (dollars in thousands):

Consolidated June 30, December 31, June 30, 2014 2013 2013



Loans accounted for on a non-accrual basis $ 4,828$ 10,565$ 14,847 Accruing loans past due 90 days or more

1,460 1,661 1,674 Real estate acquired in settlement of loans 10,308 9,310 12,377 Total $ 16,596$ 21,536$ 28,898 Non-performing assets as a percentage of net loans and other real estate 5.72 % 6.74 % 8.60 % FUSB June 30, December 31, June 30, 2014 2013 2013



Loans accounted for on a non-accrual basis $ 4,510$ 10,372$ 14,618 Accruing loans past due 90 days or more

5 - - Real estate acquired in settlement of loans 9,484 8,464 11,602 Total $ 13,999$ 18,836$ 26,220 Non-performing assets as a percentage of net loans and other real estate 6.42 % 7.59 % 9.94 % ALC June 30, December 31, June 30, 2014 2013 2013



Loans accounted for on a non-accrual basis $ 318 $ 193 $ 229 Accruing loans past due 90 days or more

1,455 1,661 1,674 Real estate acquired in settlement of loans 824 846 775 Total $ 2,597$ 2,700$ 2,678 Non-performing assets as a percentage of net loans and other real estate 3.61 % 3.78 % 3.71 % Non-performing assets as a percentage of loans, net of unearned interest and other real estate, were 5.72% as of June 30, 2014 and 6.74% at December 31, 2013. Non-performing assets decreased $4.9 million as of June 30, 2014 compared to December 31, 2013. Loans on non-accrual status decreased $5.74 million, and loans past due 90 days or more and still accruing decreased $0.2 million. As of June 30, 2014, other real estate acquired in settlement of loans consisted of 17 residential properties and 27 commercial properties totaling $9.5 million at the Bank, and 37 residential properties and 3 commercial properties totaling $0.8 million at ALC. Management is making efforts to dispose of these properties in a timely manner, and expects the level of non-performing assets to decline over time; however, continued weakness in real estate markets in certain of our service areas is negatively impacting this process. Management reviews these loans and reports monthly to the Bank's Board of Directors on their status. 42



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Deposits

Total deposits decreased 1.2%, from $484.3 million as of December 31, 2013 to $483.3 million as of June 30, 2014. Core deposits, which exclude time deposits of $100,000 or more, provide for a relatively stable funding source that supports earning assets. Core deposits totaled $398.2 million, or 82.4% of total deposits, as of June 30, 2014, compared with $391.3 million, or 80.8% of total deposits, as of December 31, 2013. Deposits, in particular core deposits, have historically been the Company's primary source of funding and have enabled the Company to successfully meet both short-term and long-term liquidity needs. Management anticipates that such deposits will continue to be the Company's primary source of funding in the future, and is making efforts to ensure that an adequate level of deposits are retained to fund the Company's activities. However, various economic and competitive factors could affect this lending source in the future. The Company's loan to deposit ratio was 56.3% as of June 30, 2014 and 62.1% as of December 31, 2013. Borrowings Other interest-bearing liabilities consist of federal funds purchased, securities sold under agreements to repurchase and FHLB advances. This category continues to be utilized as an alternative source of funds. During the second quarter of 2014, these borrowings represented 1.03% of average interest-bearing liabilities, compared with 0.09% in the second quarter of 2013.



Shareholders' Equity

As of June 30, 2014, shareholders' equity totaled $73.2 million, or 12.8% of total assets, compared with $70.1 million, or 12.3% of total assets, as of December 31, 2013. The increase in shareholders' equity during the six-months ended June 30, 2014 resulted primarily from net income of $2.0 million, combined with the increase of $0.9 million (net of tax) in accumulated other comprehensive income due to unrealized holding gains on available-for-sale investment securities, which are recorded at estimated fair value. The fair value of the available-for-sale portfolio fluctuates significantly based on changes in interest rates. Accordingly, the unrealized gains during the first six months of 2014 are not necessarily indicative of future performance of the portfolio.



LIQUIDITY AND CAPITAL RESOURCES

The Bank's primary sources of funds are customer deposits, FHLB advances, repayments of loan principal and interest from loans and investments. While scheduled principal repayments on loans and mortgage-backed securities are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition, making them less predictable. The Bank manages the pricing of its deposits to maintain a desired deposit balance. In addition, the Bank invests in short-term interest-earning assets, which provide liquidity to meet lending requirements. As of June 30, 2014, the Bank had up to $171.2 million in borrowing capacity (subject to available collateral) from the FHLB and $18.8 million in established federal funds lines. As of December 31, 2013, the Bank had up to $170.9 million in borrowing capacity (subject to available collateral) from the FHLB and $18.8 million in established federal funds lines. Of this capacity, the Bank had $5.0 million in outstanding borrowings as of both June 30, 2014 and December 31, 2013. USBI and the Bank are required to maintain certain levels of regulatory capital. As of June 30, 2014 and December 31, 2013, USBI and the Bank were in compliance with all regulatory capital requirements. Management is not aware of any condition that currently exists that would have an adverse effect on the liquidity, capital resources or operation of the Company. However, the Company is a defendant in certain claims and legal actions arising in the ordinary course of business. See Note 14 to Item 1, "Guarantees, Commitments and Contingencies," for a discussion of such claims and legal actions. 43



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