Carolina Bank (CLBH) 10-Q 2011 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2011

or

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

For the transition period from              to             

Commission File Number: 000-31877

Carolina Bank Holdings, Inc.

(Exact name of registrant as specified in its charter)

North Carolina	56-2215437
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
101 North Spring Street, Greensboro, North Carolina	27401
(Address of principal executive offices)	(Zip Code)

(336) 288-1898

(Registrant’s telephone number, including area code)

n/a

(Former name, former address and former fiscal year, if changed since last report)

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).    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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	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

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. There were 3,387,045 shares of the Issuer’s common stock, $1.00 par value, outstanding as of November 9, 2011.

CAROLINA BANK HOLDINGS, INC.

INDEX

	Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)		2
Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010		2
Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010		3
Consolidated Statements of Comprehensive Income for the three and nine months ended September  30, 2011 and 2010		4
Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2011		5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010		6
Notes to Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		27
Item 4. Controls and Procedures		33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		34
Item 4. (Reserved)		34
Item 6. Exhibits		34
Exhibit 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act		36
Exhibit 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act		38
Exhibit 32.1 Certification Pursuant to 18 U.S.C. Section 1350		40

1

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

Carolina Bank Holdings, Inc. and Subsidiary

Consolidated Balance Sheets

	September 30, 2011			December 31, 2010*
	(unaudited)
	(in thousands except share and per share data)
Assets
Cash and due from banks	$	5,579		$	5,116
Interest-bearing deposits with banks		8,175			17,710
Securities available-for-sale, at fair value		44,903			42,785
Securities held-to-maturity		452			563
Loans held for sale		71,972			53,961
Loans		489,782			514,029
Less allowance for loan losses		(12,049	)		(12,359	)
Net loans		477,733			501,670
Premises and equipment, net		18,109			18,622
Other real estate owned		8,972			9,848
Bank-owned life insurance		10,291			10,003
Other assets		15,598			16,423
Total assets	$	661,784		$	676,701
Liabilities and Stockholders’ Equity
Deposits
Non-interest bearing demand	$	53,918		$	43,564
NOW, money market and savings		320,997			303,203
Time		210,269			257,800
Total deposits		585,184			604,567
Advances from the Federal Home Loan Bank		3,099			3,165
Securities sold under agreements to repurchase		2,835			432
Subordinated debentures		19,470			19,414
Other liabilities and accrued expenses		5,500			4,841
Total liabilities		616,088			632,419
Stockholders’ equity
Preferred stock, no par value, authorized 1,000,000 shares; issued and outstanding 16,000 shares in 2011 and 2010		15,083			14,811
Common stock, $1 par value; authorized 20,000,000 shares; issued and outstanding 3,387,045 in 2011 and 2010		3,387			3,387
Common stock warrants		1,841			1,841
Additional paid-in capital		15,861			15,834
Retained earnings		8,404			7,910
Stock in directors’ rabbi trust		(828	)		(718	)
Directors’ deferred fees obligation		828			718
Accumulated other comprehensive income		1,120			499
Total stockholders’ equity		45,696			44,282
Total liabilities and stockholders’ equity	$	661,784		$	676,701

* Derived from audited consolidated financial statements.

See accompanying notes to consolidated financial statements.

2

Carolina Bank Holdings, Inc. and Subsidiary

Consolidated Statements of Operations (unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(in thousands, except per share data)
Interest income
Loans	$	7,153		$	7,771		$	21,202		$	22,790
Investment securities, taxable		333			393			1,094			1,275
Investment securities, non taxable		124			168			433			494
Interest from deposits in banks		22			16			70			60
Total interest income		7,632			8,348			22,799			24,619
Interest expense
NOW, money market, savings		630			857			1,928			2,773
Time deposits		822			1,309			2,654			4,020
Other borrowed funds		189			201			564			655
Total interest expense		1,641			2,367			5,146			7,448
Net interest income		5,991			5,981			17,653			17,171
Provision for loan losses		1,800			6,620			5,150			13,308
Net interest income after provision for loan losses		4,191			(639	)		12,503			3,863
Non-interest income
Service charges		300			231			787			682
Mortgage banking income		2,964			3,258			6,668			7,194
Gain on sale of investment securities		28			350			239			535
Gain (loss) on the sale of other real estate owned		(217	)		14			(164	)		(239	)
Other		109			177			384			493
Total non-interest income		3,184			4,030			7,914			8,665
Non-interest expense
Salaries and benefits		3,450			3,253			9,607			8,637
Occupancy and equipment		627			655			1,823			1,862
Professional fees		221			337			703			939
Outside data processing		227			260			627			717
FDIC insurance		98			262			817			781
Advertising and promotion		180			294			410			544
Stationery, printing and supplies		169			153			442			399
Impairment of other real estate owned		576			443			1,999			1,912
Other real estate owned expense		274			243			883			665
Other		540			521			1,543			1,415
Total non-interest expense		6,362			6,421			18,854			17,871
Income (loss) before income taxes		1,013			(3,030	)		1,563			(5,343	)
Income tax expense (benefit)		201			(1,226	)		197			(2,270	)
Net income (loss)		812			(1,804	)		1,366			(3,073	)
Dividends and accretion on preferred stock		292			282			872			855
Net income (loss) available (allocable) to common stockholders	$	520		$	(2,086	)	$	494		$	(3,928	)
Net income (loss) per common share
Basic	$	0.15		$	(0.62	)	$	0.15		$	(1.16	)
Diluted	$	0.15		$	(0.62	)	$	0.15		$	(1.16	)

See accompanying notes to consolidated financial statements.

3

Carolina Bank Holdings, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income (unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
	(in thousands)
Net income (loss)	$	812		$	(1,804	)	$	1,366		$	(3,073	)
Other comprehensive income:
Investment securities available for sale:
Unrealized holding gains		155			564			1,180			853
Tax effect		(53	)		(192	)		(401	)		(290	)
Reclassification of gains recognized in net income		(28	)		(350	)		(239	)		(535	)
Tax effect		10			119			81			182
		84			141			621			210
Comprehensive income (loss)	$	896		$	(1,663	)	$	1,987		$	(2,863	)

See accompanying notes to consolidated financial statements.

4

Carolina Bank Holdings, Inc. and Subsidiary

Consolidated Statement of Stockholders’ Equity (unaudited)

	Preferred Stock		Common Stock		Common Stock Warrants		Additional Paid-In Capital		Retained Earnings			Stock in Directors’ Rabbi Trust			Directors’ Deferred Fees Obligation		Accumulated Other Comprehensive Income		Total
	(in thousands)
Balance, December 31, 2010	$	14,811	$	3,387	$	1,841	$	15,834	$	7,910		$	(718	)	$	718	$	499	$	44,282
Comprehensive income
Net income		—		—		—		—		1,366			—			—		—		1,366
Other comprehensive income, net of tax		—		—		—		—		—			—			—		621		621
Directors’ deferred fees paid less deferrals of new fees		—		—		—		—		—			(110	)		110		—		—
Stock options expensed		—		—		—		27		—			—			—		—		27
Amortization of preferred stock discount		272		—		—		—		(272	)		—			—		—		—
Preferred stock dividends		—		—		—		—		(600	)		—			—		—		(600	)
Balance, September 30, 2011	$	15,083	$	3,387	$	1,841	$	15,861	$	8,404		$	(828	)	$	828	$	1,120	$	45,696

See accompanying notes to consolidated financial statements.

5

Carolina Bank Holdings, Inc. and Subsidiary

Consolidated Statements of Cash Flows (unaudited)

	Nine Months Ended September 30,
	2011			2010
	(in thousands)
Cash flows from operating activities
Net income (loss)	$	1,366		$	(3,073	)
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan losses		5,150			13,308
Depreciation		678			713
Increase in cash surrender value of bank-owned life insurance		(288	)		(293	)
Equity-based compensation		27			27
Deferred income tax (benefit)		350			(889	)
Amortization (accretion), net		—			(48	)
Amortization of subordinated debt discount		56			35
Loss on sale of other real estate owned		164			239
Gain on sale of investments		(239	)		(535	)
Impairment of other real estate owned		1,999			1,912
Increase in loans held for sale		(11,675	)		(29,073	)
Net gains from the sale of loans held for sale		(6,336	)		(6,869	)
(Increase) decrease in other assets		227			(2,539	)
Increase in accrued expenses and other liabilities		459			869
Net cash used for operating activities		(8,062	)		(26,216	)
Cash flows from investing activities
Purchases of investment securities available-for-sale		(17,686	)		(3,251	)
Maturities and calls of securities available-for-sale		4,048			257
Repayments from mortgage-backed securities available-for-sale		2,980			4,371
Repayments from mortgage-backed securities held-to-maturity		109			172
Reduction (origination) of loans, net of principal collected		13,296			(4,607	)
Proceeds from sales of investment securities		9,722			8,322
Improvements to other real estate owned		(22	)		(92	)
Additions to premises and equipment		(165	)		(121	)
Proceeds from sales of other real estate owned		4,154			6,419
Net cash provided by investing activities		16,436			11,470
Cash flows from financing activities
Net increase (decrease) in deposits		(19,383	)		8,589
Net decrease in Federal Home Loan Advances		(66	)		(5,059	)
Increase in securities sold under agreements to repurchase		2,403			2,183
Dividends paid		(400	)		(600	)
Net cash provided by (used for) financing activities		(17,446	)		5,113
Net decrease in cash and cash equivalents		(9,072	)		(9,633	)
Cash and cash equivalents at beginning of period		22,826			40,455
Cash and cash equivalents at end of period	$	13,754		$	30,822
Supplemental disclosure of cash flow information
Cash paid during the period for interest	$	5,283		$	7,428
Cash paid during the period for income taxes	$	696		$	450
Supplemental disclosure of non-cash transactions
Transfer of loans to other real estate owned	$	5,491		$	4,276
Dividends declared but not paid	$	200		$	—
Accretion of preferred stock discount	$	272		$	251

See accompanying notes to consolidated financial statements.

6

Carolina Bank Holdings, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note A – Summary

Carolina Bank Holdings, Inc. (the “Holding Company” or the “Company”) is a North Carolina corporation organized in 2000. Effective October 31, 2000, pursuant to the plan of share exchange approved by the shareholders of Carolina Bank (the “Bank”), all of the outstanding shares of common stock of the Bank were exchanged for shares of common stock of the Holding Company. The Holding Company presently has no employees.

The Bank was incorporated in August 1996, and began banking operations in November 1996. It is engaged in lending and deposit gathering activities in Guilford, Alamance, Randolph and Forsyth Counties, North Carolina and operates under the laws of North Carolina, the rules and regulations of the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks. The Bank has eight full-service banking locations, comprised of four in Greensboro and one in each of Asheboro, Burlington, High Point, and Winston-Salem. A wholesale mortgage division is located at the Greensboro corporate headquarters, and a mortgage loan production office is located in Burlington. All offices are in the Piedmont Triad region of North Carolina.

The Holding Company files periodic reports with the Securities and Exchange Commission and is also subject to regulation by the Federal Reserve Board.

Note B – Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. All significant inter-company transactions and balances have been eliminated.

Note C – Basis of presentation

In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three and nine months ended September 30, 2011 and 2010, in conformity with accounting principles generally accepted in the United States of America. Operating results for the three and nine months ended September 30, 2011 and 2010 are not necessarily indicative of the results that may be expected for annual future periods.

The organization and business of the Company, accounting policies followed, and other information are contained in the notes to the financial statements of the Company as of and for the years ended December 31, 2010 and 2009, filed with the Securities and Exchange Commission as part of the Company’s annual report on Form 10-K. These financial statements should be read in conjunction with the annual financial statements.

Note D – Use of estimates

The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

7

Note E – Stock compensation plans

The Company’s shareholders approved the 2009 Omnibus Stock Ownership and Long Term Incentive Plan (“Omnibus Plan”) in 2009 to replace three expired stock option plans, a nonqualified plan for directors (Director Plan) and two incentive stock option plans for management and employees (Employee Plans). The Omnibus Plan provides for the grant of incentive stock options, non-qualified stock options, restricted stock, long-term incentive compensation units and stock appreciation rights to employees and directors. An aggregate of 500,000 shares of the Company’s common stock have been reserved for issuance under the terms of the Omnibus Plan.

There were no stock option grants in 2010 or the first nine months of 2011. The fair value of employee plan options granted in December 2007 was $178,000, which is being expensed over a five year vesting period. Total expense related to the 2007 grants was $27,000 in the first nine months of 2011 and 2010. At September 30, 2011, there was $44,000 of total unrecognized compensation cost related to unvested share-based compensation which is expected to be recognized over a weighted-average period of 1.25 years.

Note F – Earnings per share

Earnings per share has been determined on a basic basis and a diluted basis which considers potential stock issuances. For the quarters ended September 30, 2011 and 2010, basic earnings per share has been computed based upon the weighted average common shares outstanding of 3,387,045.

The only potential issuances of Company stock are stock options granted to various directors and officers of the Bank and a warrant to purchase common stock executed in conjunction with the issuance of preferred stock to the U.S. Treasury in 2009. The following is a summary of the diluted earnings per share calculation for the three and nine months ended September 30, 2011 and 2010.

	Three Months Ended September 30,					Nine Months Ended September 30,
	2011		2010			2011		2010
	(in thousands, except per share data)
Net income (loss) available (allocable) to common stockholders	$	520	$	(2,086	)	$	494	$	(3,928	)
Weighted average outstanding shares – basic		3,387		3,387			3,387		3,387
Dilutive effect of stock options and warrants		—		—			—		—
Weighted average shares – diluted		3,387		3,387			3,387		3,387
Diluted net income (loss) per share	$	0.15	$	(0.62	)	$	0.15	$	(1.16	)

For the three and nine months ended September 30, 2011 and 2010, there were stock options and warrants covering 507,712 and 541,158 shares, respectively, that were excluded in computing diluted common shares outstanding given that they were anti-dilutive since the exercise price exceeded the average market price for the period.

8

Note G – Preferred stock and common stock warrants

In December 2008, the shareholders of the Company approved an amendment to the Articles of Incorporation authorizing the issuance of up to 1,000,000 shares of preferred stock, no par value. In January 2009, the Company issued 16,000 shares of preferred stock to the U.S. Treasury and received $16 million under the Capital Purchase Program. The Company granted a warrant to purchase 357,675 shares of common stock at a price of $6.71 per share to the U.S. Treasury as part of the preferred stock transaction. In accordance with accounting principles, the preferred stock and common stock warrant were valued independently and their relative fair market values were allocated to the $16 million received. Under the relative value method, $14,159,000 was allocated to the preferred stock and $1,841,000 to the common stock warrant. The discount of $1,841,000 on the preferred stock is accreted over five years using the effective yield method, thereby increasing preferred stock dividends. The accretion of the discount for the first nine months of 2011 and 2010 was $272,000 and $251,000, respectively. Dividends at 5% per annum are payable quarterly for the first five years; the dividend increases to 9% per annum after the fifth year.

Note H – Subordinated debentures

In December 2004, the Company issued $10,310,000 of unsecured junior subordinated debentures which accrue and pay interest quarterly at three month LIBOR plus 2% per annum. These debentures were issued to Carolina Capital Trust (“Carolina Trust”), a wholly owned subsidiary of the Company which is not consolidated in these consolidated financial statements pursuant to accounting principles governingConsolidated Variable Interest Entities. Carolina Trust acquired these debentures using the proceeds of its offerings of common securities to the Company and $10 million of Trust Preferred Securities to outside investors. The Trust Preferred Securities currently qualify as Tier 1 capital under Federal Reserve Board guidelines. The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act eliminates trust preferred securities as an element of Tier 1 capital for certain institutions. However, bank holding companies with assets of less than $15 billion as of December 31, 2009, will be permitted to include trust preferred securities that were issued before May 19, 2010, as Tier 1 capital. The Company therefore believes the Trust Preferred Securities will continue to qualify as Tier 1 capital. The Company has entered into contractual arrangements which, in the aggregate, constitute a full, irrevocable and unconditional guarantee on a subordinated basis by the Company of the obligations of Carolina Trust under the Trust Preferred Securities. The Trust Preferred Securities are redeemable upon maturity of the debentures on January 7, 2035, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by Carolina Trust in whole or in part at any time.

In the third quarter of 2008, Carolina Bank issued $9,300,000 of unsecured junior subordinated notes to outside investors which accrue and pay interest quarterly at three month LIBOR plus 4% per annum. The notes, net of unamortized expenses associated with the offering, equal to $9,160,000 and $9,104,000 at September 30, 2011 and December 31, 2010, respectively and qualify as Tier 2 capital for the Bank. The notes are redeemable upon maturity on September 30, 2018, or earlier at the Bank’s option, in whole or part subject to regulatory approval, beginning September 30, 2013. The expenses of the offering of $373,000 were capitalized at issue and are being amortized over sixty months. The notes are subordinate to the rights of payment to depositors, bankers acceptances, letters of creditors and general creditors.

Note I – Operating segments

The Company is considered to have three principal business segments in 2011 and 2010, the Commercial/Retail Bank, the Mortgage division, and the Holding Company. The Mortgage division began originating home mortgage loans through third parties and selling these loans to investors in late 2007. A retail mortgage operation was added to the mortgage division in July 2010. Financial performance, reflective of inter-company eliminations, for the three and nine months ended September 30, 2011 and 2010, and selected balance sheet information, reflective of inter-company eliminations, at September 30, 2011 and 2010 for each segment is as follows:

9

	Three months ending September 30, 2011										Three months ending September 30, 2010
	Commercial/Retail     Bank			Mortgage Division		Holding Company			Total		Commercial/Retail Bank			Mortgage Division			Holding Company			Total
	(in thousands)										(in thousands)
Interest income	$	7,123		$	503	$	6		$	7,632	$	7,692		$	654		$	2		$	8,348
Interest expense		1,078			500		63			1,641		1,659			656			52			2,367
Net interest income		6,045			3		(57	)		5,991		6,033			(2	)		(50	)		5,981
Provision for loan losses		1,800			—		—			1,800		6,620			—			—			6,620
Net interest income after provision for loan losses		4,245			3		(57	)		4,191		(587	)		(2	)		(50	)		(639	)
Non-interest income		220			2,964		—			3,184		998			3,032			—			4,030
Non-interest expense		4,303			2,038		21			6,362		4,626			1,769			26			6,421
Income (loss) before income taxes		162			929		(78	)		1,013		(4,215	)		1,261			(76	)		(3,030	)
Income tax (benefit) expense		(137	)		365		(27	)		201		(1,707	)		507			(26	)		(1,226	)
Net income (loss)	$	299		$	564	$	(51	)	$	812	$	(2,508	)	$	754		$	(50	)	$	(1,804	)
Total Assets	$	587,915		$	73,454	$	415		$	661,784	$	633,443		$	66,444		$	347		$	700,234
Net loans		477,733			71,972		—			549,705		507,548			65,330			—			572,878
Equity		579			947		44,170			45,696		(4,609	)		1,684			47,432			44,507

	Nine months ending September 30, 2011										Nine months ending September 30, 2010
	Commercial/Retail Bank			Mortgage Division		Holding Company			Total		Commercial/Retail Bank			Mortgage Division			Holding Company			Total
	(in thousands)										(in thousands)
Interest income	$	21,733		$	1,056	$	10		$	22,799	$	23,191		$	1,422		$	6		$	24,619
Interest expense		3,937			1,031		178			5,146		5,888			1,424			136			7,448
Net interest income		17,796			25		(168	)		17,653		17,303			(2	)		(130	)		17,171
Provision for loan losses		5,150			—		—			5,150		13,308			—			—			13,308
Net interest income after provision for loan losses		12,646			25		(168	)		12,503		3,995			(2	)		(130	)		3,863
Non-interest income		1,246			6,668		—			7,914		1,804			6,861			—			8,665
Non-interest expense		13,657			5,124		73			18,854		13,731			4,046			94			17,871
Income (loss) before income taxes		235			1,569		(241	)		1,563		(7,932	)		2,813			(224	)		(5,343	)
Income tax (benefit) expense		(343	)		622		(82	)		197		(3,323	)		1,129			(76	)		(2,270	)
Net income (loss)	$	578		$	947	$	(159	)	$	1,366	$	(4,609	)	$	1,684		$	(148	)	$	(3,073	)
Total Assets	$	587,915		$	73,454	$	415		$	661,784	$	633,443		$	66,444		$	347		$	700,234
Net loans		477,733			71,972		—			549,705		507,548			65,330			—			572,878
Equity		579			947		44,170			45,696		(4,609	)		1,684			47,432			44,507

The Mortgage Division experienced strong growth in originations and related fee income during 2010 due to low interest rates and due to the purchase of a retail loan production office in July of 2010. Originations and related fee income declined slightly in the first nine months of 2011 due to higher interest rates and slowing refinancing by borrowers in the first four months of 2011. Interest rate risk has been minimized by obtaining optional loan sales commitments when loan origination commitments are made or by entering into hedging transactions whereby mortgage backed securities are sold for the estimated closing value of loan commitments. Borrower fraud is a risk that has been minimized by in-house underwriting and by obtaining indemnification from the originating bank or broker for the risks the Company assumes. Warranty expenses and related warranty liabilities were established in 2009 to provide for potential claims that might arise from borrower fraud or underwriting errors. Warranty expenses were $116,000 for the three months ending September 30, 2011 and 2010 and were $323,000 and $264,000 for the nine months ending September 30, 2011 and 2010, respectively. The warranty liability, which is available to fund future warranty claims, was $715,000 and $428,000 at September 30, 2011 and December 31, 2010, respectively. Four warranty claims totaling

10

$382,000 have been paid since establishment of the mortgage division in 2007. In addition, three loans with a total current principal balance of $487,000 and fair value of $ 430,000 have been repurchased and are included in loans held for sale at fair value.

Note J – Securities

A summary of the amortized cost, gross unrealized gains and losses and estimated fair values of securities available-for-sale and held-to-maturity follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
			(in thousands)
September 30, 2011
Available for sale
Municipal securities	$	15,606	$	898	$	—	$	16,504
FNMA, FHLMC, and GNMA mortgage-backed securities		17,171		1,272		—		18,443
Corporate securities		10,164		7		487		9,684
Unrestricted stock		266		6		—		272
	$	43,207	$	2,183	$	487	$	44,903
Held to maturity
FNMA and GNMA mortgage-backed securities		452		32		—		484
	$	452	$	32	$	—	$	484
December 31, 2010
Available for sale
U.S. agency obligations	$	1,000	$	11	$	—	$	1,011
Municipal securities		19,685		74		488		19,271
FNMA, FHLMC, and GNMA mortgage-backed securities		15,275		998		—		16,273
Corporate securities		5,536		20		7		5,549
Unrestricted stock		533		148		—		681
	$	42,029	$	1,251	$	495	$	42,785
Held to maturity
FNMA and GNMA mortgage-backed securities		563		33		—		596
	$	563	$	33	$	—	$	596

11

Investments are periodically evaluated for any impairment which would be deemed other than temporary. Based upon these evaluations, the Company did not deem any debt securities to be impaired during 2010 or the first nine months of 2011. The deterioration in value is primarily attributable to changes in market demand for corporate securities, not changes in the credit risk of the corporate issuers, and the Company expects these securities to be paid in full and that any temporary impairment will be fully recoverable prior to or at maturity. The Company has the ability and intent to hold the investment securities for a reasonable period of time sufficient for a forecasted recovery or until maturity. Information pertaining to temporarily impaired securities with gross unrealized losses at September 30, 2011 and December 31, 2010, by category and length of time that individual securities have been in a continuous loss position follows:

	Less Than 12 Months				12 Months or Greater				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
	(in thousands)
September 30, 2011:
Corporate securities	$	8,228	$	487	$	—	$	—	$	8,228	$	487
Total	$	8,228	$	487	$	—	$	—	$	8,228	$	487
December 31, 2010:
Municipal securities	$	14,613	$	488	$	—	$	—	$	14,613	$	488
Corporate securities		1,020		7		—		—		1,020		7
Total	$	15,633	$	495	$	—	$	—	$	15,633	$	495

Note K – Loans and allowance for loan losses

The activity in the allowance for loan losses for the first nine months of 2011 and 2010 and related asset balances at September 30, 2011 and December 31, 2010 is summarized as follows:

12

	Construction & Development			Commercial Real Estate			Home Equity Lines			Residential Real Estate			Commercial & Industrial			Consumer & Other			Unallocated		Total
	(in thousands)
Allowance for loan losses:
2011
Beginning of year balance	$	4,478		$	3,364		$	818		$	846		$	2,746		$	79		$	28	$	12,359
Provision for loan losses		3,214			163			503			860			382			22			6		5,150
Charge-offs		(4,273	)		(569	)		(393	)		(404	)		(561	)		(6	)		—		(6,206	)
Recoveries		163			477			15			—			90			1			—		746
Balance at September 30,	$	3,582		$	3,435		$	943		$	1,302		$	2,657		$	96		$	34	$	12,049
2010
Beginning of year balance	$	2,993		$	2,961		$	903		$	856		$	2,025		$	333		$	10	$	10,081
Provision for loan losses		4,735			4,776			141			982			2,654			16			4		13,308
Charge-offs		(3,743	)		(4,338	)		(352	)		(886	)		(2,310	)		(226	)		—		(11,855	)
Recoveries		17			4			—			12			61			1			—		95
Balance at September 30,	$	4,002		$	3,403		$	692		$	964		$	2,430		$	124		$	14	$	11,629
Balances at September 30, 2011
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	801		$	787		$	402		$	522		$	1,237		$	—		$	—	$	3,749
Ending balance collectively evaluated for impairment	$	2,781		$	2,648		$	541		$	780		$	1,420		$	96		$	34	$	8,300
Loans Outstanding:
Balance at September 30,	$	52,450		$	246,976		$	64,881		$	57,142		$	61,656		$	6,677		$	—	$	489,782
Ending balance individually evaluated for impairment	$	5,672		$	29,398		$	1,551		$	7,872		$	5,269		$	5		$	—	$	49,767
Ending balance collectively evaluated for impairment	$	46,778		$	217,578		$	63,330		$	49,270		$	56,387		$	6,672		$	—	$	440,015
Balances at December 31, 2010
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	2,122		$	648		$	106		$	134		$	1,125		$	7		$	—	$	4,142
Ending balance collectively evaluated for impairment	$	2,356		$	2,716		$	712		$	712		$	1,621		$	72		$	28	$	8,217
Loans Outstanding:
Balance at December 31,	$	113,564		$	198,985		$	63,312		$	56,993		$	72,956		$	8,219		$	—	$	514,029
Ending balance individually evaluated for impairment	$	23,576		$	5,187		$	833		$	1,660		$	2,625		$	20		$	—	$	33,901
Ending balance collectively evaluated for impairment	$	89,988		$	193,798		$	62,479		$	55,333		$	70,331		$	8,198		$	—	$	480,127

A loan is past due when the borrower has not made a payment by the contractual due date. The following table presents the carrying value of loans that are past due thirty days or more. Loans which are ninety days or more past due are generally on non-accrual status, at which time all accrued interest is removed from interest income, as shown in the following table:

13

	Number of Days Past Due								Current		Total Loans		Loans Past Due 90 Days or More & Accruing
	30-59 Days		60-89 Days		90 Days or More		Total Past Due
	(in thousands)
At September 30, 2011
Real Estate Loans:
Construction & development	$	—	$	—	$	5,104	$	5,104	$	47,346	$	52,450	$	—
Commercial real estate		188		—		12,525		12,713		234,263		246,976		—
Home equity lines		—		—		775		775		64,106		64,881		—
Residential real estate		31		57		4,300		4,388		52,754		57,142		—
Total real estate		219		57		22,704		22,980		398,469		421,449		—
Commercial & industrial		170		—		1,720		1,890		59,766		61,656		—
Consumer & other		—		—		5		5		6,672		6,677		—
Total loans	$	389	$	57	$	24,429	$	24,875	$	464,907	$	489,782	$	—
At December 31, 2010
Real Estate Loans:
Construction & development	$	—	$	—	$	11,983	$	11,983	$	101,581	$	113,564	$	—
Commercial real estate		783		—		12,682		13,465		185,520		198,985		2,326
Home equity lines		245		—		832		1,077		62,235		63,312		—
Residential real estate		1,038		290		2,060		3,388		53,605		56,993		—
Total real estate		2,066		290		27,557		29,913		402,941		432,854		2,326
Commercial & industrial		71		3		2,462		2,536		70,420		72,956		—
Consumer & other		—		—		20		20		8,199		8,219		—
Total loans	$	2,137	$	293	$	30,039	$	32,469	$	481,560	$	514,029	$	2,326

Loans are determined to be impaired when, based on current information and events, it is probable that all amounts will not be collected when due according to the contractual terms of the original loan agreement. At September 30, 2011 and December 31, 2010, the total recorded investment in impaired loans amounted to approximately $49,767,000 and $33,901,000, respectively. Of these impaired loans, $24,429,000 and $27,713,000 were on non-accrual at September 30, 2011 and December 31, 2010, respectively.

The recorded investment and related information for impaired loans is summarized as follows:

14

		Impaired Loans
		At end of period						For Period Ended*
		Recorded Investment		Unpaid Principal Balance		Related Loan Loss Allowance		Average Recorded Investment		Interest Income Recognized
		(in thousands)
September 30, 2011
With no related allowance recorded
Real Estate Loans:
Construction & development		$	3,423	$	3,547	$	—	$	3,586	$	45
Commercial real estate			21,496		21,931		—		21,851		595
Home equity lines			388		405		—		395		14
Residential real estate			5,195		5,467		—		5,964		135
Total real estate			30,502		31,350		—		31,796		789
Commercial & industrial			3,941		3,972		—		4,177		131
Consumer & other			5		5		—		7		1
Total loans		$	34,448	$	35,327	$	—	$	35,980	$	921
With an allowance recorded
Real Estate Loans:	��
Construction & development		$	2,249	$	2,300	$	801	$	2,391	$	36
Commercial real estate			7,902		8,038		787		8,018		275
Home equity lines			1,163		1,174		402		1,169		43
Residential real estate			2,677		2,691		522		2,095		87
Total real estate			13,991		14,203		2,512		13,673		441
Commercial & industrial			1,328		1,338		1,237		1,358		49
Consumer & other			—		—		—		—		—
Total loans		$	15,319	$	15,541	$	3,749	$	15,031	$	490
December 31, 2010
With no related allowance recorded
Real Estate Loans:
Construction & development		$	7,233	$	7,474	$	—	$	7,712	$	207
Commercial real estate			3,141		4,032		—		3,651		83
Home equity lines			692		835		—		761		12
Residential real estate			996		1,207		—		1,163		25
Total real estate			12,062		13,548		—		13,287		327
Commercial & industrial			1,061		1,061		—		1,113		20
Consumer & other			—		—		—		—		—
Total loans		$	13,123	$	14,609	$	—	$	14,400	$	347
With an allowance recorded
Real Estate Loans:
Construction��& development		$	16,343	$	19,880	$	2,122	$	20,166	$	398
Commercial real estate			2,046		2,060		648		2,057		82
Home equity lines			141		180		106		160		—
Residential real estate			664		671		134		686		27
Total real estate			19,194		22,791		3,010		23,069		507
Commercial & industrial			1,564		1,719		1,125		1,771		66
Consumer & other			20		21		7		25		2
Total loans		$	20,778	$	24,531	$	4,142	$	24,865	$	575

* period ended September 30, 2011 includes 9 months and period ended December 31, 2010 includes 12 months

15

Loans that are past due 90 days or more or where there is serious doubt as to collectability are placed on non-accrual status. Non-accrual loans are not returned to accrual status unless principal and interest are current and borrowers have demonstrated the ability to make contractual payments. Accrued interest is reversed through a charge to income when loans are placed on non-accrual and future payments on non-accrual loans are generally applied to principal. The following is a summary of non-accrual loans at September 30, 2011 and December 31, 2010:

	September 30, 2011		December 31, 2010
	(in thousands)
Real Estate Loans:
Construction & development	$	5,104	$	11,983
Commercial real estate		12,525		10,356
Home equity lines		775		832
Residential real estate		4,300		2,060
Total real estate		22,704		25,231
Commercial & industrial		1,720		2,462
Consumer & other		5		20
Total loans	$	24,429	$	27,713

Loans are graded according to an internal loan rating classification system when originated. Loan grades are periodically re-evaluated during servicing, internal loan reviews, and external loan reviews. The general categories of the internal loan rating classification are:

• Pass – Acceptable loans

• Special Mention – Loans with potential identified weaknesses in administration or servicing.

• Criticized – Adversely classified loans with identified weaknesses, and potential or identified losses of principal and/or interest due.

The following is a breakdown of loans by the general categories of the internal rating system:

16

	Outstanding Loans at September 30, 2011 and December 31, 2010
	Construction & Development				Commercial Real Estate				Home Equity Lines of Credit
	2011		2010		2011		2010		2011		2010
	(in thousands)
Pass	$	37,436	$	83,697	$	206,217	$	169,845	$	62,892	$	60,002
Special Mention		1,158		—		8,223		3,602		320		1,683
Criticized		13,856		29,867		32,536		25,538		1,669		1,627
TOTAL	$	52,450	$	113,564	$	246,976	$	198,985	$	64,881	$	63,312
	Residential Real Estate				Commercial & Industrial				Consumer & Other
	2011		2010		2011		2010		2011		2010
	(in thousands)
Pass	$	47,558	$	52,804	$	55,962	$	68,077	$	6,753	$	8,183
Special Mention		295		326		260		251		14		16
Criticized		9,289		3,863		5,434		4,628		10		20
TOTAL	$	57,142	$	56,993	$	61,656	$	72,956	$	6,777	$	8,219

During 2011 and 2010, the Company restructured certain loans to improve the likelihood that the loans would be repaid in full under the modified terms in accordance with reasonable repayment schedules. Management evaluates each of these loans in accordance with generally accepted accounting principles to determine whether they should be reported as troubled debt restructurings. The Company adopted the amendments in Accounting Standards Update No. 2011-02 during the current period ended September 30, 2011. As required, the Company reassessed all restructurings that occurred on or after the beginning of the current fiscal year (January 1, 2011) for identification as troubled debt restructurings. The Company did not identify as troubled debt restructurings any receivables for which the allowance for credit losses had previously been measured under a general allowance for credit losses methodology.

The Company offers a variety of modifications to borrowers. The modification categories offered can generally be described in the following categories:

• Rate Modification – A modification in which the interest rate is changed.

• Term Modification – A modification in which the maturity date, timing of payments, or frequency of payments is changed.

• Interest Only Modification – A modification in which the loan is converted to interest only payments for a period of time.

• Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

• Combination Modification – Any other type of modification, including the use of multiple categories above.

Available commitments for troubled debt restructurings outstanding as of September 30, 2011 totaled $682,000.

The following tables present troubled debt restructurings as of September 30, 2011 and December 31, 2010:

17

	September 30, 2011
	Accrual Status				Non-Accrual Status				Total Modifications
	#		Amount		#		Amount		#		Amount
	($ in thousands)
Real Estate Loans:
Construction & development		4	$	708		8	$	3,758		12	$	4,466
Commercial real estate		15		14,120		18		4,519		33		18,639
Home equity lines		0		—		1		150		1		150
Residential real estate		0		—		0		—		0		—
Total real estate		19		14,828		27		8,427		46		23,255
Commercial & industrial		7		3,333		6		784		13		4,117
Consumer & other		1		7		0		—		1		7
Total loans		27	$	18,168		33	$	9,211		60	$	27,379
	December 31, 2010
	Accrual Status				Non-Accrual Status				Total Modifications
	#		Amount		#		Amount		#		Amount
	(in thousands)
Real Estate Loans:
Construction & development		0	$	—		4	$	4,090		4	$	4,090
Commercial real estate		1		700		0		—		1		700
Home equity lines		0		—		0		—		0		—
Residential real estate		0		—		0		—		0		—
Total real estate		1		700		4		4,090		5		4,790
Commercial & industrial		0		—		5		356		5		356
Consumer & other		0		—		0		—		0		—
Total loans		1	$	700		9	$	4,446		10	$	5,146

The Bank’s policy is that loans placed on non-accrual will typically remain on non-accrual status until all principal and interest payments are brought current and the prospect for future payment in accordance with the loan agreement appears relatively certain. The Bank’s policy generally refers to six months of payment performance as sufficient to warrant a return to accrual status.

Troubled debt restructurings are classified as impaired loans when modified, and fair value calculations are performed to determine the specific reserves required in the allowance for loan losses related to these loans. Troubled debt restructurings can be removed from such status and returned to non-impaired status in years subsequent to restructure if the interest rate charged at restructure was greater than or equal to the rate charged for a new extension of credit with comparable risk and if the loan is performing and there is no available information to indicated that performance will not continue.

The following tables present newly restructured loans that occurred during the three and nine months ended September 30, 2011 and 2010, respectively:

18

	New Troubled Debt Restructurings
	Three Months Ended September 30, 2011
	Rate Modifications				Term Modifications				Payment Modifications				Combination Modifications				Total Modifications
	#		Amount		#		Amount		#		Amount		#		Amount		#		Amount
	($ in thousands)
Pre-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		12	$	4,496		—	$	—		12	$	4,496
Commercial real estate		—		—		—		—		2		1,155		1		172		3	$	1,327
Home equity lines		—		—		—		—		1		150		—		—		1	$	150
Residential real estate		—		—		—		—		—		—		—		—		—	$	—
Total real estate		—		—		—		—		15		5,801		1		172		16		5,973
Commercial & industrial		—		—		—		—		—		—		1		423		1	$	423
Consumer & other		—		—		—		—		—		—		—		—		—	$	—
Total loans		—	$	—		—	$	—		15	$	5,801		2	$	595		17	$	6,396
Post-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		12	$	4,466		—	$	—		12	$	4,466
Commercial real estate		—		—		—		—		2		859		1		172		3		1,031
Home equity lines		—		—		—		—		1		150		—		—		1		150
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		15		5,475		1		172		16		5,647
Commercial & industrial		—		—		—		—		—		—		1		423		1		423
Consumer & other		—		—		—		—		—		—		—		—		—		—
Total loans		—	$	—		—	$	—		15	$	5,475		2	$	595		17	$	6,070
	Three Months Ended September 30, 2010
Pre-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		—	$	—		—	$	—		—	$	—
Commercial real estate		—		—		—		—		—		—		1		700		1		700
Home equity lines		—		—		—		—		—		—		—		—		—		—
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		—		—		1		700		1		700
Commercial & industrial		—		—		—		—		—		—		—		—		—		—
Consumer & other		—		—		—		—		—		—		—		—		—		—
Total loans		—	$	—		—	$	—		—	$	—		1	$	700		1	$	700
Post-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		—	$	—		—	$	—		—	$	—
Commercial real estate		—		—		—		—		—		—		1		700		1		700
Home equity lines		—		—		—		—		—		—		—		—		—		—
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		—		—		1		700		1		700
Commercial & industrial		—		—		—		—		—		—		—		—		—		—
Consumer & other		—		—		—		—		—		—		—		—		—		—
Total loans		—	$	—		—	$	—		—	$	—		1	$	700		1	$	700

19

	New Troubled Debt Restructurings
	Nine Months Ended September 30, 2011
	Rate Modifications				Term Modifications				Payment Modifications				Combination Modifications				Total Modifications
	#		Amount		#		Amount		#		Amount		#		Amount		#		Amount
	($ in thousands)
Pre-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		12	$	4,496		—	$	—		12	$	4,496
Commercial real estate		—		—		—		—		4		1,346		26		13,660		30	$	15,006
Home equity lines		—		—		—		—		1		150		—		—		1	$	150
Residential real estate		—		—		—		—		—		—		—		—		—	$	—
Total real estate		—		—		—		—		17		5,992		26		13,660		43		19,652
Commercial & industrial		—		—		1		441		5		3,174		2		491		8		4,106
Consumer & other		—		—		—		—		1		10		—		—		1		10
Total loans		—	$	—		1	$	441		23	$	9,176		28	$	14,151		52	$	23,768
Post-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		12	$	4,466		—	$	—		12	$	4,466
Commercial real estate		—		—		—		—		4		1,046		26		13,435		30		14,481
Home equity lines		—		—		—		—		1		150		—		—		1		150
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		17		5,662		26		13,435		43		19,097
Commercial & industrial		—		—		1		437		5		2,897		2		488		8		3,822
Consumer & other		—		—		—		—		1		7		—		—		1		7
Total loans		—	$	—		1	$	437		23	$	8,566		28	$	13,923		52	$	22,926
	Nine Months Ended September 30, 2010
Pre-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		—	$	—		—	$	—		—	$	—
Commercial real estate		—		—		—		—		—		—		1		700		1		700
Home equity lines		—		—		—		—		—		—		—		—		—		—
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		—		—		1		700		1		700
Commercial & industrial		—		—		—		—		—		—		—		—		—		—
Consumer & other		—		—		—		—		—		—		—		—		—		—
Total loans		—	$	—		—	$	—		—	$	—		1	$	700		1	$	700
Post-Modification Outstanding Recorded Investment:
Real Estate Loans:
Construction & development		—	$	—		—	$	—		—	$	—		—	$	—		—	$	—
Commercial real estate		—		—		—		—		—		—		1		700		1		700
Home equity lines		—		—		—		—		—		—		—		—		—		—
Residential real estate		—		—		—		—		—		—		—		—		—		—
Total real estate		—		—		—		—		—		—		1		700		1		700
Commercial & industrial		—		—		—		—		—		—		—		—		—		—
Consumer & other		—		—		—		—		—		—		—		—		—		—
Total loans		—	$	—		—	$	—		—	$	—		1	$	700		1	$	700

20

The following tables represent financing receivables modified as troubled debt restructurings and with a payment default, with the payment default occurring within 12 months of the restructure date, and the payment default occurring during the three and nine month periods ended September 30, 2011 and 2010, respectively:

TDRs with a payment default occurring within 12 months of restructure

	During the three months ended
	September 30, 2011				September 30, 2010
	#		Amount		#		Amount
	($ in thousands)
Real Estate Loans:
Construction & development		—	$	—		—	$	—
Commercial real estate		—		—		—		—
Home equity lines		—		—		—		—
Residential real estate		—		—		—		—
Total real estate		—		—		—		—
Commercial & industrial		—		—		—		—
Consumer & other		—		—		—		—
Total loans		—	$	—		—	$	—
	During the nine months ended
	September 30, 2011				September 30, 2010
	#		Amount		#		Amount
	($ in thousands)
Real Estate Loans:
Construction & development		—	$	—		—	$	—
Commercial real estate		14		3,419		—		—
Home equity lines		—		—		—		—
Residential real estate		—		—		—		—
Total real estate		14		3,419		—		—
Commercial & industrial		—		—		—		—
Consumer & other		—		—		—		—
Total loans		14	$	3,419		—	$	—

Troubled debt restructuring defaults can result in a higher allowance for loan losses and a corresponding higher provision for loan losses because defaults generally negatively impact the timing of and expected collections from these impaired loans. Impaired loans, which include troubled debt restructurings, are evaluated for specific additions to the allowance for loan losses by subtracting the recorded investment in these impaired loans from their fair values. Fair value is generally determined by the present value of future cash flows, collateral value, or liquidation value. Defaults generally reduce the present value of the future cash flows and can negatively impact the collateral values if declining real estate values are impacting the sale of collateral.

Note L – Fair value measurements

The Company has adopted the accounting standards within FASB Accounting Standards Codification (ASC) 820 “Fair Value Measurements and Disclosures”, which provides a framework for measuring fair value under GAAP

21

and enhances disclosures about fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. The Company has not elected the fair value option to value liabilities. Securities available-for-sale and loans held for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

When measuring fair value, valuation techniques should be appropriate in the circumstances and consistently applied. A hierarchy is used to prioritize valuation inputs into the following three levels to determine fair value:

Level 1 – quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 – observable inputs other than the quoted prices included in Level 1.

Level 3 – unobservable inputs.

Fair Value on a Recurring Basis. The Company measures certain assets at fair value on a recurring basis and the following is a general description of the methods used to value such assets.

Investment Securities Available-for-Sale

Investment securities available-for-sale are recorded at fair value. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans Held for Sale

The Company opted to account for loans held for sale at fair value which is measured based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to recurring fair value adjustments as Level 2 valuation.

Assets measured at fair value on a recurring basis at September 30, 2011 and December 31, 2010 are summarized below:

Description	Assets Measured at Fair Value		Fair Value Measured Using
			Level 1		Level 2		Level 3
					(in thousands)
At September 30, 2011:
Loans held for sale	$	71,972	$	—	$	71,972	$	—
Securities available-for-sale	$	44,903	$	272	$	44,631	$	—
At December 31, 2010:
Loans held for sale	$	53,961	$	—	$	53,961	$	—
Securities available-for-sale	$	42,785	$	681	$	42,104	$	—

22

Fair Value on a Non-recurring Basis. The Company measures certain assets at fair value on a non-recurring basis and the following is a general description of the methods used to value such assets.

Impaired Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Fair values of impaired loans are generally estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2011 and December 31, 2010, a majority of the total impaired loans were evaluated based on the fair value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as Level 2 valuation. When current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as Level 3 valuation.

Other Real Estate Owned

Fair values of other real estate owned are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as Level 2 valuation. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as Level 3 valuation.

Securities Held to Maturity

The fair values of securities held to maturity are recorded on a non-recurring basis when an impairment in value that is deemed to be other than temporary occurs. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. At September 30, 2011, there were no fair value adjustments related to $452,000 of securities held to maturity.

Assets measured at fair value on a non-recurring basis at September 30, 2011 and December 31, 2010 are summarized below:

Description	Assets Measured at Fair Value		Fair Value Measured Using
			Level 1		Level 2		Level 3
			(in thousands)
At September 30, 2011:
Impaired loans	$	46,018	$	—	$	—	$	46,018
Other real estate owned	$	8,972	$	—	$	—	$	8,972
At December 31, 2010:
Impaired loans	$	29,759	$	—	$	—	$	29,759
Other real estate owned	$	9,848	$	—	$	—	$	9,848

23

The following represents the estimated fair values and carrying amounts of financial instruments at September 30, 2011 and December 31, 2010:

	September 30, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(in thousands)
Financial Assets:
Cash and due from banks	$	8,061	$	8,061	$	5,116	$	5,116
Interest-bearing deposits with banks		5,693		5,693		17,710		17,710
Securities available for sale		44,903		44,903		42,785		42,785
Securities held to maturity		452		484		563		596
Net loans held for sale		71,972		71,972		53,961		53,961
Net loans held for investment		477,733		478,571		501,670		500,915
Accrued interest receivable		1,881		1,881		2,063		2,063
Financial Liabilities:
Demand and savings deposits		374,915		374,915		346,767		346,767
Time deposits		210,269		211,769		257,800		259,510
Federal Home Loan Bank advances		3,099		3,099		3,165		3,165
Securities sold under agreements to repurchase		2,835		2,835		432		432
Subordinated debt		9,160		9,160		9,104		9,104
Trust preferred debt		10,310		7,415		10,310		7,403
Accrued interest payable		383		383		693		693

Note M – Derivatives and financial instruments

A derivative is a financial instrument that derives its cash flows and value by reference to an underlying instrument, index or referenced interest rate. These instruments are designed to hedge exposures to interest rate risk or for speculative purposes.

Accounting guidance requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet, and measure those instruments at fair value. Changes in the fair value of those derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting.

The Mortgage Division of the Company began hedging its governmental mortgage loans, primarily FHA and VA loans, in October 2010 by selling mortgage backed securities on a forward basis. The forward sale mortgage backed securities are later purchased or closed when mandatory loan sales are consummated for the related mortgages that are originated. The value of the estimated loan commitments and open hedges are marked to market through the income statement.

The table below provides the carrying values of derivative instruments at September 30, 2011 and December 31, 2010:

24

Derivatives designated as	Carrying Value of Assets		Carrying Value of Liabilities		Gain (Loss) in Income			Notional Amount of Derivative
hedging instruments:	(in thousands)
At September 30, 2011:
Mortgage loan rate lock commitments	$	431	$	—	$	431		$	—
Mortgage backed securities forward sales	$	—	$	462	$	(462	)	$	28,000
At December 31, 2010:
Mortgage loan rate lock commitments	$	138	$	—	$	138		$	—
Mortgage backed securities forward sales	$	—	$	55	$	(55	)	$	12,500

Prior to October 2010, the Company sold mortgage loans on a best efforts basis whereby optional commitments to sell mortgage loans were consummated at approximately the same time that optional commitments were given to borrowers to originate the loans. Conventional loans which represent the majority of mortgage originations by the Mortgage Division are still sold on a best efforts basis.

Note N – Impact of recently adopted accounting standards

In April 2011, the Financial Accounting Standard Board (“FASB”) amended existing guidance for assisting a creditor in determining whether a restructuring is a troubled debt restructuring (“TDR”). The amendments clarify the guidance for a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties. This guidance is effective for interim and annual reporting periods beginning after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. For purposes of measuring impairment on newly identified troubled debt restructurings, the amendments should be applied prospectively for the first interim or annual period beginning on or after June 15, 2011. The adoption of this amendment has resulted in expanded narrative and tabular disclosures surrounding TDRs in the consolidated financial statements, as reflected in Note K.

In May 2011, the FASB issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this guidance are effective during interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. The Company is currently evaluating the impact of this amendment on the consolidated financial statements.

In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholder’s equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in a two separate consecutive statement approach. This amendment is effective for fiscal and interim periods beginning after December 15, 2011 and should be applied retrospectively. The adoption of this amendment will change the presentation of the components of comprehensive income for the Company as part of the consolidated statement of shareholder’s equity.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to September 30, 2011. None of these new standards had or is expected to have a significant impact on the Company’s consolidated financial statements.

25

Note O – Commitments

In the normal course of business there are outstanding commitments for the extension of credit which are not reflected in the financial statements. At September 30, 2011 and December 31, 2010, pre-approved but unused lines of credit for loans totaled approximately $137,298,000 and $109,728,000, respectively. In addition, we had $7,382,000 and $9,370,000 in standby letters of credit at September 30, 2011 and December 31, 2010, respectively. These commitments represent no more than the normal lending risk that we commit to borrowers. If these commitments are drawn, we will obtain collateral if it is deemed necessary based on our credit evaluation of the counter-party. We believe these commitments can be funded through normal operations.

We are committed for future lease payments on our Friendly Center office, the land for our Greensboro headquarters, our office in Winston-Salem, and a mortgage loan office in Burlington. Aggregate minimum lease payments over the next five years are $1,739,000 and $2,997,000 thereafter.

Note P – Reclassification

Certain amounts in the 2010 consolidated financial statements have been reclassified to conform to the 2011 presentation; however, such reclassifications did not have an impact on net income.

26

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist in understanding our financial condition and results of operations. Because we have no material operations and conduct no business on our own other than owning our subsidiaries, Carolina Bank and Carolina Capital Trust, and because Carolina Capital Trust has no operations other than the issuance of its trust preferred securities, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of Carolina Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, Carolina Bank Holdings, Inc. and Carolina Bank are collectively referred to herein as “we”, “our” or “us” unless otherwise noted.

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 relating to, without limitation, our future economic performance, plans and objectives for future operations, and projections of revenues and other financial items that are based on our beliefs, as well as assumptions made by and information currently available to us. The words “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “could”, “project”, “predict,” “expect,” “estimate,” “continue,” and “intend,” as well as other similar words and expressions of the future, are intended to identify forward-looking statements. Our actual results, performance, or achievements may differ materially from the results expressed or implied by our forward-looking statements.

Impact of Dodd-Frank Act.On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) into law. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry in the United States. The Dodd-Frank Act includes, among other things:

• the creation of a Financial Stability Oversight Council to identify emerging systemic risks posed by financial firms, activities and practices, and improve cooperation between federal agencies;

• the creation of a Bureau of Consumer Financial Protection authorized to promulgate and enforce consumer protection regulations relating to financial products, which would affect both banks and non-bank financial companies;

• the establishment of strengthened capital and prudential standards for banks and bank holding companies;

• enhanced regulation of financial markets, including derivatives and securitization markets;

• the elimination of certain trading activities by banks;

• a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000 per account, an extension of unlimited deposit insurance on qualifying noninterest-bearing transaction accounts, and an increase in the minimum deposit insurance fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed to deposits;

• amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations; and

• new disclosure and other requirements relating to executive compensation and corporate governance.

The Company is unable to predict the extent to which the Dodd-Frank Act or the forthcoming rules and regulations will impact the Company’s business. However, the Company believes that certain aspects of the new legislation, including, without limitation, the additional cost of higher deposit insurance coverage and the costs of compliance with disclosure

27

and reporting requirements and examinations could have a significant impact on the Company’s business, financial condition, and results of operations. Additionally, the Company cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced, or how such changes may affect the Company.

Comparison of Financial Condition

Assets. Our total assets decreased by $14.9 million, or 2.2%, from $676.7 million at December 31, 2010, to $661.8 million at September 30, 2011. During the nine months ended September 30, 2011, cash and due from banks and interest-bearing deposits with banks decreased by $9.1 million while loans held for sale increased by $18.0 million, or 33.4%, and loans held for investment decreased $24.2 million, or 4.7%. The increase in loans held for sale resulted from strong originations of mortgage loans in September 2011 which had been sold but not yet delivered to investors. We experienced slowing commercial and consumer loan demand in our primary lending markets, Guilford, Randolph, Alamance and Forsyth Counties, North Carolina in the first nine months of 2011 in addition to the slow demand experienced in 2010. The slowing demand complimented our planned asset reduction strategy to improve our capital ratios.

Liabilities. Total deposits decreased by $19.4 million, or 3.2%, from $604.6 million at December 31, 2010, to $585.2 million at September 30, 2011. Time deposits decreased $47.5 million, noninterest-bearing demand accounts increased by $10.4 million, and interest-bearing transaction accounts increased $17.8 million during the first nine months of 2011. Our branching activities are designed to enhance customer convenience and related deposit gathering activities as well as provide new sources for loans. While deposit growth has been an ongoing goal, wholesale sources of funding such as Federal Home Loan Bank (“FHLB’) advances and repurchase borrowings, may be utilized where cost beneficial and when necessary to meet liquidity requirements. Retail repurchase agreements increased $2.4 million and FHLB advances were down slightly during the first nine months of 2011. We had approximately $23.6 million in out-of-market time deposits from other institutions and $30.2 million in brokered deposits at September 30, 2011, a decrease of $12.2 million in these two types of accounts from December 31, 2010.

Stockholders’ Equity. Total stockholders’ equity increased $1.4 million at September 30, 2011 to $45.7 million from $44.3 million at December 31, 2010, due to retained net income and an increase in accumulated other comprehensive income from appreciation of investment securities available-for-sale.

Comparison of Results of Operations for the Three Months Ended September 30, 2011 and 2010

General. Net income (loss) was $812,000 and ($1,804,000) for the third quarter of 2011 and 2010, respectively. Net income (loss) available (allocable) to common stockholders was $520,000, or $0.15 per diluted share, for the three months ended September 30, 2011 compared to ($2,086,000), or ($0.62) per diluted share, for the three months ended September 30, 2010. Net income (loss) available (allocable) to common stockholders represents net income (loss) less preferred stock dividends and related discount accretion. Higher net income in 2011 resulted primarily from a lower provision for loan losses. Our primary markets in the Triad of North Carolina experienced deteriorating economic conditions in 2010 which negatively impacted our borrowers as evidenced by increasing defaults and loan charge-offs. While economic conditions have not improved substantially in 2011 in our primary markets, loan charge-offs have declined and the risk in the loan portfolio has declined as evidenced by a decrease in construction and development loans.

Net interest income.Net interest income of $5,991,000 for the three months ended September 30, 2011 was basically unchanged from the third quarter of 2010. An increase in the net yield on interest earning assets of 19 basis points in 2011 was offset by a planned decline in average interest-earning assets by $32.2 million. The net yield on interest earning assets, adjusted to a fully taxable basis, increased to 3.89% in the third quarter of 2011 from 3.70% in the third quarter of 2010. The table below provides an analysis of effective yields and rates on categories of interest-earning assets and interest-bearing liabilities for the three months ended September 30, 2011 and 2010.

28

Net Interest Income and Average Balance Analysis

	For the Three Months Ended September 30,
	2011							2010
	Average Balance (1.)		Interest Inc./Exp.		Average Yield/Cost			Average Balance (1.)		Interest Inc./Exp.		Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets
Interest bearing deposits	$	30,387	$	22		0.29	%	$	22,706	$	16		0.28	%
Non-taxable investments (2.)		13,359		184		5.46	%		16,572		247		5.91	%
Taxable investments		33,312		333		3.97	%		30,502		393		5.11	%
Loans held for sale		46,125		503		4.33	%		56,574		654		4.59	%
Loans (3.)		494,669		6,650		5.33	%		523,714		7,117		5.39	%
Interest-earning assets		617,852		7,692					650,068		8,427
Interest-earning assets						4.94	%						5.14	%
Non interest-earning assets		46,521							48,038
Total assets	$	664,373						$	698,106
Interest-bearing liabilities
Interest checking	$	34,097	$	26		0.30	%	$	31,692	$	31		0.39	%
Money market and savings		281,128		604		0.85	%		262,395		826		1.25	%
Time certificates and IRAs		218,915		822		1.49	%		285,997		1,309		1.82	%
Other borrowings		26,359		189		2.84	%		24,875		201		3.21	%
Total interest-bearing liabilities		560,499		1,641					604,959		2,367
Cost on average
Interest-bearing liabilities						1.16	%						1.55	%
Non-interest-bearing liabilities
Demand deposits		54,995							43,069
Other liabilities		3,499							3,828
Total non-interest-bearing liabilities		58,494							46,897
Total liabilities		618,993							651,856
Stockholders’ equity		45,380							46,250
Total liabilities and equity	$	664,373						$	698,106
Net interest income			$	6,051						$	6,060
Net yield on average interest-earning assets						3.89	%						3.70	%
Interest rate spread						3.78	%						3.59	%

(1.) Average balances are computed on a daily basis.

(2.) Interest income and yields related to certain investment securities exempt from federal income tax are stated on a fully taxable basis using a 34% federal tax rate, reduced by the nondeductible portion of interest expense.

(3.) Nonaccrual loans are included in the average loan balance.

29

Provision for loan losses.The provision for loan losses amounted to $1,800,000 and $6,620,000 for the three months ended September 30, 2011 and 2010, respectively. The amount of the provision for loan losses decreased in 2011 primarily because of a decline in loans outstanding, a decrease in net loan charge-offs, fewer allowances for loan losses on impaired loans, and a change in the loan mix in 2011 with a material decline in construction and development loans. We believe the allowance for loan losses is appropriate based on asset quality indicators and other factors.

Non-interest income.Total non-interest income amounted to $3,184,000 for the three months ended September 30, 2011, as compared to $4,030,000 for the three months ended September 30, 2010. Service charges increased while mortgage banking income and gain on sale of investments declined in the 2011 period. Loss on sale of real estate owned was $217,000 in the third quarter of 2011 compared to a gain of $14,000 in the third quarter of 2010.

Non-interest expense.Total non-interest expense amounted to $6,362,000 and $6,421,000 for the three months ended September 30, 2011 and 2010, respectively. Impairment of other real estate owned was $576,000 and $443,000 in the third quarter of 2011 and 2010, respectively, as real estate values in our lending markets have declined in 2010 and 2011. Lower expenses were incurred in the third quarter of 2011 in the areas of professional fees, outside data processing, FDIC insurance and advertising.

Income taxes.Income tax expense (benefit) was $201,000, or 19.8% of net income before income taxes, for the three month period ended September 30, 2011, as compared to ($1,226,000), or 40.5% of net loss before income taxes for the three month period ended September 30, 2010. Non-taxable income and income tax credits represented a larger percentage of net income (loss) before taxes in the third quarter of 2011 which resulted in the lower income tax rate in the 2011 period.

Comparison of Results of Operations for the Nine Months Ended September 30, 2011 and 2010

General. Net income (loss) for the nine months ended September 30, 2011 and 2010, amounted to $1,366,000 and $(3,073,000), respectively. Net income (loss) available (allocable) to common stockholders for the nine months ended September 30, 2011 and 2010 amounted to $494,000, or $0.15 per diluted share, and $(3,928,000), or $(1.16) per diluted share, respectively. The increase in net income in 2011 was primarily due to a lower provision for loan losses and higher net interest income.

Net interest income.Net interest income increased 2.8% to $17,653,000 for the nine months ended September 30, 2011, from $17,171,000 for the nine months ended September 30, 2010. An increase in the net yield on interest earning assets accounted for the higher net interest income in 2011 as average interest-earning assets declined in 2011. The net yield on average interest earning assets increased in 2011 due to additional focus in pricing loans and interest-bearing deposits.

Provision for loan losses.The provision for loan losses amounted to $5,150,000 for the nine months ended September 30, 2011 compared to $13,308,000 for the nine months ended September 30, 2010, a decrease of 61.3%. The amount of the provision for loan losses decreased in 2011 because of lower loan charge-offs during 2011, a decrease in loans outstanding, and a change in the loan mix in 2011 with a material decline in construction and development loans. A change in the methodology of charging off impaired real estate loans when appraisals were obtained rather than when loans were deemed uncollectible was implemented in 2010 which also resulted in a higher provision for loan losses in the first nine months of 2010. We believe the allowance for loan losses is adequate based on asset quality indicators and other factors.

Non-interest income.Total non-interest income amounted to $7,914,000 for the nine months ended September 30, 2011, as compared to $8,665,000 for the nine months ended September 30, 2010. The decrease in 2011 was primarily attributable to lower mortgage banking income and less gain on sale of investment securities in 2011. Mortgage banking income declined $526,000, or 7.3%, in the first nine months of 2011 to $6,668,000 due to reduced mortgage refinancing by consumers in 2011.

30

Non-interest expense.Total non-interest expense amounted to $18,854,000 for the nine months ended September 30, 2011, as compared to $17,871,000 for the nine months ended September 30, 2010, an increase of 5.5%. Salaries and employee benefits increased $970,000, or 11.2%, in 2011 to $9,607,000 due to an increase in the number of full-time equivalent employees to 167 from 153 a year ago. The majority of the increased compensation resulted from the expansion of the mortgage division which added a retail loan production office on July 1, 2010 and has since expanded into a number of our banking offices. Impairment of other real estate owned was $1,999,000 and $1,912,000 for the nine months ended September 30, 2011 and 2010, respectively, as real estate prices continued to weaken in 2011 after declining in 2010. Warranty expense related to the sale of mortgage loans and included in other expenses was $323,000 and $264,000 for the first nine months of 2011 and 2010, respectively.

Income taxes.Income tax expense (benefit) was $197,000, or 12.6% of net income before income taxes, for the nine months ended September 30, 2011, as compared to ($2,270,000), or 42.5% of net loss before income taxes for the nine months ended September 30, 2010. Non-taxable income and income tax credits represented a larger percentage of net income (loss) before taxes in 2011 which resulted in the lower income tax rate in the 2011 period.

Asset Quality

Non-performing assets, composed of other real estate owned, other foreclosed assets, and non-accrual loans, totaled $33,473,000 at September 30, 2011, compared to $37,576,000 at December 31, 2010. Non-performing assets, as a percentage of total assets, was 5.06% at September 30, 2011, compared to 5.55% at December 31, 2010. There were $0 and $2,326,000 loans 90 days or more past due and still accruing interest at September 30, 2011 and December 31, 2010, respectively. Other real estate owned and other foreclosed assets were $9,044,000 at September 30, 2011 and $9,863,000 at December 31, 2010. The elevated level of non-performing assets at September 30, 2011 and December 31, 2010 is related to the decline in economic conditions in our lending markets. The seasonally adjusted unemployment rate in North Carolina increased to 10.5% in September 2011 from 9.8% in December 2010 but decreased from 10.9% at December 2009. A large portion of our loans are made to businesses and real estate developers and are secured by real estate. Due to the slow economic conditions, it has been difficult for borrowers to sell businesses or real estate properties as needed to pay off their loans.

Our allowance for loan losses is composed of two parts, a specific portion related to non-performing loans and performing impaired loans and a general section related to non-impaired loans. We adopted a more conservative loan loss methodology in the second quarter of 2010 which resulted in higher allowances for loan losses in the second and third quarters of 2010. The specific portion of our allowance for loan losses, which relates to impaired loans, decreased to $3,749,000 at September 30, 2011 from $4,142,000 at December 31, 2010 and impaired loans increased to $49,767,000 at September 30, 2011 from $33,901,000 at December 31, 2010. There were several impaired loans with large specific allowances at December 31, 2010 which have been charged-off in 2011 which accounted for the higher amount of specific allowances at December 31, 2010. Net loan charge-offs amounted to $5,460,000 and $11,760,000 for the nine months ending September 30, 2011 and 2010, respectively. The general portion of our allowance for loan losses increased to $8,300,000 on non-impaired loans of $440,014,000 at September 30, 2011 from $8,217,000 on non-impaired loans of $480,127,000 at December 31, 2010. The general portion of our allowance applies to non-impaired loans and was determined by applying estimated loss ratios inherent in the loan portfolio, ranging from 0.41% on loans secured by multi-family properties to 10.97% on unsecured consumer revolving loans, to categories of non-impaired loans at each period end. The general section of our allowance also includes a qualitative component which is calculated based on nine environmental factors such as the changes in economic and business conditions that affect the collectability of the loan portfolio and changes in the value of collateral dependent loans. The general section of our allowance for loan losses increased $83,000 from December 31, 2010 to September 30, 2011 because of an increase in qualitative factors by and to $1,091,000 which was primarily offset by a change in the mix of our loans with a decrease in construction and development loans and an increase in commercial real estate loans. Regulators recommended that the qualitative factors in our general section be re-emphasized in 2011 after a recommendation to de-emphasize these factors in 2010.

31

The allowance for loan losses is increased by direct charges to operating expense, the provision for loan losses. Losses on loans or charge-offs are deducted from the allowance in the period that loans are deemed to become uncollectible or in the period that updated appraisals indicate a loss in value of non-performing, collateral dependent, real estate loans. Recoveries of previously charged-off loans are added back to the allowance. Net loan charge-offs (charge-offs minus recoveries) totaled $5,460,000 for the nine months ended September 30, 2011 compared to $11,760,000 for the same period in 2010.

Liquidity and Capital Resources

The objective of our liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for expansion. Liquidity management addresses our ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise.

Our primary sources of internally generated funds are principal and interest payments on loans receivable and cash flows generated from operations. External sources of funds include increases in deposits, repurchase agreements, lines of credit from banks, including the Federal Reserve, and advances from the Federal Home Loan Bank of Atlanta (“FHLB”).

Carolina Bank is required under applicable federal regulations to maintain specified levels of liquid investments in qualifying types of investments. Cash and due from banks, interest-bearing deposits in banks, investment securities available-for-sale, and loans held for sale by our mortgage division are the primary liquid assets of Carolina Bank. We regularly monitor Carolina Bank’s liquidity position to ensure its liquidity is sufficient to meet its needs. During the first nine months of 2011, we decreased our levels of short-term liquidity due to an increase in our loans held for sale and a planned decrease in our deposits, primarily out-of-market time deposits. Short-term liquidity in the form of cash and due from banks and interest-bearing deposits in banks, decreased to $13.8 million at September 30, 2011 from $22.8 million at December 31, 2010. We also have substantial secondary sources of liquidity in the form of unused secured lines of credit from the FHLB and the Federal Reserve of approximately $127 million at September 30, 2011.

We are subject to various regulatory capital requirements administered by the banking regulatory agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly discretionary actions by the regulators that, if undertaken, could have a direct material effect on our financial condition. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classifications are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. As of September 30, 2011 and December 31, 2010, our levels of capital exceeded all applicable published regulatory requirements. Carolina Bank met its goal of increasing Tier 1 capital to average assets to 8% in 2011 through earnings and moderate asset growth in response to regulatory requests in January 2011. Tier 1 capital to average assets for Carolina Bank was 8.15% at September 30, 2011 compared to 7.59% at December 31, 2010. Carolina Bank Holdings, Inc. also agreed to seek regulatory approval to pay dividends on its preferred stock and interest on its trust preferred securities in 2011 which was granted through July 2011 but denied for the August preferred stock dividend and denied for the third quarter trust preferred interest payment.

Due to our strong growth in recent years and our anticipation of continued growth, we increased our capital in January 2009 by issuing $16 million in preferred stock to the United States Treasury under the Capital Purchase Program. Carolina Bank also issued approximately $9 million in subordinated debt through a private placement in the third quarter of 2008 to increase capital at the bank level.

32

ITEM 4. Controls and Procedures

Our Chief Executive Officer and Chief Financial Officer have conducted an evaluation of our disclosure controls and procedures as of September 30, 2011. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in the applicable Securities and Exchange Commission Rules and Forms. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the most recent evaluation of these controls by our Chief Executive Officer and Chief Financial Officer.

Management of the Company has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, changes in the Company’s internal controls over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the third quarter of 2011. In connection with such evaluation, the Company has determined that there have been no changes in internal control over financial reporting during the third quarter that have materially affected or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

33

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There are various claims and lawsuits in which the Company and the Bank are periodically involved incidental to their business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.

Item 4. (Reserved)

Item 6. Exhibits

Exhibit No.	Description of Exhibit
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
32.1	Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act.

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.

	Carolina Bank Holdings, Inc.
Date: November 10, 2011	By:	/s/ Robert T. Braswell
		Robert T. Braswell
		President and Chief Executive Officer

Date: November 10, 2011	By:	/s/ T. Allen Liles
		T. Allen Liles
		Chief Financial and Principal Accounting Officer

34

Exhibit Index

Exhibit No.	Description of Exhibit
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
32.1	Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act.

35