10-K 1 ffis_10k.htm ANNUAL REPORT ffis_10k.htm
UNITED STATES
SECURITIES EXCHANGE COMMISSION
Washington, D.C. 20429
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2012
_____________
 
1st FINANCIAL SERVICES CORPORATION
(Name of Registrant as specified in its charter)
 
North Carolina
  
000-53264
  
26-0207901
(State or other jurisdiction of
incorporation or organization)
  
(Commission
File Number)
  
(I.R.S. Employer
Identification No.)
 
101 Jack Street
Hendersonville, North Carolina 28792
(Address of principal executive offices, including Zip Code)
 
(828) 697-3100
Registrant’s telephone number, including area code
_____________
 
Securities registered under Section 12(b) of the Act:
None
Securities registered under Section 12(g) of the Act:
Common Stock, $5.00 par value per share
 
(Title of class)
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o    No  þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o   No  þ
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  o
 
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ   No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  
 
Large accelerated filer
 o
Accelerated filer
 o
Non-accelerated filer
 o
Smaller reporting company
 þ

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o   No  þ
 
The aggregate market value of the Registrant’s common stock held by non-affiliates (stockholders holding less than 5% of an outstanding class of stock, excluding directors and executive officers) of the Registrant as of June 30, 2012, was $1.2 million based on the closing sale price of the Registrant’s common stock as reported on the OTC Bulletin Board.
 
On February 25, 2013, there were 5,204,385 outstanding shares of the Registrant’s common stock.
 
Documents Incorporated by Reference
 
Portions of Registrant’s definitive Proxy Statement to be filed with the SEC in connection with its 2013 Annual Meeting are incorporated into Part III of this Report.
 
 
 
 

FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2012

TABLE OF CONTENTS

PART I

     
Page
  
    3-17  
    18-28  
    29  
    29  

PART II


PART III


PART IV


 
2
 

PART I
 
 
CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  These statements represent expectations and beliefs of 1st Financial Services Corporation (1st Financial or the Company) including but not limited to 1st Financial’s operations, performance, financial condition, growth or strategies.  These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimates”, “believes” and variations of these words and other similar statements.  For this purpose, any statements contained in this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  These forward-looking statements involve estimates, assumptions, risks, and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation:
 
●  
there is substantial doubt about the ability of 1st Financial to continue as a going concern;

●  
1st Financial and its subsidiary, Mountain 1st Bank and Trust Company (the Bank) may be subject to additional, heightened enforcement actions, and ultimately, the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order (the Consent Order) with the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Commissioner of Banks (the Commissioner) and the Written Agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (Federal Reserve Bank), or if our condition continues to deteriorate;

●  
difficult market conditions and economic trends have adversely affected our industry and our business;

●  
financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations;

●  
our participation in the TARP Capital Purchase Program imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity;

●  
we are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our preferred stock;

●  
the limitations on incentive compensation contained in the American Recovery and Reinvestment Act of 2009  and subsequent regulations may adversely affect our ability to retain our highest performing employees;

●  
the soundness of other financial institutions could adversely affect us;

●  
increases in FDIC insurance premiums may adversely affect our net income and profitability;

●  
1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue;

●  
we need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed;

●  
our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio;

●  
we continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values;

●  
a significant percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio;

●  
our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability;

●  
our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio;

●  
our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations;
 
 
●  
the Company will be unable to grow in the short term;

●  
our business depends on the condition of the local and regional economies where we operate;

●  
our profitability is subject to interest rate risk and changes in interest rates could have an adverse effect on our operating results;

●  
competition from financial institutions and other financial service providers may adversely affect our profitability;

●  
we are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings;

●  
if the Bank loses key employees with significant business contacts in its market areas, its business may suffer;

●  
we may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability;

●  
negative publicity could damage our reputation;

●  
the Bank is subject to environmental liability risk associated with lending activities;

●  
financial services companies depend on the accuracy and completeness of information about customers and counterparties;

●  
liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows;

●  
changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition;

●  
impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations;

●  
premiums for D&O insurance may increase; we may be unable to renew our D&O insurance policy on acceptable terms;

●  
we rely on other companies to provide key components of our business infrastructure;

●  
our information systems may experience an interruption or breach in security;

●  
unpredictable catastrophic events could have a material adverse effect on 1st Financial;

●  
we may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock;

●  
our ability to pay dividends is limited and we may be unable to pay future dividends;

●  
there may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock;

●  
the trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could adversely impact the price of our stock and make it difficult for common stockholders to sell their shares;

●  
our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders;

●  
1st Financial has issued preferred stock, which ranks senior to our common stock;

●  
our preferred stock reduces net income available to holders of our common stock and earnings per common share and the warrant may be dilutive to holders of our common stock;

●  
our stock price can be volatile;

●  
our common stock is not FDIC insured; and
 
 
●  
other risks and uncertainties detailed in Part I, Item 1A of this Annual Report on Form 10-K and from time to time in our filings with the Securities and Exchange Commission (the SEC).

All forward-looking statements in this report are based on information available to us as of the date of this report.  Although we believe the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee you these expectations will be achieved.  We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

General

1st Financial Services Corporation (1st Financial, or the Company), incorporated under the laws of North Carolina, became the bank holding company for Mountain 1st Bank & Trust Company (the Bank) in May 2008.  1st Financial has essentially no other assets or liabilities other than its investment in the Bank.  1st Financial’s business activity consists of directing the activities of the Bank.  The Bank has a wholly owned subsidiary, Clear Focus Holdings LLC.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.  1st Financial and the Bank are both headquartered at 101 Jack Street, Hendersonville, North Carolina 28792.

The Bank was incorporated under the laws of the state of North Carolina on April 30, 2004, and opened for business on May 14, 2004, as a North Carolina chartered commercial bank.  At December 31, 2012, the Bank was engaged in general commercial banking primarily in nine western North Carolina counties: Buncombe, Catawba, Cleveland, Haywood, Henderson, McDowell, Polk, Rutherford, and Transylvania.  The Bank operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the FDIC).

As a North Carolina bank, the Bank is subject to examination and regulation by the FDIC and the North Carolina Commissioner of Banks (the Commissioner).  The Bank is further subject to certain regulations of the Board of Governors of the Federal Reserve System (the Federal Reserve) governing reserve requirements to be maintained against deposits and other matters.  The business and regulation of the Bank are also subject to legislative changes from time to time.  See “Supervision and Regulation.”

The Bank’s primary market area is southwestern North Carolina.  Its main office and Hendersonville South office are located in Hendersonville, North Carolina.  At December 31, 2012, the Bank also had full service branch offices in Asheville, Brevard, Columbus, Etowah, Forest City, Fletcher, Hickory, Marion, Shelby, and Waynesville, North Carolina.  The Bank’s loans and deposits are primarily generated from within its local market area.

The Company’s primary source of revenue is interest and fee income from its lending activities.  These lending activities consist principally of originating commercial operating and working capital loans, residential mortgage loans, home equity lines of credit, other consumer loans and loans secured by commercial real estate.  Management targets a loan-to-asset ratio of 80% or less.  It is management’s opinion that maintaining a loan-to-asset ratio in this range maximizes earnings potential while still providing adequate liquidity for the safe and sound operation of the Company.  At December 31, 2012, the Company’s loan-to-asset ratio was 54.6%.  This number, while below the targeted range, reflects the Bank’s desire to maintain higher liquidity levels and lower risk in the portfolio.  In addition, the economic downturn has led to a reduction in general business activity and demand for commercial and consumer credit, and as a result there is increased competition among financial institutions for loans from qualified borrowers.

Interest and dividend income from investment activities generally provides the second largest source of income to the Company after interest on loans.  Management has chosen to restrict the level of credit risk in the Company’s investment portfolio and as such it is comprised primarily of debt and mortgage-backed securities issued by agencies of the United States and government-sponsored enterprises.  Management expects to continue this practice for the foreseeable future.  Furthermore, management has historically chosen to maintain a relatively short duration with respect to the investment portfolio as a whole.  Because of the Federal Reserve’s stance of maintaining interest rates at the current low levels through mid-2015, during 2012, the Bank purchased mainly callable U.S. government agency securities, with longer stated maturities, but which are expected to be called in the current rate environment.  While this strategy has resulted in an improvement in portfolio yield, it has generally increased the market price volatility and consequently, potential mark-to-market charges against the Company’s capital.

Deposits are the primary source of the Company’s funds for lending and other investment purposes.  The Company attracts both short and long-term deposits from the general public by offering a variety of accounts and rates.  In addition to noninterest bearing checking accounts, the Company offers statement savings accounts, negotiable order of withdrawal (NOW) accounts, money market demand accounts, fixed interest rate certificates with varying maturities, and IRA deposit accounts.
 
Enforcement Policies and Actions

Federal and state laws give the Federal Reserve, the FDIC, and the Commissioner substantial powers to enforce compliance with laws, rules, and regulations.  Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices.  The banking regulators have the power to impose civil money penalties against individuals or institutions for certain violations.
 

Persons who are affiliated with depository institutions and their holding companies can be removed from any office held in that institution and banned from participating in the affairs of any financial institution.  The banking regulators frequently employ the enforcement authorities provided in federal and state law.

Enforcement Action - Consent Order

During 2009, the FDIC conducted a periodic examination of the Bank.  As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the North Carolina Commissioner of Banks (the Commissioner).

Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions:
 
 
●
  
enhance its supervision of the Bank’s activities.
 
 
●
  
assess the management team to ensure executive officers have the skills, training, abilities, and experience needed.
 
 
●
  
develop and implement a plan for achieving and maintaining Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses.
 
 
●
  
strengthen the allowance for loan and lease losses policy of the Bank.
 
 
●
  
develop and implement a strategic plan.
 
 
●
  
not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.
 
 
●
  
formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans.
 
 
●
  
reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.
 
 
●
  
cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies.
 
 
●
  
adopt a loan review and grading system.
 
 
●
  
develop a plan to systematically reduce the concentration in a limited group of borrowers.
 
 
●
  
enhance its review of its liquidity and implement a liquidity contingency and asset/liability management plan.
 
  
●
  
implement a plan and 2010 budget designed to improve and sustain earnings.
 
 
●
  
implement internal routine and control policies addressing concerns to enhance its safe and sound operation.
 
  
●
  
implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
 
 
●
  
implement a policy for managing its “owned real estate”.
 
 
●
  
forbear from soliciting and accepting “brokered deposits” without approval.

 
●
  
limit growth to 10% per year.
 
 
●
  
not pay dividends without prior approval.
 
 
 
●
  
implement policies to enhance the handling of transactions with officers and directors.
 
 
●
  
correct any violations of laws and regulations.
 
 
●
  
make quarterly progress reports.
 
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order.  A copy of the Consent Order has been filed with the Securities and Exchange Commission (the SEC) and is available on the SEC’s Internet website at www.sec.gov.  The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation.  During the period a consent order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches.  Accordingly, the Bank will defer expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.
 
Enforcement Action - Written Agreement

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, the Company executed a written agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (the Federal Reserve Bank), effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions, including, among other things that the Company or its Board of Directors shall:

●  
take appropriate steps to fully utilize the Company’s financial and managerial resources, to serve as a source of strength to the Bank.

●  
not declare or pay any dividends without approval.

●  
not directly or indirectly take dividends from the Bank without approval.

●  
not directly or indirectly, incur, increase, or guarantee any debt without approval.

●  
not directly or indirectly, purchase or redeem any shares of its stock without approval.

●  
comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve related to changes in executive officers and compensation matters.

●  
submit a written capital plan that is acceptable to the Federal Reserve Bank, implement the approved plan, and thereafter fully comply with it.

The foregoing description is a summary of the material terms of the Written Agreement, and is qualified in its entirety by reference to the Written Agreement.  A copy of the Written Agreement has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov. Each provision of the Written Agreement shall remain effective and enforceable until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

The Company and the Bank have taken and continue to take action to respond to the issues raised in the Consent Order and the Written Agreement.

"Significantly Undercapitalized" Capital Category

As of December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to the restrictions in Section 38 of the FDI Act and the related FDIC rules and regulations that apply to "significantly undercapitalized" institutions, including restrictions on:

●  
the compensation paid to senior executive officers;

●  
capital distributions;
 
 
●  
payment of management fees;

●  
asset growth;

●  
acquiring any interest in any company or insured depository institution;

●  
establishing or acquiring any additional branch office; and

●  
engaging in any new line of business.

Because of its capital category, the Bank may not accept, renew, or roll over brokered deposits, and is subject to restrictions on the rate of interest it may pay on deposits.  Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.

Going Concern Considerations

As discussed in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and in Note 2 to the accompanying consolidated financial statements, although the Company was profitable in 2012, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels.  These considerations raise substantial doubt about the Company’s ability to continue as a going concern.  Management’s plans are further discussed in Note 2 to the accompanying consolidated financial statements.  These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.

Competition and Market Area

Commercial banking in North Carolina is highly competitive, due in large part to our state’s early adoption of statewide branching.  Over the years, federal and state legislation (including the elimination of restrictions on interstate banking) has heightened the competitive environment in which all financial institutions conduct their business, and the potential for competition among financial institutions of all types has increased significantly.

Banking also is highly competitive in our market.  North Carolina is home to several of the largest commercial banks in the United States, all of which have branches located in our nine-county banking market. We compete with numerous national, regional, and community commercial banks in our markets, as well as several savings institutions, credit unions, and nonbank financial service providers.

Interest rates, both on loans and deposits, and prices of fee-based services are significant competitive factors among financial institutions generally.  Other important competitive factors include office location, office hours, quality of customer service, community reputation, continuity of personnel and services, and in the case of larger commercial customers, relative lending limits and the ability to offer sophisticated cash management and other commercial banking services.  Many of our competitors have greater resources, broader geographic markets, more extensive branch networks, and higher lending limits than we do.  They also may offer a broader menu of products and services and can better afford and make more effective use of media advertising, support services, and electronic technology than we can.  In terms of assets, we are one of the smaller commercial banks in North Carolina, and we cannot assure you we will be or continue to be an effective competitor in our banking market.  However, we believe community banks can compete successfully by providing personalized service and making timely, local decisions, and further consolidation in the banking industry is likely to create additional opportunities for community banks to capture deposits from customers who become dissatisfied as their financial institutions grow larger.  We also believe the continued growth of our banking market affords an opportunity to capture new deposits.

Substantially all of our customers are individuals, and small and medium-sized businesses.  We differentiate ourselves from our larger competitors with our focus on relationship banking, personalized service, direct customer contact, and our ability to make credit and other business decisions locally.  We also depend on our reputation as a community bank in our banking markets, our involvement in the communities we serve, the experience of our senior management team, and the quality of the members of our teams charged with the day-to-day operation of the Company.  We believe our focus allows us to be more responsive to our customers’ needs and more flexible in approving loans and customizing deposit products based on our personal knowledge of our customers.

The Company’s primary market area is the southwestern mountain region of North Carolina.  The primary economic drivers of the area are tourism and a burgeoning retirement industry, which has provided a significant stimulus to residential and resort development.  Although this area has relatively few large manufacturing facilities, it has numerous small to mid-sized businesses, which are our primary business customers.  These businesses include agricultural producers, artisans and specialty craft manufacturers, small industrial manufacturers, and a variety of service oriented industries.
 

Services

Our banking operations are primarily retail oriented and directed toward small to medium-sized businesses and individuals located in our banking market.  We derive the majority of our deposits and loans from customers in our banking market, but we also make loans and have deposit relationships with commercial and consumer customers in areas surrounding our immediate banking market.  We provide most traditional commercial and consumer banking services, but our principal activities are taking demand and time deposits and making commercial and consumer loans.  Our primary source of revenue is the interest income we derive from our lending activities.

Lending Activities

General.  We provide a variety of commercial and consumer lending products to small to medium-sized businesses and individuals for various business and personal purposes, including term and installment loans, business and personal lines of credit, equity lines of credit, and overdraft checking credit.  These lending products are offered through both conventional avenues, as well as government guaranteed lending programs such as Small Business Administration (SBA) and U.S. Department of Agriculture (USDA) loans.  For financial reporting purposes, our loan portfolio generally is divided into real estate loans, consumer installment loans, commercial and industrial loans (including agricultural production loans), and revolving consumer related loans.  We currently make credit card services available to our customers through a correspondent relationship.  Statistical information about our loan portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Loan Approval.  Certain credit risks are inherent in making loans.  These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers.  We attempt to mitigate repayment risks by adhering to internal credit policies and procedures.  These policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for exceptions to credit policies.  Our loan approval policies provide for various levels of officer lending authority.  When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, the loan request will be considered by an executive officer with a higher lending limit, executive officers combining authority or the directors’ loan committee.  We do not make any loans to any director or executive officer of the Bank unless the loan is approved by the full Board of Directors of the Bank (excluding the prospective borrower) and is on terms not more favorable than would be available to a person not affiliated with the Bank.

Credit Administration and Loan Review.  We maintain a continuous loan review system.  We also apply a credit grading system to each loan, and we use an independent consultant to review the loan files on a test basis to confirm our loan grading.  Each loan officer is responsible for each loan he or she makes, regardless of whether other individuals or committees joined in the approval.  This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.

Lending Limits.  Our lending activities are subject to a variety of lending limits imposed by federal law.  In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital.  These limits will increase or decrease in response to increases or decreases in the Bank’s level of capital.  We are able to sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our clients requiring extensions of credit in excess of these limits.

Real Estate Loans.  Our real estate loan classification includes all loans secured by real estate.  Real estate loans include those loans made to purchase, refinance, construct, or improve residential or commercial real estate, for real estate development purposes, and for various other commercial, agricultural and consumer purposes (which may or may not be related to our real estate collateral).  At December 31, 2012, loans amounting to 90.2% of our loan portfolio, excluding loans held for sale, were classified as real estate loans, up from 88.1% at December 31, 2011.  While we do originate long-term (defined as a 30-year term), fixed-rate residential first mortgages, we generally only retain a small portion of these loans in our loan portfolio.  Rather, the majority of these long-term, fixed-rate loans are sold on a flow basis to other lenders after closing and are reflected in the accompanying consolidated financial statements as “loans held for sale”.  This arrangement permits us to make long-term residential loans available to our customers and to generate fee income, while avoiding the credit and interest rate risks associated with holding a large balance of such loans in our loan portfolio.  At December 31, 2012, we had a total of $98.3 million in residential first mortgages in the loan portfolio, excluding loans held for sale, amounting to 25.4% of the total portfolio, which compares with $85.9 million, or 20.5% of the portfolio, at December 31, 2011.  These portfolio loans are predominantly variable rate or short maturity mortgages.  As of December 31, 2012, 30-year, fixed-rate residential mortgage loans held in our portfolio, totaled $13.5 million.
 
At December 31, 2012, our construction and acquisition and development loans (consumer and commercial) amounted to $69.0 million, or 17.8% of our loan portfolio, excluding loans held for sale.  This compares with $87.1 million, or 20.8% at December 31, 2011.  Other commercial real estate loans totaled $147.9 million, or 38.2% of our loan portfolio, excluding loans held for sale, at the end of 2012.  This compares with $159.1 million, or 38.0% at December 31, 2011.
 

Real estate loans also include home equity lines of credit that generally are used for consumer purposes and usually are secured by junior liens on residential real property.  Our commitment on each line is generally for a term of 15 years.  During the terms of the lines of credit, borrowers may either pay accrued interest only (calculated at variable interest rates), with their outstanding principal balances becoming due in full at the maturity of the lines, or they may make monthly payments of principal and interest.  At December 31, 2012, draws made under our home equity lines of credit accounted for $25.3 million, or 6.5% of our loan portfolio, as compared with $28.1million, or 6.7%, at December 31, 2011.

Many of our real estate loans, while secured by real estate, were made for purposes unrelated to the real estate collateral.  This generally reflects our efforts to reduce credit risk by taking real estate as collateral, whenever possible, without regard to loan purpose.  Substantially all of our real estate loans are secured by real property located in or near our market.  As such, we are impacted by the adverse changes in the real estate values in the market we serve.  Our real estate loans may be made at fixed or variable interest rates, and they generally have maturities that do not exceed five years (with the exception of home equity lines of credit as discussed above) and provide for payments based on typical amortization schedules of 25 years or less.  A real estate loan with a maturity of more than five years or that is based on an amortization schedule of more than five years generally will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period generally not exceeding five years.

Commercial and Industrial Loans.  Our commercial and industrial loan classification includes loans to small to medium-sized businesses and individuals for working capital, equipment purchases and various other business and agricultural purposes.  This classification excludes loans secured by real estate.  These loans generally are secured by business assets, such as inventory, accounts receivable, equipment, or similar assets, but they also may be made on an unsecured basis.  At December 31, 2012, our commercial and industrial loans totaled $35.2 million and accounted for 9.1% of our loan portfolio, excluding loans held for sale.  This compares with $46.9 million, or 11.2% of our loan portfolio, excluding loans held for sale, at December 31, 2011.  In addition to loans classified on our books as commercial and industrial loans, many of our loans included in the real estate loan classification are made for commercial or industrial purposes, but are classified as real estate loans on our books because they are secured by first or junior liens on real estate.  Commercial and industrial loans may be made at variable or fixed rates of interest.  However, any loan that has a maturity or amortization schedule of longer than five years normally will be made at an interest rate that varies with our prime lending rate and will include contractual provisions that allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of a period generally not exceeding five years.  Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from business cash flow.  As a result, the ability of borrowers to repay commercial loans may be substantially dependent on the success of their businesses, and the collateral for commercial loans may depreciate over time and cannot be appraised with as much precision as real estate.
 
Loan Pricing.  Generally, we price our loans based on the level of risk identified in a particular loan transaction within market constraints and conditions and in conjunction with objectives established as a part of our asset/liability management function and annual budgeting process.  At December 31, 2012, 61.2% of the total dollar amount of our loans accrued interest at variable rates, compared to 54.5% at December 31, 2011.  Management believes maintenance of the portfolio at this or higher levels of floating rate loans provides for the best earnings performance under most economic environments.

Allowance for Loan Losses.  Our Board of Directors reviews all impaired loans at least quarterly, and our management reviews asset quality trends at least monthly.  Based on these reviews and our current judgments about the credit quality of our loan portfolio and other relevant internal and external factors, we have established an allowance for loan losses.  The adequacy of the allowance is assessed by our management and reviewed by our Board of Directors at least quarterly.  Under the Consent Order, our Board is required to strengthen our allowance policy and enhance its periodic reviews of the allowance to ensure its continuing adequacy.  At December 31, 2012, our allowance was $10.7 million, or 2.76% of our total loans, excluding loans held for sale.  This compares with $10.7 million, or 2.54% at year-end 2011.  Although we increased our allowance by $5.3 million through provisions for loan losses charged to earnings, net charge-offs totaled $5.2 million and was the primary reason that there was not a change in the overall allowance from 2012 to 2011.  At December 31, 2012, we had a total of $28.6 million of nonaccrual loans, $9.8 million in foreclosed real estate and no repossessed property or loans past due 90 days or more.  At December 31, 2011, we had $33.7 million of nonaccrual loans, $19.3 million in foreclosed real estate, $1.6 million in repossessed property, and no loans past due 90 days or more.

Deposit Activities

Our deposit services include business and individual checking accounts, NOW accounts, money market checking accounts, savings accounts, and certificates of deposit.  We monitor our competition in order to keep the rates paid on our deposits at a competitive level.  Under the terms of the Consent Order, the Bank is required to comply with restrictions issued by the FDIC on the effective yields of deposit products offered by among others, banks subject to consent orders.  At December 31, 2012, our time deposits of $100,000 or more amounted to $151.6 million, or 22.2% of our total deposits, including $937,000 in brokered certificates of deposit.  Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposit), unless it first receives an appropriate waiver from the FDIC.  Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into another certificate.

Statistical information about our deposit accounts is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 

Other Banking Services

We offer other bank services including cashier’s checks, banking by mail, direct deposit and remote deposit capture.  We earn fees for most of these services, in addition to fees earned from debit and credit card transactions, sales of checks, and wire transfers.  We are associated with the Plus and Star ATM networks, which are available to our clients throughout the country.  We offer merchant banking and credit card services through a correspondent bank.  We also offer internet banking services, bill payment services, and cash management services.  We do not expect to exercise trust powers during the foreseeable future.

Investment Portfolio

At December 31, 2012, our investment portfolio totaled $255.1 million, of which $253.8 million was classified as “available for sale”.  Available-for-sale securities include mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA) or issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), including collateralized mortgage obligations.  Also included in the Company’s available-for-sale investment portfolio are debt instruments issued by U.S. governmental agencies or by government-sponsored enterprises, including FNMA, FHLMC, Federal Farm Credit Bureau (FFCB), Federal Home Loan Bank (FHLB), and the SBA.  We analyze their performance at least quarterly.  Our securities have various interest rate features, maturity dates, and call options.

Statistical information about our investment portfolio is contained in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Employees

At December 31, 2012, the Company had 146 full-time equivalent employees, including 138 full-time employees (including our executive officers) and 15 part-time employees.  We are not a party to any collective bargaining agreement with our employees, and we consider our relations with our employees to be good.

Supervision and Regulation

Our business and operations are subject to extensive federal and state governmental regulation and supervision.  The following is a brief summary of certain statutes and rules and regulations that affect or will affect us.  This summary is qualified in its entirety by reference to the particular statute and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to our business.  Supervision, regulation, and examination of the Company by the regulatory agencies are intended primarily for the protection of depositors rather than our stockholders.

General.  We are a bank holding company registered with the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the BHCA).  We are subject to supervision and examination by, and the regulations and reporting requirements of, the Federal Reserve.  Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in other activities the Federal Reserve determines are closely related and a proper incident to banking, managing, or controlling banks.

The BHCA prohibits a bank holding company from acquiring direct or indirect control of more than 5% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without the Federal Reserve’s prior approval.  Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of 1st Financial.  Control is deemed to exist if, among other things, a person acquires more than 25% of any class of voting stock of 1st Financial or controls in any manner the election of a majority of the directors of 1st Financial.  Control is presumed to exist if a person acquires more than 10% of any class of voting stock, the stock is registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act), and the acquirer will be the largest shareholder after the acquisition.

Additionally, the BHCA generally prohibits bank holding companies from engaging in a nonbanking activity, or acquiring ownership or control of more than 5% of the outstanding voting stock of any company that engages in a nonbanking activity, unless that activity is determined by the Federal Reserve to be closely related and a proper incident to banking.  In approving an application to engage in a nonbanking activity, the Federal Reserve must consider whether that activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.
 
 
The law imposes a number of obligations and restrictions on a bank holding company and its insured bank subsidiaries designed to minimize potential losses to depositors and the FDIC insurance funds.  For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee the bank’s compliance (subject to certain limits) with the terms of any capital restoration plan filed with its federal banking agency.  A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances in which, absent that policy, it might not do so.  Under the BHCA, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the Federal Reserve determines the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of a bank holding company.

The Bank is a North Carolina chartered bank.  Its deposits are insured under the FDIC’s Deposit Insurance Fund (DIF), and the Bank is subject to supervision and examination by, and the regulations and reporting requirements of the FDIC and the Commissioner.  The FDIC and the Commissioner are the Bank’s primary federal and state banking regulators.  The Bank is not a member bank of the Federal Reserve System.

As an insured bank, the Bank is prohibited from engaging as principal in any activity that is not permitted for national banks unless (1) the FDIC determines the activity or investment would not pose a significant risk to the DIF, and (2) the Bank is, and continues to be, in compliance with the capital standards that apply to it.  The Bank also is prohibited from directly acquiring or retaining any equity investment of a type or in an amount that is not permitted for national banks.

The FDIC and the Commissioner regulate all areas of the Bank’s business, including its payment of dividends and other aspects of its operations.  They examine the Bank regularly, and the Bank must furnish them with periodic reports containing detailed financial and other information about its affairs.  The FDIC and the Commissioner have broad powers to enforce laws and regulations that apply to the Bank and to require it to correct conditions that affect its safety and soundness.  These powers include issuing cease and desist orders (often referred to as ‘consent orders’), imposing civil penalties, removing officers and directors, and otherwise intervening in the Bank’s operations if they believe their examinations of the Bank, or the reports it files, indicate a need for them to exercise these powers.

The Bank’s business also is influenced by prevailing economic conditions and governmental policies, both foreign and domestic, and by the monetary and fiscal policies of the Federal Reserve.  Although the Bank is not a member bank of the Federal Reserve System, the  Federal Reserve’s actions and policy directives determine to a significant degree the cost and availability of funds it obtains from money market sources for lending and investing.  These actions and policy directives also influence, directly and indirectly, the rates of interest the Bank pays on its time and savings deposits and the rates it charges on loans.

Capital Requirements for the Bank.  As a North Carolina chartered, FDIC-insured commercial bank that is not a member of the Federal Reserve System, the Bank is required to comply with the capital adequacy standards established by the FDIC. The FDIC has issued risk-based capital and leverage capital guidelines for measuring the adequacy of a bank's capital, and all applicable capital standards must be satisfied for the Bank to be considered in compliance with the FDIC's requirements.

Under the FDIC's risk-based capital measure, the minimum ratio of a bank's total capital (Total Capital) to its risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit) (Total Capital Ratio) is 8.0%.  At least half of Total Capital must be composed of common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and various other intangible assets (Tier 1 Capital).  The remainder (Tier 2 Capital) may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves.

Under the FDIC's leverage capital measure, the minimum ratio of Tier 1 Capital to average assets (Leverage Capital Ratio), less goodwill and various other intangible assets, generally is 3.0% for banks that meet specified criteria, including having the highest regulatory rating.  All other banks generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum.  The FDIC's guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets, and a bank's "Tangible Leverage Ratio" (deducting all intangible assets) and other indicators of a bank's capital strength also will be taken into consideration by banking regulators in evaluating proposals for expansion or new activities.

The FDIC also considers a bank's interest-rate risk (arising when the interest rate sensitivity of a bank's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of its capital adequacy.  The FDIC's methodology for evaluating interest rate risk requires banks with excessive interest rate risk exposure to hold additional amounts of capital against their exposure to losses resulting from that risk.  The regulators also require banks to incorporate market risk components into their risk-based capital.  Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.
 

The Bank's capital category is determined solely for the purpose of applying the FDIC's "prompt corrective action" rules described below, and it is not necessarily an accurate representation of its or 1st Financial’s overall financial condition or prospects for other purposes.  A failure to meet the FDIC's capital guidelines could subject the Bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC and other restrictions on our business.  As described below, the FDIC also can impose other substantial restrictions on banks that fail to meet applicable capital requirements.  The Bank was deemed “significantly undercapitalized” as of December 31, 2012.  As discussed under “Enforcement Policies and Actions” in Item 1of this report, and also under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this report and Note 2 to the accompanying consolidated financial statements, the Consent Order, and the Written Agreement impose substantial restrictions on the operation of 1st Financial and the Bank, including a prohibition on accepting, renewing, or rolling over brokered deposits.

Under the terms of the Consent Order, the Bank is required to maintain Tier 1 Capital of at least 8% of total assets and a Total Risk Based Capital Ratio of at least 12%.  The Bank’s Tier 1 Capital and Total Risk Based Capital Ratios were 2.64% and 6.11%, respectively, at December 31, 2012.

Prompt Corrective Action.  The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions.  The extent of these powers will depend upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.”  The FDIC is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories.  The severity of supervisory action will depend upon the capital category in which a bank is placed.  Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

Under the FDIC’s prompt corrective action rules, an institution is considered “well capitalized” if it has (i) a total risk-based capital ratio of 10.0% or greater, (ii) a Tier I risk-based capital ratio of 6.0% or greater, (iii) a leverage ratio of 5.0% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.  An “adequately capitalized” institution is defined as one that has (i) a total risk-based capital ratio of 8.0% or greater, (ii) a Tier I risk-based capital ratio of 4.0% or greater and (iii) a leverage ratio of 4.0% or greater (or 3% or greater in the case of an institution with the highest examination rating).  An institution is considered (A) “undercapitalized” if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (B) “significantly undercapitalized” if the institution has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (C) “critically undercapitalized” if the institution has a ratio of tangible equity to total assets equal to or less than 2%.

A bank that is categorized as "undercapitalized, "significantly undercapitalized," or "critically undercapitalized," is required to submit an acceptable capital restoration plan to the FDIC.  An "undercapitalized" bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC.  In addition, the FDIC is given authority with respect to any "undercapitalized" bank to take any of the actions it is required to or may take with respect to a "significantly undercapitalized" bank if it determines those actions are necessary to carry out the purpose of the law.

At December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to certain restrictions, as discussed under ""Significantly Undercapitalized" Capital Category" in Item 1.

Limitations on Payment of Cash Dividends. As a bank holding company, we are required to adhere to the Federal Reserve’s Policy Statement on the Payment of Cash Dividends, which generally requires that we act as a source of strength and not place an undue burden on the Bank.  Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis.  However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our stockholders is dividends we receive from the Bank.  For that reason, our ability to pay dividends is effectively subject to the same limitations that apply to the Bank.  Because the Consent Order and the Written Agreement prohibit the Bank from paying dividends or making other forms of payment reducing capital of the Bank without the prior approval of the banking regulators, we are effectively prohibited from paying cash dividends to our common stockholders for the foreseeable future and while the Bank remains subject to the Consent Order and/or we remain subject to the Written Agreement.

In addition to these restrictions, other state and federal statutory and regulatory restrictions apply to our payment of cash dividends on our common stock.  Both state and federal law prohibit the Bank from making any capital distributions, including payment of a cash dividend, if it is “undercapitalized” (as that term is defined in the FDI Act), or would become undercapitalized after making the distribution.  As December 31, 2012, the Bank was deemed to be “significantly undercapitalized”. Also, the FDIC has indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would constitute an unsafe and unsound banking practice.  The FDIC has issued policy statements that provide that insured banks generally should pay dividends only from their current operating earnings, and, under the FDI Act, no dividend may be paid by an insured bank while it is in default on any assessment due the FDIC.  If the FDIC believes the Bank is engaged in, or is about to engage in, an unsafe or unsound practice, the FDIC may require, after notice and hearing, that the Bank cease and desist from that practice.
 

In addition to the above restrictions, in the future, the Company’s ability to declare and pay cash dividends will be subject to our Board of Directors’ evaluation of operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. We are subject to further limitations on cash dividends due to the U.S. Department of Treasury (U.S. Treasury) purchase of our preferred stock.  See “CPP Participation” below.

We cannot assure you that, in the future, we will have funds available to pay cash dividends or that, even if funds are available, we will pay dividends in any particular amounts or at any particular times, or that we will pay dividends at all.

Repurchase Limitations.  As a bank holding company, 1st Financial must obtain Federal Reserve approval prior to repurchasing its common stock for consideration in excess of 10% of its net worth during any 12-month period unless (i) both before and after the redemption it satisfies capital requirements for “well capitalized” bank holding companies; (ii) it has received a “one” or “two” rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues.  Under the terms of the Written Agreement, prior approval of the Federal Reserve Bank is required before 1st Financial repurchases any shares of its stock.  In addition, we are subject to further repurchase limitations due to the U.S. Treasury’s purchase of our preferred stock.  See “CPP Participation” below.

Federal Home Loan Bank System.  The Federal Home Loan Bank system provides a central credit facility for member institutions. As a member of the Federal Home Loan Bank of Atlanta (FHLB), the Bank is required to own capital stock in the FHLB in an amount at least equal to 0.15% of the Bank’s total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB under the activity-based stock ownership requirement.  On December 31, 2012, the Bank was in compliance with this requirement.

Limits on Rates Paid on Deposits and Brokered Deposits.  FDIC regulations limit the ability of insured depository institutions to accept, renew or rollover deposits by offering rates of interest, which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution’s normal market area.  Under these regulations, “well capitalized” depository institutions may accept, renew or rollover such deposits without restriction, “adequately capitalized” depository institutions may accept, renew or rollover such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and “undercapitalized” depository institutions may not accept, renew, or rollover such deposits.  Definitions of “well capitalized,” “adequately capitalized” and “undercapitalized” are the same as the definitions adopted by the FDIC to implement the prompt corrective action provisions discussed above.  North Carolina is deemed to be a high-rate market area, and as a result the markets in which the Bank operates are determined to be in a high-rate area.  The Bank obtained a waiver from the FDIC to pay interest rates within 0.75% of the average rate paid on local market deposits.

FDIC Insurance Assessments.  The FDIC uses a revised risk-based assessment system to determine the amount of our deposit insurance assessment based on the evaluation of the probability the DIF will incur a loss with respect to the Bank.  That evaluation takes into consideration risks attributable to different categories and concentrations of our assets and liabilities and any other factors the FDIC considers to be relevant, including information obtained from the Commissioner.  A higher assessment rate results in an increase in the assessments we pay the FDIC for deposit insurance.

Under the FDI Act, the FDIC may terminate our deposit insurance if it finds we have engaged in unsafe and unsound practices, are in an unsafe or unsound condition to continue operation, or have violated applicable laws, regulations, rules, or orders.  The FDIC is responsible for maintaining the adequacy of the DIF, and the amount we pay for deposit insurance is influenced not only by the assessment of the risk it poses to the DIF, but also by the adequacy of the insurance fund at any time to cover the risk posed by all insured institutions.

Community Reinvestment.  Under the Community Reinvestment Act (CRA), as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods.  The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop, consistent with the CRA, the types of products and services it believes are best suited to its particular community.  The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take those records into account in its evaluation of certain applications by those institutions.  All institutions are required to make public disclosure of their CRA performance ratings.  In its most recent CRA examination, the Bank received a “satisfactory” rating.

Federal Securities Law.  The Company’s common stock is registered under Section 12(g) of the Exchange Act and the Company files reports under the Exchange Act with the Securities and Exchange Commission (the SEC).  As a result of this registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act apply to the Company.
 
 
Transactions with Affiliates.  Although the Bank is not a member of the Federal Reserve System, it is subject to the provisions of Sections 23A and 23B of the Federal Reserve Act.  Section 23A places limits on the amount of:

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A bank’s loans or extensions of credit to, or investment in its affiliates;

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Assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve;

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The amount of loans or extensions of credit by a bank to third parties, which are collateralized by the securities or obligations of the bank’s affiliates; and

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A bank’s guarantee, acceptance, or letter of credit issued on behalf of one of its affiliates.

Transactions of the type described above are limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus.  In addition to the limitation on the amount of these transactions, each of these transactions also must meet specified collateral requirements.  The Bank also must comply with other provisions designed to avoid purchasing low-quality assets from an affiliate.

Section 23B of the Federal Reserve Act, among other things, prohibits a bank from engaging in these affiliate transactions unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Federal law also places restrictions on the Bank’s ability to extend credit to executive officers, directors, principal stockholders, and their related interests.  These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

Loans to One Borrower.  The Bank is subject to the Commissioner’s loans-to-one-borrower limits, which are substantially the same as those applicable to national banks.  Under these limits, no loans or extensions of credit to any borrower outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the capital and surplus of the Bank.  Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of capital and surplus.

Reserve Requirements.  Under Federal Reserve regulations, the Bank must maintain average daily reserves against its transaction accounts.  For 2013, we are not required to maintain reserves on the first $12.4 million of net transaction accounts (up from $11.5 million in 2012), but must maintain reserves equal to 3.0% on the aggregate balances of those accounts over $12.4 million (up from $11.5 million in 2012), up to and including $79.5 million (up from $71.0 million in 2012), and reserves equal to 10.0% on aggregate balances in excess of $79.5 million (up from $71.0 million in 2012).  The Federal Reserve may adjust these percentages.  Because our reserves are required to be maintained in the form of vault cash or in a non-interest-bearing account at the Federal Reserve or a correspondent bank, one effect of the reserve requirement is to reduce the amount of our interest-earning assets.  During 2007, the Bank adopted an internal deposit reclassification system (approved by the Federal Reserve under Regulation D), whereby significant portions of interest-bearing and noninterest bearing transaction accounts are transferred to a non-reservable savings account status.  As a result, all required reserves at December 31, 2012 and 2011 were met by the Bank’s vault cash.

Gramm-Leach-Bliley Act.  The federal Gramm-Leach-Bliley Act enacted in 1999 (the GLB Act) dramatically changed various federal laws governing the banking, securities and insurance industries.  The GLB Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them.  However, this expanded authority also presents smaller financial institutions, such as the Bank, with challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community-oriented financial institutions.

USA Patriot Act of 2001.  The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in the United States on September 11, 2001.  The Act was intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts.  The Act's impact on financial institutions of all kinds has been significant and wide ranging.  The Act contains sweeping anti-money laundering and financial transparency requirements and imposes various other regulatory requirements, including standards for verifying customer identification at account opening and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act of 2002, which became effective during 2002, is sweeping federal legislation addressing accounting, corporate governance, and disclosure issues.  The impact of the Sarbanes-Oxley Act is wide ranging as it applies to all public companies and imposes significant requirements for public company governance and disclosure requirements.
 

In general, the Sarbanes-Oxley Act mandated corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results.  It established new responsibilities for corporate chief executive officers, principal accounting officers, and audit committees in the financial reporting process and created a new regulatory body to oversee auditors of public companies.  It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire, and securities fraud and created new criminal penalties for document and record destruction in connection with federal investigations.  It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

The economic and operational effects of the Sarbanes-Oxley Act on public companies, including 1st Financial, have been and will continue to be significant in terms of the time, resources, and costs associated with compliance.  Because the Act, for the most part, applies equally to larger and smaller public companies, we will continue to be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our markets.  In accordance with the requirements of Section 404(a), management’s report on internal control is included herein as Item 9A.  The Dodd-Frank Act permanently exempted smaller companies, such as the Company, from the requirements under Section 404(b) for auditor attestation on internal controls.

Emergency Economic Stabilization Act of 2008 (EESA).  Under the EESA, the U.S. Treasury implemented the Troubled Asset Relief Program (TARP), of which the Capital Purchase Program (CPP) is a part.  Under the CPP, certain U.S. qualifying financial institutions sold senior preferred stock and warrants to the U.S. Treasury.  Eligible institutions generally applied to issue preferred stock to the U.S. Treasury in aggregate amounts between 1% and 3% of the institution’s risk-weighted assets.  Smaller community banks and bank holding companies were later allowed to issue preferred stock up to 5% of the institution’s risk- weighted assets.

Institutions participating in the TARP or CPP are required to meet certain standards for executive compensation and corporate governance, including a prohibition against incentives to take unnecessary and excessive risks, recovery of bonuses paid to senior executives based on materially inaccurate earnings or other statements and a prohibition against agreements for the payment of golden parachutes.  Additional standards with respect to executive compensation and corporate governance for institutions that have participated or will participate in the TARP, including the CPP, were enacted as part of the American Recovery and Reinvestment Act of 2008 (ARRA), described below.

CPP Participation.  On November 14, 2008, 1st Financial entered into a Letter Agreement (the Purchase Agreement) with the U.S. Treasury under the CPP, pursuant to which 1st Financial issued 16,369 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the  Preferred Stock ), having a liquidation preference of $1,000 per share, for a total price of $16,369,000.  1st Financial is required to pay cumulative dividends on the Preferred Stock.  Under the ARRA, described below, 1st Financial may redeem the Preferred Stock at any time, provided it obtains the approval of its primary federal regulator.  The Preferred Stock is generally non-voting, but does have the right to vote as a class on the issuance of any preferred stock ranking senior, any change in its terms or any merger, exchange or similar transaction that would adversely affect its rights.  The holder(s) of Preferred Stock also have the right to elect two directors if dividends have not been paid for six periods.  Due to insufficient funding at the holding company level, the Company has deferred each of the past 11 quarterly dividend payments of $205,000 on its Preferred Stock.  The Company expects to again defer the $205,000 payment of the preferred dividend in May 2013.

As part of its purchase of the Preferred Stock, the U.S. Treasury received a warrant (the Warrant) to purchase 276,815 shares of 1st Financial’s common stock at an initial exercise price of $8.87 per share.  The Warrant provides for the adjustment of the exercise price and the number of shares of 1st Financial’s common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of 1st Financial’s common stock, and upon certain issuances of 1st Financial’s common stock at or below a specified price relative to the initial exercise price.  The Warrant expires ten years from the issuance date.  Pursuant to the Purchase Agreement, the U.S. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant.

Both the Preferred Stock and the Warrant are accounted for as components of Tier 1 capital.

Further, so long as the Preferred Stock remains outstanding, 1st Financial is prohibited from declaring or paying any dividend or distribution on its common stock (other than dividends payable solely in shares of common stock), and no common stock, may be, directly or indirectly, purchased, redeemed, or otherwise acquired for consideration by 1st Financial or the Bank, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside for the benefit of the holders of shares of Preferred Stock on the applicable record date).
 

American Recovery and Reinvestment Act of 2009 (ARRA).  The ARRA was enacted on February 17, 2009.  The ARRA included a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs.  In addition, the ARRA imposed certain new executive compensation and corporate governance requirements on all current and future CPP participants, including 1st Financial, until the institution has redeemed the Preferred Stock.  The executive compensation restrictions under the ARRA and regulations issued by U.S. Treasury are more stringent than those previously in effect under the CPP, and include in part, (1) prohibitions on making golden parachute payments to senior executive officers and the next five most highly-compensated employees during such time as any obligation arising from financial assistance provided under the TARP remains outstanding (the Restricted Period), (2) prohibitions on paying or accruing bonuses or other incentive awards for certain senior executive officers and employees, except for awards of long-term restricted stock with a value equal to no greater than 1/3 of the subject employee’s annual compensation that do not fully vest during the Restricted Period or unless such compensation is pursuant to a valid written employment contract prior to February 11, 2009, and (3) requirements that TARP CPP participants provide for the recovery of any bonus or incentive compensation paid to senior executive officers and the next 20 most highly-compensated employees based on statements of earnings, revenues, gains, or other criteria later found to be materially inaccurate, with the U.S. Treasury having authority to negotiate for reimbursement.

The ARRA also set forth additional corporate governance standards for TARP recipients, including semi-annual meetings of compensation committees of the board of directors to discuss and evaluate employee compensation plans in light of an assessment of any risk posed from such compensation plans.  TARP recipients are further required by the ARRA to have in place company-wide policies regarding excessive or luxury expenditures, permit non-binding shareholder “say-on-pay” proposals to be included in proxy materials, as well as require written certifications by the compensation committee, the principal executive officer, and principal financial officer with respect to compliance.
 
Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).  On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law.  The Dodd-Frank Act was intended primarily to overhaul the financial regulatory framework following the global financial crisis and has impacted, and will continue to impact, all financial institutions, including 1st Financial and the Bank.  The Dodd-Frank Act contains provisions that have, among other things, established a Bureau of Consumer Financial Protection, established a systemic risk regulator, consolidated certain federal bank regulators, and imposed increased corporate governance and executive compensation requirements.  The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations and to prepare numerous studies and reports for the U.S. Congress.  The federal agencies are given significant discretion in drafting and implementing regulations.  Although a significant number of these regulations have been promulgated, many additional regulations are expected to be issued in 2013 and thereafter.  Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Available Information.  Our Internet website address is www.mountain1st.com.  Electronic versions of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act are available on our website.  We will provide electronic or paper copies of those filings free of charge upon request.  Requests for copies should be directed by mail to Holly L. Schreiber, Chief Financial Officer, at 101 Jack Street, Hendersonville, North Carolina 28792, or by telephone at (828) 697-3100.

Other.  The federal banking agencies, including the FDIC, have developed joint regulations requiring annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state-chartered institutions examined by state regulators.  Such regulations also establish requirements for operational and managerial standards, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards when such compensation would endanger the insured depository institution or would constitute an unsafe practice.

In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking.  The Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.
 

An investment in our securities is subject to certain risks.  You should carefully review the following risk factors and other information contained in this report and the documents incorporated by reference before deciding whether an investment in our securities is suited to your particular circumstances.  Other risks and uncertainties not presently known to us or that we currently deem immaterial or unlikely also may impair our business operations.  If any of the following risks actually occur, our business, results of operations and financial condition could suffer.  In that event, the value of our securities could decline, and you may lose all or part of your investment.  The risks discussed below also include forward-looking statements, and our actual results may differ materially from those discussed in these forward-looking statements.

Risks Related to Recent Economic Conditions and Governmental Response Efforts

There is substantial doubt about the ability of 1st Financial to continue as a going concern.

In connection with its 2011 and 2012 annual audits, the Company’s independent auditors issued an opinion stating the consolidated financial statements were prepared assuming the Company will continue as a going concern, but that substantial doubt has been raised about its ability to continue as a going concern because the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Company’s sole asset, the Bank, is under the Consent Order that requires among other provision, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under the Written Agreement that requires, among other provisions, the submission and implementation of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Company and the Bank are considered “significantly undercapitalized” based on their respective regulatory capital levels.  Meanwhile, the Bank continues to have high levels of nonperforming and impaired assets.  The future of the Company is dependent on its ability to address these matters.  If the Company fails to do so for any reason, the banking regulators may place the Bank into conservatorship or receivership, with the FDIC or the Commissioner appointed as conservator or receiver.  If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank, be exposed to significant claims by the FDIC and/or the Commissioner, and would not be able to continue as a going concern.  Accordingly, such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.

1st Financial and the Bank may be subject to additional, heightened enforcement actions, and ultimately the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition does not improve.

The Consent Order and Written Agreement require us to take certain actions and to implement certain action plans, including a plan to materially improve the Bank’s capital ratios.  In the event we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition does not improve, the banking regulators may place the Bank under conservatorship or receivership, and/or force the sale or merger of the Bank.  Unexpected events or circumstances could further prejudice our ability to achieve the minimum capital ratios required under the Consent Order.  If we fail to comply with the requirements of the Consent Order or the Written Agreement for any reason or our condition does not improve, the banking regulators may impose additional, heightened enforcement actions against us, keep the Consent Order and Written Agreement in place longer than they may otherwise have been, and/or require the preparation of a plan to sell or merge the Bank.  Ultimately, the Bank may be placed into conservatorship or receivership by the FDIC or the Commissioner, with the FDIC or the Commissioner appointed as conservator or receiver.  If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank and be exposed to significant claims by the FDIC and/or the Commissioner.  Such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.

Difficult market conditions and economic trends have adversely affected our industry and our business.

Since 2008, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively affected the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions, including 1st Financial.  In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline.  General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write-downs.  Concerns over the stability of the financial markets and the economy caused a decrease in lending by financial institutions to their customers and to each other.  This market turmoil and tightening of credit led to increased commercial and consumer loan delinquencies, lack of consumer confidence, increased market volatility and widespread reduction in general business activity.  Financial institutions have experienced decreased access to capital and to deposits or borrowings.  The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses and the prices of securities in general, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations and stock price for the foreseeable future.
 
 
We do not believe these difficult conditions are likely to significantly improve in the near future.  A sustained weakness or worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers, and the other financial institutions in our market. Specifically, it could have one or more of the following adverse effects on our business:

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A decrease in the demand for loans or other products and services offered by us;

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A decrease in the value of our loans or other assets secured by consumer or commercial real estate;

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A decrease in deposit balances due to overall reductions in the accounts of customers;

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An impairment of investment securities;

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A decreased ability to raise additional capital on terms acceptable to us or at all; or

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An increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us.  An increase in the number of delinquencies, bankruptcies, or defaults could result in a higher level of nonperforming assets, net charge-offs, and provision for loan losses, which would reduce our earnings.

Until conditions improve, our business, financial condition and results of operations may continue to be adversely affected.

Financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations.

Congress enacted the Dodd-Frank Act in 2010.  This law has significantly changed the structure of the bank regulatory system and affects the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies.  The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress.  The federal agencies are given significant discretion in drafting the implementing rules and regulations.  Although a significant number of these regulations have been promulgated, many additional regulations are expected to be issued in 2013 and thereafter.  Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

The Dodd-Frank Act also broadens the base for FDIC insurance assessments.  Assessments are now being based on the average consolidated total assets less tangible equity capital of a financial institution.  The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions, and credit unions to $250,000 per depositor, retroactive to January 1, 2008 and provided for unlimited deposit insurance on noninterest bearing transaction accounts through December 31, 2012.

The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials.  The legislation also directs the Federal Reserve to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not.

The Dodd-Frank Act created the Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws.  The Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive, or abusive” acts and practices.  It also has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets.  Banks and savings institutions with $10 billion or less in assets will be examined by their applicable bank regulators.  The Dodd-Frank Act also weakens the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.

It is difficult to quantify what specific impact the Dodd-Frank Act and related regulations have had on the Company to date and what impact yet to be written regulations will have on us in the future.  However, it is expected at a minimum, they will increase our operating and compliance costs and could increase our interest expense.

Our participation in the CPP imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity.

In November 2008, we issued Preferred Stock and a Warrant to the U.S. Treasury as part of its CPP.  The Securities Purchase Agreement, pursuant to which such securities were sold, among other things, grants the holders of such securities certain registration rights which, in certain circumstances, impose lock-up periods during which we would be unable to issue equity securities.  In addition, unless we are able to redeem the Preferred Stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% to 9%.  Depending on market conditions at the time, and whether or not we have resumed paying dividends, this increase in dividends could significantly impact our liquidity.
 

We are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our Preferred Stock.

So long as the Preferred Stock remains outstanding, no dividend or distribution may be declared or paid on our common stock (other than dividends payable solely in shares of common stock), and no common stock, may be, directly or indirectly, purchased, redeemed or otherwise acquired for consideration by 1st Financial or the Bank, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside for the benefit of the holders of shares of Preferred Stock on the applicable record date).  We have not paid dividends on the Preferred Stock since May 2010, and expect to again defer the $205,000 quarterly payment of the preferred dividend in May 2013.  As a consequence, it is unlikely 1st Financial will be permitted to pay any dividends on its common stock for at least the foreseeable future.

The limitations on incentive compensation contained in the ARRA and subsequent regulations may adversely affect our ability to retain our highest performing employees.

In the case of a company such as 1st Financial that received CPP funds, the ARRA, and subsequent regulations issued by the U.S. Treasury, contain restrictions on bonus and other incentive compensation payable to the Company’s senior executive officers.  As a consequence, we may be unable to create a compensation structure that permits us to retain our highest performing employees and attract new employees of a high caliber.  If this were to occur, our businesses and results of operations could be adversely affected.

The soundness of other financial institutions could adversely affect us.

In recent years, the financial services industry as a whole has been materially and adversely affected by significant declines in the value of real estate and other asset classes, as well as reduced capital levels and lack of liquidity.  Financial institutions have been subject to increased volatility and an overall loss in investor confidence, caused in large part by the unprecedented level of bank failures.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions, including the failure of other financial institutions, locally and nationally.  Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships.  We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients.

Increases in FDIC insurance premiums may adversely affect our net income and profitability.

Since 2008, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the DIF.  In addition, the FDIC instituted two temporary programs to further ensure customer deposits at FDIC insured banks:  deposit accounts are now insured up to $250,000 per customer (up from $100,000), made permanent in 2010 and noninterest-bearing transactional accounts were fully insured through December 31, 2012.  These programs have placed additional stress on the deposit insurance fund.  In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased assessment rates of insured institutions.  We are generally unable to control the amount of premiums the Bank is required to pay for FDIC insurance, which is determined, in part, by the risk profile of each depository institution.  If there are additional financial institution failures, the cost of resolving prior failures exceeds expectations, or the Bank’s risk profile further deteriorates, the Bank may be required to pay even higher FDIC premiums.  Any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings and financial condition.

Risks Associated to Our Business

1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue.

1st Financial is a separate and distinct legal entity from the Bank.  Historically, 1st Financial has received substantially all of its revenue from dividends received from the Bank.  These dividends have been the principal source of funds to pay dividends on 1st Financial’s common and preferred stock, and operating expense.  Various federal and/or state laws and regulations limit the amount of dividends the Bank may pay to 1st Financial, and the Bank is now further restricted with respect to the payment of dividends under the terms of the Consent Order, and by virtue of it being deemed to be “significantly undercapitalized.”  In the event the Bank continues to be unable to pay dividends to 1st Financial, 1st Financial may not be able to pay obligations, or pay dividends on its common and preferred stock.  The continuing inability to receive dividends from the Bank could have a material adverse effect on 1st Financial’s business, financial condition, and results of operations.  As discussed elsewhere, the Bank is not permitted to pay dividends to 1st Financial under the terms of the Consent Order without the prior consent of the FDIC and the Commissioner.
 
 
We need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed.

Federal and state banking regulators require us to maintain adequate levels of capital to support our operations.  On December 31, 2012, we were deemed “significantly undercapitalized” under bank regulatory guidelines and, in addition, our capital ratios were below the minimum levels required in the Consent Order and Written Agreement.  We need to increase our capital to satisfy regulatory requirements.  Management and our Board continue to pursue plans to improve our capital levels, including seeking to raise additional capital.  However, our ability to raise that additional capital depends on conditions at that time in the capital markets, economic conditions, our financial performance and condition, and other factors, many of which are outside our control.  Given the current state of the equity markets and our financial performance and condition, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.  If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company, and could result in the Bank being placed in conservatorship or receivership by the FDIC or the Commissioner.

Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.

Lending money is a substantial part of our business.  Every loan carries a degree of risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment.  This risk is affected by, among other things:

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cash flows of the borrower and/or the business activity being financed;

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in the case of a collateralized loan, changes in and uncertainties regarding future values of collateral;

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the credit history of a particular borrower;

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changes in economic and industry conditions; and

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the duration of the loan.

We use underwriting procedures and criteria we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios.  However, regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and some of those losses will result from factors beyond our control.  These factors include, among other things, changes in market, economic, business or personal conditions, or other events (including changes in market interest rates) that affect our borrowers’ abilities to repay their loans and the value of properties that collateralize loans.  Recent difficulties in the national economy and housing market, declining real estate values, high unemployment, and loss of consumer confidence, have resulted and will continue to result in increasing loan delinquencies and loan losses for all financial institutions.

We maintain an allowance for loan losses based on our current judgments about the credit quality of our loan portfolio.  The amount of our allowance is determined by our management through a periodic review and consideration of internal and external factors that affect loan collectability, including, but not limited to:

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an ongoing review of the quality, size, and diversity of our overall loan portfolio;

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evaluation of nonperforming loans;

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historical default and loss experience;

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historical recovery experience;
 
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existing economic conditions;

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risk characteristics of various classifications of loans; and

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the amount and quality of collateral, including guarantees, securing the loans.
 
There is no precise method of predicting credit losses since any estimate of loan losses is necessarily subjective and the accuracy of the estimate depends on the outcome of future events.  Therefore, we face the risk charge-offs in future periods will exceed our allowance for loan losses and additional increases in the allowance for loan losses will be required.  Additions to the allowance for loan losses would adversely affect our results of operations and financial condition, and possibly cause a decrease in our capital.
 

We continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values.

We foreclose on and take title to real estate serving as collateral for many of our loans as part of our business.  Real estate owned by us and not used in the ordinary course of our operations is referred to as “real estate acquired in settlement of loans” or “foreclosed real estate”.  At December 31, 2012, we had foreclosed real estate with an aggregate book value of $9.8 million.  We obtain appraisals prior to taking title to real estate and periodically thereafter.  However, due to the continued depressed real estate prices in our market, there can be no assurance such valuations will reflect the amount which may be paid by a willing purchaser in an arms-length transaction at the time of the final sale.  Moreover, we cannot provide assurance the losses associated with foreclosed real estate will not exceed the estimated amounts, which would adversely affect future results of our operations.

The calculation for the adequacy of write-downs of our foreclosed real estate is based on several factors, including the appraised value of the real property, economic conditions in the property’s sub-market, comparable sales, current buyer demand, availability of financing, entitlement and development obligations and costs and historic loss experience.  All of these factors have caused further write-downs in recent periods and can change without notice based on market and economic conditions.  High levels of nonperforming assets indicate that foreclosed real estate balances may continue to be high for the foreseeable future.  Increased foreclosed real estate balances have led to greater expense as we incur costs to manage and dispose of the properties.  We expect our earnings will continue to be negatively affected by various expenses associated with foreclosed real estate, including personnel costs, insurance, and taxes, completion and repair costs, valuation adjustments and other expenses associated with property ownership, as well as by the funding costs associated with assets that are tied up in foreclosed real estate.  Moreover, our ability to sell foreclosed real estate is affected by public perception that banks are inclined to accept large discounts from market value in order to quickly liquidate properties.  Any further decrease in market prices may lead to further write-downs, with a corresponding expense in our statement of operations.  Further write-downs on foreclosed real estate or an inability to sell foreclosed real estate could have a material adverse effect on our results of operations and financial conditions.  Furthermore, the management and resolution of nonperforming assets, which include foreclosed real estate, increases our costs and requires significant commitments of time from our management and directors, which can be detrimental to the performance of their other responsibilities.  The expense associated with foreclosed real estate and any further property write-downs could have a material adverse effect on our financial condition and results of operations.

A significant percentage of our loans are secured by real estate.  Continuing adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio.

While we do not have a subprime lending program, a significant percentage of our loans are secured by real estate.  Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and the level of our real estate loans reflects, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral.  However, adverse conditions in the real estate market and the economy in general have decreased real estate values in our banking markets.  If the value of our collateral for a loan falls below the outstanding balance of that loan, our ability to collect the balance of the loan by selling the underlying real estate in the event of a default will be diminished, and we would be more likely to suffer a loss on the loan.  An increase in our loan losses could have a material adverse effect on our operating results and financial condition.
 
The FDIC adopted rules aimed at placing additional monitoring and management controls on financial institutions whose loan portfolios are deemed to have concentrations in commercial real estate (CRE).  At December 31, 2012, our loan portfolio exceeded thresholds established by the FDIC for CRE concentrations and for additional regulatory scrutiny.  Indications from regulators are that strict limitations on the amount or percentage of CRE within any given portfolio are not expected, but, rather, additional reporting and analysis will be required to document management’s evaluation of the potential additional risks of such concentrations and the impact of any mitigating factors.  These rules could increase the costs of monitoring and managing this component of our loan portfolio.  This could have an adverse impact on our operating results and financial condition.
 
Our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability.

We regularly make loans secured by commercial real estate (CRE).  These types of loans generally have higher risk-adjusted returns and shorter maturities than traditional one-to-four family residential mortgage loans.  Further, loans secured by CRE properties are generally for larger amounts and involve a greater degree of risk than one-to-four family residential mortgage loans.  Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties.  Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy.  In addition, many economists believe deterioration in income-producing CRE is likely to worsen as vacancy rates continue to rise and absorption rates of existing square footage continue to decline.  Because of the current general economic slowdown, these loans represent higher risk, could result in an increase in our total net-charge offs and could require us to increase our allowance for loan losses, which could have a material adverse effect on our financial condition or results of operations.  At December 31, 2012, our loans secured by CRE totaled $147.9 million, which represented 38.2% of total loans.  For 2012 and 2011, respectively, net charge-offs on commercial real estate loans totaled $804,000 and $2.0 million respectively.  While we seek to minimize these risks in a variety of ways, there can be no assurance these measures will protect against credit-related losses.
 

Our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio.

Construction financing typically involves a higher degree of credit risk than financing on improved, owner-occupied real estate.  Risk of loss on a construction loan is largely dependent upon the accuracy of the initial estimate of the property’s value at completion of construction and the bid price and estimated cost (including interest) of construction.  If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project.  If the estimate of the value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project whose value is insufficient to assure full repayment.  When lending to builders, the cost of construction breakdown is provided by the builder, as well as supported by the appraisal.  Although our underwriting criteria are designed to evaluate and minimize the risks of each construction loan, there can be no guarantee these practices will safeguard against material delinquencies and losses to our operations.  Construction and land development loans are dependent on the successful completion of the projects they finance, however, in many cases, such construction and development projects in our primary market areas are not being completed in a timely manner, if at all.  At December 31, 2012, we had loans of $69.0 million, or 17.8% of total loans, outstanding to finance construction and land development.  For 2012, we had net charge-offs of $2.1 million.

Our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations.

A portion of our residential and commercial lending is secured by vacant or unimproved land.  Loans secured by vacant or unimproved land are generally more risky than loans secured by improved property for one-to-four-family residential mortgage loans.  Since vacant or unimproved land is generally held by the borrower for investment purposes or future use, payments on loans secured by vacant or unimproved land will typically rank lower in priority to the borrower than a loan the borrower may have on their primary residence or business.  These loans are susceptible to adverse conditions in the real estate market and local economy.  At December 31, 2012, loans secured by vacant or unimproved property totaled $43.3 million, or 11.2% of our loan portfolio.

The Company will be unable to grow in the short term.
 
As a strategy, the Company seeks to increase the size of its franchise by pursuing business development opportunities.  However, by virtue of being deemed "significantly undercapitalized" under the FDIC’s framework for prompt corrective action, the Bank may not permit its average total assets during any calendar quarter to exceed its average total assets during the preceding calendar quarter.  The Consent Order also places restrictions on asset growth.  As such, it is anticipated the Company will be unable to grow until it improves its capital condition, and will not be able to grow significantly until the Consent Order is removed.  Such restrictions on the Company’s growth are expected to adversely affect our revenue, operating results, and financial condition.

Our business depends on the condition of the local and regional economies where we operate.

We currently have offices only in western North Carolina.  Consistent with our community banking philosophy, our customer base is located in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking market.  Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate, and restructure possible problem loans.  The local economies of the communities in our banking market are relatively dependent on the tourism industry and the retirement and second home real estate market.  The economies of our banking market have been adversely affected by a general economic downturn and this downturn has affected the tourism industry and real estate values in our communities, which has adversely affected our operating results.  Further deterioration of economic conditions in our banking market could further affect our ability to generate new loan production, adversely affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results.  We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies.  And, we cannot assure you we will benefit from any market growth or favorable economic conditions in our banking market even if they do occur.

Adverse market and economic conditions in North Carolina, particularly in the real estate, agricultural, or tourism industries, disproportionately increase the risk our borrowers will be unable to make their loan payments and the risk the market value of real estate securing our loans will not be sufficient collateral.  On December 31, 2012, 90.2% of the total dollar amount of our loan portfolio was secured by liens on real estate, with 6.5% of our portfolio representing home equity lines of credit.  Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and those relatively high percentages reflect, at least in part, our policy to take real estate whenever possible as primary or additional collateral.  However, any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in North Carolina could adversely affect the value of our assets, revenue, operating results, and financial condition.
 

Our profitability is subject to interest rate risk.  Changes in interest rates could have an adverse effect on our operating results.
 
Changes in interest rates can have different effects on various aspects of our business, particularly our net interest income.  Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities.  Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control.  Interest rate risk arises in part from the mismatch (i.e., the interest rate sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets.  When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap.  When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap.  A liability-sensitive position (i.e., a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment.  An asset-sensitive position (i.e., a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment.  Our ability to manage our gap position determines to a great extent on our ability to operate profitably.  However, fluctuations in interest rates are not predictable or controllable, and we cannot assure you we will be able to manage our gap position in a manner that will allow us to be profitable.
 
At December 31, 2012, the Bank remained in an asset-sensitive position.  This reflects the construct of the Bank’s balance sheet whereby our interest-earning assets generally would be expected to reprice at a faster rate than our interest-bearing liabilities.  Therefore, a rising rate environment would generally be expected to have a positive effect on our earnings, while a falling rate environment generally would be expected to have a negative effect on our earnings.

If our historical experience with the relative insensitivity of these deposits to changes in market interest rates does not continue in the future and we experience more rapid repricing of interest-bearing liabilities than interest-earning assets in a near term rising interest rate environment, our net interest margin and net income may decline.

Competition from financial institutions and other financial service providers may adversely affect our profitability.

Commercial banking in our banking market and in North Carolina as a whole is extremely competitive.  In addition to community, super-regional, national, and international commercial banks, we compete against credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds.  We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents.  Our larger competitors have greater resources, broader geographic markets and higher lending limits than we do, and they may be able to offer more products and services and better afford and more effectively use media advertising, support services, and electronic technology than we can.  While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market.  Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts, and greater flexibility and responsiveness in working with local customers, we cannot assure you we will continue to be an effective competitor in our banking markets.

We are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings.
 
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various federal and state agencies.  Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, possible mergers and acquisitions, investments, loans and interest rates charged thereon, interest rates paid on deposits, and locations of offices.  We also are subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital.  Most of these regulations are primarily intended to protect depositors, the public and the FDIC’s deposit insurance fund, rather than stockholders.

The Sarbanes-Oxley Act of 2002, and the related rules and regulations issued by the SEC that are applicable to us, have vastly increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the costs of completing our audit and maintaining our internal controls.  The laws and regulations that apply to us could change at any time, and we cannot fully predict the effects of those changes on our business and profitability.  However, virtually any newly imposed governmental regulation is highly likely to create additional expense to the Bank and in cases such as Sarbanes-Oxley noted above, the cost can be very significant.  Implementation and adoption of regulatory and accounting rules greatly affects the business and financial results of all commercial banks and bank holding companies, and our cost of compliance would be expected to adversely affect our earnings.
 
If the Bank loses key employees with significant business contacts in its market areas, its business may suffer.
 
The Bank is largely dependent on the personal contacts of our officers and employees in its market areas.  If the Bank loses key employees temporarily or permanently, this could have a material adverse effect on the business.  The Bank could be particularly affected if its key employees go to work for competitors.  The Bank’s future success depends on the continued contributions of its existing senior management personnel, many of whom have significant local experience and contacts in its market areas.
 

We may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability.

Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market or other non-depository investments, as providing superior expected returns or seek to spread their deposits over several banks to maximize FDIC insurance coverage.  Furthermore, technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments, including products offered by other financial institutions or non-bank service providers.  Increases in short-term interest rates could increase transfers of deposits to higher yielding deposits.  Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs.  When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, or spread their accounts over several banks, we can lose a relatively inexpensive source of funds, thus increasing our funding costs.

Negative publicity could damage our reputation.

Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business.  Negative public opinion could adversely affect our ability to keep and attract customers and expose us to adverse legal and regulatory consequences.  Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct.

The Bank is subject to environmental liability risk associated with lending activities.

A significant portion of the Bank’s loan portfolio is secured by real property.  During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk hazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require the Bank to incur substantial expense and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property.  In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability.  Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards.  The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.

Financial services companies depend on the accuracy and completeness of information about customers and counterparties.

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information.  We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information.  Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows.

Liquidity is essential to our business.  Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital, possible acquisitions, and other general corporate purposes.  An inability to raise funds through deposits, borrowings, securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity.  Our retail and commercial deposits may not be sufficient to meet our funding needs in the foreseeable future.  We therefore may have to increase our reliance on funding obtained through FHLB advances, securities sold under agreements to repurchase, and other wholesale funding sources.

Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated, financial condition, including capitalization and asset quality, or adverse regulatory action against us.  Under our Consent Order, we are not permitted to accept, renew, or rollover brokered deposits.  Such restriction requires us to seek other permissible funding sources.  Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and continued deterioration in credit markets.  To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned, which could have a material adverse effect on our financial condition, results of operations and cash flows.
 

Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.

Our accounting policies are fundamental to understanding our financial results and condition.  Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results.  Some of our accounting policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain and because it is likely materially different amounts would be reported under different conditions or using different assumptions.

From time to time the Financial Accounting Standards Board (the FASB) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements.  These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition.  We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.

Impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations.

In assessing the impairment of investment securities, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuers, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.  The impact of an other-than-temporary impairment could have a material adverse effect on our business, results of operations, and financial condition.

Premiums for D&O insurance have increased.  We may be unable to renew our D&O insurance policy on acceptable terms.

Since 2008, higher levels of bank failures and the associated heightened risk of regulatory action and litigation against directors and officers of failed banks have increased the cost of directors and officers liability insurance (D&O insurance) premiums for many financial institutions.  Because of our recent losses and financial condition, the cost of D&O insurance has increased.  Any future increases in D&O insurance premiums will likely adversely impact our earnings and financial condition.  In addition, we may be unable to renew our D&O insurance coverage in the future, or we may be unable to obtain adequate replacement policies on acceptable terms.  If we are not able to secure appropriate D&O insurance coverage, we may be unable to retain our current officers and directors, or attract additional officers and directors.

We rely on other companies to provide key components of our business infrastructure.

Third-party vendors provide key components of our business infrastructure, such as internet connections, network access and core application processing.  While we have selected these third-party vendors carefully, we do not control their actions.  Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business.  Replacing these third-party vendors could also entail significant delay and expense.

Our information systems may experience an interruption or breach in security.
 
We rely heavily on communications and information systems to conduct our business.  Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems.  While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, we cannot assure you any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

Unpredictable catastrophic events could have a material adverse effect on 1st Financial.

The occurrence of catastrophic events, such as hurricanes, tropical storms, earthquakes, pandemic disease, windstorms, floods, severe winter weather (including snow, freezing water, ice storms, and blizzards), fires and other catastrophes could adversely affect 1st Financial’s consolidated financial condition or results of operations.  Unpredictable natural and other disasters could have an adverse effect on the Bank in that such events could materially disrupt its operations or the ability or willingness of its customers to access the financial services offered by the Bank.  The incidence and severity of catastrophes are inherently unpredictable.  Although the Bank carries insurance to mitigate its exposure to certain catastrophic events, these events could nevertheless reduce the Company’s earnings and cause volatility in its financial results for any fiscal quarter or year and have a material adverse effect on the Company’s financial condition and results of operations.
 

We may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock.

The market for financial services, including banking services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, and Internet-based banking.  We depend on third-party vendors for portions of our data processing services.  In addition to our ability to finance the purchase of those services and integrate them into our operations, our ability to offer new technology-based services depends on our vendors’ abilities to provide and support those services.  Future advances in technology may require us to incur substantial expense that adversely affects our operating results, and our small size and limited resources may make it impractical or impossible for us to keep pace with our larger competitors.  Our ability to compete successfully in our banking markets may depend on the extent to which we and our vendors are able to offer new technology-based services and on our ability to integrate technological advances into our operations.

Risks Related to Our Common Stock

Our ability to pay dividends is limited and we may be unable to pay future dividends.

As discussed above under “Supervision and Regulation” in Item 1, our ability to pay cash dividends is limited by regulatory restrictions as well as the need to maintain sufficient capital.  So long as our capital ratios and regulatory requirements are not satisfied, we will be unable to pay cash dividends on our common and preferred stock.

There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.

We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities.  The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.

The trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares.

Our common stock has been quoted “over-the-counter” on the Pink Sheets Electronic Quotation Service and the OTC Bulletin Board since August 2004.  However, our common stock is still relatively thinly traded.  Thinly traded stocks can be more volatile than stock trading in an active public market.  We cannot predict the extent to which an active public market for our common stock will develop or be sustained.  In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to operating performance.

We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock.  So, we cannot assure you that sales of substantial amounts of our common stock in the market, or the potential for large amounts of market sales, would not cause the price of our common stock to decline or potentially impair our ability to raise capital in the future.

Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders.

On February 15, 2013, our current directors and executive officers, as a group, had the sole or shared right to vote, or to direct the voting of, an aggregate of 560,355 shares, or 10.8%, of our outstanding common stock.  This group could purchase 297,648 additional shares under currently exercisable stock options they hold.  Because of their voting rights, in matters put to a vote of our stockholders’, it could be difficult for any group of our other stockholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management.

1st Financial has issued preferred stock, which ranks senior to our common stock.

The Company has issued 16,369 shares of Preferred Stock.  This series of preferred stock ranks senior to shares of our common stock.  As a result, 1st Financial must make dividend payments on the Preferred Stock before any dividends can be paid on the common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the Preferred Stock must be satisfied before any distributions can be made on the common stock.  Through the date of this report, the Company has deferred the payment of the last 11 quarterly preferred dividends, with the total amount deferred of $2.3 million.  Until 1st Financial pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.
 

Our Preferred Stock reduces net income available to holders of our common stock and earnings per common share and the Warrant may be dilutive to holders of our common stock.

Any dividends, whether declared or not, on our Preferred Stock will reduce any net income available to holders of common stock and our earnings per common share.  The Preferred Stock will also receive preferential treatment in the event of sale, merger, liquidation, dissolution or winding up of our company.  Additionally, the ownership interest of holders of our common stock will be diluted to the extent the Warrant is exercised.

Our stock price can be volatile.

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive.  Our stock price can fluctuate significantly in response to a variety of factors including, among other things:

●  
actual or anticipated variations in quarterly results of operations;

●  
operating results and stock price performance of other companies that investors deem comparable to us;

●  
news reports relating to trends, concerns, and other issues in the financial services industry;

●  
perceptions in the marketplace regarding us and/or our competitors;

●  
new technology used or services offered by competitors;

●  
regulatory actions against us;

●  
significant acquisitions or business combinations, strategic partnerships, joint ventures, or capital commitments by or involving us or our competitors; and

●  
changes in government regulations.

General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause our stock price to decrease regardless of operating results.

Our common stock is not FDIC insured.

The Company’s common stock is not a savings or deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental agency and is subject to investment risk, including the possible loss of principal.  Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company.  As a result, holders of our common stock may lose some or all of their investment.
 
 

The Company’s corporate offices are located in Hendersonville, North Carolina.  At December 31, 2012, the Company maintained 12 full-service banking offices and an operations center.  The following table contains information about our banking offices.

Office Location
Opening Date of Original Banking Office
Owned/Leased
52 Coxe Avenue
Asheville, NC
May 2005
Leased (1)
19 Chestnut Street, Suite 7
Brevard, NC
December 2005
Leased (1)
80 Walker Street
Columbus, NC
January 2005
Leased (1)
6534 Brevard Road
Etowah, NC
May 2006
Owned
3270 Hendersonville Road
Fletcher, NC
September 2005
Owned
102 West Main Street
Forest City, NC
July 2007
Leased (1)
101 Jack Street
Hendersonville, NC
November 2004
Leased (1), (3)
203 Greenville Highway
Hendersonville, NC
May 2004
Leased (1)
1880 North Center Street
Hickory, NC
November 2008
Leased (1)
174 Highway 70 West
Marion, NC
May 2006
Leased (2)
800 South Lafayette Street
Shelby, NC
September 2006
Owned
1637 South Main Street
Waynesville, NC
August 2004
Leased (1)

(1)  Leased from unrelated third party.
(2)  Leased from a related part on terms comparable to third-party leases.
(3)  Corporate Headquarters and Main Office

All the Company’s existing banking offices are in good condition and fully equipped for the Company’s purposes.  At December 31, 2012, the total net book value (cost less accumulated depreciation) of the Company’s premises, leasehold improvements, furniture, fixtures, and equipment was $4.4 million.  See Notes 9 and 12 to the accompanying consolidated financial statements for additional information about the Company’s property and lease obligations.
 
 
In the ordinary course of business, the Company and its subsidiaries are often involved in legal proceedings.  In the opinion of management, except as disclosed in Item 1 hereof, under the caption "Business - Enforcement Actions", neither the Company nor its subsidiaries is a party to, nor is their property the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to their business, nor has any such proceeding been terminated during the fourth quarter of the Company’s fiscal year ended December 31, 2012.
 
 
PART II
 
 
The Company’s common stock is traded over-the-counter with quotations available on the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service under the symbol “FFIS.”  There were approximately 2,400 stockholders of record as of December 31, 2012, not including the persons or entities whose stock is held in nominee or “street” name and by various banks and brokerage firms.

The table below presents the reported high and low closing prices for the Company’s common stock, along with the actual closing price for the previous eight quarters.  These quotations reflect inter-dealer prices, without retail mark up, mark down or commission and may not represent actual transactions.  No common stock dividend was declared or paid during any of the fiscal quarters listed.
 
   
High
    
Low
    
Close
  
2012
                  
First quarter
   $ 0.59     $ 0.12     $ 0.12  
Second quarter
     0.75       0.21       0.26  
Third quarter
     0.60       0.21       0.30  
Fourth quarter
     0.35       0.14       0.30  
                         
2011
                        
First quarter
   $ 0.65     $ 0.40     $ 0.45  
Second quarter
     0.60       0.31       0.38  
Third quarter
     0.51       0.30       0.30  
Fourth quarter
     0.60       0.15       0.25  

Securities Authorized for Issuance Under Equity Compensation Plans.  The following table summarizes all compensation plans and individual compensation arrangements which were in effect on December 31, 2012, and under which shares of the Company's common stock have been authorized for issuance.

EQUITY COMPENSATION PLAN INFORMATION
  
               
(c)
  
Plan category
  
(a)
Number of shares
to be issued upon exercise of outstanding options and awards
    
(b)
Weighted-average exercise price of outstanding options
and awards
    
Number of shares remaining available
for future issuance under equity compensations
plans (excluding
shares reflected in column (a))
  
                   
Equity compensation plans approved by the Company's security holders:
                  
                   
     2004 Employee and Director Stock Option Plans
     690,889     $ 8.30       273,399  
                         
     2008 Omnibus Equity Plan
     159,867       0.55       90,133  
                         
Equity compensation plans not approved by the Company's security holders
     -       -       -  
Total
     850,756     $ 6.84       363,532  
 
Dividends.  See “Item 1.  Description of Business – Supervision and Regulation” above for regulatory and CPP restrictions, which limit the ability of 1st Financial to pay dividends.

Recent Sales of Unregistered Securities.  The Company did not sell any securities within the last three fiscal years that were not registered under the Securities Act of 1933, as amended.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers.  The Company did not repurchase any shares of its common stock during the fourth quarter of 2012.
 
 
 
Not applicable.

 
Introduction

1st Financial Services Corporation (the Company or 1st Financial) is a North Carolina corporation headquartered in Hendersonville, North Carolina that when it was formed in May 2008 became the sole owner of all of the capital stock of Mountain 1st Bank & Trust Company (the Bank).  The Bank is a North Carolina state chartered, non-member bank, which was organized and incorporated under the laws of the State of North Carolina on April 30, 2004, and began operations on May 14, 2004.  As of December 31, 2012, the Bank conducted business through 12 full-service branch offices located in nine western North Carolina counties.

Because the Company has no separate operations and conducts no business on its own other than owning the Bank, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of the Bank.  However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the “Company” unless otherwise noted.

The Bank competes for loans and deposits throughout the markets it serves.  The Bank, like other financial institutions, derives most of its revenue from net interest income, which is the difference between the income it earns on loans and securities minus the interest expense it incurs on deposits and borrowings.

Management has provided the following discussion and analysis to address information about the Company’s financial condition and results of operations, which may not otherwise be apparent from the consolidated financial statements included in this Report.  Reference should be made to those statements for an understanding of the following discussion and analysis.

Factors That May Affect Future Results

The discussion and analysis that follows is intended to assist readers in the understanding and evaluation of the financial condition and results of operations of the Company.  It should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Annual Report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.

The following discussion contains certain forward-looking statements about the Company’s financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.  See also “Cautionary Note About Forward-Looking Statements” and “Risk Factor’’, which begin on pages 3 and 18, respectively.

Enforcement Policies and Actions

Federal and state laws give the Federal Reserve, the FDIC, and the Commissioner substantial powers to enforce compliance with laws, rules, and regulations.  Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices.  The banking regulators have the power to impose civil money penalties against individuals or institutions for certain violations.

Persons who are affiliated with depository institutions and their holding companies can be removed from any office held in that institution and banned from participating in the affairs of any financial institution.  The banking regulators frequently employ the enforcement authorities provided in federal and state law.

Enforcement Action - Consent Order

During 2009, the FDIC conducted a periodic examination of the Bank.  As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation agreeing to the issuance of a Consent Order with the FDIC and the Commissioner (the Consent Order).
 
Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Board of Directors or the Bank to undertake a number of actions:
 

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the Board of Directors of the Bank will enhance its supervision of the Bank’s activities, including by increasing the formality of its meetings and appointing a special Directors’ Committee.  The Committee will oversee the efforts of the Bank’s management in complying with the Consent Order and will regularly report to the full Board.

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the Bank Board will assess the Bank’s management team to ensure the Bank’s executive officers have the skills, training, abilities, and experience needed to cause the Bank to comply with the Consent Order, operate in a safe and sound manner, comply with applicable laws and regulations, and strengthen all areas of the Bank’s operations that are not currently in compliance with the Consent Order.  The Board will also assess the Bank’s management and staffing needs in order to determine if additional resources should be added to the management team.

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during the effectiveness of the Consent Order, the Bank will maintain Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses (the “Allowance for Loan Losses” or “Allowance”).

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the Bank will develop and implement a plan for achieving and maintaining the foregoing capital levels, which plan may include sales of stock by the Company and contributions of the sales proceeds by the Company to the capital of the Bank.

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the Board will strengthen the Allowance for Loan Losses policy of the Bank, periodically review the Bank’s Allowance for Loan Losses to determine its adequacy and enhance its periodic reviews of the Allowance to ensure its continuing adequacy.  Deficiencies noted will be promptly remedied by charges to earnings.

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the Bank will develop and implement a strategic plan covering at least three years and containing long-term goals designed to improve the condition of the Bank.

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the Bank will not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.  The Bank also will not extend additional credit to any borrower who has a current loan that is classified “Substandard” or listed for “Special Mention.”  A further extension of credit may be made to a borrower with a “Substandard” or “Special Mention” loan if the Bank Board determines such extension would be in the best interests of the Bank.

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the Bank will formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans as of August 31, 2009, of more than $250,000 and will promptly implement the plan.  The Board will closely monitor the Bank’s progress in fulfilling the requirements of this plan.

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the Bank will reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.  The schedule targets an aggregate reduction by 75% within 720 days of the effectiveness of the Consent Order.  The Board will monitor this effort on a monthly basis.

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the Bank will cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies within 90 days of the effectiveness of the Consent Order.

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the Bank will adopt a loan review and grading system within 90 days of the Consent Order to provide for effective periodic reviews of the Bank’s loan portfolio.  The system shall address, among other things, loan grading standards, loan categorization, and credit risk analyses.

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within 30 days of the effectiveness of the Consent Order, the Bank will develop a plan to systematically reduce the concentration of a significant portion of its extensions of credit in a limited group of borrowers. Additionally, the Bank will prepare a risk segmentation analysis with respect to certain real estate industry concentrations of credit identified by the supervisory authorities.

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the Bank will enhance its review of its liquidity by engaging in monthly analyses.  It will also develop and implement a liquidity contingency and asset/liability management plan.

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within 90 days from the effectiveness of the Consent Order, the Bank will implement a plan and 2010 budget designed to improve its net interest margin, increase interest income, reduce expenditures, and improve and sustain earnings.
 
 
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the Bank will implement internal routine and control policies addressing concerns raised by its supervisory authorities and designed to enhance its safe and sound operation.

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within 90 days of the Consent Order, the Bank will implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
 
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the Bank will implement a policy for managing its “owned real estate”.

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the Bank will forbear from soliciting and accepting “brokered deposits” unless it first receives an appropriate waiver from the FDIC; and will comply with restrictions issued by the FDIC on the effective yields of deposit products offered by, among others, banks subject to consent orders.

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a limit upon growth of 10% per year will be observed by the Bank.

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the Bank will not pay dividends or make other forms of payment reducing capital to the Company without the prior approval of the supervisory authorities while the Consent Order is in effect.

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the Bank will implement policies to enhance the Board’s focus on conflicts of interest regulations and its handling of transactions with officers and directors.

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the Bank will correct any violations of laws and regulations identified by the supervisory authorities.

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the Bank will make quarterly progress reports to the supervisory authorities detailing the form and manner of actions taken to comply with the Consent Order.
 
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order.  A copy of the Consent Order has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov.  The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
 
The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation.  During the period a Consent Order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches.  Accordingly, the Bank has deferred pursuit of its previous strategy of expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.

Enforcement Action - Written Agreement

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, 1st Financial executed a written agreement (the Written Agreement) with the Federal Reserve Bank effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions:

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the Board of Directors of 1st Financial shall take appropriate steps to fully utilize 1st Financial’s financial and managerial resources, to serve as a source of strength to the Bank, including, but not limited to, taking steps to ensure the Bank complies with the Consent Order and any other supervisory action taken by the Bank’s federal or state regulator.

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1st Financial shall not declare or pay any dividends without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve.

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1st Financial shall not directly or indirectly take dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank.

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all requests for prior approval shall be received by the Federal Reserve Bank at least 30 days prior to the proposed dividend declaration date.  All requests shall contain, at a minimum, current, and projected information on 1st Financial’s capital, earnings, and cash flow; the Bank’s capital, asset quality, earnings, and allowance for loan and lease losses; and identification of the sources of funds for the proposed payment or distribution.

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1st Financial shall not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Federal Reserve Bank.  All requests for prior written approval shall contain, but not be limited to, a statement regarding the purpose of the debt, the terms of the debt, and the planned source(s) for debt repayment, and an analysis of the cash flow resources available to meet such debt repayment.

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1st Financial shall not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Federal Reserve Bank.
 
 
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within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank an acceptable written plan to maintain sufficient capital at 1st Financial on a consolidated basis.  The plan shall, at a minimum, address, consider, and include:
 
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the consolidated organization’s and the Bank’s current and future capital requirements, including compliance with the Capital Adequacy Guidelines for Bank Holding Companies and the applicable capital adequacy guidelines for the Bank issued by the Bank’s federal regulator;

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the adequacy of the Bank’s capital, taking into account the volume of classified credits, concentrations of credit, allowance for loan and lease losses, current and projected asset growth, and projected retained earnings;

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the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Bank’s future capital requirements;

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supervisory requests for additional capital at the Bank or the requirements of any supervisory action imposed on the Bank by its federal regulator; and
 
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the requirements of Regulation Y of the Federal Reserve that 1st Financial serve as a source of strength to the Bank.
 
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1st Financial shall notify the Federal Reserve Bank, in writing, no more than 45 days after the end of any quarter in which any of 1st Financial’s capital ratios fall below the approved plan’s minimum ratios.  Together with the notification, 1st Financial shall submit an acceptable written plan that details the steps that 1st Financial will take to increase 1st Financial’s capital ratios to or above the approved plan’s minimums.

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within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank a written statement of its planned sources and uses of cash for debt service, operating expenses, and other purposes (Cash Flow Projection) for 2011. 1st Financial shall submit to the Federal Reserve Bank a Cash Flow Projection for each calendar year subsequent to 2011 at least one month prior to the beginning of that calendar year.
 
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in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, 1st Financial shall comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve.

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1st Financial shall comply with the restrictions on indemnification and severance payments of the FDI Act and the FDIC’s regulations.

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within 30 days after the end of each calendar quarter following the date of the Written Agreement, the Board of Directors shall submit to the Federal Reserve Bank written progress reports detailing the form and manner of all actions taken to secure compliance with the provisions of the Written Agreement and the results thereof, and a parent company only balance sheet, income statement, and, as applicable, report of changes in stockholders’ equity.

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1st Financial shall submit a written capital plan that is acceptable to the Federal Reserve Bank within the applicable time period set forth in the Written Agreement.  Within 10 days of approval by the Federal Reserve Bank, 1st Financial shall adopt the approved capital plan.  Upon adoption, 1st Financial shall promptly implement the approved plan, and thereafter fully comply with it.  During the term of the Written Agreement, the approved capital plan shall not be amended or rescinded without the prior written approval of the Federal Reserve Bank.

The foregoing description is a summary of the material terms of the Written Agreement and is qualified in its entirety by reference to the Written Agreement.  A copy of the Written Agreement has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov.  Each provision of the Written Agreement shall remain effective and enforceable until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

"Significantly Undercapitalized" Capital Category

At December 31, 2012, the Bank was deemed "significantly undercapitalized".  As such, the Bank is subject to the restrictions in Section 38 of the Federal Deposit Insurance Act and the related FDIC rules and regulations that apply to "significantly undercapitalized" institutions, including restrictions on:

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the compensation paid to senior executive officers;
 
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capital distributions;
 
 
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payment of management fees;

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asset growth;

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acquiring any interest in any company or insured depository institution;

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establishing or acquiring any additional branch office; and

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engaging in any new line of business.

Because of its capital category, the Bank may not accept, renew, or rollover brokered deposits, and is subject to restrictions on the rate of interest it may pay on deposits.  Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.

Going Concern Considerations

As discussed in this Item under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations," and in Note 2 to the accompanying consolidated financial statements, although the Company was profitable in 2012, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels.  In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels.  As of December 31, 2012, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels.  These considerations raise substantial doubt about the Company's ability to continue as a going concern.  Management’s plans are further discussed in Note 2 to the accompanying consolidated financial statements.  These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.

Proposed Legislation and Regulatory Action

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies.  Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system.  Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways.  If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions.  We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company.  A change in statutes, regulations, or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.

General Economic Conditions

Western North Carolina is undergoing one of the most severe economic recessions in our history.  Unemployment is close to record levels and both residential and commercial real estate values have been adversely impacted.  Since 2008, with the slowing economy, falling real estate values, and reducing interest rates, our Company experienced severe stress on our earnings from both depressed margins and worsening asset quality.  Continued weaknesses in the Western North Carolina real estate market was the primary reason for the Company’s providing an increase to the allowance for loans losses of $5.3 million and $15.8 million in 2012 and 2011, respectively.  We have experienced some margin contraction, as we are unable to reinvest proceeds from loan and security repayments at the same yields.  We also expect to continue to incur increased expense as we manage our troubled assets.  Our markets continue to feel the effects of the recession and we do not foresee substantial improvements in either unemployment levels or real estate values until late 2013 at the earliest.

Overview

The Company’s primary market area is located in the mountain region of southwestern North Carolina.  The principal business sectors in this region include service companies directly or indirectly linked to tourism, which is one of the largest economic drivers of the region, small to mid-sized manufacturing companies, real estate development, particularly relating to the ongoing growth of the area as a retirement and second home destination, the arts and crafts industry, and to a lesser degree, agriculture.
 

The Bank believes its current base of business is relatively well diversified as is the general economic base of the region as a whole.  The principal concentration identified by management within the Company’s lending portfolio is in loans secured by real estate.  At December 31, 2012, loans collateralized by real estate, comprised 90.2% of the Company’s total loan portfolio.  Management believes concentration risk within this sector of the loan portfolio is mitigated by the mix of different types of real estate held as collateral.  These include residential, multifamily, and both income-producing and owner-occupied commercial properties.  The Company’s loan portfolio includes $69.0 million in loans classified as construction or acquisition and development (of which $43.3 million are land loans) and $147.9 million in loans classified as commercial real estate (CRE), representing 17.8% and 38.2%, respectively of the total portfolio.  By way of comparison, at December 31, 2011, the Company’s loan portfolio included $87.1 million in loans classified as construction or acquisition and development (of which $44.9 million were land loans) and $159.1 million in loans classified as CRE, representing 20.8% and 38.0%, respectively, of the total portfolio.
 
In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans with high loan-to-value ratios.  At December 31, 2012, loans exceeding regulatory loan-to-value guidelines represented 111.8% of risk-based capital, primarily attributable to the Bank’s reduced capital due to losses incurred in the past several years, combined with market value declines on the underlying collateral of the Bank’s real estate loan portfolio.

Banking regulators have continued to issue guidance to banks concerning their perception of general risk levels associated with higher concentrations of CRE as a proportion of total loans and as a percentage of capital within bank loan portfolios.  It remains management’s understanding that regulatory interpretations of this guidance would not necessarily prohibit future growth for banks with concentrations of CRE, however, additional monitoring and risk management procedures are likely to be required for portfolios with higher levels of CRE and additional CRE lending may also be curtailed.  Management has continued efforts to refine enhanced monitoring systems pertaining to the Bank’s CRE portfolio, with particular emphasis on construction and land development lending, which comprises a material portion of the Bank’s CRE portfolio.  In addition to continued enhanced monitoring of this portion of the loan portfolio, management has curtailed lending to new acquisition and development projects and anticipates this component of the portfolio will decline substantially over time.

For the first five years of operation, management’s business plan had been predicated upon the relatively rapid growth and establishment of an initial branch network within the Company’s primary delineated market area.  However, due to the current economic environment, management does not expect to open new branch offices to augment the current branch network in the foreseeable future and may close certain offices to improve operating efficiencies.  Instead, management is focused on reducing its nonperforming loan portfolio and its foreclosed real estate holdings, while simultaneously growing existing branches in its primary market.

The Company’s primary source of revenue is derived from interest income produced through traditional banking activities, such as generating loans and earning interest on securities.  Additional sources of income are derived from fees on deposit accounts, Small Business Administration (SBA) and U.S. Department of Agriculture (USDA) loan originations and sales, and residential mortgage origination services.

Maintaining sound asset quality is another key focal point for the Company.  As a result of the current economic environment, the Bank experienced an increase in nonperforming assets (nonaccruing loans, foreclosed assets, and accruing loans past due 90 or more days) beginning in 2009, which resulted in a significant increase in our allowance for loan losses.  This development is further discussed under the heading “Asset Quality” below.  The business of lending to small businesses and consumers carriers with it significant credit risks, which must be continually managed.  Management monitors asset quality and credit risk on an ongoing basis and fully expects to experience credit losses in the future, but we believe we have made substantial progress in identifying and quantifying the impact of the current economic environment on our loan portfolio and overall financial condition.  Management continues to engage third-party consultants to assist in monitoring and evaluating the quality of the portfolio.  Although asset quality has significantly improved during 2012, problem assets continue to be elevated.

Financial Condition

December 31, 2012, Compared to December 31, 2011

The Company’s total assets were $710.4 million at December 31, 2012, an increase of $10.4 million, from $700.0 million at December 31, 2011.  Investment securities increased by $55.4 million, or 27.8%, from $199.7 million at December 31, 2011, to $255.1 million at December 31, 2012.  During 2012, gross loans, excluding loans held for sale, decreased by $31.2 million, or 7.5%, from $418.9 million at December 31, 2011, to $387.7 million at December 31, 2012, as management purposely slowed loan growth in response to current economic conditions.  In addition, certain customers are exhibiting a preference for deleveraging by paying off their loans.  Although the mix of deposits continued to shift from time deposits to transaction accounts, total deposits at December 31, 2012, were $683.9 million, an increase of $11.3 million, or 1.7%, from $672.6 million at December 31, 2011.  Excluding the reduction in brokered certificates of deposit of $1.6 million, retail deposits increased $12.9 million, or 1.9%.  Borrowings from the Federal Home Loan Bank, totaling $4.0 million were repaid during early 2012.  Securities sold under agreements to repurchase, the sole component of borrowings at December 31, 2012, decreased by $169,000 from year-end 2011.  The Company’s loan-to-asset ratio decreased from 59.8% at December 31, 2011, to 54.6% at December 31, 2012, principally reflecting an increase in loan repayments over loan production, combined with $5.8 million of gross charge-offs and the transfer of $7.4 million of portfolio loans to foreclosed assets during 2012.
 

As noted above, during 2012, gross loans decreased $31.2 million, or 7.5%.  The reduction in loans included declines totaling $18.1 million, or 20.8%, in construction and land development loans, $11.7 million, or 24.9%, in commercial and industrial loans, $119,000, or 4.0%, in consumer loans, $11.2 million, or 7.1%, in commercial real estate loans, and $2.8 million, or 9.8%, in home equity loans, offset by an increase of  $12.5 million, or 14.5%, in first liens on 1-4 family residential properties, excluding mortgage loans held for sale.  Overall growth plans for the Bank have been purposely slowed in response to the Consent Order and Written Agreement, the Bank’s asset quality deterioration, uncertainties with respect to the national economy, regional and local real estate markets, the domestic interest rate environment and global currency markets and in order to maintain satisfactory capital requirements.  Until the Bank’s capital levels are restored, the Bank is prohibited from increasing its assets.  The Company may achieve capital restoration through a capital raise, reducing the size of the Company’s consolidated balance sheet, or a combination of the two methods.  Management and the Board continue to pursue plans to achieve and maintain the regulatory directed capital levels.  Given the state of the current equity markets, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.  
 
Investment securities increased during the period by $55.4 million, or 27.8%.  At December 31, 2012, cash and cash equivalents increased by $1.3 million, compared with December 31, 2011.  Liquid assets, consisting of cash and demand balances due from banks, interest-earning deposits in other banks, balances due from the Federal Reserve Bank and available-for-sale investment securities totaled $292.5 million at December 31, 2012, constituting 41.2% of total assets.  This compares with $232.8 million, or 33.3% of total assets, at year-end 2011.  Proceeds from investment security sales and increased customer deposits, along with proceeds from secondary market mortgage loan sales and loan repayments continue to boost cash on deposit with the Federal Reserve Bank, providing sufficient liquidity to fund investment security purchases, combined with providing liquidity to meet depositor needs.

Foreclosed real estate decreased from $19.3 million at December 31, 2011, to $9.8 million at December 31, 2012, as the Company managed a larger volume of foreclosed real estate through the final disposition process.

Other assets decreased from $2.3 million at December 31, 2011, to $980,000 at December 31, 2012, as a result of the disposition of all the Company’s repossessed assets.  At December 31, 2011 repossessed assets totaled $1.6 million and consisted of three aircraft.

Deposits increased $11.3 million during 2012, during which time the composition of the Bank’s deposits shifted from certificates of deposit toward core transaction accounts, including checking, savings, and money market accounts.  At year-end 2012, noninterest-bearing demand accounts had increased $9.1 million, or 11.8%, to $86.0 million.  Other transaction accounts, including NOW, money market and savings accounts increased $45.8 million, or 17.9%.  At December 31, 2012, transaction accounts accounted for 56.7% of the Company’s total deposits, compared to 49.5% at December 31, 2011.  Certificates of deposit under $100,000 decreased $25.9 million, or 15.2%, while certificates of deposit over $100,000 decreased $17.7 million, or 10.5%.  The decrease in certificates of deposits was attributable to shifting customer preferences to maintain funds in more liquid accounts, such as the money market and savings accounts.  Brokered certificates of deposit totaled $937,000 at December 31, 2012, and were comprised entirely of internet certificates of deposit, compared to $2.6 million at December 31, 2011.  Management’s funding strategy remains centered around balanced growth in deposits generated through the Company’s retail branch network, supplemented through the selective use of permissible wholesale funding when such sources present a lower cost alternative to certificates of deposit pricing in the local markets in which the Company operates.  Under the Consent Order, and as a consequence of the Bank’s reduced capital levels, the Company may not attract, renew, or rollover brokered certificates of deposit, unless it first receives an appropriate waiver from the FDIC.  Accordingly, as existing brokered certificates of deposit mature, funds are being returned to the depositors.

Stockholders’ equity increased by $1.1 million, or 6.2%, during 2012, primarily as a result of the Company’s net income for the period.  At December 31, 2012, the Company’s capital ratios classified it as a “significantly undercapitalized” institution by regulatory measures.

Results of Operations

Summary

For 2012, the Company recorded net income of $1.3 million, representing an increase of $21.7 million as compared with a net loss of $20.5 million for 2011.  Net income available to common stockholders, after the effect of preferred stock dividend requirements, was $249,000 for 2012, or $0.05 per diluted share, compared with a net loss available to common stockholders of $21.5 million, or $(4.18) per diluted share, for 2011.  The increase in net income in 2012 was driven principally by a lower provision for loan losses of $10.5 million, coupled with a decrease in income tax expense of $9.4 million.  Also contributing to the change was an increase in noninterest income of $1.4 million and a decrease in noninterest expense of $914,000, partially offset by a decrease in net interest income of $512,000.  The Company recorded no income tax expense during 2012, due to the establishment of a full valuation allowance against its deferred tax asset at year-end 2011.  For 2011, the Company recorded income tax expense of $9.4 million based on a pre-tax book loss of $11.1 million.  Contributing to the income tax expense in the 2011 period was a provision of $12.9 million to increase the valuation allowance the Company maintains against its deferred tax asset.
 

For 2012, the Company’s net interest margin decreased to 2.98%, compared with 3.06% for 2011, primarily as a result of an asset shift from higher yielding loans to lower yielding investment securities.  As a result of the decline in the Company’s net interest margin, net interest income decreased $512,000 from $20.5 million for 2011 to $20.0 million for 2012 due to the adverse impact of nonaccrual loans and historically low interest rates.  Noninterest income for 2012, which primarily includes income from service charges on deposit accounts, mortgage services revenue, and gains on sale of securities sold, increased to $10.1 million, compared to $8.7 million recorded during 2011, principally due to mortgage services revenue, which totaled $2.5 million, compared to $2.0 million in 2011 and gains on sale of securities sold, which totaled $3.0 million in 2012, compared to $2.5 million in 2011.  Noninterest expense decreased $914,000 to $23.5 million for 2012, compared with $24.4 million for 2011.  Decreased problem asset management costs, including holding costs of and losses on the sale of other real estate owned and repossessed assets and loan related expense were partially offset by increased salaries and benefit expense and deposit insurance premiums.  The duration and severity of the current recession continue to have a substantial impact on the Company’s performance.  This increase in deposit insurance premiums is attributable to increased customer deposits and a higher year-over-year assessment rate based on the Bank’s capital and asset quality measures.  Strong cost control efforts continue to account for the moderate declines in a majority of operating expense categories.

Net Interest Income

The primary component of earnings for the Company is net interest income.  Net interest income is defined as the difference between interest income, principally from the loan and investment securities portfolios, and interest expense, principally on deposits and borrowings.  Changes in net interest income result from changes in volume, spread, and margin.  For this purpose, “volume” refers to the average dollar level of interest-earning assets and interest-bearing liabilities, “spread” refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities and “margin” refers to net interest income divided by average interest-earning assets.  Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-earning assets and noninterest-bearing liabilities.  During 2012 and 2011, average interest-earning assets were $671.3 million and $669.6 million, respectively.

The components of the decrease in net interest income for 2012 were a decrease in interest income of $2.3 million, or 8.3%, which was partially offset by a decrease in interest expense of $1.8 million, or 24.0%.  Interest on loans decreased by $3.0 million, or 13.0%, as a result of significantly reduced balances from loan repayments and lower yields on the loan portfolio.  Nonaccrual loans averaged $31.7 million in 2012, compared to $45.9 million in 2011 and the foregone interest on these loans decreased from $2.8 million in 2011 to $1.9 million in 2012.  The Bank reduced its deposit offering rates across all account categories during 2012 to ensure the Bank’s rates were priced competitively with market rates, in the generally declining rate environment of 2012.  Interest on deposits decreased by $1.8 million, or 23.8%, primarily due to the across-the-board rate reductions and the downward repricing of the Bank’s higher-costing time deposits during 2012, combined with a reduction in average balances, as customers moved their funds from maturing certificates of deposit into more liquid transactional accounts, such as savings and money market accounts, to maintain flexibility in their reinvestment options.

The Company’s net interest margin decreased from 3.06% for 2011 to 2.98% for 2012, primarily as a result of a shift in the composition of assets from higher-yielding loans to lower-yielding investment securities.  Average interest-earning assets for 2012 increased $1.7 million, or 0.3%, as compared to 2011.  Components of the decrease in margin were a 36 basis point decrease in the average yield on earning assets to 3.83%, partially offset by a 30 basis point reduction in the average cost of funds to 0.94%.  A shift in the composition of assets most notably contributed to the decrease in net interest income for 2012.  The Company’s decision to build and maintain a significant liquidity position in an uncertain regulatory and economic environment continues to have an adverse impact on the net interest margin.  The net interest margin will also be negatively affected if the economic environment remains sluggish, loan originations slow further, and nonaccrual loans continue at elevated levels.  Management strives to maintain a high interest-earning asset ratio, so as to maximize net interest income.  To that end, management targets an earning-asset ratio at or above 93%.  For 2012, that ratio was 94.2%, compared to 93.1% for 2011.
 

Average Balances, Income and Expenses, and Rates.  The following table sets forth certain information related to our average balance sheet and our average yields on earning assets and average costs of interest-bearing liabilities.  Such yields are derived by dividing income or expense by the average daily balance of the corresponding assets or liabilities.

Average Balances and Net Interest Income
                                                  
(dollars in thousands)
                                                      
   
For the Year
  
   
2012
    
2011
    
2010
  
    Average
Daily
Balance
    
Interest
           Average
Daily
Balance
    
Interest
           Average
Daily
Balance
    
Interest
        
       
Income/
     Average
Rate
        
Income/
     Average
Rate
        
Income/
     Average
Rate
  
       
Expense(1)(2)(3)
            
Expense(1)(2)
            
Expense(1)(2)
      
Interest-earning assets
                                                      
Loans and loans held for sale
   $ 401,427     $ 20,332       5.06 %   $ 462,885     $ 23,368       5.05 %   $ 527,650     $ 27,588       5.23 %
Investment securities
     234,104       5,260       2.25 %     164,841       4,500       2.73 %     129,877       2,884       2.22 %
Due from Federal Reserve Bank
     31,777       77       0.24 %     35,760       84       0.23 %     88,996       208       0.23 %
Interest-earning bank deposits
     4,020       41       1.02 %     6,151       76       1.24 %     3,888       56       1.44 %
Total interest-earning assets
     671,328       25,710       3.83 %     669,637       28,028       4.19 %     750,411       30,736       4.10 %
                                                                         
Noninterest-earning assets:
                                                                        
Cash and due from banks
     13,018                       15,968                       11,867                  
Property and equipment
     4,672                       5,421                       5,440                  
Interest receivable and other
     23,438                       28,199                       16,690                  
Total noninterest-earning assets
     41,128                       49,588                       33,997                  
Total assets
   $ 712,456                     $ 719,225                     $ 784,408                  
                                                                         
Interest-bearing liabilities
                                                                        
NOW accounts
     66,596       132       0.20 %     64,312       187       0.29 %     62,062       205       0.33 %
Money markets
     58,216       437       0.75 %     51,299       522       1.02 %     47,085       583       1.24 %
Savings deposits
     157,958       1,247       0.79 %     123,899       1,277       1.03 %     101,829       1,118       1.10 %
Retail time deposits
     320,920       3,852       1.20 %     332,197       4,906       1.48 %     345,906       6,906       2.00 %
Wholesale time deposits
     1,390       36       2.59 %     28,561       595       2.08 %     64,899       1,056       1.63 %
Federal funds purchased and securities sold under agreements to repurchase                                                                        
    481       1       0.26 %     910       6       0.66 %     1,096       8       0.73 %
Other borrowings
     22       -       0.53 %     3,952       18       0.46 %     46,617       415       0.89 %
Total interest-bearing liabilities
     605,583       5,705       0.94 %     605,130       7,511       1.24 %     669,494       10,291       1.54 %
                                                                         
Noninterest-bearing liabilities:
                                                                        
Demand deposits
     82,589                       72,792                       66,027                  
Interest payable and other
     4,772                       4,691                       6,170                  
Total noninterest-bearing liabilities
     87,361                       77,483                       72,197                  
Total liabilities
     692,944                       682,613                       741,691                  
                                                                         
Stockholders' equity
     19,512                       36,612                       42,717                  
Total liabilities and stockholders' equity
   $ 712,456                     $ 719,225                     $ 784,408                  
                                                                         
                                                                         
Net interest income and interest rate spread
           $ 20,005       2.89 %           $ 20,517       2.95 %           $ 20,445       2.56 %
                                                                         
Net yield on average interest-earning assets
                     2.98 %                     3.06 %                     2.72 %
                                                                         
Ratio of average interest-earning assets to average interest-bearing liabilities                                                                        
    110.86 %                     110.66 %                     112.09 %                
                                                                         
(1) Interest income includes amortization of deferred loan fees, net.
                                      
(2) Nonaccrual loans are included in gross loans but interest is not included in interest income.
                
(3) For amounts less than or equal to $1, yields are calculated using actual interest income and actual average assets not rounded values.
  

39
 
 
Rate/Volume Analysis.  The following table shows changes in interest income, interest expense, and net interest income arising from volume and rate changes for major categories of earning assets and interest-bearing liabilities.  The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar change in both.

Volume and Rate Variance Analysis
                                    
(in thousands)
                                    
   
2012 vs 2011
    
2011 vs 2010
  
   
Increase (Decrease) Due to
  
   
Volume
    
Rate
    
Total
    
Volume
    
Rate
    
Total
  
Interest income:
                                    
Loans and loans held for sale
   $ (3,113 )   $ 77     $ (3,036 )   $ (3,295 )   $ (925 )   $ (4,220 )
Investment securities
     1,655       (895 )     760       873       743       1,616  
Due from Federal Reserve Bank
     (7 )     -       (7 )     (124 )     -       (124 )
Interest-bearing bank deposits
     (23 )     (12 )     (35 )     29       (9 )     20  
Total interest income
     (1,488 )     (830 )     (2,318 )     (2,517 )     (191 )     (2,708 )
                                                 
Interest expense:
                                                
NOW accounts
   $ 6     $ (61 )   $ (55 )   $ 7     $ (25 )   $ (18 )
Money markets
     64       (149 )     (85 )     49       (110 )     (61 )
Savings deposits
     307       (337 )     (30 )     231       (72 )     159  
Retail time deposits
     (162 )     (892 )     (1,054 )     (264 )     (1,736 )     (2,000 )
Wholesale time deposits
     (676 )     117       (559 )     (702 )     241       (461 )
Federal funds purchased and securities
                                                
  sold under agreements to repurchase
     (2 )     (3 )     (5 )     (1 )     (1 )     (2 )
Other borrowings
     (9 )     (9 )     (18 )     (259 )     (138 )     (397 )
Total interest expense
     (472 )     (1,334 )     (1,806 )     (939 )     (1,841 )     (2,780 )
Net increase (decrease) in net interest income
   $ (1,016 )   $ 504     $ (512 )   $ (1,578 )   $ 1,650     $ 72  

Provision for Loan Losses

Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management.  In evaluating the allowance for loan losses, management considers factors that include growth, composition, diversification, or conversely, concentrations by industry, geography or collateral within the portfolio, historical loan loss experience, current seasoning of the portfolio, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors.

Provision for loan losses for 2012 totaled $5.3 million, a decrease of $10.5 million, compared with $15.8 million for 2011.  The reduction in the provision for loan losses is reflective of both the overall reduction in problem loans and the stabilization, for the most part, of the real estate values collateralizing our problem loans.  Higher provisioning in future quarters may occur if economic conditions do not improve, borrowers continue to experience financial difficulties, and real estate values decline.

Noninterest Income

Noninterest income increased to $10.1 million for 2012, compared to $8.7 million for 2011, representing an increase of $1.4 million, or 16.4%.  The principal components of this increase were increased mortgage services revenue and net gains on sales of investment securities.  Mortgage service revenue contributed $2.5 million to noninterest income for 2012, compared to $2.0 million for 2011, with the increase in revenue resulting from higher production and sales of residential mortgage loans to the secondary market.  During 2012, the Company sold $119.4 million of investment securities to recognize $3.0 million in gains inherent in the portfolio and to mitigate the risk of a decline in the fair value of the portfolio should market interest rates fluctuate.  During 2011, sales of investment securities totaled $94.2 million with recorded gains of $2.5 million.  Deposit service charges remained relatively constant at $1.4 million for 2012.  Also contributing to noninterest income for the period were USDA/SBA loan sale and servicing revenue, which contributed $725,000 in 2012 and $629,000 in 2011.  The Company may be unable to generate mortgage services revenue, gains on sales of investment securities, and USDA/SBA loan sale and servicing revenue in 2013, at levels comparable to those earned for this past year.  Such performance will be significantly affected by changes in market interest rates, the regulatory environment, and competition.
 

The following table is a comparative analysis of the components of noninterest income for 2012 and 2011.
 
Noninterest Income
            
(in thousands)
            
   
For the Year
  
   
2012
    
2011
  
Service charges on deposit accounts
   $ 1,419     $ 1,484  
Mortgage services revenue
     2,538       1,980  
Other service charges and fees
     574       614  
Increase in cash surrender value of life insurance
     374       435  
Gain on sale of investment securities, net
     2,965       2,458  
USDA/SBA loan sale and servicing revenue
     725       629  
Other income
     1,487       1,062  
Total
   $ 10,082     $ 8,662  
 
Noninterest Expense

Noninterest expense includes all of the operating costs of the Company, excluding interest, provision, and tax expense.  Noninterest expense totaled $23.5 million in 2012, down $914,000, or 3.7%, from $24.5 million in 2011.  Salaries and benefit expense for 2012 increased $834,000 over the 2011 period, principally due to higher commission expense related to the Company’s increased residential mortgage loan originations and sales, combined with a nonrecurring reduction in retirement benefits expense during 2011.  Loan related expense decreased $1.3 million from 2011, primarily due to the Company’s purchase of another member’s interest in an investment in real estate for $850,000, which is included in 2011 loan related expense.  Problem asset management costs, including holding costs of and losses on the sale of other real estate owned and repossessed assets, totaled $4.0 million, compared to $4.5 million in 2011.  The increase in deposit insurance premiums of $286,000 is attributable to a higher year-over-year assessment rate based on the Bank’s capital and asset quality measurements, along with increased customer deposits.  The Bank’s financial condition also led to the $189,000 year-over-year increase in corporate insurance expense.

The following table presents a comparison of the components of noninterest expense for 2012 and 2011.

Noninterest Expense
            
(in thousands)
            
   
For the Year
  
   
2012
    
2011
  
Salaries and employee benefits
   $ 9,958     $ 9,124  
Occupancy
     1,370       1,280  
Equipment
     898       934  
Advertising
     235       242  
Data processing and telecommunications
     1,910       2,112  
Deposit insurance premiums
     2,477       2,191  
Professional fees
     404       383  
Printing and supplies
     113       151  
Foreclosed assets
     4,002       4,499  
Dues and subscriptions
     148       180  
Postage
     193       187  
Loan legal
     368       434  
Loan appraisal
     114       334  
Other loan and real estate related expense
     189       1,179  
Corporate insurance
     387       198  
Other
     775       1,027  
Total
   $ 23,541     $ 24,455  
 
 
Income Taxes

The Company recorded no income tax expense during 2012, as it maintains a full valuation allowance against its deferred tax asset.  During 2011, the Company recorded income tax expense of $9.4 million based on a pre-tax loss of $11.1 million.  Included in the income tax expense for 2011 was a provision of $12.9 million to increase the valuation allowance.  See further discussion in Note 13 to the Company’s consolidated financial statements.

Liquidity
 
A function of the Bank’s Asset/Liability Management Committee is evaluating the current liquidity of the Bank and identifying and planning for future liquidity needs.  Such needs primarily consist of ensuring sufficient liquidity to meet current or expected needs for deposit withdrawals and the funding of investing activities, principally the making of loans and purchasing of securities.  Liquidity is provided by cash flows from maturing investments, loan payments and maturities, federal funds sold, and unpledged investment securities.  On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates of deposit and borrowings from the Federal Home Loan Bank (FHLB), as well as the ability to generate funds through the issuance of long-term debt and equity.  The Bank’s “on balance sheet” liquidity ratio was 37.3% at December 31, 2012.  Management considers this ratio to be more than adequate to meet known or anticipated liquidity needs.  The Company, however, has limited sources of revenue, and the Written Agreement and Consent Order do not permit the payment of dividends by the Bank to the Company.  Without this primary source of revenue from the Bank, the Company expects to continue to defer the payment of dividends on its preferred stock.

Total deposits were $683.9 million at December 31, 2012, up from $672.6 million at December 31, 2011.  Deposit growth and retention within the Company’s retail branch bank network was sufficient to meet the Company’s funding requirements during 2011 and 2012.  In prior years, the Company used brokered deposits as a supplemental liquidity source.  The Consent Order prohibits the Bank from soliciting and accepting additional brokered certificates of deposit (including the renewal of existing brokered certificates of deposit) without prior approval from the FDIC and limits the rates the Bank can offer on its deposit products.  At December 31, 2012, brokered deposits totaled $937,000, compared to $2.6 million at December 31, 2011.  It is expected sufficient funds will be available from cash on hand, investment security repayments, and loan repayments to fund maturities of certificates of deposit.  At December 31, 2012, time deposits represented 43.3% of the Bank’s total deposits, compared to 50.5% at December 31, 2011.  Certificates of deposit of $100,000 or more represented 22.2% of the Bank’s total deposits at December 31, 2012, down from 25.2% at year-end 2011.  Management believes a sizeable portion of the Bank’s certificates of deposit are relationship-oriented, and based upon prior experience, anticipates a substantial portion of outstanding certificates of deposit will renew upon maturity, or be retained in other deposit products at the Bank.  Deposit retention is also influenced by limits on the rates the Bank can offer.

Borrowings from the FHLB of $4.0 million at December 31, 2011 were repaid in early 2012.  The remaining borrowing at December 31, 2012, was securities sold under agreements to repurchase, which totaled $436,000, down from $605,000 at December 31, 2011.  Additional collateral could be provided to increase the borrowing line at the FHLB if additional liquidity is needed.  Secured borrowings lines with two financial institutions totaling $12.0 million are also available to meet liquidity needs.

Capital Resources

At December 31, 2012 and 2011, the Company’s equity totaled $19.7 million and $18.5 million, respectively.  The $1.2 million increase in equity is primarily attributable to the Company’s 2012 net income.  The Company’s equity-to-assets ratio on those dates was 2.8% and 2.6%, respectively.  The Company is subject to minimum capital requirements, which are further discussed in “PART 1, Item 1 – Business — Supervision and Regulation.”

All capital ratios categorize the Company as “significantly undercapitalized” by regulatory measures at December 31, 2012.  The Company’s regulatory capital ratios as of that date consisted of a leverage ratio of 2.64%, a Tier I risk-based capital ratio of 4.85%, and a total risk-based capital ratio of 6.11%.  At December 31, 2011, these ratios were 2.48%, 4.14%, and 5.41%, respectively.  Pursuant to the Consent Order and Written Agreement, the Company and the Bank are required to develop and adopt a plan for achieving and maintaining capital ratios in excess of the minimum thresholds for the Bank to be well-capitalized, specifically Tier 1 capital of at least 8% of total assets and a total risk-based capital ratio of at least 12%.  Given the current state of the equity markets, our ability to raise capital in the foreseeable future and remain an independent institution is unknown.

Note 17 to the accompanying consolidated financial statements presents an analysis of the Company’s and Bank’s regulatory capital position as of December 31, 2012 and 2011.
 

Asset/Liability Management

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign exchange rates, commodity prices, and other relevant market rates and prices such as equity prices.  Due to the nature of our operations, we are primarily exposed to interest rate risk and liquidity risk.
 
Interest rate risk within our consolidated balance sheets consists of reprice, option, and basis risks.  Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios.  Option risk arises from “embedded options” present in many financial instruments, such as loan prepayment options, deposit early withdrawal options, and interest rate options.  These options allow customers opportunities to benefit when market interest rates change, which typically results in higher expense or lower income for us.  Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of the profit spread on an interest-earning asset or interest-bearing liability.  Basis risk is also present in administered rate liabilities, such as savings accounts, negotiable order of withdrawal accounts, and money market accounts with respect to which historical pricing relationships to market rates may change due to the level or directional change in market interest rates.
 
We seek to avoid fluctuations in our net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates.  Accordingly, our Asset/Liability Committee (ALCO) and the Board of Directors monitor our interest rate sensitivity and liquidity on an ongoing basis.  The Board of Directors and ALCO oversee market risk management and establish risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its impact on net interest income and capital.  ALCO uses a variety of measures to gain a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships.

Management has chosen to restrict the level of credit risk in the Company’s investment portfolio and as such it is comprised primarily of debt and mortgage-backed securities issued by agencies of the United States and government-sponsored enterprises.  Management expects to continue this practice for the foreseeable future.  Furthermore, management has historically chosen to maintain a relatively short duration with respect to the investment portfolio as a whole.  Because of the Federal Reserve’s stance of maintaining interest rates at the current low levels through mid-2015, during 2012, the Bank purchased mainly callable U.S. government agency securities, with longer stated maturities, but which are expected to be called in the current rate environment.  While this strategy has resulted in an improvement in portfolio yield, it has generally increased the market price volatility and consequently, potential mark-to-market charges against the Company’s capital.
 
We use a simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates.  The model measures the impact on net interest income relative to a base-case scenario of hypothetical fluctuations in interest rates over the upcoming 12 and 24-month periods.  These simulations incorporate assumptions regarding balance sheet growth and mix, pricing, and the repricing and maturity characteristics of the existing and projected consolidated balance sheets.  Other interest rate related risks, such as prepayment, basis, and option risk, are also considered in the model.
 
ALCO continuously monitors and manages the volume of interest-sensitive assets and interest-sensitive liabilities.  Interest-sensitive assets and liabilities are those that reprice or mature within a given timeframe.  The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels.  In order to meet this objective and mitigate potential market risk, management develops and implements investment, lending, funding, and pricing strategies.

As of December 31, 2012, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 200, 300 and 400 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates as of December 31, 2012.  Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant.  However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements.  Therefore, management’s assumptions may or may not prove valid.  No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions.  Although measured, we believe the downward movements included below are neither realistic nor anticipated in the current historically low interest rate environment and the monetary policy stance the Federal Reserve has taken regarding maintaining interest rates at the current low levels through mid-2015.
 

                         
   
Percentage Change in Net Interest Income from Base
  
   
Immediate Shock
    
Gradual Ramp
  
Interest Rate Scenario (1)
  
12 Months
    
24 Months
    
12 Months
    
24 Months
  
                         
Up 400 basis points
     18.1 %     13.7 %     10.8 %     17.5 %
Up 300 basis points
     16.0 %     13.8 %     9.0 %     15.2 %
Up 200 basis points
     12.8 %     12.6 %     8.3 %     13.5 %
Base
     -       -       -       -  
Down 200 basis points
     -22.4 %     -31.4 %     -9.4 %     -21.2 %
Down 300 basis points
     -32.4 %     -45.1 %     -10.8 %     -27.3 %
Down 400 basis points
     -32.5 %     -45.3 %     -14.1 %     -33.5 %
 
 (1)
The rising and falling interest rate scenarios in the first two columns assume an immediate and parallel change in interest rates along the entire yield curve.  The gradual ramp scenarios presented in the third and fourth columns assume a gradual rise or fall in interest rates during the periods indicated.

There are material limitations with the model presented above, which include, but are not limited to:
 
 
●
  
It presents the balance sheet in a static position.  When assets and liabilities mature or reprice, they do not necessarily keep the same characteristics.
 
 
●
  
The computation of prospective impacts of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results.
 
 
●
  
The computations do not contemplate any additional actions we could undertake in response to changes in interest rates.

Lending Activities

General

The Company provides a full range of short to medium-term commercial, mortgage, construction and personal loans, both secured and unsecured through conventional products and government guaranteed lending programs.  The Company’s loan policies and procedures establish the basic guidelines governing its lending operations.  Generally, the guidelines address the types of loans the Company seeks, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations.  All loans or credit lines are subject to approval procedures and amount limitations.  These limitations apply to the borrower’s total outstanding indebtedness to the Company, including the indebtedness of any guarantor.  The policies are reviewed and approved at least annually by the Board of Directors of the Company.  The Company supplements its own supervision of the loan underwriting and approval process with periodic loan audits by internal loan examiners, as well as by third-party professionals experienced in loan review work.  The Company has focused its portfolio lending activities on typically higher yielding commercial, construction, and consumer loans.  The Company also originates one-to-four family mortgages that are typically sold into the secondary market.
 
 
The following tables provide additional information regarding the Company’s loan portfolio as of December 31 of each year indicated.  The “Loan Summary” table provides an analysis of the composition of the loan portfolio by type of loan.  The “Loan Maturity Schedule” presents (i) the aggregate contractual maturities of commercial, industrial and commercial mortgage loans and of real estate constructions loans and (ii) the aggregate amounts of such loans by variable and fixed rates as of December 31, 2012.
 
Portfolio Loan Summary (1)
                                                            
(dollars in thousands)
                                                            
   
December 31
  
   
2012
          
2011
          
2010
          
2009
          
2008
        
         
% of
          
% of
          
% of
          
% of
          
% of
  
         
Total
          
Total
          
Total
          
Total
          
Total
  
   
Amount
    
Loans
    
Amount
    
Loans
    
Amount
    
Loans
    
Amount
    
Loans
    
Amount
    
Loans
  
Construction & land development
   $ 68,954       17.8 %   $ 87,080       20.8 %   $ 114,532       23.6 %   $ 150,163       27.2 %   $ 165,017       28.5 %
1-4 family residential
     126,468       32.6 %     117,025       27.9 %     120,217       24.7 %     118,321       21.4 %     116,365       20.1 %
Multifamily
     6,292       1.6 %     5,818       1.4 %     6,417       1.3 %     7,410       1.3 %     9,018       1.6 %
Farmland
     -       - %     -       - %     965       0.2 %     -       - %     -       - %
Nonfarm, nonresidential
     147,894       38.2 %     159,120       38.0 %     173,326       35.7 %     194,337       35.1 %     193,010       33.4 %
Total real estate
     349,608       90.2 %     369,043       88.1 %     415,457       85.5 %     470,231       85.0 %     483,410       83.6 %
Commercial & industrial
     35,182       9.1 %     46,873       11.2 %     66,254       13.6 %     76,992       13.9 %     88,471       15.3 %
Consumer
     2,867       0.7 %     2,986       0.7 %     4,484       0.9 %     5,790       1.1 %     6,505       1.1 %
Total
   $ 387,657       100.0 %   $ 418,902       100.0 %   $ 486,195       100.0 %   $ 553,013       100.0 %   $ 578,386       100.0 %
                                                                                 
(1) Excluding loans held for sale
                                                                          
 
To assist with liquidity management and to comply with the Bank’s legal lending limit, we sell the guaranteed portion of certain of our SBA loans in the secondary market, yet we retain the rights to service these loans.  At the time the loan is sold, we recognize a loan servicing asset and thereafter, we recognize monthly service fee income, net of servicing asset amortization.  During 2012 and 2011, the guaranteed portion of SBA loans sold totaled $5.9 million and $7.6 million, respectively.  Gains of $697,000 and $565,000 were recognized on these sales during 2012 and 2011, respectively.  Loans serviced for others totaled $22.8 million and $18.7 million at December 31, 2012 and 2011, respectively, and the associated loan servicing asset was $280,000 and $272,000 at December 31, 2012 and 2011, respectively.  Servicing income, net of amortization, totaled $28,000 and $64,000 during 2012 and 2011, respectively.

Loan Maturity Schedule
                        
(in thousands)
                        
   
December 31, 2012
  
         
Due After One
              
   
Due Within
    
Year But Within
    
Due After
        
   
One Year
    
Five Years
    
Five Years
    
Total
  
By loan type
                        
Construction and development
   $ 25,287     $ 34,073     $ 9,594     $ 68,954  
1-4 family residential
     16,089       21,577       88,802       126,468  
Multifamily
     312       3,280       2,700       6,292  
Nonfarm, non residential
     31,443       75,672       40,779       147,894  
Total real estate
     73,131       134,602       141,875       349,608  
Commercial and industrial
     6,755       21,320       7,107       35,182  
Consumer
     1,380       1,399       88       2,867  
Total loans
   $ 81,266     $ 157,321     $ 149,070     $ 387,657  
                                 
By interest rate type
                                
Fixed rate loans
   $ 35,437     $ 50,898     $ 64,108     $ 150,443  
Variable rate loans
     45,829       106,423       84,962       237,214  
Total loans
   $ 81,266     $ 157,321     $ 149,070     $ 387,657  

Commercial and Industrial Loans

Commercial business lending is one component of the Company’s lending activities.  At December 31, 2012, the Company’s commercial and industrial loan portfolio equaled $35.2 million, or 9.1% of total loans, as compared with $46.9 million, or 11.2% of total loans at year-end 2011.  Commercial and industrial loans include both secured and unsecured loans for working capital, expansion, and other business purposes.  Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment.  The Company also makes term commercial loans secured by equipment and real estate.  Lending decisions are based on an evaluation of the financial strength, management, and credit history of the borrower, and the quality of the collateral securing the loan.  With few exceptions, the Company requires personal guarantees and secondary sources of repayment for commercial and industrial loans.
 

Although the outstanding commercial and industrial loans balance is down between year ends, the Company is focused on originating commercial and industrial loans in an effort to diversify credit risk and decrease our concentration of loans secured primarily by real estate.
 
Commercial and industrial loans generally provide greater yields and reprice more frequently than other types of loans, such as real estate loans, as most commercial loan yields are tied to the prime rate index.  Therefore, yields on most commercial loans adjust with changes in the prime rate.

General Economic Lending and Real Estate Conditions
 
Since 2008, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively affected the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions, including the Company.  In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline.  General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write-downs.  Concerns over the stability of the financial markets and the economy caused a decrease in lending by financial institutions to their customers and to each other.  This market turmoil and tightening of credit has led to increased commercial and consumer loan delinquencies, lack of consumer confidence, increased market volatility and widespread reduction in general business activity.  The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations, and stock price for the foreseeable future.
 
Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions.  As a result of these factors, bank regulatory agencies have been, and are expected to continue to be very aggressive in responding to concerns and trends identified in examinations.  This increased government action has, and is expected to continue to increase our costs and limit our ability to pursue certain business opportunities.

Commitments to Extend Credit

In  the ordinary course of business, the Company enters into various types of transactions that include commitments to extend credit that are not included in loans presented on the Company’s balance sheets.  The Company applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations.  The Company’s exposure to credit loss under commitments to extend credit is represented by the amount of these commitments.  Other than these commitments to extend credit, the Company does not have any other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenue or expense, results of operation, liquidity, capital expenditures, or capital resources that is material to investors.  See Note 16 to the Company’s consolidated financial statements and the table above for “Financial Instruments with Off-Balance-Sheet-Risk.”
 
Asset Quality

Over the course of the past several years, credit quality has deteriorated as real estate markets have been hit with slowing sales and declining prices.  The market in which the Company operates has also been affected by such downturns, albeit more recently real estate values in our market appear to have stabilized, for the most part.  The longer the current real estate market downturn persists, or real estate values fail to materially improve, the more vulnerable sales volume and prices become.

Although management believes the Company appropriately reserved for our problem assets at year-end 2012, we nonetheless continue to experience the effects of asset devaluation in our markets as the economy and businesses struggle to recover, albeit at a significantly reduced frequency and severity than we experienced in recent years.  We have allocated significant resources toward expeditious resolution of our nonperforming loans and those assets we have foreclosed upon.  We anticipate there may be some additional provisioning and charge-offs during 2013 to stay ahead of this resolution process.  At December 31, 2012, nonperforming assets were $38.4 million, down $16.3 million, or 29.8%, from $54.7 million at December 31, 2011, principally as a result of the movement of troubled assets through the disposition process.  As a percentage of period-end portfolio loans and foreclosed assets, nonperforming assets were 9.66% at December 31, 2012, versus 12.43% at year-end 2011.  The allowance for loan losses as a percentage of period-end portfolio loans increased to 2.76% at December 31, 2012, from 2.54% at December 31, 2011.  As of December 31, 2012, loans 30-89 days past due were $1.7 million, or 0.44% of portfolio loans, compared to $6.2 million, or 1.49% of portfolio loans at December 31, 2011.  There can be no assurance past due loans will remain at the current level in 2013.

The provision for loan losses was $5.3 million for 2012, compared to $15.8 million for 2011, while net charge-offs were $5.2 million in 2012, compared to net charge-offs of $21.4 million in the 2011 period.  The charge-offs in each period resulted principally from recognition of losses previously reserved for as these loans were worked through the Bank’s asset resolution process.  In addition, as part of this resolution process, management provides for additional losses through increases to its allowance for loan losses.
 

Nonperforming Assets

Potential problem loans are defined as loans currently performing that are not included in nonaccrual or loans management has concerns as to the borrower’s ability to comply with present repayment terms.  These loans could deteriorate to nonaccrual or past due status.  Therefore, management quantifies the risk associated with problem loans in assessing the adequacy of the allowance for loan losses.  The following table provides additional information about the Bank’s nonperforming assets.

Nonperforming Assets
                              
(dollars in thousands)
                              
   
December 31
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
Nonaccrual loans
   $ 28,565     $ 33,720     $ 37,799     $ 32,792     $ 10,008  
Loan past due 90 or more days and still accruing interest
     -       -       5       -       -  
  Total nonperforming loans
     28,565       33,720       37,804       32,792       10,008  
Foreclosed real estate
     9,821       19,333       7,314       1,665       645  
Repossessed assets
     -       1,617       7       -       1,423  
  Total nonperforming assets
   $ 38,386     $ 54,670     $ 45,125     $ 34,457     $ 12,076  
                                         
                                         
Allowance for loan losses
   $ 10,690     $ 10,650     $ 16,191     $ 28,231     $ 9,013  
                                         
Nonperforming loans to period end loans,
                                        
   excluding loans held for sale
     7.37 %     8.05 %     7.78 %     5.93 %     1.73 %
                                         
Allowance for loan losses to period end loans,
                                        
   excluding loans held for sale
     2.76 %     2.54 %     3.33 %     5.10 %     1.56 %
                                         
Nonperforming assets as a percentage of:
                                        
   Loans and foreclosed assets
     9.66 %     12.43 %     9.14 %     6.21 %     2.09 %
   Total assets
     5.40 %     7.81 %     6.23 %     4.35 %     1.71 %
                                         
Ratio of allowance for loan losses to nonperforming loans
     37.4 %     31.6 %     42.8 %     86.1 %     90.1 %
 
Included in foreclosed real estate at December 31, 2011, was a $6.4 million asset, which was disposed of during 2012.  Further discussion is contained in Note 8 to the accompanying consolidated financial statements.

Troubled Debt Restructurings (TDRs)

On a case-by-case basis, management determines whether an account that experiences financial difficulties should be modified as to its interest rate or repayment terms to maximize the Company’s collection of its balance.  Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the contract is modified are excluded from restructured loans once repayment performance, in accordance with the modified agreements, has been demonstrated over several payment cycles.  Loans that have interest rates reduced below comparable market rates remain classified as restructured loans; however, interest income is accrued at the reduced rate as long as the customer complies with the revised terms and conditions.  Restructured loans totaled $21.8 million at December 31, 2012, compared to $40.2 million at December 31, 2011, of which $4.8 million and $15.8 million were accruing interest at the respective period ends.  Restructured loans not accruing interest are included in nonaccrual loans in the above table.  The decrease in restructured loans resulted from decreased demand for modifications or renewals of loans in 2012, versus 2011, a year in which many borrowers experienced financial challenges, combined with $11.5 million of loans restructured prior to 2012, which were removed from this classification after having demonstrated satisfactory repayment performance.

Analysis of Allowance for Loan Losses

The level of the allowance for loan losses is established based upon management’s evaluation of portfolio composition, current and projected national and local economic conditions, and results of independent reviews of the loan portfolio by internal and external examination.  Management recognizes the inherent risk associated with commercial and consumer lending, including whether or not a borrower’s actual results of operations will correspond to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and fluctuations in interest rates; possible further depression of collateral values; and completion of projects within the original cost and time estimates.  As a result, management continues to actively monitor the Company’s asset quality and lending policies.

Management is currently making efforts to alter the composition of its loan portfolio, so a further downturn in a particular market or industry will not have a material impact on the loan portfolio as a whole or the Company’s financial condition.  Given the current condition of the real estate markets in the Company’s footprint, real estate loans have been significantly curtailed.  The Company continues to focus its lending effort toward providing credit to small businesses and consumers who are creditworthy.
 

Since late 2009, management has taken what it believes to be an aggressive stance on identifying problems with credits and placing them on nonaccrual status relatively early in its evaluation process.  Management evaluates these credits and their ultimate collectability using both internal and external portfolio loan reviews, so that any potential losses which may be incurred on these credits in the future are incorporated into its analysis of the adequacy of the Bank’s existing allowance for loan losses.  Notwithstanding the Company’s conservative approach, over the past few years, the continuing effects of the economic recession, high unemployment, and a soft real estate market have caused the Company to periodically increase its provision for loan losses.

We calculate our general allowance by applying our historical loss factors to each sector of the loan portfolio.  We use a rolling 16-quarter look-back period when computing historical annualized loss rates.  We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors.  Qualitative factors we considered in the determination of the December 31, 2012, allowance for loan losses included pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development).  Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, and other external factors.  The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments.  However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off.  In addition to our portfolio review process, various regulatory agencies periodically review our allowance for loan losses.  These agencies may require us to recognize additions to the allowance for loan losses based on their judgments and information available to them at the time of their examinations.  While we use available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes and other factors on our borrowers.
 
We believe the allowance for loan losses at December 31, 2012, is appropriate and adequate to cover probable inherent losses in the loan portfolio.  However, underlying assumptions may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which was not known to us at the time of the issuance of our consolidated financial statements.  Therefore, our assumptions may or may not prove valid.  Thus, there can be no assurance loan losses in future periods will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required.  Furthermore, while management believes it has established the allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing our portfolio, will not require adjustment to the allowance for loan losses.  Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting our business, financial condition, results of operations, and cash flows.
 

The following table presents the allocation of the allowance for loan losses at the end of each of the last five years.  The allocation is based on an evaluation of defined loan problems, historical ratios of loan losses, and other factors that may affect future loan losses in the categories of loans shown.

Allocation of the Allowance for Loan Losses
                                            
(dollars in thousands)
                                                            
   
December 31
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
         
Percent
          
Percent
          
Percent
          
Percent
          
Percent
  
         
of Total
          
of Total
          
of Total
          
of Total
          
of Total
  
   
Amount
    
Loans (1)
    
Amount
    
Loans (1)
    
Amount
    
Loans (1)
    
Amount
    
Loans (1)
    
Amount
    
Loans (1)
  
Construction & land development
   $ 5,503       17.8 %   $ 6,463       20.8 %   $ 8,499       23.6 %   $ 15,454       27.2 %   $ 3,481       28.5 %
1-4 family residential
     2,142       32.6       1,553       27.9       4,371       24.7       5,010       21.4       1,942       20.1  
Multifamily
     45       1.6       52       1.4       35       1.3       27       1.3       51       1.6  
Farmland
     -       -       -       -       12       0.2       -       -       -       -  
Nonfarm, nonresidential
     1,976       38.2       1,277       38.0       1,798       35.7       3,232       35.1       1,729       33.4  
Total real estate loans
     9,666       90.2       9,345       88.1       14,715       85.5       23,723       85.0       7,203       83.6  
Commercial & industrial
     817       9.1       1,182       11.2       1,412       13.6       3,964       13.9       1,550       15.3  
Consumer
     107       0.7       92       0.7       64       0.9       183       1.1       65       1.1  
Unallocated
     100       -       31       -       -       -       361       -       195       -  
Total
   $ 10,690       100.0 %   $ 10,650       100.0 %   $ 16,191       100.0 %   $ 28,231       100.0 %   $ 9,013       100.0 %

The following table summarizes information regarding changes in the Company’s allowance for loan losses for the following years ended December 31.
 
Loan Loss and Recovery
                              
(dollars in thousands)
                              
   
For the Year
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
Balance at beginning of year
   $ 10,650     $ 16,191     $ 28,231     $ 9,013     $ 7,571  
Provision for loan losses
     5,276       15,815       12,462       29,940       6,520  
Charge-offs
                                        
  Construction & land development
     2,272       9,537       16,008       5,746       1,556  
  1-4 family residential
     2,059       4,918       3,043       2,643       623  
  Multifamily
     -       -       184       -       -  
  Nonfarm, non residential
     830       2,035       812       543       -  
    Total real estate
     5,161       16,490       20,047       8,932       2,179  
  Commercial & industrial
     597       5,098       4,706       1,953       2,875  
  Consumer
     69       48       475       102       53  
         Total charge-offs
     5,827       21,636       25,228       10,987       5,107  
Recoveries
                                        
  Construction & land development
     216       92       411       108       6  
  1-4 family residential
     95       12       34       126       -  
  Nonfarm, non residential
     26       8       4       -       -  
    Total real estate
     337       112       449       234       6  
  Commercial & industrial
     246       154       249       27       6  
  Consumer
     8       14       28       4       17  
         Total recoveries
     591       280       726       265       29  
             Net charge-offs
     5,236       21,356       24,502       10,722       5,078  
Balance at end of year
   $ 10,690     $ 10,650     $ 16,191     $ 28,231     $ 9,013  
                                         
Average loans, excluding loans held for sale
   $ 396,246     $ 458,578     $ 520,662     $ 575,671     $ 566,412  
Period end loans, excluding loans held for sale
   $ 387,657     $ 418,902     $ 486,195     $ 553,013     $ 578,386  
Net charge-offs to average loans,
                                        
    excluding loans held for sale
     1.32 %     4.66 %     4.71 %     1.86 %     0.90 %
Allowance for loan losses to period end loans,
                                        
    excluding loans held for sale
     2.76 %     2.54 %     3.33 %     5.10 %     1.56 %

 
Investment Activities

The Bank’s portfolio of investment securities consists primarily of debt instruments of U.S. government agencies or of government-sponsored enterprises, and mortgage-backed securities.  Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as available for sale (AFS) and carried at fair value, with any unrealized gains or losses reflected as an adjustment to stockholders’ equity.  Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates and/or significant prepayment risks.  Securities for which the Bank has the ability and intent to hold the securities to maturity are classified as held to maturity securities (HTM).  HTM securities are carried at amortized cost.  It is the Bank’s policy to classify most investment securities as AFS.  The following table summarizes investment securities by type.
 
Available-for-Sale Securities Composition
                  
(in thousands)
                  
   
December 31
  
   
2012
    
2011
    
2010
  
U.S. government agencies
   $ 39,069     $ 18,215     $ 5,323  
Government-sponsored enterprises
     167,913       86,735       44,039  
Mortgage-backed securities
     46,847       90,535       81,052  
Total
   $ 253,829     $ 195,485     $ 130,414  
                         
Held-to-Maturity Securities Composition
                        
(in thousands)
                        
   
December 31
  
      2012       2011       2010  
States and political subdivisions
   $ -     $ 2,917     $ 2,765  
Other debt securities
     1,250       1,250       -  
Total
   $ 1,250     $ 4,167     $ 2,765  

 
The following table summarizes the amortized cost, fair value, and weighted-average yield of securities by contractual maturity groups.
 
Available-for-Sale Investment Securities
                  
(dollars in thousands)
                  
   
December 31, 2012
  
   
Amortized
    
Fair
        
   
Cost
    
Value
    
Yield (1)
  
U. S. Government agencies
                  
Due within one year
   $ 76     $ 76       0.64 %
Due after one but within five years
     -       -       -  
Due after five but within ten years
     3,149       3,139       2.05  
Due after ten years
     35,511       35,854       2.20  
      38,736       39,069       2.20  
                         
Government-sponsored enterprises
                        
Due within one year
     -       -       -  
Due after one but within five years
     -       -       -  
Due after five but within ten years
     59,390       59,721       2.28  
Due after ten years
     107,928       108,192       2.37  
      167,318       167,913       2.34  
                         
Mortgage-backed securities
                        
Due within one year
     -       -       -  
Due after one but within five years
     -       -       -  
Due after five but within ten years
     -       -       -  
Due after ten years
     46,738       46,847       1.77  
      46,738       46,847       1.77  
                         
Total
                        
Due within one year
     76       76       0.64  
Due after one but within five years
     -       -       -  
Due after five but within ten years
     62,539       62,860       2.26  
Due after ten years
     190,177       190,893       2.20  
    $ 252,792     $ 253,829       2.21 %
(1) Yields are calculated based on amortized cost
                        
 
Held to Maturity Securities
                  
(dollars in thousands)
                  
   
December 31, 2012
  
   
Amortized
    
Fair
        
   
Cost
    
Value
    
Yield (1)
  
Other debt securities
                  
Due within one year
   $ -     $ -       - %
Due after one but within five years
     -       -       -  
Due after five but within ten years
     1,250       1,250       4.04  
Due after ten years
     -       -       -  
    $ 1,250     $ 1,250       4.04 %
                         
Total
                        
Due within one year
   $ -     $ -       - %
Due after one but within five years
     -       -       -  
Due after five but within ten years
     1,250       1,250       4.04  
Due after ten years
     -       -       -  
    $ 1,250     $ 1,250       4.04 %
(1) Yields are calculated based on amortized cost
                        
 
The Company does not engage in, nor does it presently intend to engage in, securities trading activities and therefore does not maintain a trading account.  At December 31, 2012, there were no securities of any issuer (other than governmental agencies or government-sponsored enterprises) that exceeded 10% of the Company’s stockholders’ equity.
 

Sources of Funds

Deposit Activities

The Bank provides a range of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts, IRAs, and certificates of deposit.  These accounts generally earn interest at rates established by management based on asset/liability planning, earnings budgets, competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits.  Management believes one of the primary keys to the long-term success of the Company is the acquisition of demand deposit accounts and other transaction accounts.  Accordingly, we strive to establish relationships with customers, which will facilitate and attract core deposits.  While certificates of deposit are certainly a significant component in the funding of the Company, management endeavors to use these instruments as an entrée into a full relationship with each customer resulting in a complete banking relationship inclusive of the customer’s transaction accounts.

The following table summarizes the average balances outstanding and average interest rates for each major category of deposits for the following years.
 
Deposits
                                                      
(dollars in thousands)
                                                      
   
For the Year
  
   
2012
    
2011
    
2010
  
   
Average
    
% to Total
  
Average
    
Average
    
% to Total
  
Average
    
Average
    
% to Total
  
Average
  
   
Balance
    
Deposits
  
Rate
    
Balance
    
Deposits
  
Rate
    
Balance
    
Deposits
  
Rate
  
Interest-bearing deposits
                                                  
NOW accounts
   $ 66,596       9.7 %     0.20 %   $ 64,312       9.6 %     0.29 %   $ 62,062       9.0 %     0.33 %
Money market
     58,216       8.4       0.75       51,299       7.6       1.02       47,085       6.9       1.24  
Savings
     157,958       23.0       0.79       123,899       18.4       1.03       101,829       14.8       1.10  
Time deposits under $100
     158,160       23.0       1.16       183,499       27.3       1.56       209,463       30.4       1.93  
Time deposits of $100 or greater
     164,150       23.9       1.25       177,259       26.3       1.49       201,342       29.3       1.95  
Total interest-bearing deposits
     605,080       88.0       0.94       600,268       89.2       1.25       621,781       90.4       1.59  
Noninterest-bearing deposits
     82,589       12.0       -       72,792       10.8       -       66,027       9.6       -  
Total
   $ 687,669       100.0 %     0.83 %   $ 673,060       100.0 %     1.11 %   $ 687,808       100.0 %     1.43 %
 
The following table presents information regarding maturities of certificates of deposit with balances of $100,000 or more at December 31, 2012.

Maturities of Time Deposits of $100,000 or More
        
(dollars in thousands)
            
   
December 31, 2012
  
         
Weighted
  
         
Average
  
   
Amount
    
Rate
  
Maturing in:
            
Three months or less
   $ 35,347       1.04 %
Over three months to six months
     27,232       0.88 %
Over six months to twelve months
     51,625       0.99 %
Over twelve months
     37,406       1.55 %
Total
   $ 151,610       1.12 %
 
Recent Accounting Pronouncements

See Note 1 to the Company’s consolidated financial statements for a full description of recent accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition.

Inflation and Other Issues

Because our assets and liabilities are primarily monetary in nature, the effect of inflation on our assets is less significant compared to most commercial and industrial companies.  However, inflation does have an impact on the growth of total assets in the banking industry and the resulting need to increase capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio.  Inflation also has a significant effect on other expenses, which tend to rise during periods of general inflation.  Notwithstanding these effects of inflation, management believes our financial results are influenced more by our ability to react to changes in interest rates and general economic conditions impacting the creditworthiness of customers than directly by inflation.
 
Except as discussed above, management is not aware of trends, events, or uncertainties that will have or that are reasonably likely to have a material adverse effect on the Company’s liquidity, capital resources, or operations.
 
 
 
Critical Accounting Policies and Estimates

General.  The Company’s accounting and financial reporting policies are in conformity, in all material respects, to accounting principles generally accepted in the U.S. and to general practices within the financial services industry.  The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of income and expense during the reporting period.

While we base estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates.  Management, in conjunction with the Company’s independent registered public accounting firm, has discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of our Board of Directors.
 
We consider accounting policies and estimates to be critical to our financial condition, results of operations, or cash flows if the accounting policy or estimate requires management to make assumptions about matters that are highly uncertain and for which different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial condition, results of operations, or cash flows.
 
Our significant accounting policies are discussed in Note 1 to our consolidated financial statements.  Of those significant accounting policies, we have determined that accounting for our allowance for loan losses, foreclosed real estate, the realization of our deferred tax asset, and the determination of fair value of financial instruments are deemed critical because of the valuation techniques used and the sensitivity of the amounts recorded in our consolidated financial statements to the methods, assumptions, and estimates underlying these balances.  Accounting for these critical areas requires subjective and complex judgments and could be subject to revision as new information becomes available.
 
Allowance for Loan Losses.  We consider our accounting policies related to the allowance for loan losses to be critical, as these policies involve considerable subjective judgment and estimation by management.  The allowance for loan losses is a reserve established through a provision for loan losses charged to expense.  The allowance for loan losses represents our best estimate of probable inherent losses that have been incurred within the existing portfolio of loans.  The allowance for loan losses is necessary to reserve for estimated probable loan losses inherent in the loan portfolio.  Our allowance for loan losses methodology is based on historical loss experience by loan type, specific homogeneous risk pools, and specific loss allocations.  Our process for determining the appropriate level of the allowance for loan losses is designed to account for asset deterioration as it occurs.  The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, potential problem loans, criticized loans, and loans charged-off or recovered, among other factors.
 
The level of the allowance for loan losses reflects our continuing evaluation of specific lending risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio.  Portions of the allowance for loan losses may be allocated for specific loans.  However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off.  While we use our best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications and collateral valuation.
 
We record allowances for loan losses on specific loans when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan.  Specific allowances for loans considered individually significant and that exhibit probable or observed weaknesses are determined by analyzing, among other things, the borrower’s ability to repay amounts owed, guarantor support, collateral deficiencies, the relative risk rating of the loan, and economic conditions impacting the borrower’s industry.
 
The starting point for the general component of the allowance is the historical loss experience of specific types of loans.  We calculate historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual loan net charge-offs to the total population of loans in the pool.  We use a 16-quarter look-back period when computing historical annualized loss rates.
 
 
We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors.  Qualitative factors we considered in the determination of the December 31, 2012, allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development).  Factors evaluated may include, without limitation, changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, and other external factors. The general reserve portion of the allowance for loan losses calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.
 
Loans identified as losses by management, internal loan review, and/or bank examiners are charged-off.  We review each impaired loan on a loan-by-loan basis to determine whether the impairment should be recorded as a charge-off or a reserve based on our assessment of the status of the borrower and the underlying collateral.  In general, for collateral dependent loans, the impairment is recorded as a charge-off unless the fair value was based on an internal valuation pending receipt of a third party appraisal or other extenuating circumstances.  Consumer loan accounts are charged-off generally based on pre-defined past due time periods.

Foreclosed Real Estate.  The value of our foreclosed real estate portfolio represents another accounting estimate that depends heavily on current economic conditions.  Foreclosed real estate is carried at fair value less estimated selling costs, establishing a new cost basis.  Fair value of such real estate is reviewed regularly and writedowns are recorded when it is determined the carrying value of the real estate exceeds the fair value less estimated selling costs.  Writedowns resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income.  Costs relating to the development and improvement of such properties are capitalized.
 
The fair value of properties in the foreclosed real estate portfolio is generally determined from appraisals obtained from independent appraisers.  We review the appraisal assumptions for reasonableness and may make adjustments when necessary to reflect current market conditions.  Such assumptions may not prove to be valid.  Moreover, no assurance can be given that changing economic conditions and other relevant factors impacting our foreclosed real estate portfolio will not cause actual occurrences to differ from underlying assumptions thus adversely impacting our business, financial condition, results of operations, and cash flows.
 
Realization of Net Deferred Tax Asset.  We use certain assumptions and estimates in determining income taxes payable or refundable, deferred income tax liabilities and assets for events recognized differently in our financial statements and income tax returns, and income tax expense.  Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations.  We exercise considerable judgment in evaluating the amount and timing of recognition of the resulting income tax liabilities and assets.  These judgments and estimates are reevaluated on a periodic basis as regulatory and business factors change.
 
We include the current and deferred tax impact of our tax positions in the consolidated financial statements only when it is more likely than not (likelihood of greater than 50%) that such positions will be sustained by taxing authorities, with full knowledge of relevant information, based on the technical merits of the tax position.  While we support our tax positions by unambiguous tax law, prior experience with taxing authorities, and analysis that considers all relevant facts, circumstances and regulations, we must still rely on assumptions and estimates to determine the overall likelihood of success and proper quantification of a given tax position.
 
Based on our projections of future operating results over the next several years, cumulative tax losses over the previous three years, tax loss deductibility limitations as discussed below and available tax planning strategies, we have a full valuation allowance against the net deferred tax asset at December 31, 2012.
 
Analysis of our ability to realize deferred tax assets requires us to apply significant judgment and is inherently subjective because it requires the future occurrence of circumstances that cannot be predicted with certainty.  While we recorded a full valuation allowance against our net deferred tax asset for financial reporting and regulatory capital purposes at December 31, 2012 and 2011, the net operating losses are able to be carried forward for income tax purposes for up to twenty years.  Thus, to the extent we return to sustained profitability and generate sufficient taxable income in the future, we will be able to use a portion of the net operating losses for income tax purposes and reverse a portion of the valuation allowance for financial reporting purposes.  The determination of how much of the net operating losses we will be able to use and, therefore, how much of the valuation allowance that may be reversed and the timing is based on our future results of operations and the amount and timing of actual loan charge-offs and asset writedowns.
 
Fair Value Measurements.  We use fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures.  Additionally, we may be required to record other assets at fair value on a nonrecurring basis.  These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or writedowns of individual assets.  Further, we include in the notes to the consolidated financial statements information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used, and the related impact to income.  Additionally, for financial instruments not recorded at fair value, we disclose the estimate of their fair value.
 
 
Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date.  Accounting standards establish a three-level hierarchy for disclosure of assets and liabilities recorded at fair value.  The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable.  Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data.  The three levels of inputs that are used to classify fair value measurements are as follows:
 
 
●
  
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.  Level 1 instruments generally include securities traded on active exchange markets, such as the New York Stock Exchange, as well as securities that are traded by dealers or brokers in active over-the-counter markets.  Instruments we classify as Level 1 are instruments that have been priced directly from dealer trading desks and represent actual prices at which such securities have traded within active markets.  Level 1 instruments also include commercial loans held for sale for which binding sales contracts have been entered into as of the balance sheet date.
 
 
●
  
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques, such as matrix pricing, for which all significant assumptions are observable in the market.  Instruments we classify as Level 2 include securities that are valued based on pricing models that use relevant observable information generated by transactions that have occurred in the market place that involve similar securities.  Level 2 instruments also include mortgage loans held for sale that are valued based on prices for other mortgage whole loans with similar characteristics and commercial loans held for sale that are based on independent collateral appraisals.
 
 
●
  
Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market.  These unobservable assumptions reflect the Company’s estimates of assumptions market participants would use in pricing the asset or liability.  Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques.
 
We attempt to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.  When available, we use quoted market prices to measure fair value.  If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently-sourced market parameters.  Most of our financial instruments use either of the foregoing methodologies, collectively Level 1 and Level 2 measurements, to determine fair value adjustments recorded to our financial statements.  However, in certain cases, when market observable inputs for model-based valuation techniques may not be readily available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.
 
The degree of management judgment involved in determining the fair value of an instrument is dependent upon the availability of quoted market prices or observable market parameters.  For instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value.  When observable market prices and parameters are not fully available, management judgment is necessary to estimate fair value.  In addition, changes in the market conditions may reduce the availability of quoted prices or observable data.  For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable.  When significant adjustments are required to available observable inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs.  When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.
 
Significant judgment may be required to determine whether certain assets measured at fair value are included in Level 2 or Level 3.  If fair value measurement is based upon recent observable market activity of such assets or comparable assets (other than forced or distressed transactions) that occur in sufficient volume and do not require significant adjustment using unobservable inputs, those assets are classified as Level 2.  If not, they are classified as Level 3.  Making this assessment requires significant judgment.
 


 CONSOLIDATED FINANCIAL STATEMENTS

For the Years Ended December 31, 2012 and 2011

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 
 
 
To the Board of Directors and Stockholders of
1st Financial Services Corporation
Hendersonville, North Carolina

We have audited the accompanying consolidated balance sheets of 1st Financial Services Corporation and Subsidiary (the "Company") as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity and cash flows for the years then ended.  These consolidated financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of 1st Financial Services Corporation and Subsidiary as of December 31, 2012 and 2011, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Company’s wholly owned subsidiary, Mountain 1st Bank & Trust Company ("the Bank"), is under a regulatory Consent Order with the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks that requires, among other provisions, capital ratios to be maintained at certain heightened levels. In addition, the Company is under a Written Agreement with the Federal Reserve Bank of Richmond that requires, among other provisions, the submission and implementation of a capital plan to improve the Company and the Bank’s capital levels. As of December 31, 2012, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels. These considerations raise substantial doubt about the Company's ability to continue as a going concern. Management’s plans are further discussed in Note 2. These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.
 
 
/s/ Elliott Davis, PLLC  
   
Greenville, South Carolina
March 4, 2013

 
           
Consolidated Balance Sheets
            
December 31, 2012 and 2011
            
   
December 31
  
(dollars in thousands, except share and per share data)
  
2012
    
2011
  
Assets
            
Cash and noninterest-bearing bank deposits
   $ 9,710     $ 15,579  
Due from Federal Reserve Bank
     26,503       16,170  
Interest-bearing deposits with banks
     2,435       5,554  
Total cash and cash equivalents
     38,648       37,303  
Investment securities available for sale
     253,829       195,485  
Investment securities held to maturity (fair value of $1,250
          
    at December 31, 2012 and $4,378 at December 31, 2011)
     1,250       4,167  
Restricted equity securities
     3,052       3,903  
Loans held for sale
     5,805       8,694  
Portfolio loans
     387,657       418,902  
Allowance for loan losses
     (10,690 )     (10,650 )
Net portfolio loans
     376,967       408,252  
Bank-owned life insurance
     13,326       12,952  
Property and equipment, net
     4,410       4,942  
Accrued interest receivable
     2,343       2,721  
Foreclosed real estate
     9,821       19,333  
Other assets
     980       2,273  
Total assets
   $ 710,431     $ 700,025  
                 
Liabilities and Stockholders’ Equity
                
Liabilities
                
Demand deposits
   $ 85,959     $ 76,874  
NOW accounts
     71,685       66,402  
Savings deposits
     169,031       137,062  
Money market accounts
     60,868       52,349  
Time deposits under $100
     144,687       170,633  
Time deposits of $100 and greater
     151,610       169,324  
Total deposits
     683,840       672,644  
Securities sold under agreements to repurchase
     436       605  
Accrued interest payable
     822       1,052  
Other borrowings
     -       3,952  
Other liabilities
     5,651       3,230  
Total liabilities
     690,749       681,483  
                 
Commitments and Contingencies
                
                 
Stockholders’ equity
                
Preferred stock, no par value; 10,000,000 shares authorized;
          
16,369 shares issued and outstanding
     16,192       15,989  
Common stock, $5.00 par value; 35,000,000 shares authorized;
          
5,204,385 and 5,168,546 shares issued and outstanding at              
December 31, 2012 and December 31, 2011, respectively
     26,022       25,843  
Common stock warrant
     1,016       1,016  
Additional paid-in capital
     16,993       17,173  
Retained deficit
     (41,178 )     (42,245 )
Accumulated other comprehensive income
     637       766  
Total stockholders’ equity
     19,682       18,542  
   Total liabilities and stockholders’ equity
   $ 710,431     $ 700,025  
                 
See accompanying notes to consolidated financial statements
          


           
Consolidated Statements of Operations
            
For the Years Ended December 31, 2012 and 2011
            
             
   
For the Year
  
(dollars in thousands, except per share data)
  
2012
    
2011
  
Interest income
            
Loans and fees on loans
   $ 20,332     $ 23,368  
Investment securities
     5,260       4,500  
Due from Federal Reserve Bank
     77       84  
Interest-earning deposits with banks
     41       76  
Total interest income
     25,710       28,028  
Interest expense
                
Deposits
     5,704       7,487  
Federal funds purchased and securities sold under
                
  agreements to repurchase
     1       6  
Other borrowings
     -       18  
Total interest expense
     5,705       7,511  
Net interest income
     20,005       20,517  
Provision for loan loss
     5,276       15,815  
Net interest income after provision for loan losses
     14,729       4,702  
Noninterest income
                
Service charges on deposit accounts
     1,419       1,484  
Mortgage services revenue
     2,538       1,980  
Other service charges and fees
     574       614  
Increase in cash surrender value of life insurance
     374       435  
Gains on sales of investment securities, net
     2,965       2,458  
USDA/SBA loan sale and servicing revenue
     725       629  
Other income
     1,487       1,062  
Total noninterest income
     10,082       8,662  
Noninterest expense
                
Salaries and employee benefits
     9,958       9,124  
Occupancy
     1,370       1,280  
Equipment
     898       934  
Advertising
     235       242  
Data processing and telecommunications
     1,910       2,112  
Deposit insurance premiums
     2,477       2,191  
Professional fees
     404       383  
Printing and supplies
     113       151  
Foreclosed assets
     4,002       4,499  
Dues and subscriptions
     148       180  
Postage
     193       187  
Loan legal
     368       434  
Loan appraisal
     114       334  
Other loan and real estate related expense
     189       1,179  
Corporate insurance
     387       198  
Other
     775       1,027  
Total noninterest expense
     23,541       24,455  
Income (loss) before income taxes
     1,270       (11,091 )
Income tax expense
     -       9,388  
Net income (loss)
     1,270       (20,479 )
Accretion of preferred stock to redemption value
     203       203  
Dividends on preferred stock
     818       818  
Net income (loss) available to common stockholders
   $ 249     $ (21,500 )
                 
Basic net income (loss) per share
   $ 0.05     $ (4.18 )
Diluted net income (loss) per share
   $ 0.05     $ (4.18 )
Basic weighted average shares outstanding
     5,203,152       5,142,174  
Diluted weighted average shares outstanding
     5,203,152       5,142,174  
                 
See accompanying notes to consolidated financial statements
                

 
           
Consolidated Statements of Comprehensive Income (Loss)
            
For the Years Ended December 31, 2012 and 2011
            
             
   
For the Year
  
(dollars in thousands)
  
2012
    
2011
  
Net income (loss)
   $ 1,270     $ (20,479 )
Other comprehensive income (loss), before tax
                
   Investment securities available for sale
                
      Change in net unrealized gains during the period
     (3,304 )     1,985  
      Reclassification adjustment included in net income (loss)
     2,965       2,458  
          Other comprehensive income (loss), before tax
     (339 )     4,443  
Income tax expense (benefit)
                
    related to items of other comprehensive income (loss)
     (210 )     2,752  
          Other comprehensive income (loss), net of tax
     (129 )     1,691  
Comprehensive income (loss)
   $ 1,141     $ (18,788 )
                 
See accompanying notes to consolidated financial statements
                

                                                 
Consolidated Statements of Changes in Stockholders’ Equity
                                      
For the Years Ended December 31, 2012 and 2011
                                            
                                                       
(dollars in thousands, except share data)
                                
Accumulated
        
                                             
Other
        
                                 
Additional
          
Comprehensive
        
   
Common Stock
    
Preferred Stock
    
Paid-in
    
Retained
    
Income
        
   
Shares
    
Amount
    
Warrant
    
Shares
    
Amount
    
Capital
    
Deficit
    
(Loss)
    
Total
  
Balance, December 31, 2010
     5,097,058     $ 25,485     $ 1,016       16,369     $ 15,786     $ 17,533     $ (21,563 )   $ (925 )   $ 37,332  
Issuance of common stock pursuant to restricted stock plan
     86,488       433       -       -       -       (433 )     -       -       -  
Common stock cancelled pursuant to restricted stock plan
     (15,000 )     (75 )     -       -       -       63       -       -       (12 )
Forfeiture of nonvested stock options
     -       -       -       -       -       (40 )     -       -       (40 )
Compensation expense related to restricted stock plan
     -       -       -       -       -       49       -       -       49  
Compensation expense related to stock option plan
     -       -       -       -       -       1       -       -       1  
Accretion of preferred stock to redemption value
     -       -       -       -       203       -       (203 )     -       -  
Net loss
     -       -       -       -       -       -       (20,479 )     -       (20,479 )
Other comprehensive income, net of tax
     -       -       -       -       -       -       -       1,691       1,691  
Balance, December 31, 2011
     5,168,546       25,843       1,016       16,369       15,989       17,173       (42,245 )     766       18,542  
Issuance of common stock pursuant to restricted stock plan
     86,488       432       -       -       -       (432 )     -       -       -  
Common stock redeemed
     (10,097 )     (50 )     -       -       -       50       -       -       -  
Common stock cancelled pursuant to restricted stock plan
     (40,552 )     (203 )     -       -       -       167       -       -       (36 )
Compensation expense related to stock option plan
     -       -       -       -       -       35       -       -       35  
Accretion of preferred stock to redemption value
     -       -       -       -       203       -       (203 )     -       -  
Net income
     -       -       -       -       -       -       1,270       -       1,270  
Other comprehensive income (loss), net of tax
     -       -       -       -       -       -       -       (129 )     (129 )
Balance, December 31, 2012
     5,204,385     $ 26,022     $ 1,016       16,369     $ 16,192     $ 16,993     $ (41,178 )   $ 637     $ 19,682  
                                                                         
See accompanying notes to consolidated financial statements
                                                  

 
           
Consolidated Statements of Cash Flows
            
For the Years Ended December 31, 2012 and 2011
            
             
   
For the Year
  
(dollars in thousands)
  
2012
    
2011
  
Cash flows from operating activities
            
Net income (loss)
   $ 1,270     $ (20,479 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
                
Depreciation
     938       1,011  
Provision for loan losses
     5,276       15,815  
Deferred income taxes
     -       9,493  
Amortization of premium on securities, net of discount accretion
     1,323       853  
Origination of held-for-sale loans
     (113,623 )     (86,928 )
Proceeds from sales of held-for-sale loans
     118,895       91,114  
Net gains on sales of investment securities
     (2,965 )     (2,458 )
Net gains on sales of USDA and SBA loans
     (697 )     (565 )
Net gains on sales of held-for-sale loans
     (2,383 )     (1,854 )
Net losses on sales of foreclosed real estate
     12       353  
Net (gains) losses on sale of repossessed assets
     (66 )     2  
Net losses on sale or disposal of equipment
     39       34  
Stock compensation benefit
     (1 )     (2 )
Writedown of foreclosed real estate
     983       3,077  
Writedown of repossessed assets
     1,221       -  
Increase in cash surrender value of bank-owned life insurance
     (374 )     (435 )
Changes in assets and liabilities:
                
Accrued interest receivable
     378       (365 )
Other assets
     (324 )     862  
Accrued interest payable
     (230 )     (813 )
Other liabilities
     2,495       (246 )
Net cash provided by operating activities
     12,167       8,469  
Cash flows from investing activities
                
Purchases of investment securities available for sale
     (304,312 )     (223,157 )
Sales of investment securities available for sale
     122,385       96,629  
Maturities of investment securities available for sale
     21,439       13,703  
Calls of investment securities available for sale
     106,500       52,114  
Purchases of investment securities held to maturity
     -       (205 )
Maturities of investment securities held to maturity
     -       50  
Purchases of restricted equity securities
     (188 )     (250 )
Redemptions of restricted equity securities
     1,039       1,863  
Proceeds from sale of foreclosed real estate
     13,290       2,735  
Proceeds from sale of repossessed assets
     3,048       -  
Net decrease in loans
     19,347       33,424  
Purchases of property and equipment
     (445 )     (59 )
Net cash used for investing activities
     (17,897 )     (23,153 )
Cash flows from financing activities
                
Net increase (decrease) in deposits
     11,196       (1,693 )
Net decrease in securities sold under agreements
                
to repurchase and federal funds purchased
     (169 )     (99 )
Repayment of  FHLB advances
     (3,952 )     -  
Net decrease in other borrowings
     -       (3,619 )
Net cash provided by (used for) financing activities
     7,075       (5,411 )
Net increase (decrease) in cash and cash equivalents
     1,345       (20,095 )
Cash and cash equivalents, beginning of year
     37,303       57,398  
Cash and cash equivalents, end of year
   $ 38,648     $ 37,303  
                 
Supplemental disclosure of cash flow information
                
Transfer of loans to foreclosed real estate
   $ 4,773     $ 11,828  
Transfer of investment in real estate partnership to foreclosed real estate
     -       6,356  
Transfer of loans to repossessed assets
     2,586       1,617  
Transfer of loans to held-to-maturity securities
     -       1,250  
Transfer of held-to-maturity securities to available-for-sale securities
     2,917       -  
Sales of nonaccrual loans
     1,167       300  
Loans made to finance sale of foreclosed real estate
     -       202  
Interest paid
     5,935       8,324  
                 
See accompanying notes to consolidated financial statements
                
 
 
Notes to Consolidated Financial Statements
 
Note 1 – Summary of Significant Accounting Policies

Business and Basis of Presentation

1st Financial Services Corporation (1st Financial or the Company), a bank holding company registered under the Bank Holding Company Act of 1956, as amended, is the parent company for Mountain 1st Bank & Trust Company (the Bank).  The Company essentially has no other assets or liabilities other than its investment in the Bank.  Clear Focus Holdings, LLC. is a wholly owned real estate holdings subsidiary of the Bank.  The Company is regulated, supervised, and examined by the Board of Governors of the Federal Reserve System (the Federal Reserve), and the North Carolina Commissioner of Banks (the Commissioner).  The Company’s business activity consists of directing the activities of the Bank.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.

The Bank is a federally insured non-member commercial bank, incorporated under the laws of North Carolina on April 30, 2004.  The Bank commenced operations on May 14, 2004.  The Bank provides financial services through its branch network located in western North Carolina and operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (FDIC).  The Bank competes with other financial institutions and numerous other non-financial services commercial entities offering financial services products.  The Bank is further subject to the regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.  The Bank’s customers are principally located in western North Carolina.

The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry.  Following is a summary of the more significant policies.

Business Segments

The Company reports its activities as a single business segment.  In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to resource allocation and performance assessment.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company, the Bank, and the Bank’s wholly owned subsidiary, Clear Focus Holdings, LLC.  All intercompany transactions and balances have been eliminated in consolidation.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and the reported amounts of income and expense for the periods presented.  Actual results could differ significantly from those estimates.

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, the realization of the deferred tax asset, and the determination of the fair value of financial instruments.

Cash and Cash Equivalents

For the purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and short-term interest-bearing deposits.  Cash and cash equivalents have maturities of three months or less.  Accordingly, the carrying amount of such instruments is considered to be a reasonable estimate of fair value.
 
Investment Securities
 
Management determines the appropriate classification of investment securities at the time of purchase.  Securities are classified as held to maturity when the Company has both the positive intent and ability to hold the securities to maturity.  Held-to-maturity securities are stated at amortized cost.  Securities that are bought and held principally for the purpose of selling in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.  Securities not classified as held to maturity or trading are classified as available for sale.  Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of stockholders’ equity.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The fair value of securities is based on quoted market prices or dealer quotes.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value.  The impairment is charged to earnings and a new cost basis for the security is established.  To determine whether an impairment is other than temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary.  Evidence considered in this assessment includes the reasons for the impairment, the severity, and duration of the impairment, changes in value subsequent to year-end, and forecasted performance of the investee.
 
At December 31, 2012 and 2011, the Company had no trading securities.  At those dates, all of the Company’s investment securities were classified as available for sale or held to maturity.

Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective-interest method.  Dividend and interest income are recognized when earned.  The cost of securities sold is based on the specific identification method.  Gains and losses are recorded on the trade date.

Other Investments

The Bank accounts for its investments in a real estate partnership and restricted equity securities using either the cost or the equity method of accounting. The accounting treatment depends upon the Bank’s percentage ownership and degree of management influence.

Under the cost method of accounting, the Bank records investments in stock at cost and generally recognizes cash dividends received as income. If cash dividends received exceed the investee’s earnings since the investment date, these payments are considered a return of investment and reduce the cost of the investment.
 
Under the equity method of accounting, the Bank records its initial investment at cost. Subsequently, the carrying amount of the investment is increased or decreased to reflect the Bank’s share of income or loss of the investee. The Bank’s recognition of earnings or losses from an equity method investment is based on the Bank’s ownership percentage in the investment and the investee’s earnings.

Bank Owned Life Insurance

In December 2007, the Bank purchased $6.0 million in life insurance policies on certain key employees and in January 2008 purchased an additional $5.0 million.  These policies are recorded on the Company’s consolidated balance sheet at their cash surrender value, or the amount that can be realized, and any income from these policies and changes in the net cash surrender values are recorded in Other Noninterest Income on the Company’s Consolidated Statement of Operations.
 
Loans Held for Sale

The Company originates single family, residential first mortgage loans on a pre-sold, flow basis.  Loans held for sale are carried at the lower of cost or fair value in the aggregate as determined by outstanding commitments from investors.  At closing, these loans, together with their servicing rights, are sold to other financial institutions under prearranged terms.  The Company recognizes certain origination and service release fees upon the sale, which are classified as mortgage services revenue in the Company’s Consolidated Statements of Operations.

Loans

Loans are generally reported at their outstanding principal balances net of any unearned income, charge-offs, and unamortized deferred fees and costs on originated loans.  Unearned income, deferred fees and costs, and discounts and premiums are amortized to income over the contractual life of the loan.

Past due and delinquent status is based on contractual terms.  Interest on loans deemed past due continues to accrue until the loan is placed in nonaccrual status.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The accrual of interest is discontinued when it is determined there is a more than normal risk of future uncollectability. In most cases, loans are automatically placed in nonaccrual status by the loan system when the loan payment becomes 90 days delinquent and no acceptable arrangement has been made between the Company and the borrower. The accrual of interest on some loans, however, may continue even after the loan becomes 90 days delinquent in special circumstances deemed appropriate by the Company. Loans may be manually placed in nonaccrual status if it is determined that some factor other than delinquency (such as imminent foreclosure or bankruptcy proceedings) causes the Company to believe that more than a normal amount of risk exists with regard to collectability. When the loan is placed in nonaccrual status, accrued interest receivable is reversed. Thereafter, any cash payments received on the nonaccrual loan are applied as a principal reduction until the entire amortized cost has been recovered. Any additional amounts received are reflected in interest income. Loans are returned to accrual status when the loan is brought current and ultimate collectability of principal and interest is no longer in doubt.

Nonrefundable fees and certain direct costs associated with the origination of loans are deferred and recognized as a yield adjustment over the contractual life of the related loans, or if the related loan is held for sale, until the loan is sold.  Recognition of deferred fees and costs is discontinued on nonaccrual loans until they return to accrual status or are charged-off.

Allowance for Loan Losses

The allowance for loan losses represents an amount that the Company believes will be adequate to absorb probable losses inherent in the loan portfolio as of the balance sheet date.  Assessing the adequacy of the allowance for loan losses is a process requiring considerable judgment.  Such judgment is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of the overall loan portfolio; economic conditions that may impact the overall loan portfolio or an individual borrower’s ability to repay; the amount and quality of collateral securing the loans; its historical loan loss experience; and borrower and collateral specific considerations for loans individually evaluated for impairment.

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense.  The allowance for loan losses represents the Company’s best estimate of probable losses that have been incurred within the existing portfolio of loans.  The Company’s allowance methodology is based on historical loss experience by loan type, specific homogeneous risk pools, and specific loss allocations.  The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for asset deterioration as it occurs.  The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, loan payment delinquencies, potential problem loans, criticized loans, and loans charged-off or recovered, among other factors.

The level of the allowance for loan losses reflects the Company’s continuing evaluation of specific lending risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio.  Lending risks are driven primarily by the type of loans within the portfolio.

Portions of the allowance for loan losses may be allocated to specific loans.  However, the entire allowance for loan losses is available for any loan that, in the Company’s judgment, should be charged-off.  While the Company utilizes its best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond its control, including the performance of the loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications and collateral valuation.

An allowance for loan losses on specific loans is recorded for an impaired loan when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan.  Specific allowances for loans considered individually significant and that exhibit probable or observed weaknesses are determined by analyzing the borrower’s ability to repay amounts owed, guarantor support, collateral deficiencies, the relative risk rating of the loan, and economic conditions impacting the borrower’s industry, among other things.

The starting point for the general component of the allowance is the historical loss experience of specific types of loans.  The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual loan net charge-offs to the total population of loans in the pool.  The Company uses a rolling 16-quarter look-back period when computing annualized historical loss rates.

Historical loss percentages are adjusted for qualitative environmental factors derived from macroeconomic indicators and other factors.  Qualitative factors considered in the determination of the December 31, 2012 and 2011, allowance for loan losses include pervasive factors that generally impact the borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development).  Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructuring loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition, and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, peer comparisons, and other external factors.  The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Loans identified as losses by management, internal loan review, and/or bank examiners are charged-off.  Each impaired loan is reviewed on a loan-by-loan basis to determine whether the impairment should be recorded as a charge-off or a reserve based on an assessment of the status of the borrower and the underlying collateral.  In general, for collateral dependent loans, any impairment is recorded as a charge-off unless the fair value was based on an internal valuation pending receipt of a third party appraisal or other extenuating circumstances.  Consumer loan accounts are generally charged-off on pre-defined past due time periods.

A loan is considered impaired when full payment according to the terms of the loan agreement is not probable or when the terms of a loan are modified. The portion of the allowance related to loans that are deemed impaired is based on discounted cash flows using the loan’s initial effective interest rate, the loan’s observable market price, or the fair value of the collateral for collateral dependent loans.  At December 31, 2012, the Company had impaired loans of $49.0 million, which included $28.6 million in nonaccrual loans and $4.8 million in performing restructured loans.  At December 31, 2011, the Company had impaired loans of $61.7 million, which included $33.7 million in nonaccrual loans and $15.8 million in performing restructured loans.
 
Troubled Debt Restructurings

In situations where, for economic or legal reasons related to a borrower’s financial difficulties, a concession to the borrower is granted that the Company would not otherwise consider, the related loan is classified as a troubled debt restructuring.  The restructuring of a loan may include the transfer from the borrower to the Company of real estate, receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan, a modification of the loan terms, or a combination of the above.  The accrual of interest continues on a troubled debt restructuring as long as the loan is performing in accordance with the restructured terms.

A troubled debt restructured loan (TDR), which was on nonaccrual status prior to being restructured remains on nonaccrual status until six months of satisfactory borrower performance has been experienced, at which time management would consider returning it to accrual status.  Loans that are considered TDRs are classified as performing, unless they are either on nonaccrual status or 90 days or more delinquent, in which case they are considered nonperforming.  The balance of nonperforming TDRs was $17.0 million, representing 28 loans at December 31, 2012.  If a restructured loan was on accrual status prior to being restructured, the restructured loan is reviewed, based on current information and events surrounding the loan and the borrower, to determine whether it should remain on accrual status.  The Company computes impairment on TDRs that are on nonaccrual status and charges off the impairment when identified against the allowance for loan losses.  Performing TDRs are not considered impaired for this analysis purpose.  The balance of accruing restructured loans was $4.8 million, representing 21 loans, at December 31, 2012.  On a quarterly basis, the Company individually reviews all TDRs to determine whether they ought to be reclassified, based on the above criteria.

Foreclosed Real Estate

Foreclosed real estate consists of property acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure.  Foreclosed real estate is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure.  The initial recorded value may be subsequently reduced by additional write-downs, which are charged to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value.  Costs related to the improvement of the property are capitalized, whereas those related to holding the property are expensed.  Such properties are held for sale, and accordingly, no depreciation or amortization expense is recognized.  As of December 31, 2012, the Company held $9.8 million of foreclosed real estate, compared to $19.3 million at December 31, 2011.

Reclassifications

Certain amounts in the 2011 consolidated financial statements were reclassified to conform to the 2012 presentation.  These reclassifications had no effect on stockholders’ equity or results of operations as previously presented.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation.  Depreciation is computed by the straight-line method and is charged to operations over the estimated useful lives of the assets.  Useful lives for buildings are 40 years and range from 3 to 12 years for leasehold improvements, 5 to 15 years for furniture and fixtures and 3 to 5 years for computer and telecommunications equipment.
 
Maintenance, repairs, renewals, and minor improvements are charged to expense as incurred.  Major improvements are capitalized and depreciated.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Advertising Costs

Advertising, promotional, and other business development costs are generally expensed as incurred.  External costs incurred in producing media advertising are expensed the first time the advertising takes place.  External costs relating to direct mailing costs are expensed in the period in which the direct mailings are sent.

Income Taxes
 
The provision for income taxes consists of amounts currently payable to taxing authorities and the net change in income taxes payable or refundable in future years.  Income taxes deferred to future years are determined using the asset and liability method.  Under this method, deferred income taxes are determined based on temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates expected to be in effect when such amounts are realized or settled.

In the event the future tax consequences of differences between the financial reporting base and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required.  A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized.  In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.
 
Net Income (Loss) Per Share

Basic income (loss) per share represents the net income or loss available to common stockholders divided by the weighted-average number of common shares outstanding during the period.  Dilutive income per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued.  Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method.  For 2012, basic weighted-average shares and diluted weighted-average shares outstanding totaled 5,203,152, which resulted in basic net income per share and diluted net income per share of $0.05.  For 2011, basic weighted-average shares and diluted weighted-average shares outstanding totaled 5,142,174, which resulted in basis net income (loss) per share and diluted net income (loss) per share of $(4.18).  No stock options or warrants were included in the computation for 2012 or 2011, as their effect would have been anti-dilutive.

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income and other comprehensive income (loss).  Other comprehensive income (loss) consists of unrealized gains and losses on investment securities available for sale, net of taxes.  Comprehensive income (loss) is presented in the statements of stockholders’ equity and comprehensive income (loss).

Stock Compensation
 
The Company’s stock option plans, which are stockholder-approved, provide for stock options to be granted primarily to directors, officers and other key associates.  Options granted under the 2004 Directors’ Stock Option Plan (the Directors Plan) are non-qualified stock options, while options granted under the 2004 Employee Stock Option Plan (the Employee Plan) may be either incentive stock options or non-qualified stock options.   In 2008, the Company’s stockholders approved the 2008 Omnibus Equity Plan (the Omnibus Plan), pursuant to which incentive stock options, non-qualified stock options, performance shares, stock appreciation rights and restricted stock may be granted to officers and employees of the Company and the Bank, and non-qualified stock options and restricted stock awards may be granted to directors of the Company and the Bank.

Stock option awards are granted with an exercise price equal to, or higher than, the market price of the Company’s shares at the date of grant.  Options vest ratably over a pre-determined period, generally five years, and expire after ten years from the date of grant, except that awards provide for accelerated vesting if there is a change in control, as defined in the stock option plan.  At December 31, 2012, no shares were available to be granted under the Directors Plan, 273,399 shares remained available for award under the Employee Plan, and 90,133 shares remained available for award under the Omnibus Plan.  All of the options outstanding at December 31, 2012 were fully vested.

The Company recognizes compensation costs related to share-based payment transactions over the period that an employee provides service in exchange for the award.  The fair value at the date of grant of the stock option is estimated using the Black-Scholes option-pricing model based on the following assumptions.  The dividend yield is based on estimated future dividend yields.  The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant.  Expected volatilities are generally based on historical volatilities.  The expected term of share options granted is generally derived from historical experience.  Compensation expense is recognized on a straight-line basis over the stock option vesting period.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Management believes that the over-the-counter (OTC) quoted market prices of the Company’s stock do not reflect an accurate value of the stock since the stock is not traded in large volumes and the OTC bid and ask quotes are for very small share lots.  The Plans themselves contemplate that there is no efficient market unless the stock is listed on an exchange.  The Plans assign the responsibility to value the stock at each grant date to the Board of Directors, until such time as the Company’s stock trades on a stock exchange.

Fair Valuation Measurements

The Company provides disclosures about the fair value of assets and liabilities recognized in the consolidated balance sheets in periods subsequent to initial recognition, including whether the measurements are made on a recurring basis (for example, investment securities available-for-sale) or on a nonrecurring basis (for example, impaired loans).

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  Under the fair value hierarchy, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  Three levels of inputs are used to measure fair value:

●
Level 1 – quoted prices in active markets for identical assets or liabilities;

●
Level 2 – observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and

●
Level 3 – unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Disclosures about the fair value of all financial instruments whether or not recognized in the consolidated balance sheets for which it is practicable to estimate that value are required.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly impacted by the assumptions used, including the discount rate and estimates of future cash flows.  In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.  For additional information regarding fair value estimates and methodologies, see Note 19, Fair Value of Financial Instruments.

Derivative Instruments and Hedging Activities

Generally accepted accounting principles require an entity to recognize all derivatives as either assets or liabilities in the balance sheet, and measure those instruments at fair value.  Changes in the fair value of those derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting.  The Company does not currently engage in any activities that qualify for hedge accounting.  Accordingly, changes in fair value of these derivative instruments are included in gain on sales of loans held for sale in the consolidated statement of operations.

Risk and Uncertainties

In the normal course of business, the Company encounters two significant types of overall risk: economic and regulatory. There are three main components of economic risk: credit risk, market risk, and concentration of credit risk. Credit risk is the risk of default on the Company’s loan portfolios that results from borrowers’ inability or unwillingness to make contractually required payments, or default on repayment of investments securities. Market risk includes primarily interest rate risk. The Company is exposed to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or different bases, than its interest-earning assets. Market risk also reflects the risk of declines in the valuation of loans held for sale and in the value of the collateral underlying loans and the value of real estate held by the Company. Concentration of credit risk refers to the risk that, if the Company extends a significant portion of its total outstanding credit to borrowers in a specific geographical area or industry or on the security of a specific form of collateral, the Company may experience disproportionately high levels of default and losses if those borrowers, or the value of such type of collateral, is adversely impacted by economic or other factors that are particularly applicable to such borrowers or collateral. Concentration of credit risk is also similarly applicable to the investment securities portfolio.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The Company and the Bank are subject to the regulations of various government agencies: regulatory risk.  These regulations can and do change significantly from period to period.  The Company and the Bank also undergo periodic examinations by regulatory agencies, which may subject them to changes with respect to asset valuations, amount of required allowance for loan losses, or operating restrictions.

Subsequent Events

In preparing these financial statements, the Company has evaluated events and transactions through our filing date for potential recognition or disclosure in the consolidated financial statements.

Recently Issued Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting and/or disclosure of financial information by the Company.
 
Disclosures about Troubled Debt Restructurings (TDRs) required by Accounting Standards Update (ASU) 2010-20 were deferred by the Financial Accounting Standards Board (FASB) in ASU 2011-01 issued in January 2011.  In April 2011 the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR.  The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present.  Disclosures related to TDRs under ASU 2010-20 have been presented in Note 5.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the Accounting Standards Certification (ASC) was amended by ASU 2011-03.  The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control.  The other criteria to assess effective control were not changed.  The amendments were effective for the Company beginning January 1, 2012, and had no material effect on the financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements.  The amendments were effective for the Company beginning January 1, 2012, and had no material effect on the financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011.  The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity.  The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements.  The amendment was applicable to the Company on January 1, 2012, and was applied retrospectively.  The amendment had no material effect on the financial statements.

The FASB amended the Comprehensive Income topic of the ASC in February 2013.  The amendment addresses reporting of amounts reclassified out of accumulated other comprehensive income.  Specifically, the amendment does not change the current requirements for reporting net income or other comprehensive income in financial statements.  However, the amendment does require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component.  In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income.  The amendment will be effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012.  Early adoption is permitted.  The Company does not expect these amendments to have a material effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Note 2 - Enforcement Actions and Going Concern Considerations

Consent Order.  During 2009, the FDIC conducted a periodic examination of the Bank.  As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the Commissioner.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions:
 
●
enhance its supervision of the Bank’s activities.
   
●
assess the management team to ensure executive officers have the skills, training, abilities, and experience needed.
   
●
develop and implement a plan for achieving and maintaining Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses.
   
●
strengthen the Allowance policy of the Bank.
   
●
develop and implement a strategic plan.
   
●
not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.
   
●
formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans.
   
●
reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.
   
●
cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies.
   
●
adopt a loan review and grading system.
   
●
develop a plan to systematically reduce the concentration in a limited group of borrowers.
   
●
enhance its review of its liquidity and implement a liquidity contingency and asset/liability management plan.
   
●
implement a plan and 2010 budget designed to improve and sustain earnings.
   
●
implement internal routine and control policies addressing concerns to enhance its safe and sound operation.
   
●
implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
   
●
implement a policy for managing its “owned real estate”.
   
●
forebear from soliciting and accepting “brokered deposits” without approval.
   
●
limit growth to 10% per year.
   
●
not pay dividends without prior approval.
   
●
implement policies to enhance the handling of transactions with officers and directors.
   
●
correct any violations of laws and regulations.
   
●
make quarterly progress reports.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order.  The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation.  During the period a consent order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches.  Accordingly, the Bank will defer expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.
 
Written Agreement.  As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, the Company executed a written agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (the Federal Reserve Bank), effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions, including, among other things that the Company or its Board of Directors shall:

●
take appropriate steps to fully utilize the Company’s financial and managerial resources, to serve as a source of strength to the Bank.

●
not declare or pay any dividends without approval.

●
not directly or indirectly take dividends from the Bank without approval.

●
not directly or indirectly, incur, increase, or guarantee any debt without approval.

●
not directly or indirectly, purchase or redeem any shares of its stock without approval.

●
comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve related to changes in executive officers and compensation matters.

●
submit a written capital plan that is acceptable to the Federal Reserve Bank, implement the approved plan, and thereafter fully comply with it.

The Company and the Bank have taken and continue to take action to respond to the issues raised in the Consent Order and the Written Agreement.

Going Concern Considerations

The going concern assumption is a fundamental principle in the preparation of financial statements.  It is the responsibility of management to assess the Company’s ability to continue as a going concern.  In assessing this assumption, the Company has taken into account all available information about the future, which is at least, but is not limited to, 12 months from the balance sheet date.  The Bank suffered recurring losses that eroded regulatory capital ratios during 2009, 2010, and 2011, resulting from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression.

The effects of the current economic environment are being felt across many industries, with financial services and residential real estate being particularly hard hit.  The effects of the economic downturn have been particularly severe during the last several years.  The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, has seen a decline in the value of the collateral securing its portfolio, as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank.  As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011.  For 2012, the Bank recorded a $5.3 million provision to increase the allowance for loan losses to a level which, in management’s best judgment, adequately reflected the risk inherent in the loan portfolio as of December 31, 2012.  Nevertheless, given the current economic climate, management recognizes the possibility of further deterioration in the loan portfolio during 2013.  For 2012, the Bank recorded net loan charge-offs of $5.2 million, or 1.32% of average loans, as compared to net loan charge-offs of $21.4 million, or 4.66% of average loans, for 2011.  Although asset quality has significantly improved during 2012, the Company’s lowered capital ratios have placed it in a weakened position to respond to adverse unforeseen events in the future.

The Company and the Bank operate in a highly regulated industry and must plan for the liquidity needs of each entity separately.  A variety of sources of liquidity are available to the Bank to meet its short-term and long-term funding needs.  Although a number of these sources have been limited following execution of the Consent Order with the FDIC and the Commissioner and the Written Agreement with the Federal Reserve Bank, management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during the next 12 months in an effort to ensure the sources available are sufficient to meet the Bank’s projected liquidity needs for at least the next 12 months, but if the Bank is unable to meet its liquidity needs, then the Bank may be placed into a federal conservatorship or receivership by the FDIC, with the FDIC appointed conservator or receiver.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The Company relies on dividends from the Bank as its primary source of liquidity.  The Company is a legal entity separate and distinct from the Bank.  Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends.  In addition, the terms of the Consent Order described above further limits the Bank’s ability to pay dividends to the Company to satisfy its funding needs.  Due to the regulatory restrictions which exist, that restrict cash payments between the Bank and the Company, the Company may be unable to realize its assets and discharge its liabilities in the normal course of business, in which case the Company could be liquidated.

The Company will also need to raise substantial additional capital to increase its capital levels to meet the standards set forth by the Consent Order and the Written Agreement.  The Company’s ability to raise additional capital depends on conditions in the capital markets, economic conditions, and the Company’s financial performance and conditions, among other factors.  Given the current state of the equity markets and the Company’s financial performance and condition, the Company’s ability to raise capital in the next 12 months and remain an independent institution is unknown.  If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company and could result in the Bank being placed in conservatorship or receivership by the FDIC or the Commissioner, and the Company could be liquidated.
 
These matters raise substantial doubt about the Company’s ability to continue as a going concern.  As a result of management’s assessment of the Company’s ability to continue as a going concern, the accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.
 
Note 3 - Restrictions on Cash

The Company is required to maintain average reserve balances, computed by applying prescribed percentages to its various types of deposits, either at the Company or on deposit with the Federal Reserve Bank.  At December 31, 2012 and 2011, all required reserves were met by the Company’s vault cash.

At December 31, 2012, cash and cash equivalents totaling $941,000 were pledged as collateral against the Bank’s debit card and corporate credit card activity.  At December 31, 2011, cash and cash equivalents totaling $6.9 million were pledged as collateral, $6.1 million of which was pledged against the Bank’s check clearing activity.  During 2012, investment securities were substituted as collateral against the Bank’s check clearing activity.

Note 4 - Investment Securities

The Company maintains a portfolio of investment securities as part of its asset/liability and liquidity management program, which emphasizes effective yields and maturities to match its funding needs.  The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest-rate sensitivity needs for the Company.

Unrealized gains and losses on available-for-sale securities are reported net of tax as a separate component of stockholders’ equity.  Realized gains and losses on the sale of available-for-sale securities are determined using the specific-identification method.  Premiums and discounts are recognized in interest income using the effective interest rate method over the period to maturity or call date.

Available-for-sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held-to-maturity securities.  The Company held no private-label mortgage-backed securities; the mortgage-backed securities owned by the Company have been issued by governmental entities, such as the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Investments in available-for-sale securities are as follows:
 
Available-for-Sale Securities
(in thousands)
      
   
December 31, 2012
  
         
Gross
    
Gross
        
   
Amortized
    
Unrealized
    
Unrealized
    
Fair
  
   
Cost
    
Gains
    
Losses
    
Value
  
U.S. government agencies
   $ 38,736     $ 465     $ 132     $ 39,069  
Government-sponsored enterprises
     167,318       696       101       167,913  
Mortgage-backed securities
     46,738       250       141       46,847  
Total
   $ 252,792     $ 1,411     $ 374     $ 253,829  
                                 
                                 
   
December 31, 2011
  
           
Gross
    
Gross
          
     
Amortized
    
Unrealized
    
Unrealized
      
Fair
  
     
Cost
    
Gains
    
Losses
      
Value
  
U.S. government agencies
   $ 18,182     $ 147     $ 114     $ 18,215  
Government-sponsored enterprises
     86,230       518       13       86,735  
Mortgage-backed securities
     89,825       844       134       90,535  
Total
   $ 194,237     $ 1,509     $ 261     $ 195,485  

At December 31, 2012 and December 31, 2011, investment securities with an amortized cost of $35.5 million and $28.8 million and a fair value of $35.8 million and $29.2 million, respectively, were pledged as collateral for lines of credit, securities sold under agreements to repurchase, and other banking purposes.  Additionally, at December 31, 2012, investment securities with an amortized cost of $7.2 million and fair value of $7.3 million were pledged to the Federal Reserve Bank against the Bank’s check clearing activity.  During 2012, proceeds from sales of investment securities were $122.4 million.  The gross realized gain on the sale of investment securities totaled $3.1 million with $120,000 gross losses, resulting in a net realized gain of $3.0 million.  U.S. government-sponsored securities totaling $106.5 million were called in 2012.  During 2011, proceeds from the sale of investment securities totaled $96.6 million.  The gross realized gain on the sale of investment securities totaled $2.5 million with no gross realized losses.  During 2011, U.S. government-sponsored securities totaling $52.1 million were called.

Held-to-maturity securities are bonds, notes and debentures, for which the Company has the positive intent and ability to hold to maturity and are reported at cost, adjusted by premiums and discounts that are recognized in interest income using the effective interest rate method over the period to maturity or call date.  During 2012, held-to-maturity securities with an amortized cost of $2.9 million and fair value of $3.2 million were transferred to available-for-sale.  Investments in held-to-maturity securities are as follows:

 
Held-to-Maturity Securities
(in thousands)
                  
   
December 31, 2012
  
         
Gross
    
Gross
        
   
Amortized
    
Unrealized
    
Unrealized
    
Fair
  
   
Cost
    
Gains
    
Losses
    
Value
  
Other debt securities
   $ 1,250     $ -     $ -     $ 1,250  
Total
   $ 1,250     $ -     $ -     $ 1,250  
                                 
                                 
   
December 31, 2011
  
           
Gross
    
Gross
          
   
Amortized
    
Unrealized
    
Unrealized
    
Fair
  
   
Cost
    
Gains
    
Losses
    
Value
  
States and political subdivisions
   $ 2,917     $ 211     $ -     $ 3,128  
Other debt securities
     1,250       -       -       1,250  
Total
   $ 4,167     $ 211     $ -     $ 4,378  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Declines in the fair value of individual held-to-maturity and available-for-sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value.  Related write-downs are included in earnings as realized losses.  The Company experienced no declines in the value of securities that were considered to be other than temporary in nature during 2012 or 2011.

The following table details the gross unrealized losses and related fair values in the Company’s available-for-sales and held-to-maturity investment securities portfolio.  This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position.

Available-for-Sale Securities - Temporarily Impaired
                                
(in thousands)
                                    
   
December 31, 2012
  
   
Less Than 12 Months
    
12 Months or More
    
Total
  
   
Fair
    
Unrealized
    
Fair
    
Unrealized
    
Fair
    
Unrealized
  
   
Value
    
Losses
    
Value
    
Losses
    
Value
    
Losses
  
U. S. government agencies
   $ 7,494     $ 49     $ 2,160     $ 83     $ 9,654     $ 132  
Government sponsored enterprises
     25,807       101       -       -       25,807       101  
Mortgage-backed securities
     20,957       129       1,048       12       22,005       141  
Total
   $ 54,258     $ 279     $ 3,208     $ 95     $ 57,466     $ 374  
                                                 
                                                 
   
December 31, 2011
  
   
Less Than 12 Months
    
12 Months or More
    
Total
  
   
Fair
    
Unrealized
    
Fair
    
Unrealized
    
Fair
    
Unrealized
  
   
Value
    
Losses
    
Value
    
Losses
    
Value
    
Losses
  
U. S. government agencies
   $ 3,303     $ 1     $ 2,305     $ 113     $ 5,608     $ 114  
Government sponsored enterprises
     6,985       13       -       -       6,985       13  
Mortgage-backed securities
     17,421       134       -       -       17,421       134  
Total
   $ 27,709     $ 148     $ 2,305     $ 113     $ 30,014     $ 261  

As of December 31, 2012, a total of three individual U.S. government agency securities (two U.S. Department of Agriculture securities and one Small Business Administration security) and one mortgage-backed security were in a continuous loss position for 12 months or more.  As of December 31, 2011, only the three individual U.S. government agency securities referenced above were in a continuous loss position for 12 months or more.  The Company has the ability and intent to hold these three securities until such time as the value recovers or the security matures.  The Company believes, based on their credit ratings, that the deterioration in value is attributable to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered to be other than temporary.

No held-to-maturity securities were in an unrealized loss position at December 31, 2012 or 2011.
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
The aggregate amortized cost and fair value of available-for-sale and held-to-maturity investment securities by remaining contractual maturity are shown below.  Actual expected maturities differ from contractual maturities because issuers may have the right to call or prepay obligations.
 
Available-for-Sale Investment Securities
                        
(in thousands)
                        
   
December 31
  
   
2012
    
2011
  
   
Amortized
    
Fair
    
Amortized
    
Fair
  
   
Cost
    
Value
    
Cost
    
Value
  
U. S. government agencies
                        
Due within one year
   $ 76     $ 76     $ 31     $ 31  
Due after one but within five years
     -       -       135       134  
Due after five but within ten years
     3,149       3,139       -       -  
Due after ten years
     35,511       35,854       18,016       18,050  
Government-sponsored enterprises
                                
Due within one year
     -       -       -       -  
Due after one but within five years
     -       -       -       -  
Due after five but within ten years
     59,390       59,721       52,236       52,668  
Due after ten years
     107,928       108,192       33,994       34,067  
Mortgage-backed securities
     46,738       46,847       89,825       90,535  
Total
   $ 252,792     $ 253,829     $ 194,237     $ 195,485  
                                 
                                 
Held-to-Maturity Investment Securities
                                
(in thousands)
                                
   
December 31
  
      2012       2011  
   
Amortized
    
Fair
    
Amortized
    
Fair
  
   
Cost
    
Value
    
Cost
    
Value
  
States and political subdivisions
                                
Due within one year
   $ -     $ -     $ 100     $ 100  
Due after one but within five years
     -       -       401       432  
Due after five but within ten years
     -       -       200       232  
Due after ten years
     -       -       2,216       2,364  
Other debt securities
                                
Due within one year
     -       -       -       -  
Due after one but within five years
     -       -       -       -  
Due after five but within ten years
     1,250       1,250       1,250       1,250  
Due after ten years
     -       -       -       -  
Total
   $ 1,250     $ 1,250     $ 4,167     $ 4,378  
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Note 5 - Loans
 
The following is a summary of the major components of loans, excluding loans held for sale.

Loans
            
(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Real estate:
            
Construction & land development
   $ 68,954     $ 87,080  
1-4 family residential
     126,468       117,025  
Mutlifamily
     6,292       5,818  
Nonfarm, nonresidential
     147,894       159,120  
     Total real estate
     349,608       369,043  
Commercial & industrial
     35,182       46,873  
Consumer
     2,867       2,986  
      387,657       418,902  
Allowance for loan losses
     (10,690 )     (10,650 )
Total
   $ 376,967     $ 408,252  
 
At December 31, 2012, the Company had $28.6 million in nonaccruing loans, compared to $33.7 million at December 31, 2011.  The year-to-date foregone interest associated with these loans, which averaged $31.7 million for the year ended December 31, 2012 and $45.9 million for the year ended December 31, 2011, was $1.9 million and $2.8 million for the respective periods.

The Company sells the guaranteed portion of certain of our SBA loans in the secondary market, yet we retain the rights to service these loans.  At the time the loan is sold, we recognize a loan servicing asset and thereafter, we recognize monthly service fee income, net of servicing asset amortization.  During 2012 and 2011, the guaranteed portion of SBA loans sold totaled $5.9 million and $7.6 million, respectively.  Gains of $697,000 and $565,000 were recognized on these sales during 2012 and 2011, respectively.  Loans serviced for others totaled $22.8 million and $18.7 million at December 31, 2012 and 2011, respectively, and the associated loan servicing asset was $280,000 and $272,000 at December 31, 2012 and 2011, respectively. Servicing income, net of amortization, totaled $28,000 and $64,000 during 2012 and 2011, respectively.

Credit Quality Indicators.  As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans and (v) the general economic conditions in the State of North Carolina.

The Company uses a risk grading matrix to assign a risk grade to each of its commercial loans.  Loans are graded on a scale of 1 to 9.  A description of the general characteristics of the nine risk grades is as follows:

●
Rating 1 –Extremely Low Risk.  Low Risk Assets are of the highest quality with an unquestioned capacity for repayment.  These borrowers are generally international, national, or regional in scope and the debt rating, if available, is AAA (S&P) or Aaa (Moody’s).  The borrower has ready access to all public financing markets.  Management has a demonstrated successful track record and a succession plan is in place for highly qualified replacements.  Financial statements are audited without qualification by reputable CPA firms.  Loans are also considered extremely low risk prime when the collateral consists of properly margined bank certificates of deposit and shorter-term U.S. government securities.

●
Rating 2 –Minimal Risk.  Minimal Risk assets have a history of consistently superior earnings and cash flow.  Very strong liquidity and low leverage.  The balance sheet is well capitalized and the secondary source of repayment is well defined and of unquestioned quality.  These borrowers also have ready access to all public finance markets as evidenced by debt ratings, if available, of AA (S&P) or Aaa (Moody’s).  These assets can also be those secured by properly margined long-term U.S. government bonds.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
●
Rating 3 –Moderate Risk. Moderate Risk assets have consistently satisfactory earnings and cash flow. They possess no disclosed weaknesses; however, financial analysis reveals factors such as leverage, liquidity, or debt service to be less than optimal or susceptible to changes in the business cycle. Access to other financing sources exists and private placement may be possible. Unqualified audited statements are preferred; however, reviewed statements are also acceptable. The borrower may not be able to survive a significant downturn; however, the debt is supported by high quality unrestricted liquid collateral.

●
Rating 4 –Satisfactory Risk. Satisfactory Risk assets possess adequate earnings, cash flow, leverage, and capital when compared to their industry. Debt service does not place an undue strain on the business. The borrower is not strong enough to sustain major financial setbacks. The asset has a readily apparent weakness such as being relatively new, new management with an unproven track record, low liquidity or equity, volatile profitability and cash flow. Guarantor(s) and collateral that provide an acceptable and readily quantifiable secondary source of repayment always support these assets.

●
Rating 5 –Acceptable Risk –“Management Watch.” Acceptable Risk assets are those that warrant closer than normal attention due to adverse conditions affecting the borrower, the borrowers industry, or the general economic environment. Above average risk is reflected through erratic earnings and cash flow, inconsistent debt service coverage, or strained liquidity or leverage. Uncertain events may have taken place such as unanticipated management changes or pending litigation that could have a significant negative impact. Collateral and/or guarantor(s) adequately protect these assets.

●
Rating 6 –Special Mention.  A Special Mention asset has potential weaknesses that deserve management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date.  Special Mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification.

●
Rating 7 –Substandard.  Loans with a well-defined weakness, some loss may be possible, though not anticipated.  A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any.  Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility the Bank will sustain some loss if the deficiencies are not corrected.  Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.

●
Rating 8 –Doubtful.  A Doubtful asset has all the weaknesses inherent in an asset classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.  The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined.  Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans.   A substandard credit with 50 percent or more liquidated collateral value shortfall would generally be considered doubtful, unless other substantive credit factors justified otherwise.

●
Rating 9 –Loss.  Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.  Losses are taken in the period in which they determined to be uncollectible.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following is a summary of information pertaining to credit quality.
 
Loan Analysis by Credit Quality Indicators
                                      
(in thousands)
                                          
   
December 31, 2012
  
   
Construction
& Land
Development
    
1-4 Family
Residential
    
Multifamily
    
Nonfarm,
Nonresidential
    
Commercial & Industrial
    
Consumer
    
Total
  
Extremely low risk - 1
   $ -     $ -     $ -     $ -     $ 3,552     $ -     $ 3,552  
Minimal risk - 2
     -       -       -       240       130       -       370  
Moderate risk - 3
     596       1,729       2,600       11,948       4,246       17       21,136  
Satisfactory risk -4
     6,545       11,122       2,049       49,371       16,358       292       85,737  
Acceptable risk - 5
     22,286       10,290       1,643       49,051       9,297       4       92,571  
Special mention - 6
     14,824       6,924       -       20,980       648       -       43,376  
Substandard - 7
     15,711       5,133       -       16,304       951       12       38,111  
Doubtful - 8
     -       42       -       -       -       -       42  
Consumer, not graded
     8,992       91,228       -       -       -       2,542       102,762  
Total
   $ 68,954     $ 126,468     $ 6,292     $ 147,894     $ 35,182     $ 2,867     $ 387,657  
                                                         
                                                         
   
December 31, 2011
  
   
Construction
& Land
Development
    
1-4 Family
Residential
    
Multifamily
    
Nonfarm,
Nonresidential
    
Commercial & Industrial
    
Consumer
    
Total
  
Extremely low risk - 1
   $ -     $ -     $ -     $ -     $ 2,880     $ -     $ 2,880  
Minimal risk - 2
     -       -       -       262       608       -       870  
Moderate risk - 3
     1,959       2,558       2,850       16,400       1,981       14       25,762  
Satisfactory risk -4
     18,558       14,399       1,069       69,119       21,016       276       124,437  
Acceptable risk - 5
     25,464       10,016       1,899       38,071       11,036       15       86,501  
Special mention - 6
     13,034       3,101       -       13,724       4,917       -       34,776  
Substandard - 7
     17,639       9,717       -       21,432       3,836       24       52,648  
Doubtful - 8
     2       1,808       -       112       599       -       2,521  
Consumer, not graded
     10,424       75,426       -       -       -       2,657       88,507  
Total
   $ 87,080     $ 117,025     $ 5,818     $ 159,120     $ 46,873     $ 2,986     $ 418,902  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following is a summary loan aging analysis.
 
Loan Aging Analysis
                                          
(in thousands)
                                          
   
December 31, 2012
  
               
Total
              
     Past Due and Accruing           Past Due           Total  
   
30-59 days
    
60-89 days
    
90 or more days
    
Nonaccrual
    
& Nonaccrual
    
Current
    
Loans
  
Construction & land development
   $ 173     $ -     $ -     $ 10,012     $ 10,185     $ 58,769     $ 68,954  
1-4 family residential
     713       102       -       6,774       7,589       118,879       126,468  
Multifamily
     -       -       -       -       -       6,292       6,292  
Farmland
     -       -       -       -       -       -       -  
Nonfarm, non residential
     469       -       -       11,523       11,992       135,902       147,894  
   Total real estate loans
     1,355       102       -       28,309       29,766       319,842       349,608  
Commercial & industrial
     249       -       -       246       495       34,687       35,182  
Consumer
     -       2       -       10       12       2,855       2,867  
Total loans
   $ 1,604     $ 104     $ -     $ 28,565     $ 30,273     $ 357,384     $ 387,657  
                                                         
                                                         
   
December 31, 2011
  
                 
Total
                  
    Past Due and Accruing           Past Due           Total  
   
30-59 days
    
60-89 days
    
90 or more days
    
Nonaccrual
    
& Nonaccrual
    
Current
    
Loans
  
Construction & land development
   $ 4,304     $ 180     $ -     $ 9,243     $ 13,727     $ 73,353     $ 87,080  
1-4 family residential
     524       180       -       11,994       12,698       104,327       117,025  
Multifamily
     -       -       -       -       -       5,818       5,818  
Farmland
     -       -       -       -       -       -       -  
Nonfarm, non residential
     187       -       -       8,847       9,034       150,086       159,120  
   Total real estate loans
     5,015       360       -       30,084       35,459       333,584       369,043  
Commercial & industrial
     849       -       -       3,597       4,446       42,427       46,873  
Consumer
     13       -       -       39       52       2,934       2,986  
Total loans
   $ 5,877     $ 360     $ -     $ 33,720     $ 39,957     $ 378,945     $ 418,902  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following tables outline the changes in the allowance for loan losses by collateral type, the allowances for loans individually and collectively evaluated for impairment, and the amount of loans individually and collectively evaluated for impairment at December 31, 2012 and December 31, 2011.
 
Allowance for Loan Losses and Recorded Investment in Loans Receivable
                                
(in thousands)
                                                      
   
As of and for the Year Ended December 31, 2012
  
   
Construction & Land Development
    
1-4 Family Residential
    
Multifamily
    
Farmland
    
Nonfarm, Nonresidential
    
Commercial & Industrial
    
Consumer
    
Unallocated
    
Total
  
Allowance for Loan Losses
                                                  
Beginning balance
   $ 6,463     $ 1,553     $ 52     $ -     $ 1,277     $ 1,182     $ 92     $ 31     $ 10,650  
Provision for loan losses
     1,096       2,553       (7 )     -       1,503       (14 )     76       69       5,276  
Charge-offs
     (2,272 )     (2,059 )     -       -       (830 )     (597 )     (69 )     -       (5,827 )
Recoveries
     216       95       -       -       26       246       8       -       591  
Ending balance
   $ 5,503     $ 2,142     $ 45     $ -     $ 1,976     $ 817     $ 107     $ 100     $ 10,690  
                                                                         
Ending allowance balance for loans  individually evaluated for impairment
   $ 1,834     $ 171     $ -     $ -     $ 1,142     $ 146     $ 2     $ -     $ 3,295  
                                                                         
Ending allowance balance for loans collectively evaluated for impairment
   $ 3,669     $ 1,971     $ 45     $ -     $ 834     $ 671     $ 105     $ 100     $ 7,395  
                                                                         
Loans Receivable
                                                                        
Total period-end balance
   $ 68,954     $ 126,468     $ 6,292     $ -     $ 147,894     $ 35,182     $ 2,867     $ -       387,657  
Balance of loans individually evaluated for impairment
   $ 15,676     $ 8,308     $ -     $ -     $ 20,476     $ 4,458     $ 48     $ -     $ 48,966  
Balance of loans collectively evaluated for impairment
   $ 53,278     $ 118,160     $ 6,292     $ -     $ 127,418     $ 30,724     $ 2,819     $ -     $ 338,691  
                                                                         
                                                                         
   
As of and for the Year Ended December 31, 2011
  
   
Construction & Land Development
    
1-4 Family Residential
    
Multifamily
    
Farmland
    
Nonfarm, Nonresidential
    
Commercial & Industrial
    
Consumer
    
Unallocated
    
Total
  
Allowance for Loan Losses
                                                                  
Beginning balance
   $ 8,499     $ 4,371     $ 35     $ 12     $ 1,798     $ 1,412     $ 64     $ -     $ 16,191  
Provision for loan losses
     7,409       2,088       17       (12 )     1,506       4,714       62       31       15,815  
Charge-offs
     (9,537 )     (4,918 )     -       -       (2,035 )     (5,098 )     (48 )     -       (21,636 )
Recoveries
     92       12       -       -       8       154       14       -       280  
Ending balance
   $ 6,463     $ 1,553     $ 52     $ -     $ 1,277     $ 1,182     $ 92     $ 31     $ 10,650  
                                                                         
Ending allowance balance for loans  individually evaluated for impairment
   $ 2,152     $ 185     $ -     $ -     $ 284     $ 110     $ 2     $ -     $ 2,733  
Ending allowance balance for loans collectively evaluated for impairment
   $ 4,311     $ 1,368     $ 52     $ -     $ 993     $ 1,072     $ 90     $ 31     $ 7,917  
                                                                         
Loans Receivable
                                                                        
Total period-end balance
   $ 87,080     $ 117,025     $ 5,818     $ -     $ 159,120     $ 46,873     $ 2,986     $ -     $ 418,902  
Balance of loans individually evaluated for impairment
   $ 19,081     $ 14,795     $ -     $ -     $ 23,662     $ 4,152     $ 51     $ -     $ 61,741  
Balance of loans collectively evaluated for impairment
   $ 67,999     $ 102,230     $ 5,818     $ -     $ 135,458     $ 42,721     $ 2,935     $ -     $ 357,161  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following table summarizes information relative to impaired loans.
 
Impaired Loan Schedule
                                    
(in thousands)
                                    
   
December 31, 2012
  
   
Construction &
    
1-4 Family
    
Nonfarm
    
Commercial
              
   
Land Development
    
Residential
    
Non residential
    
& Industrial
    
Consumer
    
Total
  
With no related allowance recorded
                                    
Recorded investment
   $ 11,010     $ 7,008     $ 9,979     $ 3,372     $ -     $ 31,369  
Unpaid principal balance
     14,532       8,173       10,303       3,481       -       36,489  
Related allowance
     -       -       -       -       -       -  
Average recorded investment
     12,147       7,273       10,134       4,108       -       33,662  
Interest income recognized
     410       301       456       270       -       1,437  
With an allowance recorded
                                                
Recorded investment
   $ 4,666     $ 1,300     $ 10,497     $ 1,086     $ 48     $ 17,597  
Unpaid principal balance
     4,793       1,362       11,130       1,086       48       18,419  
Related allowance
     1,834       171       1,142       146       2       3,295  
Average recorded investment
     4,824       1,371       10,788       1,156       49       18,188  
Interest income recognized
     262       64       430       71       2       829  
Total
                                                
Recorded investment
   $ 15,676     $ 8,308     $ 20,476     $ 4,458     $ 48     $ 48,966  
Unpaid principal balance
     19,325       9,535       21,433       4,567       48       54,908  
Related allowance
     1,834       171       1,142       146       2       3,295  
Average recorded investment
     16,971       8,644       20,922       5,264       49       51,850  
Interest income recognized
     672       365       886       341       2       2,266  
                                                 
                                                 
   
December 31, 2011
  
   
Construction &
    
1-4 Family
    
Nonfarm
    
Commercial
                  
   
Land Development
    
Residential
    
Non residential
    
& Industrial
    
Consumer
    
Total
  
With no related allowance recorded
                                                
Recorded investment
   $ 9,767     $ 12,341     $ 20,608     $ 3,759     $ -     $ 46,475  
Unpaid principal balance
     14,686       16,415       22,075       8,096       -       61,272  
Related allowance
     -       -       -       -       -       -  
Average recorded investment
     16,289       15,274       20,822       5,458       -       57,843  
Interest income recognized
     546       521       984       33       -       2,084  
With an allowance recorded
                                                
Recorded investment
   $ 9,314     $ 2,454     $ 3,054     $ 393     $ 51     $ 15,266  
Unpaid principal balance
     10,102       2,476       3,054       396       51       16,079  
Related allowance
     2,152       185       284       110       2       2,733  
Average recorded investment
     10,172       1,891       3,099       377       10       15,549  
Interest income recognized
     354       72       173       12       -       611  
Total
                                                
Recorded investment
   $ 19,081     $ 14,795     $ 23,662     $ 4,152     $ 51     $ 61,741  
Unpaid principal balance
     24,788       18,891       25,129       8,492       51       77,351  
Related allowance
     2,152       185       284       110       2       2,733  
Average recorded investment
     26,461       17,165       23,921       5,835       10       73,392  
Interest income recognized
     900       593       1,157       45       -       2,695  
 
Included in impaired loans, are troubled debt restructurings (TDRs), which totaled $21.8 million at December 31, 2012, of which $4.8 million were accruing interest at that date.  The allowance for loan losses associated with these loans, on the basis of a current evaluation of loss was $220,000.  At December 31, 2011, impaired loans, determined to be TDRs totaled $40.2 million, $15.8 million of which were accruing interest with an associated allowance for loan losses of $313,000.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Troubled Debt Restructurings

The following table summarizes the pre-modification and post-modification balance of troubled debt restructurings at the dates indicated.

(in thousands, except contracts)
                                    
   
At December 31
  
   
2012
    
2011
  
   
Number of
Contracts
    
Pre-Modification Outstanding Recorded Investment
    
Post-Modification Outstanding Recorded Investment
    
Number of
Contracts
    
Pre-Modification Outstanding Recorded Investment
    
Post-Modification Outstanding Recorded Investment
  
                                     
Construction & land development
     9     $ 9,471     $ 6,580       20     $ 10,516     $ 8,275  
1-4 family residential
     23       8,024       6,583       37       16,817       11,825  
Nonfarm, nonresidential
     13       9,089       8,608       24       17,851       17,360  
  Total real estate loans
     45       26,584       21,771       81       45,184       37,460  
Commercial and industrial
     3       142       20       7       4,643       2,655  
Consumer
     1       51       48       1       51       51  
  Total loans
     49     $ 26,777     $ 21,839       89     $ 49,878     $ 40,166  

The following table summarizes, by class, loans that were modified resulting in troubled debt restructurings during the periods indicated.

(in thousands, except contracts)
                                    
   
For the Year Ended December 31
  
   
2012
    
2011
  
   
Number of
Contracts
    
Pre-Modification Outstanding Recorded Investment
    
Post-Modification Outstanding Recorded Investment
    
Number of
Contracts
    
Pre-Modification Outstanding Recorded Investment
    
Post-Modification Outstanding Recorded Investment
  
                                     
Construction & land development
     4     $ 4,331       2,759       18     $ 8,927     $ 7,771  
1-4 family residential
     5       1,776       1,771       32       10,589       9,599  
Nonfarm, nonresidential
     6       2,240       2,187       20       12,290       12,509  
  Total real estate loans
     15       8,347       6,717       70       32,436       29,879  
Commercial and industrial
     1       114       9       5       4,615       2,638  
Consumer
     -       -       -       1       51       51  
  Total loans
     16     $ 8,461     $ 6,726       76     $ 37,102     $ 32,568  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following table summarizes, by type of concession, loans that were modified resulting in troubled debt restructurings during the periods indicated.

(in thousands, except contracts)
                        
   
For the Year Ended December 31
  
   
2012
    
2011
  
   
Number of Contracts
    
Recorded
Investment
  
Number of Contracts
    
Recorded Investment
  
                         
Rate concessions
     -     $ -       -     $ -  
Term concessions
     8       4,203       27       12,191  
Rate and term concessions
     6       1,111       24       12,919  
Total rate or term concessions
     14       5,314       51       25,110  
Foreclosures
     2       1,412       25       7,458  
Total concessions
     16     $ 6,726       76     $ 32,568  

The following table summarizes troubled debt restructurings removed from this classification during the periods indicated.

(in thousands, except contracts)
                        
   
For the Year Ended December 31
  
   
2012
    
2011
  
   
Number of Contracts
    
Recorded
Investment
  
Number of Contracts
    
Recorded Investment
  
                         
Construction & land development
     15     $ 4,052       -     $ -  
1-4 family residential
     19       6,273       -       -  
Nonfarm, nonresidential
     17       10,370       -       -  
  Total real estate loans
     51       20,695       -       -  
Commercial and industrial
     5       2,635       -       -  
  Total loans
     56     $ 23,330       -     $ -  

The following table summarizes, by class, loans modified resulting in troubled debt restructurings within the previous 12-month period for which there was a payment default during the periods indicated.

(in thousands, except contracts)
                        
   
For the Year Ended December 31
  
   
2012
     2011  
   
Number of Contracts
     Recorded Investment    
Number of Contracts
    
Recorded Investment
  
                         
Construction & land development
     2     $ 1,453       5     $ 2,690  
1-4 family residential
     1       155       13       6,308  
Nonfarm, nonresidential
     -       -       5       1,293  
  Total real estate loans
     3       -       23       10,291  
Commercial and industrial
     -       -       1       1,947  
  Total loans
     3     $ 1,608       24     $ 12,238  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The following table provides information about the Bank’s nonperforming assets as of December 31, 2012 and 2011.

Nonperforming Assets
            
(dollars in thousands)
            
   
December 31
  
   
2012
    
2011
  
Nonaccrual loans
   $ 28,565     $ 33,720  
Loans past due 90 or more days and still accruing interest
     -       -  
  Total nonperforming loans
     28,565       33,720  
Foreclosed real estate
     9,821       19,333  
Repossessed assets
     -       1,617  
  Total nonperforming assets
   $ 38,386     $ 54,670  
                 
Allowance for loan losses
   $ 10,690     $ 10,650  
                 
Nonperforming loans to period-end loans,
                
   excluding loans held for sale
     7.37 %     8.05 %
                 
Allowance for loan losses to period-end loans,
                
   excluding loans held for sale
     2.76 %     2.54 %
                 
Nonperforming assets as a percentage of:
                
   Loans, foreclosed real estate, and repossessed assets
     9.66 %     12.43 %
   Total assets
     5.40 %     7.81 %
                 
Ratio of allowance for loan losses to nonperforming loans
     37.4 %     31.6 %
 
Note 6 - Foreclosed Real Estate and Repossessed Assets

The following table shows the composition of foreclosed real estate.

(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Construction & land development
   $ 7,164     $ 8,795  
1-4 family residential
     433       1,477  
Nonfarm, nonresidential
     2,224       9,061  
Balance at end of period
   $ 9,821     $ 19,333  

The following table summarizes the activity in foreclosed real estate for the years ended December 31, 2012 and 2011.

(in thousands)
            
   
For the Year
  
   
2012
    
2011
  
Balance at beginning of year
   $ 19,333     $ 7,314  
Additions from loans
     4,773       11,828  
Additions from investment in real estate partnership
     -       6,356  
Sales
     (13,302 )     (3,088 )
Write-downs
     (983 )     (3,077 )
Balance at end of period
   $ 9,821     $ 19,333  

As of December 31, 2012, the Company had no repossessed assets.  As of December 31, 2011, repossessed assets totaled $1.6 million and were comprised of three aircraft, which were sold in 2012.
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Note 7 - Restricted Equity Securities

The Bank, as a member institution is required to own stock in the Federal Home Loan Bank of Atlanta (FHLB).  No ready market exists for this stock and it has no quoted market value; however, redemption of this stock has historically been at par.  At December 31, 2012 and 2011, the Bank owned $1.1 million and $2.1 million, respectively, in FHLB stock.  Investments in FHLB stock, in excess of the minimum amount required by the FHLB, are redeemed at the discretion of the FHLB.  During 2012, $1.0 million of excess FHLB stock was redeemed, which represented all stock in excess of the minimum amount required.  Also included in restricted equity securities at December 31, 2012 and 2011, was an investment in the Senior Housing Crime Prevention Fund of $500,000, an investment in Pacific Coast Bankers Bank stock of $102,000, and an investment in Capital South Partners, LLC (a Small Business Investment Corporation), which totaled $1.4 million at December 31, 2012, compared to $1.2 million at December 31, 2011.

Note 8 - Investment in Real Estate Partnership

During 2009, the Bank became a member in a limited liability corporation (LLC).  The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time.  The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC.  During 2010, the Bank received $311,000 as reduction of principal from the sale of a sub-parcel of one of the two properties.  As of December 31, 2011, the Bank’s investment in the LLC was $6.4 million and classified as foreclosed real estate.

During the second quarter of 2011, the Bank purchased the interest of the other members of the LLC, for $850,000 in order to begin foreclosure proceedings against the remaining loan in the LLC, the cost of which was included in loan related expense in the 2011 period.  The Company sold this property, with a carrying value of $6.4 million, in the second quarter of 2012 for a gain on sale of $168,000.

Note 9 - Property and Equipment

The following table highlights the components of property and equipment and accumulated depreciation for the years ended
December 31, 2012 and 2011.

(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Premises:
            
     Land and land improvements
   $ 832     $ 816  
     Buildings
     1,602       1,602  
Leasehold improvements
     2,143       2,146  
Furniture and fixtures
     3,730       3,730  
Computer and telecom equipment and software
     1,390       1,190  
Other
     26       26  
Property and equipment, total
     9,723       9,510  
Less accumulated depreciation
     (5,313 )     (4,568 )
Property and equipment
   $ 4,410     $ 4,942  

Depreciation expense was $938,000 for 2012, compared to $1.3 million for 2011.
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Note 10 - Time Deposits

Time deposits totaled $296.3 million at December 31, 2012, compared to $340.0 million at December 31, 2011.  Of that total, time deposits in denominations of $100,000 or more were $151.6 million and $169.3 million at December 31, 2012 and December 31, 2011, respectively.  Interest expense on deposits of $100,000 or more aggregated $2.1 million and $2.6 million for the year ended December 31, 2012 and 2011, respectively.  Time deposits maturing subsequent to December 31, 2012, are as follows:

(in thousands)
      
Maturing in
  
Amount
  
2013
   $ 240,307  
2014
     24,384  
2015
     13,063  
2016
     11,394  
2017
     7,149  
    $ 296,297  
 
At December 31, 2012 and 2011, the Company had $937,000 and $2.6 million, respectively in brokered certificates of deposit.  Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposit), unless it first receives an appropriate waiver from the FDIC.  Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into another certificate.

Note 11 - Borrowings

At December 31, 2012, the Company’s borrowings totaled  $436,000 and consisted solely of securities sold under agreements to repurchase.  At December 31, 2011, the Company’s borrowings consisted of $4.0 million in advances from the  FHLB, all of which were paid off in early 2012, and securities sold under agreements to repurchase of $604,000.  Additional information on borrowings as of December 31, 2012 and 2011 is summarized below:

(dollars in thousands)
            
   
2012
    
2011
  
             
Outstanding balance at December 31
   $ 436     $ 4,557  
                 
Year-end weighted-average rate
     0.21 %     0.48 %
                 
Daily average balance outstanding during the year
   $ 503     $ 4,862  
                 
Weighted-average rate for the period
     0.27 %     0.49 %
                 
Maximum outstanding at any month-end during the year
   $ 588     $ 5,142  

Securities sold under agreements to repurchase are considered overnight secured borrowing arrangements and are collateralized by investment securities.

As of December 31, 2012, the Company had lines of credit from unrelated banks totaling $12 million.  These lines of credit, which are at the lender’s discretion and may be canceled at any time, are available on a one-day basis and are secured by investment securities.  As of December 31, 2012, the Company had no outstanding balances on these lines.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
Note 12 - Leases

As of December 31, 2012, the Company leases office space under non-cancelable operating leases.  Future minimum lease payments required under the leases are as follows:
 
(in thousands)
      
For the
      
Year
  
Amount
  
2013
   $ 647  
2014
     527  
2015
     251  
2016
     189  
2017
     74  
Thereafter
     36  
    $ 1,724  

The leases contain options for renewals after the expiration of the current lease terms.  The cost of such renewals is not included above.
Total rent expense for 2012 and 2011 was $676,000 and $560,000, respectively.

Note 13 - Income Taxes

The following tables present the Company’s current and deferred income tax provision for the years ended December 31, 2012 and 2011.  The Company recorded no income tax expense during 2012, due to the establishment of a full valuation allowance against its deferred tax asset at year-end 2011.
 
The components of income tax expense are as follows:

(in thousands)
                  
   
Current
    
Deferred
    
Total
  
For the year 2012
                  
   Federal
   $ -     $ -     $ -  
   State
     -       -       -  
    $ -     $ -     $ -  
For the year 2011
                        
   Federal
   $ -     $ 7,708     $ 7,708  
   State
     -       1,680       1,680  
    $ -     $ 9,388     $ 9,388  

Reconciliation between the income tax expense and the amount computed by applying the statutory federal income tax rate of 34% to loss before income taxes is as follows:

(in thousands)
            
   
For the Year
  
   
2012
    
2011
  
                 
Tax at statutory federal rate
   $ 432     $ (3,771 )
State income tax (benefit), net of federal expense before valuation allowance
     36       (524 )
Nondeductible employee stock compensation
     -       (13 )
Deferred tax asset valuation allowance change, net
     (337 )     13,960  
Cash surrender value of life insurance
     (127 )     (148 )
Other
     (4 )     (116 )
Income tax expense
   $ -     $ 9,388  
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
The significant components of deferred tax assets and liabilities are summarized as follows:

(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Deferred tax assets
            
Allowance for loan losses
   $ 4,055     $ 4,079  
Pre-opening expenses
     10       11  
Nonqualified stock compensation
     575       575  
Foreclosed real estate
     1,213       2,630  
Net operating loss carryforward
     11,069       10,212  
Credit carryforward
     166       161  
Capital loss carryforward
     85       115  
Other
     481       386  
Deferred loan costs, net
     371       287  
Deferred tax  asset, gross
     18,025       18,456  
Valuation allowance
     (17,646 )     (17,983 )
Deferred tax  asset, net of valuation allowance
     379       473  
                 
Deferred tax liabilities
                
Unrealized gains on securities available for sale
     400       481  
Depreciation
     325       404  
Other
     54       69  
Deferred tax liabilities, gross
     779       954  
Deferred tax asset (liability), net
   $ (400 )   $ (481 )
 
Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value.  A valuation allowance is recognized against deferred tax assets when, based on the consideration of all available evidence using a more likely that not criteria, it is determined that some portion of these tax benefits may not be realized.  This assessment requires consideration of all sources of taxable income available to realize the deferred tax asset including taxable income in prior carryback years, future reversals of existing temporary differences, tax planning strategies and future taxable income exclusive of reversing temporary differences and carryforwards.  The predictability that future taxable income, exclusive of reversing temporary differences, will occur is the most subjective of these four sources.  The presence of cumulative losses in recent years is considered significant negative evidence, making it difficult for a company to rely on future taxable income, exclusive of reversing temporary differences and carryforwards, as a reliable source of taxable income to realize a deferred tax asset.  Judgment is a critical element in making this assessment.

During 2010, the Company reached a three-year cumulative pre-tax loss position and at that time, recorded a partial valuation allowance in the amount of $4.0 million.  During 2011, based upon additional losses and the weighting ascribed to this evidence, the Company determined a full valuation allowance was necessary under the accounting standards and established an allowance totaling $18.0 million to reflect its estimate of net realizable value as of the financial statement date.  As of December 31, 2012, the valuation allowance totaled $17.6 million.
 
Pursuant to accounting pronouncement ASC 740-10, the Company has reviewed its income tax positions and specifically considered the recognition and measurement requirements of the benefits recorded in its financial statements for tax positions taken or expected to be taken in its tax returns.  Based on its evaluation of these tax positions for its open tax years, the Company has not recorded any tax liability or uncertain tax positions as of December 31, 2012 and 2011.  Federal tax returns have been examined by the Internal Revenue Service through 2008.

Note 14 - Retirement Plans

The Company has a 401(k)/Profit Sharing Plan (401(k) Plan), which is available to all full-time employees and part-time employees working more than 1,000 hours per year.  The 401(k) Plan provides that employee contributions are 100% vested at all times.  In 2011, the Company matched employee contributions in an amount equal to 100% of employee contributions, which did not exceed 3% of compensation and 50% of employee contributions over 3% and up to 5% of compensation.  Under the 401(k) Plan, the initial 3% Company matching contribution under the 401(k) Plan was 100% vested at all times.  The additional 2% match under the 401(k) Plan, as well as any discretionary Company contributions under the Profit Sharing Plan, was fully vested after three years.
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
 
In 2011, in an effort to reduce salary and benefit costs, the Company’s matching contributions were suspended.  There were no discretionary contributions made in 2012 or 2011.

The Company also has a supplemental executive retirement plan, which provides certain officers of the Company post-retirement cash payment for 15 years following their normal retirement age, stated to be 62.  Expense related to this Plan totaled $246,000 in 2012, compared to $88,000 in 2011 due to the forfeiture in 2011 of a $169,000 accrued benefit by a former executive officer of the Company.  At December 31, 2012 and 2011, the Company had accrued liabilities of $1.2 million and $1.0 million, respectively, related to this Plan.  The discount rate used by the Company to determine the present value of the normal retirement benefit was 6.17% at December 31, 2012 and 2011.
 
Note 15 - Stock Based Compensation
 
Stock Option Plans

The Employee Stock Option Plan and the Director Stock Option Plan provide up to 497,110 shares (adjusted for all stock splits) of the Company’s common stock may be issued under each of these plans for a combined total of 994,220 shares.  Options granted under the Employee Stock Option Plan and the Director Stock Option Plan may be vested immediately and expire no more than 10 years from date of grant.  The exercise price for any options granted under these plans is set by the Board of Directors at the date of grant (and is adjusted on a pro rata basis for any subsequent stock split).  No options were granted under either the Director Stock Option Plan or the Employee Stock Option Plan in 2012 or 2011.  Forfeited options totaled 2,930 and 92,224 for 2012 and 2011, respectively.  The total number of options outstanding at December 31, 2012 was 497,110 in the Director Stock Option Plan and 193,779 in the Employee Stock Option Plan.

No stock compensation expense was recognized by the Company in 2012 related to the vesting of stock options.  During 2011, $1,000 of stock compensation expense was recognized while separately, $40,000 of stock compensation expense was reversed upon the forfeiture of nonvested stock options.  It is the Company’s policy to issue shares to satisfy option exercises.  There were no options exercised during 2012 or 2011 and as of December 31, 2012, there was no unrecognized compensation cost related to the outstanding stock options.  There is no intrinsic value in the stock options as of December 31, 2012, as the exercise prices are greater than the last traded price of the Company’s common stock.

A summary of the activity in the Company’s Stock Option Plans and related information for 2012 and 2011 is as follows:
                         
   
Outstanding Options
    
Exercisable Options
  
         
Weighted
          
Weighted
  
         
Average
          
Average
  
   
Number
    
Exercise
    
Number
    
Exercise
  
   
Outstanding
    
Price
    
Outstanding
    
Price
  
At December 31, 2010
     786,043     $ 8.42       780,043     $ 8.41  
Options granted
     -       -       -       -  
Options vested
     -       -       -       -  
Restricted stock grants
     -       -       -       -  
Options forfeited
     (92,224 )     9.28       (86,224 )     9.24  
At December 31, 2011
     693,819       8.31       693,819       8.31  
Options granted
     -       -       -       -  
Options vested
     -       -       -       -  
Restricted stock grants
     -       -       -       -  
Options forfeited
     (2,930 )     10.75       (2,930 )     10.75  
At December 31, 2012
     690,889     $ 8.30       690,889     $ 8.30  
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Additional information concerning outstanding options under the Company’s Plans as of December 31, 2012, is as follows:

                       
Weighted Average
  
                 
Average
    
Remaining
  
Exercise
    
Number
    
Number
    
Intrinsic
    
Contractual Life
  
Price
    
Outstanding
    
Exercisable
    
Value
    
(in Years)
  
$ 5.63       457,897       457,897     $ -       1.49  
  13.31       214,686       214,686       -       2.75  
  14.08       12,056       12,056       -       2.49  
  20.60       6,250       6,250       -       2.92  
Total
       690,889       690,889     $ -       1.91  

Service-Based Awards

In 2008, the Company’s stockholders approved the Omnibus Plan, pursuant to which incentive stock options, nonqualified stock options, performance shares, stock appreciation rights, and restricted stock may be granted to officers and employees of the Company and the Bank, and nonqualified stock options and restricted stock awards may be granted to directors of the Company and the Bank.  An additional 250,000 shares of the Company’s common stock was reserved and made available for awards under the Omnibus Plan.  The shares granted generally vest ratably over a period of three or five years.

Nonvested share activity under the Plan for 2012 and 2011 is as follows:

         
Weighted
  
         
Average
  
         
Grant Date
  
   
Shares
    
Fair Value
  
Outstanding at December 31, 2010
     58,165     $ 2.60  
Granted
     86,488       0.38  
Vested
     (13,722 )     2.63  
Forfeited
     (15,000 )     2.15  
Outstanding at December 31, 2011
     115,931       1.00  
Granted
     86,488       0.22  
Vested
     (2,000 )     5.52  
Forfeited
     (40,552 )     0.88  
Outstanding at December 31, 2012
     159,867     $ 0.55  
 
Compensation expense recognized for nonvested service-based shares in 2012 and 2011 totaled $35,000 and $49,000 respectively.  Separately, $36,000 and $12,000 of stock compensation expense was reversed during 2012 and 2011, respectively, upon the forfeiture of nonvested service-based shares.  As of December 31, 2012, there was $17,000 of total unrecognized compensation cost related to service-based nonvested share-based compensation arrangements granted under the Omnibus Plan.  This cost is expected to be recognized over a remaining weighted-average period of 10.8 months.

Note 16 - Contingent Liabilities, Commitments, and Uncertainties
 
Litigation

In the normal course of business, the Company is often involved in various legal proceedings.  Management believes any liability resulting from such proceedings will not be material to the consolidated financial statements.
 
Commitments

Effective October 2008, the Bank entered into an agreement with a third-party to provide data processing services through October 31, 2015, at a monthly charge of approximately $115,000.  The contract stipulates the Company is liable for a penalty in the event of early termination.  The early termination penalty ratably declines as the contract matures.
 
90
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Risks and Uncertainties

In the normal course of its business, the Company encounters numerous risks.  Two of the most significant of these types of risk are economic and regulatory.  There are three main components of economic risk; interest rate risk, credit risk, and market risk.  The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets.  Credit risk is the risk of default on the Company’s loan portfolio that results from borrowers’ inability or unwillingness to make contractually required payments.  Market risk reflects changes in the value of collateral underlying loans receivable, the valuation of real estate held by the Company, and the valuation of loans held for sale and investment securities available for sale.

The Company is subject to the regulations of various governmental agencies.  These regulations can and do change significantly from period to period.  The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances, and operation restrictions, resulting from the regulators’ judgments based on information available to them at the time of their examination.  See Note 2 – Enforcements Actions for discussion of the Consent Order and the Written Agreement entered into by the Bank and the Company, respectively, during 2010.

Financial Instruments with Off-Balance-Sheet-Risk

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheets.  The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments.  A summary of the Company’s commitments are as follows:

(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Commitments to extend credit
   $ 38,762     $ 40,557  
Standby letters of credit
     251       368  
  Total
   $ 39,013     $ 40,925  

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Company evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party.  Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Collateral held varies as specified above, and is required in instances which the Company deems necessary.  Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements.  The Company has not recorded a liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary, as such amounts were not considered material.

Concentrations of Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and amounts due from banks with loans accounting for the most significant risk.
 
91
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily in western North Carolina.  Management does not consider the loan portfolio to be significantly concentrated in loans to any single borrower or a relatively small number of borrowers.  Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly affected by economic conditions.
 
Recently, banking regulators have raised concern and have heightened regulatory scrutiny regarding loan portfolios with concentrations of loans collateralized by real estate, particularly commercial real estate (CRE).  They have defined CRE to include construction loans, acquisition and development loans, loans collateralized with tracts of raw land for speculative purposes, any sort of commercial premise unless it is owner occupied and a number of other subcategories.  Slightly more than 90% of the Bank’s loan portfolio is collateralized by real estate.

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios (LTV).  Regulatory guidelines state that the total amount of all loans in excess of the regulatory loan-to-value ratio limits should not exceed 100% of a bank’s total risk-based capital.  These types of loans totaled $26.8 million at December 31, 2012, representing 111.8% of the Company’s total risk-based capital.

The Company’s investment portfolio consists principally of obligations of the United States, its agencies, government sponsored enterprises and general obligation municipal securities.  In the opinion of management, there is no concentration of credit risk in the Company’s investment portfolio.

The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions.  Management believes credit risk associated with correspondent accounts is not significant.

Note 17 - Stockholders’ Equity

Preferred Stock

In November 2008, under the U.S. Department of the Treasury (U.S. Treasury) TARP Capital Purchase Program (CPP), 1st Financial issued to the U.S. Treasury 16,369 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (Preferred Stock), and a 10-year warrant to purchase up to 276,815 shares of common stock at an exercise price of $8.87 per share (Warrant), for aggregate proceeds of $16,369,000.  The allocated carrying values of the Warrant and the Preferred Stock on the date of issuance (based on their relative fair values) were $1,016,000 and $15,353,000, respectively.  Cumulative dividends on the Preferred Stock are payable at 5% per annum through November 14, 2013, and at a rate of 9% per annum thereafter.  The Preferred Stock will be accreted to the redemption price of $16,369,000 over five years.  The Warrant is exercisable at any time until November 14, 2018, and the number of shares of common stock underlying the Warrant and the exercise price are subject to adjustment for certain dilutive events.

Each share of Preferred Stock issued and outstanding has a liquidation preference of $1,000 and is redeemable at the Company’s option, subject to prior regulatory approval, at a redemption price equal to $1,000 plus accrued and unpaid dividends.

The Preferred Stock has a preference over the Company’s common stock upon liquidation.  Dividends on the Preferred Stock, if declared, are payable quarterly in arrears.  The Company’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event the Company fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period.

Due to insufficient funding at the holding company level and restrictions placed on it under the Consent Order and the Written Agreement, as of December 31, 2012, the Company had deferred the payment of the last 10 quarterly dividends on the Preferred Stock, with the total amount deferred equaling $2.0 million.  The Company subsequently deferred payment of the quarterly dividend in February, 2012.  Until the Company pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.
 
Restriction on Dividends

As a North Carolina banking corporation, the Bank may not pay cash dividends if it is “undercapitalized” (as that term is defined in the Federal Deposit Insurance Act) or would become undercapitalized after making the payment.  Regulatory authorities may further limit payment of dividends when it is determined that such a limitation is in the public interest and is necessary to ensure a bank’s financial soundness.  As discussed in Note 2, the Bank is restricted from paying dividends without the approval of the FDIC and the Commissioner.

As discussed in Note 2, the Company is also restricted from paying dividends without the approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve.
 
92
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory (and possibly additional discretionary) actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the applicable regulations.

As of December 31, 2012, the most recent notification from the Bank’s primary regulator categorized the Bank as “significantly undercapitalized” under the regulatory framework for prompt corrective action.  Since that date, no conditions or events have occurred, of which the Company is aware, that have resulted in a material change in the Company’s or the Bank’s category.

The table below summarizes the Company and the Bank’s capital ratios at December 31, 2012 and 2011:

                           
To be "Well Capitalized"
  
               
For Capital Adequacy
    
Under Prompt Corrective
  
   
Actual
    
Purposes
    
Action Provisions
  
(dollars in thousands)
  
Amount
    
Ratio
    
Amount
    
Ratio
    
Amount
    
Ratio
  
As of December 31, 2012
                                    
Total Capital (to Risk-weighted Assets)
                                    
Company
   $ 24,029       6.11 %   $ 31,438       8.00 %     n/a       n/a  
Bank
     24,014       6.11 %     31,438       8.00 %   $ 39,298       10.00 %
Tier I Capital (to Risk-weighted Assets)
                                                
Company
   $ 19,045       4.85 %   $ 15,719       4.00 %     n/a       n/a  
Bank
     19,030       4.84 %     15,719       4.00 %   $ 23,579       6.00 %
Tier I Capital (to Average Assets)
                                                
Company
   $ 19,045       2.64 %   $ 28,822       4.00 %     n/a       n/a  
Bank
     19,030       2.64 %     28,822       4.00 %   $ 36,028       5.00 %
                                                 
As of December 31, 2011
                                                
Total Capital (to Risk-weighted Assets)
                                                
Company
   $ 23,204       5.41 %   $ 34,328       8.00 %     n/a       n/a  
Bank
     23,219       5.41 %     34,328       8.00 %   $ 42,910       10.00 %
Tier I Capital (to Risk-weighted Assets)
                                                
Company
   $ 17,775       4.14 %   $ 17,164       4.00 %     n/a       n/a  
Bank
     17,790       4.14 %     17,164       4.00 %   $ 25,746       6.00 %
Tier I Capital (to Average Assets)
                                                
Company
   $ 17,775       2.48 %   $ 28,701       4.00 %     n/a       n/a  
Bank
     17,790       2.48 %     28,701       4.00 %   $ 35,876       5.00 %
 
Note 18 - Related Party Transactions

The Company has deposit and loan relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated.  Deposits held at the Bank by directors, executive officers and their associated companies were $3.1 million and $2.8 million at December 31, 2012 and 2011, respectively.  The following is a reconciliation of loans directly outstanding to executive officers, directors and their affiliates.

(in thousands)
            
   
December 31
  
   
2012
    
2011
  
Balance at beginning of year
   $ 13,808     $ 15,788  
New loans and advances
     113       85  
Repayments
     (3,276 )     (2,065 )
Charge-offs
     (719 )     -  
Relationship changes
     (981 )     -  
Balance at end of year
   $ 8,945     $ 13,808  
 
93
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
The Company also enters into other transactions in the ordinary course of business with affiliates.  The following transaction was entered into with an affiliate.

The Company leases the site for its Marion branch from a company of which a director of the Company is a member.  The initial lease term was for five years, with options to renew the lease for up to four successive three-year renewal terms.  The terms of the lease call for a $3,500 per month rental payment during the initial term.  Rental payments for each renewal term will be adjusted by the aggregate increase in the Consumer Price Index for all Urban Consumers for the immediately preceding lease term.  During 2011, the Company exercised its option to renew the lease for three years at the same $3,500 monthly rental amount.  Lease payments under this lease totaled $42,000 in both 2012 and 2011.

Note 19 - Fair Value of Financial Instruments

Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holding of a particular financial instrument.  In cases where quoted market prices are not available, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.  Finally, the fair value estimates presented herein are based on pertinent information available to management as of December 31, 2012 and 2011, respectively.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Noninterest Bearing Bank Deposits, Federal Funds Sold, Interest Bearing Deposits with Banks, and Due from Federal Reserve Banks

The carrying amounts for cash and noninterest bearing bank deposits, federal funds sold, interest bearing deposits with banks and due from Federal Reserve banks approximate fair value because of the short maturities of those instruments.  These instruments are considered cash and cash equivalents.

Investment Securities

Fair values for investment securities are based on quoted market price if such information is available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Investment in Real Estate Partnership

During 2009, the Bank became a member in a limited liability corporation (LLC).  The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time.  The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC.  During 2011, the Bank received $311,000 as reduction of principal from the sale of sub-parcels of one of the two properties.  As of December 31, 2010, the Bank’s investment in the LLC was $6.4 million.

During the second quarter of 2011, the Bank purchased the interest of the other LLC members for $850,000.  This cost was included as other loan and real estate related expense in the Consolidated Statement of Operations.  In late July 2011, the LLC began foreclosure proceedings against the remaining loan in the LLC.  Accordingly, this investment was classified as foreclosed real estate at December 31, 2011.  The Company sold this property, with a carrying value of $6.4 million, in the second quarter of 2012 for a gain on sale of $168,000.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Loans Held for Sale

Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.

Loans

For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics.  The fair value of other types of loans is estimated by discounting the future cash flows using the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Bank Owned Life Insurance

The carrying value of life insurance approximates fair value since this investment is carried at cash surrender value, as determined by the insurer.

Deposits, Short-term Borrowings and Long-term Debt

The fair value of demand deposits and savings accounts is the amount payable on demand at the reporting date.  The fair value of time deposits, short-term borrowings, and long-term debt is estimated based upon the discounted value of projected future cash outflows using the rates currently offered for instruments of similar remaining maturities.

Accrued Interest Receivable and Accrued Interest Payable

The carrying amounts of accrued interest receivable and accrued interest payable are assumed to approximate fair values.

Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value:

Level 1
Valuation can be based on quoted prices in active markets for identical assets or liabilities.
 
Level 2
Valuation can be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active/or models using inputs that are observable or can be corroborated by observable market data of substantially the full term or the assets or liabilities.
 
Level 3
Valuation can be based on using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.

Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holding of a particular financial instrument.  In cases where quoted market prices are not available, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
 
95
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Assets Measured at Fair Value on a Recurring Basis

Fair values for investment securities are based on quoted market price if such information is available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.  Investment securities are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured 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.

Assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011 are as follows:

(in thousands)
                        
    December 31, 2012  
   
December 31 2012
    
Quoted Market Price
in Active Markets
(Level 1)
  
Significant Other
Observable Inputs
(Level 2)
  
Significant
Unobservable Inputs
(Level 3)
  
Available-for-sale securities:
                        
U.S. government agencies
   $ 39,069     $ -     $ 39,069     $ -  
Government-sponsored enterprises
     167,913       -       167,913       -  
Mortgage-backed securities
     46,847       -       46,847       -  
Total
   $ 253,829     $ -     $ 253,829     $ -  
                                 
                                 
      December 31, 2011  
   
December 31 2011
    
Quoted Market Price
in Active Markets
(Level 1)
  
Significant Other
Observable Inputs
(Level 2)
  
Significant
Unobservable Inputs
(Level 3)
  
Available-for-sale securities:
                                
U.S. government agencies
   $ 18,215     $ -     $ 18,215     $ -  
Government-sponsored enterprises
     86,735       -       86,735       -  
Mortgage-backed securities
     90,535       -       90,535       -  
Total
   $ 195,485     $ -     $ 195,485     $ -  
 
The Company had no liabilities carried at fair value or measured at fair value on a recurring basis as of December 31, 2012 or 2011.

Assets Measured at Fair Value on a Nonrecurring Basis

Impaired loans are evaluated and valued at the time the loan is identified as impaired, and are carried at the lower of cost or market value.  Market value is measured based on the value of the collateral securing these loans or net present value of expected future cash flows discounted at the loan’s effective interest rate.  Collateral may be real estate and/or business assets, including equipment, inventory, and/or accounts receivable.  The value of business equipment, inventory, and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis.  Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s selling costs and other expenses.  Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Foreclosed real estate is adjusted to fair value, less estimated carrying costs and costs to sell, upon transfer of the loans to foreclosed real estate.  Subsequently, foreclosed real estate is carried at the lower of the carrying value or the fair value, less estimated carrying costs and costs to sell.  Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral.
 
Mortgage loans held for sale are carried at the lower of cost or fair value.  The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.
 
96
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Assets measured at fair value on a non-recurring basis as of December 31, 2012 and 2011 are as follows:

(in thousands)
                        
    December 31, 2012  
   
December 31
2012
    
Quoted Market Price
in Active Markets
(Level 1)
  
Significant Other
Observable Inputs
(Level 2)
  
Significant
Unobservable Inputs
(Level 3)
  
Impaired loans:
                        
  Construction and land development
   $ 13,842     $ -     $ 13,842     $ -  
  1-4 family residential
     8,137       -       8,137       -  
  Nonfarm, non residential
     19,334       -       19,334       -  
Total impaired real estate loans
     41,313               41,313       -  
  Commercial and industrial
     4,312       -       4,312       -  
  Consumer
     46       -       46       -  
    Total impaired loans
     45,671       -       45,671       -  
Mortgage loans held for sale
     5,805       -       5,805       -  
Foreclosed real estate
     9,821       -       9,821       -  
Total
   $ 61,297     $ -     $ 61,297     $ -  
                                 
                                 
    December 31, 2011  
   
December 31
2011
    
Quoted Market Price
in Active Markets
(Level 1)
  
Significant Other
Observable Inputs
(Level 2)
  
Significant
Unobservable Inputs
(Level 3)
  
Impaired loans:
                                
  Construction and land development
   $ 16,929     $ -     $ 16,929     $ -  
  1-4 family residential
     14,610       -       14,610       -  
  Nonfarm, non residential
     23,378       -       23,378       -  
Total impaired real estate loans
     54,917               54,917          
  Commercial and industrial
     4,042       -       4,042       -  
  Consumer
     49       -       49       -  
    Total impaired loans
     59,008       -       59,008       -  
Mortgage loans held for sale
     8,694       -       8,694       -  
Foreclosed real estate
     19,333       -       19,333       -  
Total
   $ 87,035     $ -     $ 87,035     $ -  
 
The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis as of December 31, 2012, or 2011.

Carrying Amounts and Estimated Fair Value of Financial Assets and Liabilities Not Measured at Fair Value

The following table presents the carrying values and estimated fair values of the Company’s other financial instruments as of the dates indicated, all of which are considered Level 3 fair value estimates.  These fair value estimates are subject to fluctuation based on the amount and timing of expected cash flows as well as the choice of discount rate used in the present value calculation.  This table excludes financial instruments for which the carrying amount approximates fair value.  Since the fair value is estimated as of the balance sheet date, the amounts that will actually be realized or paid upon settlement or maturity of these instruments could be significantly different.  In addition, any income taxes, or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair values presented.
 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
The following table presents the carrying values and estimated fair values of the Company’s financial instruments at December 31, 2012 and 2011.

(in thousands)
                        
   
December 31
  
   
2012
    
2011
  
         
Estimated
          
Estimated
  
   
Carrying
    
Fair
    
Carrying
    
Fair
  
   
Amount
    
Value
    
Amount
    
Value
  
Financial instruments-assets
                        
Loans (1)
   $ 331,296     $ 332,764     $ 349,244     $ 350,401  
Financial instruments-liabilities
                                
Deposits
     683,840       681,389       672,644       669,855  
                                 
(1) includes loans, net, less impaired loans valued based on the underlying collateral
  

The Company is predominantly an asset based lender with real estate serving as collateral on a substantial majority of loans.  Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair values of the underlying real estate collateral.  Such fair values are obtained using independent appraisals, which the Company considers to be level 2 inputs.

Real estate acquired in settlement of loans is adjusted to fair value upon transfer of the loans.  Subsequently, the assets are carried at the lower of carrying value or fair value less costs to sell.  Fair value is based upon independent market prices, fair values of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or current appraised value, the Company records the asset as non-recurring level 2 inputs.

Mortgage loans held for sale are carried at the lower of cost or fair value.  The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics and accordingly, considered non-recurring level 2 inputs.

There were no transfers of assets measured at fair value between Level 1 and Level 2 measurements during the year ended December 31, 2012.

 
 
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
  
Note 20 - Parent Company Financial Information

The following is condensed financial information of 1st Financial Services, Inc. (parent company only).

Condensed Balance Sheets
            
   
December 31
  
   
2012
    
2011
  
Assets
            
Cash and cash equivalents
   $ 45     $ 60  
Investment in banking subsidiary
     19,667       18,557  
Total assets
   $ 19,712     $ 18,617  
                 
Liabilities and Stockholders' Equity
                
Accounts payable and accrued expense
   $ 30     $ 75  
Stockholders' equity
     19,682       18,542  
Total liabilities and stockholders' equity
   $ 19,712     $ 18,617  
                 
                 
Condensed Statements of Income (Loss)
                
   
For the Year
  
      2012       2011  
Income
   $ -     $ -  
Expense
     (2 )     100  
Income (loss) before income taxes and equity in undistributed net income (loss) of subsidiary
     2       (100 )
Income tax benefit
     -       (63 )
Income (loss) before equity in undistributed net income (loss) of subsidiary
     2       (37 )
Equity in undistributed net income (loss) of banking subsidiary
     1,268       (20,442 )
Net income (loss)
   $ 1,270     $ (20,479 )
                 
                 
Condensed Statements of Cash Flows
                
   
For the Year
  
      2012       2011  
Cash Flows From Operating Activities
                
Net income (loss)
   $ 1,270     $ (20,479 )
Adjustments to reconcile net income (loss) to net cash provided (used) for operating activities
                
    Equity in undistributed net income(loss) of banking subsidiary
     (1,268 )     20,442  
    Net change in other assets
     -       68  
    Net change in other liabilities
     (45 )     (4 )
      Net cash provided by (used in) operating activities
     (43 )     27  
                 
Cash Flows From Investing Activities
                
Payment from subsidiary
     28       -  
      Net cash provided by investing activities
     28       -  
                 
Cash Flows From Financing Activities
                
     Net cash provided by financing activities
     -       -  
     Net increase (decrease) in cash and cash equivalents
     (15 )     27  
                 
Cash and cash equivalents, beginning of year
     60       33  
Cash and cash equivalents, end of year
   $ 45     $ 60  
 

Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our principal executive and principal financial officer, has concluded based on its evaluation as of the end of the period covered by this report, that our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) are effective to ensure that information required to be disclosed by 1st Financial in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting for 1st Financial.  Our internal control over financial reporting is a process designed under the supervision of our principal executive and principal financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.  Management has made a comprehensive review, evaluation, and assessment of our internal control over financial reporting as of December 31, 2012.  In making its assessment of internal control over financial reporting, management used the criteria issued by the Committee of  Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control— Integrated Framework.  Based on the evaluation, management determined that there were no material weaknesses in internal control and concluded that internal control over financial reporting for 1st Financial as of December 31, 2012, is effective.

In accordance with Section 404 of the Sarbanes-Oxley of 2002, management makes the following assertions:

●
Management has implemented a process to monitor and assess both the design and operating effectiveness of internal control over financial reporting.

●
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this Annual Report on Form 10-K.

Changes In Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting that occurred during the fourth quarter of 2012 that has materially affected or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
PART III
 
 
Directors and Executive Officers.  The information regarding our directors and executive officers is incorporated by reference from the information under the headings "Proposal 1: Election of Directors” and “Executive Officers" in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Audit Committee.  Information regarding our audit committee is incorporated by reference from the information under the captions “Committees of Our Board – General” and “Audit Committee” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Audit Committee Financial Expert.  Information about our Board of Directors' determination as to whether the Company has a financial expert serving on its audit committee is incorporated by reference from the information under the caption "Committees of Our Board –– Audit Committee –– Audit Committee Financial Expert" in our definitive proxy statement to be distributed in connection with our 2013 annual meeting of stockholders.

Section 16(a) Beneficial Ownership Reporting Compliance. Information regarding compliance by our directors, executive officers and principal stockholders with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference from the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Code of Ethics.  Our Board of Directors has adopted a Code of Ethics that applies to the Company's directors and to all our executive officers, including without limitation, our chief executive officer and principal accounting officer.  A copy will be provided without charge to any person upon request.  Requests for copies should be directed by mail to Janet King, Corporate Secretary at 101 Jack Street, Hendersonville, North Carolina 28792, or by telephone to (828) 697-3100.

Information regarding compensation paid or provided to our executive officers and directors is incorporated by reference from the information under the headings “Executive Compensation,” and “Director Compensation” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Beneficial Ownership of Securities.  Information regarding the beneficial ownership of our common stock by our directors, executive officers and principal stockholders is incorporated by reference from the information under the caption “Beneficial Ownership of Our Common Stock” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Securities Authorized for Issuance Under Equity Compensation Plans.  Information regarding securities authorized for issuance under our equity compensation plans is incorporated by reference from Item 5.

Information regarding transactions between us and our directors and executive officers is incorporated by reference from the information under the caption  “Transactions with Related Persons” of our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

Information regarding our independent directors is incorporated by reference from the information under the caption “Corporate Governance – Director Independence” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.

The information required by this Item is incorporated by reference from the information under the caption “Services and Fees During 2012 and 2011” in our definitive Proxy Statement to be distributed in connection with our 2013 annual meeting of stockholders.
 
 
PART IV

(a)  
Financial statements.  The following financial statements are included in Item 8 of this Report:

●  
Reports of Independent Registered Public Accounting Firms
●  
Consolidated Balance Sheets as of December 31, 2012 and 2011
●  
Consolidated Statements of Operations for the Years Ended December 31, 2012 and 2011
●  
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2012 and 2011
●  
Consolidated Statements of Changes in Stockholders’ Equity Ended December 31, 2012 and 2011
●  
Consolidated Statements of Cash Flows for the Years Ended December 31, 2012 and 2011
●  
Notes to Financial Statements – December 31, 2012 and 2011

(b)  
Exhibits.  An exhibit index listing exhibits that are being filed or furnished with, or incorporated by reference into, this Report appears immediately following the signature page and is incorporated herein by reference.

(c)  
Financial statement schedules.  No separate financial statement schedules are being filed as all required schedules either are not applicable or are contained in the financial statements listed above or in Item 7 of this Report.
 
 


In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
  1st FINANCIAL SERVICES CORPORATION  
       
Date: March 4, 2013
By:
/s/ Michael G. Mayer  
    Michael G. Mayer  
    Chief Executive Officer  
 
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature
  
Title
  
Date
         
/s/ Michael G. Mayer
  
Director and Chief Executive Officer (Principal Executive Officer)
  
March 4, 2013
Michael G. Mayer        
         
/s/ Holly L. Schreiber
  
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
  
March 4, 2013
Holly L. Schreiber
        
         
/s/ Mary K. Dopko
  
Senior Vice President and Controller (Principal Accounting Officer)
  
March 4, 2013
Mary K. Dopko        
         
/s/ Bradley B. Schnyder
  
Director
  
March 4, 2013
Bradley B. Schnyder
        
         
/s/ William H. Burton
  
Chairman and Director
  
March 4, 2013
William H. Burton
        
         
/s/ Michael D. Foster
  
Director
  
March 4, 2013
Michael D. Foster
        
         
/s/ Van F. Phillips
  
Director
  
March 4, 2013
Van F. Phillips
        
         
/s/ Vincent K. Rees
  
President and Director
  
March 4, 2013
Vincent K. Rees
        
 
 
 
Exhibit
Number
  
 
Description
     
3.01
  
Registrant’s Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.01 to the Annual Report on Form 10-K filed with the SEC on March 27, 2009)
     
3.02
  
Registrant’s Bylaws, as amended (incorporated herein by reference to Exhibit 3.02 the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
3.03    Articles of Amendment (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K filed with the SEC on June 17, 2010)
     
4.01
  
Form of Certificate for the Series A Preferred Stock (incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K filed with the SEC on November 18, 2008)
     
4.02
  
Warrant dated November 14, 2008, for the purchase of shares of Common Stock (incorporated by reference to Exhibit 4.2 to the Current Report on Form 8-K filed with the SEC on November 18, 2008)
     
10.01*
  
Split Dollar Insurance Plan, Election Form, and Policy Endorsement between the Bank and Mary K. Dopko (incorporated herein by reference to Exhibit 10.11 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.02*
  
Salary Continuation Agreement between the Bank and Vincent K. Rees (incorporated herein by reference to Exhibit 10.13 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.03*
  
Salary Continuation Agreement between the Bank and Peggy H. Denny (incorporated herein by reference to Exhibit 10.14 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.04*
  
2004 Employee Stock Option Plan (incorporated herein by reference to Exhibit 10.17 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.05*
  
Amendment No. 1 to the 2004 Employee Stock Option Plan (incorporated herein by reference to Exhibit 10.18 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.06*
  
Form of Employee Stock Option Agreement relative to the 2004 Employee Stock Option Plan (incorporated herein by reference to Exhibit 10.19 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.07*
  
2004 Director Stock Option Plan (incorporated herein by reference to Exhibit 10.20 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.08*
  
Amendment No. 1 to 2004 Director Stock Option Plan (incorporated herein by reference to Exhibit 10.21 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.09*
  
Form of Director Stock Option Agreement relative to 2004 Director Stock Option Plan (incorporated herein by reference to Exhibit 10.22 to the Current Report on Form 8-K filed with the SEC on May 30, 2008)
     
10.10*
  
2008 Omnibus Equity Plan (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on August 1, 2008)
     
10.11*
  
2008 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K filed with the SEC on August 1, 2008)
     
10.12*
  
Form of Indemnification Agreement by and between the Registrant and each of its directors, and one of its officers, Peggy H. Denny (incorporated by reference to Exhibit 10(xv) to the Current Report on Form 8-K filed with the SEC on August 1, 2008)
 
 
10.13*
  
Employment Agreement between Registrant and the Bank, and Peggy H. Denny (incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K filed with the SEC on November 18, 2008)
     
10.14*
  
Employment Agreement between Registrant and the Bank, and Vincent K. Rees (incorporated by reference to Exhibit 10.5 to the Current Report on Form 8-K filed with the SEC on November 18, 2008)
     
10.15
  
Letter Agreement dated November 14, 2008, between the Registrant and the United States Department of the Treasury (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on November 18, 2008)
     
10.16*
  
Amended Endorsement Split Dollar Agreement between the Bank and Vincent K. Rees (incorporated by reference to Exhibit 10.4 to the Current Report on Form 8-K filed with the SEC on February 2, 2009)
     
10.17*
  
Amended Endorsement Split Dollar Agreement between the Bank and Peggy H. Denny (incorporated by reference to Exhibit 10.6 to the Current Report on Form 8-K filed with the SEC on February 2, 2009)
     
10.18
  
Stipulation to the Issuance of a Consent Order between the Bank, and the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks (incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed with the SEC on March 3, 2010)
     
10.19
  
Lease agreement dated December 15, 2005, between the Bank and Great Meadows, Inc. with which Director Van F. Phillips is a principal officer and which relates to the Bank’s Marion branch office (incorporated by reference to Exhibit 10.31 to the Annual Report on Form 10-K filed with the SEC on March 30, 2010)
     
10.20*
  
Employment Agreement between Registrant and the Bank, and Holly L. Schreiber (incorporated by reference to Exhibit 99.1 to the Current Report on Form 8-K filed with the SEC on May 5, 2010)
     
10.21
  
Stipulation and Consent to the Issuance of an Order to Pay Civil Money Penalty and Order to Pay a Civil Money Penalty (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on November 8, 2010)
     
10.22
  
Written Agreement between the Company and the Federal Reserve Bank of Richmond (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on October 25, 2010)
     
21.01
  
List of Subsidiaries (filed herewith)
     
23.01
  
Consent of Elliott Davis PLLC (filed herewith)
     
31.01
  
Rule 13a-14(a)/15(d)-14(a) Certification by Michael G. Mayer (filed herewith)
     
31.02
  
Rule 13a-14(a)/15(d)-14(a) Certification by Holly L. Schreiber (filed herewith)
     
32.01
  
Rule 1350 Certifications (filed herewith)
     
99.01
  
Certification Pursuant to the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009 (filed herewith)
     
101   The following materials from the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, formatted in eXtensible Business Reporting Language (XBRL); (i) the Consolidated Balance Sheets at December 31, 2012 and December 31, 2011, (ii) Consolidated Statements of Income (Loss) for the years ended December 31, 2012 and 2011, (iii) Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2012 and 2011, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2012 and 2011, and (iv) Notes to Consolidated Financial Statements**.

*management contracts and compensatory arrangements
 
** Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
 
 
105