News Column

PEOPLES BANCORP OF NORTH CAROLINA INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company's Consolidated Financial Statements and Notes thereto on pages A-28 through A-64 of the Company's 2013 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2014 Annual Meeting of Shareholders.



Introduction

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company. The Company is the parent company of the Bank and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the "FDIC").



Overview

Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses. Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses. Economic conditions in 2014 continue to demonstrate signs of improvement. While the general trends are positive, the lack of significant recoveries in the housing and job markets continue to stress various segments of our customer base and therefore limit the impact of the economic recovery to our financial condition and results of operations. With the unemployment rate continuing to be higher than historical norms and home prices well below pre-crisis levels, the primary indicators of economic activity for our markets continue to point to challenging business conditions that have slowed our return to pre-crisis levels of earnings. This is also reflected in our local markets, as the unemployment rate in our primary markets remains above the national and state unemployment rates. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") into law. This legislation made extensive changes to the laws regulating financial products and services as well as firms and companies offering financial products and services. The Dodd-Frank Act also altered certain corporate governance matters affecting public companies. The legislation requires substantial rulemaking and mandates numerous additional studies, the results of which could impact future legislative and regulatory action. We continue to evaluate this legislation including its related rules and regulations, and we continue to assess the extent to which it will impact our current and future operations. While we are unable to determine all ramifications of the Dodd-Frank Act at this time, we expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies, the full extent of the impact of such requirements will have on financial institutions' operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements. 24 -------------------------------------------------------------------------------- Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends. Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. While we continue to focus our resources in and around our current footprint, we do consider other avenues of growth that could add shareholder value. The Federal Reserve has maintained the Federal Funds Rate at 0.25% since December 2008. This historically low rate has had a negative impact on earnings and will continue to have a negative impact on our net interest income in future periods. The negative impact of low interest rates has been partially offset by earnings realized on interest rate contracts utilized by the Bank. Additional information regarding the Bank's interest rate contacts is provided below in the section entitled "Asset Liability and Interest Rate Risk Management." On December 23, 2008, the Company entered into a Securities Purchase Agreement ("Purchase Agreement") with the U.S. Department of the Treasury ("UST") pursuant to the Capital Purchase Program ("CPP") under the Troubled Asset Relief Program ("TARP"). Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a Warrant to purchase 357,234 shares of the Company's common stock. Proceeds from this issuance of Series A preferred shares were allocated between preferred stock and the Warrant based on their relative fair values at the time of the sale. Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the Warrant. The discount recorded on the Series A preferred stock that resulted from allocating a portion of the proceeds to the Warrant was being accreted directly to retained earnings over a five-year period applying a level yield. The Series A preferred stock qualified as Tier 1 capital and paid cumulative dividends at a rate of 5% per annum for the first five years (i.e., through December 23, 2013) and 9% per annum thereafter. The Series A preferred stock was redeemable at the stated amount of $1,000 per share plus any accrued and unpaid dividends. Under the terms of the original Purchase Agreement, the Company could not redeem the Series A preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital. However, with the enactment of the American Recovery and Reinvestment Act of 2009 ("ARRA"), the Company could redeem the Series A preferred shares at any time, if approved by the Company's primary regulator. The Series A preferred stock was non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock. The UST sold all of its Series A preferred stock in a public auction in June 2012, and, as a result, the Company is no longer subject to the executive compensation and corporate governance standards imposed by TARP. The Company purchased 12,530 shares of the 25,054 outstanding shares of Series A preferred stock from the UST. The shares were purchased for $933.36 per share, for a total purchase price of $11,778,576, including $83,575 accrued and unpaid dividends on the Series A preferred stock. The Company retired the 12,530 shares purchased. The $834,999 difference between the $12,530,000 face value of the Series A preferred stock retired and the $11,695,001 purchase price of the Series A preferred stock retired was credited to retained earnings effective June 30, 2012. Remaining Series A preferred shares were redeemable at any time at par. During 2012, the Company completed its repurchase of the Warrant to purchase 357,234 shares of the Company's common stock. The Company repurchased the Warrant for a total price of $425,000. The exercise price of the Warrant was $10.52 per common share and was exercisable at anytime on or before December 18, 2018. The Company is no longer accreting the discount associated with the Warrant, as the discount remaining at the time of repurchase was included in the cost of the Warrant. As of December 31, 2013, the Company had accreted a total of $478,000 of the discount related to the Series A preferred stock. The Company received regulatory approval in December 2013 to repurchase and redeem the remaining 12,524 outstanding shares of its Series A preferred stock. The repurchase and redemption was completed on January 17, 2014 and was reflected on the Company's Consolidated Balance Sheets as of December 31, 2013. "Accrued interest payable and other liabilities" at December 31, 2013 includes $12.6 million for the payment to preferred shareholders of principal and accrued dividends on January 17, 2014. 25 -------------------------------------------------------------------------------- Summary of Significant Accounting Policies The Company's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition. Many of the Company's accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. A more complete description of the Company's significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company's 2013 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2014 Annual Meeting of Shareholders. Many of the Company's assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectibility of loans is reflected through the Company's estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectibility. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company's internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in this management's discussion and analysis and the Notes to the Consolidated Financial Statements. GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The table below presents the balance of securities available for sale, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of June 30, 2014 and December 31, 2013. (Dollars in thousands) June 30, 2014 Fair Value Level 1 Level 2 Level 3 Measurements Valuation Valuation Valuation Mortgage-backed securities $ 117,514 - 117,514 - U.S. Government sponsored enterprises $ 25,101 - 25,101 -



State and political subdivisions $ 148,629 - 148,629

- Corporate bonds $ 3,487 - 3,487 - Trust preferred securities $ 750 - - 750 Equity securities $ 1,684 1,684 - - (Dollars in thousands) December 31, 2013 Fair Value Level 1 Level 2 Level 3 Measurements Valuation Valuation Valuation Mortgage-backed securities $ 123,977 - 123,977 - U.S. Government sponsored enterprises $ 22,143 - 22,143 -



State and political subdivisions $ 145,368 - 145,368

- Corporate bonds $ 3,463 - 3,463 - Trust preferred securities $ 1,250 - - 1,250 Equity securities $ 1,689 1,689 - - Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities. 26 -------------------------------------------------------------------------------- The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2014: (Dollars in thousands) Investment Securities Available for Sale Level 3 Valuation Balance, beginning of period $ 1,250 Change in book value - Change in gain/(loss) realized and unrealized



-

Purchases/(sales and calls) (500 ) Transfers in and/or (out) of Level 3



-

Balance, end of period $



750

Change in unrealized gain/(loss) for assets still held in Level 3 $

-

The Bank's June 30, 2014 and December 31, 2013 fair value measurements for impaired loans and other real estate on a non-recurring basis are presented below. The fair value measurement process uses certified appraisals and other market-based information; however, in many cases, it also requires significant input based on management's knowledge of and judgment about current market conditions, specific issues relating to the collateral, and other matters. As a result, all fair value measurements for impaired loans and other real estate are considered Level 3. (Dollars in thousands) Total Gains/(Losses) for Fair Value the Six Months Measurements Level 1 Level 2 Level 3 Ended June 30, 2014 Valuation Valuation Valuation June 30, 2014

Impaired loans $ 36,983 - - 36,983 (433 ) Other real estate $ 3,532 - - 3,532 (150 ) (Dollars in thousands) Total Gains/(Losses) for Fair Value the Year Ended Measurements Level 1 Level 2 Level 3 December 31, December 31, 2013 Valuation Valuation Valuation 2013

Impaired loans $ 39,780 - - 39,780 (3,207 ) Other real estate $ 1,679 - - 1,679 (581 ) At each reporting period, the Bank determines which loans are impaired. Accordingly, the Bank's impaired loans are reported at their estimated fair value on a non-recurring basis. An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral. The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank. REAS is staffed by certified appraisers that also perform appraisals for other companies. Factors, including the assumptions and techniques utilized by the appraiser, are considered by management. If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses. An allowance for each impaired loan that is non-collateral dependent is calculated based on the present value of projected cash flows. If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses. Impaired loans under $250,000 are not individually evaluated for impairment, with the exception of the Bank's TDR loans in the residential mortgage loan portfolio, which are individually evaluated for impairment. Accruing impaired loans were $27.7 million, $27.6 million and $26.2 million at June 30, 2014, December 31, 2013 and June 30, 2013, respectively. Interest income recognized on accruing impaired loans was $681,000, $579,000 and $1.3 million for the six months ended June 30, 2014, the six months ended June 30, 2013 and the year ended December 31, 2013, respectively. Interest income recognized on accruing impaired loans was $325,000 and $286,000 for the three months ended June 30, 2014 and 2013, respectively. No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual. 27 -------------------------------------------------------------------------------- Results of Operations Summary. Net earnings were $2.6 million or $0.45 basic and diluted net earnings per share for the three months ended June 30, 2014, as compared to $1.6 million or $0.29 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, for the same period one year ago. After adjusting for dividends and accretion on preferred stock, net earnings available to common shareholders were $2.6 million or $0.45 basic and diluted net earnings per common share for the three months ended June 30, 2014, as compared to $1.5 million or $0.26 basic and diluted net earnings per common share, for the same period one year ago. The increase in second quarter earnings is attributable to a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by a decrease in non-interest income. The annualized return on average assets was 1.00% for the three months ended June 30, 2014 compared to 0.64% for the same period one year ago, and annualized return on average shareholders' equity was 11.08% for the three months ended June 30, 2014 compared to 6.55% for the same period one year ago. Year-to-date net earnings as of June 30, 2014 were $5.1 million or $0.91 basic and diluted net earnings per share, as compared to $3.4 million or $0.60 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, for the same period one year ago. After adjusting for dividends and accretion on preferred stock, net earnings available to common shareholders for the six months ended June 30, 2014 were $5.1 million or $0.91 basic and diluted net earnings per common share, as compared to $3.1 million or $0.55 basic and diluted net earnings per common share, for the same period one year ago. The increase in year-to-date earnings is primarily attributable to a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by a decrease in non-interest income and an increase in non-interest expense, as discussed below. The annualized return on average assets was 1.01% for the six months ended June 30, 2014 compared to 0.68% for the same period one year ago, and annualized return on average shareholders' equity was 11.33% for the six months ended June 30, 2014 compared to 6.80% for the same period one year ago. Net Interest Income. Net interest income, the major component of the Company's net earnings, was $8.5 million for the three months ended June 30, 2014, compared to $7.5 million for the same period one year ago. This increase was primarily due to an increase in interest income due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities combined with a decrease in interest expense due to a reduction in the cost of funds. Interest income increased $667,000 or 7% for the three months ended June 30, 2014 compared to the same period one year ago. The increase was primarily due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities. The average yield on investment securities available for sale for the quarters ended June 30, 2014 and 2013 was 3.55% and 2.67%, respectively. The average yield on earning assets for the quarters ended June 30, 2014 and 2013 was 4.34% and 3.97%, respectively. During the quarter ended June 30, 2014, average investment securities available for sale increased $4.2 million to $295.2 million from $291.0 million for the three months ended June 30, 2013. During the quarter ended June 30, 2014, average loans increased $12.2 million to $619.7 million from $607.5 million for the three months ended June 30, 2013. Interest expense decreased $287,000 or 21% for the three months ended June 30, 2014 compared with the same period one year ago due to lower cost of funds and a reduction in certificates of deposit. The average rate paid on interest-bearing checking and savings accounts was 0.13% for the three months ended June 30, 2014 as compared to 0.21% for the same period one year ago. The average rate paid on certificates of deposit was 0.58% for the three months ended June 30, 2014 compared to 0.73% for the same period one year ago. During the quarter ended June 30, 2014, average certificates of deposit decreased $22.6 million to $210.3 million from $232.9 million for the three months ended June 30, 2013. The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the three months ended June 30, 2014 and 2013. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders' equity. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate of 37.96% for securities that are both federal and state tax exempt and an effective tax rate of 31.96% for federal tax exempt securities. Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported. 28 --------------------------------------------------------------------------------

Three months ended Three months ended June 30, 2014 June 30, 2013 Yield Average Yield / Average / (Dollars in thousands) Balance



Interest Rate Balance Interest Rate Interest-earning assets:

Loans receivable $ 619,675



7,491 4.85% 607,481 7,439 4.91% Investments - taxable

125,403 758 2.42% 139,546 225 0.65% Investments - nontaxable* 175,107



1,901 4.38% 157,283 1,747 4.46% Other

18,060



12 0.26% 48,588 28 0.23%

Total interest-earning assets 938,245



10,162 4.34% 952,898 9,439 3.97%

Cash and due from banks 47,399 28,002 Other assets 52,362 54,430 Allowance for loan losses (13,018 ) (14,286 ) Total assets $ 1,024,988 1,021,044



Interest-bearing liabilities:

NOW, MMDA & savings deposits $ 392,186 125 0.13% 374,531 200 0.21% Time deposits 210,251 303 0.58% 232,868 422 0.73% FHLB borrowings 65,000 549 3.39% 70,000 635 3.64% Trust preferred securities 20,619 97 1.89% 20,619 100 1.96% Other 45,597



11 0.09% 41,965 15 0.14%

Total interest-bearing liabilities 733,653 1,085 0.59% 739,983 1,372 0.74% Demand deposits 195,383 176,974 Other liabilities 4,786 4,714 Shareholders' equity 92,388 100,054 Total liabilities and shareholder's equity $ 1,026,210 1,021,725 Net interest spread $ 9,077 3.75% 8,067 3.23% Net yield on interest-earning assets 3.88% 3.40% Taxable equivalent adjustment Investment securities $ 586 530 Net interest income $ 8,491 7,537 *Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $25.4 million in 2014 and $19.3 million in 2013. Tax rates of 6.00% and 6.90% were used to calculate the tax equivalent yield on these securities in 2014 and 2013, respectively. Year-to-date net interest income as of June 30, 2014 increased 11.5% to $16.9 million compared to $15.2 million for the same period one year ago. This increase was primarily due to an increase in interest income due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities combined with a decrease in interest expense due to a reduction in the cost of funds. Interest income increased $1.1 million or 6% for the six months ended June 30, 2014 compared with the same period in 2013. This increase was primarily due to an increase in the yield on investment securities and an increase in the average outstanding balance of investment securities. The average yield on investment securities available for sale for the six months ended June 30, 2014 and 2013 was 3.56% and 2.66%, respectively. The average yield on earning assets for the six months ended June 30, 2014 and 2013 was 4.35% and 4.06%, respectively. During the six months ended June 30, 2014, average investment securities available for sale increased $8.3 million to $297.1 million from $288.8 million for the six months ended June 30, 2013. During the six months ended June 30, 2014, average loans increased $4.3 million to $618.6 million from $614.3 million for the six months ended June 30, 2013. Interest expense decreased $638,000 or 23% for the six months ended June 30, 2014 compared with the same period in 2013 primarily due to lower cost of funds and a reduction in certificates of deposit. The average rate paid on interest-bearing checking and savings accounts was 0.13% for the six months ended June 30, 2014 as compared to 0.23% for the same period one year ago. The average rate paid on certificates of deposits was 0.60% for the six months ended June 30, 2014 compared to 0.75% for the same period one year ago. Average certificates of deposit decreased $22.8 million to $214.8 million for the six months ended June 30, 2014 from $237.6 million for the six months ended June 30, 2013. 29

-------------------------------------------------------------------------------- The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the six months ended June 30, 2014 and 2013. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders' equity. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate of 37.96% for securities that are both federal and state tax exempt and an effective tax rate of 31.96% for federal tax exempt securities. Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported. Six months ended Six months ended June 30, 2014 June 30, 2013 Yield Average Yield / Average / (Dollars in thousands) Balance



Interest Rate Balance Interest Rate Interest-earning assets:

Loans receivable $ 618,574



14,893 4.86% 614,241 15,079 4.95% Investments - taxable

127,983



1,549 2.44% 144,278 567 0.79% Investments - nontaxable*

174,556



3,833 4.43% 150,499 3,342 4.48% Other

19,359



24 0.25% 35,885 40 0.22%

Total interest-earning assets 940,472



20,299 4.35% 944,903 19,028 4.06%

Cash and due from banks 45,403 26,884 Other assets 49,579 55,406 Allowance for loan losses (13,307 ) (14,496 ) Total assets $ 1,022,147 1,012,697



Interest-bearing liabilities:

NOW, MMDA & savings deposits $ 389,248 251 0.13% 371,502 418 0.23% Time deposits 214,825 637 0.60% 237,615 889 0.75% FHLB borrowings 65,000 1,094 3.40% 70,000 1,296 3.73% Trust preferred securities 20,619 193 1.89% 20,619 199 1.96% Other 44,582 21 0.10% 39,371 32 0.16% Total interest-bearing liabilities 734,274 2,196 0.60% 739,107 2,834 0.77% Demand deposits 193,985 169,921 Other liabilities 5,185 4,611 Shareholders' equity 91,331 100,532 Total liabilities and shareholder's equity $ 1,024,775 1,014,171 Net interest spread $ 18,103 3.75% 16,194 3.29% Net yield on interest-earning assets 3.88% 3.40% Taxable equivalent adjustment Investment securities $ 1,178 1,016 Net interest income $ 16,925 15,178 *Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $24.1 million in 2014 and $19.2 million in 2013. Tax rates of 6.00% and 6.90% were used to calculate the tax equivalent yield on these securities in 2014 and 2013, respectively. Changes in interest income and interest expense can result from variances in both volume and rates. The following table presents the impact on the Company's tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each. 30 -------------------------------------------------------------------------------- Six months ended June 30, 2014 Three months ended June 30, 2014 compared to six months ended June compared to three months ended June 30, 30, 2013 2013 Changes in Changes in Total Changes in Changes in Total average average Increase average average Increase (Dollars in thousands) volume rates (Decrease) volume rates (Decrease) Interest income: Loans: Net of unearned income $ 148 (96 ) 52 105 (291 ) (186 ) Investments - taxable (54 ) 587 533 (131 ) 1,113 982 Investments - nontaxable 196 (42 ) 154 531 (40 ) 491 Other (19 ) 3 (16 ) (20 ) 4 (16 ) Total interest income 271 452 723 485 786 1,271 Interest expense: NOW, MMDA & savings deposits 7 (82 ) (75 ) 16 (183 ) (167 ) Time deposits (37 ) (82 ) (119 ) (77 ) (175 ) (252 ) FHLB borrowings (44 ) (42 ) (86 ) (88 ) (114 ) (202 ) Trust preferred securities - (3 ) (3 ) - (6 ) (6 ) Other 1 (5 ) (4 ) 3 (13 ) (10 ) Total interest expense (73 ) (214 ) (287 ) (146 ) (491 ) (637 ) Taxable equivalent net interest income $ 344 666



1,010 631 1,277 1,908

Provision for Loan Losses. The provision for loan losses for the three months ended June 30, 2014 was $67,000, as compared to $773,000 for the same period one year ago. The decrease in the provision for loan losses is primarily attributable to a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014 and a reduction in net charge-offs of $786,000 during the three months ended June 30, 2014, as compared to the same period one year ago. The provision for loan losses for the six months ended June 30, 2014 was a credit of $282,000, as compared to an expense of $1.8 million for the same period one year ago. The decrease in the provision for loan losses is primarily attributable to a $1.7 million decrease in net charge-offs during the six months ended June 30, 2014 compared to the same period one year ago and a $5.2 million reduction in non-accrual loans from June 30, 2013 to June 30, 2014. The credit to provision for loan losses in the six months ended June 30, 2014 resulted from, and was considered appropriate as part of, management's assessment and estimate of the risks in the total loan portfolio and determination of the total allowance for loan losses. The primary factors contributing to the decrease in the allowance for loan losses at June 30, 2014 to $12.7 million from $13.5 million at December 31, 2013 were the continuing positive trends in indicators of potential losses on loans, primarily non-accrual loans and the reduction in net charge-offs since 2010, as shown below: 31 --------------------------------------------------------------------------------

(Dollars in thousands) Net charge-offs Net charge-offs as a percent of average loans outstanding Six months ended Six months ended June 30, Years ended December 31, June 30, Years ended December 31, 2014 2013 2013 2012 2011 2010 2014 2013 2013 2012 2011 2010 Real estate loans Construction and land development $ (22 ) 689 400 4,201 6,923 10,135 -0.04% 0.96% 0.58% 4.99% 6.40% 6.84% Single-family residential 134 593 1,613 814 2,049 2,853 0.07% 0.30% 0.82% 0.39% 0.91% 1.15% Single-family residential - 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Banco de la Gente stated income 123 154 132 668 675 425 0.25% 0.30% 0.26% 1.25% 1.23% 0.98% Commercial (30 ) 225 395 563 1,247 753 -0.01% 0.12% 0.20% 0.27% 0.59% 0.43% Multifamily and farmland - - - - - - 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Total real estate loans 205 1,661 2,540 6,246 10,894 14,166 0.04% 0.32% 0.48% 1.12% 1.80% 2.14% - - - - - - Loans not secured by real estate Commercial loans 167 357 458



451 193 1,668 0.25% 0.59% 0.73% 0.75%

0.34% 3.41% Farm loans - - - - - - 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Consumer loans (1) 172 203 508 408 434 524 1.78% 2.12% 5.27% 4.00% 4.05% 4.73% All other loans - - - - - - 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Total loans $ 544 2,221 3,506



7,105 11,521 16,358 0.09% 0.37% 0.57% 1.10%

1.65% 2.16%

Provision for loan losses for the period $ (282 ) 1,827 2,584



4,924 12,632 16,438

Allowance for loan losses at end of period $ 12,675 14,029 13,501 14,423 16,604 15,493 Total loans at end of period $ 633,336 608,072 620,960 619,974 670,497 726,160



Non-accrual loans at end of period $ 10,921 16,107 13,836 17,630 21,785 40,062

Allowance for loan losses as a percent of total loans outstanding at end of period 2.00% 2.31% 2.17%



2.33% 2.48% 2.13%

Non-accrual loans as a percent of total loans outstanding at end of period 1.72% 2.65% 2.23%



2.84% 3.25% 5.52%

(1) The loss ratio for Consumer loans is elevated because overdraft charge-offs related to DDA and NOW accounts are reported in Consumer Loan charge-offs and recoveries. The net overdraft charge-offs are not considered material and are therefore not shown separately.

Another factor considered in taking a credit to provision expense in the six months ended June 30, 2014 was the continuing decline in the construction and land development portfolio. This portfolio has experienced the highest percentage of loss since 2010 as shown in the table above. The balance outstanding declined to $59.8 million at June 30, 2014 from $63.7 million at December 31, 2013, continuing the decline in this portfolio from the maximum balance of $213.7 million at December 31, 2008. Also, the net losses in this portfolio declined to a credit in the six months ended June 30, 2014 of $22,000 as opposed to a net loss of $689,000 for the same period in 2013. Non-Interest Income. Total non-interest income was $3.1 million for the three months ended June 30, 2014, compared to $3.3 million for the same period one year ago. This decrease is primarily attributable to a $352,000 decrease in gains on sale of securities and a $127,000 decrease in mortgage banking income due to a reduction in mortgage loan activity. These decreases in non-interest income were partially offset by a $111,000 increase in service charges and fees primarily due to an increase in commercial checking service charge income and a $185,000 increase in miscellaneous non-interest income primarily due to a reduction in losses and write-downs on foreclosed properties for the three months ended June 30, 2014, as compared to the same period one year ago. Non-interest income was $6.0 million for the six months ended June 30, 2014, compared to $6.7 million for the same period one year ago. This decrease is primarily attributable to a $588,000 decrease in gains on sale of securities and a $407,000 decrease in mortgage banking income due to a reduction in mortgage loan activity. These decreases in non-interest income were partially offset by a $246,000 increase in service charges and fees primarily due to an increase in commercial checking service charge income for the six months ended June 30, 2014, as compared to the same period one year ago. Non-Interest Expense. Total non-interest expense was $8.1 million for the three months ended June 30, 2014, compared to $8.0 million for the same period one year ago. This increase is primarily due to a $146,000 increase in occupany expense primarily due to an increase in depreciation expense, which was due to a $145,000 increase in furniture and equipment depreciation expense during the three months ended June 30, 2014, as compared to the same period one year ago. Non-interest expense was $16.2 million for the six months ended June 30, 2014, as compared to $15.7 million for the same period one year ago. This increase is primarily due to a $356,000 increase in occupancy expense primarily due to an increase in depreciation expense, which was primarily due to a $257,000 increase in furniture and equipment depreciation expense during the six months ended June 30, 2014, as compared to the same period one year ago.



Income Taxes. The Company reported income tax expense of $916,000 and $461,000 for the three months ended June 30, 2014 and 2013, respectively. This represented an effective tax rate of 26% and 22% for the respective periods.

32 --------------------------------------------------------------------------------



The Company reported income taxes of $1.8 million and $979,000 for the six months ended June 30, 2014 and 2013, respectively. This represented an effective tax rate of 26% and 22% for the respective periods.

Analysis of Financial Condition Investment Securities. Available for sale securities were $297.2 million at June 30, 2014 compared to $297.9 million at December 31, 2013. Average investment securities available for sale for the six months ended June 30, 2014 were $295.2 million compared to $293.8 million for the year ended December 31, 2013. Loans. At June 30, 2014, loans were $633.3 million compared to $621.0 million at December 31, 2013. Loans originated or renewed during the three months ended June 30, 2014, amounting to approximately $91.8 million, were offset by paydowns and payoffs of existing loans. Average loans represented 66% and 65% of average earning assets for the six months ended June 30, 2014 and the year ended December 31, 2013, respectively. The Company had $2.0 million and $497,000 in mortgage loans held for sale as of June 30, 2014 and December 31, 2013, respectively. Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Real estate mortgage loans include both commercial and residential mortgage loans. At June 30, 2014, the Company had $104.7 million in residential mortgage loans, $84.0 million in home equity loans and $280.6 million in commercial mortgage loans, which include $224.7 million secured by commercial property and $55.9 million secured by residential property. Residential mortgage loans include $56.6 million made to customers in the Company's traditional banking offices and $48.2 million in mortgage loans originated in the Company's Latino banking offices. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.



At June 30, 2014, the Company had $59.8 million in construction and land development loans. The following table presents a breakout of these loans.

(Dollars in thousands) Number of Balance Non-accrual Loans Outstanding Balance Land acquisition and development - commercial purposes 63 $ 14,078 $ 30 Land acquisition and development - residential purposes 273 36,028 5,186 1 to 4 family residential construction 41 6,153 - Commercial construction 6 3,584 - Total construction and land development 383 $



59,843 $ 5,216

Total TDR loans amounted to $11.7 million and $21.9 million at June 30, 2014 and December 31, 2013, respectively. The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower. There were $1.5 million and $335,000 in performing loans classified as TDR loans at June 30, 2014 and December 31, 2013, respectively. Allowance for Loan Losses. The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are: the Bank's loan loss experience; the amount of past due and non-performing loans; specific known risks; the status and amount of other past due and non-performing assets; underlying estimated values of collateral securing loans; current and anticipated economic conditions; and



other factors which management believes affect the allowance for potential

credit losses. 33

-------------------------------------------------------------------------------- Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank's originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan's performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank's Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank's Credit Administration. Any issues regarding the risk assessments are addressed by the Bank's senior credit administrators and factored into management's decision to originate or renew the loan. The Bank's Board of Directors reviews, on a monthly basis, an analysis of the Bank's reserves relative to the range of reserves estimated by the Bank's Credit Administration. As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than $1.0 million, excluding loans in default, and loans in process of litigation or liquidation. The third party's evaluation and report is shared with management and the Bank's Board of Directors. Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk. Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses. The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment. When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management's current evaluation of the Bank's loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below. The general allowance reflects reserves established under GAAP for collective loan impairment. These reserves are based upon historical net charge-offs using the greater of the last two, three, four or five years' loss experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves. The unallocated allowance is determined through management's assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management's acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the unallocated portion may fluctuate from period to period based on management's evaluation of the factors affecting the assumptions used in calculating the allowance. Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Bank's loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with GAAP and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations. Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment. The allowance for loan losses at June 30, 2014 was $12.7 million or 2.00% of total loans compared to $13.5 million or 2.17% of total loans at December 31, 2013. 34

--------------------------------------------------------------------------------



The following table presents the percentage of loans assigned to each risk grade at June 30, 2014 and December 31, 2013.

Percentage of Loans By Risk Grade Risk Grade 6/30/2014 12/31/2013



Risk Grade 1 (Excellent Quality) 2.17% 2.40% Risk Grade 2 (High Quality)

20.56% 18.82% Risk Grade 3 (Good Quality) 50.74% 49.49% Risk Grade 4 (Management Attention) 16.75% 18.69% Risk Grade 5 (Watch) 4.84% 5.05% Risk Grade 6 (Substandard) 4.62% 5.25% Risk Grade 7 (Doubtful) 0.00% 0.00% Risk Grade 8 (Loss) 0.01% 0.00% At June 30, 2014, including non-accrual loans, there were six relationships exceeding $1.0 million in the Watch risk grade (which totaled $12.4 million) and four relationships exceeding $1.0 million in the Substandard risk grade (which totaled $9.8 million). Non-performing Assets. Non-performing assets totaled $14.8 million at June 30, 2014, or 1.42% of total assets, compared to $16.4 million at December 31, 2013, or 1.58% of total assets. Non-accrual loans were $10.9 million at June 30, 2014 and $13.8 million at December 31, 2013. As a percentage of total loans outstanding, non-accrual loans were 1.72% at June 30, 2014 compared to 2.23% at December 31, 2013. Non-accrual loans include $5.2 million in construction and land development loans, $5.1 million in commercial and residential mortgage loans and $558,000 in other loans at June 30, 2014 as compared to $6.5 million in construction and land development loans, $7.0 million in commercial and residential mortgage loans and $277,000 in other loans at December 31, 2013. The Bank had loans 90 days past due and still accruing totaling $392,000 and $882,000 as of June 30, 2014 and December 31, 2013, respectively. Other real estate totaled $3.5 million at June 30, 2014 as compared to $1.7 million at December 31, 2013. Deposits. Total deposits at June 30, 2014 were $811.5 million compared to $799.4 million at December 31, 2013. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposit of denominations less than $100,000, were $699.1 million at June 30, 2014 as compared to $683.9 million at December 31, 2013. Certificates of deposit in amounts of $100,000 or more totaled $112.2 million at June 30, 2014 as compared to $115.3 million at December 31, 2013. At June 30, 2014, brokered deposits were $11.0 million as compared to $15.1 million at December 31, 2013. Brokered deposits outstanding as of June 30, 2014 had a weighted average rate of 0.13% with a weighted average original term of ten months as compared to brokered deposits outstanding at December 31, 2013, which had a weighted average rate of 0.14% with a weighted average original term of eight months. Borrowed Funds. Borrowings from the FHLB totaled $65.0 million at June 30, 2014 and December 31, 2013. The average balance of FHLB borrowings for the three months ended June 30, 2014 was $65.0 million compared to $69.7 million for the year ended December 31, 2013. The FHLB borrowings outstanding at June 30, 2014 had interest rates ranging from 1.79% to 4.26% and maturity dates ranging from 2014 to 2019.



Securities sold under agreements to repurchase were $46.8 million at June 30, 2014 compared to $45.4 million at December 31, 2013.

Junior Subordinated Debentures (related to Trust Preferred Securities). In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II ("PEBK Trust II"), which issued $20.0 million of guaranteed preferred beneficial interests in the Company's junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued in December 2001 by PEBK Capital Trust, a wholly owned Delaware statutory trust of the Company, and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the Consolidated Financial Statements. The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities. 35 -------------------------------------------------------------------------------- These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, which right became effective on June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount plus any accrued but unpaid interest. Asset Liability and Interest Rate Risk Management. The objective of the Company's Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. The Company manages its exposure to fluctuations in interest rates through policies established by our Asset/Liability Committee ("ALCO"). ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities. The Company's rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. Average rate sensitive assets for the six months ended June 30, 2014 totaled $940.5 million, exceeding average rate sensitive liabilities of $734.3 million by $206.2 million. The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company. The Company did not have any interest rate derivatives outstanding as of June 30, 2014. Included in the rate sensitive assets are $281.2 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee ("FOMC"). The Company utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At June 30, 2014, the Company had $195.1 million in loans with interest rate floors. The floors were in effect on $192.8 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 1.01% higher than the indexed rate on the promissory notes without interest rate floors. Liquidity. The objectives of the Company's liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company's liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of June 30, 2014, such unfunded commitments to extend credit were $165.3 million, while commitments in the form of standby letters of credit totaled $3.5 million. The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposit of denominations less than $100,000. The Company considers these to be a stable portion of the Company's liability mix and the result of on-going consumer and commercial banking relationships. As of June 30, 2014, the Company's core deposits totaled $699.1 million, or 86% of total deposits. The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreements to repurchase and FHLB borrowings. The Bank is also able to borrow from the Federal Reserve Bank ("FRB") on a short-term basis. The Company's policies include the ability to access wholesale funding of up to 40% of total assets. The Company's wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina. The Company's ratio of wholesale funding to total assets was 7.29% as of June 30, 2014. 36 -------------------------------------------------------------------------------- At June 30, 2014, the Bank had a significant amount of deposits in amounts greater than $100,000. The cost of these deposits is more susceptible to changes in the interest rate environment than other deposits. Access to the brokered deposit market could be restricted if the Bank were to fall below the well capitalized level. The Bank has a line of credit with the FHLB equal to 20% of the Bank's total assets, with an outstanding balance of $65.0 million at June 30, 2014 and December 31, 2013. At June 30, 2014, the carrying value of loans pledged as collateral to the FHLB totaled $126.2 million compared to $132.9 million at December 31, 2013. As additional collateral, the Bank has pledged securities to the FHLB. At June 30, 2014, the market value of securities pledged to the FHLB totaled $14.7 million compared to $17.3 million at December 31, 2013. The remaining availability under the line of credit with the FHLB was $23.4 million at June 30, 2014 compared to $21.6 million at December 31, 2013. The Bank had no borrowings from the FRB at June 30, 2014 or December 31, 2013. FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At June 30, 2014, the carrying value of loans pledged as collateral to the FRB totaled $313.8 million compared to $315.2 million at December 31, 2013. The Bank also had the ability to borrow up to $54.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of June 30, 2014. The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 35.55% at June 30, 2014 and 35.65% at December 31, 2013. The minimum required liquidity ratio as defined in the Bank's Asset/Liability and Interest Rate Risk Management Policy is 10%. Contractual Obligations and Off-Balance Sheet Arrangements. The Company's contractual obligations and other commitments as of June 30, 2014 and December 31, 2013 are summarized in the table below. The Company's contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below. (Dollars in thousands) December June 30, 2014 31, 2013 Contractual Cash Obligations Long-term borrowings $ 65,000 65,000 Junior subordinated debentures 20,619 20,619 Operating lease obligations 4,873 3,743 Total $ 90,492 89,362 Other Commitments Commitments to extend credit $ 165,317 146,243 Standby letters of credit and financial guarantees written 3,509 4,361 Total $ 168,826 150,604 The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Further discussions of derivative instruments are included above in the section entitled "Asset Liability and Interest Rate Risk Management". Capital Resources. Shareholders' equity was $93.0 million, or 8.9% of total assets, as of June 30, 2014, compared to $83.7 million, or 8.1% of total assets, as of December 31, 2013. This increase reflects an increase in retained earnings and an increase in accumulated other comprehensive income resulting from an increase in the unrealized gain on investment securities During 2012, the Company purchased 12,530 shares of the Company's 25,054 outstanding shares of Series A preferred stock from the UST. The shares were purchased for $933.36 per share, for a total purchase price of $11,778,576, including $83,575 accrued and unpaid dividends on the Series A preferred stock. The Company retired the 12,530 shares purchased. The $834,999 difference between the $12,530,000 face value of the Series A preferred stock retired and the $11,695,001 purchase price of the Series A preferred stock retired was credited to retained earnings effective June 30, 2012. Remaining Series A preferred shares were redeemable at any time at par. 37 -------------------------------------------------------------------------------- During 2012, the Company completed its repurchase of the Warrant to purchase 357,234 shares of the Company's common stock. The Company repurchased the Warrant for a total price of $425,000. The exercise price of the Warrant was $10.52 per common share and was exercisable at any time on or before December 18, 2018. The Company is no longer accreting the discount associated with the Warrant, as the discount remaining at the time of repurchase was included in the cost of the Warrant. As of December 31, 2013, the Company had accreted a total of $478,000 of the discount related to the Series A preferred stock. The Company received regulatory approval in December 2013 to repurchase and redeem the remaining 12,524 outstanding shares of its Series A preferred stock. The repurchase and redemption was completed on January 17, 2014 and was reflected on the Company's Consolidated Balance Sheets as of December 31, 2013. "Accrued interest payable and other liabilities" at December 31, 2013 includes $12.6 million for the payment to preferred shareholders of principal and accrued dividends on January 17, 2014. Annualized return on average equity for the six months ended June 30, 2014 was 11.33% compared to 6.67% for the year ended December 31, 2013. Total cash dividends paid on common stock were $454,000 and $337,000 for the six months ended June 30, 2014 and 2013, respectively. The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights. The Board of Directors does not currently anticipate issuing any additional series of preferred stock. Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital at June 30, 2014 and December 31, 2013 includes $20.0 million in trust preferred securities. The Company's Tier 1 capital ratio was 14.80% and 14.83% at June 30, 2014 and December 31, 2013, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company's total risk-based capital ratio was 16.11% and 16.14% at June 30, 2014 and December 31, 2013, respectively. In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company's Tier 1 leverage capital ratio was 10.69% and 10.08% at June 30, 2014 and December 31, 2013, respectively. The Bank's Tier 1 risk-based capital ratio was 14.13% and 14.43% at June 30, 2014 and December 31, 2013, respectively. The total risk-based capital ratio for the Bank was 15.44% and 15.73% at June 30, 2014 and December 31, 2013, respectively. The Bank's Tier 1 leverage capital ratio was 10.20% and 9.79% at June 30, 2014 and December 31, 2013, respectively. A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at June 30, 2014. On July 2, 2013, the Federal Reserve Board approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations. Capital levels at the Company and the Bank currently exceed the new capital requirements, which will be effective on January 1, 2015. 38



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