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ASB BANCORP INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The objective of this section is to help readers understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and the notes to consolidated financial statements that appear at the end of this annual report. 32 -------------------------------------------------------------------------------- Table of Contents Operating Strategy Our primary objective is to operate and grow a profitable community-oriented financial institution serving customers in our primary market areas. We seek to achieve this through the adoption of a business strategy to provide superior financial services to help our customers and communities prosper by focusing on our core values while achieving sustainable profitability and reasonable returns for our stockholders. We plan to continue our focus on loan growth in 2014. In recent years, we hired senior management with substantial experience in consumer and commercial banking to help us diversify our product offerings and expand our consumer and commercial deposit and lending products, while maintaining high asset quality standards. Our operating strategies include the following: • continue to provide competitive products, services and pricing to individuals and businesses in the communities served by our branch offices; • profitable growth of our residential mortgage banking; • profitable growth of our commercial and industrial lending activities and small business relationships; and • increase efficiencies and productivity bank wide. Continue to provide competitive products, services and pricing to individuals and businesses in the communities served by our branch offices. We have continually operated as a community-oriented financial institution since we were established in 1936. We are committed to meeting the financial needs of the communities in which we operate, and we are dedicated to providing quality personal service to our customers. We provide a broad range of consumer and business financial services through our network of banking center offices. As we continue to refine our information technology, infrastructure and operations to support business growth, we will remain steadfast in our pursuit of ways to become a highly efficient bank with an emphasis on managing costs while providing more innovative, productive ways of doing business. Profitable growth of our residential mortgage banking. Residential mortgage lending remains an important part of our lending activities. We originate fixed and adjustable-rate residential mortgage loans that are retained in our loan portfolio. However, most of the fixed-rate residential mortgage loans that we originate are sold into the secondary market with servicing released as part of our efforts to reduce our interest rate risk. At December 31, 2013, residential mortgage loans totaled $161.4 million, or 35.9% of our total loan portfolio. Profitable growth of our commercial and industrial lending activities and small business relationships. We intend to expand our commercial and industrial lending activities and to originate an increased number of small business loans. Management has hired additional experienced lending officers and credit management personnel over the past several years in order to continue to safely manage this type of lending. Commercial and industrial lending has increased recently as we have managed our problem loans and experienced higher loan demand. Our goal is to increase this portion of our portfolio using conservative underwriting practices to increase the yield in our loan portfolio. Also, our focus on creating a full relationship with clients has enhanced our value proposition and contributed to growth in business services and deposit activities. 33 -------------------------------------------------------------------------------- Table of Contents Increase efficiencies and productivity bank wide. We seek to increase our profitability by improving efficiencies and productivity throughout the Bank. This necessitates right-sizing the Bank's cost structure for revenue growth by allocating resources in alignment with our strategic priorities. This will require a laser-like focus that must be embedded in the culture of the Bank, having infrastructure, processes, procedures, technology and the like that makes it easier, simpler, faster and less expensive to conduct business. We plan to evaluate the Bank's processes, policies, and technology to make it easy for the customer to do business with the Bank - simpler, faster and easier. This includes facilitating our teams' abilities to recognize opportunities, delivering on commitments to customers and aligning our overall cost structure with our operating revenues. Overview Income. Our primary source of pre-tax income is net interest income. Net interest income is the difference between interest income, which is the income that we earn on our loans and securities, and interest expense, which is the interest that we pay on our deposits and borrowings. Other significant sources of pre-tax income are deposit and other service charge income, mortgage banking income derived from the sale of loans in the secondary market, income from debit card services, and income from the sale of securities. Allowance for Loan Losses. The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio. We evaluate the need to establish allowances against losses on loans on a monthly basis. When additional allowances are necessary, a provision for loan losses is charged to earnings. Expenses. The noninterest expense we incur in operating our business consists of salaries and employee benefits expenses, occupancy expenses, federal deposit insurance premiums and assessments, data processing expenses and various other miscellaneous expenses. Our noninterest expenses also include expenses related to shareholder communications and meetings, stock exchange listing fees, the employee stock ownership plan, stock compensation plans, and legal and accounting services. Salaries and employee benefits expenses consist primarily of salaries, wages and bonuses paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. We recognized additional employee compensation expenses during 2013 stemming from our adoption of equity-based benefit plans. See note 11 in the notes to consolidated financial statements included in this annual report for the amount of future compensation expense to be recognized on the shares of common stock granted under these plans. Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of depreciation charges, rental expenses, furniture and equipment expenses, maintenance, real estate taxes and costs of utilities. Depreciation of premises and equipment is computed using the straight-line method based on the useful lives of the related assets, which range from three to forty years. Data processing expenses are the fees we pay to third parties for processing customer information, deposits and loans. Federal deposit insurance premiums and assessments are payments we make to the Federal Deposit Insurance Corporation for insurance of our deposit accounts. Other expenses include expenses for professional services, advertising, office supplies, postage, telephone, foreclosed properties, insurance and other miscellaneous operating expenses. 34 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. The following represent our critical accounting policies: Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to earnings. Management's estimates of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: loss exposure at default; the amount and timing of future cash flows on impaired loans; value of collateral; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance monthly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks, as an integral part of their examination process, periodically review our allowance for loan losses and may require us to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect our earnings. See notes 1 and 4 included in the notes to consolidated financial statements included in this annual report. Fair Value of Investments. Securities are characterized as available for sale or held to maturity based on management's ability and intent regarding such investment at acquisition. On an ongoing basis, management estimates the fair value of its investment securities based on information and assumptions it deems reliable and reasonable, which may be quoted market prices or if quoted market prices are not available, fair values extrapolated from the quoted prices of similar instruments. Based on this information, an assessment must be made as to whether any decline in the fair value of an investment security should be considered as an other than temporary impairment and recorded in noninterest income as a loss on investments. The determination of such impairment is subject to a variety of factors, including management's judgment and experience. See notes 2 and 13 of the notes to the consolidated financial statements included in this annual report. Foreclosed Real Estate. The Company's valuations of its foreclosed real estate involve significant judgments and assumptions by management, which have a material impact on the reported values of foreclosed real estate assets and noninterest expense recorded in the financial statements. The judgments and assumptions used by management are described in "Foreclosed Real Estate" under note 1 of the notes to the consolidated financial statements included in this annual report. 35 -------------------------------------------------------------------------------- Table of Contents Pension Plan. The Company has a noncontributory defined benefit pension plan. This plan is accounted for under the provisions of ASC Topic 715: Compensation-Retirement Benefits, which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status of a benefit plan is measured as the difference between plan assets at fair value and the benefit obligation. For a pension plan, the benefit obligation is the projected benefit obligation. ASC Topic 715 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. Management must make certain estimates and assumptions when determining the projected benefit obligation. These estimates and assumptions include the expected return on plan assets, the rate of compensation increases over time, and the appropriate discount rate to be used in determining the present value of the obligation. See note 11 of the notes to the consolidated financial statements included in this annual report. Comparison of Financial Condition at December 31, 2013 and December 31, 2012 General. Total assets decreased $16.3 million, or 2.2%, to $733.0 million at December 31, 2013 from $749.4 million at December 31, 2012. Investment securities decreased $53.8 million, or 22.1%, to $189.6 million at December 31, 2013 from $243.4 million at December 31, 2012, primarily due to the sale of investment securities to fund loan growth. Loans receivable, net of deferred fees, increased $61.5 million, or 15.9%, to $449.2 million at December 31, 2013 from $387.7 million at December 31, 2012 as new loan originations exceeded loan repayments, prepayments, and foreclosures. Of the $61.5 million increase in loans receivable at December 31, 2013, $43.6 million were in commercial mortgages that were at fixed rates, the majority of which carry five-year to seven-year calls allowing for re-pricing opportunities. Loans. Loan originations totaled $313.1 million for the year ended December 31, 2013 compared to $207.4 million for the year ended December 31, 2012. Residential mortgage loan originations, largely from residential purchase transactions, totaled $120.6 million in 2013 compared to $110.7 million in 2012, while residential construction and land development loan originations totaled $21.9 million in 2013 compared to $11.0 million in 2012. Originations of commercial mortgage, commercial construction and land development, and commercial and industrial loans totaled $102.3 million, $14.8 million and $9.7million, respectively, for the year ended December 31, 2013 compared to $61.9 million, $1.1 million and $5.9 million, respectively, for the year ended December 31, 2012. Revolving mortgage originations totaled $18.7 million in 2013 compared to $7.1 million in 2012, while consumer loan originations totaled $25.2 million in 2013 compared to $9.8 million in 2012. The increase in consumer loan originations mostly attributable to indirect automobile financing through local automobile dealers. Origination activity was significantly offset by $150.0 million of normal loan repayments and prepayments and $105.8 million in loan sales for the year ended December 31, 2013, compared to $139.9 million and $91.0 million, respectively, for the year ended December 31, 2012. 36 -------------------------------------------------------------------------------- Table of Contents Loan Portfolio Composition The following table sets forth the composition of our loan portfolio at the dates indicated. December 31, 2013 2012 2011 (dollars in thousands) Amount Percent Amount Percent Amount Percent Commercial: Commercial mortgage $ 171,993 38.23 % $ 138,804 35.76 % $ 139,947 32.30 % Commercial construction and land development 15,593 3.47 % 5,161 1.34 % 22,375 5.17 % Commercial and industrial 14,770 3.28 % 11,093 2.86 % 17,540 4.05 % Total 202,356 44.98 % 155,058 39.96 % 179,862 41.52 % Non-commercial: Residential mortgage 161,437 35.89 % 163,571 42.14 % 175,866 40.59 % Residential construction and land development 8,759 1.95 % 3,729 0.96 % 3,907 0.90 % Revolving mortgage 49,561 11.02 % 48,221 12.42 % 51,044 11.78 % Consumer 27,719 6.16 % 17,552 4.52 % 22,588 5.21 % Total 247,476 55.02 % 233,073 60.04 % 253,405 58.48 % Total loans 449,832 100.00 % 388,131 100.00 % 433,267 100.00 % Less: Net deferred loan origination fees 598 410 384 Less: Allowance for loan losses 7,307 8,513 10,627 Loans receivable, net $ 441,927 $ 379,208 $ 422,256 December 31, 2010 2009 (dollars in thousands) Amount Percent Amount Percent Commercial: Commercial mortgage $ 164,553 32.88 % $ 197,239 32.98 % Commercial construction and land development 28,473 5.69 % 30,158 5.04 % Commercial and industrial 17,656 3.53 % 22,794 3.81 % Total 210,682 42.10 % 250,191 41.83 % Non-commercial: Residential mortgage 180,439 36.06 % 190,965 31.93 % Residential construction and land development 8,670 1.73 % 15,141 2.53 % Revolving mortgage 53,432 10.68 % 55,038 9.20 % Consumer 47,212 9.43 % 86,768 14.51 % Total 289,753 57.90 % 347,912 58.17 % Total loans 500,435 100.00 % 598,103 100.00 % Less: Net deferred loan origination fees 432 502 Less: Allowance for loan losses 12,676 8,994 Loans receivable, net $ 487,327 $ 588,607 37-------------------------------------------------------------------------------- Table of Contents Loan Portfolio Maturities The following tables set forth certain information at December 31, 2013 regarding the dollar amount of loan principal repayments becoming due during the periods indicated. The tables do not include any estimate of prepayments that significantly shorten the average life of our loans and may cause our actual repayment experience to differ from that shown below. Demand loans, which are loans having no stated schedule of repayments and no stated maturity, are reported as due in one year or less. December 31, 2013 Commercial Construction Commercial Commercial and Land and Total (in thousands) Mortgages Development Industrial Commercial Amounts due in: One year or less $ 20,687 $ 1,184 $ 3,112 $ 24,983 More than one year through two years 12,461 6,667 464 19,592 More than two years through three years 13,360 952 1,302 15,614 More than three years through five years 76,034 1,036 6,201 83,271 More than five years through ten years 38,951 5,717 3,568 48,236 More than ten years through fifteen years 10,500 37 - 10,537 More than fifteen years - - 123 123 Total $ 171,993 $ 15,593 $ 14,770 $ 202,356 December 31, 2013 Residential Construction Residential and Land Revolving Total Non- Total (in thousands) Mortgages Development Mortgages Consumer Commercial Loans Amounts due in: One year or less $ 656 $ 213 $ 266 $ 1,219 $ 2,354 $ 27,337 More than one year through two years 2,326 - 197 1,375 3,898 23,490 More than two years through three years 1,762 - 651 856 3,269 18,883 More than three years through five years 12,204 - 2,986 8,953 24,143 107,414 More than five years through ten years 6,820 - 30,425 14,688 51,933 100,169 More than ten years through fifteen years 14,265 - 15,036 - 29,301 39,838 More than fifteen years 123,404 8,546 - 628 132,578 132,701 Total $ 161,437 $ 8,759 $ 49,561 $ 27,719 $ 247,476 $ 449,832 38-------------------------------------------------------------------------------- Table of Contents Fixed vs. Adjustable Rate Loans The following table sets forth the dollar amount of all loans at December 31, 2013 that have contractual maturities after December 31, 2014 and have either fixed interest rates or floating or adjustable interest rates. The amounts shown below exclude unearned loan origination fees. Due After December 31, 2014 Floating or Fixed Adjustable (in thousands) Rates Rates Total Commercial: Commercial mortgage $ 105,616 $ 45,690 $ 151,306 Commercial construction and land development 3,023 11,386 14,409 Commercial and industrial 7,447 4,211 11,658 Total commercial 116,086 61,287 177,373 Non-commercial: Residential mortgage 73,042 87,739 160,781 Residential construction and land development 2,303 6,243 8,546 Revolving mortgage 44 49,251 49,295 Consumer 26,500 - 26,500 Total non-commercial 101,889 143,233 245,122 Total loans receivable $ 217,975 $ 204,520 $ 422,495 Some of our adjustable rate loans contain rate floors that are equal to the initial interest rate on the loan. When market interest rates fall below the rate floor loan rates do not adjust further downward. As market interest rates rise in the future, the interest rates on these loans may rise based on the contract rate (index plus the margin) exceeding the initial interest rate floor; however, contract interest rates will only increase when the index plus margin exceed the imposed rate floor. 39 -------------------------------------------------------------------------------- Table of Contents Loan Activity The following table shows loans originated, purchased and sold during the periods indicated, including residential mortgage loans intended for sale in the secondary market. Year Ended December 31, (in thousands) 2013 2012 2011 2010 2009 Total loans at beginning of period $ 388,967 $ 428,846 $ 495,713 $ 592,497 $ 586,618 Loans originated: Commercial: Commercial mortgage 102,280 61,910 32,688 43,547 74,382 Construction and land development 14,772 1,050 1,068 - - Commercial and industrial 9,698 5,853 7,199 7,737 10,742 Non-commercial: Residential mortgage 120,555 110,682 81,705 121,439 131,017 Construction and land development 21,913 10,986 10,734 15,845 12,142 Revolving mortgage 18,683 7,107 6,385 7,966 20,524 Consumer 25,237 9,830 483 523 26,248 Total loans originated 313,138 207,418 140,262 197,057 275,055 Loans purchased: Commercial: Commercial mortgage 55 2,909 125 2,191 6,209 Construction and land development - - 560 41 - Total loans purchased 55 2,909 685 2,232 6,209 Total loans originated and purchased 313,193 210,327 140,947 199,289 281,264 Deduct: Loan principal repayments 150,027 139,879 131,393 163,910 151,368 Loan sales 105,849 90,955 68,850 97,103 116,352 Foreclosed loans transferred to foreclosed properties 708 17,464 3,533 12,585 2,968 Charge-offs 525 3,995 6,134 18,863 2,193 Deductions (additions) for other items (1) (1,018 ) (2,087 ) (2,096 ) 3,612 2,504 Net loan activity during the period 57,102 (39,879 ) (66,867 ) (96,784 ) 5,879 Total loans at end of period $ 446,069 $ 388,967 $ 428,846 $ 495,713 $ 592,497 -------------------------------------------------------------------------------- (1) Other items consist of deferred loan fees, the allowance for loan losses and loans in process. Loan originations come from a number of sources. The primary sources of loan originations are existing customers, walk-in traffic, advertising and referrals from customers. We generally sell in the secondary market long-term fixed-rate residential mortgage loans that we originate. Our decision to sell loans is based on prevailing market interest rate conditions, interest rate management and liquidity needs. 40 -------------------------------------------------------------------------------- Table of Contents Investment Security Portfolio At December 31, 2013, our securities portfolio consisted of mortgage-backed securities issued by Freddie Mac, Fannie Mae and Ginnie Mae, securities of U.S. government agencies and corporations, securities of various government sponsored entities and securities of state and local governments. Our securities portfolio is used to invest excess funds for increased yield, manage interest rate risk and as collateralization for public unit deposits. At December 31, 2013, our securities portfolio represented 25.9% of total assets, compared to 32.5% at December 31, 2012, primarily due to a $61.5 million increase in loans receivable to $449.2 million at December 31, 2013. Securities classified as available for sale were $185.3 million of our securities portfolio at December 31, 2013, while $4.2 million of our securities portfolio was classified as held to maturity. Securities classified as held to maturity are United States government sponsored entity, mortgage-backed and state and local government securities. In addition, at December 31, 2013, we had $3.1 million of other investments held at cost, which consisted solely of Federal Home Loan Bank of Atlanta common stock. Securities decreased by $53.8 million, or 22.1%, to $189.6 million at December 31, 2013 from $243.4 million at December 31, 2012. The following table sets forth the amortized costs and fair values of our investment securities at the dates indicated. For all periods presented, our mortgage-backed and related securities did not include any private label issues or real estate mortgage investment conduits, but do include securities backed by the U.S. Small Business Administration ("SBA"). December 31, 2013 2012 2011 Amortized Fair Amortized Fair Amortized Fair (dollars in thousands) Cost Value Cost Value Cost Value Securities available for sale: U.S. government agencies and corporations $ 3,532 $ 3,449 $ 12,025 $ 12,247 $ 41,305 $ 42,367 Mortgage-backed and similar securities 129,712 128,538 174,686 177,098 186,011 188,870 State and local government 56,089 52,629 48,183 48,652 11,359 11,914 Other equity securities 728 713 711 739 689 712 Total available for sale 190,061 185,329 235,605 238,736 239,364 243,863 Securities held to maturity: U.S. government agencies and corporations 1,052 1,154 1,065 1,209 1,078 1,218 Mortgage-backed and similar securities 765 815 1,166 1,249 1,726 1,847 State and local government 2,424 2,563 2,418 2,724 2,414 2,688 Total held to maturity 4,241 4,532 4,649 5,182 5,218 5,753 Total securities $ 194,302 $ 189,861 $ 240,254 $ 243,918 $ 244,582 $ 249,616 41 -------------------------------------------------------------------------------- Table of Contents The following table sets forth the stated maturities and weighted average yields of investment securities at December 31, 2013. Weighted average yields on tax-exempt securities are presented on a taxable equivalent basis using a federal marginal tax rate of 34%. Certain mortgage-backed securities have adjustable interest rates and will reprice annually within the various maturity ranges. These repricing schedules are not reflected in the table below. Weighted average yield calculations on investments available for sale do not give effect to changes in fair value that are reflected as a component of equity. More than One Year More than Five Years One Year or Less To Five Years To Ten Years Weighted Weighted Weighted Carrying Average Carrying Average Carrying Average (dollars in thousands) Value (1) Yield Value (1) Yield Value (1) Yield Securities available for sale: U.S. government agencies and corporations $ 323 1.94 % $ 2,030 1.16 % $ 1,097 1.62 % Mortgage-backed and similar securities 46 4.01 % 3,410 1.04 % 18,027 1.62 % State and local government - 0.00 % - 0.00 % 10,688 2.70 % Total available for sale 369 2.20 % 5,440 1.08 % 29,812 2.01 % Securities held to maturity: U.S. government agencies and corporations - 0.00 % 1,052 3.98 % - 0.00 % Mortgage-backed and similar securities - 0.00 % 430 4.53 % 335 4.91 % State and local government - 0.00 % - 0.00 % 956 5.56 % Total held to maturity - 0.00 % 1,482 4.14 % 1,291 5.39 % Total securities $ 369 2.20 % $ 6,922 1.74 % $ 31,103 2.15 % More than Ten Years Total Weighted Weighted Carrying Average Carrying Average (dollars in thousands) Value (1) Yield Value (1) Yield Securities available for sale: U.S. government agencies and corporations $ - 0.00 % $ 3,450 1.38 % Mortgage-backed and similar securities 107,055 1.41 % 128,538 1.43 % State and local government 41,940 3.39 % 52,628 3.25 % Other equity securities 713 0.00 % 713 0.00 % Total available for sale 149,708 1.96 % 185,329 1.94 % Securities held to maturity: U.S. government agencies and corporations - 0.00 % 1,052 3.98 % Mortgage-backed and similar securities - 0.00 % 765 4.70 % State and local government 1,468 5.43 % 2,424 5.48 % Total held to maturity 1,468 5.43 % 4,241 4.97 % Total securities $ 151,176 1.99 % $ 189,570 2.01 % (1) Carrying value is fair value for securities available for sale and amortized cost for securities held to maturity. 42 -------------------------------------------------------------------------------- Table of Contents Deposits We accept deposits primarily from individuals and businesses who are located in our primary market area or who have a preexisting lending relationship with us. We rely on competitive pricing, customer service, account features and the location of our branch offices to attract and retain deposits. Deposits serve as the primary source of funds for our lending and investment activities. Deposit accounts offered include individual and business checking accounts, money market accounts, individual NOW accounts, savings accounts and certificates of deposit. Noninterest-bearing accounts consist of free checking and commercial checking accounts. The following table sets forth the balances of our deposit accounts at the dates indicated. December 31, 2013 2012 2011 (dollars in thousands) Total Percent Total Percent Total Percent Non-interest-bearing accounts $ 74,019 12.92 % $ 65,295 11.29 % $ 54,102 8.89 % NOW accounts 142,434 24.87 % 141,276 24.43 % 132,812 21.84 % Money market accounts 154,545 26.98 % 152,838 26.43 % 137,901 22.67 % Savings accounts 34,724 6.06 % 29,686 5.13 % 24,880 4.09 % Core deposits 405,722 70.83 % 389,095 67.28 % 349,695 57.49 % Certificates of deposit 167,064 29.17 % 189,204 32.72 % 258,541 42.51 % Total $ 572,786 100.00 % $ 578,299 100.00 % $ 608,236 100.00 % Core deposits, which exclude certificates of deposit, increased $16.6 million, or 4.3%, to $405.7 million at December 31, 2013 from $389.1 million at December 31, 2012. Also during 2013, noninterest-bearing deposits, NOW deposits, money market deposits and savings deposits increased $8.7 million, $1.2 million, $1.7 million and $5.0 million, respectively. While we continued to place greater emphasis on attracting lower cost core deposits, our core deposit growth was also significantly affected by sustained low deposit rates in our competitive markets as the spread between core deposits and certificate time deposits remained narrow throughout 2013. Certificates of deposit decreased $22.1 million, or 11.7%, to $167.1 million at December 31, 2013 from $189.2 million at December 31, 2012. The decrease reflects management's continued focus on reducing deposit interest rates to improve the Bank's net interest margin. A portion of these funds moved into our other types of interest-bearing deposits, including money market accounts. Our need for loan funding, ability to invest these funds for a positive return and consideration of other customer relationships influence our willingness to match competitors' rates to retain these accounts. The following table indicates the amount of jumbo certificates of deposit by time remaining until maturity at December 31, 2013. Jumbo certificates of deposit require minimum deposits of $100,000. (in thousands) Amount Maturity period: Three months or less $ 9,468 Over three through six months 6,531 Over six through twelve months 9,281 Over twelve months 23,819 Total $ 49,099 43-------------------------------------------------------------------------------- Table of Contents The following table sets forth time deposits classified by rates at the dates indicated. December 31, (in thousands) 2013 2012 2011 0.00 - 1.00% $ 119,451 $ 108,421 $ 79,693 1.01 - 2.00% 42,122 63,426 95,151 2.01 - 3.00% 4,968 15,949 79,163 3.01 - 4.00% 523 1,171 3,282 4.01 - 5.00% - 237 1,252 Total $ 167,064 $ 189,204 $ 258,541 The following table sets forth the amount and maturities of time deposits at December 31, 2013. Amount Due More Than More Than Percent of Less Than One Year to Two Years to More Than Total Time (dollars in thousands) One Year Two Years Three Years Three Years Total Deposits 0.00 - 1.00% $ 74,442 $ 27,395 $ 13,635 $ 3,979 $ 119,451 71.50 % 1.01 - 2.00% 18,617 16,029 2,677 4,799 42,122 25.22 % 2.01 - 3.00% 1,206 1,908 1,854 - 4,968 2.97 % 3.01 - 4.00 523 - - - 523 0.31 % Total $ 94,788 $ 45,332 $ 18,166 $ 8,778 $ 167,064 100.00 % The following table sets forth deposit activity for the periods indicated. Year Ended December 31, (in thousands) 2013 2012 2011 Beginning balance $ 578,299 $ 608,236 $ 619,757 Increase (decrease) before interest credited (7,741 ) (34,040 ) (17,743 ) Interest credited 2,228 4,103 6,222 Net increase (decrease) in deposits (5,513 ) (29,937 ) (11,521 ) Ending balance $ 572,786 $ 578,299 $ 608,236 44-------------------------------------------------------------------------------- Table of Contents Borrowings We use borrowings from the FHLB of Atlanta, federal funds purchased and other short-term borrowings to supplement our supply of funds for loans and investments and for interest rate risk management, which are summarized in the following table. Year Ended December 31, (dollars in thousands) 2013 2012 2011 Maximum balance outstanding at any month-end during period: FHLB advances $ 50,000 $ 60,000 $ 60,000 Overnight and short-term borrowings 787 984 1,617 Average balance outstanding during period: FHLB advances $ 50,000 $ 59,208 $ 60,245 Overnight and short-term borrowings 542 616 1,049 Weighted average interest rate during period: FHLB advances 3.93 % 4.03 % 4.01 % Overnight and short-term borrowings 0.18 % 0.32 % 0.29 % Balance outstanding at end of period: FHLB advances $ 50,000 $ 50,000 $ 60,000 Overnight and short-term borrowings 787 411 758 Weighted average interest rate at end of period: FHLB advances 3.88 % 3.88 % 3.97 % Overnight and short-term borrowings 0.10 % 0.27 % 0.52 % Our FHLB advances are fixed-rate borrowings that, at the option of the FHLB of Atlanta, can be converted to variable rates. If the FHLB of Atlanta exercises its options to convert the fixed-rate advances to variable rates, then the Bank can accept the new terms or repay the advance without any prepayment penalty. Had the Bank elected to prepay the advances at December 31, 2013, the prepayment penalties were estimated at approximately $4.7 million. During the fourth quarter of 2012, a FHLB advance for $10.0 million at a rate of 4.46% that would have matured in June of 2017 was prepaid incurring a prepayment penalty of $1.7 million. The interest expense savings is approximately $445,000 per annum over the remaining term. 45 -------------------------------------------------------------------------------- Table of Contents Average Balances and Yields The following tables present information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting annualized average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense for twelve-month periods by the average balances of assets or liabilities, respectively, for the periods presented. Average balances have been calculated using daily balances. Nonaccrual loans are included in average balances only. Loan fees are included in interest income on loans and are not material. Tax-exempt income on loans and on investment securities has been calculated on a tax-equivalent basis using a federal marginal tax rate of 34%. For the Year Ended December 31, 2013 2012 Interest Interest Average and Yield/ Average and Yield/ (dollars in thousands) Balance Dividends Cost Balance Dividends Cost Assets Interest-earning deposits with banks $ 50,486 $ 188 0.37 % $ 57,361 $ 203 0.35 % Loans receivable 421,415 19,058 4.52 % 418,569 19,553 4.67 % Investment securities 65,072 1,523 3.06 % 70,222 1,322 2.19 % Mortgage-backed and similar securities 166,324 2,101 1.26 % 199,030 3,835 1.93 % Other interest-earning assets 3,199 82 2.56 % 3,842 79 2.06 % Total interest-earning assets 706,496 22,952 3.31 % 749,024 24,992 3.37 % Allowance for loan losses (8,239 ) (10,451 ) Noninterest-earning assets 53,229 43,093 Total assets $ 751,486 $ 781,666 Liabilities and equity NOW accounts $ 142,453 296 0.21 % $ 135,441 525 0.39 % Money market accounts 153,804 376 0.24 % 143,622 473 0.33 % Savings accounts 32,366 32 0.10 % 27,463 45 0.16 % Certificates of deposit 182,727 1,524 0.83 % 228,558 3,060 1.34 % Total interest-bearing deposits 511,350 2,228 0.44 % 535,084 4,103 0.77 % Overnight and short-term borrowings 542 1 0.18 % 616 2 0.32 % Federal Home Loan Bank advances 50,000 1,965 3.93 % 59,208 2,387 4.03 % Total interest-bearing liabilities 561,892 4,194 0.75 % 594,908 6,492 1.09 % Noninterest-bearing deposits 71,508 60,099 Other noninterest-bearing liabilities 12,145 10,451 Total liabilities 645,545 665,458 Total equity 105,941 116,208 Total liabilities and equity $ 751,486 $ 781,666 Net interest income $ 18,758 $ 18,500 Interest rate spread 2.56 % 2.28 % Net interest margin 2.72 % 2.50 % Average interest-earning assets to average interest-bearing liabilities 125.74 % 125.91 % 46-------------------------------------------------------------------------------- Table of Contents For the Year Ended December 31, 2012 2011 Interest Interest Average and Yield/ Average and Yield/ (dollars in thousands) Balance Dividends Cost Balance Dividends Cost Assets Interest-earning deposits with banks $ 57,361 $ 203 0.35 % $ 33,089 $ 85 0.26 % Loans receivable 418,569 19,553 4.67 % 471,260 23,538 4.99 % Investment securities 70,222 1,322 2.19 % 70,327 1,681 2.53 % Mortgage-backed and similar securities 199,031 3,835 1.93 % 145,940 3,507 2.40 % Other interest-earning assets 3,842 79 2.06 % 3,927 40 1.02 % Total interest-earning assets 749,025 24,992 3.37 % 724,543 28,851 4.00 % Allowance for loan losses (10,451 ) (12,083 ) Noninterest-earning assets 43,092 53,689 Total assets $ 781,666 $ 766,149 Liabilities and equity NOW accounts $ 135,441 525 0.39 % $ 132,903 934 0.70 % Money market accounts 143,622 473 0.33 % 134,672 721 0.54 % Savings accounts 27,463 45 0.16 % 23,853 72 0.30 % Certificates of deposit 228,558 3,060 1.34 % 273,840 4,495 1.64 % Total interest-bearing deposits 535,084 4,103 0.77 % 565,268 6,222 1.10 % Overnight and short-term borrowings 616 2 0.32 % 1,049 3 0.29 % Federal Home Loan Bank advances 59,208 2,387 4.03 % 60,245 2,417 4.01 % Total interest-bearing liabilities 594,908 6,492 1.09 % 626,562 8,642 1.38 % Noninterest-bearing deposits 60,099 52,467 Other noninterest-bearing liabilities 10,451 4,969 Total liabilities 665,458 683,998 Total equity 116,208 82,151 Total liabilities and equity $ 781,666 $ 766,149 Net interest income $ 18,500 $ 20,209 Interest rate spread 2.28 % 2.62 % Net interest margin 2.50 % 2.80 % Average interest-earning assets to average interest-bearing liabilities 125.91 % 115.64 % 47-------------------------------------------------------------------------------- Table of Contents Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on our net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the volume and rate columns. Changes attributable to changes in both rate and volume have been allocated proportionally based on the absolute dollar amounts of change in each. Year Ended December 31, 2013 Year Ended December 31, 2012 Compared to the Compared to the Year Ended December 31, 2012 Year Ended December 31, 2011 Increase (Decrease) Increase (Decrease) Due to: Due to: (in thousands) Volume Rate Net Volume Rate Net Interest income: Interest-earning deposits with banks $ (25 ) $ 10 $ (15 ) $ 78 $ 40 $ 118 Loans receivable 132 (627 ) (495 ) (2,524 ) (1,461 ) (3,985 ) Investment securities (102 ) 303 201 (3 ) (356 ) (359 ) Mortgage-backed and similar securities (560 ) (1,174 ) (1,734 ) 1,112 (784 ) 328 Other interest-earning assets (15 ) 18 3 (1 ) 40 39 Total interest-earning assets (570 ) (1,470 ) (2,040 ) (1,338 ) (2,521 ) (3,859 ) Interest expense: NOW accounts 26 (255 ) (229 ) 18 (427 ) (409 ) Money market accounts 32 (129 ) (97 ) 45 (293 ) (248 ) Savings accounts 7 (20 ) (13 ) 10 (37 ) (27 ) Certificates of deposit (533 ) (1,003 ) (1,536 ) (678 ) (757 ) (1,435 ) Total interest-bearing deposits (468 ) (1,407 ) (1,875 ) (605 ) (1,514 ) (2,119 ) Overnight and short-term borrowings - (1 ) (1 ) (1 ) - (1 ) Federal Home Loan Bank advances (363 ) (59 ) (422 ) (42 ) 12 (30 ) Total interest-bearing liabilities (831 ) (1,467 ) (2,298 ) (648 ) (1,502 ) (2,150 ) Net increase (decrease) in net interest income $ 261 $ (3 ) $ 258 $ (690 ) $ (1,019 ) $ (1,709 ) Comparison of Results of Operations for the Years Ended December 31, 2013 and 2012 Overview. Net income was $1.5 million, or $0.31 per share, for the year ended December 31, 2013 compared to net income of $862,000 or $0.17 per share, for the year ended December 31, 2012, primarily due to a $2.4 million decrease in provisions for loan losses which resulted in a net recovery of loan loss reserves of $(681,000) for the year ended December 31, 2013 compared to a provision expense of $1.7 million for the year ended December 31, 2012, which was partially offset by a $1.4 million decrease in noninterest income. Our primary source of income is net interest income, which increased to $18.8 million for 2013 from $18.5 million for 2012. Noninterest expenses increased $302,000 during 2013. 48 -------------------------------------------------------------------------------- Table of Contents Net Interest Income. Net interest income increased $258,000, or 1.4%, for the year ended December 31, 2013 as compared to the year ended December 31, 2012, primarily due to the decrease in interest expense on deposits exceeding the decrease in interest and dividend income on securities. Total interest expense decreased $2.3 million, or 35.4%, during the year ended December 31, 2013, primarily resulting from a 33 basis point decrease in the rates paid on interest-bearing deposits as well as a decrease of $23.7 million, or 4.4%, in the average balances of interest-bearing deposits, reflecting a decline in average certificates of deposit that was partially offset by growth in average balances of NOW, money market, and savings accounts. The Company continued its focus on core deposit growth, from which it excludes certificates of deposit. The lower cost of total interest-bearing liabilities, a decrease of 34 basis points during 2013, includes a decrease of $9.3 million in the average balances of Federal Home Loan Bank advances and overnight and short-term borrowings for the year ended December 31, 2013, primarily due to the repayment of $10.0 million in FHLB advances during the fourth quarter of 2012, although the 3.93% average rate paid on the remaining FHLB advances continues to negatively impact net interest income. Total interest and dividend income decreased $2.0 million, or 8.2%, during the year ended December 31, 2013. Loan interest income decreased $495,000, or 2.5%, during the year ended December 31, 2013, primarily due to a 15 basis point decrease in the yield earned on loans during 2013. Income from securities decreased by $1.5 million, primarily due to a 67 basis point decrease in the yield earned on mortgage-backed and similar securities, which was partially offset by an 87 basis point increase in the yield earned on other investment securities. The average balance of mortgage-backed and related securities decreased $32.7 million during 2013, and the average balance of other investment securities decreased $5.2 million, primarily due to the sale of securities to fund loan growth. Provision for Loan Losses. A net recovery of loan loss reserves were recorded in the amount of $(681,000) for the year ended December 31, 2013 compared to provision expense of $1.7 million for the year ended December 31, 2012. The significant decrease in the provision was primarily supported by declines in the Bank's trailing three-year loss history and recent trends of substantially improved levels of delinquent and nonperforming loans used to estimate general loan loss reserves. Net loan charge-offs decreased $3.3 million to $525,000 for the year ended December 31, 2013 from $3.8 million for the year ended December 31, 2012. The allowance for loan losses totaled $7.3 million, or 1.63% of total loans, at December 31, 2013 compared to $8.5 million, or 2.20% of total loans, at December 31, 2012. Noninterest Income. During the year ended December 31, 2013, total noninterest income decreased $1.5 million, or 15.0%, to $8.0 million compared to $9.5 million for the year ended December 31, 2012. The decrease in noninterest income was primarily the result of a $2.3 million decrease in gains realized from sales of investment securities, resulting from sales of fewer securities at smaller net gains. The remaining increase in noninterest income of $898,000 primarily related to increases of $506,000 in gains on sales of foreclosed properties, $189,000 in other income from an investment in a small business investment company, $188,000 in mortgage banking income, $156,000 in income from leased foreclosed properties and $147,000 in income from debit card services, which were partially offset by decreases of $246,000 in deposit and other service charge income and $42,000 in other miscellaneous income. Noninterest Expenses. Noninterest expenses increased $302,000, or 1.2%, to $25.4 million for the year ended December 31, 2013 compared to $25.1 million for the year ended December 31, 2012. The increase was primarily attributable to increases of $1.2 million in salaries and employee benefits, $809,000 in foreclosed property expenses and $318,000 in other noninterest expenses, which were partially offset by a decrease of $1.7 million for debt prepayment penalties recorded in 2012. The increase in salaries and employee benefits was primarily due to increases of $1.0 million relating to the Company's equity incentive plan and $478,000 in employee compensation expenses, which were partially offset by a $499,000 one-time credit to pension expense resulting from the curtailment of benefits for future service. The increase in other noninterest expenses was primarily attributable to increased loan related expenses due to higher loan originations during 2013. 49 -------------------------------------------------------------------------------- Table of Contents Income Tax Expense. We recorded a provision for income tax expense of $625,000 for the year ended December 31, 2013 compared to $302,000 for the year ended December 31, 2012, primarily due to an increase in pre-tax income to $2.1 million in 2013 compared to $1.2 million in 2012. The effective tax rate was 30.1% for the year ended December 31, 2013 compared to 25.9% for the year ended December 31, 2012, primarily attributable to the combined effect of increased nondeductible stock option expense and a one time expense of $113,000 related to an increase in state income taxes that resulted from the reduction in state income tax rates applied to net deferred tax assets deductible in future periods. Total Comprehensive Income (Loss). Total comprehensive income or loss for the periods presented consists of net income, the change in unrealized gains and losses on securities available for sale and certain changes in our benefit obligations under our retirement plans, net of tax. We reported a total comprehensive loss of $2.9 million for the year ended December 31, 2013 compared to a total comprehensive loss of $876,000 for the year ended December 31, 2012. The changes in the components of comprehensive income or loss were net income of $1.5 million in 2013 compared to net income of $862,000 in 2012, a $4.8 million decrease in unrealized gain position on securities available for sale in 2013 to a net unrealized loss position compared to an $821,000 decrease in unrealized gains on securities available for sale in 2012 and a $525,000 decrease in defined benefit pension plan obligations in 2013 compared to a $917,000 increase in 2012. The decrease in defined benefit obligations reflected in other comprehensive income (loss) primarily resulted from an increase in the assumed discount rate at December 31, 2013 compared to December 31, 2012. Comparison of Results of Operations for the Years Ended December 31, 2012 and 2011 Overview. Net income was $862,000, or $0.17 per share, for the year ended December 31, 2012 compared to net income of $1.2 million, or $0.23 per share, for the year ended December 31, 2011 primarily due to a decrease in net interest income and an increase in noninterest expenses, partially offset by a decrease in the provision for loan losses and an increase in noninterest income. Our primary source of income is net interest income, which decreased to $18.5 million for 2012 from $20.2 million for 2011. The provision for loan losses decreased $2.1 million to $1.7 million for the year ended December 31, 2012 compared to $3.8 million for the year ended December 31, 2011. The significant decrease in the provision for loan losses was due to a decrease of $2.0 million in net loan charge-offs to $3.8 million in 2012 from $5.8 million in 2011. Noninterest income increased $2.0 million during the year ended December 31, 2012, while noninterest expenses increased by $3.0 million during 2012. 50 -------------------------------------------------------------------------------- Table of Contents Net Interest Income. Net interest income decreased by $1.7 million, or 8.5%, for the year ended December 31, 2012 as compared to the year ended December 31, 2011, primarily due to a decrease in interest on loans. Total interest income decreased by $3.9 million, or 13.4%, as loan interest income decreased by $4.0 million, or 17.0%, during the year ended December 31, 2012, primarily due to a decrease in average loan balances of $52.7 million, or 11.2%, because loan repayments and charge-offs were not replaced by new loan originations, and a 32 basis point decrease in the yield earned on loans during 2012. Income from securities decreased by $31,000 primarily due to a decrease in the yield earned on investment securities and mortgage-backed and related securities of 34 basis points and 48 basis points, respectively, and a decrease in the average balance of investment securities of $105,000, offset by a increase of $53.1 million in the average balance of mortgage-backed and related securities. The increased average balances of mortgage-backed and related securities were primarily due to the reinvestment into securities of proceeds from loan repayments and from the issuance of common stock in connection with the Bank's mutual to stock conversion during the fourth quarter of 2011. Total interest expense decreased by $2.1 million, or 24.9%, during the year ended December 31, 2012, primarily resulting from a 29 basis point decrease in the rates paid on interest-bearing liabilities as well as a decrease of $31.7 million, or 5.1%, in the average balances of interest-bearing liabilities. Interest-bearing liabilities decreased primarily due to a decrease in average deposit balances of $30.2 million, or 5.3%, reflecting a decline in average certificates of deposit that was partially offset by growth in average balances of NOW, money market, and savings accounts. The lower cost of interest-bearing liabilities resulted primarily from a decrease of 33 basis points in the cost of deposits. The decrease in the cost of deposits was due primarily to our continued focus on reducing deposit interest rates by not aggressively competing for certificates of deposit. The average balances of Federal Home Loan Bank advances and overnight and short-term borrowings for the year ended December 31, 2012 decreased $1.5 million due to the repayment of $10.0 million in FHLB advances during the fourth quarter of 2012. Provision for Loan Losses. The provision for loan losses was $1.7 million for the year ended December 31, 2012 compared to $3.8 million for the year ended December 31, 2011. The decrease in the provision was a result of a decrease in net loan charge-offs in 2012, as well as a $1.6 million reduction in the Bank's general loan loss reserves related to its historical loss rates from certain high risk commercial construction and land development loans and from commercial real estate loan participations purchased, both of which carry no current impaired balances. Net loan charge-offs were $3.8 million for the year ended December 31, 2012 compared to $5.8 million for the year ended December 31, 2011. The provision for loan losses was also affected by the overall $45.0 million contraction of the loan portfolio during 2012. Noninterest Income. During the year ended December 31, 2012, total noninterest income increased $2.0 million, or 27.4%, to $9.4 million from $7.4 million for the year ended December 31, 2011. The increase in noninterest income was primarily the result of a $1.8 million increase in gains realized from sales of investment securities, as certain securities were replaced by securities that are expected to perform better under rising rates, a $600,000 increase in gains from sales of residential mortgage loans, a $152,000 increase in income from debit card services due to increased transactions, which were partially offset by a $472,000 decrease in other deposit service fees, mainly related to reduced overdraft fees. Noninterest Expenses. Noninterest expenses increased by $3.0 million, or 13.7%, to $25.1 million for the year ended December 31, 2012 compared to $22.1 million for the year ended December 31, 2011. The increase was primarily attributable to a $1.7 million FHLB prepayment penalty, and a $1.3 million increase in salaries and employee benefits, primarily due to increased staffing and increases in expenses for the Bank's pension plan and ESOP. In January of 2013, the Bank approved the curtailment of benefits under its qualified and nonqualified defined benefit pension plans. While the action had no effect on the 2012 financial position and results of operations, the Bank's annual expenses related to its pension plans are expected to decline by approximately $536,000 before income taxes in 2013 due to a one-time curtailment credit of approximately $465,000, and by a minimum of $100,000 before income taxes in subsequent periods based on current actuarial estimates. 51 -------------------------------------------------------------------------------- Table of Contents Income Tax Expense. We recorded a provision for income tax expense of $302,000 for the year ended December 31, 2012 compared to $588,000 for the year ended December 31, 2011, primarily due to pre-tax income of $1.2 million in 2012 compared to pre-tax income of $1.8 million in 2011. The effective tax rate was 25.9% for the year ended December 31, 2012 compared to 33.1% for the year ended December 31, 2011, with the decrease primarily resulting from the increase in favorable permanent tax differences relative to the size of the pre-tax income in 2012 compared to 2011. Total Comprehensive Income (Loss). Total comprehensive income or loss for the periods presented consists of net income, the change in unrealized gains and losses on securities available for sale, and certain changes in our benefit obligations under our retirement plans, net of tax. We reported a total comprehensive loss of $876,000 for the year ended December 31, 2012 compared to total comprehensive income of $3.5 million for the year ended December 31, 2011. The changes in the components of comprehensive income or loss were net income of $862,000 in 2012 compared to a net income of $1.2 million in 2011, an $821,000 decrease in unrealized gains on securities available for sale in 2012 compared to a $3.1 million increase in unrealized gains on securities available for sale in 2011, and a $917,000 increase in defined benefit pension plan obligations in 2012 compared to a $837,000 increase in 2011. The increase in defined benefit obligations primarily resulted from a decrease in the assumed discount rate. Risk Management Overview. Managing risk is an essential part of successfully managing a financial institution. Our most prominent risk exposures are credit risk, interest rate risk and market risk. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan or investment when it is due. Interest rate risk is the potential reduction of interest income as a result of changes in interest rates. Market risk arises from fluctuations in interest rates that may result in changes in the values of financial instruments, such as available-for-sale securities that are accounted for on a mark-to-market basis. Other risks that we face are operational risk, liquidity risks and reputation risk. Operational risks include risks related to fraud, regulatory compliance, processing errors, technology and disaster recovery. Liquidity risk is the possible inability to fund obligations to depositors, lenders or borrowers. Reputation risk is the risk that negative publicity or press, whether true or not, could cause a decline in our customer base or revenue. Credit Risk Management. Our strategy for credit risk management focuses on having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans. We do not offer Alt-A, sub-prime or no-documentation mortgage loans. When a borrower fails to make a required loan payment, we take a number of steps to have the borrower cure the delinquency and restore the loan to current status. When the loan becomes 15 days past due, a late notice is sent to the borrower. When the loan becomes 30 days past due, a more formal letter is sent. Between 15 and 30 days past due, telephone calls are also made to the borrower. After 30 days, we regard the borrower in default. At 60 days delinquent, the borrower may be sent a letter from our attorney and we may commence collection proceedings. If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the real property securing the loan generally is sold at foreclosure. Generally, when a consumer loan becomes 60 days past due, we institute collection proceedings and attempt to repossess any personal property that secures the loan. Management informs the board of directors monthly of the amount of loans delinquent more than 30 days, all loans in foreclosure and repossessed property that we own. Analysis of Nonperforming Assets and Classified Assets. We consider repossessed assets and loans that are 90 days or more past due and certain loans that are less than 90 days past due, but that we will not be able to collect the full amount of, to be nonperforming assets. Loans are generally placed on nonaccrual status when they become 90 days delinquent, or sooner if the facts and circumstances indicate that we will not be able to collect the full amount of the loan, at which time the accrual of interest ceases and accrued interest is reversed and deducted from income. Typically, payments received on a nonaccrual loan are first applied to the outstanding principal balance to the extent that principal is due and then recognized as interest income. 52 -------------------------------------------------------------------------------- Table of Contents Real estate that we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until it is sold. Property acquired through foreclosure is recorded at the lower of its cost or fair market value at the date of foreclosure. Any holding costs and declines in fair value after acquisition of the property result in charges against income. The following table provides information with respect to our nonperforming assets at the dates indicated. At December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Nonaccruing loans (1): Commercial: Commercial mortgage $ 373 $ - $ 833 $ 3,810 $ 6,666 Construction and land development 11 40 14,695 5,205 438 Commercial and industrial 139 114 2,595 377 1,408 Total nonaccruing commercial loans 523 154 18,123 9,392 8,512 Non-commercial: Residential mortgage 549 808 1,922 3,194 5,558 Construction and land development - - 110 553 456 Revolving mortgage 116 155 440 191 489 Consumer 9 34 27 94 1,463 Total nonaccruing non-commercial loans 674 997 2,499 4,032 7,966 Total nonaccruing loans 1,197 1,151 20,622 13,424 16,478 Accruing loans past due 90 days or more: Non-commercial: Residential mortgage - - - - 91 Consumer - - - - 15 Total accruing non-commercial loans past due 90 days or more - - - - 106 Total accruing loans past due 90 days or more - - - - 106 Total nonperforming loans (nonaccruing and 90 days or more past due) 1,197 1,151 20,622 13,424 16,584 Foreclosed properties 14,233 19,411 8,125 10,650 3,699 Total nonperforming assets 15,430 20,562 28,747 24,074 20,283 Performing troubled debt restructurings (2) 5,255 5,065 1,142 15,233 19,113 Performing troubled debt restructurings and total nonperforming assets $ 20,685 $ 25,627 $ 29,889 $ 39,307 $ 39,396 Total nonperforming loans to total loans 0.27 % 0.30 % 4.76 % 2.68 % 2.77 % Total nonperforming loans to total assets 0.16 % 0.15 % 2.61 % 1.79 % 2.21 % Total nonperforming assets to total assets 2.10 % 2.74 % 3.63 % 3.21 % 2.71 % Performing troubled debt restructurings and total nonperforming assets to total assets 2.82 % 3.42 % 3.78 % 5.24 % 5.26 % -------------------------------------------------------------------------------- (1) Troubled debt restructurings do not include troubled debt restructurings that remain on nonaccrual status and are included in nonaccrual loans above. (2) Performing troubled debt restructurings exclude nonaccrual troubled debt restructurings. 53-------------------------------------------------------------------------------- Table of Contents The following table provides information with respect to changes in our nonperforming assets. At December 31, (dollars in thousands) 2013 2012 $ change % change Nonperforming Loans: Nonaccruing Loans (1) Commercial: Commercial mortgage $ 373 $ - $ 373 n/a Commercial construction and land development 11 40 (29 ) -72.5 % Commercial and industrial 139 114 25 21.9 % Total nonaccruing commercial 523 154 369 239.6 % Non-commercial: Residential mortgage 549 808 (259 ) -32.1 % Revolving mortgage 116 155 (39 ) -25.2 % Consumer 9 34 (25 ) -73.5 % Total nonaccruing non-commercial loans 674 997 (323 ) -32.4 % Total nonaccruing loans 1,197 1,151 46 4.0 % Accruing loans past due 90 days or more: Total accruing loans past due 90 days or more - - - 0.0 % Total nonperforming loans 1,197 1,151 46 4.0 % Foreclosed properties 14,233 19,411 (5,178 ) -26.7 % Total nonperforming assets 15,430 20,562 (5,132 ) -25.0 % Performing troubled debt restructurings (2) 5,255 5,065 190 3.8 % Performing troubled debt restructurings and total nonperforming assets $ 20,685 $ 25,627 (4,942 ) -19.3 % -------------------------------------------------------------------------------- (1) Troubled debt restructurings do not include troubled debt restructurings that remain on nonaccrual status and are included in nonaccrual loans above. (2) Performing troubled debt restructurings exclude nonaccrual troubled debt restructurings. Nonperforming assets decreased $5.1 million, or 25.0%, to $15.4 million, or 2.10% of total assets, at December 31, 2013, compared to $20.6 million, or 2.74%, of total assets, at December 31, 2012. Nonperforming assets included $1.2 million in nonperforming loans and $14.2 million in foreclosed real estate at December 31, 2013, compared to $1.2 million and $19.4 million, respectively, at December 31, 2012. Nonperforming loans increased $46,000, or 4.0%, to $1.2 million at December 31, 2013 from $1.2 million at December 31, 2012, and $708,000 in collateral on nonperforming loans was moved into foreclosed real estate, while performing troubled debt restructurings increased $190,000, or 3.8%, when comparing the same periods. Total performing troubled debt restructurings and nonperforming assets decreased $4.9 million, or 19.3%, to $20.7 million, or 2.82% of total assets, at December 31, 2013, compared to $25.6 million, or 3.42% of total assets, at December 31, 2012. As of December 31, 2013, nonperforming loans totaled $1.2 million, while foreclosed properties totaled $14.2 million. Nonperforming loans included one commercial mortgage that totaled $373,000, one commercial land development loan that totaled $11,000, two commercial and industrial loans that totaled $139,000, seven residential mortgages that totaled $549,000, and two home equity loans that totaled $116,000. As of December 31, 2013, the nonperforming loans had specific reserves of $115,000. Foreclosed real estate at December 31, 2013 included eleven properties with a total carrying value of $14.2 million compared to 18 properties with a total carrying value of $19.4 million at December 31, 2012. During 2013, there were five new properties in the amount of $708,000 added to foreclosed real estate, while twelve properties totaling $4.4 million were sold. The Bank also added $1.8 million in loss provisions. 54 -------------------------------------------------------------------------------- Table of Contents The Bank's largest foreclosed property resulted from a loan relationship that had an original purpose of constructing a mixed-use retail, commercial office, and residential condominium project located in western North Carolina. As a result of this foreclosure, the Bank acquired 44 of the 48 condominium units in the building. Following an additional write-down of approximately $630,000 on the loans secured by this collateral in the fourth quarter of 2012, the Bank recorded this foreclosed property in the amount of $9.8 million. During the year ended December 31, 2013, the Bank recorded additional write-downs totaling $1.6 million, which resulted in an adjusted recorded amount of $8.2 million at December 31, 2013. We periodically modify loans to extend the term or make other concessions to help borrowers stay current on their loan and to avoid foreclosure. At December 31, 2013, we had $5.8 million of these modified loans, which are also referred to as troubled debt restructurings, of which $5.3 million were performing in accordance with their restructured terms, compared to $5.2 million at December 31, 2012, of which $5.1 million were performing in accordance with their restructured terms. The increase in troubled debt restructurings since December 31, 2012 was primarily the result of the newly restructured loans added during 2013 exceeding the 2013 total for loan repayments, loans for which the collateral was transferred to foreclosed properties and loans charged off. All troubled debt restructurings were restructured in order to help the borrowers remain current on their debt obligation. At December 31, 2013, $519,000 of the total $5.8 million of troubled debt restructurings were not performing according to their restructured terms and were included in the nonperforming asset table above as nonaccruing loans. Interest income that would have been recorded had nonaccruing loans been current according to their original terms amounted to $104,000 for the year ended December 31, 2013 compared to $849,000 for the year ended December 31, 2012. Interest income recognized on nonperforming loans was $306,000 for the year ended December 31, 2013 compared to $231,000 for the year ended December 31, 2012. At December 31, 2013, our nonaccruing loans included the following: ? Commercial Mortgage Loans ? One loan secured by a commercial building located in western North Carolina. As of December 31, 2013, the loan was considered impaired and nonaccruing with a remaining balance of $373,000. The Bank had a specific reserve of $34,000 as of December 31, 2013. ? Residential Mortgage Loans ? Seven loans to multiple borrowers on one- to four-family residential properties with an aggregate balance of $549,000 as of December 31, 2013. At December 31, 2013, our performing troubled debt restructurings included the following: ? Commercial Mortgage Loans ? One loan for the purchase of an existing mobile home park to be used for future development secured by nonowner-occupied commercial real estate located in coastal South Carolina. The loan was modified in the second quarter of 2012, which extended the terms of the loan and required scheduled principal payments. The future performance of the loan is dependent upon the guarantor group's willingness and ability to service the debt. Such willingness and ability was demonstrated by the fact that, as of December 31, 2012, the loan was a performing troubled debt restructuring with a balance of $3.1 million that matures in May of 2014. As of December 31, 2013, the loan was considered impaired and had a specific reserve of $583,000. ? Residential Mortgage Loans ? Ten loans to multiple unrelated borrowers on one- to four-family residential properties with an aggregate balance of $2.1 million as of December 31, 2013. 55 -------------------------------------------------------------------------------- Table of Contents Foreclosed properties consisted of the following at the dates indicated. At December 31, 2013 2012 2011 (dollars in thousands) Number Amount Number Amount Number Amount By foreclosed loan type: Commercial mortgage - $ - 2 $ 1,709 3 $ 3,045 Commercial construction and land development 9 13,822 10 16,642 2 1,683 Residential mortgage 2 411 5 944 10 1,660 Residential construction and land development - - 1 116 3 1,737 Total 11 $ 14,233 18 $ 19,411 18 $ 8,125 An analysis of foreclosed real estate follows: Year Ended December 31, (dollars in thousands) 2013 2012 2011 Beginning balance $ 19,411 $ 8,125 $ 10,650 Transfers from loans 708 17,464 3,533 Capitalized cost 39 22 41 Loss provisions (1,846 ) (1,308 ) (1,574 ) Net gain (loss) on sale of foreclosed properties 330 (176 ) (410 ) Net proceeds from sales of foreclosed properties (4,409 ) (4,716 ) (4,115 ) Ending balance $ 14,233 $ 19,411 $ 8,125 Federal regulations require us to review and classify our assets on a regular basis. In addition, the FDIC and the NCCoB have the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful, and loss. "Substandard assets" must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. "Doubtful assets" have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full questionable on the basis of currently existing facts, conditions, and values, and there is a high possibility of loss. Assets classified "loss" are considered uncollectible and of such little value that continued recognition as an asset of the institution is not warranted. The regulations also provide for a "special mention" category, described as assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving close attention. When we classify an asset as substandard or doubtful we may establish a specific allowance for loan losses. If we classify an asset as loss, we charge off an amount equal to 100% of the portion of the asset classified loss. 56 -------------------------------------------------------------------------------- Table of Contents The following table shows the aggregate amounts of our classified and special mention assets at the dates indicated. At December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Classified loans: Substandard loans $ 3,481 $ 3,969 $ 23,972 $ 31,854 $ 34,329 Doubtful loans - - 2 - - Loss loans - 4 569 265 197 Total classified loans 3,481 3,973 24,543 32,119 34,526 Special mention loans 34,787 35,149 34,584 30,490 34,432 Total classified and special mention loans 38,268 39,122 59,127 62,609 68,958 Total other classified and special mention assets - - - - - Total classified and special mention assets $ 38,268 $ 39,122 $ 59,127 $ 62,609 $ 68,958 The following table shows the aggregate amounts of our classified loans at the dates indicated and the related changes in our classified loans. At December 31, (dollars in thousands) 2013 2012 $ change % change Classified loans: Substandard loans $ 3,481 $ 3,969 $ (488 ) -12.3 % Loss loans - 4 (4 ) -100.0 % Total classified loans 3,481 3,973 (492 ) -12.4 % Special mention loans 34,787 35,149 (362 ) -1.0 % Total classified and special mention loans $ 38,268 $ 39,122 $ (854 ) -2.2 % Other than as disclosed in the above tables, there are no other loans where management has serious doubts about the ability of the borrowers to comply with the present loan repayment terms. At December 31, 2013, classified loans totaling $3.5 million included $1.2 million in nonaccruing loans that were previously discussed as nonperforming loans. The remaining $2.3 million in performing classified loans primarily included the following: ? Commercial Mortgage Loans ? One loan on commercial retail property located in western North Carolina. As of December 31, 2013, the loan was performing with a balance of $518,000. 57 -------------------------------------------------------------------------------- Table of Contents ? Residential Mortgage Loans ? Twelve loans to multiple unrelated borrowers for one- to- four-family residential properties with an aggregate balance of $938,000 as of December 31, 2013. ? Revolving Mortgage Loans ? Eight loans to multiple unrelated borrowers for revolving Home Equity Lines of Credit with an aggregate balance of $476,000 as of December 31, 2013. Classified assets include loans that are classified due to factors other than payment delinquencies, such as lack of current financial statements and other required documentation, insufficient cash flows or other deficiencies, and, therefore are not included as nonperforming assets. At December 31, 2013, special mention loans included the following large potentially problematic loan: ? Commercial Mortgage Loans ? One loan for the purchase of an existing mobile home park to be used for future development secured by nonowner-occupied commercial real estate located in coastal South Carolina. The loan was modified in the second quarter of 2012, which extended the terms of the loan and required scheduled principal payments. The future performance of the loan is dependent upon the guarantor group's willingness and ability to service the debt. Such willingness and ability was demonstrated by the fact that, as of December 31, 2013, the loan was a performing troubled debt restructuring with a balance of $3.1 million that matures in May of 2014. As of December 31, 2013, the loan was considered impaired and had a specific reserve of $583,000. 58-------------------------------------------------------------------------------- Table of Contents The following table provides information about delinquencies, including nonaccruing loans, in our loan portfolio at the dates indicated. Delinquent 31-89 Days Delinquent 90 Days or More Number Principal Number Principal of Balance of Balance (dollars in thousands) Loans of Loans of Loans of Loans At December 31, 2013 Commercial: Commercial mortgage 1 $ 372 - $ - Commercial construction and land development - - 1 11 Commercial and industrial 4 165 1 79 Non-commercial: Residential mortgage 6 241 7 549 Revolving mortgage 9 434 1 24 Consumer 114 300 - - Total delinquent loans 134 $ 1,512 10 $ 663 At December 31, 2012 Commercial: Commercial mortgage 1 $ 393 - $ - Commercial construction and land development 1 16 1 40 Commercial and industrial 7 135 1 114 Non-commercial: Residential mortgage 9 875 10 808 Revolving mortgage 4 203 2 60 Consumer 158 492 4 28 Total delinquent loans 180 $ 2,114 18 $ 1,050 At December 31, 2011 Commercial: Commercial mortgage - $ - 1 $ 833 Commercial construction and land development 1 363 7 6,251 Commercial and industrial 9 2,177 4 506 Non-commercial: Residential mortgage 12 1,426 11 1,922 Residential construction and land development - - 1 110 Revolving mortgage 11 751 4 407 Consumer 213 939 7 27 Total delinquent loans 246 $ 5,656 35 $ 10,056 At December 31, 2010 Commercial: Commercial mortgage 3 $ 2,298 3 $ 3,363 Commercial construction and land development 4 462 4 3,451 Commercial and industrial 20 288 2 290 Non-commercial: Residential mortgage 48 4,996 20 2,878 Residential construction and land development 2 282 3 553 Revolving mortgage 19 576 7 191 Consumer 165 1,387 9 94 Total delinquent loans 261 $ 10,289 48 $ 10,820 59-------------------------------------------------------------------------------- Table of Contents Delinquent 31-89 Days Delinquent 90 Days or More Number Principal Number Principal of Balance of Balance (dollars in thousands) of Loans of Loans of Loans of Loans At December 31, 2009 Commercial: Commercial mortgage 3 $ 2,226 3 $ 6,293 Commercial construction and land development 3 95 3 438 Commercial and industrial 39 1,689 9 210 Non-commercial: Residential mortgage 58 7,024 27 4,707 Residential construction and land development 3 569 4 456 Revolving mortgage 35 1,318 10 589 Consumer 297 3,254 118 1,512 Total delinquent loans 438 $ 16,175 174 $ 14,205 60-------------------------------------------------------------------------------- Table of Contents The following table provides information about changes in our delinquencies, including nonaccruing loans, in our loan portfolio at the dates indicated. At December 31, (dollars in thousands) 2013 2012 $ change % change Delinquent 31-89 Days Commercial: Commercial mortgage $ 372 $ 393 $ (21 ) -5.3 % Commercial construction and land development - 16 (16 ) -100.0 % Commercial and industrial 165 135 30 22.2 % Non-commercial: Residential mortgage 241 875 (634 ) -72.5 % Revolving mortgage 434 203 231 113.8 % Consumer 300 492 (192 ) -39.0 % Total loans delinquent 31-89 days 1,512 2,114 (602 ) -28.5 % Delinquent 90 Days or More Commercial construction and land development 11 40 (29 ) -72.5 % Commercial and industrial 79 114 (35 ) -30.7 % Non-commercial: Residential mortgage 549 808 (259 ) -32.1 % Revolving mortgage 24 60 (36 ) -60.0 % Consumer - 28 (28 ) -100.0 % Total loans delinquent 90 days or more 663 1,050 (387 ) -36.9 % Total delinquent loans $ 2,175 $ 3,164 $ (989 ) -31.3 % The $602,000 decrease in loans 31 to 89 days past due to December 31, 2013 from December 31, 2012 was primarily due to a $634,000 decrease in residential mortgage loans. The $1.5 million in loans 31 to 89 days past due at December 31, 2013 was comprised of 134 loans with an average balance of approximately $11,000, the largest of which had a balance of $372,000. The $387,000 decrease in loans 90 days or more past due to December 31, 2013 from December 31, 2012 was primarily due to a $259,000 decrease in residential mortgage loans. The $663,000 in loans 90 days or more past due at December 31, 2013 was comprised of 10 loans with an average balance of approximately $66,000, the largest of which had a balance of $143,000. 61 -------------------------------------------------------------------------------- Table of Contents Analysis and Determination of the Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio. On a monthly basis, we evaluate the need to establish allowances for probable losses on loans. When additional allowances are necessary, a provision for loan losses is charged to earnings and when allowance reductions are warranted, a recovery of loan losses is recognized in earnings. Our methodology for assessing the appropriateness of the allowance for loan losses is reviewed periodically by the board of directors. The board of directors also reviews the allowance for loan losses established on a quarterly basis. General Valuation Allowance. We establish a general valuation allowance for loans that should be adequate to reserve for the estimated credit losses inherent in each segment of our loan portfolio, given the facts and circumstances as of the valuation date for all loans in the portfolio that have not been classified. Estimated loss percentages are assigned to loans based upon factors that include historical loan losses, delinquency trends, volume and interest rate trends, bank policy changes, and national, regional and local economic conditions. These loss factors will be evaluated at least annually by our Asset Quality Committee, which consists of our President and Chief Executive Officer, our Executive Vice President and Chief Financial Officer, our Executive Vice President and Chief Lending Officer, and other key personnel from our credit, finance, and risk management departments, and documentation of this review is maintained in the Asset Quality Committee minutes. The Asset Quality Committee may also determine that certain events or circumstances have taken place that would impact the loan portfolio for the time period being reviewed, such as a natural disaster. In such cases, methodologies should be based on events that might not yet be recognized in the loan grading or performance of the loan groupings. The Asset Quality Committee reports to the audit committee of our board of directors on a quarterly basis. Specific Valuation Allowance. The allowance for loan losses takes into consideration that specific losses on loans deemed to be impaired are recognized in accordance with the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") Topic 310. Pursuant to ASC Topic 310, we deem a loan to be impaired when it is probable that we will not be able to collect all amounts due, including principal and interest, according to the contractual terms of the loan agreement. Generally, all classified loans (loans classified substandard, doubtful, and loss) are considered impaired and are measured for impairment under ASC Topic 310 in order to determine if an impairment reserve is required. In addition, loans that are deemed to be troubled debt restructurings are considered impaired and evaluated for an impairment reserve under ASC Topic 310. Further, any non-accrual loan is considered impaired unless there is strong and credible evidence that the loan will begin performing according to the contractual terms of the loan agreement within a reasonable period of time. Such evidence must be well documented in a credit memorandum for the loan file. Any impaired loan, when evaluated for an impairment reserve under ASC Topic 310 and no requirement for such reserve is determined, will still be deemed impaired and will not be analyzed with respect to a general valuation allowance. Rather, such loan will continue to be included in impaired loans under ASC Topic 310 with a zero reserve. ASC Topic 310 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, for collateral dependent loans, the fair value of the collateral, net of estimated costs of disposal. Since full collection of principal and interest is not expected for impaired loans, income accrual is normally discontinued on such loans at the time they first become impaired. 62 -------------------------------------------------------------------------------- Table of Contents Unallocated Valuation Allowance. Our allowance for loan losses methodology may also include an unallocated component to reflect the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio. Methodology change - In the fourth quarter of 2012, the Bank modified its loan loss methodology for unimpaired commercial construction and land development and its unimpaired commercial mortgage loans. This change resulted in further segmentation of these classes of loans and the related historical charge-off rates. The purpose was to allocate the substantial historical charge-offs rates, created by two segments of these loan classes, against the significantly diminished credit exposure to the Bank within these same classes. Specifically, additional sub segments of loans on large tracts of unimproved land or land development loans in excess of $1.0 million and purchased participations from a failed bank in out of market commercial mortgage loans were created. This change in methodology resulted in a nonrecurring reduction of approximately $1.6 million in the Bank's reserves on loans not considered impaired in 2012. The Bank made no changes to its allowance methodology in 2013. The following table sets forth the allowance for loan losses by loan class at the dates indicated. At December 31, 2013 2012 % of % of % of Loans in % of Loans in Allowance Class Allowance Class (dollars in to Total to Total to Total to Total thousands) Amount Allowance Loans Amount Allowance Loans Commercial: Commercial mortgage $ 3,193 43.70 % 38.23 % $ 4,110 48.28 % 35.76 % Commercial construction and land development 836 11.44 % 3.47 % 160 1.88 % 1.34 % Commercial and industrial 531 7.27 % 3.28 % 590 6.93 % 2.86 % Total commercial 4,560 62.41 % 44.98 % 4,860 57.09 % 39.96 % Non-commercial: Residential mortgage 1,074 14.70 % 35.89 % 1,841 21.63 % 42.14 % Residential construction and land development 366 5.01 % 1.95 % 243 2.85 % 0.96 % Revolving mortgage 834 11.41 % 11.02 % 1,123 13.19 % 12.42 % Consumer 473 6.47 % 6.16 % 446 5.24 % 4.52 % Total non-commercial 2,747 37.59 % 55.02 % 3,653 42.91 % 60.04 % Total allowance for loan losses $ 7,307 100.00 % 100.00 % $ 8,513 100.00 % 100.00 % 63-------------------------------------------------------------------------------- Table of Contents At December 31, 2011 2010 % of % of % of Loans in % of Loans in Allowance Class Allowance Class (dollars in to Total to Total to Total to Total thousands) Amount Allowance Loans Amount Allowance Loans Commercial: Commercial mortgage $ 4,496 42.31 % 32.30 % $ 5,486 43.28 % 32.88 % Commercial construction and land development 1,399 13.16 % 5.17 % 1,232 9.72 % 5.69 % Commercial and industrial 730 6.87 % 4.05 % 782 6.17 % 3.53 % Total commercial 6,625 62.34 % 41.52 % 7,500 59.17 % 42.10 % Non-commercial: Residential mortgage 2,125 20.00 % 40.59 % 2,207 17.41 % 36.06 % Residential construction and land development 189 1.78 % 0.90 % 749 5.91 % 1.73 % Revolving mortgage 1,092 10.27 % 11.78 % 1,021 8.05 % 10.68 % Consumer 596 5.61 % 5.21 % 1,041 8.21 % 9.43 % Total non-commercial 4,002 37.66 % 58.48 % 5,018 39.58 % 57.90 % Total 10,627 100.00 % 100.00 % 12,518 98.75 % 100.00 % Unallocated - 0.00 % 0.00 % 158 1.25 % 0.00 % Total allowance for loan losses $ 10,627 100.00 % 100.00 % $ 12,676 100.00 % 100.00 % At December 31, 2009 % of % of Loans in Allowance Class to Total to Total (dollars in thousands) Amount Allowance Loans Commercial: Commercial mortgage $ 3,432 38.16 % 32.98 % Commercial construction and land development 494 5.49 % 5.04 % Commercial and industrial 381 4.24 % 3.81 % Total commercial 4,307 47.89 % 41.83 % Non-commercial: Residential mortgage 1,489 16.56 % 31.93 % Residential construction and land development 242 2.69 % 2.53 % Revolving mortgage 688 7.65 % 9.20 % Consumer 2,069 23.00 % 14.51 % Total non-commercial 4,488 49.90 % 58.17 % Total 8,795 97.79 % 100.00 % Unallocated 199 2.21 % 0.00 % Total allowance for loan losses $ 8,994 100.00 % 100.00 % 64-------------------------------------------------------------------------------- Table of Contents Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and our results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established our allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that the FDIC and the NCCoB, in reviewing our loan portfolio, will not require us to increase our allowance for loan losses. The FDIC and the NCCoB may require us to increase our allowance for loan losses based on judgments different from ours. In addition, because future events affecting borrowers and collateral value cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operation. Analysis of Loan Loss Experience. The following table sets forth an analysis of the allowance for loan losses for the periods indicated. At or For the Years Ended December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Balance at beginning of period $ 8,513 $ 10,627 $ 12,676 $ 8,994 $ 6,403 Provision for (recovery of) loan losses (681 ) 1,700 3,785 22,419 4,655 Charge offs: Commercial: Commercial mortgage - 593 1,121 6,074 - Commercial construction and land development 24 2,651 1,959 7,926 - Commercial and industrial 24 203 953 692 214 Total commercial charge-offs 48 3,447 4,033 14,692 214 Non-commercial: Residential mortgage 30 224 604 1,767 82 Residential construction and land development - 24 551 351 94 Revolving mortgage 198 56 504 919 199 Consumer 354 244 442 1,135 1,605 Total non-commercial charge-offs 582 548 2,101 4,172 1,980 Total charge-offs 630 3,995 6,134 18,864 2,194 Recoveries: Commercial: Commercial mortgage 14 2 7 - - Commercial construction and land development - 8 1 - - Commercial and industrial 33 11 86 12 9 Total commercial recoveries 47 21 94 12 9 Non-commercial: Residential mortgage - 66 37 - - Revolving mortgage 6 6 69 - 1 Consumer 52 88 100 115 120 Total non-commercial recoveries 58 160 206 115 121 Total recoveries 105 181 300 127 130 Net charge-offs 525 3,814 5,834 18,737 2,064 Balance at end of period $ 7,307 $ 8,513 $ 10,627 $ 12,676 $ 8,994 65-------------------------------------------------------------------------------- Table of Contents At or For the Years Ended December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Allowance for loan losses to nonperforming loans 610.44 % 739.62 % 51.53 % 94.43 % 54.23 % Allowance for loan losses to total loans outstanding at the end of the period 1.63 % 2.20 % 2.45 % 2.54 % 1.51 % Net charge-offs to average loans outstanding during the period 0.12 % 0.91 % 1.24 % 3.33 % 0.34 % Liquidity Management. Liquidity is the ability to meet current and future financial obligations of a short- term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and borrowings from the Federal Home Loan Bank of Atlanta. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. We regularly adjust our investments in liquid assets based upon our assessment of (i) expected loan demand, (ii) expected deposit flows, (iii) yields available on securities and interest-earning deposits we place with other banks; and (iv) the objectives of our asset-liability management policy. Our most liquid assets are cash and cash equivalents and interest-bearing deposits. The level of these assets depends on our operating, financing, lending and investing activities during any given period. At December 31, 2013, cash and cash equivalents totaled $52.8 million, including $43.8 million in interest-bearing deposits in other banks, of which $24.3 million was on deposit with the Federal Reserve Bank. Securities totaling $185.3 million classified as available-for-sale also provided an additional source of liquidity at December 31, 2013. In addition, at December 31, 2013, we had the ability to borrow a total of approximately $50.8 million from the FHLB of Atlanta and approximately $7.3 million from the Federal Reserve Bank's discount window. At December 31, 2013, we had $50.0 million in Federal Home Loan Bank advances outstanding and $2.0 million in letters of credit to secure public funds deposits. A significant use of our liquidity is the funding of loan originations. At December 31, 2013, we had $127.4 million in commitments to extend credit outstanding. Certificates of deposit due within one year of December 31, 2013 totaled $94.8 million, or 56.7% of certificates of deposit. We believe the large percentage of certificates of deposit that mature within one year reflects customers' hesitancy to invest their funds for long periods due to the recent low interest rate environment and local competitive pressure. If these maturing deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due within one year of December 31, 2013. Based on past experience, we believe that a significant portion of our certificates of deposit will remain with us. We believe we have the ability to attract and retain deposits by adjusting the interest rates offered. In addition, we believe that our branch network, which is presently comprised of 13 full-service branch offices located throughout our primary market area, and the general cash flows from our existing lending and investment activities will afford us sufficient long-term liquidity. 66-------------------------------------------------------------------------------- Table of Contents The following tables present our contractual obligations as of the dates indicated. Payments due by period Less than One to Three to More than (in thousands) Total One Year Three Years Five Years Five Years At December 31, 2013 Long-term debt obligations $ 50,000 $ - $ - $ 50,000 $ - Operating lease obligations 1,798 362 724 222 490 Total $ 51,798 $ 362 $ 724 $ 50,222 $ 490 At December 31, 2012 Long-term debt obligations $ 50,000 $ - $ - $ 40,000 $ 10,000 Operating lease obligations 2,159 362 724 523 550 Total $ 52,159 $ 362 $ 724 $ 40,523 $ 10,550 Capital Management. We are subject to various regulatory capital requirements administered by the FDIC and the NCCoB, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2013, we exceeded all of our regulatory capital requirements and were considered "well capitalized" under regulatory guidelines. We strive to manage our capital for maximum shareholder benefit. The capital from our stock offering significantly increased our liquidity and capital resources. Over time, the initial level of liquidity will be reduced as net proceeds from the stock offering are used for general corporate purposes, including the funding of lending activities. Our financial condition and results of operations will be enhanced by the capital from the offering, resulting over time in increased net interest-earning assets and net income. However, the large increase in equity resulting from the capital raised in the conversion offering will, initially, have an adverse impact on our return on equity. To help us better manage our capital, we may consider the use of such tools as continued common share repurchases and the declaration of cash dividends as regulations permit. The Company had the following actual and required regulatory capital amounts as of the periods indicated: Regulatory Requirements Minimum for Capital Minimum to Be Actual Adequacy Purposes Well Capitalized (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio ASB Bancorp, Inc. December 31, 2013 Tier I leverage capital $ 107,275 14.35 % $ 29,904 4.00 % $ 37,380 5.00 % Tier I risk-based capital 107,275 24.14 % 17,776 4.00 % 26,664 6.00 % Total risk-based capital 112,852 25.39 % 35,552 8.00 % 44,440 10.00 % December 31, 2012 Tier I leverage capital $ 112,508 14.69 % $ 30,632 4.00 % $ 38,290 5.00 % Tier I risk-based capital 112,508 27.72 % 16,237 4.00 % 24,356 6.00 % Total risk-based capital 117,638 28.98 % 32,475 8.00 % 40,594 10.00 % 67-------------------------------------------------------------------------------- Table of Contents The Bank had the following actual and required regulatory capital amounts as of the periods indicated: Regulatory Requirements Minimum for Capital Minimum to Be Actual Adequacy Purposes Well Capitalized (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio Asheville Savings Bank, S.S.B. December 31, 2013 Tier I leverage capital $ 93,441 12.67 % $ 29,489 4.00 % $ 36,861 5.00 % Tier I risk-based capital 93,441 21.07 % 17,737 4.00 % 26,605 6.00 % Total risk-based capital 99,006 22.33 % 35,474 8.00 % 44,342 10.00 % NC Savings Bank capital 100,748 13.92 % 36,184 5.00 % n/a n/a December 31, 2012 Tier I leverage capital 90,388 12.06 % 29,983 4.00 % 37,479 5.00 % Tier I risk-based capital 90,388 22.35 % 16,174 4.00 % 24,262 6.00 % Total risk-based capital 95,498 23.62 % 32,349 8.00 % 40,436 10.00 % NC Savings Bank capital 98,914 13.48 % 36,680 5.00 % n/a n/a A reconciliation of equity under generally accepted accounting principles and regulatory capital amounts follows: ASB Bancorp Asheville Savings Bank December 31, December 31, (in thousands) 2013 2012 2013 2012 Total GAAP equity $ 101,088 $ 111,529 $ 87,279 $ 89,372 Accumulated other comprehensive income, net of tax 7,373 3,067 7,348 3,104 Disallowed deferred tax assets (1,186 ) (2,088 ) (1,186 ) (2,088 ) Tier I capital 107,275 112,508 93,441 90,388 Unrealized gains on available for sale equity securities - 13 - 13 Allowable portion of allowance for loan losses 5,577 5,117 5,565 5,097 Total risk-based capital $ 112,852 $ 117,638 99,006 95,498 Disallowed portion of allowance for loan losses n/a n/a 1,742 3,416 NC Savings Bank capital n/a n/a $ 100,748 $ 98,914 There were no dividends declared by the Bank to the Company in the year ended December 31, 2013. Off-Balance Sheet Arrangements. In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers' requests for funding and take the form of loan commitments, unused lines of credit and letters of credit. For the years ended December 31, 2013 and 2012, we did not engage in any off-balance sheet transactions reasonably likely to have a material effect on our financial condition, results of operations or cash flows. 68-------------------------------------------------------------------------------- Table of Contents |