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CITIZENS BANCSHARES CORP /GA/ - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS

August 14, 2014

INTRODUCTION

Citizens Bancshares Corporation (the "Company") is a holding company that provides a full range of commercial and personal banking services to individuals and corporate customers in its primary market areas, metropolitan Atlanta and Columbus, Georgia, and Birmingham and Eutaw, Alabama through its wholly owned subsidiary, Citizens Trust Bank (the "Bank"). The Bank is a member of the Federal Reserve System and operates under a state charter. The Company serves its customers through 10 full-service financial centers in Georgia and Alabama. Forward Looking Statements

In addition to historical information, this report on Form 10-Q may contain forward-looking statements. For this purpose, any statements contained herein, including documents incorporated by reference, that are not statements of historical fact may be deemed to be forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties. Without limiting the foregoing, the words "believe," "anticipates," "plan," expects," and similar expressions are intended to identify forward-looking statements. Forward-looking statements are based on current management expectations and, by their nature, are subject to risk and uncertainties because of the possibility of changes in underlying factors and assumptions. Actual conditions, events or results could differ materially from those contained in or implied by such forward-looking statements for a variety of reasons, including: sharp and/or rapid changes in interest rates; significant changes in the economic scenario from the current anticipated scenario which could materially change anticipated credit quality trends and the ability to generate loans and gather deposits; significant delay in or inability to execute strategic initiatives designed to grow revenues and/or control expenses; unanticipated issues during the integration of acquisitions; and significant changes in accounting, tax or regulatory practices or requirements. The Company undertakes no obligation to, nor does it intend to, update forward-looking statements to reflect circumstances or events that occur after the date hereof or to reflect the occurrence of unanticipated events. The following discussion is of the Company's financial condition as of June 30, 2014 and December 31, 2013, and the changes in the financial condition and results of operations for the three and six month periods ended June 30, 2014 and 2013.



Critical Accounting Policies

In response to the Securities and Exchange Commission's ("SEC") Release No. 33-8040, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, the Company has identified the following as the most critical accounting policies upon which its financial status depends. The critical policies were determined by considering accounting policies that involve the most complex or subjective decisions or assessments. The Company's most critical accounting policies relate to: Investment Securities - The Company classifies investments in one of three categories based on management's intent upon purchase: held to maturity securities which are reported at amortized cost, trading securities which are reported at fair value with unrealized holding gains and losses included in earnings, and available for sale securities which are recorded at fair value with unrealized holding gains and losses included as a component of accumulated other comprehensive income. The Company had no investment securities classified as trading securities during 2014 or 2013. Page 29 of 48



Premiums and discounts on available for sale and held to maturity securities are amortized or accreted using a method which approximates a level yield.

Gains and losses on sales of investment securities are recognized upon disposition, based on the adjusted cost of the specific security. A decline in market value of any security below cost that is deemed other than temporary is charged to earnings or OCI resulting in the establishment of a new cost basis for the security. Loans- Loans are reported at principal amounts outstanding less unearned income and the allowance for loan losses. Interest income on loans is recognized on a level-yield basis. Loan fees and certain direct origination costs are deferred and amortized over the estimated terms of the loans using the level-yield method. Discounts on loans purchased are accreted using the level-yield method over the estimated remaining life of the loan purchased. Allowance for Loan Losses- The Company provides for estimated losses on loans receivable when any significant and permanent decline in value occurs. These estimates for losses are based, not only on individual assets and their related cash flow forecasts, sales values, and independent appraisals, but also on the volatility of certain real estate markets, and the concern for disposing of real estate in distressed markets. For loans that are pooled for purposes of determining the necessary provisions, estimates are based on loan types, history of charge-offs, and other delinquency analyses. Therefore, the value used to determine the provision for losses is subject to the reasonableness of these estimates. The adequacy of the allowance for loan losses is reviewed on a monthly basis by management and the Board of Directors. On a semi-annual basis an independent comprehensive review of the methodology and allocation of the allowance for loan losses is performed. This assessment is made in the context of historical losses as well as existing economic conditions, and individual concentrations of credit. Loans are charged against the allowance when, in the opinion of management, such loans are deemed uncollectible and subsequent recoveries are added to the allowance. Other Real Estate Owned - Other real estate owned is reported at the lower of cost or fair value less estimated disposal costs, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. Any excess of the loan balance at the time of foreclosure over the fair value of the real estate held as collateral is treated as a charge-off against the allowance for loan losses. Any subsequent declines in value are charged to earnings. Income Taxes - Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date. In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company's assets and liabilities result in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such assets is required. A valuation allowance is provided for the portion of a deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies. The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company's financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain income tax positions have been recorded. A description of other accounting policies are summarized in Note 1, Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements of the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The Company has followed those policies in preparing this report. Page 30 of 48 FINANCIAL CONDITION

At June 30, 2014, the Company had total assets of $406,773,000 compared to $387,733,000 at December 31, 2013. The increase is primarily related to a $26,668,000 increase in interest bearing deposits with banks, partially offset by a $3,438,000 decrease in cash and due from banks and a $5,209,000 decrease in available for sale investment securities. Interest-bearing deposits with banks primarily represent funds maintained on deposit at the Federal Reserve Bank (FRB) and the Federal Home Loan Bank (FHLB). These funds fluctuate daily and are used to manage the Company's liquidity position in light of the current economic environment. At June 30, 2014, total assets consisted primarily of $136,824,000 in investment securities and $184,469,000 in net loans representing 34% and 45% of total assets, respectively. Investment securities and net loans represented 37% and 47% of total assets at December 31, 2013. Loans typically provide higher interest yields than other types of interest-earning assets and, therefore, continue to be the largest component of the Company's assets. Net loans receivable increased by $2,350,000 at June 30, 2014 compared to December 31, 2013. This increase was primarily due to continued efforts by the Company to pursue opportunities to enhance its lending strategies and continued investment in the resources and lending associates to strengthen lending efforts.



At June 30, 2014, OREO decreased by $596,000 to $6,808,000 compared to $7,404,000 reported at the year-end of 2013. This decrease primarily related to the sale of OREO properties and limited additions to the OREO balance.

Cash value of life insurance, a comprehensive compensation program for directors and certain senior managers of the Company, increased $187,000 to $10,135,000 at June 30, 2014. The increase primarily represents the earnings on the premiums paid over the life of the insurance contract. The Company's liabilities at June 30, 2014 totaled $358,219,000 and consisted primarily of $353,524,000 in deposits, representing an increase of $16,562,000 compared to total deposits of $336,962,000 at December 31, 2013. FHLB advances totaled $264,000 compared to $273,000 at December 31, 2013. The Company's asset/liability management program, which monitors the Company's interest rate sensitivity as well as volume and mix changes in earning assets and interest bearing liabilities, may impact the growth of the Company's balance sheet as it seeks to maximize net interest income. INVESTMENT SECURITIES The composition of the Company's investment securities portfolio reflects the Company's investment strategy of maximizing portfolio yields commensurate with risk and liquidity considerations. The primary objective of the Company's investment strategy is to maintain an appropriate level of liquidity and provide a tool to assist in controlling the Company's interest rate sensitivity position, while at the same time producing adequate levels of interest income. Page 31 of 48 Other investments consist of Federal Home Loan Bank and Federal Reserve Bank stock which are restricted and have no readily determined market value. The Company is required to maintain an investment in the FHLB and the FRB as part of its membership conditions. The level of investments at the FHLB is primarily determined by the amount of outstanding advances. The FRB investment level is 6 percent of the par value of the bank's common stock outstanding and paid-in-capital. These investments are carried at cost.



At June 30, 2014 and December 31, 2013, the investment securities portfolio represented approximately 34% and 37%, respectively, of the Company's total assets.

LOANS Loans outstanding, by classification, are summarized as follows (in thousands): June 30, December 31, 2014 2013



Commercial, financial, and agricultural $ 23,854$ 20,292 Commercial Real Estate

118,280 120,180 Single-Family Residential 33,739 34,864 Construction and Development 5,078 3,626 Consumer 6,476 6,314 187,427 185,276 Allowance for loan losses 2,958 3,157 $ 184,469$ 182,119 The Company does not have any concentrations of loans exceeding 10% of total loans of which management is aware and which are not otherwise disclosed as a category of loans in the table above or in other sections of this Quarterly Report on Form 10-Q. A substantial portion of the Company's loan portfolio is secured by real estate in metropolitan Atlanta and Birmingham. The largest component of loans in the Company's loan portfolio is real estate loans. At June 30, 2014 and December 31, 2013, real estate loans, which represent commercial and industrial real estate and other loans secured by single-family properties, totaled $152.0 million and $155.0 million, respectively, and represented 81.1% and 83.7% of loans, respectively, net of unearned income for the period. As stated above, a substantial portion of the Company's loan portfolio is collateralized by real estate in metropolitan Atlanta and Birmingham markets. Accordingly, the ultimate collectability of a substantial portion of the Company's loan portfolio is susceptible to changes in market conditions in the metropolitan Atlanta and Birmingham areas.



The Company's loans to area churches, which are generally secured by real

estate, were approximately $47.2 million and $40.9 million at June 30, 2014 and

December 31, 2013, respectively.



The Company's loans to area convenience stores were approximately $8.9 million

and $9.2 million at June 30, 2014 and December 31, 2013, respectively. Loans to

convenience stores are generally secured by real estate.



The Company's loans to area hotels, which are generally secured by real estate,

were approximately $25.0 million and $25.7 million at June 30, 2014 and December 31, 2013, respectively. Page 32 of 48 NONPERFORMING ASSETS Nonperforming assets include nonperforming loans, real estate acquired through foreclosure, and repossessed assets. Nonperforming loans generally include loans and leases whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulties or are past due with respect to principal or interest more than 90 days and have been placed on nonaccrual status. Accrued interest income is reversed when a loan is placed on nonaccrual status. Interest collections on nonaccruing loans and leases for which the ultimate collectability of principal is uncertain are applied as principal reductions; otherwise, such collections are credited to income when received. Nonperforming loans may be restored to accrual status when all principal and interest is current and the full repayment of the remaining contractual principal and interest is expected, or when the loan becomes well-secured and is in the process of collection. With the exception of the loans included within nonperforming assets in the table below, management is not aware of any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed which (1) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent any information on material credits of which management is aware that causes management to have serious doubts as to the abilities of such borrowers to comply with the loan repayment terms.

For the period, nonperforming assets decreased by $1,939,000 to $12,585,000 compared to $14,524,000 at December 31, 2013. This decrease is primarily related to a $596,000 decrease in OREO and a $1,378,000 decrease in nonaccrual loans. The Company charged-off $358,000 in nonperforming loans during the first six months of 2014 which is a decrease of $450,000 compared to $808,000 charged-off for the same period last year. At June 30, 2014, nonperforming assets represent 3.09% of total assets compared to 3.75% at December 31, 2013. There were no loans greater than 90 days past due and still accruing interest at December

31, 2013. Page 33 of 48



The table below presents a summary of the Company's nonperforming assets at June 30, 2014 and December 31, 2013.

June 30, December 31, 2014 2013 (in thousands, except financial ratios) Nonperforming assets: Nonperforming loans:

Restructured nonperforming loans (TDRs) $ 3,302$ 4,482 Other nonaccrual loans 2,440



2,638

Past-due loans of 90 days or more and still accruing 35 - Nonperforming loans 5,777



7,120

Real estate acquired through foreclosure 6,808

7,404 Total nonperforming assets $ 12,585$ 14,524 Ratios:

Nonperforming loans to loans, net of unearned income 3.08 %



3.84 %

Nonperforming assets to loans, net of unearned income, and real estate acquired through foreclosure

6.48 %



7.54 %

Nonperforming assets to total assets 3.09 %



3.75 %

Allowance for loan losses to nonperforming loans 51.20 %



44.34 %

Allowance for loan losses to nonperforming assets 23.50 %

21.74 % TROUBLED DEBT RESTRUCTURINGS Loans to be restructured are identified based on an assessment of the borrower's credit status, which involves, but is not limited to, a review of financial statements, payment delinquency, non-accrual status, and risk rating. Determining the borrower's credit status is a continual process that is performed by the Company's staff with periodic participation from an independent external loan review group. Troubled debt restructurings ("TDR") generally occur when a borrower is experiencing, or is expected to experience, financial difficulties in the near-term and it is probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. The Company seeks to assist these borrowers by working with them to prevent further difficulties, and ultimately to improve the likelihood of recovery on the loan while ensuring compliance with the Federal Financial Institutions Examination Council (FFIEC) guidelines. To facilitate this process, a formal concessionary modification that would not otherwise be considered may be granted resulting in classification of the loan as a TDR. All concessionary modifications are considered troubled debt restructurings. The modification may include a change in the interest rate or the payment amount or a combination of both. Substantially all modifications completed under a formal restructuring agreement are considered TDRs. Modifications can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accruing status, depending on the individual facts and circumstances of the borrower. These restructurings rarely result in the forgiveness of principal or interest. Page 34 of 48 With respect to commercial TDRs, an analysis of the credit evaluation, in conjunction with an evaluation of the borrower's performance prior to the restructuring, are considered when evaluating the borrower's ability to meet the restructured terms of the loan agreement. Nonperforming commercial TDRs may be returned to accrual status based on a current, well-documented credit evaluation of the borrower's financial condition and prospects for repayment under the modified terms. This evaluation must include consideration of the borrower's sustained historical repayment performance for a reasonable period (generally a minimum of six months) prior to the date on which the loan is returned to accrual status. In connection with consumer loan TDRs, a nonperforming loan will be returned to accruing status when current as to principal and interest and upon a sustained historical repayment performance (generally a minimum of six months). The following table summarizes the Company's TDRs and loan modifications (in thousands): June 30, December 31, 2014 2013



Troubled Debt Restructured Loans: Restructured loans still accruing $ 6,636$ 6,177 Restructured loans nonaccruing

3,302 4,482



Total restructured and modified loans $ 9,938$ 10,659

Troubled debt restructured loans that have performed in accordance with the restructured terms of the agreement for one year and for which an interest rate concession was not granted are removed from the TDR classification.

ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is primarily available to absorb losses inherent in the loan portfolio. Credit exposures deemed uncollectible are charged against the allowance for loan losses. The Company provides for estimated losses on loans receivable when any significant and permanent decline in value occurs. These estimates for losses are based on individual assets and their cash flow forecasts, sales values, independent appraisals, the volatility of certain real estate markets, and concern for disposing of real estate in distressed markets. For loans that are pooled for purposes of determining the necessary provisions, estimates are based on loan types, history of charge-offs, and other delinquency analyses. Therefore, the value used to determine the provision for losses is subject to the reasonableness of these estimates. The adequacy of the allowance for loan losses is reviewed on a monthly basis by management and the Board of Directors. On a semi-annual basis an independent review of the adequacy of allowance for loan losses is performed. This assessment is made in the context of historical losses as well as existing economic conditions, and individual concentrations of credit. Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in the judgment of management, should be charged-off. Based on the Company's evaluation, and the continued overall improvement of the credit quality in the loan portfolio, a provision for loan losses was deemed not necessary for the first half of 2014. For the same six month period last year, a provision for loan losses of $275,000 was charged against operating earnings. Approximately $385,000 of the allowance for loan losses was allocated to loans management considered impaired at June 30, 2014 compared to $3,000 at December 31, 2013. At June 30, 2014, management believes the allowance for loan losses is adequate. Management uses available information to recognize losses on loans; however, future additions to the allowance may be necessary based on changes in economic conditions, particularly in the metropolitan Atlanta, Georgia and Birmingham, Alabama areas. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Page 35 of 48 The following table summarizes loans, changes in the allowance for loan losses arising from loans charged off, recoveries on loans previously charged off by loan category, and additions to the allowance which have been charged to operating expense as of and for the six months ended June 30, 2014 and 2013 (amount in thousands, except financial ratios): 2014 2013

Loans, net of unearned income $ 187,427



$ 180,913

Average loans, net of unearned income and the allowance for loan losses $ 179,314



$ 178,819

Allowance for loan losses at the beginning of period $ 3,157

$ 3,509

Loans charged-off: Commercial, financial, and agricultural -



6

Real estate - loans 260



687

Installment loans to individuals 98



115

Total loans charged-off 358



808

Recoveries of loans previously charged off: Commercial, financial, and agricultural 24



18

Real estate - loans 112



382

Installment loans to individuals 23

38 Total loans recovered 159 438 Net loans charged-off 199 370 Additions to allowance for loan losses charged to operating expense -



275

Allowance for loan losses at period end $ 2,958



$ 3,414

Ratio of net loans charged-off to average loans, net of unearned income and the allowance for loan losses

0.11 %



0.21 %

Ratio of allowance for loan losses to loans, net of unearned income 1.58 % 1.89 % Page 36 of 48 The following table presents the allocation of the allowance for loan losses. The allocation is based on an evaluation of defined loan problems, historical ratios of loan losses, and other factors that may affect future loan losses in the categories of loans shown (amount in thousands): June 30, 2014 December 31, 2013 Percent of Percent of Amount Total Loans Amount Total Loans Commercial, financial, and agricultural $ 251 13 % $ 384 11 % Commercial Real Estate 1,913 63 % 1,721 65 % Single-family Residential 508 18 % 731 19 % Construction and Development 139 3 % 126 2 % Consumer 147 3 % 195 3 % Total allowance for loan losses $ 2,958 100 % $

3,157 100 % DEPOSITS Deposits are the Company's primary source of funding loan growth. Total deposits at June 30, 2014 increased by 4.9% or $16,562,000 to $353,524,000 compared to December 31, 2013. The bank has a stable core deposit base with a high percentage of non-interest bearing deposits. Noninterest-bearing deposits increased by $12,741,000, or 17.9% to $83,883,000 and interest-bearing deposits increased by $3,821,000, or 1.4%, to $269,641,000 for the six month period ending June 30, 2014. On an average basis, noninterest-bearing deposits increased to $83,091,000 for the first six months of the year compared to $73,897,000 for the year ended December 31, 2013. Average interest-bearing deposits decreased by $1,356,000 to $269,478,000 for the first six months of the year compared to $270,834,000 for the year ended December 31, 2013. At June 30, 2014, the Company's cost of funds was approximately 0.23% compared to 0.26%

for the same period last year. The Company participates in Certificate of Deposit Account Registry Services ("CDARS"), a program that allows its customers the ability to benefit from the FDIC insurance coverage on their time deposits over the $250,000 limit. At June 30, 2014 and December 31, 2013, the Company had $23,778,000 and $22,375,000, respectively, in CDARS deposits. Participation in this program has enhanced the Company's ability to retain customers with time deposits higher than the FDIC$250,000 insurance coverage limit.



The following is a summary of interest-bearing deposits (in thousands):

June 30, December 31, 2014 2013



NOW and money market accounts $ 95,425$ 92,793 Savings accounts

35,532 31,948 Time deposits of $100,000 or more 107,728 107,490 Other time deposits 30,956 33,589 $ 269,641$ 265,820 Page 37 of 48 OTHER BORROWED FUNDS The Company continues to emphasize funding earning asset growth through core deposits; however, the Company has relied on other borrowings as a supplemental funding source. Other borrowings consist of Federal funds purchased, short-term borrowings, and FHLB advances. These advances are collateralized by FHLB stock, a blanket lien on 1-4 family and multifamily mortgage loans, certain commercial real estate loans and investment securities. As of June 30, 2014 and December 31, 2013, total loans pledged as collateral was $30,488,000 and $33,186,000, respectively. Maturity Callable Type June 30, 2014 December 31, 2013 (in thousands) August 2026 (1) - $ 264 - $ 273 Total Principal Outstanding $ 264$ 273

Weighted Average Rate at Period End - %

- %



(1) Represents an Affordable Housing Program (AHP) award used to subsidize loans

for homeownership or rental initiatives. The AHP is a principal reducing

credit, scheduled to mature on August 17, 2026 with an interest rate of zero.

At June 30, 2014 the Company had a $80.0 million line of credit facility at the FHLB of which $20.3 million was committed consisting of advances of $0.3 million and a letter of credit to secure public deposits in the amount of $20.0 million. The Company also had $21.0 million of borrowing capacity at the Federal Reserve Bank discount window. Page 38 of 48 RESULTS OF OPERATIONS Net Interest Income:

Net interest income is the principal component of a financial institution's income stream and represents the difference, or spread, 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. For the three-month period ended June 30, 2014, net interest income decreased by $21,000 or 0.7% to $3,176,000 compared to $3,197,000 reported for the same period last year. Total interest income decreased $42,000 or 1.2% compared to $3,429,000 for the same three month period in 2013. Interest income on loans declined $133,000 due to a challenging lending environment, loan payoffs, and lower lending rates. Interest income on investment securities increased by $83,000 primarily due to the taxable investment portfolio having a higher average investment balance compared to the second quarter of 2013. Also, due to the decreased prepayments in the Company's mortgage-backed sector of its securities portfolio, investment yields on taxable investments increased by 42 basis points to 2.11 percent compared to the three month period ended June 30, 2013. Total interest expense for the period decreased by $21,000 or 9.1% compared to the same three month period in 2013 as the Company continues to lower its funding cost and improve its deposit mix. At June 30, 2014, the Company's cost of funds was approximately 0.23% compared to 0.26% for the same period last year.

On a year-to-date basis, net interest income increased by $105,000 or 1.7% to $6,340,000 compared to $6,235,000 reported for the same period last year. Total interest income increased by $61,000 or 0.9% to $6,763,000 compared to the same six month period in 2013. Interest income on investment securities increased by $247,000 primarily due to the taxable investment portfolio having a higher average investment balance compared to the first half of 2013. Also, due to the decreased prepayments in the Company's mortgage-backed sector of its securities portfolio, investment yields on taxable investments increased by 49 basis points to 2.13 percent compared to the six month period ended June 30, 2013. Total interest expense for the six month period ended June 30, 2014, decreased by $44,000 or 9.4% compared to the same period in 2013 as the Company lowered its funding cost and improved its deposit mix. At June 30, 2014, the Company maintained an annualized net interest margin on a fully tax equivalent basis of 3.63% compared to 3.69% in the previous quarter end and 3.69% reported at June 30, 2013. The decrease in the net interest margin on a fully tax equivalent basis is due to the repricing of existing loans with lower interest rates due to competitive pressures, coupled with loans rolling off at higher-yielding rates to be replaced with lower-yielding loans due to the prolonged superlow interest rate environment. The Company continues to pursue opportunities to enhance its lending and is investing in the resources and lending associates to strengthen our efforts.



The Company has an asset/liability management program which monitors the Company's interest rate sensitivity and ensures the Company is competitive in the loan and deposit market. The Company continues to monitor its asset/liability mix and will make changes as appropriate to ensure it is properly positioned to react to changing interest rates and inflationary trends.

Provision for loan losses

In the first half of 2014, due to the continued improvement in the credit quality of the Company's loan portfolio, a provision for loan losses was deemed not necessary. For the first half of 2013, the Company charged against operating earnings a provision for loan losses of $275,000. Page 39 of 48

The allowance for loan losses was $2,958,000, $3,157,000, and $3,414,000 at June 30, 2014, December 31, 2013, and June 30, 2013, respectively. The allowance for loan losses was 51.20%, 44.34%, and 34.36% of nonperforming loans at June 30, 2014, December 31, 2013, and June 30, 2013, respectively. The provision for loan losses and the resulting allowance for loan losses are based on changes in the size and character of the Company's loan portfolio, changes in nonperforming and past due loans, the existing risk of individual loans, concentrations of loans to specific borrowers or industries, and economic conditions. At June 30, 2014 the Company considered its allowance for loan losses to be adequate. Noninterest income: Noninterest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and commissions earned through insurance sales. In addition, gains and losses realized from the sale of investment portfolio securities and sales of assets are included in noninterest income. Noninterest income totaled $1,017,000 for the three month period ended June 30, 2014, a decrease of $182,000 or 15.2% compared with the same period last year. This decline is primarily due to gains on the sale of investments of $103,000 reported for the second quarter of 2013 compared to only $6,000 in 2014. Service charges on deposits also declined for the period by $91,000. Year-to-date, noninterest income decreased by $440,000 or 18.1% to $1,996,000 compared to the same period last year. This decline is primarily due to gains on the sale of investments of $244,000 reported for the first half of 2013 compared to only $6,000 in 2014. Service charges on deposits and other operating income also declined for the period by $156,000 and $46,000, respectively. Noninterest expense:



Noninterest expense includes compensation and benefits, occupancy expenses, advertising and marketing, professional fees, office supplies, data processing, telephone expenses, miscellaneous items, and other losses.

Non-interest expense in the second quarter of 2014 declined by $478,000 to $3,623,000 compared to $4,101,000 for the same quarter last year primarily due to a decrease in net OREO expenses of $363,000 due to a decrease in writedowns by $144,000 compared to the second quarter of 2013. Non-interest expense continues to be closely managed as net occupancy and equipment expense decreased $33,000, FDIC insurance expense decreased $54,000, and other operating expenses decreased $47,000 which were partially off-set by an increase in salaries and employee benefits expenses of $19,000. For the six month period ended June 30, 2014, noninterest expense decreased by $647,000 or 8.2%.OREO related expenses decreased by $380,000 to $276,000 from $656,000 for the same period last year. Due to improved credit quality the Company has foreclosed on fewer properties in 2014 and market values have stabilized resulting in lower write-downs on foreclosed properties. The Company continues its efforts to manage its core expenses by managing staffing levels to an optimal level and cutting unnecessary expenditures.



INTEREST RATE SENSITIVITY MANAGEMENT

Interest rate sensitivity management involves managing the potential impact of interest rate movements on net interest income within acceptable levels of risk. The Company seeks to accomplish this by structuring the balance sheet so that repricing opportunities exist for both assets and liabilities in equivalent amounts and time intervals. Imbalances in these repricing opportunities at any point in time constitute a financial institution's interest rate risk. The Company's ability to reprice assets and liabilities in the same dollar amounts and at the same time minimizes interest rate risk. Page 40 of 48 One method of measuring the impact of interest rate sensitivity is the cumulative gap analysis. The difference between interest rate sensitive assets and interest rate sensitive liabilities at various time intervals is referred to as the gap. The Company is liability sensitive on a short-term basis as reflected in the following table. Generally, a net liability sensitive position indicates that there would be a negative impact on net interest income in an increasing rate environment. However, interest rate sensitivity gap does not necessarily indicate the impact of general interest rate movements on the net interest margin, since all interest rates and yields do not adjust at the same velocity and the repricing of various categories of assets and liabilities is subject to competitive pressures and the needs of the Company's customers. In addition, various assets and liabilities indicated as repricing within the same period may in fact reprice at different times within such period and at different rates. The following table shows the contractual maturities of all interest rate sensitive assets and liabilities at June 30, 2014. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Taking a conservative approach, the Company has included demand deposits such as NOW, money market, and savings accounts in the three month category. However, the actual repricing of these accounts may extend beyond twelve months. The interest rate sensitivity gap is only a general indicator of potential effects of interest rate changes on net interest income. The following table sets forth the distribution of the repricing of the Company's interest rate sensitive assets and interest rate sensitive liabilities as of June 30, 2014. Cumulative amounts as of June 30, 2014 Maturing and repricing within 3 3 to 12 1 to 5 Over Months Months Years 5 Years Total (amounts in thousands, except ratios) Interest-sensitive assets: Interest-bearing deposits with other banks $ 49,495 $ - $ - $ - $ 49,495 Certificates of deposit - 350 - - 350 Investments - - 13,883 122,193 136,076 Loans 35,656 12,601 98,959 40,211 187,427 Total interest-sensitive assets $ 85,151$ 12,951$ 112,842$ 162,404$ 373,348 Interest-sensitive liabilities: Deposits (a) $ 165,476$ 60,455$ 43,710 $ - $ 269,641 Other borrowings - - - 264 264 Total interest-sensitive liabilities $ 165,476$ 60,455$ 43,710$ 264$ 269,905 Interest-sensitivity gap $ (80,325 )$ (47,504 )$ 69,132$ 162,140$ 103,443 Cumulative interest-sensitivity gap (80,325 ) (127,829 ) (58,697 ) 103,443 103,443 Cumulative interest-sensitivity gap to total interest-sensitive assets (21.51 )% (34.24 )% (15.72 )% 27.71 % 27.71 %



(a) Savings, Now, and money market deposits totaling $130,957 are included in the maturing in 3 months classification.

Page 41 of 48 LIQUIDITY

Liquidity is the ability of the Company to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities. Liquidity management involves maintaining the Company's ability to meet the day-to-day cash flow requirements of its customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, the Company would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the needs of the communities it serves. Additionally, the Company requires cash for various operating needs including: dividends to shareholders; business combinations; capital injections to its subsidiary; the servicing of debt; and the payment of general corporate expenses. The Company has access to various capital markets and on March 6, 2009, the Company issued 7,462 shares of a Fixed Rate Cumulative Perpetual Preferred Stock, Series A, to the U.S. Department of the Treasury ("Treasury") under the TARP Program for an investment of $7,462,000. On August 13, 2010, the Company exchanged the outstanding 7,462 shares of Series A Preferred Stock for 7,462 shares of Series B Preferred Stock. No monetary consideration was given in connection with this exchange. The Company also issued 4,379 shares of Series C Preferred Stock for $4,379,000 to the Treasury on September 17, 2010. However, the primary source of liquidity for the Company is dividends from its bank subsidiary. Statutory and regulatory limitations apply to the Bank's payment of dividends to the Company as well as the Company's payment of dividends to its stockholders. The Georgia Department of Banking and Finance regulates the Bank's dividend payments and must approve dividend payments that exceed 50 percent of the Bank's prior year net income. The payment of dividends may also be affected or limited by other factors, such as the requirement by federal agencies to maintain adequate capital above regulatory guidelines and that bank holding companies and insured banks pay dividends out of current earnings. Asset and liability management functions not only serve to assure adequate liquidity in order to meet the needs of the Company's customers, but also to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that the Company can earn a return that meets the investment requirements of its shareholders. Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both requirements. The asset portion of the balance sheet provides liquidity primarily through loan principal repayments, maturities of investment securities and, to a lesser extent, sales or paydowns of investment securities available for sale and held to maturity. Other short-term investments such as federal funds sold and maturing interest bearing deposits with other banks are additional sources

of liquidity funding. The liability portion of the balance sheet provides liquidity through various customers' interest bearing and noninterest bearing deposit accounts. Federal funds purchased and other short-term borrowings from the Federal Reserve Bank Discount Window and the Federal Home Loan Bank are additional sources of liquidity and, basically, represent the Company's incremental borrowing capacity. At June 30, 2014 the Company had a $80.0 million line of credit facility at the FHLB of which $20.3 million was committed consisting of advances of $0.3 million and a letter of credit to secure public deposits in the amount of $20.0 million. The Company also had $21.0 million of borrowing capacity at the Federal Reserve Bank discount window. These sources of liquidity are short-term in nature and are used as necessary to fund asset growth and meet short-term liquidity needs. CAPITAL RESOURCES Stockholders' equity increased $2,246,000 for the six month period ended June 30, 2014 primarily due to an increase in other comprehensive income, net of income taxes, of $1,610,000. This increase is attributed to the volatility in interest rates and swings in credit spreads, and their impact on the fair value of the Company's available for sale securities portfolio. Retained earnings also increased by $598,000 due to net income of $889,000, partially offset by $118,000 in preferred dividends paid to the U.S. Treasury and $173,000 in cash dividends paid to common stockholders. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of total and Tier 1 capital to risk weighted assets, and Tier 1 capital to average assets. The Company's total and Tier 1 capital to risk weighted assets and Tier 1 to average assets were 19%, 18% and 11% at June 30, 2014 and 19%, 18% and 11% at December 31, 2013. The Bank's total and Tier 1 capital to risk weighted assets and Tier 1 to average assets were 19%, 18% and 10% at June 30, 2014 and December 31, 2013, respectively. At June 30, 2014, the Company and the Bank met all capital adequacy requirements to which it is subject and is considered to be ''well capitalized" under regulatory standards.



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