Heritage Financial 10-Q 2013 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2013

Commission File Number 001-34902

HERITAGE FINANCIAL GROUP, INC.

(A Maryland Corporation)

IRS Employer Identification Number 38-3814230

721 N. Westover Blvd., Albany, GA 31707

229-420-0000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 and 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.  Yes x No o

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

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the exchange Act).  Yes o No x

Indicate the number of shares outstanding of each issuer’s classes of common equity, as of the latest practicable date:  At May 10, 2013, there were 7,881,260 shares of issuer’s common stock outstanding.

HERITAGE FINANCIAL GROUP, INC.

INDEX

		Page
		Number
PART I – FINANCIAL INFORMATION
ITEM 1.	FINANCIAL STATEMENTS
	CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 2013 AND DECEMBER 31, 2012	3
	CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012	4
	CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012	5
	CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND THE YEAR ENDED DECEMBER 31, 2012	6
	CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012	8
	CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.	10
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	56
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	74
ITEM 4.	CONTROLS AND PROCEDURES	78
PART II – OTHER INFORMATION
ITEM 1	LEGAL PROCEEDINGS	79
ITEM 1A	RISK FACTORS	79
ITEM 2	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	79
ITEM 3	DEFAULTS UPON SENIOR SECURITIES	79
ITEM 4	MINE SAFETY DISCLOSURES	79
ITEM 5	OTHER INFORMATION	79
ITEM 6	EXHIBITS	80

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

	Unaudited March 31,			December 31,
	2013				2012
Assets
Cash and due from banks	$	37,916			$	23,993
Interest-bearing deposits in banks		149,216				15,393
Federal funds sold		3,152				4,306
Total cash and cash equivalents		190,284				43,692
Securities available for sale, at fair value		267,307				221,406
Federal Home Loan Bank stock, at cost		5,992				4,330
Other equity securities, at cost		1,010				1,010
Loans held for sale		18,905				15,608
Loans		687,051				597,579
Covered loans		65,815				72,425
Less allowance for loan losses		9,105				9,061
Loans, net		743,761				660,943
Other real estate owned		4,391				3,242
Covered other real estate owned		9,460				9,467
Total other real estate owned		13,851				12,709
FDIC loss-share receivable		52,012				60,731
Premises and equipment, net		33,524				33,015
Goodwill and intangible assets		4,666				4,235
Cash surrender value of bank owned life insurance		23,584				23,382
Other assets		15,654				16,445
	$	1,370,550			$	1,097,506
Liabilities and Stockholders' Equity
Deposits
Noninterest-bearing	$	151,709			$	116,272
Interest-bearing		943,850				753,282
Total deposits		1,095,559				869,554
Federal funds purchased and securities sold under repurchase agreements		34,251				33,219
Other borrowings		102,210				60,000
Other liabilities		17,875				14,084
Total liabilities		1,249,895				976,857
Commitment and Contingencies
Stockholders' equity
Preferred stock, par value; $0.01; 5,000,000  shares authorized;none issued		-				-
Common stock, par value $0.01; 45,000,000 shares authorized;7,881,260 and  8,172,486 shares issued, respectively		79				82
Capital surplus		78,341				82,154
Retained earnings		50,227				46,299
Accumulated other comprehensive loss, net of tax of $2,737 and  $2,566		(4,106	)			(3,849	)
Unearned employee stock ownership plan (ESOP) shares,372,511 and 385,836 shares		(3,886	)			(4,037	)
Total stockholders' equity		120,655				120,649
	$	1,370,550			$	1,097,506

See Notes to Consolidated Financial Statements.

3

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Income (Unaudited)

For the Three Months Ended March 31, 2013 and 2012

(Dollars in Thousands)

	For the Three Months Ended March 31,
	2013			2012
Interest income
Interest and fees on loans	$	13,369		$	10,147
Interest on loans held for sale		504			182
Interest on taxable securities		866			979
Interest on nontaxable securities		285			299
Interest on federal funds sold		1			15
Interest on deposits in other banks		22			37
		15,047			11,659
Interest expense
Interest on deposits		1,054			1,263
Interest on other borrowings		749			672
		1,803			1,935
Net interest income		13,244			9,724
Provision for loan losses		485			400
Net interest income after provision		12,759			9,324
Noninterest income
Service charges on deposit accounts		1,154			1,020
Bankcard services income		762			824
Other service charges, commissions and fees		99			85
Brokerage fees		481			446
Mortgage banking activities		1,793			689
Bank-owned life insurance		202			140
Gain on sales of securities		-			42
Gain on acquisitions		4,188			-
Accretion of FDIC loss share receivable		(2,963	)		(498	)
Other		94			35
		5,810			2,783
Noninterest expense
Salaries and employee benefits		6,430			5,536
Equipment and occupancy		1,666			1,324
Advertising and marketing		187			180
Professional fees		215			238
Information services expenses		1,182			1,052
Gain on sales and write-downs of other real estate owned		(25	)		(7	)
Loss on sales and write-downs of FDIC acquired other real estate owned		24			174
Foreclosed asset expenses		215			221
Foreclosed FDIC-acquired asset expenses		421			162
FDIC insurance and other regulatory fees		256			245
Acquisition related expenses		792			331
Deposit intangible expenses		194			201
Other operating expenses		1,233			1,144
		12,790			10,801
Income before income taxes		5,779			1,306
Applicable income tax		1,851			335
Net income	$	3,928		$	971
Earnings per common share:
Basic earnings per share	$	0.52		$	0.12
Diluted earnings per share	$	0.52		$	0.12
Weighted average-common shares outstanding:		7,526,344			8,144,382
Basic		7,528,522			8,145,730
Diluted

See Notes to Consolidated Financial Statements.

4

HERITAGE FINANCIAL GROUP, INC AND SUBSIDIARY

Consolidated Statements of Comprehensive Income (Unaudited)

For the Three Months Ended March 31, 2013 and 2012

(Dollars in Thousands)

	For the Three Months Ended March 31,
	2013			2012
Net income	$	3,928		$	971
Other comprehensive income (loss):
Accretion of realized gain on terminated cash flow hedge, net of tax of $- and $20 for 2013 and 2012, respectively		-			(29	)
Unrealized gain on cash flow hedge, net of tax of $198 and $201 for 2013 and 2012, respectively		297			301
Unrealized holding gains on investments arising during the period, net of tax (benefit) of $(370)  and $129 for 2013 and 2012, respectively		(554	)		194
Reclassification adjustment for investment gains included in net income, net of tax of $- and $17 for 2013 and 2012, respectively		-			(25	)
Total other comprehensive income  (loss)		(257	)		441
Comprehensive income	$	3,671		$	1,412

See Notes to Consolidated Financial Statements.

5

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

For the Three Months Ended March 31, 2013 (Unaudited)

And The Year Ended December 31, 2012

(Dollars in Thousands, except per share data)

																Accumulated
																Other
													Unearned			Compre-
	Common Stock						Capital			Retained			ESOP			hensive
	Shares			Par Value			Surplus			Earnings			Shares			Loss			Total
Balance, December 31, 2011		8,712,031		$	87		$	88,393		$	42,374		$	(4,642	)	$	(2,076	)	$	124,136
Net income		-			-			-			6,757			-			-			6,757
Cash dividend declared,$0.36 per share		-			-			-			(2,832	)		-			-			(2,832	)
Issuance of  15,600 shares of restricted common stock		15,600			-			-			-			-			-			-
Forfeiture of  326  shares of restricted common stock		(326	)		-			-			-			-			-			-
Repurchase of  554,819  shares of common stock		(554,819	)		(5	)		(7,215	)		-			-			-			(7,220	)
Stock-based compensation expense		-			-			858			-			-			-			858
Other comprehensive loss		-			-			-			-			-			(1,773	)		(1,773	)
Tax benefit from stock-based compensation plans		-			-			7			-			-			-			7
ESOP shares earned 53,302  shares		-			-			64			-			605			-			669
Tax benefit on ESOP expense		-			-			47			-			-			-			47
Balance, December 31, 2012		8,172,486		$	82		$	82,154		$	46,299		$	(4,037	)	$	(3,849	)	$	120,649

See Notes to Consolidated Financial Statements.

6

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)

For the Three Months Ended March 31, 2013 (Unaudited)

And The Year Ended December 31, 2012

(Dollars in Thousands, except per share data)

															Accumulated
															Other
												Unearned			Compre-
	Common Stock						Capital			Retained		ESOP			hensive
	Shares			Par Value			Surplus			Earnings		Shares			Loss			Total
Balance, December 31, 2012		8,172,486		$	82		$	82,154		$	46,299	$	(4,037	)	$	(3,849	)	$	120,649
Net income		-			-			-			3,928		-			-			3,928
Repurchase of  291,266  shares of common stock		(291,266	)		(3	)		(4,081	)		-		-			-			(4,084	)
Stock-based compensation expense		-			-			230			-		-						230
Other comprehensive loss		-			-			-			-		-			(257	)		(257	)
Excess tax benefit  from stock-based compensation plans		-			-			(1	)		-		-			-			(1	)
ESOP shares earned, 13,325  shares		-			-			35			-		151			-			186
Excess tax benefit on ESOP  expense		-			-			4			-		-			-			4
Balance, March 31, 2013		7,881,260		$	79		$	78,341		$	50,227	$	(3,886	)	$	(4,106	)	$	120,655

See Notes to Consolidated Financial Statements.

7

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 (Dollars in thousands)

	Three Months Ended March 31,
	2013			2012
OPERATING ACTIVITIES	$	3,928		$	971
Net income
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		589			501
Amortization of deposit intangibles		194			201
Provision for loan losses		485			400
ESOP compensation expense		186			156
Provision (benefit) for deferred taxes		1,829			(59	)
Stock-based compensation expense		230			209
Accretion of gain on termination of cash flow hedge		-			(49	)
Amortization of available for sale discounts and premiums, net		545			1,130
Gain on sales of securities available for sale		-			(42	)
Gain on sales and write-downs of other real estate owned		(25	)		(7	)
Loss on sales and write-downs of FDIC-acquired other real estate owned		24			174
Increase in bank-owned life insurance		(202	)		(140	)
Excess tax benefit related to stock-based compensation plans		1			1
Excess tax related to ESOP		(4	)		(23	)
Decrease in FDIC loss share receivable		5,756			384
Accretion of FDIC loss share receivable		2,963			498
Decrease (increase) in interest receivable		(302	)		485
(Decrease) increase in interest payable		160			(183	)
Decrease (increase) in loans held for sale		(3,297	)		2,740
Decrease in prepaid FDIC assessment		344			178
Gain on acquisitions		4,188			-
Net other operating activities		(3,761	)		(443	)
Total adjustments		9,903			6,111
Net cash provided by operating activities		13,831			7,082
INVESTING ACTIVITIES
Increase in interest-bearing deposits in banks		(133,823	)		(4,073	)
Purchases of securities available for sale		(41,754	)		(34,286	)
Proceeds from sales of securities available for sale		10,125			16,461
Proceeds from maturities and calls of securities available for sale		6,500			11,500
Purchase of bank owned life insurance		-			(7,000	)
Decrease in Federal Home Loan Bank stock		235			-
Decrease in federal funds sold		1,154			13,988
Increase in loans, net		(11,423	)		(2,793	)
Purchases of premises and equipment		(1,062	)		(755	)
Net cash received from acquisition activity		153,179			-
Proceeds from sales of other real estate owned		1,090			1,906
Net cash used in investing activities		(15,779	)		(5,052	)

See Notes to Consolidated Financial Statements.

8

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

 (Dollars in thousands)

	Three Months Ended March 31,
	2013			2012
FINANCING ACTIVITIES
(Decrease) increase  in deposits	$	13,919		$	(15,445	)
Increase in federal funds purchased and securities sold under repurchase agreements		1,033			2,178
Proceeds from other borrowings		5,000			-
Excess benefit related to stock-based compensation plans		(1	)		(1	)
Excess tax related to ESOP		4			23
Repurchase of common stock		(4,084	)		(520	)
Dividends paid to stockholders		-			(348	)
Net cash provided by  (used in) financing activities		15,871			(14,113	)
Net increase (decrease) in cash and due from banks		13,923			(12,083	)
Cash and due from banks at beginning of period		23,993			34,521
Cash and due from banks at end of period	$	37,916		$	22,438
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	1,643		$	2,118
Income taxes	$	18		$	2,150
NONCASH TRANSACTIONS
Principal balances of loans transferred to other real estate owned	$	1,446		$	654

See Notes to Consolidated Financial Statements.

9

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES

Heritage Financial Group, Inc.  (the “Company”), a Maryland corporation, was incorporated in May 2010 and organized by Heritage MHC (the “MHC”), Heritage Financial Group and HeritageBank of the South ( the “Bank”) to facilitate the second-step conversion  from the mutual holding company structure to the stock holding company structure (the “Conversion”).  Upon consummation of the Conversion, which occurred on November 30, 2010, the Company became the holding company for the Bank and a 100% publicly owned stock holding company.  As a result of the Conversion, each share of Heritage Financial Group’s common stock owned by public shareholders was exchanged for 0.8377 shares of the Company’s common stock, with cash being paid in lieu of issuing fractional shares.  All shares and per share information for periods prior to the Conversion have been adjusted to reflect the 0.8377:1 exchange ratio on publicly traded shares.  All references to the Company refer to Heritage Financial Group for periods prior to the completion of the Conversion.

The consolidated financial statements include the accounts of the Company and its subsidiary.  Significant intercompany transactions and balances have been eliminated in consolidation.

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

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

The accompanying consolidated financial information of the Company as of March 31, 2013 and 2012 is unaudited; however, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations.  The results of operations for the three months ended March 31, 2013, are not necessarily indicative of the results that may be expected for the full year. These statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

10

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES (continued)

Recently Adopted Accounting Pronouncements

In October 2012, ASU 2012-06, “Business Combinations (Topic 805) - Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution (a consensus of the FASB Emerging Issues Task Force).” ASU 2012-06 clarifies the applicable guidance for subsequently measuring an indemnification asset recognized as a result of a government-assisted acquisition of a financial institution. Under ASU 2012-06, when a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and, subsequently, a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets). The amendments are effective for fiscal years beginning on or after December 15, 2012 and early adoption is permitted. The amendments are to be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution. The Company adopted this standard on October 1, 2012. The effect of adopting this standard did not have a material effect on the consolidated financial statements.

11

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 2. EARNINGS PER SHARE

Basic earnings per share represent income available attributable to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unallocated shares of the Employee Stock Ownership Plan and unvested shares of issued restricted stock. For the three months ended March 31, 2013, potential common shares of 372,607 respectively, were not included in the calculation of diluted earnings per share because the assumed exercise of such shares would be anti-dilutive.

 The table below sets forth our earnings per share:

	Three Months ended March 31,
	2013		2012
	(dollars in thousands, except per share data)
Basic earnings and shares:
Net income	$	3,928		$	971
Weighted-average basic shares outstanding		7,526,344			8,144,382
Basic earnings per share	$	0.52		$	0.12
Diluted earnings and shares:
Net income	$	3,928		$	971
Weighted-average basic shares outstanding		7,526,344			8,144,382
Add:  Stock options and nonvested shares		2,178			1,348
Weighted-average diluted shares outstanding		7,528,522			8,145,730
Diluted earnings per share	$	0.52		$	0.12

12

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 3. SHARE BASED COMPENSATION

On May 17, 2006, the Company’s stockholders approved the 2006 Equity Incentive Plan (the “Plan”).  The purpose of the Plan is to promote the long-term growth and profitability of Heritage Financial Group, Inc, to provide directors, advisory directors, officers and employees of Heritage Financial Group, Inc. and its affiliates with an incentive to achieve corporate objectives, to attract and retain individuals of outstanding competence, and to provide such individuals with an equity interest in Heritage Financial Group, Inc.  Under the Plan, the Compensation Committee of the Board of Directors has discretion to award up to 645,990 shares, of which 461,422 were available as stock options or stock appreciation rights and 184,568 shares were available as restricted stock awards.  As of March 31, 2013, there were approximately 12,800 restricted stock awards and 49,593 options available to be granted from the 2006 Plan.

On June 22, 2011, the Company’s stockholders approved the 2011 Equity Incentive Plan (the “2011 Plan”).  Under the 2011 Plan, the Compensation Committee has the discretion to award up to 573,481 shares, of which 409,429 were available as stock options or stock appreciation rights and 163,852 were available as restricted stock awards.  On July 1, 2011, the Company granted 117,530 restricted stock awards and 334,870 stock options from this plan. On October 1, 2012, the Company granted 15,600 restricted stock awards and 31,900 stock options from this plan.    There were no awards granted from this plan during the three months ended March 31, 2013. As of March 31, 2013, there were approximately 31,082 restricted stock awards and 48,419 options available to be granted from the 2011 Plan.

The Company granted restricted awards that may not be sold or otherwise transferred until certain restrictions have lapsed.  The unearned compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse (generally one to five years).  The share-based expense for these awards was determined based on the market price of the Company's stock at the date of grant applied to the total number of shares that were anticipated to fully vest, amortized over the vesting period.  As of March 31, 2013, there was approximately $1.1 million of unrecognized compensation associated with these awards.  For the three months ended March 31, 2013 and 2012, we recognized compensation expense associated with these awards of approximately $84,000 and $74,000, respectively.

The Company recognized compensation expense related to stock options of approximately $146,000 and $135,000 for each of the three months ended March 31, 2013 and 2012, respectively.  At March 31, 2013, there was approximately $1.9 million of unrecognized compensation related to stock options.

13

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES

The amortized cost and fair value of securities available for sale with gross unrealized gains and losses are summarized as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
	(dollars in thousands)
March 31, 2013:
U.S. Government sponsored agencies (GSEs)	$	40,411	$	89	$	(75	)	$	40,425
State and municipal securities		47,479		1,329		(827	)		47,981
Corporate debt securities		1,000		-		(130	)		870
GSE residential mortgage-backed securities		177,061		1,304		(718	)		177,647
Total debt securities		265,951		2,722		(1,750	)		266,923
Equity securities		207		177		-			384
Total securities	$	266,158	$	2,899	$	(1,750	)	$	267,307

December 31, 2012:
U.S. Government sponsored agencies (GSEs)	$	20,996	$	50	$	(27	)	$	21,019
State and municipal securities		40,509		1,362		(298	)		41,573
Corporate debt securities		1,150		-		(130	)		1,020
GSE residential mortgage-backed securities		156,469		1,434		(406	)		157,497
Total debt securities		219,124		2,846		(861	)		221,109
Equity securities		207		93		(3	)		297
Total securities	$	219,331	$	2,939	$	(864	)	$	221,406

The amortized cost and fair value of debt securities available for sale by contractual maturity are shown below.  Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without penalty.  Therefore, these securities are not included in the maturity categories in the following maturity summary.

	March 31, 2013				December 31, 2012
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(dollars in thousands)
One year or less	$	-	$	-	$	150	$	150
One to five years		2,899		2,771		1,786		1,661
Five to ten years		45,262		45,727		20,920		21,264
Over ten years		40,936		41,162		40,006		40,834
Mortgage-backed securities		177,061		177,647		156,469		157,497
	$	266,158	$	267,307	$	219,331	$	221,406

Securities with a carrying value of approximately $108.6 million and $94.6 million at March 31, 2013 and December 31, 2012, respectively, were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law.  The balance of pledged securities in excess of the pledging requirements was $20.1 million and $18.0 million at March 31, 2013 and December 31, 2012, respectively.

14

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

The gross realized gains and losses recognized in income are reflected in the following table:

		For the three months ended March 31,
		2013		2012
		(dollars in thousands)
Gross gains recognized on sales of securities	$	-	$	42
Gross losses recognized on sales of securities		-		-
Net realized gains on sales of securities available for sale	$	-	$	42

The following table shows the gross unrealized losses and fair value of securities aggregated by category and length of time that securities have been in a continuous unrealized loss position.

	Less Than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(dollars in thousands)
March 31, 2013 :
U.S. Government sponsored agencies (GSEs)	$	18,909	$	(75	)	$	-	$	-		$	18,909	$	(75	)
State and municipal securities		20,270		(785	)		284		(42	)		20,554		(827	)
Corporate debt securities		-		-			870		(130	)		870		(130	)
GSE residential mortgage-backed securities		90,797		(675	)		2,850		(43	)		93,647		(718	)
Subtotal, debt securities		129,976		(1,535	)		4,004		(215	)		133,980		(1,750	)
Equity securities		-		-			-		-			-		-
Total temporarily impaired securities	$	129,976	$	(1,535	)	$	4,004	$	(215	)	$	133,980	$	(1,750	)

December 31, 2012 :
U.S. Government sponsored agencies (GSEs)	$	5,481	$	(27	)	$	-	$	-		$	5,481	$	(27	)
State and municipal securities		10,981		(226	)		1,377		(72	)		12,358		(298	)
Corporate debt securities		-		-			1,020		(130	)		1,020		(130	)
GSE residential mortgage-backed securities		62,235		(337	)		4,634		(69	)		66,869		(406	)
Subtotal, debt securities		78,697		(590	)		7,031		(271	)		85,728		(861	)
Equity securities		-		-			204		(3	)		204		(3	)
Total temporarily impaired securities	$	78,697	$	(590	)	$	7,235	$	(274	)	$	85,932	$	(864	)

15

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

At March 31, 2013, total securities with unrealized losses increased to $1.7 million, or 1.3% of the securities, compared to $864,000, or 1.0% of the securities, at December 31, 2012.  The unrealized losses in 2013 relate principally to 16 agencies, 53 state and municipal obligations, one corporate debt securities and 66 mortgage-backed securities.  In analyzing an issuer's financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer's financial condition, and the issuer's anticipated ability to pay the contractual cash flows of the investments.

The Company does not currently intend to sell the securities within the portfolio and it is not more-likely-than-not that the Company will be required to sell the debt securities; therefore, management does not consider these investments to be other-than-temporarily impaired at March 31, 2013. Management continues to monitor all of these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of these securities may be sold or are other than temporarily impaired, which would require a charge to earnings in such periods.  At March 31, 2013, the Company held certain investment securities having continuous unrealized loss positions for more than 12 months.  All of these losses were in one corporate security, six mortgage-backed securities, and two municipal securities. The unrealized loss arose from changes in interest rates and market conditions as of March 31, 2013.

Other-Than-Temporary Impairment

The Company reviews its investment portfolio on a quarterly basis judging each investment for other-than-temporary impairment (“OTTI”).  Management does not have the intent to sell any of the temporarily impaired investments and believes it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The OTTI analysis focuses on the duration and amount a security is below book value and assesses a calculation for both a credit loss and a non credit loss for each measured security considering the security’s type, performance, underlying collateral, and any current or potential debt rating changes.  The OTTI calculation for credit loss is reflected in the income statement while the non credit loss is reflected in other comprehensive income.

The Company holds Freddie Mac (“FHLMC”) preferred stock, and OTTI was recorded in the amount of the investment after the U.S. Government placed the company into conservatorship in September 2008.  The preferred stock has been reduced to a nominal book value for tracking purposes.  The investment is currently valued at $171,000. During the twelve months ended December 30, 2008 the Company recognized a write-down of $1.5 million through non-interest income representing other-than-temporary impairment on the investment.

The Company holds a single issue trust preferred security issued by Royal Bank of Scotland (“RBS”).  The security suspended payments under the EU agreement for 24 months beginning April 1, 2011.  The Company valued the security by projecting estimated cash flows using the Moody’s Ba2 marginal default rate.  The difference in the present value and the carrying value of the security was the OTTI credit portion.  During the twelve months ended December 31, 2011 the Company recognized a write-down of $43,000 through non-interest income representing OTTI on the security.  At March 31, 2013, the book value of the security was recorded at $207,000 which agrees to the present value of the security and therefore no OTTI was recorded in 2013 and 2012.  At March 31, 2013, the fair value of the security was $213,000 with $6,000 of an unrealized gain recorded in other comprehensive income.

16

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 4. SECURITIES (Continued)

The following table presents more detail on selective Company security holdings as of March 31, 2013.  These details are listed separately due to the inherent level of risk for OTTI on these securities.

			Current Credit		Book		Fair		Unrealized		Present Value Discounted
Description	Cusip#		Rating		Value		Value		Loss		Cash Flow
Marketable equity securities
FHLMC Preferred Stock		313400657	Ca		$	-	$	171	$	-	$	171
Trust preferred securities
RBS Capital Fund		74928K208		B3		207		213		-		213

The following table presents a roll-forward of the cumulative amount of credit losses on the Company’s investment securities that have been recognized through earnings.

	March 31, 2013		December 31, 2012
Beginning balance of credit losses	$	1,543	$	1,543
Other-than-temporary impairment credit losses		-		-
Ending balance of cumulative credit losses recognized in earnings	$	1,543	$	1,543

Restricted Equity Securities

The investment in the common stock of the Federal Home Loan Bank of Atlanta is accounted for by the cost method, which also represents par value, and is made for long-term business affiliation reasons.  In addition, this investment is subject to restrictions relating to sale, transfer or other disposition.  Dividends are recognized in income when declared.  The carrying value of this investment at March 31, 2013 and December 31, 2012 was $6.0 million and $4.3 million, respectively.   The estimated fair value of this investment is $6.0 million as of March 31, 2013, and therefore is not considered impaired.

Other equity securities represent an investment in the common stock of the Chattahoochee Bank of Georgia (“Chattahoochee”), a de novo bank in Gainesville, Georgia.  The Company accounts for this investment by the cost method.  This investment represents approximately 4.9% of the outstanding shares of Chattahoochee.  Since its initial capital raise, Chattahoochee has not had any stock transactions, and therefore, no fair market value is readily available.  The carrying value of this investment at March 31, 2013 and December 31, 2012 was $1.0 million.  The Company plans to hold this investment for the foreseeable future, and did not consider it impaired as of March 31, 2013.

17

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS)

The composition of loans is summarized as follows:

	March 31,			December 31,
	2013				2012
Commercial real estate:
Nonresidential	$	225,946			$	212,570
Multifamily		24,280				21,293
Farmland		20,749				20,141
Total commercial real estate loans		270,975				254,004
Construction and land		37,659				33,340
Residential real estate:
Mortgage loans, 1-4 families		166,312				161,883
Home equity		25,842				27,345
Total Residential real estate loans		192,154				189,228
Consumer and other:
Indirect auto loans		944				1,304
Direct auto loans		6,876				6,801
Other		12,111				17,393
Total consumer loans		19,931				25,498
Commercial and industrial loans		83,015				83,659
		603,734				585,729
Loans acquired through FDIC-assisted acquisitions
Non-Covered		83,317				11,850
Covered		65,815				72,425
Total loans		149,132				670,004
Total allowance for loan losses		(9,105	)			(9,061	)
Loans, net	$	743,761			$	660,943

Commercial Real Estate

Commercial real estate lending includes real estate loans secured primarily by multifamily dwellings, retail establishments, hotels, motels, warehouses, small office buildings, farmland, and other nonresidential properties located in our market areas.

18

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

These loans typically involve large balances to single borrowers or groups of related borrowers.  Because payments on loans secured by nonresidential and multifamily real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy.  If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower's ability to repay the loan may be impaired.

Loans secured by farmland typically involve large balances, and repayments are often dependent on the successful operation of the farm, making them subject to adverse weather and economic conditions.  If the cash flow from the farm operations declines, the borrower’s ability to repay the loan may be impaired.

Construction and Land

Construction and land lending consist of loans for the construction of one- to four-family residences, multifamily residences and commercial properties.  Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction.  Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios.

Residential real estate

Residential real estate lending consist of loans secured by first mortgages on one- to four-family residences, including home equity lines of credit, in our lending area, and on occasion, outside our lending area for customers whose primary residences are within the Company’s lending area.

Consumer and Other Lending

Consumer and other lending includes a variety of secured consumer loans, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. Consumer loans may entail greater risk, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance.  As a result, consumer loan collections are dependent on the borrower's continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.

Commercial and Industrial Lending

Commercial and industrial lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment.  Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory.  This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.

19

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Activity in the allowance for loan losses and recorded investment in loans by segment:

	Commercial Real Estate			Residential Real Estate			Construction and Land		Commercial and Industrial			Consumer and Other			Total
	(dollars in thousands)
Balance, January 1, 2013	$	2,744		$	3,251		$	978	$	1,724		$	364		$	9,061
Add (deduct):
Charge-offs		(70	)		(165	)		-		(177	)		(39	)		(451	)
Recoveries		-			18			-		1			26			45
Provision for loan losses		79			(12	)		58		285			40			450
Balance, March 31, 2013	$	2,753		$	3,092		$	1,036	$	1,833		$	391		$	9,105
Allowance:
Ending balance: specific	$	696		$	990		$	304	$	314		$	130		$	2,434
Ending balance: collective	$	2,057		$	2,102		$	732	$	1,519		$	261		$	6,671
Loans:
Ending balance: individually evaluated for impairment	$	5,498		$	4,326		$	3,855	$	944		$	124		$	14,747
Ending balance: collectively evaluated for impairment	$	265,477		$	187,828		$	33,804	$	82,071		$	19,807		$	588,987

20

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Activity in the allowance for loan losses and recorded investment in loans by segment:

	Commercial Real Estate			Residential Real Estate			Construction and Land			Commercial and Industrial			Consumer  and Other			Total
	(dollars in thousands)
Balance, January 1, 2012	$	1,878		$	2,440		$	1,270		$	1,551		$	355		$	7,494
Add (deduct):
Charge-offs		(166	)		(498	)		(81	)		(208	)		(188	)		(1,141	)
Recoveries		-			75			1			35			97			208
Provision for loan losses		1,032			1,234			(212	)		346			100			2,500
Balance, December  31, 2012	$	2,744		$	3,251		$	978		$	1,724		$	364		$	9,061
Allowance:
Ending balance: specific	$	429		$	1,294		$	304		$	206		$	68		$	2,301
Ending balance: collective	$	2,315		$	1,957		$	674		$	1,518		$	296		$	6,760
Loans:
Ending balance: individually evaluated for impairment	$	4,938		$	4,596		$	3,881		$	1,149		$	120		$	14,684
Ending balance: collectively evaluated for impairment	$	249,066		$	184,632		$	29,459		$	82,510		$	25,378		$	571,045

Impaired Loans

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual term of the loan.  Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties.  These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

21

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2013:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2013
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	-	$	-	$	-	$	-	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		3,417		3,417		-		4,305		-
Residential real estate:
Mortgage loans, 1-4 families		539		563		-		401		-
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		14		15		-		16		-
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	5,498	$	5,652	$	696	$	5,537	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		438		504		304		462		-
Residential real estate:
Mortgage loans, 1-4 families		3,702		4,066		907		4,129		-
Home equity		85		89		83		93		-
Consumer and other:
Indirect auto loans		18		24		-		24		-
Direct auto loans		32		45		21		39		-
Other		74		106		109		98		-
Commercial and industrial loans		930		968		314		908		-
Total
Commercial real estate	$	5,498	$	5,652	$	696	$	5,537	$	-
Construction and land		3,855		3,921		304		4,767		-
Residential real estate		4,326		4,718		990		4,623		-
Consumer and other		124		175		130		161		-
Commercial and industrial loans		944		983		314		924		-
Total	$	14,747	$	15,449	$	2,434	$	16,012	$	-

22

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Impaired loans by class are presented below for 2012:

									Interest
			Unpaid				Average		Income
	Recorded		Principal		Related		Recorded		Recognized
	Investment		Balance		Allowance		Investment		YTD 2012
	(dollars in thousands)
Loans with no related allowance recorded
Commercial real estate:
Nonresidential	$	-	$	-	$	-	$	-	$	-
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		3,443		3,469		-		4,606		134
Residential real estate:
Mortgage loans, 1-4 families		535		553		-		324		19
Home equity		-		-		-		-		-
Consumer and other:
Indirect auto loans		-		-		-		-		-
Direct auto loans		-		-		-		-		-
Other		-		-		-		-		-
Commercial and industrial loans		877		878		-		769		11
Loans with related allowance recorded
Commercial real estate:
Nonresidential	$	4,938	$	5,195	$	429	$	4,975	$	101
Multifamily		-		-		-		-		-
Farmland		-		-		-		-		-
Construction and land		438		504		304		472		-
Residential real estate:
Mortgage loans, 1-4 families		3,782		4,061		1,054		4,414		52
Home equity		279		321		240		290		8
Consumer and other:
Indirect auto loans		30		43		-		35		1
Direct auto loans		23		36		16		28		0
Other		67		77		52		75		4
Commercial and industrial loans		272		278		206		282		13
Total
Commercial real estate	$	4,938	$	5,195	$	429	$	4,975	$	101
Construction and land		3,881		3,973		304		5,078		134
Residential real estate		4,596		4,935		1,294		5,028		60
Consumer and other		120		156		68		138		5
Commercial and industrial loans		1,149		1,156		206		1,051		24
Total	$	14,684	$	15,415	$	2,301	$	16,270	$	324

23

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Below is an analysis of the age of recorded investment in loans that are past due as of March 31, 2013.

	30-59		60-89		Greater		Total
	Days		Days		Than		Past				Total
	Past Due		Past Due		90 Days		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	542	$	-	$	5,498	$	6,040	$	219,906	$	225,946
Multifamily		-		-		-		-		24,280		24,280
Farmland		-		-		-		-		20,749		20,749
Total commercial real estate loans		542		-		5,498		6,040		264,935		270,975
Construction and land		-		216		1,838		2,054		35,605		37,659
Residential real estate:
Mortgage loans, 1-4 families		349		-		4,235		4,584		161,728		166,312
Home equity		-		-		85		85		25,757		25,842
Total residential real estate loans		349		-		4,320		4,669		187,485		192,154
Consumer and other:
Indirect auto loans		5		-		18		23		921		944
Direct auto loans		2		-		32		34		6,842		6,876
Other		13		2		72		87		12,024		12,111
Total consumer and other loans		20		2		122		144		19,787		19,931
Commercial and industrial loans		187		-		945		1,132		81,883		83,015
Total	$	1,098	$	218	$	12,723	$	14,039	$	589,695	$	603,734

24

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Below is an analysis of the age of recorded investment in loans that are past due as of December 31, 2012.

	30-59		60-89		Greater		Total
	Days		Days		Than		Past				Total
	Past Due		Past Due		90 Days		Due		Current		Loans
	(dollars in thousands)
Commercial real estate:
Nonresidential	$	-	$	744	$	4,938	$	5,682	$	206,888	$	212,570
Multifamily		-		-		-		-		21,293		21,293
Farmland		-		-		-		-		20,141		20,141
Total commercial real estate loans		-		744		4,938		5,682		248,322		254,004
Construction and land		-		-		3,881		3,881		29,459		33,340
Residential real estate:
Mortgage loans, 1-4 families		1,233		-		4,475		5,708		156,175		161,883
Home equity		50		-		114		164		27,181		27,345
Total residential real estate loans		1,283		-		4,589		5,872		183,356		189,228
Consumer and other:
Indirect auto loans		5		5		30		40		1,264		1,304
Direct auto loans		2		6		23		31		6,770		6,801
Other		72		-		67		139		17,254		17,393
Total consumer and other loans		79		11		120		210		25,288		25,498
Commercial and industrial loans		14		-		1,149		1,164		82,495		83,659
Total	$	1,376	$	755	$	14,677	$	16,809	$	568,920	$	585,729

There were no accruing loans that were greater than 90 days past due at March 31, 2013 and December 31, 2012.

25

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Troubled Debt Restructuring (TDR) Modifications

Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties.  These concessions are a part of the Company’s loss mitigation activities and could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.  Certain TDR’s are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, typically considered six to twelve months.

At March 31, 2013, the Company had troubled debt restructurings totaling $6.6 million, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates.  Included in nonaccruing loans at March 31, 2013, are troubled debt restructurings of $4.6 million.  In addition, at that date the Company had troubled debt restructurings totaling $2.0 million that were performing in accordance with their modified terms and are not included in nonaccruing loans.

The following tables include the recorded investment and number of modifications for modified loans.  The Company reports the recorded investment in the loans prior to a modification and also the recorded investment in the loans after the loans were restructured.  Management has also disclosed the recorded investment and number of modifications for troubled debt restructurings within the last year where a concession has been made that then defaulted in the current reporting period.

Troubled Debt Restructurings for the periods ended:

	As of March 31, 2013
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications		Recorded Investment
Commercial real estate		2	$	852	$	814
Residential real estate		5		7,268		2,370
Construction and land		2		3,574		3,417
Commercial and industrial loans		1		17		14
Consumer and other		-		-		-
Total		10	$	11,711	$	6,615

26

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	December 31, 2012
			Recorded
	Number		Investment
	of Modifications		Prior to Modifications			Recorded Investment
	(dollars in thousands)
Commercial real estate		3		$	1,071		$	997
Residential real estate		5			7,268			2,409
Construction and land		1			3,574			3,443
Commercial and industrial loans		1			17			14
Consumer and other		-			-			-
Total		10		$	11,930		$	6,863

Troubled Debt Restructuring Modifications that Subsequently Defaulted for the periods ended:

	As of March 31, 2013
	Number
	of		Recorded
	Modifications		Investment
Commercial real estate		2	$	814
Residential real estate		4		2,365
Construction and land		1		1,400
Commercial and industrial loans		1		14
Consumer and other		-		-
Total		8	$	4,593

	December 31, 2012
		Number
		of		Recorded
		Modifications		Investment
		(dollars in thousands)
Commercial real estate			3	$	997
Residential real estate			4		2,402
Construction and land			1		3,443
Commercial and industrial loans			1		14
Consumer and other			-		-
Total			9	$	6,856

27

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Allowance for Loan and Lease Losses (ALLL)

The Company establishes provisions for loan losses, which are charged to income, at a level the Company believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio.

In evaluating the level of the allowance for loan losses, the Company considers the types of loans and the amount of loans in the loan portfolio, five year historical loss experience, migration analysis, probability of default, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.

The Company analyzes the non-FDIC-acquired loan portfolios through the use of pools of homogenous loan types and through a specific quarterly review of larger problem loans. It is expected that a certain percentage of loans will move through the asset quality grades from pass, to classified and ultimately loss.  The Company evaluates the non-FDIC loan portfolio through review of four loan pool categories.

1. Pass credits with risk ratings 1-5

2. Special mention with risk ratings 6-7

3. Substandard with risk rating 8 and still accruing

4. Impaired loans 9-11 – Nonaccrual and troubled debt restructurings

Asset quality grades are described in detail subsequently.

The allowance consists of two components:

1. A general amount – The Company analyzes the historical migration of loans through each risk rating category and analyzes the history of losses as it relates to the various loan types and collateral types in order to evaluate and estimate the volume, magnitude and direction of these events. These risk factors and other factors are applied to our review of the Pass credits with risk ratings 1-5 pool and other assets specially mentioned with risk rating 6-7 pool. These factors are also applied to the substandard pool; however, in addition to reviewing the pool, a select group of individual loans are reviewed.  The results of the individual review are factored in with the historical loss analysis and applied to the pool.

2. A specific amount – Impaired loans are reviewed individually for specific amounts that are representative of identified credit exposures that are readily predictable by the current performance of the borrower and underlying collateral. Impaired loans with balances lower than $500,000 are not typically reviewed on an individual basis due to their small size.  Instead, a historical loss analysis is used for these loans, which assumes the loan migration to default is likely, and the assumed loss is recorded as a specific amount.

Even though the ALLL is composed of two components, the entire ALLL is available to absorb any credit losses.

28

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

The Company assesses the allowance for loan losses on a quarterly basis and we make provisions for loan losses as necessary in order to maintain the proper level of allowance.  While the Company uses available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require the Company to recognize additional provisions based on their judgment of information available to them at the time of their examination.  The allowance for loan losses is maintained at a level that represents management's best estimate of inherent losses in the loan portfolio, where such losses were both probable and reasonably estimable.  The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.

In September 2012, the Company modified its asset quality grading system by dividing it into eleven categories instead of eight.  This modification added one new pass level, an additional criticized level and a new classified level. The new grading system did not cause a change to the allowance methodology for loan losses and was created to help the Company better manage credit quality.

A summary of the asset grading system is as follows:

Risk Rating	Numerical Rating	Description	Regulatory Classification
Pass	1	Exceptional/Highest Quality	N/A
Pass	2	Excellent/High Quality	N/A
Pass	3	Strong/Above Average	N/A
Pass	4	Good/Average	N/A
Pass	5	Acceptable with more than average risk	N/A
Special Mention	6	Special Mention Loans	Criticized
Special Mention -  Elevated risk	7	Special Mention Loans with added risk exposure	Criticized
Substandard	8	Substandard/Inadequately Protected	Classified
Impaired Loans	9	Nonaccrual Loans	Classified
Doubtful	10	Doubtful	Classified
Loss	11	Loss	Classified

Pass-1-Exceptional/Highest Quality – Loans in this category are secured by certificates of deposit.  There is no credit risk exposure in this category.

Pass-2-Excellent/High Quality – Loans in this category have excellent balance sheet and income statement and improving trends, including net worth, liquidity, working capital, leverage, cash flow and profitability. Financial ratios are superior within industry when industry comparison is available.

29

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Pass-3-Strong/Above Average – Loans in this category have current and complete financial statements; Solid balance sheet and income statement with stable to improving trends  in areas such as net worth, liquidity, working capital, leverage, cash flow  and profitability; Leverage and ratios are better than industry standards when industry comparison is available; Debt service coverage, both historically and proposed, is more than adequate based on financial analysis; The borrower’s industry is stable to improving; Loans are properly structured and documented, and require only normal supervision and monitoring; Consistently meets debt obligations in a timely manner; Individual borrower or guarantor, with above average liquid net worth and minimal contingent liabilities.

Pass-4-Good/Average - Loans in this category have sound risk profiles, good net worth and debt service coverage ratios; Financial statements are current and complete; Satisfactory balance sheet and income statement reflecting  adequate profitability, net worth, working capital, cash flow and leverage position; Financial analysis demonstrates adequate debt service coverage; Leverage and ratios are in line with industry averages when industry comparison is available; Debt service coverage, both historically and proposed, is adequate based on financial analysis; Loans are properly structured and documented and require only minimal supervision; contingent liabilities have been thoroughly analyzed and repayment sources are adequate to cover existing debt service; Individual borrower or guarantor with acceptable net worth and liquidity.

Pass-5-Acceptable with more than average risk - Loans in this category are those which are acceptable with more than average risk due to one or more factors, which could lead to financial difficulty if not closely managed. This rating may include those credits from higher categories that have declining trends in financial performance or credit quality. This category may also include credits that have previously been criticized or classified, but have improved in credit quality.

Special Mention 6-Special Mention Loans - Loans in this category are not currently adequate.  These loans are considered weaker due to less than adequate repayment history, and/or their collateral may not adequately protect the Bank from loss in the event of liquidation or foreclosure.  If left uncorrected, these weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. As a general rule, credits in this category will be delinquent less than 30 days and will not be chronically past due.  Loans in this category are not intended to remain in category 6 permanently as it should become evident fairly quickly whether or not the weaknesses can be cured and the loan upgraded.  If the weakness cannot be corrected, the relationship will more than likely need to be downgraded to a 7 or 8.

 Special Mention Elevated Risk 7-Special Mention Loans with added risk exposure – Loans in this category have one or more potential weaknesses discussed in asset quality grade 6, but the borrower is still cooperative, satisfactory repayment plans are in place, and file documentation reflects the ability of the borrower to repay the debt as currently structured

Substandard 8-Substandard/Inadequately Protected – Loans in this category are inadequately protected by the current sound net worth and repayment capacity of the borrower or of the collateral pledged, if any.  Credit analysis has proven well-defined weaknesses in debt service coverage, net worth and/or poor loan structure.  There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  A reserve allocation of the estimated amount of loss or collateral shortfall has been made to the ALLL.  These loans are considered to be impaired loans and the chance of a loss is reasonably probable.

30

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

Impaired Loans 9-Nonaccrual Loans – Loans in this category are impaired with a loss potential of either principal or interest that is probable or likely to occur.  Once a loan enters this category, the estimated loss will be charged off.

Doubtful 10-Doubtful - Loans in this category have all of the weaknesses inherent in those classified as Substandard, with the additional characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable.  This assessment should be made on current facts, conditions and values.  The probability of some loss is extremely high, but because of certain important and reasonably specific pending factors (i.e., merger/liquidation, capital injection, refinancing plans, and/or perfection of liens), the amount of loss cannot yet be determined, but may total 50% of the outstanding balance.  Determination of the pending factors should generally be resolved within six months and the asset partially, or fully, charged-off or moved to substandard.  All doubtful assets must be placed on nonaccrual.  A reserve allocation or charge off of at least 50% is normally recommended for such loans.

Loss 11-Loss - Loans in this category are considered uncollectible and of such little value that their continuance as active assets of the Bank is not warranted.  This classification does not mean that the loss has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing it off.  Once the loan is placed in this category, any determined loss will be charged-off within 30 days

Credit quality indicators for loans by class are presented below for March 31, 2013 and December 31, 2012.

	As of March 31, 2013
								Construction
	Non-							and
	Residential		Multifamily			Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-		$	-	$	-		$	-
Pass 2		-			-		-			66
Pass 3		64,699			3,150		7,147			9,626
Pass 4		145,215			19,396		13,092			17,436
Pass 5		8,438			40		361			6,552
Special Mention 6		895			-		-			-
Special Mention Elevated 7		-			1,694		78			124
Substandard 8		1,201			-		71			2,017
Impaired Loans 9		5,498			-		-			1,838
Doubtful 10		-			-		-			-
Loss 11		-			-		-			-
Total	$	225,946		$	24,280	$	20,749		$	37,659

31

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2012
							Construction
	Non-						and
	Residential		Multifamily		Farmland		Land
	(dollars in thousands)
Commercial Real Estate Credit Exposure
Pass 1	$	-	$	-	$	-	$	-
Pass 2		-		-		-		68
Pass 3		63,944		3,820		6,459		7,202
Pass 4		135,189		15,214		12,258		16,732
Pass 5		4,711		41		1,275		5,332
Special Mention 6		907		-		-		-
Special Mention Elevated 7		-		1,707		-		-
Substandard 8		2,881		511		149		125
Impaired Loans 9		4,938		-		-		3,881
Doubtful 10		-		-		-		-
Loss 11		-		-		-		-
Total	$	212,570	$	21,293	$	20,141	$	33,340

	As of March 31, 2013
	Commercial and Industrial
	(dollars in thousands)
Commercial and Industrial Credit Exposure
Pass 1	$	1,535
Pass 2		296
Pass 3		25,506
Pass 4		50,280
Pass 5		4,054
Special Mention 6		77
Special Mention Elevated 7		38
Substandard 8		284
Impaired Loans 9		945
Doubtful 10		-
Loss 11		-
Total	$	83,015

32

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2012
	Commercial and Industrial
	(dollars in thousands)
Commercial and Industrial Credit Exposure
Pass 1	$	1,194
Pass 2		366
Pass 3		29,447
Pass 4		46,916
Pass 5		3,781
Special Mention 6		86
Special Mention Elevated 7		6
Substandard 8		713
Impaired Loans 9		1,150
Doubtful 10		-
Loss 11		-
Total	$	83,659

	As of March 31, 2013
	Mortgage		Home Equity
	(dollars in thousands)
Residential Real Estate Credit Exposure
Pass 1-5	$	159,046	$	25,605
Special Mention 6		289		-
Special Mention Elevated 7		161		-
Substandard 8		2,581		152
Impaired Loans 9		4,235		85
Doubtful 10		-		-
Loss 11		-		-
Total	$	166,312	$	25,842

33

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5. LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)

	As of December 31, 2012
	Mortgage		Home Equity
	(dollars in thousands)
Residential Real Estate Credit Exposure
Pass 1-5	$	154,067	$	26,922
Special Mention 6		357		-
Special Mention Elevated 7		-		-
Substandard 8		3,202		144
Impaired Loans 9		4,257		279
Doubtful 10		-		-
Loss 11		-		-
Total	$	161,883	$	27,345

	As of March 31, 2013
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	908	$	6,844	$	11,997
Special Mention 6		-		-		-
Special Mention Elevated 7		-		-		1
Substandard 8		18		-		41
Impaired Loans 9		18		32		72
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	944	$	6,876	$	12,111

	As of December 31, 2012
	Indirect		Direct
	Auto		Auto		Other
	(dollars in thousands)
Consumer and Other Credit Exposure
Pass 1-5	$	1,252	$	6,778	$	17,280
Special Mention 6		-		-		-
Special Mention Elevated 7		-		-		1
Substandard 8		22		-		45
Impaired Loans 9		30		23		67
Doubtful 10		-		-		-
Loss 11		-		-		-
Total	$	1,304	$	6,801	$	17,393

34

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company elected to account for loans acquired in the Tattnall Bank, Citizens Bank of Effingham (“Citizens”), First Southern National Bank (“First Southern”) and Frontier Bank (“Frontier”) acquisitions under ASC 310–30.  ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable.  ASC 310 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans which fall under the scope of this statement. Loans with specific evidence of deterioration in credit quality were accounted for under ASC 310.  In addition, the Company determined it would not be able to collect all the contractually required principal and interest payments on other loans in the portfolio which did not have specific evidence of credit quality due to multiple factors, including the deterioration of the economy since origination of these loans, the decline in real estate values in the market areas of the loans, and the poor underwriting standards under which these loans were originated.  These loans are accounted for by analogy to ASC 310. The following tables detail the fair value of loans covered and not covered under loss share agreements accounted under ASC 310-30.

	March 31,		December 31,
	2013		2012
Loans not covered by loss -sharing agreements:	(dollars in thousands)
Commercial real estate	$	30,851	$	6,359
Residential real estate		34,938		2,110
Construction and land		7,756		494
Commercial and industrial		5,125		1,574
Consumer and other		4,647		1,313
		83,317		11,850

	March 31,		December 31,
	2013		2012
Loans covered by loss-sharing agreements:	(dollars in thousands)
Commercial real estate	$	18,849	$	21,820
Residential real estate		30,735		32,846
Construction and land		13,370		14,248
Commercial and industrial		2,216		2,670
Consumer and other		645		841
		65,815		72,425

The Bank entered into loss-sharing agreements as part of the acquisitions of Citizens and First Southern.  The covered loans above are covered pursuant to the FDIC loss-share agreements.  Those agreements provide for the FDIC to reimburse the Company for 80% of covered losses associated with these loans, pursuant to the terms of the agreements.

35

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following table represents the loans receivable as of March 31, 2013 and reflects reclassifications from the balances reported at December 31, 2012:

	Acquired Loans Without Specific Evidence of Deterioration in Credit Quality			Acquired Loans With Specific Evidence of Deterioration in Credit Quality			Total Loans Acquired
	(dollars in thousands)
Contractually required principal and interest	$	222,870		$	40,357		$	263,227
Non-accretable difference		(36,899	)		(22,545	)		(59,444	)
Cash flows expected to be collected		185,971			17,812			203,783
Accretable yield		(52,078	)		(2,573	)		(54,651	)
Basis in acquired loans	$	133,893		$	15,239		$	149,132

The following table is a summary of changes in the accretable yields of acquired loans since December 31, 2011 and reflect refinements to the Company's initial estimate:

(dollars in thousands)	Accretable Yield
Balance at December 31, 2011	$	31,096
Additions		-
Reclassification from non-accretable difference		22,349
Accretion included in interest income		(23,251	)
Adjustments to estimates of expected cash flows		(1,312	)
Balance at December 31, 2012	$	28,882
Additions		22,707
Reclassification from non-accretable difference		6,308
Accretion included in interest income		(6,531	)
Adjustments to estimates of expected cash flows		3,285
Balance at March 31, 2013	$	54,651

36

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following is a summary of the allowance for loan losses for the FDIC-acquired loans for 2013:

	Commercial Real Estate		Residential Real Estate			Construction and Land		Commercial and Industrial			Consumer  and  Other		Total
	(dollars in thousands)
		-		-
Balance, January 1, 2013	$	-	$	-		$	-	$	-		$	-	$	-
Add (deduct):
Charge-offs		-		(1	)		-		(34	)		-		(35	)
Recoveries		-		-			-		-			-		-
Provision for loan losses - noncovered		-		-			-		-			-		-
Provision for loan losses - covered		-		1			-		34			-		(35	)
Balance, March 31, 2013	$	-	$	-		$	-	$	-		$	-	$	-
Allowance:
Ending balance: specific	$	-	$	-		$	-	$	-		$	-	$	-
Ending balance: collective	$	-	$	-		$	-	$	-		$	-	$	-
Loans:
Ending balance: individually evaluated for impairment	$	15,774	$	6,267		$	9,011	$	444		$	1,914	$	33,410
Ending balance: collectively evaluated for impairment	$	33,926	$	59,406		$	12,115	$	6,897		$	3,378	$	115,722

37

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 6. FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

The following is a summary of the allowance for loan losses for the FDIC-acquired loans for 2012:

	Commercial Real Estate			Residential Real Estate			Construction and Land			Commercial and Industrial			Consumer  and  Other			Total
	(dollars in thousands)
		-			-
Balance, January 1, 2012	$	-		$	-		$	-		$	-		$	-		$	-
Add (deduct):
Charge-offs		(1,114	)		(951	)		(907	)		(433	)		(26	)		(3,431	)
Recoveries		-			-			-			-			-			-
Provision for loan losses - noncovered		-			-			-			-			12		��	12
Provision for loan losses - covered		1,114			951			907			433			14			3,419
Balance, December  31, 2012	$	-		$	-		$	-		$	-		$	-		$	-
Allowance:
Ending balance: specific	$	-		$	-		$	-		$	-		$	-		$	-
Ending balance: collective	$	-		$	-		$	-		$	-		$	-		$	-
Loans:
Ending balance: individually evaluated for impairment	$	8,149		$	3,562		$	6,573		$	153		$	46		$	18,483
Ending balance: collectively evaluated for impairment	$	20,030		$	31,394		$	8,169		$	4,091		$	2,108		$	65,792

38

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 7. FDIC LOSS SHARE RECEIVABLE

A significant portion of the Company’s loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all covered losses as well as certain expenses incurred in connection with those assets. The Company estimated the amount that will be received from the FDIC under the loss share agreements that will result from losses incurred as the Company disposes of covered assets, and the Company’s recorded the estimate as a receivable from the FDIC. The Company discounted the receivable for the expected timing and receipt of those cash flows using a risk free rate plus a premium for risk. The accretion of the FDIC receivable discount is recorded into noninterest income using the level yield method over the estimated life of the receivable.

The FDIC receivable for loss share agreements is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if the Company sells the assets. The Company reviews and updates the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. Increases in expected cash flows on covered FDIC-acquired loans impact the FDIC loss share receivable by reducing the receivable over the shorter of the estimated life of the loan or the expected life of the indemnification asset.  Conversely, decreases in expected cash flows first impact accretable discounts to the extent available and then impact the allowance for loan losses while also increasing the FDIC loss share receivable.  The FDIC receivable fluctuates as loss estimates and expected cash flows related to covered loans and other real estate owned change.

The following tables provide changes in the loss-share receivable from the FDIC for the periods indicated.

For the period ended March 31, 2013:
	(dollars in thousands)
Balance, December 31, 2012	$	60,731
Decrease in expected losses on covered assets		(190	)
Accretion included in noninterest income		(2,963	)
Reimbursements from the FDIC		(5,566	)
Balance, March 31, 2013	$	52,012

For the year ended December 31, 2012:
	(dollars in thousands)
Balance, December 31, 2011	$	83,901
Decrease in expected losses on covered assets		(1,042	)
Accretion included in noninterest income		(5,028	)
Reimbursements from the FDIC		(17,100	)
Balance, December 31, 2012	$	60,731

39

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8.  OTHER REAL ESTATE OWNED (OREO)

The following table provides a summary of information pertaining to OREO for periods ended March 31, 2013 and December 31, 2012.

	OREO			Covered  OREO			Total
	(dollars in thousands)
Balance, December 31, 2012	$	3,242		$	9,467		$	12,709
Acquired in Frontier  acquisition		786			-			786
Additions		430			840			1,270
Sales		(61	)		(804	)		(865	)
Writedowns		(6	)		(43	)		(49	)
Balance, March 31, 2013	$	4,391		$	9,460		$	13,851

	OREO			Covered  OREO			Total
	(dollars in thousands)
Balance, December 31, 2011	$	3,362		$	10,047		$	13,409
Additions		2,695			8,152			10,847
Sales		(2,366	)		(7,969	)		(10,335	)
Writedowns		(449	)		(763	)		(1,212	)
Balance, December 31, 2012	$	3,242		$	9,467		$	12,709

40

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS

Determination of Fair Value

Fair value 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. Current accounting guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements).

Fair Value Hierarchy

The three levels of the fair value hierarchy are described below:

Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

Level 2 – Quoted prices in markets that are not active, or inputs that are observable, either directly, for substantially the full term of the asset or liability. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals;

Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

The fair value hierarchy is based on the lowest level input that is significant to the fair value measurement of the asset and liability in its entirety.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

Fair Value Option

Fair Value Measurements and Disclosures (ASC 820) allow companies to report selected financial assets and liabilities at fair value.  The changes in fair value are recognized in earnings and the assets and liabilities measured under this methodology are required to be displayed separately on the balance sheet.   In certain circumstances, fair value enables a company to more accurately align its financial performance with the economic value of hedged assets. Fair value enables a company to mitigate the non-economic earnings volatility caused from financial assets and financial liabilities being carried at different bases of accounting, as well as to more accurately portray the active and dynamic management of a company’s balance sheet.

On September 30, 2012, the Company made the election to record mortgage loans held for sale at fair value.   The following is a description of mortgage loans held for sale including the specific reasons for electing fair value and the strategies for managing these assets on a fair value basis.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

Mortgage Loans Held for Sale

The Company records mortgage loans held for sale at fair value in order to eliminate the complexities and inherent difficulties of achieving hedge accounting and to better align reported results with the underlying economic changes in value of the loans and related hedge instruments. This election impacts the timing and recognition of origination fees and costs, as well as servicing value, which are now recognized in earnings at the time of origination. Interest income on mortgage loans held for sale is recorded on an accrual basis in the consolidated statement of income under the heading “Interest income – loans, including fees.” The mark to market adjustments related to loans held for sale and the associated economic hedges are captured in mortgage banking activities.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The primary financial instruments that the Company carries at fair value include investment securities, derivative instruments, and mortgage loans held for sale.

The Company used the following methods and significant assumptions to estimate fair value for assets and liabilities measured on a recurring basis.

Securities:  Securities in an active market where quoted prices are available are classified within Level 1 of the valuation hierarchy.  Level 1 securities include highly liquid government securities and certain other financial products.  If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs or quoted prices of securities with similar characteristics and are classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation and more complex pricing models or discounted cash flows are used.

Mortgage loans held for sale:  The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics predominantly consisting of those conforming to government sponsored entity or agency standards. The fair value measurements consider observable data that may include market trade pricing from brokers and the mortgage-backed security markets.

The Company classifies interest rate lock commitments (“IRLCs”) on residential mortgage loans held for sale on a gross basis within other liabilities or other assets. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. Projected “pull-through” rates are determined quarterly by the Mortgage Division, using the Company’s historical data and the current interest rate environment to reflect the Company’s best estimate of the likelihood that a commitment will ultimately result in a closed loan. The loan servicing value is also included in the fair value of IRLCs.

Derivative assets and liabilities:The Companyuses derivatives to manage various financial risks. The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data. The fair value of interest rate lock commitments, which are related to mortgage loan commitments, is based on quoted market prices adjusted for commitments that the Company does not expect to fund.

42

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The credit risk associated with the underlying cash flows of an instrument carried at fair value was a consideration in estimating the fair value of certain financial instruments. Credit risk was considered in the valuation through a variety of inputs, as applicable, including, the actual default and loss severity of the collateral, and level of subordination. The assumptions used to estimate credit risk applied relevant information that a market participant would likely use in valuing an instrument. Because mortgage loans held for sale are sold within a few weeks of origination, it is unlikely to demonstrate any of the credit weaknesses discussed above and as a result, there were no credit related adjustments to fair value during the three months ended March 31, 2013 and twelve month periods ended December 31, 2012.

The following tables present financial assets measured at fair value at March 31, 2013 and December 31, 2012, on a recurring basis and the change in fair value for those specific financial instruments in which fair value has been elected.  The changes in the fair value of economic hedges were also recorded in mortgage banking activities and are designed to partially offset the change in fair value of the mortgage loans held for sale and interest rate lock commitments referenced in the following tables.

	Recurring Fair Value Measurements at March 31, 2013
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	40,425	$	-	$	40,425	$	-
State and municipal securities		47,981		-		47,981		-
Corporate debt securities		870		-		870		-
GSE residential mortgage-backed securities		177,647		-		177,647		-
Equity securities		384		177		207		-
Total available for sale investment securities		267,307		177		267,130		-
Mortgage loans held for sale		18,905		-		18,905		-
Other assets(1)		469		-		469		-
Total assets at fair value	$	286,681	$	177	$	286,504	$	-
Liabilities
Interest rate swap – cash flow hedge	$	1,663	$	-	$	1,663	$	-
Total liabilities at fair value	$	1,663	$	-	$	1,663	$	-

(1) This amount includes mortgage related interest rate lock commitments and derivative financial instruments to hedge interest rate risk. Interest rate lock commitments were recorded on a gross basis.

43

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

	Recurring Fair Value Measurements at December 31, 2012
	Total Carrying Value		Level 1		Level 2		Level 3
	(dollars in thousands)
Assets
Available for sale investment securities:
U.S. Government sponsored agencies (GSEs)	$	21,019	$	-	$	21,019	$	-
State and municipal securities		41,573		-		41,573		-
Corporate debt securities		1,020		-		1,020		-
GSE residential mortgage-backed securities		157,497		-		157,497		-
Equity securities		297		93		204		-
Total available for sale investment securities		221,406		93		221,313		-
Mortgage loans held for sale		15,608		-		15,608		-
Other assets(1)		287		-		-		287
Total assets at fair value	$	237,301	$	93	$	236,921	$	287
Liabilities
Interest rate swap – cash flow hedge	$	2,158	$	-	$	2,158	$	-
Total liabilities at fair value	$	2,158	$	-	$	2,158	$	-

(1) This amount includes mortgage related interest rate lock commitments and derivative financial instruments to hedge interest rate risk. Interest rate lock commitments were recorded on a gross basis.

44

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The following tables present a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (level 3) during the three months ended March 31, 2013 and the year ended December 31, 2012.  There were no transfers into or out of Level 3. There were no transfers between Level 1, and Level 2 during these periods.

The three months ended  March  31, 2013:		Other Assets(1)
	(dollars in thousands)
Beginning Balance December 31, 2012		$	287
Total gains (losses) included in earnings:(2)
Issuances			619
Settlements and closed loans			(437)
Expirations			-
Total gains (losses) included in other comprehensive income			-
Ending Balance March 31, 2013(3)		$	469

The year ended December 31, 2012:		Other Assets(1)
	(dollars in thousands)
Beginning Balance December 31, 2011		$	-
Total gains (losses) included in earnings:(2)
Issuances			437
Settlements and closed loans			(150)
Expirations			-
Total gains (losses) included in other comprehensive income			-
Ending Balance December 31, 2012(3)		$	287

(1) Includes mortgage related IRLCs and derivative financial instruments entered into to hedge interest rate risk.

(2) Amounts included in earnings are recorded in mortgage banking activities.

(3) Represents the amount included in earnings attributable to the changes in unrealized gains/losses relating to IRLCs and derivatives still held at period end.

A significant unobservable input utilized in the determination of fair value of other assets was a pull through rate, which was 70% as of March 31, 2013. A pull through rate is management’s assumption as to the percentage of loans in the pipeline that will close and eventually fund. It is based on the Company’s historical fall-out activity. Significant increases in this input in isolation would result in a significantly higher fair value measurement and significant decreases would result in a significantly lower fair value measurement. In addition, IRLCs’ fair value includes mortgage servicing rights that do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees.

45

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

	For Items Measured at Fair Value Pursuant to Election of the Fair Value Option: Fair Value Gain related to Mortgage Banking Activities
	Three Months Ended
	March 31, 2013		March 31, 2012
	(dollars in thousands)
Mortgage loans held for sale	$	841	$	-

The following tables present the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale including escrow for which the fair value option (“FVO”) has been elected as of March 31, 2013 and December 31, 2012.

	March 31, 2013
	Aggregate Fair Value			Aggregate Unpaid  Principal Balance with Escrow Under FVO			Fair Value Over Unpaid Principal
Loans held for sale		$	18,905		$	18,533		$	372

	December 31, 2012
	Aggregate Fair Value			Aggregate Unpaid  Principal Balance with Escrow Under FVO			Fair Value Over Unpaid Principal
Loans held for sale		$	15,608		$	15,277		$	331

Assets Measured at Fair Value on a Nonrecurring Basis

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

The following is a description of the valuation methodologies used for instruments measured at fair value on a non-recurring basis and recognized in the accompanying consolidated balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

46

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

Impaired Loans:  Loan impairment is reported when full payment under the loan terms is not expected.  In accordance with the provisions of the loan impairment guidance (ASC 310-10-35), individual loans are carried at their fair value. Write downs of impaired loans are estimated using the present value of expected cash flows or the appraised value of the underlying collateral discounted as necessary due to management’s estimates of changes in economic conditions.  A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require an increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan impairment as non-recurring Level 2.  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 loan impairment as non-recurring Level 3.

OREO (including covered):   Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets 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 assets as nonrecurring Level 2.  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 nonrecurring Level 3.

The following table summarizes financial assets measured at fair value on a nonrecurring basis:

	Non Recurring Fair Value Measurements at March 31, 2013
	Total Carrying Value			Level 1			Level 2			Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)		$	14,747		$	-		$	-		$	14,747
OREO			4,391			-			-			4,391
Covered OREO			9,460			-			-			9,460
Total		$	28,598		$	-		$	-		$	28,598

	Non Recurring Fair Value Measurements at December 31, 2012
	Total Carrying Value			Level 1			Level 2			Level 3
	(dollars in thousands)
Assets
Impaired Loans(1)		$	14,684		$	-		$	-		$	14,684
OREO			3,242			-			-			3,242
Covered OREO			9,467			-			-			9,467
Total		$	27,393		$	-		$	-		$	27,393

(1) Amounts represent the fair value of collateral for impaired loans allocated to the allowance for loan and lease losses. Fair values are determined using independent third party valuations and borrower records, discounted as appropriate (Level 3).

47

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

The following table presents quantitative information about financial and nonfinancial assets measured at fair value on a nonrecurring basis using Level 3 valuation inputs:

Quantitative Information about Level 3 Fair Value Measurements:

(dollars in thousands)	Fair Value at March 31, 2013		Valuation Technique	Unobservable Input	Range (Weighted Average)
Impaired loans	$	14,747	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 100% (70%)
OREO		4,391	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 90% (75%)
Covered OREO		9,460	Discounted appraisals (1)	Appraisal adjustments (2)	0% to 90% (67%)

(1) Fair value is generally based on appraisals of the underlying collateral.

(2) Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments such as historical loss experience on the type of collateral.

Assets and Liabilities Not Measured at Fair Value on a Recurring or Nonrecurring Basis

The following is a description of the valuation methodologies used for instruments not measured at fair value on a recurring or non-recurring basis and recognized in the accompanying consolidated balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Cash and short-term investments: The carrying amounts reported in the Consolidated Balance Sheets for cash and short-term investments, such as federal funds sold, approximated the fair value of those instruments. The Company classifies cash and short-term investments in Level 1 of the fair value hierarchy.

Other Investments:  The carrying amount of Federal Home Loan Bank stock and other equity securities approximates fair value.  The Company classifies Federal Home Loan Bank stock and other equity securities in Level 3 of the fair value hierarchy.

FDIC Loss-Share Receivable:  Because the FDIC will reimburse the Company for certain acquired loans, should the Company experience a loss, an indemnification asset is recorded at fair value at the acquisition date.  The indemnification asset is recognized at the same time as the indemnified loans and measured on the same basis, subject to collectability or contractual limitations. The shared- loss agreements on the acquisition date reflect the reimbursements expected to be received from the FDIC, using an appropriate discount rate, which reflects counterparty credit risk and other uncertainties.  The shared-loss agreements continue to be measured on the same basis as the related indemnified loans, and the loss share receivable is impacted by changes in estimated cash flows associated with these loans.

Loans:  The carrying amount of variable-rate loans that reprice frequently and have no significant change in credit risk approximates fair value.  The fair value of fixed-rate loans is estimated based on discounted contractual cash flows, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.  The fair value of impaired loans is estimated based on discounted contractual cash flows or underlying collateral values, where applicable.

Covered Loans:  Covered loans include loans on which the majority of losses would be covered by loss-sharing agreements with the FDIC.  Management initially valued these assets at fair value using mostly unobservable inputs and, as such, has classified these assets as Level 3.

48

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

Deposits:  The carrying amount of demand deposits, savings deposits and variable-rate certificates of deposit approximates fair value.  The fair value of fixed-rate certificates of deposit is estimated based on discounted contractual cash flows using interest rates currently being offered for certificates of similar maturities.

Federal Funds Purchased and Securities Sold Under Repurchase Agreements:  The fair value of fixed rate federal funds purchased and securities sold under repurchase agreements is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

Other Borrowings:  The carrying amount of variable rate advances approximates fair value.  The fair value of fixed rate advances is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.

The following tables present the assets that are measured at fair value on a non-recurring basis by level within the fair value hierarchy as reported on the consolidated statements of financial position.

	Carrying		Fair Value Measurements at March 31, 2013
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	190,284	$	190,284	$	190,284	$	-	$	-
Other investments		7,002		7,002		-		-		7,002
Loans,excluding covered loans		687,051		698,465		-		-		698,465
Covered loans		65,815		65,815		-		-		65,815
FDIC loss-share receivable		52,012		52,012				-		52,012
Total assets at fair value	$	1,002,164	$	1,013,578	$	190,284	$	-	$	823,294
Liabilities
Deposits	$	1,095,559	$	1,072,964	$	-	$	-	$	1,072,964
Federal funds purchased and securities sold under repurchase agreements		34,251		35,588		-		-		35,588
Other borrowings		102,210		100,786		-		-		100,786
Total liabilities at fair value	$	1,232,020	$	1,209,338	$	-	$	-	$	1,209,338

49

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 9. FAIR VALUE MEASUREMENTS (Continued)

	Carrying		Fair Value Measurements at December 31, 2012
	Value		Total Fair Value		Level 1		Level 2		Level 3
			(dollars in thousands)
Assets
Cash and short-term investments	$	43,692	$	43,692	$	43,692	$	-	$	-
Other investments		5,340		5,340		-		-		5,340
Loans,excluding covered loans		597,579		607,018		-		-		607,018
Covered loans		72,425		72,425		-		-		72,425
FDIC loss-share receivable		60,731		60,731				-		60,731
Total assets at fair value	$	779,767	$	789,206	$	43,692	$	-	$	745,514
Liabilities
Deposits	$	869,554		862,726	$	-	$	-	$	862,726
Federal funds purchased and securities sold under repurchase agreements		33,219		32,812		-		-		32,812
Other borrowings		60,000		63,985		-		-		63,985
Total liabilities at fair value	$	962,773	$	959,523	$	-	$	-	$	959,523

Current accounting guidance requires fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on settlements using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets, and, in many cases, could not be realized in immediate settlement of the instrument. Current accounting guidance excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

50

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10. DERIVATIVE FINANCIAL INSTRUMENTS

The Company’s asset-liability management policy allows the use of certain derivative financial instruments for hedging purposes in managing the Company’s interest rate risk.  The Company does not enter into derivatives or other financial instruments for trading or speculative purposes.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  The most common derivative instruments include interest rate swaps, caps, floors and collars.

Derivative Instruments – Interest Rate Swap Agreement

The Company is exposed to interest rate risk in the course of its business operations and manages a portion of this risk through the use of a derivative financial instrument, in the form of an interest rate swap (cash flow hedge). The Company accounts for its interest rate swap in accordance with ASC 815, Derivatives and Hedging, which requires that all derivatives be recognized as assets or liabilities in the balance sheet at fair value.

The Company utilizes the interest rate swap agreement to essentially convert a portion of its variable-rate debt to a fixed rate (cash flow hedge). For derivatives designated as hedging exposure to variable cash flows of a forecasted transaction (cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. For derivatives that are not designated as hedging instruments, changes in the fair value of the derivatives are recognized in earnings immediately. In applying hedge accounting for derivatives, the Company establishes a method for assessing the effectiveness of the hedging derivative and a measurement approach for determining any ineffective aspect of the hedge upon the inception of the hedge.

Cash Flow Hedge of Interest Rate Risk

During the first quarter 2012, the Company entered into a forward starting interest rate swap agreement with a notional amount of $50.0 million to protect against variability in the expected future cash flows attributed to changes in the benchmark interest rate Libor beginning February 1, 2016 and ending February 1, 2024 on the designated notional amount of variable rate Bank debt.

The Company recognized an after-tax unrealized loss on its cash flow hedge in other comprehensive income of $998,000 as of March 31, 2013.

The Company recognized a $1.7 million cash flow hedge liability in other liabilities on the balance sheet at March 31, 2013.  There was no ineffectiveness in the cash flow hedge during the three months ended March 31, 2013.

Credit risk related to the derivative arises when amounts receivable from the counterparty (derivative dealer) exceed those payable. The Company controls the risk of loss by only transacting with derivative dealers that are national market makers whose credit ratings are strong. Each party to the interest rate swap is required to provide collateral in the form of cash or securities to the counterparty when the counterparty’s exposure to a mark-to-market replacement value exceeds certain negotiated limits. These limits are typically based on current credit ratings and vary with ratings changes.  As of March 31, 2013, the Company was required to provide collateral of $1.6 million for the derivative.  Also, the Company has a netting agreement with the counterparty.

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HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10. DERIVATIVE FINANCIAL INSTRUMENTS (continued)

Derivative Instruments – Mortgage Lending Activities

The Company maintains a risk management program to manage interest rate risk and pricing risk associated with its mortgage lending activities. The risk management program includes the use of forward contracts and other derivatives that are recorded in the financial statements at fair value and are used to offset changes in value of the mortgage inventory due to changes in market interest rates. As a normal part of its operations, the Company enters into derivative contracts to economically hedge risks associated with overall price risk related to IRLCs and mortgage loans held for sale for which the fair value option has been elected. Fair value changes occur as a result of interest rate movements as well as changes in the value of the associated servicing rights. Derivative instruments used include forward commitments, mandatory commitments and best effort commitments. All derivatives are carried at fair value in the Consolidated Balance Sheets in other assets or other liabilities. A net gain of $182,000 was recorded for all related commitments as of March 31, 2013.

The Company’s risk management derivatives are based on underlying risks primarily related to interest rates and forward sales commitments. Forwards are contracts for the delayed delivery or net settlement of an underlying instrument, such as a mortgage loan, in which the seller agrees to deliver on a specified future date, either a specified instrument at a specified price or yield or the net cash equivalent of an underlying instrument. These hedges are used to preserve the Company’s position relative to future sales of loans to third parties in an effort to minimize the volatility of the expected gain on sale from changes in interest rate and the associated pricing changes, see Note 9 Fair Value for further information.

Credit and Market Risk Associated with Derivatives

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk at that time would be equal to the net derivative asset position, if any, for that counterparty. The Company minimizes the credit or repayment risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed periodically by the Company’s Risk Management area. The Company’s derivative positions were as follows:

	Contract Amount
	March 31, 2013		December 31,  2012
	(dollars in thousands)
Fannie Mae mortgage-backed securities Forward commitments	$	23,500	$	13,500
Mandatory loan sale commitments		-		-
Best efforts sale commitments		33,341		18,366
Total commitments	$	56,841	$	49,107

52

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 11. SEGMENT INFORMATION

The Company’s operating segments include banking and mortgage banking.  The reportable segments are determined by the products and services offered, and internal reporting.  Segment performance is evaluated using net interest income and non-interest income. Income taxes are allocated based on income before income taxes, and indirect expenses (includes management fees) are allocated based on various internal factors for each segment. Transactions among segments are made at fair value. Information reported internally for performance assessment follows.

Three months ended March 31, 2013	Bank		Mortgage Banking			Holding Company			Totals
	(dollars in thousands)
Net interest income (expense)	$	13,225	$	408		$	-		$	13,244
Provision for loan losses		485		-			-			485
Noninterest income		3,622		1,793			6			5,810
Noninterest expense		10,398		2,206			186			12,790
Income tax expense (benefit)		1,921		(1	)		(69	)		1,851
Segment profit (loss)		4,043	$	(4	)	$	(111	)	$	3,928
Segment assets at March  31, 2013	$	1,338,071	$	20,849		$	11,630		$	1,370,550

Three months ended March 31, 2012	Bank		Mortgage Banking		Holding Company			Totals
	(dollars in thousands)
Net interest income (expense)	$	9,524	$	200	$	-		$	9,724
Provision for loan losses		400		-		-			400
Noninterest income		2,526		257		-			2,783
Noninterest expense		10,213		384		204			10,801
Income tax expense (benefit)		389		24		(78	)		335
Segment profit (loss)		1,048	$	49	$	(126	)	$	971
Segment assets at March  31, 2012	$	997,298	$	7,085	$	23,797		$	1,075,510

53

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12. ACQUISITION ACTIVITY

Frontier Bank

On March 8, 2013, HeritageBank of the South entered into a definitive whole-bank purchase and assumption agreement with the FDIC to acquire Frontier, a full-service bank based in LaGrange, Georgia.  The Georgia Department of Banking and Finance closed Frontier Bank and, by Order of the Georgia Superior Court, appointed the FDIC as Receiver.  The Bank acquired a majority of all assets, with the exception of certain loans and all the OREO as of the bid valuation date of December 19, 2012, and assumed substantially all of the liabilities of Frontier.

The agreement with the FDIC did not involve a loss-sharing agreement but did include an asset purchase discount of $34.8 million. The Bank also received a cash payment from the FDIC in the amount of $97.5 million.

The Company elected to account for loans acquired in the Frontier acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope.

The fair values of the assets acquired and liabilities assumed in conjunction with the acquisition as of the closing date are detailed in the following table:

	Acquired		Fair Value and Other Adjustments				As Recorded by the Company
Assets	(dollars in thousands)
Cash and cash equivalents	$	55,660	$	97,519		(a)	$	153,179
Securities available to sale		22,241		-				22,241
FHLB and other bank stock		1,897		-				1,897
Loans		98,041		(24,715	)	(b)		73,326
Other real estate owned		1,620		(834	)	(c)		786
Core deposit intangibles		-		625		(d)		625
Other assets		1,788		-				1,788
Total Assets	$	181,247	$	72,595			$	253,842
Liabilities
Noninterest-bearing deposits	$	23,683	$	-			$	23,683
Interest-bearing deposits		187,896		507		(e)		188,403
Other borrowings		32,068		5,210		(f)		37,278
Deferred tax liability		-		1,675		(g)		1,675
Other liabilities		289		-				289
Total Liabilities	$	243,936	$	7,392			$	251,328
Liabilities assumed over assets acquired	$	62,689
Aggregate fair value adjustments			$	65,203
Gain on acquisition, net of tax							$	2,514

54

HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 12. ACQUISITION ACTIVITY (continued)

Explanations

(a) The adjustment represents the cash received from the FDIC to reflect the acquisition of excess liabilities assumed over assets acquired and the asset purchase discount.

(b) The adjustment reflects fair value adjustments based on the evaluation of the acquired loan portfolio. The fair value adjustment includes adjustments for estimated credit losses, liquidity and servicing costs.

(c) The adjustment represents the estimated credit losses in the acquired other real estate owned.

(d) The adjustment represents the consideration paid for the value of the core deposit base assumed in the acquisition.  The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be ten years.

(e) The adjustment is necessary because the weighted average interest rate of the CD's acquired exceeded the cost of similar funding at the time of acquisition.  The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio.

(f) The adjustment is necessary because the weighted average interest rate of the other borrowings assumed exceeded the cost of similar funding at the time of acquisition.  The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the borrowings.

(g) The amount respresents the deferred tax liability recorded as a result of the recorded gain on acquisition.

NOTE 13. SUBSEQUENT EVENTS

Subsequent events and transactions that occurred after March 31, 2013 but prior to May 10, 2013, the date these financial statements were available to be issued, have been evaluated for potential recognition or disclosure in these financial statements.  There were no subsequent events that require disclosure in the financial statements.

55

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

Forward-Looking Statements.When used in this Quarterly Report on Form 10-Q and in other filings by the Company with the Securities and Exchange Commission (the  “SEC”), in the Company's press releases or other public or shareholder communications, and in oral statements made with the approval of an authorized executive officer, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” “intends” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Such statements are subject to certain risks and uncertainties, including, among other things, (i) expected cost savings, synergies and other benefits from the Company’s merger and acquisition activities might not be realized within the anticipated time frames or at all, and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, might be greater than expected; (ii) changes in economic conditions, either nationally or in the Company’s market areas; (iii) fluctuations in interest rates; (iv) the risks of lending and investing activities, including changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for loan losses; (v) the possibility of other-than-temporary impairments of securities held in the Company’s securities portfolio; (vi) the Company’s ability to access cost-effective funding; (vii) fluctuations in real estate values and both residential and commercial real estate market conditions; (viii) demand for loans and deposits in the Company’s market areas; (ix) legislative or regulatory changes that adversely affect the Company’s business, including, without limitation, the Dodd-Frank Wall Street Reform and Consumer Protection Act and its implementing regulations, and the new overdraft protection regulations and customers’ responses thereto; (x) monetary and fiscal policies of the Federal Reserve Board and the U.S. Government and other governmental initiatives affecting the financial services industry; (xi) results of examinations of the Company and the Bank by their regulators, including the possibility that the regulators may, among other things, require the Company to increase its allowance for loan losses or to write-down assets; (xii) costs and effects of litigation, including settlements and judgments; (xiii) compliance risk with the FDIC loss-share agreements; (xiv) competition; and (xv) performance risk of mortgage loans sold on the secondary market.  The Company wishes to advise readers that the factors listed above could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

The Company does not undertake, and specifically declines, any obligation-to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

General.  Heritage Financial Group, Inc. (“Heritage” or the “Company”) is a $1.4 billion bank holding company headquartered in Albany, Georgia.  The principal business of Heritage is operating its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”).  Heritage primarily conducts commercial banking, retail banking, mortgage banking and wealth management activities through its bank subsidiary.  As of March 31, 2013, HeritageBank operated in Georgia, Florida and Alabama through 29 full-service branch locations, 12 mortgage offices and 4 investment offices.HeritageBank provides credit based products, deposit accounts, corporate cash management, investment support and other services to commercial and retail clients.

Strategy.  Our business strategy is to operate a well-capitalized and profitable financial institution dedicated to serving the needs of our customers.  We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services.  We intend to continue to operate as a commercial and consumer lender.  We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees.  Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open or acquire additional branches as opportunities arise.  In addition to our branch system, we continue to expand electronic services for our customers.  We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.

56

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

Expansion Efforts.  A key element of our business strategy is increasing our presence and growing the “Heritage” brand in the markets we currently serve and expanding our operations beyond our original Southwest Georgia market by entering new markets in other parts of Georgia, Florida, and Alabama that present attractive opportunities for expansion consistent with our capital availability.  This expansion of our market beyond southwest Georgia began in 2006, when we commenced operating a branch in Ocala, Florida.

We have pursued this expansion program through both prudent, disciplined internal growth and strategic acquisitions.  Many troubled financial institutions throughout our market footprint have closed or curtailed their lending activities, decreased their assets or sold branches to improve their capital which has given us the opportunity to expand through organic loan demand and attractive branch acquisitions.  We have also hired highly regarded and experienced lending officers and commercial bankers and expanded into new market areas that are contiguous to our existing market areas.  These recent activities reflect our ability to take advantage of these expansion opportunities.

In April 2012, we opened a commercial banking office in Macon, Georgia, and in June 2012, we completed the purchase of a single branch in Auburn, Alabama.  The Auburn, Alabama branch purchase resulted in the transfer of $11 million in loans and $19 million in deposits.  In August 2012, we hired a new management team to operate our mortgage division which is expected to lead significant growth in our mortgage business, particularly in the Atlanta, Georgia market.  In March 2013, we completed an FDIC-assisted whole-bank purchase of Frontier Bank, a nine branch full service bank based in LaGrange, Georgia with approximately $98.0 million in loans and $212.0 million in deposits.

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with U.S. generally accepted accounting principles and with general practices within the banking industry. There have been no significant changes to our Critical Accounting Policies as described in our Annual Report on Form 10-K for the year ended December 31, 2012.

57

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

Off-Balance Sheet Arrangements, Contractual Obligations and Commitments.  The following table presents our longer term, non-deposit related, contractual obligations and commitments to extend credit to our borrowers, in aggregate and by payment due dates.  In addition to the commitments below, we had overdraft protection available in the amounts of $11.6 million at March 31, 2013.

	March 31, 2013
	Less than One Year		One through Three Years		Four through Five Years		After Five Years		Total
	(In thousands)
Contractual obligations:
Federal Home Loan Bank advances	$	-	$	20,073	$	50,269	$	31,868	$	102,210
Fed funds purchased and securities sold under  repurchase agreement		4,251		10,000		10,000		10,000		34,251
Operating leases (premises)		370		833		572		1,775		3,550
Total advances and operating leases	$	4,621	$	30,906	$	60,841	$	43,643	$	140,011
Off-balance sheet loan commitments:
Undisbursed portions of loans closed	$	-	$	-	$	-	$	-	$	-
Commitments to originate loans		60,752		-		-		-		60,752
Unused lines of credit		80,709		10,362		2,545		22,748		116,364
Total loan commitments		141,461		10,362		2,545		22,748		177,116
Total contractual obligations and loan commitments	$	146,082	$	41,268	$	63,386	$	66,391	$	317,127

58

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

Comparison of Financial Condition at March 31, 2013 and December 31, 2012

General.  Total assets increased by $273.0 million, or 24.9%, to $1.371 billion at March 31, 2013, from $1.098 billion at December 31, 2012.  Cash and due from banks increased $13.9 million, or 58.0%, to $37.9 million at March 31, 2013 from $24.0 million at December 31, 2012.  Total interest-earning assets increased $264.7 million, or 28.6%, to $1.191 billion at March 31, 2013, from $0.927 billion at December 31, 2012.  Loans increased $82.9 million, securities available for sale increased $45.9 million, interest-bearing deposits in banks increased $133.8 million, and loans held for sale increased $3.3 million, offset in part by a decrease in federal funds sold of $1.2 million.  At the same time, deposits increased $226.0 million, other borrowings increased $42.2 million, federal funds purchased and securities sold under repurchase agreements increased $1.0 million, and stockholders’ equity remained unchanged.  The growth in loans and deposits for the first quarter of 2013 was primarily driven by the Frontier FDIC-assisted acquisition.

Cash and Securities.  We significantly increased our liquidity position as a percentage of total assets as a result of the Frontier FDIC-assisted acquisition where the amount of deposits assumed significantly exceeded the amount of loans and other earning assets acquired.  Cash and securities (including bank deposits and federal funds sold) increased in the aggregate $192.5 million, or 72.6%, to $457.6 million, or 33.4% of total assets, at March 31, 2013, from $265.1 million, or 24.2% of total assets, at December 31, 2012.

At March 31, 2013, our securities portfolio consisted of $40.4 million in U.S. Government agency sponsored securities, $177.6 million U.S. government agency mortgage-backed securities, $48.0 million in state and municipal securities, and $1.3 million in corporate debt and equity securities.  These corporate debt and equity securities had a net unrealized loss based on fair value of $130,000.  We currently intend to hold these securities to maturity.  We believe it is probable that we will be able to collect the amounts due under the contractual terms of the securities portfolio.  Therefore we do not believe any securities experienced other than temporary impairment at March 31, 2013.  See Note 4 to the Condensed Notes to the Consolidated Financial Statements contained in this Form 10-Q for additional information.

We expect to lower our excess liquidity balance on a percent of total assets basis in cash, funds due from banks, federal funds sold, and securities throughout 2013.  We believe that utilizing some of our excess liquidity to increase our loan portfolio is a prudent strategy to maintain through 2013.

Loans.  Our loan portfolio increased $82.9 million, or 12.4%, to $752.9 million at March 31, 2013, from $670.0 million at December 31, 2012.

Overall, the change in the loan portfolio is consistent with our strategy to grow our loans through FDIC-assisted acquisitions and organically through our nonresidential, commercial and industrial, and residential lending. We continue to emphasize commercial lending as noted with the growth in nonresidential coupled with an emphasis on residential real estate lending for mortgage loans, 1-4 families.  Outside of FDIC-acquired loans, the only major loan categories that reported reductions were home equity residential real estate and commercial and industrial loans.

As a result of the Frontier acquisition, we added $73.3 million in non-covered loans at fair value, and we expanded our core loan portfolio by $18.0 million by adding new lending relationships from high-quality borrowers, in part offset by a decline in the FDIC-acquired loans of $8.4 million.  We also see more opportunities to take market share from the regional and community banks competing within our market footprint.  We continue to seek opportunities to grow our loan portfolio through organic growth, branch acquisitions, loan purchases, FDIC-assisted opportunities, and whole bank acquisitions.

59

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

At March 31, 2013, we had approximately $18.9 million in loans held for sale, which are mortgage loans generated to be sold to investors, as compared to $15.6 million at the end of 2012.  The increase was driven by our continued focus on this line of business.  We typically hold these loans for less than ninety days and earn the stated rate on the note until they are purchased by the investor.  See Note 9 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q for additional information.

Delinquencies and Non-performing Assets.As of March 31, 2013, our total loans delinquent for 30 to 89 days was $1.3 million or 0.22% of total loans, excluding FDIC-acquired loans.  At March 31, 2013, our nonperforming assets, excluding FDIC-acquired, totaled $15.8 million, or 1.15% of total assets, compared to $17.3 million, or 1.58% of total assets at December 31, 2012. This $1.5 million, or 8.9%, decrease was primarily driven by the positive resolution of non-performing assets migrating back to performing status during the first quarter of 2013.

Our loan portfolio has included FDIC-acquired loans since December 2009, which are generally recorded at a deep discount from the contractual principal value and accounted for under ASC 310-30.  These loans acquired through FDIC-assisted acquisitions are excluded from the delinquent loan tables below because they are accounted for in a different manner.  See Note 6 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q for more information concerning our FDIC-acquired loans.    Included in non-accruing loans at March 31, 2013, are troubled debt restructurings of $4.6 million, which involve forgiving a portion of interest or principal on loans or making loans at a rate materially below market.

The table below sets forth the amounts and categories of non-performing assets in our loan portfolio, excluding loans and foreclosed assets acquired through FDIC-assisted acquisitions, at the dates indicated.

	March 31, 2013		December 31, 2012		Amount Change			Percent Change
	(Dollars in thousands)
Non-performing loans	$	12,723	$	14,677	$	(1,954	)		(13.3	) %
OREO		3,028		2,620		408			15.6
Total	$	15,751	$	17,297	$	(1,546	)		(8.9	)  %

Non-performing loans, excluding FDIC-acquired, decreased to 2.11% of total loans, excluding FDIC-acquired, at March 31, 2013 from 2.51% at the end of 2012 primarily driven by the positive trends in our non-performing loans migrating back to performing status after six months of payment performance.  We are cautiously optimistic that the positive trend of non-performing loans, excluding FDIC-acquired, will continue to improve as a percentage of total loans, excluding FDIC-acquired, for 2013.

OREO, excluding assets acquired through FDIC-assisted acquisitions, increased from $2.6 million at December 31, 2012 to $3.0 million at March 31, 2013.  We continue to aggressively confront credit quality issues in our loan portfolio.  OREO experienced a slight increase driven by additions in excess of sales and write downs for the first quarter of 2013.  We believe the current value of each OREO asset represents our estimated disposition value less selling expenses based on current appraisals and market data, and all of these properties are being marketed actively for disposition.  As of March 31, 2013, we had gross proceeds on sales of OREO, excluding FDIC-acquired assets, of approximately $80,000 and recorded net gains of approximately $13,000 on those sales.  See Note 7 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q for more information.

60

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

Our internally criticized (watch list) and classified assets, excluding FDIC-acquired loans, totaled $25.5 million at March 31, 2013, compared to $28.2 million at December 31, 2012.  This includes loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the nonperforming asset categories.  These balances include the aforementioned nonperforming loans, OREO, and repossessed assets.  These loans have been considered in management's determination of the adequacy of our allowance for loan losses.

Our internal loan review processes strive to identify weaknesses in loans prior to performance issues.  However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses.  We have taken actions to prevent losses in our current portfolio with our special assets committee.  We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development.

Allowance for Loan Losses.  Our allowance for loan losses at March 31, 2013 and December 31, 2012 was $9.1 million.   Excluding FDIC-acquired loans, the allowance for loan losses to total loans was 1.51% at March 31, 2013 and 1.55% at December 31, 2012.  This decrease reflects improving credit trends in our loan portfolio, and we are cautiously optimistic the improvement will continue into 2013.

The following table sets forth asset quality information, excluding FDIC-acquired loans for the periods indicated:

	Loans by Type as of
	March  31, 2013		December 31, 2012		March 31, 2012
	(dollars in thousands)
Non-FDIC-acquired loans:
Nonresidential	$	225,946	$	212,570	$	150,492
Multifamily		24,280		21,293		18,577
Farmland		20,749		20,141		17,150
Construction and land		37,659		33,340		24,375
Mortgage loans, 1-4 families		166,312		161,883		132,172
Home equity		25,842		27,345		25,220
Consumer and other		19,931		25,498		21,935
Commercial and industrial		83,015		83,659		59,697
		603,734		585,729		449,618
Loans acquired through FDIC-assisted acquisitions:
Non-covered loans		83,317		11,850		17,384
Covered loans		65,815		72,425		95,493
		149,132		84,275		112,877
Total loans	$	752,866	$	670,004	$	562,495

61

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

	Asset Quality Data
	(Excluding loans acquired through
	FDIC-Assisted acquisitions) as of
	March 31, 2013			December 31, 2012			March 31, 2012
	(dollars in thousands)
Allowance for loan losses to total loans		1.51	%		1.55	%		1.70	%
Allowance for loan losses to average loans		1.53	%		1.62	%		1.35	%
Allowance for loan losses to non-performing loans		71.56	%		61.73	%		71.42	%
Accruing loans past due 30-89 days	$	1,316		$	2,131		$	452
Nonaccrual loans		12,723			14,677			10,681
Loans - 90 days past due & still accruing		-			-			-
Total non-performing loans		12,723			14,677			10,681
OREO and repossessed assets		3,028			2,620			2,992
Total non-performing assets	$	15,751		$	17,297		$	13,673
Non-performing loans to total loans		2.11	%		2.51	%		2.38	%
Non-performing assets to total assets		1.15	%		1.58	%		1.27	%
Net charge-offs QTD to average loans (annualized)		0.27	%		0.19	%		0.24	%
Net charge-offs QTD	$	406		$	933		$	265

For further information on the loan portfolio and allowance for loan losses, see Note 5 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

Premises and Equipment. Premises and equipment increased $509,000, or 1.5%, at March 31, 2013, primarily driven by our Valdosta, Georgia branch during the first quarter of 2013.

Intangible Assets, Goodwill and Other Assets.  Intangible assets and goodwill increased from $4.2 million at December 31, 2012 by $431,000 to $4.7 million at March 31, 2013, driven by the addition of the core deposit intangible from the Frontier acquisition of $625,000 offset by the amortization expense of $194,000 related to core deposit intangibles during the first quarter of 2013.

Cash surrender value of bank owned life insurance (“BOLI”) increased from $23.4 million at December 31, 2012 by $202,000 to $23.6 million at March 31, 2013, driven by the earnings of the BOLI policies for the quarter.  Other assets decreased $791,000 for the first quarter of 2013, primarily due to a reduction in deferred tax assets of $1.7 million offset in part by increases in our mortgage derivative of $182,000 and several other asset accounts related to the Frontier acquisition.

62

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

Deposits.  Total deposits increased $226.0 million, or 26.0%, to $1.096 billion at March 31, 2013 compared with $0.870 billion at December 31, 2012, primarily driven by the deposits acquired from the Frontier acquisition of $212.1 million, core deposit growth of $34.0 million and wholesale deposit growth of $23.8 million, which was offset in part by $24.5 million in planned time deposit runoff associated with Frontier internet and single service customers and $19.4 million in planned runoff of retail time deposits.

Borrowings and Other Liabilities.  The total amount of other borrowings increased $42.2 million from $60.0 million at December 31, 2012 to $102.2 million at March 31, 2013 driven by the FHLB borrowings we acquired from Frontier and recorded at fair value of $37.3 million.  We also took advantage of historic long-term rates and added a $5.0 million 10 year fixed rate FHLB advance.  The weighted average rate on these advances was 2.59% for the first quarter of 2013 compared to 3.61% for 2012.  Federal funds purchased increased by $1.1 million and securities sold under agreements to repurchase decreased by $84,000 for a net increase of $1.0 million, or 3.1%, as a result of an increase in our federal funds purchased from Chattahoochee Bank of Georgia.

Equity.  Total equity increased $6,000 to $120.7 million at March 31, 2013, compared with $120.6 million at December 31, 2012, primarily driven by net income of $3.9 million, stock-based compensation of $230,000, and the allocation of $186,000 in ESOP shares offset in part by the repurchase of common shares of $4.1 million and other comprehensive loss of $257,000.

63

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

Average Balances, Net Interest Income, Yields Earned and Rates Paid

The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates.  Yields on tax-exempt obligations have been computed on a tax equivalent basis using an assumed tax rate of 34%.  Nonaccruing loans have been included in the table as loans carrying a zero yield.

	Three Months Ended March 31,
	2013								2012
	(Dollars in Thousands)
	Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance			Interest Earned/ Paid		Yield/ Rate
Interest-Earning Assets:
Loans	$	698,905		$	13,875		8.05	%	$	564,935		$	10,329		7.35	%
Investment Securities		237,729			1,248		2.13			257,863			1,278		1.99
Other short-term investments		45,613			24		0.21			60,361			52		0.35
Total interest-earning assets		982,247			15,147		6.25			883,159			11,659		5.37
Non-interest earning assets		166,599								188,442
Total assets		1,148,846								1,071,601
Interest-Bearing Liabilities:
Interest checking, money market, savings		475,176			287		0.24	%		492,791			439		0.36	%
Time deposits		321,970			767		0.97			292,152			824		1.13
Total interest-bearing deposits		797,146			1,052		0.54			784,943			1,263		0.65
Federal Funds purchased and Securities sold under repurchase agreements		34,273			328		3.88			33,823			330		3.93
Other Borrowings		65,965			421		2.59			35,000			342		3.93
Total interest bearing liabilities		897,384			1,803		0.81			853,766			1,935		0.91
Non-interest bearing liabilities:
Demand deposits		119,059								85,139
Other liabilities		11,603								7,202
Total non-interest bearing liabilities		130,662								92,341
Total liabilities		1,028,046								946,107
Shareholder’s equity		120,800								125,494
Total liabilities and shareholder’s equity		1,148,846								1,071,601
Net interest income				$	13,344							$	9,724
Net interest rate spread							5.44	%							4.46	%
Net earning assets	$	84,863							$	29,393
Net interest margin							5.51	%							4.49	%
Average interest-earning assets to average
interest-bearing
Liabilities		1.09	x							1.03	x

64

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

Rate/Volume Analysis

The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  It distinguishes between the changes related to outstanding balances and those due to the changes in interest rates.  The change in interest attributable to rate has been determined by applying the change in rate between years to average balances outstanding in the later year.  The change in interest due to volume has been determined by applying the rate from the earlier year to the change in average balances outstanding between years.  Changes that are not solely due to volume have been consistently attributed to rate.

	Three Months Ended March 31,
	2013 vs. 2012
	Increase (Decrease)						Total
	Due to						Increase
	Volume			Rate			(Decrease)
	(Dollars in Thousands)
Interest-earning assets:
Loans	$	9,852		$	(6,306	)	$	3,546
Investment Securities		(401	)		371			(30	)
Other short-term investments		(51	)		23			(28	)
Total interest-earning assets	$	9,400		$	(5,912	)	$	3,488
Interest-bearing liabilities:
Interest checking, money market, savings	$	(63	)	$	(89	)	$	(152	)
Time deposits		338			(397	)		(59	)
Federal Funds purchased and Securities sold under repurchase agreements		18			(20	)		(2	)
Other borrowings		1,217			(1,138	)		79
Total interest bearing liabilities	$	1,510		$	(1,644	)	$	(134	)
Net interest income							$	3,622

65

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

Comparison of Operating Results for the Three Month Periods Ended March 31, 2013 and 2012

General.  During the quarter ended March 31, 2013, we recorded net income of $3.9 million, or $0.52 basic and diluted earnings per share, compared to a net income of $971,000, or $0.12 basic and diluted earnings per share, for the quarter ended March 31, 2012.  This $3.0 million improvement in operating results reflects increases in net interest income and noninterest income partially offset by an increase in  noninterest expense.

Interest Income.  Total interest income for the first quarter of 2013 increased $3.4 million, or 29.1%, to $15.0 million, compared to $11.7 million for the same quarter in 2012.  The increase was due to a $99.0 million, or 11.2%, increase in average interest-earning assets to $982.2 million for the first quarter of 2013 compared to $883.2 million for the same quarter in 2012 with the increase primarily driven by organic loan growth.  Also positively impacting interest income was the balance sheet structural shift from lower yielding short-term investments to higher yielding loans as a percentage of interest-earning assets.  Moreover, the yield on interest-earning assets improved by 88 basis points to 6.25% during the first quarter of 2013 as compared to 5.37% for the same quarter in 2012.

Interest income on loans for the first quarter of 2013 was $13.9 million compared to $10.3 million for the same quarter in 2012.  The $3.6 million increase in interest income on loans was primarily driven by the increase in yield compared to the prior year on FDIC-acquired loans, which carry a higher interest rate as compared to traditional loans.  Also benefiting our increased interest income on loans was organic loan growth driven by our Valdosta, Macon, Auburn, Ocala and Statesboro markets during the first quarter of 2013.   These markets helped increase our average loan portfolio balance by $134 million while the 70 basis point increase in the weighted average yield on loans to 8.05% for the first quarter of 2013 compared to 7.35% for the same quarter in 2012 was driven by improved accretion on FDIC-acquired loans.

Interest income on investment securities for the first quarter of 2013 was $1.2 million compared to $1.3 million for the same quarter in 2012.  The weighted average yield on investments for the first quarter of 2013 improved 14 basis points to 2.13% compared to 1.99% for the first quarter of 2012.  However, a reduction in the average balance of investment securities of $20.1 million for the first quarter of 2013 negatively impacted the interest income on investment securities as investment balances were used to fund loan growth.  We anticipate the yield on our investment portfolio to decline during 2013 as a result of this low interest rate environment as maturing investments are replaced with lower yielding investments.

Interest income on other short-term investments for the first quarter of 2013 decreased to $24,000 compared to $52,000 for the same quarter in 2012.  The decline was driven by a reduction in the average balance of other short-term investments of $14.7 million as excess liquidity was used to fund organic loan growth.  The average yield on other short-term investments declined 14 basis points to 0.21% for the first quarter of 2013 compared to 0.35% for same quarter in 2012.

Interest Expense.  Total interest expense for the first quarter of 2013 decreased $133,000, or 6.9%, to $1.8 million compared to $1.9 million for the same quarter in 2012.  The decrease in interest expense was primarily the result of a decline in the weighted average cost of interest-bearing liabilities for the first quarter of2013 of 10 basis points to 0.81% compared to 0.91% for same quarter in 2012.  The decrease in interest expense was in part offset by growth in the average balance of interest-bearing liabilities for the first quarter of 2013 of $43.6 million, or 5.1%, compared to the same quarter in 2012.  We anticipate the change in the cost of interest-bearing liabilities to be minimal in 2013 unless market interest rates either increase or decrease significantly.

Interest expense on deposits for the first quarter of 2013 was $1.1 million compared to $1.3 million for the same quarter in 2012.  The decrease in interest expense on deposits for the first quarter of 2013 was driven by a decline in the weighted average cost on deposits of 11 basis points to 0.54% compared to 0.65% for the same quarter in 2012, due to a decrease in market rates of interest.  The decrease in interest expense was in part offset by growth in interest-bearing deposits of $12.2 million for the first quarter of 2013.

66

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

Interest expense on federal funds purchased and securities sold under repurchase agreements slightly decreased to $328,000 for the first quarter of 2013 compared to $330,000 for the same quarter in 2012.  The decrease in the interest expense on federal funds purchased and securities sold under repurchase agreements for the first quarter of 2013 was primarily driven by a reduction in the weighted average rate paid on these borrowings of 5 basis points to 3.88% compared to 3.93% for the same quarter in 2012.  The decrease in interest expense for the first quarter in 2013 was offset by an increase in the average balance of federal funds purchased and securities sold under repurchase agreements of $450,000 compared to the same quarter in 2012.

Interest expense on other borrowings, consisting of FHLB advances, increased $79,000 to $421,000 for the first quarter of 2013 compared to $342,000 for the same quarter in 2012.  The increase in the interest expense on other borrowings for the first quarter of 2013 was primarily driven by an increase in the average balance of other borrowings of $31.0 million compared to the same quarter in 2012.  The increase in interest expense for the first quarter of 2013 was offset in part by a significant reduction in the weighted average rate paid on these borrowings of 134 basis points to 2.59% compared to 3.93% for the same quarter in 2012.  The increase in other borrowings is part of our strategy to take advantage of historically low interest rates to fund future loan growth.

Net Interest Income.  Net interest income for the first quarter of 2013 increased $3.6 million, or 37.2%, to $13.3 million compared to $9.7 million for the same quarter in 2012.  The overall increase was primarily driven by an increase in the yield and balance of interest-earning assets on top of a decline in the cost of interest-bearing liabilities partially offset by balance growth in interest-bearing liabilities.  The net interest spread for the first quarter of 2013 increased 98 basis points to 5.44% compared to 4.46% for the same quarter in 2012.  The net interest margin for the first quarter of 2013 improved 102 basis points to 5.51% from 4.49% for the same quarter in 2012.  The primary reason the net interest margin increased significantly for the first quarter of 2013 was the result of increased loan accretion for FDIC-acquired loans increasing the weighted average yield on loans 70 basis points compared to the same quarter in 2012.  We also expect loan accretion for FDIC-acquired loans to continue to positively impact the net interest margin for 2013.

Our asset-liability management policy seeks to mitigate interest rate risk by making our balance sheet as neutral as possible to changes in interest rates.  Although our goal is to be neutral to changes in rates, we will not take undue risk to achieve this goal.  Therefore, we remain exposed to fluctuation in interest rates.  See Item 3. - Quantitative and Qualitative Disclosures About Market Risk.

Provision for Loan Losses.  During the first quarter of 2013, we recorded provision for loan losses expense of $485,000 compared to $400,000 for the same quarter in 2012.  The increase in provision expense was primarily driven by an increase of $50,000 related to noncovered loans primarily driven by organic loan growth coupled with an increase of $35,000 related to individually assessed FDIC-acquired covered loans where 80% of the expense related to covered loans is reimbursable from the FDIC.  We include five years of historical losses in our allowance calculation for all periods.  The use of this timeframe has recently resulted in an overall increase in historical losses.  However, offsetting the upward trend in losses is a change in the portfolio mix where loan growth has occurred.  Specifically, positive growth occurred in nonresidential loans as a percentage of the loan portfolio which carries a lower historical loss rate compared to other loan categories.  In addition, criticized and classified loans have decreased as a percentage of the overall loan portfolio.

67

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

The following table presents the provision for loan losses in more detail for the periods indicated.

	For the three months Ended March 31,
	2013		2012
Provision for loan losses – noncovered	$	450		$	400
Provision for loan losses – FDIC-acquired noncovered		-			-
Provision for loan losses – noncovered		450			400
Provision for loan losses- FDIC-acquired covered		35			-
Provision for loan losses	$	485		$	400

  For further information on the loan portfolio and allowance for loan losses, see the Delinquencies and Non-performing Assets and Allowance for Loan Losses of this section and  see Notes 5 and 6 of the Condensed Notes to Consolidated Financial Statements contained in this Form 10-Q.

Noninterest Income.  A summary of noninterest income, excluding securities transactions, gain on acquisitions and accretion of FDIC loss-share receivable, is presented in the table below.

	Three Months Ended  March 31,
	2013			2012			$ Chg			% Chg
	(Dollars in thousands)
Service charges on deposit accounts	$	1,154		$	1,020		$	134			13.1	%
Bankcard services income		762			824			(62	)		(7.5	)
Other service charges, commissions and fees		99			85			14			16.5
Brokerage fees		481			446			35			7.9
Mortgage banking activities		1,793			689			1,104			160.2
Bank-owned life insurance		202			140			62			44.3
Other		94			35			59			168.6
Total noninterest income	$	4,585		$	3,239		$	1,346			41.6	%
Noninterest income as a percentage of average assets (annualized)		1.60	%		1.21	%

The increase in service charges on deposit accounts was primarily driven by an increase in fees for services per account and an increase in overdraft fees primarily driven by our overall customer base increase.   The decrease in bankcard services income was primarily driven by our reduced income per transaction offset in part by our increased customer base and usage.  The improvement in brokerage fees was primarily driven by our expansion of brokerage offices. The increase in mortgage banking activities was primarily driven by increased volume resulting in our focus of expanding our mortgage banking business compared to the prior year.  The increase in bank-owned life insurance income was primarily driven by our 2012 purchases of bank-owned life insurance.

68

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

Noninterest Expense.  A summary of noninterest expense, excluding acquisition related expenses, loss on sales and write-down of FDIC-acquired OREO and foreclosed FDIC-acquired asset expenses, is presented in the table below.

	Three Months Ended  March 30,
	2013			2012			$ Chg			% Chg
	(Dollars in thousands)
Salaries and employee benefits	$	6,430		$	5,536		$	894			16.1	%
Equipment		812			667			145			21.7
Occupancy		854			657			197			30.0
Advertising and marketing		187			180			7			3.9
Legal and accounting		119			119			-			-
Consulting & other professional fees		97			119			(22	)		(18.5	)
Directors fees and retirement		157			165			(8	)		(4.8	)
Telecommunications		230			231			(1	)		(0.4	)
Supplies		134			154			(20	)		(13.0	)
Data processing fees		951			821			130			15.8
Gain on sales and write-downs of other real estate owned		(25	)		(7	)		(18	)		257.1
Foreclosed asset expenses		215			221			(6	)		(2.7	)
FDIC insurance and other regulatory fees		256			245			11			4.5
Deposit intangible expenses		194			201			(7	)		(3.5	)
Other operating		942			825			117			14.2
Total noninterest expenses	$	11,553		$	10,134		$	1,419			14.0	%
Noninterest expenses as a percentage of average assets (annualized)		4.02	%		3.78	%

The increase in salaries and employee benefits was primarily due the hiring of 30 full-time equivalent employees (“FTE’s”), a 9.3% increase from the prior year, related primarily to our mortgage banking expansion.  We also anticipate the Frontier acquisition to add approximately 39 FTE’s to the Bank on a prospective basis.

The increases in equipment, occupancy, data processing, and other operating expenses were primarily due to the mortgage banking expansion and the Frontier acquisition.

Foreclosed asset expense for FDIC-acquired assets was up from the prior year related to our continued efforts to resolve problem assets within the loss-sharing agreements.

The acquisition related expenses increased from $792,000 for the first quarter of 2013 compared to $331,000 for the same quarter in 2012 driven by expenses related to the Frontier acquisition.

69

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

Income Tax Expense.  Income tax expense for the first quarter of 2013 was $1.9 million compared to income tax expense of $335,000 for the same quarter in 2012.  Our effective tax rate for the first quarter of 2013 was 32.0% compared to 25.7% for the same quarter in 2012.

Accounting for FDIC-Assisted Acquisitions

General.  We perform ongoing assessments of the estimated cash flows of our FDIC-acquired loan portfolios accounted under ASC 310-30.  At March 31, 2013, the fair value of the FDIC-acquired loan portfolios consisted of $65.8 million in covered and $83.3 million in non-covered loans compared with $95.5 million in covered and $17.4 million in non-covered loans at March 31, 2012.  The principal balance of the FDIC-acquired loan portfolios totaled $149.1 million at March 31, 2013 compared with $112.9 million at March 31, 2012.  The increase in FDIC-acquired loans was driven by the Frontier acquisition, which added $73.3 million of non-covered loans, offset in part by portfolio paydowns and resolutions of $37.1 million.

The factors considered in the allowance for loan losses for FDIC-acquired loans are driven by a regular assessment of the expected cash flows of the loans.  We perform periodic valuation procedures to re-estimate the expected cash flows on FDIC-acquired loan pools and compare the present value of expected cash flows to the carrying value of the loans at the pool level.  In order to estimate expected cash flows, we specifically review these loans each period to assist in the determination of appropriate probability of default and loss given default assumptions to be applied to the remainder of the portfolio. The estimate of expected cash flows may also be adjusted for management's estimate of probable losses on specific loan types dependent upon trends in observable market and industry data, such as prepayment speeds and collateral values. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. Separately, FDIC-acquired loans individually assessed, or not pooled, go through the same re-estimate of expected cash flows calculation, and when a shortfall of discount is considered likely an allowance is recorded and a corresponding charge-off is recorded immediately, which results in an immediate use of the allowance.

During the first quarter of 2013, the FDIC-acquired loan pools did not experience any charge-offs or record any increase in allowance for loan losses and experienced improvement in cash flows, which positively impacted the FDIC-acquired loan accretion related to the pooled loans.  During the first quarter of 2013, the FDIC-acquired loans individually assessed experienced charge-offs of $35,000 related to inadequate discounts as a result of the re-estimation of cash flows for such loans.  The charge-offs for FDIC-acquired loans individually assessed did not increase the allowance for loan losses at March 31, 2013.

FDIC Loss-Share Receivable.  At March 31, 2013, the FDIC loss-share receivable associated with covered FDIC-acquired assets decreased $8.7 million to $52.0 million, or 36.4% of the principal balance of covered FDIC-acquired assets, compared to $60.7 million, or 38.9% of the principal balance of covered FDIC-acquired assets at December 31, 2012. The principal balance of the covered FDIC-acquired assets totaled $142.9 million at March 31, 2013 compared with $156.0 million at December 31, 2012.  The reduction in the FDIC loss-share receivable for the first quarter of 2013 was primarily driven by $5.6 million of reimbursements received from the FDIC and $3.0 million of negative accretion, resulting from the improvement in cash flows for the FDIC-acquired loan pools, included in noninterest income of the consolidated statements of operations.  We have also recorded an FDIC true-up (“clawback”) liability of $1.3 million for all FDIC loss share agreements as of March 31, 2013.  This FDIC clawback liability was driven by an improvement in estimates of expected cash flows for the FDIC-acquired assets covered under loss-sharing agreements.

70

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

Noninterest Income. The negative accretion for FDIC loss-share receivable was $3.0 million for the first quarter of 2013 compared to negative accretion of $498,000 for the same quarter in 2012.  The increase in negative accretion was primarily driven by the improvement in the expected cash flows of the FDIC-acquired performing loan pools and the first quarter FDIC true-up liability accrual in part offset by increased provision expense on individually assessed FDIC-acquired covered loans.  See Accounting for FDIC-Acquired Loans of this section for additional information.

Noninterest Expense. The loss on sale and write-downs of FDIC-acquired OREO decreased to $24,000 for the first quarter of 2013 compared to $174,000 for the same quarter in 2012; however, foreclosed FDIC-acquired asset expenses increased to $421,000 for the first quarter of 2013 compared to $162,000 for the same quarter in 2012.

See Notes 6 and 7 to the Condensed Notes to the Consolidated Financial Statements contained in this Form 10-Q for additional information about the accounting for FDIC-acquired loans and FDIC loss-share receivable.

Liquidity and Capital Resources

We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure a safe and sound operation.  Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans.  Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows.  Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained.

Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements.  The Company strives to maintain an adequate liquidity position by managing the balances and maturities of interest earning assets and interest bearing liabilities so that the balance it has in short-term investments at any given time will adequately cover any reasonably anticipated immediate need for funds.

Our liquidity, represented by cash and cash equivalents, is a product of our operating, investing and financing activities.  Liquidity management is both a daily and long-term function of business management.  Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds.  On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities.

If additional liquidity were needed, the Bank would turn to short-term borrowings as an alternative immediate funding source and would consider other appropriate actions such as promotions to increase core deposits or the sale of a portion of our unpledged investment portfolio.  In addition, we could draw on additional alternative immediate funding sources from lines of credit extended to us from our correspondent banks and/or the FHLB.  At March 31, 2013, the Bank had total federal funds credit lines with six correspondent banks of $74.0 million, with no outstanding advances.  The Bank also maintains a credit facility with the FHLB of $155.1 million with total outstanding advances of $97.1 million at March 31, 2013.

At March 31, 2013, total deposits increased $226.0 million, or 26.0%, to $1.096 billion for the first quarter of 2013 compared to $0.870 billion for linked quarter and increased $226.8 million, or 26.1%, from $0.869 billion for the same quarter in 2012 primarily driven by the deposits acquired from the Frontier acquisition of $212.1 million, core deposit growth of $34.0 million and wholesale deposit growth of $23.8 million, which was offset in part by $24.5 million in planned time deposit runoff associated with Frontier internet and single service customers and $19.4 million in planned runoff of retail time deposits.  Federal funds purchased and securities sold under agreements to repurchase increased $1.1 million, or 3.1%, to $34.3 million for the first quarter of 2013 compared to $33.2 million for the linked quarter and decreased $3.0 million from $37.2 million for the same quarter in 2012.  Also, FHLB advances increased $42.2 million, or 70.3%, to $102.2 million for the first quarter of 2013 compared to $60.0 million for the linked quarter and increased $67.2 from $35.0 million for the same quarter in 2012.  The growth in FHLB advances on a linked-quarter basis was primarily driven by the FHLB borrowings we acquired in the Frontier acquisition of $37.3 million and a $5.0 million 10 year fixed rate FHLB advance.

71

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

The liquidity and capital resources of the Company are monitored continuously by the Company’s Board-authorized Risk Management Committee with day to day responsibility delegated to the Asset/ Liability Management Committee (“ALCO”) and on a periodic basis by state and federal regulatory authorities.  As determined under guidelines established by these regulatory authorities, the Company’s and the Bank’s liquidity ratios at March 31, 2013, were considered satisfactory.  At that date, the Bank’s short-term investments were adequate to cover any reasonably immediate need for funds.  The Company is aware of no events or trends likely to result in a negative material change in liquidity.

The consolidated statements of cash flows for the first quarter of 2013 detail cash flows from operating, investing and financing activities.  For the first quarter of 2013, net cash provided by operating activities and financing activities was $13.8 million and $15.9 million, respectively, offset in part by net cash used in investing activities of $15.8 million, resulting in a net linked quarter increase in cash to $13.9 million.

The Company filed a shelf offering on Form S-3 with the SEC on October 25, 2012. Under the shelf registration statement, which was declared effective by the SEC on November 7, 2012, the Company may offer and sell from time to time in the future, in one or more offerings, common stock, preferred stock, debt securities, warrants, depository shares, or units consisting of any combination of the foregoing.

The aggregate offering price of all securities that may be sold under the registration statement will not exceed $60 million. This shelf offering will give the Company flexibility to take advantage of acquisition opportunities that may arise in the future by accessing the capital markets on a timely and cost-effective basis. The specifics of any future offering, along with the prices and terms of any such securities offered by the Company, will be determined at the time of any such offering and will be described in detail in a prospectus supplement filed in connection with such offering. At this present time, the Company has no specific plans for an offering.

72

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

Regulatory Capital Ratios for the Company and HeritageBank of the South at March 31, 2013

The Company’s and the Bank’s regulatory capital levels exceed the minimums required by state and federal authorities.  The following table reflects the Company’s and the Bank’s compliance at March 31, 2013 with regulatory capital requirements.  These calculations are based on total risk weighted assets of $791.1 million consolidated and $779.5 million for the Bank as of March 31, 2013, and average total assets of $1.2 billion consolidated and $1.2 billion for the Bank for the three months ended March 31, 2013.  These consolidated capital ratios are based on the capital requirements for bank holding companies issued by the Board of Governors of the Federal Reserve System.  The Georgia Department of Banking and Finance, by policy, requires the Bank to maintain 4% of Tier 1 capital to average total assets of the Federal Reserve Requirements included in the table.

	Actual					For Capital Adequacy Purposes					Minimum Required to Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Total Capital to Risk Weighted Assets
Consolidated	$	128,555		16.3	%	$	63,288		8.0	%		N/A
HeritageBank of the South		117,866		15.1	%		62,357		8.0	%	$	77,946		10.0	%
Tier I Capital to Risk Weighted Assets
Consolidated		120,096		15.2	%		31,644		4.0	%		N/A
HeritageBank of the South		109,407		14.0	%		31,179		4.0	%		46,768		6.0	%
Tier I Capital to Average Total Assets
Consolidated		120,096		10.4	%		45,983		4.0	%		N/A
HeritageBank of the South		109,407		9.6	%		45,671		4.0	%		57,089		5.0	%

73

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset and Liability Management and Market Risk

Our Risk When Interest Rates Change.  The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time.  Market rates change over time.  Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities.  The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.

How We Measure Our Risk of Interest Rate Changes.  As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk.  In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.

To manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to understand, measure, monitor, and control the risk.  These policies are designed to allow us to implement strategies to minimize the effects of interest rate changes to net income and capital position by properly matching the maturities and repricing terms of our interest earning assets and interest bearing liabilities.  These policies are implemented by the ALCO, which is composed of senior management members.  The ALCO establishes guidelines for and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity requirements.  The objectives are to manage assets and funding sources to produce results that limit negative changes in net income and capital while supporting liquidity, capital adequacy, growth, risk and profitability goals.  Senior managers oversee the process on a daily basis.  The ALCO meets monthly to review, among other things, economic conditions and interest rate outlook, current and projected needs and capital position, anticipated changes in the volume and mix of assets and liabilities, interest rate risk exposure, liquidity position and net portfolio present value.  The committee also recommends strategy changes, as appropriate, based on their review.  The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors on a quarterly basis.

In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have focused our strategies on:

· Limiting the percentage of long-term fixed-rate loans within our portfolio;

· Originating a mix of variable-rate and shorter term fixed-rate loans;

· Originating prime-based home equity lines of credit;

· Managing deposit relationships for stability and a lower cost of funds position;

· Continuing the origination of consumer loans.

74

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset and Liability Management and Market Risk (Continued)

The Risk Management Committee has oversight over the asset-liability management of the Company.  This committee regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on net income and the market value of portfolio equity.  Market value of portfolio equity is a measurement of the value of the balance sheet at a fixed point in time.  It is summarized as the fair value of assets less the fair value of liabilities.  The committee reviews computations of the value of capital at current interest rates and alternative interest rates.  The variance in the net portfolio value between current interest rate computations and alternative rate computations represents the potential impact on capital if rates were to change.

The Company is directly exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin.  The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading.  The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk.  The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no direct exposure to foreign currency exchange rate risk or commodity price risk.

Interest rates play a major part in the net interest income of a financial institution.  The sensitivity to rate changes is known as “interest rate risk.”  The repricing of interest-earning assets and interest-bearing liabilities can influence the changes in net interest income.

The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates.  The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings.  The analysis of the impact on net interest income over a twelve-month period is subjected to a shock in interest rates of 100, 200, 300,  and 400 basis point increase or decrease in market rates on net interest income and is monitored on a quarterly basis.  We also monitor regulatory required interest rate risk analysis, which simulates more dramatic changes to rates.

The Company’s strategy is to mitigate interest risk to the extent possible as part of the Company’s overall business strategy. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk.  These strategies aim to achieve neutrality to interest rate risk.  Although we strive to have our net interest income neutral to changes in rates, due to the inherent nature of our business, we will never be completely neutral to changes in rates.  As of March 31, 2013, a drop in interest rates would decrease our net interest income and an increase in rates would increase our net interest income, also known as being “asset sensitive.”  The asset sensitivity position was in part driven by our acquisition of Frontier, which added excess liquidity to our balance sheet, coupled with our strategic decision to extend some of our interest bearing liabilities.  We plan to maintain our asset sensitivity position by focusing our efforts to extend liabilities and increase variable rate assets.  We feel the level of interest rate risk is at an acceptable level, and is within our internal policy limits.

The ALCO monitors and analyzes interest rate risk.  This committee is comprised of members of senior management and meets on a monthly basis and reviews the simulations listed above, as well as other interest rate risk reports.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or “shock” in market interest rates over a twelve month period.  Due to the historically low level of interest rates, we do not believe downward shocks greater than 100 basis points are relevant.  In addition, due to the historically low interest rate environment, there is concern that we may see a dramatic increase in interest rates at some point.  To address this concern, we increased our upward interest rate shocks to include a shock of 400 basis points.

	Effect
Market	on Net
Rate	Interest
Change	Income
+400		21.0	%
+300		15.8	%
+200		11.6	%
+100		6.7	%
-100		-6.7	%

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Quarterly Financial Summary - Unaudited

The following table presents condensed information relating to quarterly periods presented.

	For the Three Months Ended
	March 31, 2013		December   31, 2012		September   30, 2012		June 30, 2012		March 31, 2012
	(dollars in thousands expect per share data)
Results of Operations:
Net interest income	$	13,244	$	14,530	$	12,713	$	10,159	$	9,724
Provision for loan losses		485		2,507		1,934		1,091		400
Net interest income after provision for loan losses		12,759		12,023		10,779		9,068		9,324
Total noninterest income		5,810		2,873		4,361		3,679		2,783
Total noninterest expense		12,790		12,095		11,978		10,674		10,801
Income before income taxes		5,779		2,801		3,162		2,073		1,306
Applicable income tax		1,851		373		1,164		713		335
Net income	$	3,928	$	2,428	$	1,998	$	1,360	$	971
Per Share Data:
Weighted average shares – basic		7,526,344		7,720,839		7,942,852		8,071,354		8,144,382
Weighted average shares – diluted		7,528,522		7,722,867		7,944,983		8,702,935		8,145,730
Basic earnings per share	$	0.52	$	0.31	$	0.25	$	0.17	$	0.12
Diluted earnings per share		0.52		0.31		0.25		0.17		0.12

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ITEM 4. CONTROLS AND PROCEDURES

(a)  Evaluation of Disclosure Controls and Procedures

An evaluation of our disclosure controls and procedures (as defined in Rule 13(a)-14(c) under the Securities Exchange Act (the “Exchange Act”)) as of March 31, 2013, was carried out under the supervision and with the participation of our Chief Executive Officer, Chief Financial Officer and several other members of our senior management within the 40-day period preceding the filing date of this quarterly report.  Our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2013, the Company’s disclosure controls and procedures were effective in ensuring that the information required to disclosed by the Company in the reports it files or submits under the Exchange Act is: (i) accumulated and communicated to the Company’s management (including its Chief Executive Officer and Chief Financial Officer) in a timely manner; and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

The Company does not expect that its disclosure controls and procedures over financial reporting will prevent all errors and all fraud.  A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met.  Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns in controls or procedures can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.  The design of any control procedure also is 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 future conditions; over time, controls may become inadequate because of change in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

b) Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Act) that occurred during the quarter ended March 31, 2013, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the normal course of business, the Company occasionally becomes involved in various legal proceedings.  In our opinion, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors disclosed in Item 1A. of Part 1 in our Annual Report on Form 10-K for the year ended December 31, 2012.

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

There were no unregistered sales of equity securities during the quarter ended March 31, 2013.

In October 2012, the Company's Board of Directors approved a stock repurchase program expiring in October 2013, which authorized the repurchase of 397,000 shares of common stock, or approximately 5% of the shares currently outstanding.  As of March 31, 2013, the company had purchased 364,135 shares at a weighted average price of $13.92 per share under the plan for a total of $5.1 million.

Additionally, in April 2013, the Company’s Board of Directors approved another stock repurchase program adding 394,000 shares, or 5% of the Company's currently outstanding common stock, and has extended the program for an additional year.  As a result, the Company has a total authorization to repurchase up to approximately 427,000 shares that expires in April 2014, unless the program is extended or completed earlier.

The repurchases may be made from time to time in open-market or negotiated transactions as deemed appropriate by the Company and will depend on market conditions.

	Total Number of Shares Purchased		Average Price Paid Per Share		Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares that may yet be Purchased Under the Plans or Programs
January		55,000	$	14.02		55,000		269,091
February		236,226	$	14.02		236,226		32,865
March		-	$	-		-		32,865
Total		291,226	$	$14.02		291,226		32,865

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION

None.

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ITEM 6. EXHIBITS

Exhibit Number	Document	Reference to Prior Filing or Exhibit Number Attached Hereto
2.8	Purchase and Assumption Agreement dated March 8, 2013 by and among the FDIC, receiver of Frontier Bank, Lagrange, Georgia; HeritageBank of the South; and the FDIC in its corporate capacity.	a
12.1	Ratio of Earnings to Fixed Charges	12.1
31.1	Rule 13a-14(a)/15d-14(a) Certifications of Chief Executive Officer	31.1
31.2	Rule 13a-14(a)/15d-14(a) Certifications of Chief Financial Officer	31.2
32	Section 1350 Certifications	32
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Labels Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

a Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on March 12, 2013.

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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.

		HERITAGE FINANCIAL GROUP, INC.
Date:           May 10, 2013	By:	/s/ O. Leonard Dorminey
		O. Leonard Dorminey
		President and Chief Executive Officer
Date:           May 10, 2013	By:	/s/ T. Heath Fountain
		T. Heath Fountain
		Executive Vice President,
		Chief Administrative Officer and
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

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