News Column

EASTERN VIRGINIA BANKSHARES INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

We present management's discussion and analysis of financial information to aid the reader in understanding and evaluating our financial condition and results of operations. This discussion provides information about the major components of our results of operations, financial condition, liquidity and capital resources. This discussion should be read in conjunction with the Unaudited Consolidated Financial Statements and Notes to the Interim Consolidated Financial Statements presented elsewhere in this report and the Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in the 2013 Form 10-K. Operating results include those of all our operating entities combined for all periods presented.



Internet Access to Corporate Documents

Information about the Company can be found on the Company's investor relations website at http://www.evb.org. The Company posts its annual reports, quarterly reports, current reports, definitive proxy materials and any amendments to those documents as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. All such filings are available at no charge. The information on the Company's website is not, and shall not be deemed to be, a part of this Quarterly Report on Form 10-Q or incorporated into any other filings the Company makes with the SEC. Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, certain statements may be contained in the Company's future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to products or services, the performance or disposition of portions of the Company's asset portfolio, future changes to the Bank's branch network, the payment of dividends and the ability to realize deferred tax assets; (iii) statements of future financial performance and economic conditions; (iv) statements regarding the adequacy of the allowance for loan losses; (v) statements regarding the effect of future sales of investment securities or foreclosed properties; (vi) statements regarding the Company's liquidity; (vii) statements of management's expectations regarding future trends in interest rates, real estate values, and economic conditions generally and in the Company's markets; (viii) statements regarding future asset quality, including expected levels of charge-offs; (ix) statements regarding potential changes to laws, regulations or administrative guidance; (x) statements regarding business initiatives related to and the use of proceeds from the private placements ("the Private Placements") and the rights offering (the "Rights Offering") the Company completed in 2013, including expected future interest expenses and net interest margin following the prepayment of long-term FHLB advances; and (xi) statements of assumptions underlying such statements. Words such as "believes," "anticipates," "expects," "intends," "targeted," "continue," "remain," "will," "should," "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:



factors that adversely affect our business initiatives related to the use of

proceeds from the Rights Offering and the Private Placements, including,

without limitation, changes in market conditions that adversely affect our

ability to dispose of or work out assets adversely classified by us on

advantageous terms or at all;

our ability and efforts to assess, manage and improve our asset quality;

the strength of the economy in the Company's target market area, as well as

general economic, market, political, or business factors;

changes in the quality or composition of our loan or investment portfolios,

including adverse developments in borrower industries, decline in real estate

values in our markets, or in the repayment ability of individual borrowers or

issuers;

the effects of our adjustments to the composition of our investment portfolio;

the impact of government intervention in the banking business;

an insufficient allowance for loan losses;

our ability to meet the capital requirements of our regulatory agencies;

42



changes in laws, regulations and the policies of federal or state regulators

and agencies, including rules to implement the Basel III capital framework and

for calculating risk weighted assets;

adverse reactions in financial markets related to the budget deficit of the

United States government;

changes in the interest rates affecting our deposits and loans;

the loss of any of our key employees;

changes in our competitive position, competitive actions by other financial

institutions and the competitive nature of the financial services industry and

our ability to compete effectively against other financial institutions in our

banking markets;

our potential growth, including our entrance or expansion into new markets, the

opportunities that may be presented to and pursued by us and the need for

sufficient capital to support that growth;

changes in government monetary policy, interest rates, deposit flow, the cost

of funds, and demand for loan products and financial services;

our ability to maintain internal control over financial reporting;

our ability to realize our deferred tax assets, including in the event we

experience an ownership change as defined by Section 382 of the Code;



our ability to raise capital as needed by our business;

our reliance on secondary sources, such as FHLB advances, sales of securities

and loans, federal funds lines of credit from correspondent banks and

out-of-market time deposits, to meet our liquidity needs;

possible changes to our Board of Directors, including in connection with the

Private Placements and deferred dividends on our Series A Preferred Stock;

the future prospects of the combined organization following the acquisition of

VCB; and

other circumstances, many of which are beyond our control.

All of the forward-looking statements made in this report are qualified by these factors, and there can be no assurance that the actual results anticipated by the Company will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, the Company or its business or operations. The reader should refer to risks detailed under Item 1A. "Risk Factors" included in the 2013 Form 10-K and otherwise included in our periodic and current reports filed with the SEC for specific factors that could cause our actual results to be significantly different from those expressed or implied by our forward-looking statements. The Company cautions the reader that the above list of important factors is not all-inclusive. These forward-looking statements are made as of the date of this report, and the Company undertakes no obligation to update any forward-looking statements to reflect the impact of any circumstances or events, including unanticipated events, that arise after the date the forward-looking statements are made. Critical Accounting Policies



The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.

Allowance for Loan Losses The Company establishes the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower's ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. For more information see the section titled "Asset Quality" within this Item 2.

43 Impairment of Loans The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due, according to the contractual terms of the loan agreement. The Company does not consider a loan impaired during a period of insignificant payment shortfalls if we expect the ultimate collection of all amounts due. Impairment is measured on a loan by loan basis for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans, representing consumer, one to four family residential first and seconds and home equity lines, are collectively evaluated for impairment. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. TDRs are also considered impaired loans. A TDR occurs when the Company, for economic or legal reasons related to the borrower's financial condition, grants a concession (including, without limitation, rate reductions to below-market rates, payment deferrals, forbearance and, in some cases, forgiveness of principal or interest) to the borrower that it would not otherwise consider. For more information see the section titled "Asset Quality" within Item 2. Impairment of Securities Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on the Company's ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company's best estimate of the present value of cash flows expected to be collected from debt securities, the Company's intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery. Other Real Estate Owned Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at estimated fair market value of the property, less estimated disposal costs, if any. Any excess of cost over the estimated fair market value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings. Goodwill With the adoption of ASU 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment," the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company's goodwill, all of which was recognized in connection with the acquisition of branches in 2003 and 2008, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis were discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company completed the annual goodwill impairment test during the fourth quarter of 2013 and determined there was no impairment to be recognized in 2013. If the underlying estimates and related assumptions change in the future, the Company may be required to record impairment charges. 44 Retirement Plan The Company has historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant's account will be credited with an "interest" credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.

Accounting for Income Taxes Determining the Company's effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company's tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income

tax provision and accrual. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is "more likely than not" that all or a portion of the deferred tax asset will not be realized. "More likely than not" is defined as greater than a 50% chance. Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed. For more information, see Item 1. "Financial Statements," under the heading "Note 4. Deferred Income Taxes" in this Quarterly Report on Form 10-Q and Item 8. "Financial Statements and Supplementary Data," under the headings "Note 1. Summary of Significant Accounting Policies" and "Note 10. Income Taxes" in the 2013 Form 10-K.



For further information concerning accounting policies, refer to Item 8. "Financial Statements and Supplementary Data," under the heading "Note 1. Summary of Significant Accounting Policies" in the 2013 Form 10-K.

45 Business Overview The Company provides a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets. The Company is committed to delivering strong long-term earnings using a prudent allocation of capital, in business lines where we have demonstrated the ability to compete successfully. During the first six months of 2014, the national and local economies continued to show limited signs of recovery with the main challenges continuing to be persistent unemployment above historical levels and uneven economic growth. Local markets also experienced harsh winter weather during the first quarter of 2014 that further slowed economic activity. Macro-economic and political issues continue to temper the global economic outlook and as such the Company remains cautiously optimistic regarding the limited signs of improvement seen in our local markets. Despite this, the Company believes that our local markets are poised for stronger growth in the coming months and years than the economic recovery has provided in our markets in recent periods.



Strategic Initiatives and Pending Acquisition of Virginia Company Bank

The Company has used a portion of the gross proceeds from its Private Placements and Rights Offerings in 2013 (the "2013 Capital Initiative") for general corporate purposes, including strengthening its balance sheet, the accelerated resolution and disposition of assets adversely classified by the Company (consisting of other real estate owned and classified loans), and improvement of the Company's balance sheet through the restructuring of FHLB advances. During the third quarter of 2013, the Company prepaid $107.5 million of its long-term FHLB advances, and also accelerated the resolution and disposition of adversely classified assets. The extinguishment of the higher rate long-term FHLB advances triggered an $11.5 million prepayment penalty that was fully recognized during the third quarter of 2013. During May 2014, the Company announced its intent to repay up to $15.0 million of the Company's Series A Preferred Stock originally issued to the Treasury through TARP. The Company plans to effectuate a portion of this repayment through one or more transactions during the second half of 2014. During the remainder of 2014, the Company also plans to focus on online and mobile banking options offered to the Bank's customers, including introducing or improving the Bank's portfolio of internet and mobile banking products and services. As the Company executes these business strategies, senior management and the board of directors will continue to evaluate other initiatives that they believe will best position the Company for long-term success. While the Company largely has worked through the economic challenges of the past few years, the Company will look at the remainder of 2014 and into 2015 as an opportunity to strengthen its current branch network in existing markets and explore business development initiatives and strategic opportunities to grow the Company's business. The Company completed one such initiative - the acquisition of a 4.9% interest in Southern Trust Mortgage, LLC - during May 2014. In addition, on May 29, 2014, the Company announced the signing of a definitive merger agreement pursuant to which the Company would acquire VCB via a merger of VCB with and into EVB, with EVB surviving (such acquisition, the "Acquisition"). For more information on this pending acquisition refer to Item 1. "Financial Statements," under the heading "Note 16. Proposed Acquisition" in this Quarterly Report on Form 10-Q and the Company's Current Report on Form 8-K filed with

the SEC on May 30, 2014. 46



Summary of Second Quarter 2014 and Year to Date Operating Results and Financial Condition

Table 1: Performance Summary

Three Months Ended June 30, (dollars in thousands, except per share data) 2014 2013 Net income (1) $ 1,655 $ 673 Net income available to common shareholders (1) $ 1,114 $ 297 Basic income per common share $ 0.10 $ 0.04 Diluted income per common share $ 0.06 $ 0.04 Return on average assets (annualized) 0.43 % 0.11 % Return on average common shareholders' equity (annualized) 4.76 % 1.48 % Net interest margin (tax equivalent basis) 3.82 % 3.21 % Six Months Ended June 30,

(dollars in thousands, except per share data) 2014



2013

Net income (1) $ 3,651$ 1,753 Net income available to common shareholders (1) $ 2,592$ 1,001 Basic income per common share $ 0.22$ 0.15 Diluted income per common share $ 0.15$ 0.14 Return on average assets (annualized) 0.50 % 0.19 % Return on average common shareholders' equity (annualized) 5.68 % 2.58 % Net interest margin (tax equivalent basis) 3.88 % 3.22 %



(1) The difference between net income and net income available to common shareholders is the effective dividend to holders of the Company's Series A Preferred Stock.

The Company's results continue to be positively impacted by asset quality improvements and the extinguishment of long-term FHLB advances in the third quarter of 2013, as discussed in greater detail below. The prepayment of these advances has significantly improved the Company's financial position and net interest margin for the three and six months ended June 30, 2014 as compared to the three and six months ended June 30, 2013.



For the three months ended June 30, 2014, the following were significant factors in the Company's reported results:

Increase in net interest income of $962 thousand from the same period in 2013,

principally due to a $1.4 million decrease in interest expense that was

primarily driven by the elimination of higher-rate, longer term FHLB advances

during the third quarter of 2013 and the current low rate environment;



Net interest margin (tax equivalent basis) increased 61 basis points to 3.82%

during the second quarter of 2014 as compared to 3.21% for the same period in

2013;

No provision for loan losses during the second quarter of 2014 compared to $600

thousand for the same period in 2013, reflecting the Company's conservative

approach to provisioning for the allowance for loan losses in prior periods and

a reduction in net charge-offs to $288 thousand for the second quarter of 2014

from $2.3 million in the same period of 2013;

Increase in nonperforming assets of $1.6 million from March 31, 2014 to June

30, 2014 due primarily to the Company placing three loans on nonaccrual status

as a result of the continued deteriorating financial condition of the borrowers

in the second quarter of 2014;

Expenses related to FDIC insurance premiums declined to $305 thousand, compared

to $596 thousand for the same period in 2013, as the Company faced lower FDIC

insurance assessment rates following termination of the Written Agreement;

Other operating expenses increased $270 thousand during the second quarter of

2014 as compared to the same period in 2013 and was driven primarily by higher

legal and professional fees; and

Increase in the effective dividend on preferred stock of $165 thousand from the

same period in 2013 due primarily to the dividend rate of the Company's Series

A Preferred Stock increasing from 5% to 9% in the first quarter of 2014. 47



For the six months ended June 30, 2014, the following were significant factors in the Company's reported results:

Increase in net interest income of $2.2 million from the same period in 2013,

principally due to a $2.8 million decrease in interest expense due to the same

factors as discussed for the three month comparison above;

Net interest margin (tax equivalent basis) increased 66 basis points to 3.88%

for the six months ended June 30, 2014 as compared to 3.22% for the same period

in 2013;

Provision for loan losses of $250 thousand compared to $1.2 million for the

same period in 2013, reflecting a reduction in net charge-offs to $399 thousand

for the six months ended June 30, 2014, from $3.7 million in the same period of

2013;

Decrease in nonperforming assets of $1.4 million during the first six months of

2014 as compared to December 31, 2013 due to the Company's continued focus on

credit quality initiatives to improve its asset quality and resolve

nonperforming assets;

Expenses related to FDIC insurance premiums of $637 thousand, compared to $1.2

million for the same period in 2013;

Other operating expenses increased $345 thousand during the first six months of

2014 as compared to the same period in 2013 and was driven primarily by higher

legal and professional fees; and

Increase in the effective dividend on preferred stock of $307 thousand from the

same period in 2013 due primarily to the dividend rate of the Company's Series

A Preferred Stock increasing from 5% to 9% in the first quarter of 2014. Capital Management As we first reported in our Quarterly Report on Form 10-Q for March 31, 2011, the Company has taken actions to preserve capital by deferring its regular quarterly cash dividend with respect to its Series A Preferred Stock which the Company originally issued to the Treasury in connection with the Company's participation in the Treasury's Capital Purchase Program in January 2009. On October 21, 2013, the Treasury sold all 24,000 shares of Series A Preferred stock held by Treasury to private investors. On May 15, 2014, the Company deferred its fourteenth consecutive dividend on the Series A Preferred Stock. As of June 30, 2014, the Company had accumulated $4.7 million for dividends on the Series A Preferred Stock. In addition, because dividends on the Series A Preferred Stock have not been paid for more than six quarters, the authorized number of directors on the Company's Board of Directors has increased by two, and the holders of the Series A Preferred Stock have the right, voting as a class, to elect two directors to the Company's Board of Directors at any annual meeting (or a special meeting called for that purpose) until all owed and unpaid dividends on the Series A Preferred Stock have been paid. To date the holders of the Series A Preferred Stock have not yet exercised this right. The Company is also not currently paying dividends on its common stock and Series B Preferred Stock. On July 24, 2014, the Company declared $5.5 million of current and all deferred but accumulated dividends on its Series A Preferred Stock, payable on August 15, 2014. The Company had also previously deferred regularly scheduled interest payments on its outstanding Junior Subordinated Debentures relating to its trust preferred securities beginning with the second quarter of 2011, as permitted under the related indenture. During the second quarter of 2014, the Company paid all current and deferred interest on its outstanding Junior Subordinated Debentures. The actions to suspend and defer dividend and interest payments to preserve capital, while difficult, have been necessary to ensure the financial strength of the Company. As economic conditions improve, and as the Company is able to generate earnings to support its current and future capital needs, the Company plans to restore dividends on its common stock and Series B Preferred Stock. For additional information about regulatory capital requirements applicable to the Company and the Company's former formal and informal regulatory agreements, refer to Item 1. "Financial Statements," under the headings "Note 13. Capital Requirements" and "Note 14. Regulatory Agreements," respectively in this Quarterly Report on Form 10-Q. Results of Operations As discussed above, the Company's results of operations for the three and six months ended June 30, 2014 were primarily driven by improved net interest margins related to the extinguishment of long-term FHLB advances in the third quarter of 2013. These improved financial results were achieved despite decreased yields on the Company's loan portfolio, the largest segment of earning assets, during the three and six months ended June 30, 2014 as compared to the same periods in 2013. Additionally, a reduced provision for loan losses positively impacted earnings during the three and six months ended June 30, 2014. Credit quality continues to receive significant management attention to ensure that the Company continues to identify credit problems and improve the quality of its asset portfolio, with reduced levels of nonperforming assets from December 31, 2011 to June 30, 2014 demonstrating the Company's positive asset quality progress. The Company remains diligent and focused on the management of its credit quality and is fully committed to quickly and aggressively addressing problem credits. Additional analysis and breakout of the Company's nonperforming assets are presented later in this Item 2 under the caption "Asset Quality". The remainder of this analysis discusses the results of operations under the component sections of net interest income and net interest margin, noninterest income, noninterest expense and income taxes. 48



Net Interest Income and Net Interest Margin

Net interest income, the fundamental source of the Company's earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and investment securities, while deposits and short-term borrowings represent the major portion of interest-bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations and the yield of our interest earning assets compared to our cost of funding these assets. Net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets, and represents the Company's net yield on its earning assets. Net interest margin is an indicator of the Company's effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competitive pressures, Federal Reserve Board policies and the economy. The spread that can be earned between interest earning assets and interest-bearing liabilities is also dependent to a large extent on the slope of the yield curve, which in recent periods has been significantly impacted by initiatives of the Federal Reserve Board intended to lower long-term interest rates. 49 Table 2 presents the average balances of assets and liabilities, the average yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the three and six months ended

June 30, 2014 and 2013.



Table 2: Average Balance Sheet and Net Interest Margin Analysis

(dollars in thousands) Three Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate (1) Balance Expense Rate (1) Assets: Securities Taxable $ 236,634$ 1,338 2.27 % $ 257,275$ 1,307 2.04 % Restricted securities 6,779 89 5.27 % 8,949 83 3.72 % Tax exempt (2) 29,521 294 3.99 % 22,988 218 3.80 % Total securities 272,934 1,721 2.53 % 289,212 1,608 2.23 % Interest bearing deposits in other banks 5,097 4 0.31 % 58,826 40 0.27 % Federal funds sold 121 - 0.00 % 114 - 0.00 % Loans, net of unearned income (3) 685,491 8,562 5.01 % 674,528 9,052 5.38 % Total earning assets 963,643 10,287 4.28 % 1,022,680 10,700 4.20 % Less allowance for loan losses (14,898 ) (18,992 ) Total non-earning assets 98,403



94,736

Total assets $ 1,047,148



$ 1,098,424

Liabilities & Shareholders' Equity: Interest-bearing deposits Checking $ 259,279$ 233 0.36 % $ 246,254$ 234 0.38 % Savings 89,334 30 0.13 % 90,779 40 0.18 % Money market savings 113,929 116 0.41 % 127,579 134 0.42 % Large dollar certificates of deposit (4) 99,525 307 1.24 % 129,854 428 1.32 % Other certificates of deposit 124,096 292 0.94 % 129,523 390 1.21 % Total interest-bearing deposits 686,163 978 0.57 % 723,989 1,226 0.68 % Federal funds purchased and repurchase agreements 3,274 5 0.61 % 3,432 5 0.58 % Short-term borrowings 68,547 36 0.21 % - - 0.00 % Long-term borrowings - - 0.00 % 117,500 1,187 4.05 % Trust preferred debt 10,310 88 3.42 % 10,310 87 3.38 % Total interest-bearing liabilities 768,294 1,107 0.58 % 855,231 2,505 1.17 % Noninterest-bearing liabilities Demand deposits 134,605 126,706 Other liabilities 4,801 7,261 Total liabilities 907,700 989,198 Shareholders' equity 139,448 109,226 Total liabilities and shareholders' equity $ 1,047,148$ 1,098,424 Net interest income (2) $ 9,180$ 8,195

Interest rate spread (2)(5) 3.70 % 3.03 % Interest expense as a percent of average earning assets 0.46 % 0.98 % Net interest margin (2)(6) 3.82 %

3.21 % Notes:



(1) Yields are annualized and based on average daily balances.

(2) Income and yields are reported on a tax equivalent basis assuming a federal

tax rate of 34%, with a $90 adjustment for 2014 and a $67 adjustment in 2013.

(3) Nonaccrual loans have been included in the computations of average loan

balances.

(4) Large dollar certificates of deposit are certificates issued in amounts of

$100 or greater.

(5) Interest rate spread is the average yield on earning assets, calculated on a

fully taxable basis, less the average rate incurred on interest-bearing

liabilities.

(6) Net interest margin is the net interest income, calculated on a fully taxable

basis, expressed as a percentage of average earning assets. 50 (dollars in thousands) Six Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate (1) Balance Expense Rate (1) Assets: Securities Taxable $ 238,849$ 2,845 2.40 % $ 261,544$ 2,729 2.10 % Restricted securities 7,006 191 5.50 % 9,088 169 3.75 % Tax exempt (2) 29,893 600 4.05 % 17,968 344 3.86 % Total securities 275,748 3,636 2.66 % 288,600 3,242 2.27 % Interest bearing deposits in other banks 6,288 8 0.26 % 54,514 65 0.24 % Federal funds sold 132 - 0.00 % 234 - 0.00 % Loans, net of unearned income (3) 681,821 17,112 5.06 % 674,306 18,008 5.39 % Total earning assets 963,989 20,756 4.34 % 1,017,654 21,315 4.22 % Less allowance for loan losses (14,842 ) (19,674 ) Total non-earning assets 98,946



91,764

Total assets $ 1,048,093



$ 1,089,744

Liabilities & Shareholders' Equity: Interest-bearing deposits Checking $ 258,234$ 461 0.36 % $ 245,404$ 470 0.39 % Savings 89,757 60 0.13 % 89,529 80 0.18 % Money market savings 116,494 241 0.42 % 129,950 283 0.44 % Large dollar certificates of deposit (4) 100,143 608 1.22 % 128,327 859 1.35 % Other certificates of deposit 124,591 595 0.96 % 131,262 808 1.24 % Total interest-bearing deposits 689,219 1,965 0.57 % 724,472 2,500 0.70 % Federal funds purchased and repurchase agreements 3,329 10 0.61 % 3,363 10 0.60 % Short-term borrowings 70,754 71 0.20 % - - 0.00 % Long-term borrowings - - 0.00 % 117,500 2,361 4.05 % Trust preferred debt 10,310 176 3.44 % 10,310 174 3.40 % Total interest-bearing liabilities 773,612 2,222 0.58 % 855,645 5,045 1.19 % Noninterest-bearing liabilities Demand deposits 132,074 122,171 Other liabilities 4,745 7,226 Total liabilities 910,431 985,042 Shareholders' equity 137,662 104,702 Total liabilities and shareholders' equity $ 1,048,093$ 1,089,744 Net interest income (2) $ 18,534$ 16,270

Interest rate spread (2)(5) 3.76 % 3.03 % Interest expense as a percent of average earning assets 0.46 % 1.00 % Net interest margin (2)(6) 3.88 %

3.22 % Notes:



(1) Yields are annualized and based on average daily balances.

(2) Income and yields are reported on a tax equivalent basis assuming a federal

tax rate of 34%, with a $183 adjustment for 2014 and a $105 adjustment in 2013.



(3) Nonaccrual loans have been included in the computations of average loan

balances.

(4) Large dollar certificates of deposit are certificates issued in amounts of

$100 or greater.

(5) Interest rate spread is the average yield on earning assets, calculated on a

fully taxable basis, less the average rate incurred on interest-bearing

liabilities.

(6) Net interest margin is the net interest income, calculated on a fully taxable

basis, expressed as a percentage of average earning assets. 51 Interest Income and Expense



Net interest income and net interest margin

Net interest income in the second quarter of 2014 increased $962 thousand, or 11.8%, when compared to the second quarter of 2013. Net interest income in the six months ended June 30, 2014 increased $2.2 million, or 13.5%, when compared to the same period in 2013. The Company's net interest margin increased to 3.82% and 3.88% for the three and six months ended June 30, 2014, representing 61 and 66 basis point increases, respectively, over the Company's net interest margins for the three and six months ended June 30, 2013.



The most significant factors impacting net interest income and net interest margin during these periods were as follows:

Positive Impacts:

Extinguishment of higher-rate long-term FHLB advances during the third quarter

of 2013, which drove declines in the Company's interest expense and rate paid

on average interest-bearing liabilities;

Decreases in the average balances of and average rates paid on total

interest-bearing deposits;

Increasing yields on the investment securities portfolio driven by increases in

interest rates over the comparable periods and rebalancing efforts during late

2013 and the first half of 2014, which largely consisted of accelerated

prepayments on lower yield Agency mortgage-backed and Agency CMO securities and

a greater allocation of the portfolio to SBA Pool securities and higher

yielding, longer duration municipal securities; and

Increasing average loan balances.

Negative Impacts:

Decreasing yields on the Company's loan portfolio; and

Decreasing average balances of interest bearing deposits in other banks.

Total interest income Total interest income decreased 4.1% and 3.0% for the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, respectively. These declines in total interest income were driven primarily by declines in the yield on the loan portfolio and a decrease in average investment securities. These declines were partially offset by higher yields on investment securities and higher average loan balances. Loans Average loan balances increased for both the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, due primarily to the purchase of $27.2 million in performing one-to-four family residential mortgage loans in the first quarter of 2014 and the origination of a line of credit to fund loan originations through Southern Trust Mortgage, LLC (balance of $11.6 million as of June 30, 2014) in the second quarter of 2014. These additions to the Company's loan portfolio were partially offset by weak loan demand in the Company's markets as a result of the continuing challenging economic conditions, such that the Company's average loan balances increased $11.0 million and $7.5 million for the three and six months ended June 30, 2014, as compared to average balances for the same periods in 2013. In addition, due to the historically low interest rate environment, loans were originated during the second quarter and first six months of 2014 at much lower yields than seasoned loans in the Company's loan portfolio, which has contributed significantly to average yields on the loan portfolio declining 37 and 33 basis points for the three and six months ended June 30, 2014, as compared to the same periods in 2013. Total average loans were 71.1% of total average interest-earning assets for the three months ended June 30, 2014, compared to 66.0% for the three months ended June 30, 2013. Total average loans were 70.7% of total average interest-earning assets for the six months ended June 30, 2014, compared to 66.3% for the six months ended June 30, 2013. Investment securities

Average investment securities balances declined 5.6% and 4.5% for the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, due to the Company's efforts to rebalance the securities portfolio, while the yields on investment securities increased 30 and 39 basis points for the three and six months ended June 30, 2014 as compared to the same periods in 2013. Increasing yields on the investment securities portfolio were driven by increases in interest rates over the comparable periods and portfolio rebalancing efforts during late 2013 and the first half of 2014, which largely consisted of accelerated prepayments on lower-yield Agency mortgage-backed and Agency CMO securities and allocating a greater proportion of the portfolio to SBA Pool securities and higher yielding, longer duration municipal securities. 52



Interest bearing deposits in other banks

Average interest bearing deposits in other banks decreased significantly for both the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, due to the overall decrease in our average total deposits, the purchase of $27.2 million in performing one-to-four family mortgage loans in the first quarter of 2014 and declines in average total borrowings that were largely due to extinguishing the Company's long-term FHLB advances during the third quarter of 2013. Interest-bearing deposits Average total interest-bearing deposit balances and related rates paid decreased for both the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, contributing to the reductions in interest expense in the second quarter and first six months of 2014. Retail deposits continued to shift from higher priced certificates of deposit and money market savings accounts to lower priced checking (or "NOW") accounts. Borrowings

Average total borrowings and related rates paid on average total borrowings decreased for both the three and six month periods ended June 30, 2014, as compared to the same periods in 2013, significantly driving the reduction in interest expense in the second quarter and first half of 2014. These decreases were primarily due to the extinguishment of $117.5 million higher rate long-term FHLB advances during the third quarter of 2013. The long-term FHLB advances were partially replaced with short-term FHLB advances at a significantly lower rate. Noninterest Income Noninterest income is comprised of all sources of income other than interest income on our earning assets. Significant revenue items include fees collected on certain deposit account transactions, debit and credit card fees, other general services, earnings from other investments we own in part or in full, gains or losses from investments, and gains or losses on sales of investment securities, loans, and fixed assets.



The following tables depict the components of noninterest income for the three and six months ended June 30, 2014 and 2013:

Table 3: Noninterest Income

Three Months Ended June 30, (dollars in thousands) 2014 2013 Change $ Change % Service charges and fees on deposit accounts $ 837 $ 729 $ 108 14.8 % Debit/credit card fees 378 375 3 0.8 % Gain on sale of available for sale securities, net 109 58 51 87.9 % Gain on sale of bank premises and equipment - 25 (25 ) -100.0 % Other operating income 315 263 52 19.8 % Total noninterest income $ 1,639$ 1,450 $

189 13.0 % Six Months Ended June 30, (dollars in thousands) 2014 2013 Change $ Change % Service charges and fees on deposit accounts $ 1,659$ 1,495$ 164 11.0 % Debit/credit card fees 687 708 (21 ) -3.0 % Gain on sale of available for sale securities, net 489 525 (36 ) -6.9 % Gain on sale of bank premises and equipment 5 26 (21 ) -80.8 % Other operating income 691 644 47 7.3 % Total noninterest income $ 3,531$ 3,398$ 133 3.9 % 53



Key changes in the components of noninterest income for the three and six months ended June 30, 2014, as compared to the same periods in 2013, are discussed below:

Service charges and fees on deposit accounts increased due to increases in

service charge fees on checking accounts;

Gain on sale of available for sale securities, net increased for the second

quarter of 2014 compared to the same period of 2013 and was primarily the

result of the Company adjusting the composition of the investment portfolio as

part of the Company's overall asset/liability management strategy. The Company

generated gains during the first six months of 2014 by selling a portion of its

previously impaired agency preferred securities (FNMA & FHLMC) to remove

classified assets from the Company's balance sheet and to fund purchases of

taxable securities to increase the Company's sources of taxable income. The

Company will continue to strategically evaluate opportunities to further adjust

the composition of its investment portfolio through the balance of 2014;

Gain on sale of bank premises and equipment decreased as disposal gains on

company vehicles were recognized in the second quarter of 2013 with no such

gain being recognized in the second quarter of 2014; and

Other operating income increased for the three and six months ended June 30,

2014, as compared to the same periods in 2013, primarily due to higher earnings

from bank owned life insurance policies during 2014, and with respect to the

three months ended June 30, 2014, higher earnings from the Bank's subsidiaries

compared to the second quarter of 2013. Noninterest Expense Noninterest expense includes all expenses with the exception of those paid for interest on borrowings and deposits. Significant expense items included in this component are salaries and employee benefits, occupancy and other operating expenses.



The following tables depict the components of noninterest expense for the three and six months ended June 30, 2014 and 2013:

Table 4: Noninterest Expense

Three Months Ended June 30, (dollars in thousands) 2014 2013 Change $ Change % Salaries and employee benefits $ 4,748$ 4,146$ 602 14.5 % Occupancy and equipment expenses 1,267 1,271

(4 ) -0.3 % Telephone 211 310 (99 ) -31.9 % FDIC expense 305 596 (291 ) -48.8 % Consultant fees 279 213 66 31.0 % Collection, repossession and other real estate owned 89 126 (37 ) -29.4 % Marketing and advertising 270 246 24 9.8 % Loss on sale of other real estate owned 28 118 (90 ) -76.3 % Impairment losses on other real estate owned 6 133 (127 ) -95.5 % Other operating expenses 1,316 1,046 270 25.8 % Total noninterest expenses $ 8,519$ 8,205$ 314 3.8 % Six Months Ended June 30, (dollars in thousands) 2014 2013 Change $ Change %

Salaries and employee benefits $ 9,334$ 8,295$ 1,039 12.5 % Occupancy and equipment expenses 2,586 2,527

59 2.3 % Telephone 422 565 (143 ) -25.3 % FDIC expense 637 1,183 (546 ) -46.2 % Consultant fees 622 429 193 45.0 % Collection, repossession and other real estate owned 156 252 (96 ) -38.1 % Marketing and advertising 437 480 (43 ) -9.0 % Loss on sale of other real estate owned 15 155 (140 ) -90.3 % Impairment losses on other real estate owned 11 143 (132 ) -92.3 % Other operating expenses 2,477 2,132 345 16.2 % Total noninterest expenses $ 16,697$ 16,161 $

536 3.3 % 54



Key changes in the components of noninterest expense for the three and six months ended June 30, 2014, as compared to the same periods in 2013, are discussed below:

Salaries and employee benefits increased for the three and six month periods

due to annual merit increases, lower deferred compensation on loan originations

(which increased current compensation expense) and higher group term insurance

costs;

Telephone expenses decreased for the three and six month periods as a result of

changing vendors during the first quarter of 2014 which generated cost savings;

FDIC expense decreased for the three and six month periods due to lower base

assessment rates resulting from the improvement in the Bank's overall composite

rating in connection with the termination of the Written Agreement in July

2013, and corresponding decreases in FDIC insurance assessment rates during

2014;

Consultant fees increased for the three and six months periods due to

additional consulting charges that were related to compliance and loan

operations;

Collection, repossession and other real estate owned expenses decreased for the

three and six month periods due to declines in carrying balances of OREO and

classified assets;

Marketing and advertising expense was elevated for the three month period due

to increased expenditures on television, radio and newspaper advertising.

However, for the six month period, marketing and advertising expense declined

due to lower expenditures on television, radio and newspaper advertising that

were partially offset by new branch opening expenses in the same period of

2013;

Loss on the sale of other real estate owned declined for the three and six

month periods and were driven by lower OREO balances and stabilization of real

estate prices in our markets;

Impairment losses on other real estate owned have decreased as OREO balances

have continued to decline and real estate prices in our markets have continued

to stabilize; and

Other operating expenses increased for the three and six month periods

primarily due to higher legal and professional services primarily related to

the Company's investment in Southern Trust Mortgage, LLC, and increased customer check and coupon incentives. Income Taxes The Company recorded income tax expense of $555 thousand for the three months ended June 30, 2014, compared to income tax expense of $100 thousand for the same period of 2013, reflecting a $455 thousand increase in income tax expense. The Company recorded income tax expense of $1.3 million for the six months ended June 30, 2014, compared to income tax expense of $449 thousand for the same period of 2013, reflecting a $835 thousand increase in income tax expense. The increase in income tax expense from the second quarter and first six months of 2013 to the same periods of 2014 was the result of the Company's pretax income increasing by approximately $1.4 million and $2.7 million, respectively, partially offset by increases in the amount of tax-exempt income on investment securities (as the Company rebalanced its securities portfolio during 2013) and increases in tax-exempt income from bank owned life insurance policies. Asset Quality



Provision and Allowance for Loan Losses

The allowance for loan losses is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the loan portfolio, and is based on periodic evaluations of the collectability and historical loss experience of loans. A provision for loan losses, which is a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in management's judgment, is appropriate to absorb probable losses in the loan portfolio. Actual credit losses are deducted from the allowance for loan losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent. Subsequent recoveries, if any, are credited to the allowance for loan losses. 55 The allowance for loan losses is comprised of a specific allowance for identified problem loans and a general allowance representing estimations done pursuant to either FASB ASC Topic 450 "Accounting for Contingencies", or FASB ASC Topic 310 "Accounting by Creditors for Impairment of a Loan." The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when deemed appropriate. The general component covers non-classified or performing loans and those loans classified as substandard, doubtful or loss that are not impaired. The general component is based on migration analysis adjusted for qualitative factors, such as economic conditions, interest rates and unemployment rates. The Company uses a risk grading system for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans. Loans are graded on a scale from 1 to 9. Non-impaired real estate and commercial loans are assigned an allowance factor which increases with the severity of risk grading. A general description of the characteristics of the risk grades is as follows:



Pass Grades

Risk Grade 1 loans have little or no risk and are generally secured by cash or

cash equivalents;

Risk Grade 2 loans have minimal risk to well qualified borrowers and no

significant questions as to safety;

Risk Grade 3 loans are satisfactory loans with strong borrowers and secondary

sources of repayment;

Risk Grade 4 loans are satisfactory loans with borrowers not as strong as risk

grade 3 loans but may exhibit a higher degree of financial risk based on the

type of business supporting the loan; and

Risk Grade 5 loans are loans that warrant more than the normal level of

supervision and have the possibility of an event occurring that may weaken the

borrower's ability to repay. Special Mention



Risk Grade 6 loans have increasing potential weaknesses beyond those at which

the loan originally was granted and if not addressed could lead to inadequately

protecting the Company's credit position. Classified Grades



Risk Grade 7 loans are substandard loans and are inadequately protected by the

current sound worth or paying capacity of the obligor or the collateral

pledged. These have well defined weaknesses that jeopardize the liquidation of

the debt with the distinct possibility the Company will sustain some loss if

the deficiencies are not corrected;

Risk Grade 8 loans are doubtful of collection and the possibility of loss is

high but pending specific borrower plans for recovery, its classification as a

loss is deferred until its more exact status is determined; and

Risk Grade 9 loans are loss loans which are considered uncollectable and of

such little value that their continuance as a bank asset is not warranted.

The Company uses a past due grading system for consumer loans, including one to four family residential first and seconds and home equity lines. The past due status of a loan is based on the contractual due date of the most delinquent payment due. The past due grading of consumer loans is based on the following categories: current, 1-29 days past due, 30-59 days past due, 60-89 days past due and over 90 days past due. The consumer loans are segregated between performing and nonperforming loans. Performing loans are those that have made timely payments in accordance with the terms of the loan agreement and are not past due 90 days or more. Nonperforming loans are those that do not accrue interest, are greater than 90 days past due and accruing interest or considered impaired. Non-impaired consumer loans are assigned an allowance factor which increases with the severity of past due status. This component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio. The Company's ALL Committee is responsible for assessing the overall appropriateness of the allowance for loan losses and monitoring the Company's allowance for loan losses methodology, particularly in the context of current economic conditions and a rapidly changing regulatory environment. The ALL Committee at least annually reviews the Company's allowance for loan losses methodology. The allocation methodology applied by the Company includes management's ongoing review and grading of the loan portfolio into criticized loan categories (defined as specific loans warranting either specific allocation, or a classified status of substandard, doubtful or loss). The allocation methodology focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, management's ongoing review and grading of the loan portfolio, consideration of migration analysis and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of classified loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. In determining the allowance for loan losses, the Company considers its portfolio segments and loan classes to be the same. 56 For financial periods prior to and including the quarter ended September 30, 2013, in lieu of applying a migration analysis the Company considered historical loss experience based on a rolling three year average of historical loan loss experience. For more information, see the information contained in Part I, Item 7 of the 2013 Form 10-K under the heading "Asset Quality - Provision and Allowance for Loan Losses." Management believes that the level of the allowance for loan losses is appropriate in light of the credit quality and anticipated risk of loss in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various 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 for loan losses through increased provisions for loan losses or may require that certain loan balances be charged-off or downgraded into classified loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examinations. 57



The following table presents the Company's loan loss experience for the periods indicated:

Table 5: Allowance for Loan Losses

Six Months Ended June 30, (dollars in thousands) 2014 2013 Average loans outstanding* $ 681,821$ 674,306

Allowance for loan losses, January 1 $ 14,767$ 20,338 Charge-offs: Commercial, industrial and agricultural (290 ) (559 ) Real estate - one to four family residential: Closed end first and seconds (304 ) (269 ) Home equity lines (54 ) (58 ) Real estate - construction:

One to four family residential - (51 ) Other construction, land development and other land - (950 ) Real estate - non-farm, non-residential: Owner occupied - (449 ) Non-owner occupied - (1,534 ) Consumer (86 ) (75 ) Other (26 ) (72 ) Total loans charged-off (760 ) (4,017 ) Recoveries:

Commercial, industrial and agricultural 30 102 Real estate - one to four family residential: Closed end first and seconds 211 33 Home equity lines 13 1 Real estate - construction:

One to four family residential 6 31 Other construction, land development and other land 2 67 Real estate - non-farm, non-residential: Owner occupied 27 - Non-owner occupied 3 - Consumer 55 58 Other 14 20 Total recoveries 361 312 Net charge-offs (399 ) (3,705 ) Provision for loan losses 250 1,200

Allowance for loan losses, June 30 $ 14,618$ 17,833 Ratios: Ratio of allowance for loan losses to total loans outstanding, end of period 2.09 % 2.66 %



Ratio of annualized net charge-offs to average loans outstanding during the period

0.12 % 1.11 %



*Net of unearned income and includes nonaccrual loans.

As a result of taking a conservative approach to provision for loan losses in prior periods in light of uncertain economic and financial market conditions, the Company made provision for loan losses of $0 and $250 thousand, respectively for the three and six months ended June 30, 2014, as compared to $600 thousand and $1.2 million for the same period of 2013. Net charge-offs for the three and six months ended June 30, 2014 were $288 thousand and $399 thousand, respectively, compared to $2.3 million and $3.7 million, respectively for the same periods of 2013. This represents, on an annualized basis, 0.17% and 0.12% of average loans outstanding for the three and six months ended June 30, 2014 and 1.36% and 1.11% of average loans outstanding for the same periods of 2013. The contribution to the provision in the first six months of 2014 and 2013 was made in response to sustained credit quality issues in our loan portfolio as well as current market conditions, both nationally and in our markets, which indicate that credit quality issues may adversely impact our loan portfolio and our earnings in future periods. The provision for loan losses declined during the first six months of 2014 compared to the same period of 2013 in part due to asset quality improvements made during 2013 and 2014. 58

Net charge-offs decreased $3.3 million, or 89.2%, from the six months ended June 30, 2013 to the same period of 2014 due to improvements in some of the Company's credit quality metrics, including continued decreases in nonperforming assets, and other factors, which are reflective of slowly improving economic conditions. However, the Company continues to aggressively focus on credit quality initiatives to improve its asset quality and resolve nonperforming assets. The allowance for loan losses at June 30, 2014 was $14.6 million, compared with $14.8 million at December 31, 2013. This represented 2.09% of period end loans at June 30, 2014, compared with 2.25% of year end loans at December 31, 2013. The following table shows the allocation of the allowance for loan losses at the dates indicated. Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loan.



Table 6: Allocation of Allowance for Loan Losses

At June 30, At December 31, 2014 2013 (dollars in thousands) Allowance Percent Allowance Percent Commercial, industrial and agricultural $ 1,196 8.16 % $ 1,787 8.17 % Real estate - one to four family residential: Closed end first and seconds 2,578 34.50 % 2,859 33.25 % Home equity lines 1,845 13.98 % 1,642 15.19 % Real estate - multifamily residential 108 2.86 % 79 2.75 % Real estate - construction:

One to four family residential 301 2.46 %

364 2.46 % Other construction, land development and other land 2,492 3.56 % 1,989 3.30 % Real estate - farmland 127 1.03 % 116 1.24 % Real estate - non-farm, non-residential: Owner occupied 2,119 18.38 % 3,236 19.26 % Non-owner occupied 2,628 10.86 % 1,770 11.39 % Consumer 355 2.17 % 387 2.55 % Other 869 2.04 % 538 0.44 %



Total allowance for loan losses $ 14,618 100.00 % $ 14,767 100.00 %

(Percent is portfolio loans in category divided by total loans)

Tabular presentations of commercial loans by credit quality indicator and consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at June 30, 2014 and December 31, 2013 can be found under Item 1. "Financial Statements," under the heading "Note

3. Loan Portfolio." Nonperforming Assets The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management's practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. As of June 30, 2014, management is not aware of any potential problem loans to place immediately on nonaccrual status. When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across our loan portfolio. 59 Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal. Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at estimated fair market value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the estimated fair market value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to property are capitalized. Net operating income or expenses of such properties are included in collection, repossession and other real estate owned expenses. The following table presents information concerning nonperforming assets as of and for the six months ended June 30, 2014 and the year ended December 31, 2013: Table 7: Nonperforming Assets June 30, December 31, (dollars in thousands) 2014 2013 Change $ Change % Nonaccrual loans* $ 9,770$ 11,018$ (1,248 ) -11.3 % Loans past due 90 days and accruing interest - - - - Total nonperforming loans 9,770 11,018 (1,248 ) -11.3 % Other real estate owned 601 800 (199 ) -24.9 % Total nonperforming assets $ 10,371$ 11,818$ (1,447 ) -12.2 % Nonperforming assets to total loans and other real estate owned 1.48 % 1.80 % Allowance for loan losses to nonaccrual loans 149.61 % 134.03 % Annualized net charge-offs to average loans for the period 0.12 % 1.11 % Allowance for loan losses to period end loans 2.09 % 2.25 %



* Includes $4.0 million and $4.2 million in nonaccrual TDRs at June 30, 2014 and December 31, 2013, respectively.

The following table presents the change in the OREO balance for the six months ended June 30, 2014 and 2013: Table 8: OREO Changes June 30, (dollars in thousands) 2014 2013 Change $ Change % Balance at the beginning of period, gross $ 1,054$ 5,558$ (4,504 ) -81.0 % Transfers from loans 289 1,095 (806 ) -73.6 % Sales proceeds (462 ) (2,950 ) 2,488 84.3 % Previously recognized impairment losses on disposition (157 ) - (157 ) -100.0 % Loss on disposition (15 ) (155 ) 140 90.3 % Balance at the end of period, gross 709 3,548 (2,839 ) -80.0 % Less valuation allowance (108 ) (954 ) 846 88.7 % Balance at the end of period, net $ 601$ 2,594$ (1,993 ) -76.8 % 60



The following table presents the change in the valuation allowance for OREO for the six months ended June 30, 2014 and 2013:

Table 9: OREO Valuation Allowance Changes

June 30, (dollars in thousands) 2014 2013 Balance at the beginning of period $ 254$ 811 Valuation allowance 11 143 Charge-offs (157 ) - Balance at the end of period $ 108$ 954 Nonperforming assets were $10.4 million or 1.48% of total loans and other real estate owned at June 30, 2014 compared to $11.8 million or 1.80% at December 31, 2013. Nonperforming assets increased from 2007 through 2010 as a result of the continued challenging economic conditions which significantly increased unemployment, reduced profitability of local businesses, and reduced the ability of many of our customers to keep their loans current. Nonperforming assets began to trend downward during 2011, continued this trend throughout 2012 and 2013 and decreased by $1.4 million during the first six months of 2014. The sluggish economic recovery and continuing asset quality issues in the Company's loan portfolio have prompted the Company to maintain the heightened level of the allowance for loan losses as compared to historical levels, which is 149.61% of nonaccrual loans at June 30, 2014, compared to 134.03% at December 31, 2013. Nonperforming loans decreased $1.2 million or 11.3% during the six months ended June 30, 2014 to $9.8 million. Nonaccrual loans were $9.8 million at June 30, 2014, a decrease of approximately $1.2 million or 11.3% from $11.0 million at December 31, 2013. Of the current $9.8 million in nonaccrual loans, $9.2 million or 93.9% is secured by real estate in our market area. Of these real estate secured loans, $4.9 million are residential real estate, $3.5 million are commercial properties, $590 thousand are farmland, and $132 thousand are real estate construction. Nonaccrual loans increased $1.5 million during the second quarter of 2014 and was primarily due to the Company placing three loans on nonaccrual status as a result of the continued deteriorating financial condition of the borrowers.



As of June 30, 2014 and December 31, 2013, there were no loans past due 90 days and still accruing interest.

Other real estate owned, net of valuation allowance at June 30, 2014 was $601 thousand, a decrease of $199 thousand or 24.9% from $800 thousand at December 31, 2013. The balance of other real estate owned at June 30, 2014 was comprised of 10 properties of which $423 thousand are residential real estate, $165 thousand are real estate construction properties and $13 thousand are commercial properties. During the six months ended June 30, 2014, new foreclosures included four properties totaling $289 thousand transferred from loans. Sales of seven other real estate owned properties for the six months ended June 30, 2014 resulted in a net loss of $15 thousand. Subsequent to June 30, 2014, one property was sold resulting in a net loss of approximately $25 thousand that will be recognized in the third quarter of 2014. The remaining properties are being actively marketed and the Company does not anticipate any material losses associated with these properties. The Company recorded losses of $11 thousand in its consolidated statements of income for the six months ended June 30, 2014, due to valuation adjustments on other real estate owned properties as compared to $143 thousand for the same period of 2013. Asset quality continues to be a top priority for the Company. The Company continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets, as demonstrated by the $2.0 million, or 76.8%, decrease in other real estate owned from June 30, 2013 to June 30, 2014. For more information on asset disposition strategies, see "Strategic Initiatives and Pending Acquisition of Virginia Company Bank" in this Item 2. As discussed earlier in this Item 2, the Company measures impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. TDRs are considered impaired loans. TDRs occur when we agree to modify the original terms of a loan by granting a concession due to the deterioration in the financial condition of the borrower. These concessions can be temporary and are made in an attempt to avoid foreclosure and with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include, without limitation, rate reductions to below market rates, payment deferrals, forbearance, and, in some cases, forgiveness of principal or interest. 61



A tabular presentation of loans individually evaluated for impairment by class of loans at June 30, 2014 and December 31, 2013 can be found under Item 1. "Financial Statements," under the heading "Note 3. Loan Portfolio."

At June 30, 2014, the balance of impaired loans was $44.2 million, for which there were specific valuation allowances of $6.0 million. At December 31, 2013, the balance of impaired loans was $35.5 million, for which there were specific valuation allowances of $5.7 million. The average balance of impaired loans was $38.9 million for the six months ended June 30, 2014, compared to $41.2 million for the year ended December 31, 2013. Impaired loans increased by approximately $8.7 million from December 31, 2013 to June 30, 2014, primarily due to the deteriorating financial condition of two large commercial relationships. The Company's balance of impaired loans remains elevated over historical levels as a result of the continued challenging economic conditions which have significantly increased unemployment, reduced profitability of local businesses, and reduced the ability of many of our customers to keep their loans current.



The following table presents the balances of TDRs at June 30, 2014 and December 31, 2013:

Table 10: Troubled Debt Restructurings (TDRs)

June 30, December 31, (dollars in thousands) 2014 2013 Change $ Change % Performing TDRs $ 16,383$ 16,026$ 357 2.2 % Nonperforming TDRs* 3,963 4,188 (225 ) -5.4 % Total TDRs $ 20,346$ 20,214$ 132 0.7 %



* Included in nonaccrual loans in Table 7: Nonperforming Assets.

At the time of a TDR, the loan is placed on nonaccrual status. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. Financial Condition Summary At June 30, 2014, the Company had total assets of $1.06 billion, an increase of $29.0 million or 2.8% from $1.03 billion at December 31, 2013. The increase in total assets was principally the result of increases in restricted securities, loans, short-term borrowings and shareholders' equity, and partially offset by decreases in cash and short-term investments, interest bearing deposits with banks, investment securities, deferred income taxes and interest-bearing deposits.


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Source: Edgar Glimpses


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