Bay Banks of Virginia (BAYK) 10-Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2013

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 0-22955

BAY BANKS OF VIRGINIA, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

VIRGINIA	54-1838100
(STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)	(I.R.S. EMPLOYER IDENTIFICATION NO.)

100 SOUTH MAIN STREET, KILMARNOCK, VA 22482

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(804) 435-1171

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  yes    ¨  no

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    x  yes    ¨  no

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨	Smaller reporting company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  yes    x  no

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

4,817,856 shares of common stock on November 6, 2013

FORM 10-Q

For the interim period ending September 30, 2013.

INDEX

PART I - FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 2013 (UNAUDITED) AND DECEMBER 31, 2012		3
CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER  30, 2013 AND 2012 (UNAUDITED)		4
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012 (UNAUDITED)		5
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 (UNAUDITED)		6
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER  30, 2013 AND 2012 (UNAUDITED)		7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS		8
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	30
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	37
ITEM 4.	CONTROLS AND PROCEDURES	37
PART II - OTHER INFORMATION
ITEM 1.	LEGAL PROCEEDINGS	38
ITEM 1A.	RISK FACTORS	38
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	38
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	38
ITEM 4.	MINE SAFETY DISCLOSURES	38
ITEM 5.	OTHER INFORMATION	38
ITEM 6.	EXHIBITS	38

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PART I – FINANCIAL INFORMATION

ITEM  1. FINANCIAL STATEMENTS

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED BALANCE SHEETS

	September 30, 2013			December 31, 2012 (1)
	(Unaudited)
ASSETS
Cash and due from banks	$	7,537,010		$	4,757,889
Interest-bearing deposits		13,026,634			35,166,448
Federal funds sold		497,188			48,009
Securities available for sale, at fair value		39,954,790			36,700,520
Restricted securities		1,623,350			1,584,700
Loans receivable, net of allowance for loan losses of $2,979,344 and $3,093,623		245,885,715			235,474,626
Loans held for sale		161,000			669,900
Premises and equipment, net		10,884,404			11,611,688
Accrued interest receivable		1,068,966			1,070,763
Other real estate owned, net		3,910,728			3,151,346
Bank owned life insurance		5,081,916			—
Goodwill		2,807,842			2,807,842
Mortgage servicing rights		535,034			—
Other assets		1,965,487			1,753,945
Total assets	$	334,940,064		$	334,797,676
LIABILITIES
Noninterest-bearing deposits	$	57,094,032		$	50,467,907
Savings and interest-bearing demand deposits		115,334,496			117,954,879
Time deposits		99,535,358			106,751,785
Total deposits		271,963,886			275,174,571
Securities sold under repurchase agreements		9,430,510			6,459,839
Federal Home Loan Bank advances		15,000,000			15,000,000
Other liabilities		1,905,785			1,578,295
Total liabilities		298,300,181			298,212,705
SHAREHOLDERS’ EQUITY
Common stock ($5 par value; authorized - 10,000,000 shares; outstanding - 4,817,856 and 4,810,856 shares, respectively)		24,089,280			24,054,280
Additional paid-in capital		2,757,449			2,670,021
Retained earnings		11,233,602			10,241,396
Accumulated other comprehensive loss, net		(1,440,448	)		(380,726	)
Total shareholders’ equity		36,639,883			36,584,971
Total liabilities and shareholders’ equity	$	334,940,064		$	334,797,676

(1) Derived from the audited consolidated financial statements.

See Notes to Consolidated Financial Statements.

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

	For the three months ended				For the nine months ended
	September 30,				September 30,
	2013		2012		2013			2012
INTEREST INCOME
Loans, including fees	$	3,182,155	$	3,209,477	$	9,471,186		$	9,698,516
Securities:
Taxable		103,029		143,605		344,691			524,549
Tax-exempt		100,833		55,154		225,813			187,779
Federal funds sold		197		141		533			2,751
Interest-bearing deposit accounts		13,293		7,488		48,810			23,111
Total interest income		3,399,507		3,415,865		10,091,033			10,436,706
INTEREST EXPENSE
Deposits		582,396		705,026		1,813,684			2,171,147
Federal funds purchased		8		389		398			389
Securities sold under repurchase agreements		3,259		4,213		13,273			12,280
FHLB advances		102,275		141,813		347,424			423,660
Total interest expense		687,938		851,441		2,174,779			2,607,476
Net interest income		2,711,569		2,564,424		7,916,254			7,829,230
Provision for loan losses		304,000		680,000		566,000			1,322,685
Net interest income after provision for loan losses		2,407,569		1,884,424		7,350,254			6,506,545
NON-INTEREST INCOME
Income from fiduciary activities		165,574		164,914		492,688			482,756
Service charges and fees on deposit accounts		270,295		248,381		811,421			608,070
VISA-related fees		252,078		254,539		657,794			626,662
Other service charges and fees		399,455		233,001		874,676			677,796
Secondary market lending fees (refer to Note 2)		665,100		177,003		965,832			375,898
Bank owned life insurance income		46,922		—		81,916			—
Net gains on sale of securities available for sale		12,992		454,944		283,706			957,760
Loss on securities with other-than-temporary impairment		—		—		(168,000	)		—
Portion of loss recognized in other comprehensive income		—		—		48,000			—
Net impairment recognized in income		—		—		(120,000	)		—
Net gains (losses) on fixed assets		165,068		—		165,068			(4,906	)
Other income		7,812		21,625		34,129			80,025
Total non-interest income		1,985,296		1,554,407		4,247,230			3,804,061
NON-INTEREST EXPENSES
Salaries and employee benefits		1,603,510		1,398,991		4,941,259			4,345,629
Occupancy expense		490,983		469,740		1,476,731			1,520,105
Bank franchise tax		43,935		42,990		131,805			128,970
VISA expense		213,052		207,707		558,529			515,811
Telephone expense		50,243		46,770		152,212			121,831
FDIC assessments		105,150		102,582		310,099			310,284
Debit card expense		21,661		57,373		58,842			173,222
Foreclosure property expense		34,472		54,062		95,964			159,848
Other real estate losses		239,972		121,057		493,871			444,906
Consulting expense		89,236		53,453		117,751			174,558
Other expense		653,571		565,531		1,909,771			1,869,403
Total non-interest expenses		3,545,785		3,120,256		10,246,834			9,764,567
Net income before income taxes		847,080		318,575		1,350,650			546,039
Income tax expense		226,986		86,036		358,444			110,823
Net income	$	620,094	$	232,539	$	992,206		$	435,216
Basic Earnings Per Share
Average basic shares outstanding		4,817,856		2,610,856		4,816,523			2,610,856
Earnings per share, basic	$	0.13	$	0.09	$	0.21		$	0.17
Diluted Earnings Per Share
Average diluted shares outstanding		4,820,172		2,612,258		4,818,903			2,612,684
Earnings per share, diluted	$	0.13	$	0.09	$	0.21		$	0.17

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

	For the three months ended						For the nine months ended
	September 30, 2013			September 30, 2012			September 30, 2013			September 30, 2012
Net income	$	620,094		$	232,539		$	992,206		$	435,216
Other comprehensive (loss) income:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during the period		(125,338	)		93,068			(1,441,933	)		308,985
Deferred tax benefit (expense)		42,615			(31,643	)		490,257			(105,055	)
Reclassification of net securities (gains) and impairments recognized in net income		(12,992	)		(454,944	)		(163,706	)		(957,760	)
Deferred tax benefit		4,417			154,681			55,660			325,638
Unrealized losses adjustment, net of tax		(91,298	)		(238,838	)		(1,059,722	)		(428,192	)
Defined benefit pension plan:
Net periodic pension cost		22,436			17,860			67,309			53,580
Net pension loss		(22,436	)		(17,860	)		(67,309	)		(53,580	)
Deferred tax benefit		—			—			—			—
Defined benefit pension plan adjustment, net of tax		—			—			—			—
Post retirement benefit plan:
Net periodic cost		1,124			735			3,372			2,206
Net loss		(1,124	)		(735	)		(3,372	)		(2,206	)
Deferred tax benefit		—			—			—			—
Post retirement benefit plan adjustment, net of tax		—			—			—			—
Total other comprehensive loss		(91,298	)		(238,838	)		(1,059,722	)		(428,192	)
Comprehensive income (loss)	$	528,796		$	(6,299	)	$	(67,516	)	$	7,024

See Notes to Consolidated Financial Statements.

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

	Shares of Common Stock		Common Stock		Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Loss			Total Shareholders’ Equity
NINE MONTHS ENDED SEPTEMBER 30, 2013
(unaudited)
Balance at beginning of period		4,810,856	$	24,054,280	$	2,670,021	$	10,241,396	$	(380,726	)	$	36,584,971
Net income		—		—		—		992,206		—			992,206
Other comprehensive loss		—		—		—		—		(1,059,722	)		(1,059,722	)
Stock-based compensation		7,000		35,000		87,428		—		—			122,428
Balance at end of period		4,817,856	$	24,089,280	$	2,757,449	$	11,233,602	$	(1,440,448	)	$	36,639,883

See Notes to Consolidated Financial Statements.

6

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

Nine months ended September 30,	2013			2012
Cash Flows From Operating Activities
Net income	$	992,206		$	435,216
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		567,144			588,678
Net amortization and accretion of securities		295,348			196,708
Provision for loan losses		566,000			1,322,685
Stock-based compensation		122,428			2,925
Deferred income tax benefit		(7,259	)		—
Gain on securities available-for-sale		(283,706	)		(957,760	)
Impairment loss on securities available-for-sale		120,000			—
Increase in OREO valuation allowance		248,641			221,734
Loss on sale of other real estate		245,230			223,172
(Gain) loss on disposal of fixed assets		(165,068	)		4,906
Loan originations for sale to FNMA		(19,118,613	)		(15,813,400	)
Loan sales to FNMA		19,691,104			13,923,081
Gain on loans sold to FNMA		(334,991	)		(247,081	)
(Increase) decrease in accrued income and other assets		(843,219	)		314,257
Increase (decrease) in other liabilities		880,667			(2,323	)
Net cash provided by operating activities		2,975,912			212,798
Cash Flows From Investing Activities
Proceeds from maturities and principal paydowns of available-for-sale securities		2,774,338			2,651,986
Proceeds from sales and calls of available-for-sale securities		9,432,875			15,225,843
Purchase of bank owned life insurance		(5,000,000	)		—
Purchases of available-for-sale securities		(17,198,766	)		(7,228,452	)
(Purchases) sales of restricted securities		(38,650	)		406,500
Decrease (increase) in overnight funds in other banks		22,139,814			(70,329	)
(Increase) decrease in federal funds sold		(449,179	)		1,954,368
Loan originations and principal collections, net		(13,018,316	)		(7,184,585	)
Proceeds from sale of other real estate		1,075,899			718,094
Net sales (purchases) of premises and equipment		325,208			(73,451	)
Net cash provided by investing activities		43,223			6,399,974
Cash Flows From Financing Activities
Increase in demand, savings, and other interest-bearing deposits		4,005,742			6,760,084
Net decrease in time deposits		(7,216,427	)		(4,273,593	)
Net increase in securities sold under repurchase agreements		2,970,671			751,435
Net cash (used in) provided by financing activities		(240,014	)		3,237,926
Net increase in cash and due from banks		2,779,121			9,850,698
Cash and due from banks at beginning of period		4,757,889			4,728,895
Cash and due from banks at end of period	$	7,537,010		$	14,579,593
Supplemental Schedule of Cash Flow Information
Cash paid for:
Interest	$	2,159,229		$	2,617,304
Income taxes		211,943			109,961
Non-cash investing and financing:
Unrealized loss on investment securities		(1,605,639	)		(648,776	)
Change in fair value of pension and post-retirement obligation		—			—
Loans transferred to other real estate owned		2,312,627			2,012,095
Changes in deferred taxes resulting from OCI transactions		545,918			220,504

See Notes to Consolidated Financial Statements.

7

Notes to Consolidated Financial Statements

Note 1: General

Bay Banks of Virginia, Inc. (the “Company”) owns 100% of the Bank of Lancaster (the “Bank”), 100% of Bay Trust Company, Inc. (the “Trust Company”) and 100% of Steptoes Holdings, LLC (“Steptoes Holdings”). The consolidated financial statements include the accounts of the Bank, the Trust Company, Steptoes Holdings and Bay Banks of Virginia, Inc.

The Company completed a private stock placement of 2,200,000 shares of its common stock for $4.25 per share at the end of the day on December 31, 2012, which materially increased the number of shares outstanding and the level of capital.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to the general practices within the banking industry. In management’s opinion, all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. These consolidated financial statements should be read in conjunction with the financial statements and notes to financial statements included in the Company’s 2012 Annual Report to Shareholders.

Certain amounts in the consolidated financial statements of prior periods have been reclassified to conform to current year presentations. The reclassifications had no effect on net income, net income per share or shareholders’ equity as previously reported.

Note 2: Significant Accounting Policies

Loans

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market area.

Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, and charge-offs. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees and certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield via straight line amortization over the contractual term of the loan, adjusted for early pay-offs.

The accrual of interest is generally discontinued at the time a loan is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Payments received for loans no longer accruing interest are applied to the unpaid principal balance. Loans greater than 90 days past due may remain on accrual status if the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are charged off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual and past due policies are materially the same for all types of loans.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. Any interest received on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well secured and in the process of collection.

Allowance for loan losses

The allowance for loan losses (“ALL”) reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the allowance for losses each quarter. To determine the total allowance for loan losses, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and pools of loans analyzed on a segmented basis. Considerations include historical experience, the nature and volume of the loan portfolio, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available.

During the third quarter of 2012, management enhanced the ALL calculation methodology by changing the historical loss factor period from six quarters to the length of a business cycle. This increased the historical loss period to 16 quarters, since the then current business cycle was assumed to have begun in the fourth quarter of 2008. As the length of that business cycle extended, so did the length of the historical loss factor period. During the third quarter of 2013, management ceased this approach and determined that 19 quarters of historical losses will be used henceforth. This change in methodology produced an immaterial change in the ALL calculation.

The allowance consists of specific, general, and unallocated components. Generally, large adversely risk rated loans, loans in bankruptcy, non-accruing loans, or loans more than 30 days past due, are evaluated to determine which are impaired for purposes of establishing the

8

specific component. For those loans determined to be impaired, a specific allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component collectively evaluates smaller commercial loans, residential mortgages and consumer loans, grouped into segments. Historical loss experience is calculated and applied to each segment, then adjusted for qualitative factors. Qualitative factors include changes in the local economic outlook, including unemployment, interest rates, inflation rates and real estate trends; the level and trend of past due and nonaccrual loans; strength of policies and procedures; and oversight of credit risk and quality of underwriting. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained if needed to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

Management employs a risk rating system to evaluate and consistently categorize loan portfolio credit risk. Loans assigned risk rating grades include all commercial loans, commercial loans secured by real estate (commercial mortgages), large residential loans secured by real estate (residential mortgages), loans to real estate developers and contractors, large consumer loans with chronic delinquency, and troubled debt restructures. All other loans not specifically assigned a risk rating are monitored as a discreet pool of loans generally based on delinquency status. Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention and any collateral may not be fully adequate to secure loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The specific component of the ALL calculation evaluates large adversely classified loans for impairment, as noted above. Adversely classified loans are considered to be those loans risk rated as substandard, doubtful or loss. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not considered impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Accrual of interest may or may not be discontinued for any given impaired loan. Impairment is measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Because large groups of smaller balance homogeneous loans are collectively evaluated for impairment, the Company does not generally separately identify smaller balance individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

The general component of the ALL calculation collectively evaluates groups of loans in segments, as noted above. Segments are not disaggregated into classes. These segments are 1) Construction, land and land development; 2) Farmland; 3) Residential first mortgages; 4) Residential revolving and junior mortgages; 5) Commercial mortgages (non-owner-occupied); 6) Commercial mortgages (owner-occupied); 7) Commercial and industrial; and 8) Consumer. Every loan is assigned to a segment. Segments 1 through 6 are secured by real estate. Segments 7 and 8 are secured by other types of collateral or are unsecured. A given segment may not reflect the purpose of a loan. For example, a business owner may provide his residence as collateral for a loan to his company, in which case the loan would be grouped in a residential mortgage segment.

Construction and development loans carry risks that the project will not be finished according to schedule or according to budget and the value of the collateral, at any point in time, may be less than the principal amount of the loan. These loans also bear the risk that the general contractor may face financial pressure unrelated to the project. Loans secured by land, farmland and residential mortgages carry the risk of continued credit-worthiness of the borrower and changes in value of the underlying real estate collateral. Commercial mortgages and commercial and industrial loans carry risks associated with the profitable operation of a business and its related cash flows. Additionally, commercial and industrial loans carry risks associated with the value of collateral other than real estate which may depreciate over time. Consumer loans carry risks associated with the continuing credit-worthiness of the borrower and are more likely than real estate loans to be adversely affected by divorce, unemployment, personal illness or bankruptcy of an individual. Consumer loans secured by automobiles carry risks associated with rapidly depreciating collateral. Consumer loans include credit cards.

Additions to the allowance for loan losses are made by charges to earnings through the provision for loan losses. Charge-offs are credit exposures deemed to be uncollectible and the allowance for loan losses is reduced by these. Recoveries of previously charged off amounts are credited back to the allowance for loan losses. Charge-off policies are materially the same for all types of loans.

9

In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants a concession to a borrower that it would not otherwise consider, the related loan is deemed to be a troubled debt restructuring (“TDR”). Management strives to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. All TDRs are considered impaired and are measured for impairment as noted above.

Mortgage Servicing Rights (“MSRs”)

The Company has sold mortgages that it has originated to a third party for a number of years. Due to the low volume of mortgage sales prior to 2013 and the immateriality of the asset associated with retention of the mortgage servicing rights to the balance sheet, the Company had not recorded the mortgage servicing rights asset at the time of the sale of the mortgage to the third party prior to 2013. The Company recognized the cumulative mortgage servicing right in the third quarter of 2013. The overstatement of income in 2013 of approximately $215,000 after tax ($325,000 pre-tax adjusted for a 34% tax rate) represents the fair value of servicing rights retained prior to 2013. The Company will be accounting for the mortgage servicing rights under the fair value method going forward.

The Company has evaluated this uncorrected misstatement in consideration and accordance with the guidance from Staff Accounting Bulletins (“SAB”) 99 and 108, in order to determine whether it is material to the financial statements taken as a whole. The Company’s evaluation process included consideration of the nature, cause, amount and effect of the misstatement from both a quantitative and qualitative perspective.

It is management’s judgment that the adjustment to the 2013 financial statements for mortgage servicing rights, related to 2012 and prior, is not material to the 2013 balance sheet, results of operations and cash flows taken as a whole. Management believes that users of the Company’s financial statements and other financial information will not consider the adjustment material to their investment decision process.

Note 3: Amendments to the Accounting Standards Codification

In December 2011, the Financial Accounting Standards (“FASB”) issued Accounting Standards Update “(ASU”) 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU clarify the scope for derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either offset or subject to netting arrangements. An entity is required to apply the amendments for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Company has included the required disclosures from ASU 2013-02 in the consolidated financial statements.

10

Note 4: Securities

The aggregate amortized costs and fair values of the available-for-sale securities portfolio are as follows:

Available-for-sale securities September 30, 2013 (unaudited)	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
U.S. Government agencies	$	9,537,023	$	11,603	$	(71,604	)	$	9,477,022
State and municipal obligations		28,535,384		102,745		(1,189,126	)		27,449,003
Certificates of deposits		1,985,000		11,765		—			1,996,765
Auction rate securities		1,080,000		—		(48,000	)		1,032,000
	$	41,137,407	$	126,113	$	(1,308,730	)	$	39,954,790

Available-for-sale securities December 31, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
U.S. Government agencies	$	9,411,627	$	78,178	$	(25,990	)	$	9,463,815
State and municipal obligations		23,480,871		412,759		(44,102	)		23,849,528
Certificates of deposits		1,985,000		3,271		(1,094	)		1,987,177
Auction rate securities		1,400,000		—		—			1,400,000
	$	36,277,498	$	494,208	$	(71,186	)	$	36,700,520

Gross realized gains and gross realized losses on sales an calls of securities were as follows:

	For the three months ended September 30,				For the nine months ended September 30,
	2013		2012		2013			2012
Gross realized gains	$	12,992	$	454,944	$	285,286		$	959,588
Gross realized losses		—		—		(1,580	)		(1,828	)
Net realized gains	$	12,992	$	454,944	$	283,706		$	957,760

Average yields on securities were 2.40% and 2.66% for the three months ended September 30, 2013 and 2012, respectively; and 2.28% and 2.83% for the nine months ended September 30, 2013 and 2012, respectively.

The aggregate amortized cost and market values of the investment securities portfolio by contractual maturity at September 30, 2013 are as follows:

	Amortized Cost		Fair Value
Due one year or less	$	5,805,769	$	5,808,257
Due after one year through five years		14,945,406		14,889,307
Due after five years through ten years		16,772,341		15,963,447
Due after ten years		3,613,891		3,293,779
	$	41,137,407	$	39,954,790

Securities with a market value of $11.7 million and $8.1 million were pledged as collateral for repurchase agreements and for other purposes as required by law as of September 30, 2013 and December 31, 2012, respectively.

Securities in an unrealized loss position at September 30, 2013 and December 31, 2012, by duration of the unrealized loss, are shown below. With the exception of the auction rate security, the unrealized loss positions were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All agency securities, states and municipalities securities and certificates of deposit are investment grade or better and their losses are considered temporary. Management does not intend to sell the securities and does not expect to be required to sell the securities. Furthermore, all amortized cost bases are expected to be recovered. Bonds with unrealized loss positions at September 30, 2013 included 16 certificates of deposit and 52 municipals. Bonds with unrealized loss positions at December 31, 2012 included three certificates of deposit, 10 municipals and two federal agencies. The tables are shown below.

11

	Less than 12 months				12 months or more				Total
September 30, 2013 (unaudited)	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	6,915,018	$	71,604	$	—	$	—	$	6,915,018	$	71,604
States and municipal obligations		15,959,238		1,152,849		1,699,461		36,277		17,658,699		1,189,126
Certificates of deposits		—		—		—		—		—		—
Auction rate securities		1,032,000		48,000		—		—		1,032,000		48,000
Total temporarily impaired securities	$	23,906,256	$	1,272,453	$	1,699,461	$	36,277	$	25,605,717	$	1,308,730

	Less than 12 months				12 months or more				Total
December 31, 2012	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
U.S. Government agencies	$	1,080,438	$	25,990	$	—	$	—	$	1,080,438	$	25,990
States and municipal obligations		2,863,106		37,731		1,037,825		6,371		3,900,931		44,102
Certificates of deposits		742,906		1,094		—		—		742,906		1,094
Auction rate securities		—		—		—		—		—		—
Total temporarily impaired securities	$	4,686,450	$	64,815	$	1,037,825	$	6,371	$	5,724,275	$	71,186

The following table summarized cumulative credit related other-than temporary impairment losses recognized on the one auction rate security held by the Company (no other-than-temporary-impairment was recognized in the other income statement period presented):

	For the nine months ended September 30, 2013
Balance, beginning of the period	$	—
Impairment losses recognized during the period		120,000
Realized losses from sales		—
Balance, end of period	$	120,000

The Company holds one $1.2 million face amount South Carolina Student Loan Corporation auction rate security. During the second quarter of 2013, the South Carolina Student Loan Corporation made a tender and exchange offer with regards to these auction rate securities with the provision that 50% of the security holders were required for the tender offer to be consummated. The tender offer was not accepted by the required 50% of security holders. As a result of the tender and exchange offer, the Company determined that the value of these auction rate securities were other than temporarily impaired. The market value of the securities was estimated based on Level 3 inputs (refer to Note 11). The Company recognized a other-than-temporary impairment charge of $120 thousand in income, plus a $48 thousand unrealized loss component with $31,680, net of tax effect, in accumulated other comprehensive income related to this security during the nine months ended September 30, 2013.

The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $1.1 million at September 30, 2013 and $ 1.1 million at December 31, 2012. The investment in FHLB stock is a required investment related to the Company’s membership with FHLB. This investment is carried at cost since there is no ready market and redemptions have historically has been made at par. The Company does not consider this investment to be other-than-temporarily impaired at September 30, 2013 and no impairment has been recognized. FHLB stock is shown in the restricted securities line item on the consolidated balance sheets and is not a part of the available for sale securities portfolio.

12

Note 5: Loans

The following is a summary of the balances of loans:

	September 30, 2013			December 31, 2012
	(unaudited)
Loans secured by real estate:
Construction, Land and Land Development	$	28,837,320		$	29,024,294
Farmland		1,283,588			1,442,757
Commercial Mortgages (Non-Owner Occupied)		15,022,880			13,420,551
Commercial Mortgages (Owner Occupied)		33,659,674			33,634,384
Residential First Mortgages		113,917,591			106,885,794
Residential Revolving and Junior Mortgages		24,083,948			26,982,512
Commercial and Industrial loans		25,961,533			20,524,547
Consumer Loans		6,098,525			6,653,410
Total loans	$	248,865,059		$	238,568,249
Allowance for loan losses		(2,979,344	)		(3,093,623	)
Loans, net	$	245,885,715		$	235,474,626

The recorded investment in past due and non-accruing loans is shown in the following table. A loan past due by more than 90 days is generally placed on nonaccrual unless it is both well secured and in the process of collection.

Loans Past Due and Non-accruing September 30, 2013 (unaudited)	30-89 Days Past Due		90 Days or More Past Due and Still Accruing		Nonaccruals		Total Past Due and Nonaccruals		Current		Total Loans
Construction, Land and Land Development	$	65,217	$	—	$	596,202	$	661,419	$	28,175,901	$	28,837,320
Farmland		—		—		—		—		1,283,588		1,283,588
Commercial Mortgages (Non-Owner Occupied)		—		—		—		—		15,022,880		15,022,880
Commercial Mortgages (Owner Occupied)		—		—		274,322		274,322		33,385,352		33,659,674
Residential First Mortgages		428,194		—		1,483,554		1,911,748		112,005,843		113,917,591
Residential Revolving and Junior Mortgages		7,544		—		91,860		99,404		23,984,544		24,083,948
Commercial and Industrial		347,777		—		—		347,777		25,613,756		25,961,533
Consumer Loans		117,756		31,336		3,513		152,605		5,945,920		6,098,525
Total	$	966,488	$	31,336	$	2,449,451	$	3,447,275	$	245,417,784	$	248,865,059

Loans Past Due and Non-accruing December 31, 2012	30-89 Days Past Due		90 Days or More Past Due and Still Accruing		Nonaccruals		Total Past Due and Nonaccruals		Current		Total Loans
Construction, Land and Land Development	$	230,866	$	—	$	655,397	$	886,263	$	28,138,031	$	29,024,294
Farmland		—		—		—		—		1,442,757		1,442,757
Commercial Mortgages (Non-Owner Occupied)		—		—		318,418		318,418		13,102,133		13,420,551
Commercial Mortgages (Owner Occupied)		—		71,254		819,467		890,721		32,743,663		33,634,384
Residential First Mortgages		761,981		502		2,677,788		3,440,271		103,445,523		106,885,794
Residential Revolving and Junior Mortgages		18,081		—		1,257,915		1,275,996		25,706,516		26,982,512
Commercial and Industrial		100,886		50,075		—		150,961		20,373,586		20,524,547
Consumer Loans		12,193		3,688		1,479		17,360		6,636,050		6,653,410
Total	$	1,124,007	$	125,519	$	5,730,464	$	6,979,990	$	231,588,259	$	238,568,249

Non-accruing loans that are not 90 days or more past due are $1.7 million at September 30, 2013 and $2.8 million at December 31, 2012.

13

Note 6: Allowance for Loan Losses

A disaggregation of and an analysis of the change in the allowance for loan losses by segment is shown below.

	Construction, Land and Land Development			Farmland			Commercial Mortgages (Non Owner Occupied)			Commercial Mortgages (Owner Occupied)			Residential First Mortgages			Residential Revolving and Junior Mortgages			Commercial and Industrial		Consumer Loans			Unallocated			Total
For the Three Months Ended September 30, 2013 (unaudited)
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	227,749		$	2,000		$	84,000		$	428,808		$	1,049,489		$	669,423		$	250,000	$	266,210		$	5,468		$	2,983,147
(Charge-offs)		(2,195	)		—			—			—			(8,694	)		(252,744	)		—		(50,392	)		—			(314,025	)
Recoveries		3,099			—			—			—			—			471			1,500		1,153			—			6,223
Provision		(51,653	)		(2,000	)		(11,000	)		(61,808	)		184,959			166,056			61,500		23,413			(5,468	)		303,999
Ending Balance	$	177,000		$	—		$	73,000		$	367,000		$	1,225,754		$	583,206		$	313,000	$	240,384		$	—		$	2,979,344
Individually evaluated for impairment	$	—		$	—		$	—		$	—		$	385,417		$	188,206		$	—	$	33,384		$	—		$	607,007
Collectively evaluated for impairment	$	177,000		$	—		$	73,000		$	367,000		$	840,337		$	395,000		$	313,000	$	207,000		$	—		$	2,372,337

14

	Construction, Land and Land Development			Farmland		Commercial Mortgages (Non Owner Occupied)			Commercial Mortgages (Owner Occupied)		Residential First Mortgages			Residential Revolving and Junior Mortgages			Commercial and Industrial			Consumer Loans			Unallocated			Total
For the Three Months Ended September 30, 2012 (unaudited)
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	173,871		$	1,000	$	89,000		$	374,796	$	1,235,341		$	610,440		$	287,832		$	261,210		$	307,468		$	3,340,958
(Charge-offs)		(142,618	)		—		—			—		(451,078	)		(6,714	)		(65,000	)		(39,590	)		—			(705,000	)
Recoveries		—			—		242			—		1,934			—			—			19,530			—			21,706
Provision		130,888			—		(242	)		165,794		384,161			59,156			222,866			24,060			(306,683	)		680,000
Ending Balance	$	162,141		$	1,000	$	89,000		$	540,590	$	1,170,358		$	662,882		$	445,698		$	265,210		$	785		$	3,337,664
Individually evaluated for impairment	$	91,141		$	—	$	—		$	194,590	$	404,358		$	487,882		$	186,698		$	74,210		$	—		$	1,438,879
Collectively evaluated for impairment	$	71,000		$	1,000	$	89,000		$	346,000	$	766,000		$	175,000		$	259,000		$	191,000		$	785		$	1,898,785

15

	Construction, Land and Land Development			Farmland			Commercial Mortgages (Non Owner Occupied)			Commercial Mortgages (Owner Occupied)			Residential First Mortgages			Residential Revolving and Junior Mortgages			Commercial and Industrial			Consumer Loans			Unallocated			Total
For the Nine Months Ended September 30, 2013 (unaudited)
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	191,882		$	2,000		$	106,000		$	545,084		$	1,209,454		$	517,253		$	262,000		$	252,210		$	7,740		$	3,093,623
(Charge-offs)		(2,195	)		—			—			—			(373,706	)		(252,744	)		(16,897	)		(105,281	)					(750,823	)
Recoveries		19,951			—			18,889			—			24,360			471			1,535			5,339						70,545
Provision		(32,638	)		(2,000	)		(51,889	)		(178,084	)		365,646			318,226			66,362			88,116			(7,740	)		565,999
Ending Balance	$	177,000		$	—		$	73,000		$	367,000		$	1,225,754		$	583,206		$	313,000		$	240,384		$	—		$	2,979,344
Individually evaluated for impairment	$	—		$	—		$	—		$	—		$	385,417		$	188,206		$	—		$	33,384		$	—		$	607,007
Collectively evaluated for impairment	$	177,000		$	—		$	73,000		$	367,000		$	840,337		$	395,000		$	313,000		$	207,000		$	—		$	2,372,337

For the Nine Months Ended September 30, 2012 (unaudited)	Construction, Land and Land Development			Farmland		Commercial Mortgages (Non Owner Occupied)			Commercial Mortgages (Owner Occupied)			Residential First Mortgages			Residential Revolving and Junior Mortgages			Commercial and Industrial			Consumer Loans			Unallocated			Total
ALLOWANCE FOR LOAN LOSSES:
Beginning Balance	$	190,500		$	—	$	88,000		$	554,318		$	1,161,551		$	719,121		$	281,650		$	185,000		$	8,401		$	3,188,541
(Charge-offs)		(200,278	)		—		(283,569	)		—			(654,622	)		(39,388	)		(250,427	)		(114,971	)		—			(1,543,256	)
Recoveries		—			—		285,326			—			1,934			—			10,869			71,564			—			369,693
Provision		171,919			1,000		(757	)		(13,728	)		661,495			(16,851	)		403,606			123,617			(7,616	)		1,322,686
Ending Balance	$	162,141		$	1,000	$	89,000		$	540,590		$	1,170,358		$	662,882		$	445,698		$	265,210		$	785		$	3,337,664
Individually evaluated for impairment	$	91,141		$	—	$	—		$	194,590		$	404,358		$	487,882		$	186,698		$	74,210		$	—		$	1,438,879
Collectively evaluated for impairment	$	71,000		$	1,000	$	89,000		$	346,000		$	766,000		$	175,000		$	259,000		$	191,000		$	785		$	1,898,785

Loan receivables evaluated for impairment individually and collectively by segment as of September 30, 2013 and December 31, 2012 are as follows:

As of September 30, 2013	Construction, Land and Land Development		Farmland		Commercial Mortgages (Non Owner Occupied)		Commercial Mortgages (Owner Occupied)		Residential First Mortgages		Residential Revolving and Junior Mortgages		Commercial and Industrial		Consumer Loans		Total
LOAN RECEIVABLES:
Ending Balance:
Individually evaluated for impairment	$	452,603	$	—	$	264,056	$	2,321,551	$	4,862,797	$	365,278	$	—	$	39,400	$	8,305,685
Collectively evaluated for impairment		28,384,717		1,283,588		14,758,824		31,338,123		109,054,794		23,718,670		25,961,533		6,059,125		240,559,374
Total Gross Loans	$	28,837,320	$	1,283,588	$	15,022,880	$	33,659,674	$	113,917,591	$	24,083,948	$	25,961,533	$	6,098,525	$	248,865,059
As of December 31, 2012
LOAN RECEIVABLES:
Ending Balance:
Individually evaluated for impairment	$	275,650	$	—	$	—	$	1,617,001	$	4,278,290	$	1,336,761	$	—	$	73,978	$	7,581,680
Collectively evaluated for impairment		28,748,644		1,442,757		13,420,551		32,017,383		102,607,504		25,645,751		20,524,547		6,579,432		230,986,569
Total Gross Loans	$	29,024,294	$	1,442,757	$	13,420,551	$	33,634,384	$	106,885,794	$	26,982,512	$	20,524,547	$	6,653,410	$	238,568,249

16

Internal risk rating grades are generally assigned to commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, smaller residential mortgages which are impaired, loans to real estate developers and contractors, consumer loans greater than $250,000 with chronic delinquency, and TDRs, as shown in the following table. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades (refer to Note 2) are evaluated as new information becomes available for each borrowing relationship or at least quarterly.

	Construction,				Commercial		Commercial
As of September 30, 2013	Land and				Mortgages		Mortgages		Commercial
INTERNAL RISK	Land				(Non-Owner		(Owner		and
RATING GRADES	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	22,124,916	$	1,283,588	$	8,929,269	$	23,766,686	$	22,752,433	$	78,856,892
Watch		4,109,037		—		3,447,988		6,987,815		2,276,135		16,820,975
Special mention		1,313,018		—		2,306,567		167,562		467,364		4,254,511
Substandard		1,290,349		—		339,056		2,737,611		465,601		4,832,617
Doubtful		—		—		—		—		—		—
Total	$	28,837,320	$	1,283,588	$	15,022,880	$	33,659,674	$	25,961,533	$	104,764,995

	Construction,				Commercial		Commercial
As of December 31, 2012	Land and				Mortgages		Mortgages		Commercial
INTERNAL RISK	Land				(Non-Owner		(Owner		and
RATING GRADES	Development		Farmland		Occupied)		Occupied)		Industrial		Total
Grade:
Pass	$	21,877,355	$	1,442,757	$	7,362,289	$	23,974,131	$	16,418,910	$	71,075,442
Watch		4,746,266		—		2,824,575		6,680,142		2,866,739		17,117,722
Special mention		1,162,388		—		2,574,371		338,902		759,554		4,835,215
Substandard		1,038,285		—		659,316		2,641,209		479,344		4,818,154
Doubtful		200,000		—		—		—		—		200,000
Total	$	29,024,294	$	1,442,757	$	13,420,551	$	33,634,384	$	20,524,547	$	98,046,533

Loans not assigned internal risk rating grades are comprised of smaller residential mortgages and smaller consumer loans. Payment activity of these loans is reviewed monthly by management. However, some of these loans are graded when the borrower’s total exposure to the Bank exceeds the limits noted above. Loans are considered to be nonperforming when they are delinquent by 90 days or more or non-accruing and credit risk is primarily evaluated by delinquency status, as shown in the table below.

			Residential
	Residential		Revolving
As of September 30, 2013 (unaudited)	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (1)		Mortgages (2)		Loans (3)		Total
Performing	$	112,434,037	$	23,992,088	$	6,063,676	$	142,489,801
Nonperforming		1,483,554		91,860		34,849		1,610,263
Total	$	113,917,591	$	24,083,948	$	6,098,525	$	144,100,064

			Residential
	Residential		Revolving
As of December 31, 2012	First		and Junior		Consumer
PAYMENT ACTIVITY STATUS	Mortgages (4)		Mortgages (5)		Loans (6)		Total
Performing	$	104,207,504	$	25,724,597	$	6,648,243	$	136,580,344
Nonperforming		2,678,290		1,257,915		5,167		3,941,372
Total	$	106,885,794	$	26,982,512	$	6,653,410	$	140,521,716

(1) Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $5,169,080 as of September 30, 2013.

(2) Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $382,611.

(3) Consumer Loans which have been assigned a risk rating grade of Substandard totaled $41,311 as of September 30, 2013.

(4) Residential First Mortgages which have been assigned a risk rating grade of Substandard totaled $4,676,938 as of December 31, 2012.

(5) Residential Revolving and Junior Mortgages which have been assigned a risk rating grade of Substandard totaled $536,019 and Doubtful totaled $847,581 as of December 31, 2012.

(6) Consumer Loans which have been assigned a risk rating grade of Substandard totaled $75,409 as of December 31, 2012.

17

The following tables show the Company’s recorded investment and the customers’ unpaid principal balances for impaired loans, with the associated allowance amount, if applicable as of September 30, 2013 and December 31, 2012 along with the average recorded investment and interest income recognized for the three and nine months ended September 30, 2013 and 2012.

	As of September 30, 2013
IMPAIRED LOANS
(unaudited)	Recorded		Customers’ Unpaid		Related
With no related allowance:	Investment		Principal Balance		Allowance
Construction, land & land development	$	452,603	$	453,438	$	—
Farmland		—		—		—
Residential First Mortgages		2,603,288		2,604,644		—
Residential Revolving and Junior Mortgages (1)		98,153		98,153		—
Commercial Mortgages (Non-owner occupied)		264,056		264,056		—
Commercial Mortgages (Owner occupied)		2,321,551		2,327,734		—
Commercial & industrial		—		—		—
Consumer (2)		—		—		—
	$	5,739,651	$	5,748,025	$	—
With an allowance recorded:
Construction, land & land development	$	—	$	—	$	—
Farmland		—		—		—
Residential First Mortgages		2,259,509		2,259,509		385,417
Residential Revolving and Junior Mortgages (1)		267,125		842,698		188,206
Commercial Mortgages (Non-owner occupied)		—		—		—
Commercial Mortgages (Owner occupied)		—		—		—
Commercial & industrial		—		—		—
Consumer (2)		39,400		39,400		33,384
	$	2,566,034	$	3,141,607	$	607,007
Total Impaired Loans:
Construction, land & land development	$	452,603	$	453,438	$	—
Farmland		—		—		—
Residential First Mortgages		4,862,797		4,864,153		385,417
Residential Revolving and Junior Mortgages (1)		365,278		940,851		188,206
Commercial Mortgages (Non-owner occupied)		264,056		264,056		—
Commercial Mortgages (Owner occupied)		2,321,551		2,327,734		—
Commercial & industrial		—		—		—
Consumer (2)		39,400		39,400		33,384
	$	8,305,685	$	8,889,632	$	607,007

(1) Junior mortgages include equity lines

(2) Includes credit cards

18

	As of December 31, 2012
IMPAIRED LOANS
With no related allowance:	Recorded Investment		Customers’ Unpaid Principal Balance		Related Allowance
Construction, land & land development	$	213,768	$	213,914	$	—
Farmland		—		—		—
Residential First Mortgages		1,495,910		1,495,910		—
Residential Revolving and Junior Mortgages (1)		971,654		1,785,259		—
Commercial Mortgages (Non-owner occupied)		—		—		—
Commercial Mortgages (Owner occupied)		758,391		758,391		—
Commercial & industrial		—		—		—
Consumer (2)		—		—		—
	$	3,439,723	$	4,253,474	$	—
With an allowance recorded:
Construction, land & land development	$	61,882	$	65,566	$	25,882
Farmland		—		—		—
Residential First Mortgages		2,782,380		2,807,875		467,454
Residential Revolving and Junior Mortgages (1)		365,107		381,452		101,253
Commercial Mortgages (Non-owner occupied)		—		—		—
Commercial Mortgages (Owner occupied)		858,610		858,610		165,084
Commercial & industrial		—		—		—
Consumer (2)		73,978		73,978		74,210
	$	4,141,957	$	4,187,481	$	833,883
Total Impaired Loans:
Construction, land & land development	$	275,650	$	279,480	$	25,882
Farmland		—		—		—
Residential First Mortgages		4,278,290		4,303,785		467,454
Residential Revolving and Junior Mortgages (1)		1,336,761		2,166,711		101,253
Commercial Mortgages (Non-owner occupied)		—		—		—
Commercial Mortgages (Owner occupied)		1,617,001		1,617,001		165,084
Commercial & industrial		—		—		—
Consumer (2)		73,978		73,978		74,210
	$	7,581,680	$	8,440,955	$	833,883

(1) Junior mortgages include equity lines

(2) Includes credit cards

19

	For the Three Months Ended				For the Three Months Ended
	September 30, 2013				September 30, 2012
	Average		Interest		Average		Interest
IMPAIRED LOANS	Recorded		Income		Recorded		Income
(unaudited)	Investment		Recognized		Investment		Recognized
With no related allowance:
Construction, land & land development	$	232,837	$	6,670	$	—	$	—
Farmland		—		—		—		—
Residential First Mortgages		2,402,503		27,216		1,812,224		4,175
Residential Junior Mortgages (1)		98,153		1,349		155,161		666
Commercial Mortgages (Non-owner occupied)		132,028		3,963		—		—
Commercial Mortgages (Owner occupied)		1,804,619		29,497		585,849		6,888
Commercial & industrial		—		—		315,959		—
Consumer (2)		—		—		—		—
	$	4,670,140	$	68,695	$	2,869,193	$	11,729
With an allowance recorded:
Construction, land & land development	$	—	$	—	$	263,002	$	—
Farmland		—		—		—		—
Residential First Mortgages		2,051,204		34,255		2,138,124		19,047
Residential Junior Mortgages (1)		267,375		2,256		1,621,845		—
Commercial Mortgages (Non-owner occupied)		—		—		—		—
Commercial Mortgages (Owner occupied)		—		—		1,012,224		—
Commercial & industrial		—		—		198,590		—
Consumer (2)		55,806		1,161		84,210		2,430
	$	2,374,385	$	37,672	$	5,317,995	$	21,477
Total
Construction, land & land development	$	232,837	$	6,670	$	263,002	$	—
Farmland		—		—		—		—
Residential First Mortgages		4,453,707		61,471		3,950,348		23,222
Residential Junior Mortgages (1)		365,528		3,605		1,777,006		666
Commercial Mortgages (Non-owner occupied)		132,028		3,963		—		—
Commercial Mortgages (Owner occupied)		1,804,619		29,497		1,598,073		6,888
Commercial & industrial		—		—		514,549		—
Consumer (2)		55,806		1,161		84,210		2,430
	$	7,044,525	$	106,367	$	8,187,188	$	33,206

(1) Junior mortgages include equity lines.

(2) Includes credit cards.

20

	For the Nine Months Ended				For the Nine Months Ended
	September 30, 2013				September 30, 2012
	Average		Interest		Average		Interest
IMPAIRED LOANS	Recorded		Income		Recorded		Income
(unaudited)	Investment		Recognized		Investment		Recognized
With no related allowance:
Construction, land & land development	$	123,216	$	6,670	$	—	$	—
Farmland		—		—		—		—
Residential First Mortgages		1,929,720		69,037		1,794,078		46,668
Residential Junior Mortgages (1)		97,700		1,471		142,643		4,416
Commercial Mortgages (Non-owner occupied)		66,014		3,963		—		—
Commercial Mortgages (Owner occupied)		1,547,535		47,054		347,402		17,678
Commercial & industrial		—		—		316,615		—
Consumer (2)		—		—		—		—
	$	3,764,185	$	128,195	$	2,600,738	$	68,762
With an allowance recorded:
Construction, land & land development	$	—	$	—	$	264,230	$	—
Farmland		—		—		—		—
Residential First Mortgages		1,898,593		84,640		1,691,635		50,864
Residential Junior Mortgages (1)		255,017		5,969		1,637,318		—
Commercial Mortgages (Non-owner occupied)		—		—		—		—
Commercial Mortgages (Owner occupied)		—		—		1,014,007		15,900
Commercial & industrial		—		—		144,926		—
Consumer (2)		64,679		4,238		65,658		6,480
	$	2,218,289	$	94,847	$	4,817,774	$	73,244
Total
Construction, land & land development	$	123,216	$	6,670	$	264,230	$	—
Farmland		—		—		—		—
Residential First Mortgages		3,828,313		153,677		3,485,713		97,532
Residential Junior Mortgages (1)		352,717		7,440		1,779,961		4,416
Commercial Mortgages (Non-owner occupied)		66,014		3,963		—		—
Commercial Mortgages (Owner occupied)		1,547,535		47,054		1,361,409		33,578
Commercial & industrial		—		—		461,541		—
Consumer (2)		64,679		4,238		65,658		6,480
	$	5,982,474	$	223,042	$	7,418,512	$	142,006

(1) Junior mortgages include equity lines.

(2) Includes credit cards.

Smaller non-accruing loans and non-accruing loans that are not graded because they are included in homogenous pools generally do not meet the criteria for impairment testing, and are therefore excluded from impaired loan disclosures. At September 30, 2013 and December 31, 2012, non-accruing loans excluded from impaired loan disclosure totaled $1,102,681 and $721,951, respectively. If interest on these non-accruing loans had been accrued, such income would have approximated $12,164 and $6,181 during the three months ended September 30, 2013 and 2012, respectively, and $26,008 and $8,622 during the nine months ended September 30, 2013 and 2012, respectively.

Loans modified as TDR’s are considered impaired and are individually evaluated for the amount of impairment in the ALL. The following table presents, by segments of loans, information related to loans modified as TDRs during the nine months ended September 30, 2013 and 2012.

21

	For the three months ended September 30, 2013						For the three months ended September 30, 2012
TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Construction, land & land development (1)		2	$	45,110	$	45,110		—	$	—	$	—
Residential Revolving and Junior Mortgages (1)		—		—		—		1		59,827		59,827
Consumer (2)		1		7,953		7,953		—		—		—
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment				Number of Loans		Recorded Investment
Residential First Mortgages (2)		1	$	105,797				—		—

(1) Modification was an extension of the loan term.

(2) Modification was a capitalization of the interest.

	For the nine months ended September 30, 2013						For the nine months ended September 30, 2012
TROUBLED DEBT RESTRUCTURINGS	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Construction, land & land development (1)		2	$	45,110	$	45,110		—	$	—	$	—
Residential First Mortgages (2)		1		206,505		205,091		1		650,113		647,094
Residential Revolving and Junior Mortgages (1)		—		—		—		1		59,827		59,827
Commercial Mortgages (Owner occupied) (3)		—		—		—		1		479,115		479,115
Consumer (2)		1		7,953		7,953		1		94,210		74,210
TROUBLED DEBT RESTRUCTURINGS THAT SUBSEQUENTLY DEFAULTED	Number of Loans		Recorded Investment				Number of Loans		Recorded Investment
Construction, land & land development (1)		—	$	—				1	$	142,618
Residential First Mortgages (3)		1		105,797				—		—
Commercial and industrial (1)		—		—				2		65,000

(1) Modifications were an extension of the loan term.

(2) Modifications were capitalization of interest for the 2013 modifications and an extension of loan terms for the 2012 modifications.

(3) Modifications were capitalization of interest.

Note 7: Earnings per share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock.

	Three Months Ended								Nine Months Ended
	September 30, 2013				September 30, 2012				September 30, 2013				September 30, 2012
(Unaudited)	Average Shares		Per share Amount		Average Shares		Per share Amount		Average Shares		Per share Amount		Average Shares		Per share Amount
Basic earnings per share		4,817,856	$	0.13		2,610,856	$	0.09		4,816,523	$	0.21		2,610,856	$	0.17
Effect of dilutive securities:
Stock options		2,316				1,402				2,380				1,828
Diluted earnings per share		4,820,172	$	0.13		2,612,258	$	0.09		4,818,903	$	0.21		2,612,684	$	0.17

For the three months ended September 30, 2013 and 2012, options on 170,215 and 115,860 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive. For the nine months ended September 30, 2013 and 2012, options on 170,215 and 110,360 shares, respectively, were not included in computing diluted earnings per share because their effects were anti-dilutive.

Note��8: Stock-Based Compensation

On June 28, 2013, the Company registered a new stock-based compensation plan, which superseded all other plans. There are 385,000 shares available for grant under this plan at September 30, 2013.

Stock-based compensation expense related to stock awards during the nine month periods ended September 30, 2013 and 2012 was $122,429 and $2,925, respectively. There was no unrecognized compensation expense related to stock options as of September 30, 2013. A total of 89,500 options were granted and vested during the nine months ended September 30, 2013. Compensation expense for stock options is the estimated fair value of options granted using the Black-Scholes Model amortized on a straight-line basis over the vesting period of the award. The fair value of options granted under the former 2003 Incentive Stock Option Plan and the former 2008 Non-Employee Directors Stock Option Plan during the nine months ended September 30, 2013 was $1.08, respectively. The variables used in these calculations include the historical dividend yield of 3.6%, expected life of the options of five years, expected stock price volatility of 33.8%, and a risk-free interest rate of 0.86%, which is assumed to be the rate on 5-year U.S. Treasury bonds.

22

Stock option plan activity for the nine months ended September 30, 2013 (unaudited) is summarized below:

	Shares			Weighted Average Exercise Price		Average Remaining Contractual Life (in years)		Aggregate Intrinsic Value (1)
Options outstanding, January 1		120,617		$	9.51		5.4
Granted		89,500			5.25
Forfeited		(8,972	)		9.00
Exercised		—			—
Expired		(7,596	)		13.80
Options outstanding, September 30		193,549			7.39		7.0	$	13,229
Options exercisable, September 30		193,549			7.39		7.0	$	13,229

(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on September 30, 2013. This amount changes based on changes in the market value of the Company’s common stock.

As of February 21, 2013, a total of 7,000 shares of the Company’s common stock was awarded to the Chief Executive Officer, the Executive Vice President and the Chief Financial Officer. These shares vested immediately and $36,750 in compensation expense was recognized on that date.

Note 9: Employee Benefit Plans

The Company has a non-contributory, defined benefit pension plan for full-time employees over 21 years of age. Under this cash balance plan, until December 31, 2012, the account balance for each participant would grow each year with annual pay credits based on age and years of service and monthly interest credits based on an amount established each year by the Company’s Board of Directors. Effective December 31, 2012, this plan was frozen to new participants. Annual pay credits have been discontinued, but each participant’s account balance will continue to grow based on monthly interest credits. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act.

The Company sponsors a postretirement benefit plan covering current and future retirees who acquire age 55 and 10 years of service or age 65 and 5 years of service. The post-retirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses. The plan is unfunded and funded as benefits are due.

Components of Net Periodic Benefit Cost

(Unaudited)

	Pension Benefits						Post Retirement Benefits
Nine months ended September 30,	2013			2012			2013		2012
Service cost	$	—		$	190,714		$	17,213	$	19,501
Interest cost		107,444			133,724			22,430		22,468
Expected return on plan assets		(160,996	)		(241,398	)		—		—
Amortization of unrecognized prior service cost		—			(40,472	)		—		—
Amortization of unrecognized net loss		67,309			53,580			3,372		2,206
Remaining amortization of unrecognized net loss due to settlements		62,280			168,580			—		—
Net gain due to curtailment		—			(291,413	)		—		—
Amortization of transition obligation		—			—			2,185		2,185
Net periodic benefit cost	$	76,037		$	(26,685	)	$	45,200	$	46,360

The Company expects to make no contribution to its pension plan and $23,945 to its post-retirement benefit plan in 2013. The Company has contributed $3,992 toward the post-retirement plan during the first nine months of 2013.

23

Note 10: Long Term Debt

On September 30, 2013, the Bank had FHLB debt consisting of two advances (see table below). The $10 million advance was restructured during the second quarter of 2013 to extend the maturity and reduce the interest rate from 4.23% to a three month LIBOR-based floating rate advance.

Advances on the FHLB lines are secured by a blanket lien on qualified 1 to 4 family residential real estate loans with a lendable collateral value of $56.0 million. Immediate available credit, as of September 30, 2013, was $40.0 million. With additional collateral, the total line of credit is worth $66.8 million, with $50.8 million available.

The two advances are shown in the following table.

Description	Balance		Originated		Current Interest Rate			Maturity Date
Adjustable Rate Hybrid	$	10,000,000		4/12/2013		2.38	%		4/13/2020
Fixed Rate Hybrid		5,000,000		5/20/2011		2.69	%		5/20/2014
	$	15,000,000

Note 11: Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

Level 1 –	Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –	Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –	Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Defined benefit plan assets: Defined benefit plan assets are recorded at fair value on an annual basis at year end.

24

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012:

			Fair Value Measurements at September 30, 2013 Using
Description	Balance		Level 1		Level 2		Level 3
	(unaudited)
Securities available for sale:
U. S. Government agencies	$	9,477,022	$	—	$	9,477,022	$	—
State and municipal obligations		27,449,003		—		27,449,003		—
Certificates of deposit		1,996,765		—		1,996,765		—
Auction rate securities		1,032,000		—		—		1,032,000
Total securities available for sale:	$	39,954,790	$	—	$	38,922,790	$	1,032,000

				Fair Value Measurements at December 31, 2012 Using
Description	Balance			Level 1			Level 2		Level 3
Securities available for sale:
U. S. Government agencies	$	9,463,815		$	—		$	9,463,815	$	—
State and municipal obligations		23,849,528			—			23,849,528		—
Certificates of deposit		1,987,177			—			1,987,177		—
Auction rate security		1,400,000			—			—		1,400,000
Total securities available for sale	$	36,700,520		$	—		$	35,300,520	$	1,400,000
Defined benefit plan assets:
Cash and cash equivalents		(5,539	)		(5,539	)		—		—
Mutual funds - fixed income		1,091,176			1,091,176			—		—
Mutual funds - equity		1,759,171			1,759,171			—		—
Total defined benefit plan assets	$	2,844,808		$	2,844,808		$	—	$	—

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: Other real estate owned (“OREO”) is measured at fair value less cost to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. The initial fair value of OREO is based on an appraisal done at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense on the Consolidated Statements of Income.

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The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis during the period.

			Fair Value Measurements at September 30, 2013 Using
Description	Balance		Level 1		Level 2		Level 3
	(unaudited)
Impaired Loans, net	$	1,959,027	$	—	$	—	$	1,959,027
Other real estate owned, net		3,910,728		—		—		3,910,728

			Fair Value Measurements at December 31, 2012 Using
Description	Balance		Level 1		Level 2		Level 3
Impaired Loans, net	$	3,308,074	$	—	$	—	$	3,308,074
Other real estate owned, net		3,151,346		—		—		3,151,346

The following table displays quantitative information about Level 3 Fair Value Measurements as of September 30, 2013:

Description	Balance		Valuation Technique	Unobservable Input	Range (Weighted Average)
	(unaudited)
Impaired Loans, net	$	1,959,027	Discounted appraised value	Selling Cost		10% - 20% (10	%)
				Lack of Marketability		0% - 100% (35	%)
Other real estate owned, net		3,910,728	Discounted appraised value	Selling Cost		3% - 13% (6	%)
				Lack of Marketability		7% - 30% (15	%)

The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2012:

Description	Balance		Valuation Technique	Unobservable Input	Range (Weighted Average)
	(unaudited)
Impaired Loans, net	$	3,308,074	Discounted appraised value	Selling Cost		0% - 20% (11	%)
				Lack of Marketability		10% - 100% (27	%)
Other real estate owned, net		3,151,346	Discounted appraised value	Selling Cost		6% - 13% (6	%)
				Lack of Marketability		10% - 20% (16	%)

The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheet under the applicable captions.

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			Fair Value Measurements at September 30, 2013 Using
Description	Balance as of September 30, 2013		Level 1		Level 2		Level 3
	(unaudited)
Financial Assets:
Cash and due from banks	$	7,537,010	$	7,537,010	$	—	$	—
Interest-bearing deposits		13,026,634		13,026,634		—		—
Federal funds sold		497,188		497,188		—		—
Securities available-for-sale		39,954,790		—		38,922,790		1,032,000
Restricted securities		1,623,350		—		—		1,623,350
Loans, net		245,885,715		—		—		251,573,000
Accrued interest receivable		1,068,966		—		1,068,966		—
Financial Liabilities:
Non-interest-bearing deposits	$	57,094,032	$	57,094,032	$	—	$	—
Savings and other interest-bearing deposits		115,334,496		—		115,334,496		—
Time deposits		99,535,358		—		—		101,560,000
Securities sold under repurchase agreements		9,430,510		—		9,430,510		—
FHLB advances		15,000,000		—		16,074,695		—
Accrued interest payable		172,361		—		172,361		—

			Fair Value Measurements at December 31, 2012 Using
Description	Balance as of December 31,2012		Level 1		Level 2		Level 3
Financial Assets:
Cash and due from banks	$	4,757,889	$	4,757,889	$	—	$	—
Interest-bearing deposits		35,166,448		35,166,448		—		—
Federal funds sold		48,009		48,009		—		—
Securities available-for-sale		36,700,520		—		35,300,520		1,400,000
Restricted securities		1,584,700		—		—		1,584,700
Loans, net		235,474,626		—		—		244,038,921
Accrued interest receivable		1,070,763		—		1,070,763		—
Financial Liabilities:
Non-interest-bearing deposits	$	50,467,907	$	50,467,907	$	—	$	—
Savings and other interest-bearing deposits		117,954,879		—		117,954,879		—
Time deposits		106,751,785		—		—		109,449,974
Securities sold under repurchase agreements		6,459,839		—		6,459,839		—
FHLB advances		15,000,000		—		16,483,342		—
Accrued interest payable		156,812		—		156,812		—

The carrying amounts of cash and due from banks, interest-bearing deposits, federal funds sold or purchased, accrued interest and non-interest-bearing deposits, are payable on demand, or are of such short duration that carrying value approximates market value.

Securities available for sale are carried at the fair values measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Therefore carrying value equals market value. The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does not consider the lack of liquidity and uncertainty in the market that would affect the valuation.

Time deposits are presented at estimated fair value using interest rates offered for deposits of similar remaining maturities.

The fair value of the FHLB advances is estimated by discounting the future cash flows using the current interest rate offered for similar advances.

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The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At September 30, 2013 and December 31, 2012, the fair value of loan commitments and standby letters of credit was immaterial and therefore, they are not included in the table above.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 12: Changes in Accumulated Other Comprehensive Income (Loss)

Changes in accumulated other comprehensive income (loss) (“AOCI”) balances, including amounts reclassified out of AOCI, are shown in the following table.

	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Three months ended September 30, 2013 (unaudited)
Beginning balance	$	(689,229	)	$	(659,921	)	$	(1,349,150	)
Change in net unrealized holding gains on securities, before reclassifications, net of tax benefit of $42,615		(82,723	)		—			(82,723	)
Reclassification for previously unrealized net (gains) and impairments on securities recognized in net income, net of tax of $4,417		(8,575	)		—			(8,575	)
Balance at September 30, 2013	$	(780,527	)	$	(659,921	)	$	(1,440,448	)
Three months ended September 30, 2012 (unaudited)
Beginning balance	$	571,376		$	(315,391	)	$	255,985
Change in net unrealized holding gains on securities, before reclassifications, net of tax of $31,643		61,425			—			61,425
Reclassification for previously unrealized net (gains) on securities recognized in net income, net of tax of $154,681		(300,263	)		—			(300,263	)
Balance at September 30, 2012	$	332,538		$	(315,391	)	$	17,147

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	Net Unrealized Gains (Losses) on Securities			Pension and Post-retirement Benefit Plans			Accumulated Other Comprehensive Income (Loss)
Nine months ended September 30, 2013 (unaudited)
Beginning balance	$	279,195		$	(659,921	)	$	(380,726	)
Change in net unrealized holding gains on securities, before reclassifications, net of tax benefit of $490,257		(951,676	)		—			(951,676	)
Reclassification for previously unrealized net (gains) and impairments on securities recognized in net income, net of tax of $55,660		(108,046	)		—			(108,046	)
Balance at September 30, 2013	$	(780,527	)	$	(659,921	)	$	(1,440,448	)
Nine months ended September 30, 2012 (unaudited)
Beginning balance	$	760,730		$	(315,391	)	$	445,339
Change in net unrealized holding gains on securities, before reclassifications, net of tax of $105,055		203,930			—			203,930
Reclassification for previously unrealized net (gains) on securities recognized in net income, net of tax of $325,638		(632,122	)		—			(632,122	)
Balance at September 30, 2012	$	332,538		$	(315,391	)	$	17,147

Reclassification for previously unrealized gains and impairments on securities are reported in the consolidated statements of income as “Gains on sale of securities available for sale” and “net impairment recognized in income” with the corresponding income tax effect being reflected as a component of income tax expense. During the nine months ended September 30, 2013 and 2012, the Company reported net gains on sales of securities of $283,706 and $957,760, respectively; the tax effect of these transactions was $55,660 and $325,658, respectively, which was included as a component of income tax expense. Similarly, for the nine month period ended September 30, 2013, the Company recorded a net impairment loss on an other-than-temporarily-impaired security of $120,000, with a corresponding tax effect of $40,800 included as a component of income tax expense (refer to Note 4).

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the results of operations and the financial condition of Bay Banks of Virginia, Inc. (the “Company”). This discussion should be read in conjunction with the above consolidated financial statements and the notes thereto.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

EXECUTIVE SUMMARY

Earnings increased 167% for the third quarter of 2013 compared to the third quarter of 2012 and 128% for the first nine months of 2013 compared to the first nine months of 2012. This allowed earnings per share to increase to $0.21 for the nine months ended September 30, 2013, even after the Company nearly doubled the number of shares outstanding as a result of its private placement of 2,200,000 shares of common stock in December 2012.

The third quarter results are highlighted by loan growth and increased earnings. The capital position remains solid. During the third quarter, the Bank’s loan portfolio grew by $14.2 million, and the portfolio of loans serviced for Fannie Mae grew by $4.7 million. The Company’s new residential loan production office which opened in Middlesex County in May of this year, has had a positive impact on loan growth. Core earnings remained a focus and the Company is working on prudent growth into contiguous markets. Asset quality remains good, with nonperforming assets at 1.9% of total assets. Mobile banking will be available to the Bank’s customers in the fourth quarter and the Company continues to make other changes which will be significant to the long-term success of the bank.

On September 30, 2013, the Bank closed a branch office, consolidating the accounts into two nearby branches. Transaction volumes in the branches continue to decline. Cost savings from the office closure is expected to be approximately $100,000 annually. The closed office is being marketed for sale and no impairment of the value of the property is expected.

On July 1, 2013, the Trust Company sold its former headquarters building and recognized a gain of $165 thousand from the sale. Expected cost savings are estimated to be $30 thousand annually.

The portfolio of loans serviced for Fannie Mae grew by $15.0 million since December 31, 2012 to $57.9 million as of September 30, 2013. As a result, the Bank began recognizing mortgage servicing rights in the third quarter which resulted in a cumulative adjustment of $535 thousand, with an after-tax impact of approximately $353 thousand.

Asset quality remains good. Non-performing assets are now 1.9% of assets as of September 30, 2013 compared to 2.7% at December 31, 2012. They are down to $6.4 million as of September 30, 2013 compared to $9.0 million as of December 31, 2012. OREO balances are $3.9 million as of September 30, 2013 compared to $3.2 million as of December 31, 2012. During the first nine months of 2013, ten OREO properties were sold and eight were added through foreclosures. Non-accruing loan balances are down to $2.4 million as of September 30, 2013 as compared to $5.7 million at December 31, 2012.

Annualized net loan charge-offs against the allowance for loan losses (“ALL”) are down to 0.38% of total loans during the first nine months of 2013 compared to 0.65% during the first nine months of 2012. This has resulted in corresponding reductions in provision for loan losses expense.

The net interest margin declined to 3.51% for the first nine months of 2013 compared to 3.60% for the same period in 2012. It has become increasingly difficult to reduce the cost of funds by the same or more than the reductions the Company is seeing in yields on loans and investments. As this historic low-rate climate continues, loan yields continue to decline, contributing to reduced interest income. In order to drive increases in interest income, the Bank’s main source of revenue, management is concentrating on loan growth via cautious expansion into new markets. Since December 31, 2012, loan balances have grown by $10.4 million. The refinance of a FHLB advance and scheduled maturities of time deposits in 2013, are expected to help to reduce the Company’s cost of funds. Maturities of time deposits are typically renewed at lower rates, leave the bank or transfer to a lower-cost checking or savings account.

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Finally, the Company’s core capital levels and regulatory ratios remain substantially higher than what is considered “well capitalized” by the Company’s regulators, due in no small part to last fall’s successful capital raise. The Company took no Troubled Asset Relief Program (“TARP”) or Small Business Lending Fund (“SBLF”) investments from the U.S. Treasury. In July 2013, the FDIC and Federal Reserve approved a final rule to implement Basel III capital reforms, among other changes required by the Dodd-Frank Act. The Company expects the impact of these rules to not be significant to the Company based on its present capital position. The Company expects to comply with the new common equity requirements and other capital requirements under these reforms.

For more information, visit the Company’s website at www.baybanks.com. Information contained on the Company’s website is not a part of this report.

EARNINGS SUMMATION

For the three months ended September 30, 2013 and 2012, net income was $620 thousand and $233 thousand, respectively, an increase of $387 thousand or 167%. Diluted earnings per average share for the three months ended September 30, 2013 and 2012 were $0.13 and $0.09, respectively. Return on average assets was 0.74% for the three months ended September 30, 2013 compared to 0.29% for the three months ended September 30,2012. Return on average equity was 6.82% and 5.09% for the three months ended September 30, 2013 and 2012, respectively.

For the nine months ended September 30, 2013 and 2012, net income was $992 thousand and $435 thousand, respectively, an increase of $557 thousand or 128.0%. Diluted earnings per average share for the nine months ended September 30, 2013 and 2012 were $0.21 and $0.17, respectively. Return on average assets was 0.40% for the nine months ended September 30, 2013 compared to 0.18% for the nine months ended September 30,2012. Return on average equity was 3.6% and 2.1% for the nine months ended September 30, 2013 and 2012, respectively.

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RESULTS OF OPERATIONS

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest-earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, the associated yields and rates, and the volume of non-performing assets have an effect on net interest income, the net interest margin, and net income.

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 2012

NET INTEREST INCOME

Net Interest Income Analysis (unaudited)	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis) (Dollars in Thousands)	Three months ended 9/30/2013							Three months ended 9/30/2012
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	23,144	$	103		1.78	%	$	24,115	$	144		2.39	%
Tax-exempt investments (1)		19,520		153		3.14	%		10,044		83		3.31	%
Total investments		42,664		256		2.40	%		34,159		227		2.66	%
Gross loans (2)		245,332		3,182		5.19	%		240,698		3,209		5.33	%
Interest-bearing deposits		18,313		13		0.28	%		12,398		7		0.23	%
Federal funds sold		451		—		0.17	%		664		—		0.08	%
Total Interest Earning Assets	$	306,760	$	3,451		4.50	%	$	287,919	$	3,443		4.78	%
INTEREST-BEARING LIABILITIES:
Savings deposits	$	45,490	$	18		0.16	%	$	47,025	$	35		0.30	%
NOW deposits		41,378		16		0.15	%		39,857		24		0.24	%
Time deposits => $100,000		45,194		254		2.23	%		51,223		294		2.30	%
Time deposits < $100,000		55,439		264		1.89	%		62,303		317		2.04	%
Money market deposit accounts		29,111		30		0.41	%		22,595		36		0.64	%
Total Deposits	$	216,612	$	582		1.07	%	$	223,003	$	706		1.27	%
Federal funds purchased	$	5	$	—		0.60	%	$	218	$	—		0.70	%
Securities sold under repurchase agreements		9,514		3		0.11	%		6,321		4		0.25	%
FHLB advances		15,000		102		2.70	%		15,000		142		3.80	%
Total Interest-Bearing Liabilities	$	241,131	$	687		1.13	%	$	244,542	$	852		1.40	%
Net interest income and net interest margin			$	2,764		3.60	%			$	2,591		3.60	%
Non-interest-bearing deposits	$	56,080		—		0.00	%	$	47,518		—		0.00	%
Total Cost of funds						0.92	%						1.17	%
Net interest rate spread						3.58	%						3.61	%

Notes:

(1) Income and yield assumes a federal tax rate of 34%.

(2) Includes Visa program and nonaccrual loans.

Interest income for the three months ended September 30, 2013, on a tax-equivalent basis, was $3.5 million, an increase of $8 thousand from the third quarter of 2012. Interest expense for the three months ended September 30, 2013, was $687 thousand, a decrease of $165 thousand from the third quarter of 2012, due mainly to reductions in both balances and costs of time deposits. Net interest income for the three months ended September 30, 2013, on a tax-equivalent basis, was $2.8 million, an increase of $173 thousand from the third quarter of 2012. The annualized net interest margin was 3.60% for both the three months ended September 30, 2013 and 2012. The deposit mix continues to improve as lower cost balances in checking and money market accounts have increased while higher cost time deposit balances have declined. Further reductions in the cost of funds are anticipated as time deposits mature and are replaced at lower rates. As long as market rates remain low, this positive trend is expected to continue.

32

The net interest spread, which is the difference between the annualized yield on earning assets and the total cost of funds, decreased to 3.58% for the three months ended September 30, 2013, compared to 3.61% for the three months ended September 30, 2012.

NON-INTEREST INCOME

Non-interest income for the three months ended September 30, 2013 increased $431 thousand, or 27.7%, compared to the three months ended September 30, 2012. This increase was primarily due to the recognition of $535 thousand in mortgage servicing rights (Refer to Note 2), increased commissions of $158 thousand from Investment Advantage, which is the Bank’s non-deposit products program and $165 thousand from a gain on the sale of a building. These increases were partially offset by reduced gains on the sales of securities of $441 thousand.

NON-INTEREST EXPENSE

For the three months ended September 30, 2013, non-interest expenses totaled $3.5 million, an increase of $426 thousand, or 13.6%, compared to the same period in 2012. The largest component of non-interest expense is salaries and benefits, which increased by $204 thousand. This increase was the result of commissions related to increased mortgage loan activity which were $176 thousand higher and other benefits were higher by $65 thousand primarily due to severances. OREO losses increased $119 thousand.

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2012

NET INTEREST INCOME

Net Interest Income Analysis (unaudited)	Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis) (Dollars in Thousands)	Nine months ended 9/30/2013							Nine months ended 9/30/2012
	Average Balance		Income/ Expense		Yield/ Cost			Average Balance		Income/ Expense		Yield/ Cost
INTEREST EARNING ASSETS:
Taxable investments	$	24,965	$	345		1.84	%	$	27,218	$	525		2.57	%
Tax-exempt investments (1)		15,166		342		3.01	%		10,902		285		3.48	%
Total investments		40,131		687		2.28	%		38,120		810		2.83	%
Gross loans (2)		237,856		9,471		5.31	%		240,725		9,699		5.37	%
Interest-bearing deposits		26,759		49		0.24	%		12,695		23		0.24	%
Federal funds sold		682		1		0.20	%		1,799		3		0.20	%
Total Interest Earning Assets	$	305,428	$	10,208		4.46	%	$	293,339	$	10,535		4.79	%
INTEREST-BEARING LIABILITIES:
Savings deposits	$	46,095	$	71		0.20	%	$	47,566	$	136		0.38	%
NOW deposits		40,989		60		0.20	%		38,710		64		0.22	%
Time deposits => $100,000		46,110		769		2.23	%		51,533		887		2.30	%
Time deposits < $100,000		56,889		805		1.89	%		63,294		974		2.06	%
Money market deposit accounts		28,186		110		0.52	%		22,865		110		0.64	%
Total Deposits	$	218,269	$	1,815		1.11	%	$	223,968	$	2,171		1.30	%
Federal funds purchased	$	77	$	—		0.74	%	$	73	$	—		0.41	%
Securities sold under repurchase agreements		8,280		13		0.21	%		6,147		12		0.27	%
FHLB advances		15,000		347		3.09	%		15,000		424		3.77	%
Total Interest-Bearing Liabilities	$	241,626	$	2,175		1.20	%	$	245,188	$	2,607		1.42	%
Net interest income and net interest margin			$	8,033		3.51	%			$	7,928		3.60	%
Non-interest-bearing deposits	$	52,532		—		0.00	%	$	45,543		—		0.00	%
Total Cost of funds						0.98	%						1.20	%
Net interest rate spread						3.48	%						3.59	%

Notes:

(1) Income and yield assumes a federal tax rate of 34%.

(2) Includes Visa program and nonaccrual loans.

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Interest income for the nine months ended September 30, 2013, on a fully tax-equivalent basis, was $10.2 million, a decrease of $327 thousand from the first nine months of 2012, due primarily to reduced loan balances, but also from lower yields on loans and investments. Interest expense for the nine months ended September 30, 2013, was $2.2 million, a decrease of $432 thousand compared to the first nine months of 2012, due primarily to reduced average balances and costs of time deposits. Net interest income for the nine months ended September 30, 2013, on a fully tax-equivalent basis, was $8.0 million, increasing $105 thousand from the first nine months of 2012. The annualized net interest margin was 3.51% for the nine months ended September 30, 2013, down from 3.60% for the same period in 2012. The main reason for the decrease is lower yields on investments. However, reductions in deposit costs and related interest expense have helped to mitigate the reduced interest income. Also, the mix of deposits continues to improve as lower cost balances in checking and money market accounts have increased while higher cost time deposit balances have declined. Further reductions in the cost of funds are anticipated as time deposits mature and are replaced at lower rates. As long as market rates remain low, this positive trend is expected to continue.

The net interest spread, which is the difference between the annualized yield on earning assets and the annualized cost of funds, declined to 3.48% for the nine months ended September 30, 2013, compared to 3.59% for the nine months ended September 30, 2012.

NON-INTEREST INCOME

Non-interest income for the nine months ended September 30, 2013 increased by $443 thousand, or 11.6%, compared to the nine months ended September 30, 2012. The change in non-interest income was driven by the following changes:

Increases:

• Recognition of mortgage servicing rights of $535 thousand.

• $203 thousand in service changes and fees on deposit accounts driven mainly by the Overdraft Privilege Program introduced in 2012.

• An increase of $169 thousand in commissions from Investment Advantage, the Bank’s non-deposit products program.

• Gain of $165 thousand recognized on the sale of a building.

Decreases:

• Net gains on sale of securities available for sale of $674 thousand.

NON-INTEREST EXPENSE

For the nine months ended September 30, 2013, non-interest expenses totaled $10.2 million, an increase of $482 thousand, or 4.9%, compared to $9.8 million for the same period in 2012. The largest component of non-interest expense is salaries and benefits, which increased by $595 thousand, due primarily to higher commissions related to increased mortgage lending activities, incentive compensation related to stock-based compensation and certain benefits.

Increases in salary and benefits expense were partially offset by the following expense decreases:

• A decrease of $57 thousand in consulting expenses resulting from the completion of prior year revenue enhancing projects.

• A decrease of $49 thousand from a fraud investigation completed in 2012.

• Occupancy expense decreased by $43 thousand for the first nine months of 2013 compared to the similar period in 2012, a result of decreased building maintenance expense and software contract expense.

• OREO costs, including losses on OREO, which was reclassified into non-interest expense from non-interest income, have improved by $64 thousand.

AVERAGE INTEREST-EARNINGS ASSETS AND AVERAGE INTEREST-BEARING LIABILITIES

Average interest-earning assets increased 4.1% to $305.4 million for the nine months ended September 30, 2013, as compared to $293.3 million for the nine months ended September 30, 2012, a result of higher average interest-bearing deposit balances in the Bank’s account at the Federal Reserve Bank of Richmond, which was driven by receipt of cash from the issuance of new capital in December 2012, declines in average loan balances, and increases in non-interest bearing checking accounts. Average interest-earning assets as a percent of total average assets was 91.2% for the nine months ended September 30, 2013 as compared to 92.2% for the same period in 2012. The loan portfolio, with $237.9 million in average balances as of September 30, 2013, is the largest category of interest-earning assets.

Average interest-bearing liabilities decreased 1.5% to $241.6 million for the nine months ended September 30, 2013, as compared to $245.2 million for the nine months ended September 30, 2012. The largest category of interest-bearing liabilities is time deposits, with combined average balances of $103.0 million for the nine months ended September 30, 2013, down from $114.8 million for the similar period in 2012.

ASSET QUALITY

In the first nine months of 2013, asset quality improved. Non-performing assets, which include OREO and non-performing loans, declined $2.6 million to $6.4 million, or 1.9% of assets. This level also represents 2.7% of loans plus OREO.

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Non-Performing Assets

(Dollars in Thousands)	September 30, 2013						December 31, 2012
	(unaudited)
	$			%			$			%
(percentages are as a percent of total loans)
Loans past due 90 days or more and still accruing	$	31			0.01	%	$	126			0.1	%
Non-accruing loans		2,449			1.0	%		5,730			2.4	%
Total non-performing loans	$	2,480			1.1	%	$	5,856			2.4	%
Allowance for loan losses	$	2,979			1.27	%	$	3,094			1.29	%
Allowance to non-performing loans		120.1	%					52.8	%
(percentages are as a percent of total loans plus OREO)
Other real estate owned		3,911			1.6	%		3,151			1.3	%
Total non-performing assets	$	6,391			2.7	%	$	9,007			3.7	%

Non-performing loans, which include loans past due 90 days or more and still accruing, plus non-accruing loans, as a percentage of total loans, decreased to 1.1% as of September 30, 2013 compared to 2.4% as of December 31, 2012. Non-accruing loans totaled $2.4 million as of September 30, 2013, down from $5.7 million at year-end 2012.

Loans charged off during the first nine months of 2013, net of recoveries, totaled $680 thousand compared to $1.2 million for the first nine months of 2012. This represents a decline in the annualized net charge-off ratio to 0.38% for the first nine months of 2013 compared to 0.64% for the first nine months of 2012, reflecting an improvement in asset quality. The majority of the charge-offs were anticipated and specific reserves had been provided for them in the ALL. Management is maintaining an adequate level of the ALL at 1.27% and 1.29% of total loans for September 30, 2013 and December 31, 2012, respectively.

Classified assets increased by $1.1 million during the first nine months of 2013 to $15.4 million, or 39.3% of Tier 1 capital plus the allowance for loan losses. Risk rating grades are assigned conservatively, causing some homogenous loans, such as residential mortgages, to fall into the pool of adversely risk rated loans and thereby evaluated for impairment, even though they may be performing as agreed and therefore not impaired.

As of September 30, 2013, loans valued at $8.3 million were considered impaired, whereas $7.6 million were considered impaired as of December 31, 2012. Between December 31, 2012 and September 30, 2013, 13 loans were identified as impaired and six were dispensed through foreclosures and charge-offs. Management has reviewed the impaired credits and the underlying collateral and expects no additional losses above those which are specifically reserved in ALL.

FINANCIAL CONDITION

Total assets remained relatively flat at $334.9 million as of September 30, 2013 compared to $334.8 million at December 31, 2012. Cash and due from banks, which produces no income, increased to $7.5 million on September 30, 2013 from $4.7 million at year-end 2012, a result of normal daily fluctuation in deposit transactions. Interest-bearing deposits at other banks, which is mainly the Bank’s cash on deposit at the Federal Reserve Bank of Richmond, has declined by $22.1 million since year end 2012 as those funds have been redeployed into assets earning higher yields.

During the nine months ended September 30, 2013, gross loans increased by $10.3 million or 4.3%, to $248.9 million from $238.6 million at year-end 2012. The largest component of this increase was a $7.0 million related to residential first mortgages.

The Bank had $3.9 million of OREO at September 30, 2013 and $3.2 million at December 31, 2012. As of September 30, 2013, OREO consists of 11 residences, 16 lots, two former convenience stores, a seafood house, one former nursery property and one commercial business property. During the first nine months of 2013, nine properties with a total book value of $2.3 million from eight borrowers were added through foreclosures, and 10 properties with a total book value of $1.3 million were sold. Write-downs of book value on OREO properties totaled $249 thousand during the first nine months of 2013, compared to $222 thousand for the same period in 2012. All properties maintained as OREO are valued at the lesser of carrying value or fair value less estimated costs to sell and are actively marketed.

As of September 30, 2013, securities available for sale at fair value totaled $40.0 million as compared to $36.7 million on December 31, 2012. This represents a net increase of $3.3 million or 9.1% for the nine months. As of September 30, 2013, these securities represented 11.9% of total assets and 13.1% of earning assets. All securities in the Company’s investment portfolio are classified as available-for-sale and marked to market on a monthly basis. These gains or losses, net of tax, are booked as an adjustment to shareholders’ equity, and are not realized as an adjustment to earnings until the securities are actually sold or an other than temporary impairment occurs. One security, with a fair value of $1.0 million, is deemed to be other than temporarily impaired by $120 thousand.

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In the second quarter of 2013, the Company purchased $5.0 million of bank owned life insurance in order to offset the cost of employee benefits.

As of September 30, 2013, total deposits were $272.0 million compared to $275.2 million at year-end 2012. This represents a decrease in balances of $3.2 million or 1.2% during the nine months. The decline consisted of $7.2 million of reductions in time deposit balances and $2.7 million in savings and interest-bearing demand deposits partially offset by an increase of $6.6 million in non-interest bearing deposits.

As of September 30, 2013, securities sold under repurchase agreements increased $2.9 million to $9.4 million from $6.5 million at December 31, 2012. This increase was the result of normal seasonality for these customers.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates are major factors for liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At September 30, 2013, cash totaled $7.5 million, federal funds sold totaled $497 thousand, interest-bearing deposits totaled $13.0 million, and securities and loans maturing in one year or less totaled $31.5 million. This results in a liquidity ratio as of September 30, 2013 of 15.7% as compared to 18.6% as of December 31, 2012. The Company determines this ratio by dividing the sum of cash and cash equivalents, investment securities maturing in one year or less, loans maturing in one year or less and federal funds sold, by total assets. The Bank has a formal liquidity management policy and contingency plan. Given current economic uncertainty, management is maintaining a historically high level of liquidity.

In addition, as noted earlier, the Company has a line of credit with the FHLB of $66.8 million, plus federal funds lines of credit with correspondent banks totaling $20.3 million.

CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allows management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as shareholders’ equity, is comprised mainly of outstanding common stock and retained earnings. Capital can be increased with securities offerings or through earnings. On December 31, 2012, the Company sold a total of 2,200,000 shares of its common stock at a purchase price of $4.25 per share to certain accredited investors in a private placement exempt from registration under the Securities Act of 1933 pursuant to Section 4(2) thereof and Rule 506 of Regulation D promulgated thereunder. The Company received gross proceeds of $9.35 million from such private placement. The Company has a formal capital policy and plan, and management believes that the capital level at September 30, 2013, which was enhanced by this successful private placement, supports plans for growth.

Several factors impact shareholders’ equity, including net income, and regulatory capital requirements. The Company’s capital resources are also impacted by net unrealized gains or losses on securities. The available-for-sale securities portfolio is marked to market monthly and unrealized gains or losses, net of taxes, are recognized as accumulated other comprehensive income (loss) on the balance sheets and statement of changes in shareholders’ equity. Another factor affecting accumulated other comprehensive income (loss) is changes in the market value of the Company’s pension and post-retirement benefit plans. The Company’s shareholders’ equity before accumulated other comprehensive income (loss) was $38.1 million on September 30, 2013 compared to $37.0 million on December 31, 2012. Accumulated other comprehensive loss increased $1.1 million between December 31, 2012 and September 30, 2013, primarily as a result of increases in unrealized losses in the investment portfolio.

Book value per share, before accumulated other comprehensive loss, on September 30, 2013, compared to December 31, 2012, increased to $7.90 from $7.68. Book value per share, including accumulated other comprehensive loss, increased to $7.61 on September 30, 2013 from $7.60 on December 31, 2012. No cash dividends were paid for the nine-month period ended September 30, 2013, nor for the comparable period ended September 30, 2012. Of the 10,000,000 common shares authorized, 4,817,856 were outstanding on September 30, 2013, up 7,000 shares from 4,810,856 on December 31, 2012, a result of stock awarded to the Company’s Chief Executive Officer, Executive Vice President and Chief Financial Officer.

The Bank is subject to minimum regulatory capital ratios as defined by Federal Financial Institutions Examination Council guidelines. These ratios continue to be well in excess of regulatory minimums. As of September 30, 2013, the Bank maintained Tier 1 capital of $30.3 million, net risk weighted assets of $237.9 million, and Tier 2 capital of $3.0 million. On September 30, 2013, the Tier 1 leverage ratio was 9.12%, the capital to risk weighted assets ratio was 12.74%, and the total capital ratio to risk weighted assets ratio was 13.99%.

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OFF BALANCE SHEET COMMITMENTS

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments may involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Off Balance Sheet Arrangements
(unaudited)	September 30, 2013		December 31, 2012
(Dollars in Thousands)
Total Loan Commitments Outstanding	$	36,597	$	30,459
Standby-by Letters of Credit		338		359

The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon takedown of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.

There have been no material changes to the off balance sheet items disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operation” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

CONTRACTUAL OBLIGATIONS

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

RECENT ACCOUNTING PRONOUNCEMENTS

Refer to Note 3, Amendments to the Accounting Standards Codification, for information related to the adoption of new amendments to the Accounting Standards Codification.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions. Based upon their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic Securities and Exchange Commission filings as of September 30, 2013.

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CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

There was no change to the Company’s internal control over financial reporting during the nine months ended September 30, 2013 that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

ITEM 1A. RISK FACTORS

Not required.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None to report.

ITEM 3. DEFAULT UPON SENIOR SECURITIES

None to report.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM  5. OTHER INFORMATION

None to report.

ITEM 6. EXHIBITS

31.1	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification Pursuant to 18 U.S.C Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101	The following materials from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012, (iii) Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2013, (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012, and (v) Notes to Consolidated Financial Statements.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Bay Banks of Virginia, Inc.
	(Registrant)
November 12, 2013	By:	/s/ Randal R. Greene
		Randal R. Greene
		President and Chief Executive Officer
		(Principal Executive Officer)
	By:	/s/ Deborah M. Evans
		Deborah M. Evans
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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