Park Sterling (PSTB) 10-Q 2013 Q2 Quarterly report

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D. C. 20549

FORM 10-Q 

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

For the quarterly period ended June 30, 2013

or

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

For the transition period from ________ to _________

Commission File Number 001-35032

PARK STERLING CORPORATION 

(Exact name of registrant as specified in its charter) 

North Carolina	27-4107242
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

1043 E. Morehead Street, Suite 201
Charlotte, North Carolina	28204
(Address of principal executive offices)	(Zip Code)

(704) 716-2134

(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer ☐	Accelerated Filer ☒	Non-accelerated filer ☐	Smaller reporting company ☐
	(Do not check if a smaller reporting company)

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

As of August 7, 2013, the registrant had outstanding 44,714,734 shares of common stock, $1.00 par value per share.

PARK STERLING CORPORATION

Table of Contents

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance SheetsJune 30, 2013 and December 31, 2012	2
	Condensed Consolidated Statements of IncomeThree and Six Months Ended June 30, 2013 and 2012	3
	Condensed Consolidated Statements of Comprehensive Income (Loss)Three and Six Months Ended June 30, 2013 and 2012	4
	Condensed Consolidated Statements of Changes in Shareholders’ EquitySix Months Ended June 30, 2013 and 2012	5
	Condensed Consolidated Statements of Cash FlowsSix Months Ended June 30, 2013 and 2012	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition andResults of Operations	51
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	73
Item 4.	Controls and Procedures	73
Part II.	Other Information
Item 1.	Legal Proceedings	73
Item 1A.	Risk Factors	73
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	73
Item 3.	Defaults Upon Senior Securities	74
Item 4.	Mine Safety Disclosures	74
Item 5.	Other Information	74
Item 6.	Exhibits	74

 

PARK STERLING CORPORATION

Part I.Financial Information

Item 1.  Financial Statements 

 

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(Dollars in thousands)

	June 30, 2013			December 31, 2012 *
ASSETS
Cash and due from banks	$	11,746		$	36,716
Interest-earning balances at banks		100,469			101,431
Federal funds sold		495			45,995
Investment securities available-for-sale, at fair value		329,720			245,571
Nonmarketable equity securities		5,905			7,422
Loans held for sale		10,985			14,147
Loans:
Non-covered		1,219,513			1,254,954
Covered		85,146			101,753
Less allowance for loan losses		(10,847	)		(10,591	)
Net loans		1,293,812			1,346,116
Premises and equipment, net		56,929			57,222
Bank-owned life insurance		47,019			46,133
Deferred tax asset		42,298			42,629
Other real estate owned (covered of $6,542 and $6,646, respectively; andnon-covered of $9,741 and $18,427, respectively)		16,283			25,073
Goodwill		24,717			24,717
FDIC indemnification asset		14,848			18,697
Core deposit intangible		9,143			9,658
Accrued interest receivable		3,961			3,821
Other assets		4,593			7,446
Total assets	$	1,972,923		$	2,032,794
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing	$	265,246		$	243,495
Interest-bearing		1,327,859			1,388,509
Total deposits		1,593,105			1,632,004
Short-term borrowings		2,176			10,143
FHLB advances		55,000			70,000
Subordinated debt		21,812			21,573
Accrued interest payable		449			516
Accrued expenses and other liabilities		23,324			22,856
Total liabilities		1,695,866			1,757,092
Shareholders' equity:
Preferred stock, no par value
5,000,000 shares authorized; 20,500 issued and outstanding at June 30, 2013 andDecember 31, 2012		20,500			20,500
Common stock, $1.00 par value200,000,000 shares authorized;44,700,805 and 44,575,853 shares issued and outstanding at June 30, 2013and December 31, 2012, respectively		44,701			44,576
Additional paid-in capital		221,935			220,996
Accumulated deficit		(6,869	)		(13,568	)
Accumulated other comprehensive income (loss)		(3,210	)		3,198
Total shareholders' equity		277,057			275,702
Total liabilities and shareholders' equity	$	1,972,923		$	2,032,794

     *Derived from audited financial statements.

 The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

2

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except per share data)

	Three Months Ended June 30					Six Months Ended June 30
	2013			2012		2013			2012
Interest income
Loans, including fees	$	18,805		$	10,416	$	36,945		$	22,526
Federal funds sold		7			15		24			23
Taxable investment securities		1,068			969		1,934			1,989
Tax-exempt investment securities		195			186		385			371
Nonmarketable equity securities		25			28		73			92
Interest on deposits at banks		44			28		106			38
Total interest income		20,144			11,642		39,467			25,039
Interest expense
Money market, NOW and savings deposits		379			333		786			659
Time deposits		527			720		1,135			1,541
Short-term borrowings		1			-		7			3
FHLB advances		137			148		274			309
Subordinated debt		429			341		858			708
Total interest expense		1,473			1,542		3,060			3,220
Net interest income		18,671			10,100		36,407			21,819
Provision for loan losses		75			899		384			1,022
Net interest income after provision for loan losses		18,596			9,201		36,023			20,797
Noninterest income
Service charges on deposit accounts		616			299		1,380			613
Income from fiduciary activities		731			661		1,439			1,260
Gain on sale of securities available for sale		104			489		104			489
Bankcard services income		830			223		1,428			451
Mortgage banking income		977			540		1,945			1,001
Income from bank-owned life insurance		528			260		909			519
Other noninterest income		320			91		469			185
Total noninterest income		4,106			2,563		7,674			4,518
Noninterest expense
Salaries and employee benefits		8,800			5,871		17,578			11,995
Occupancy and equipment		1,980			910		3,888			1,730
Advertising and promotion		150			108		370			269
Legal and professional fees		861			614		1,754			926
Deposit charges and FDIC insurance		409			250		896			541
Data processing and outside service fees		1,640			696		3,293			2,045
Communication fees		448			196		880			428
Core deposit intangible amortization		257			102		514			204
Net cost (earnings) of operation of other real estate owned		(36	)		809		(464	)		1,331
Loan and collection expense		679			295		1,005			539
Postage and supplies		298			124		627			320
Other tax expense		127			70		303			139
Other noninterest expense		1,309			790		2,309			1,371
Total noninterest expense		16,922			10,835		32,953			21,838
Income before income taxes		5,780			929		10,744			3,477
Income tax expense		1,968			251		3,692			1,076
Net income		3,812			678		7,052			2,401
Preferred dividends		302			-		353			-
Net income to common shareholders	$	3,510		$	678	$	6,699		$	2,401
Basic earnings per common share	$	0.08		$	0.02	$	0.15		$	0.07
Diluted earnings per common share	$	0.08		$	0.02	$	0.15		$	0.07
Weighted-average common shares outstanding
Basic		44,143,301			32,120,367		44,078,262			32,097,867
Diluted		44,204,581			32,120,402		44,137,495			32,097,900

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

3

PARK STERLING CORPORATION 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Dollars in thousands)

	Three Months Ended June 30						Six Months Ended June 30
	2013			2012			2013			2012
Net income	$	3,812		$	678		$	7,052		$	2,401
Unrealized holding gains (losses) onavailable-for-sale securities		(9,299	)		749			(10,117	)		1,593
Income tax effect		3,378			(219	)		3,764			(525	)
Reclassification of gains recognized in net income,reported as gain on sale of securities available for sale on the condensed consolidated statement of income		(104	)		(489	)		(104	)		(489	)
Income tax effect		49			143			49			161
Total other comprehensive income (loss)		(5,976	)		184			(6,408	)		740
Total comprehensive income	$	(2,164	)	$	862		$	644		$	3,141

 

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

4

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

Six Months Ended June 30, 2013 and 2012

(Dollars in thousands)

	Preferred Stock				Common Stock							Additional Paid-In			Accumulated			Accumulated Other Comprehensive			Total Shareholders'
	Shares		Amount		Shares			Amount			Capital			Deficit			Income (Loss)			Equity
Balance at December 31, 2011		-	$	-		32,643,627		$	32,644		$	172,390		$	(17,860	)	$	2,880		$	190,054
Issuance of restricted stockgrants		-		-		63,000			63			(63	)		-			-			-
Share-based compensation expense		-		-		-			-			991			-			-			991
Comprehensive income:
Net income		-		-		-			-			-			2,401			-			2,401
Unrealized holding gains onavailable-for-sale securities,net of taxes		-		-		-			-			-			-			740			740
Balance at June 30, 2012		-	$	-		32,706,627		$	32,707		$	173,318		$	(15,459	)	$	3,620		$	194,186
Balance at December 31, 2012		20,500	$	20,500		44,575,853		$	44,576		$	220,996		$	(13,568	)	$	3,198		$	275,702
Issuance of restricted stockgrants		-		-		141,500			142			(142	)		-			-			-
Forfeitures of restricted stockgrants		-		-		(16,860	)		(17	)		17			-			-			-
Exercise of stock options		-		-		312			-			1			-			-			1
Share-based compensation expense		-		-		-			-			1,063			-			-			1,063
Dividends on preferred stock		-		-		-			-			-			(353	)		-			(353	)
Comprehensive income:
Net income		-		-		-			-			-			7,052			-			7,052
Unrealized holding losses onavailable-for-sale securities,net of taxes		-		-		-			-			-			-			(6,408	)		(6,408	)
Balance at June 30, 2013		20,500	$	20,500		44,700,805		$	44,701		$	221,935		$	(6,869	)	$	(3,210	)	$	277,057

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

5

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

	Six Months Ended June 30,
	2013			2012
Cash flows from operating activities
Net income	$	7,052		$	2,401
Adjustments to reconcile net income to netcash provided by operating activities:
Accretion on acquired loans		(4,639	)		(3,692	)
Net (accretion) amortization on investments		358			(129	)
Other depreciation and amortization		3,890			865
Provision for loan losses		384			1,022
Share-based compensation expense		1,063			991
Deferred income taxes		4,144			926
Amortization of FDIC indemnification asset		38			-
Net gains on sales of investment securities available-for-sale		(104	)		(489	)
Net gains on sales of loans held for sale		(1,218	)		(429	)
Net (gains) losses on sales of premises and equipment		(16	)		9
Net gains on sales of other real estate owned		(1,335	)		(159	)
Writedowns on other real estate owned		1,012			1,042
Income from bank-owned life insurance		(909	)		(519	)
Proceeds from loans held for sale		64,578			30,580
Disbursements for loans held for sale		(60,198	)		(29,228	)
Change in assets and liabilities:
Increase in FDIC indemnification asset		(1,425	)		-
(Increase) decrease in accrued interest receivable		(140	)		659
Decrease in other assets		2,877			2,284
Decrease in accrued interest payable		(67	)		(1,308	)
Increase in accrued expenses and other liabilities		707			763
Net cash provided by operating activities		16,052			5,589
Cash flows from investing activities
Net decrease in loans		50,567			41,840
Purchases of premises and equipment		(1,403	)		(777	)
Proceeds from sales of premises and equipment		50			4
Purchases of investment securities available-for-sale		(143,634	)		(51,719	)
Proceeds from sales of investment securities available-for-sale		22,815			22,537
Proceeds from maturities and call of investment securities available-for-sale		26,195			18,829
FDIC reimbursement of recoverable covered asset losses		5,236			-
Proceeds from sale of other real estate owned		13,392			4,954
Net redemptions of nonmarketable equity securities		1,517			3,040
Net cash provided (used) by investing activities		(25,265	)		38,708
Cash flows from financing activities
Net decrease in deposits		(38,899	)		(4,603	)
Advances (repayments) of long-term borrowings		(15,000	)		15,000
Decrease in short-term borrowings		(7,967	)		(8,087	)
Payment of preferred dividends		(353	)		-
Net cash provided (used) by financing activities		(62,219	)		2,310
Net increase (decrease) in cash and cash equivalents		(71,432	)		46,607
Cash and cash equivalents, beginning		184,142			28,541
Cash and cash equivalents, ending	$	112,710		$	75,148
Supplemental disclosures of cash flow information:
Cash paid for interest	$	3,127		$	2,850
Cash paid for income taxes		37			60
Supplemental disclosure of noncash investing and financing activities:
Change in unrealized gain on available-for-sale securities, net of tax	$	(6,408	)	$	740
Loans transferred to other real estate owned		4,279			6,178

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements

6

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1   - Basis of Presentation

Park Sterling Corporation (the “Company”) was formed on October 6, 2010 to serve as the holding company for Park Sterling Bank (the “Bank”) and is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). At June 30, 2013 and December 31, 2012, the Company’s primary operations and business were that of owning the Bank.

The accompanying unaudited condensed consolidated financial statements and notes have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with GAAP. Because the accompanying unaudited condensed consolidated financial statements do not include all of the information and footnotes required by GAAP, they should be read in conjunction with the Company’s audited consolidated financial statements and accompanying footnotes (the “2012 Audited Financial Statements”) included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the Securities and Exchange Commission (“SEC”) on March 15, 2013 (the “2012 Form 10-K”).

In management’s opinion, the accompanying unaudited condensed consolidated financial statements reflect all normal, recurring adjustments necessary to present fairly the financial position of the Company as of June 30, 2013 and December 31, 2012, and the results of its operations and cash flows for the three- and six-months ended June 30, 2013 and 2012. Operating results for the three- and six-month periods ended June 30, 2013 are not necessarily indicative of the results that may be expected for the year or for other interim periods.

Tabular information, other than share and per share data, is presented in thousands of dollars.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates that are susceptible to significant change in the near term are the valuation of purchased credit-impaired (“PCI”) loans, the valuation of the allowance for loan losses, the determination of the need for a deferred tax asset valuation allowance and the fair value of financial instruments and other accounts.

Certain amounts reported in prior periods have been reclassified to conform to the current period presentation.

Note 2   -Recent Accounting Pronouncements 

In February 2013, the FASB issued Accounting Standards Update No. 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" ("ASU 2013-02"). This guidance is the culmination of the FASB's deliberation on reporting reclassification adjustments from accumulated other comprehensive income ("AOCI"). The amendments in ASU 2013-02 do not change the current requirements for reporting net income or other comprehensive income. However, the amendments require disclosure of amounts reclassified out of AOCI in its entirety, by component, on the face of the statement of income or in the notes thereto. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This standard is effective prospectively for annual and interim reporting periods beginning after December 15, 2012. The Company has adopted this standard and the required disclosures are presented in the condensed consolidated financial statements.

7

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited) 

Note 3  -Business Combinations

Generally, acquisitions are accounted for under the acquisition method of accounting in accordance with FASB Accounting Standards Codification (“ASC”) 805,Business Combinations. Both the purchased assets and liabilities assumed are recorded at their respective acquisition date fair values. Determining the fair value of assets and liabilities, especially the loan portfolio, is a complicated process involving significant judgment regarding methods and assumptions used to calculate estimated fair values. Fair values are preliminary and subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available.

Citizens South

On October 1, 2012, Citizens South was merged with and into the Company, with the Company as the surviving legal entity, in accordance with an Agreement and Plan of Merger dated as of May 13, 2012. Under the terms of the Citizens South merger agreement, Citizens South stockholders received either $7.00 in cash or 1.4799 shares of the Company’s Common Stock for each Citizens South share they owned immediately prior to the merger, subject to the limitation that the total consideration paid in the merger would consist of 30% in cash and 70% in Common Stock. The Citizens South merger was structured to be tax-free to Citizens South stockholders with respect to the shares of Common Stock received in the merger and taxable with respect to the cash received in the merger. Cash was paid in lieu of fractional shares. The aggregate merger consideration consisted of 11,857,226 shares of Common Stock and $24.3 million in cash. Based on the $4.94 per share closing price of the Common Stock on September 28, 2012, the last trading date prior to consummation of the merger, the transaction value was $82.9 million. In addition, in connection with the merger, the preferred stock previously issued by Citizens South to the United States Department of the Treasury (the “Treasury”) in connection with Citizens South’s participation in the Small Business Lending Fund (“SBLF”) program was converted to 20,500 shares of a substantially identical newly created series of the Company’s preferred stock. See Note 10 – Preferred Stock for further discussion.

Citizens South operated 21 full service branches in North Carolina, South Carolina and Georgia at the date of acquisition. The acquisition of Citizens South was part of the Company’sbusiness plan seeking accelerated organic growth and to acquire regional and community banks in the Carolinas and Virginia.

The assets and liabilities assumed from Citizens South were recorded at their fair value as of the closing date of the merger. Goodwill of $22.5 million was initially recorded at the time of acquisition. As a result of refinements to the fair value mark on loans, bank-owned life insurance, other real estate owned (“OREO”), the FDIC indemnification asset and other assets, goodwill as indicated below is $1.6 million greater than the goodwill estimated in the Company’s 2012 audited consolidated financial statements. Goodwill as of December 31, 2012 has been retrospectively adjusted. The following table summarizes the consideration paid by the Company in the merger with Citizens South and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date:

8

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

	As Recorded by Citizens South		Fair Value and Other Merger Related Adjustments			As Recorded by the Company
Consideration Paid
Cash						$	24,283
Common shares issued (11,857,226 shares)							58,575
Fair value of noncontrolling interest							20,500
Fair Value of Total Consideration Transferred						$	103,358
Recognized amounts of identifiable assets acquired and liabilities assumed:
Cash and cash equivalents	$	48,661	$	(82	)	$	48,743
Securities		88,068		2,275			90,343
Nonmarketable equity securities		5,390		-			5,390
Loans held for sale		1,695		-			1,695
Loans, net of allowance		694,016		(12,340	)		681,676
Premises and equipment		25,443		4,326			29,769
Core deposit intangibles		1,032		5,168			6,200
Other real estate owned		18,957		(3,169	)		15,788
Bank owned life insurance		18,879		(79	)		18,800
Deferred tax asset		3,560		875			4,435
FDIC indemnification asset		20,652		1,846			22,498
Other assets		4,338		(320	)		4,018
Total assets acquired	$	930,691	$	(1,500	)	$	929,355
Deposits	$	826,134	$	2,166		$	828,300
Short term borrowings		7,678		-			7,678
Junior subordinated debt		15,464		(6,627	)		8,837
Other liabilities		418		4,859			5,277
Total liabilities assumed	$	849,694	$	398		$	850,092
Total identifiable assets	$	80,997	$	(1,898	)	$	79,263
Goodwill resulting from acquisition						$	24,095

9

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 4 - Investment Securities

The amortized cost, unrealized gains and losses, and estimated fair value of securities available-for-sale at June 30, 2013 and December 31, 2012 are as follows:

Amortized Cost and Fair Value of Investment Portfolio

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
June 30, 2013
Securities available-for-sale:
U.S. Government agencies	$	516	$	51	$	-		$	567
Municipal securities		16,083		879		-			16,962
Residential agency mortgage-backed securities		96,662		1,051		(466	)		97,247
Commercial mortgage-backed securities		65,163		-		(4,293	)		60,870
All other debt securities		156,397		579		(2,901	)		154,075
Total investment securities	$	334,822	$	2,559	$	(7,660	)	$	329,720
December 31, 2012
Securities available-for-sale:
U.S. Government agencies	$	518	$	65	$	-		$	583
Municipal securities		16,258		1,727		-			17,986
Residential agency mortgage-backed securities		156,492		3,188		(567	)		159,113
Commercial mortgage-backed securities		-		-		-			-
All other debt securities		67,181		1,017		(309	)		67,889
Total investment securities	$	240,450	$	5,997	$	(876	)	$	245,571

At June 30, 2013 and December 31, 2012, investment securities with a fair market value of $95.6 million and $102.5 million, respectively, were pledged to secure public and trust deposits, to secure interest rate swaps, and for other purposes as required and permitted by law.

The amortized cost and fair value of investment securities available-for-sale at June 30, 2013 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of the Company’s residential mortgage-backed securities are backed by an agency of the U.S. government. None of our residential mortgage-backed securities are private label securities.

At June 30, 2013, commercial mortgage-backed securities include $55.2 million of delegated underwriting and servicing (DUS) bonds collateralized by multi-family properties and backed by an agency of the U.S. Government, and $10.0 million of private-label securities collateralized by commercial properties. There were commercial mortgage-backed holdings in securities available-for-sale at December 31, 2012.

10

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Maturities of Investment Portfolio

	June 30, 2013
	Amortized Cost		Fair Value
	(Dollars in thousands)
U.S. Government agencies
Due after one year through five years	$	516	$	567
Municipal securities
Due under one year		700		710
Due after ten years		15,383		16,252
Residential agency mortgage-backed securities
Due after five years through ten years		19,233		19,260
Due after ten years		77,429		77,987
Commercial mortgage-backed securities
Due after five years through ten years		65,163		60,870
All other debt securities
Due after five years through ten years		8,316		8,192
Due after ten years		148,082		145,882
Total investment securities	$	334,822	$	329,720

 

Securities available-for-sale of $22.8 million were sold in the six months ended June 30, 2013 resulting in a gross gain of $0.01 million. During the six months ended June 30, 2012, the Company sold $22.5 million of securities available-for-sale, resulting in a gross gain of $0.5 million.

Management periodically evaluates each investment security for other than temporary impairment, relying primarily on industry analyst reports, observation of market conditions and interest rate fluctuations. The following table shows gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, for investment securities with unrealized losses at June 30, 2013 and December 31, 2012. Since none of the unrealized losses relate to the marketability of the securities or the issuer’s ability to honor redemption obligations, and it is more likely than not that the Company will not have to sell the investments before recovery of their amortized cost basis, none of the securities are deemed to be other than temporarily impaired. At June 30, 2013 and December 31, 2012, one corporate debt security has been in a continuous loss position for twelve months or more. This unrealized loss is due to market volatility and uncertainty since the security was purchased. Management believes that the unrealized losses are temporary and fully expects to collect all cash flows.

11

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Investment Portfolio Gross Unrealized Losses and Fair Value

	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
June 30, 2013
Securities available-for-sale:
Residential agency mortgage-backed securities	$	23,835	$	(466	)	$	-	$	-		$	23,835	$	(466	)
Commercial mortgage-backed securities		60,870		(4,293	)		-		-			60,870		(4,293	)
All other debt securities		85,329		(2,810	)		409		(91	)		85,738		(2,901	)
Total temporarily impairedsecurities	$	170,034	$	(7,569	)	$	409	$	(91	)	$	170,443	$	(7,660	)
December 31, 2012
Securities available-for-sale:
Residential agency mortgage-backed securities	$	40,041	$	(567	)	$	-	$	-		$	40,041	$	(567	)
All other debt securities		30,931		(224	)		415		(85	)		31,346		(309	)
Total temporarily impairedsecurities	$	70,972	$	(791	)	$	415	$	(85	)	$	71,387	$	(876	)

The Company has nonmarketable equity securities consisting of investments in several financial institutions and the investments in CSBC Statutory Trust I and Community Capital Corporation Statutory Trust I. These investments totaled $5.9 million at June 30, 2013 and $7.4 million December 31, 2012. Included in these amounts at June 30, 2013 and December 31, 2012 was $4.9 million and $6.3 million, respectively, of Federal Home Loan Bank (“FHLB”) stock. All nonmarketable equity securities were evaluated for impairment as of June 30, 2013 and December 31, 2012. The following factors have been considered in determining the carrying amount of FHLB stock: (1) management’s current belief that the Company has sufficient liquidity to meet all operational needs in the foreseeable future and would not need to dispose of the stock below recorded amounts, (2) management’s belief that the FHLB has the ability to absorb economic losses given the expectation that the FHLB has a high degree of government support and (3) redemptions and purchases of the stock are at the discretion of the FHLB. At June 30, 2013 and December 31, 2012, the Company estimated that the fair values of nonmarketable equity securities equaled or exceeded the cost of each of these investments, and, therefore, the investments were not impaired.

12

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 5 – Loans and Allowance for Loan Losses

The Company’s loan portfolio was comprised of the following at:

	June 30, 2013						December 31, 2012
	PCI loans		All other loans		Total		PCI loans		All other loans			Total
	(dollars in thousands)
Commercial:
Commercial and industrial	$	6,124	$	118,649	$	124,773	$	7,323	$	111,809		$	119,132
Commercial real estate (CRE) - owner-occupied		39,958		234,085		274,043		44,925		254,491			299,416
CRE - investor income producing		71,470		297,086		368,556		85,959		285,998			371,957
Acquisition, construction and development (AC&D)		34,270		94,884		129,154		39,541		101,120			140,661
Other commercial		148		3,373		3,521		742		4,886			5,628
Total commercial loans		151,970		748,077		900,047		178,490		758,304			936,794
Consumer:
Residential mortgage		37,037		143,158		180,195		40,483		148,049			188,532
Home equity lines of credit (HELOC)		1,748		146,938		148,686		1,949		161,676			163,625
Residential construction		9,309		43,360		52,669		11,265		41,547			52,812
Other loans to individuals		1,521		21,375		22,896		2,095		13,458			15,553
Total consumer loans		49,615		354,831		404,446		55,792		364,730			420,522
Total loans		201,585		1,102,908		1,304,493		234,282		1,123,034			1,357,316
Deferred costs (fees)		-		166		166		-		(609	)		(609	)
Total loans, net of deferred costs (fees)	$	201,585	$	1,103,074	$	1,304,659	$	234,282	$	1,122,425		$	1,356,707

Included in the June 30, 2013 and December 31, 2012 loan totals is $85.1 million and $101.7 million, respectively, of covered loans pursuant to FDIC loss share agreements assumed by the Bank in connection with the Citizens South merger. At June 30, 2013, approximately $81.2 million is included in PCI loans and $3.9 million is included in all other loans. At December 31, 2012, $96.9 million is included in PCI loans and $4.8 million is included in all other loans.

At June 30, 2013 and December 31, 2012, the Company had sold participations in loans aggregating $8.1 million and $10.8 million, respectively, to other financial institutions on a nonrecourse basis. Collections on loan participations and remittances to participating institutions conform to customary banking practices.

The Bank accepts residential mortgage loan applications and funds loans of qualified borrowers. Funded loans are sold with limited recourse to investors under the terms of pre-existing commitments. The Bank executes all of its loan sales agreements under best efforts contracts with investors. The Company does not service residential mortgage loans for the benefit of others.

Loans sold with limited recourse are 1-4 family residential mortgages originated by the Company and sold to various other financial institutions. Various recourse agreements exist, ranging from thirty days to twelve months. The Company’s exposure to credit loss in the event of nonperformance by the other party to the loan is represented by the contractual notional amount of the loan. Since none of the loans has ever been returned to the Company, the amount of total loans sold with limited recourse does not necessarily represent future cash requirements. The Company uses the same credit policies in making loans held for sale as it does  for on-balance sheet instruments. Total loans sold with limited recourse in the six months ended June 30, 2013 were $63.5 million. Total loans sold with limited recourse in the six months ended June 30, 2012 were $42.5 million.

At June 30, 2013 and December 31, 2012, the carrying value of loans pledged as collateral on FHLB borrowings totaled $302.4 million and $144.2 million, respectively. At June 30, 2013 and December 31, 2012, the carrying value of loans pledged as collateral on the Federal Reserve Discount Window totaled $146.9 million and $83.1 million, respectively.

13

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Concentrations of Credit-Loans are primarily made within the Company’s operating footprint of North Carolina, South Carolina and Georgia. Real estate loans can be affected by the condition of the local real estate market. Commercial and industrial loans can be affected by the local economic conditions. The commercial loan portfolio has concentrations in business loans secured by real estate and real estate development loans. Primary concentrations in the consumer loan portfolio include home equity lines of credit and residential mortgages. At June 30, 2013 and December 31, 2012, the Company had no loans outstanding with non-U.S. entities.

14

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Allowance for Loan Losses-The following tables present, by portfolio segment, the activity in the allowance for loan losses for the three and six months ended June 30, 2013 and June 30, 2012.

	Commercial and industrial			CRE - owner- occupied			CRE - investor income producing			AC&D			Other commercial			Residential mortgage			Home equity lines of credit			Residential construction			Other loans to individuals			Total
For the three months ended June 30, 2013	(dollars in thousands)
Allowance for Loan Losses, excluding PCI:
Balance, beginning of period	$	1,676		$	322		$	1,235		$	4,218		$	6		$	349		$	1,440		$	450		$	66		$	9,762
Provision for loan losses		407			57			(101	)		(687	)		(2	)		(101	)		364			39			24			-
Charge-offs		(543	)		(40	)		(18	)		(6	)		-			(2	)		(509	)		(2	)		(13	)		(1,133	)
Recoveries		45			4			303			405			-			21			16			31			9			834
Net charge-offs		(498	)		(36	)		285			399			-			19			(493	)		29			(4	)		(299	)
Balance, end of period	$	1,585		$	343		$	1,419		$	3,930		$	4		$	267		$	1,311		$	518		$	86		$	9,463
PCI Impairment Allowance for Loan Losses:
Balance, beginning of period	$	-		$	-		$	-		$	385		$	-		$	318		$	3		$	245		$	36		$	987
PCI impairment charge-offs		-			-			-			-			-			-			-			-			-			-
PCI impairment recoveries		-			-			-			25			-			-			-			-			-			25
Net PCI impairment charge-offs		-			-			-			25			-			-			-			-			-			25
PCI provision for loan losses		216			-			1			35			-			76			-			44			-			372
Benefit attributable to FDIC loss shareagreements		(104	)		-			(1	)		(192	)		-			-			-			-			-			(297	)
Total provision for loan losses charged to operations		112			-			-			(157	)		-			76			-			44			-			75
Provision for loan losses recorded through FDIC lossshare receivable		104			-			1			192			-			-			-			-			-			297
Balance, end of period	$	216		$	-		$	1		$	445		$	-		$	394		$	3		$	289		$	36		$	1,384
Total Allowance for Loan Losses	$	1,801		$	343		$	1,420		$	4,375		$	4		$	661		$	1,314		$	807		$	122		$	10,847
For the six months ended June 30, 2013
Allowance for Loan Losses, excluding PCI:
Balance, beginning of period	$	849		$	496		$	1,102		$	4,157		$	8		$	454		$	1,463		$	1,046		$	49		$	9,624
Provision for loan losses		1,201			(120	)		105			(975	)		(4	)		(215	)		398			(562	)		45			(127	)
Charge-offs		(556	)		(40	)		(221	)		(6	)		-			(4	)		(591	)		(2	)		(29	)		(1,449	)
Recoveries		91			7			433			754			-			32			41			36			21			1,415
Net charge-offs		(465	)		(33	)		212			748			-			28			(550	)		34			(8	)		(34	)
Balance, end of period	$	1,585		$	343		$	1,419		$	3,930		$	4		$	267		$	1,311		$	518		$	86		$	9,463
PCI Impairment Allowance for Loan Losses:
Balance, beginning of period	$	225		$	-		$	-		$	542		$	-		$	200		$	-		$	-		$	-		$	967
PCI impairment charge-offs		-			-			(16	)		(14	)		(386	)		-			-			-			-			(416	)
PCI impairment recoveries		-			-			-			25			-			-			-			-			-			25
Net PCI impairment charge-offs		-			-			(16	)		11			(386	)		-			-			-			-			(391	)
PCI provision for loan losses		(9	)		-			17			(108	)		386			194			3			289			36			808
Benefit attributable to FDIC loss shareagreements		(104	)		-			(1	)		(192	)		-			-			-			-			-			(297	)
Total provision for loan losses charged to operations		(113	)		-			16			(300	)		386			194			3			289			36			511
Provision for loan losses recorded through FDIC lossshare receivable		104			-			1			192			-			-			-			-			-			297
Balance, end of period	$	216		$	-		$	1		$	445		$	-		$	394		$	3		$	289		$	36		$	1,384
Total Allowance for Loan Losses	$	1,801		$	343		$	1,420		$	4,375		$	4		$	661		$	1,314		$	807		$	122		$	10,847

15

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

	Commercial and industrial			CRE - owner- occupied			CRE - investor income producing			AC&D			Other commercial			Residential mortgage			Home equity lines of credit			Residential construction			Other loans to individuals			Total
For the three months ended June 30, 2012	(dollars in thousands)
Allowance for Loan Losses:
Balance, beginning of period	$	980		$	804		$	1,872		$	3,218		$	18		$	326		$	1,717		$	580		$	41		$	9,556
Provision for loan losses		420			(333	)		(32	)		310			(8	)		310			(375	)		354			(1	)		645
PCI provision for loan losses		-			-			-			-			-			254			-			-			-			254
Charge-offs		(228	)		(74	)		(521	)		(12	)		-			(99	)		-			(328	)		-			(1,262	)
Recoveries		8			-			7			194			-			1			28			-			-			238
Net charge-offs		(220	)		(74	)		(514	)		182			-			(98	)		28			(328	)		-			(1,024	)
Ending balance	$	1,180		$	397		$	1,326		$	3,710		$	10		$	792		$	1,370		$	606		$	40		$	9,431
For the six months ended June 30, 2012
Allowance for Loan Losses:
Balance, beginning of period	$	703		$	740		$	2,106		$	3,883		$	17		$	309		$	1,898		$	455		$	43		$	10,154
Provision for loan losses		855			(277	)		(205	)		(91	)		87			326			(391	)		479			(15	)		768
PCI provision for loan losses		-			-			-			-			-			254			-			-			-			254
Charge-offs		(397	)		(74	)		(575	)		(357	)		(94	)		(99	)		(165	)		(328	)		(1	)		(2,090	)
Recoveries		19			8			-			275			-			2			28			-			13			345
Net charge-offs		(378	)		(66	)		(575	)		(82	)		(94	)		(97	)		(137	)		(328	)		12			(1,745	)
Ending balance	$	1,180		$	397		$	1,326		$	3,710		$	10		$	792		$	1,370		$	606		$	40		$	9,431

16

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The following table presents, by portfolio segment, the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment measurement method and the related recorded investment in loans at June 30, 2013 and December 31, 2012.

	Commercial and industrial		CRE - owner- occupied		CRE - investor income producing		AC&D		Other commercial		Residential mortgage		Home equity lines of credit		Residential construction		Other loans to individuals		Total
At June 30, 2013	(dollars in thousands)
Allowance for Loan Losses:
Individually evaluated for impairment	$	321	$	-	$	203	$	64	$	-	$	130	$	261	$	-	$	-	$	979
Collectively evaluated for impairment		1,264		343		1,216		3,866		4		137		1,050		518		86		8,484
		1,585		343		1,419		3,930		4		267		1,311		518		86		9,463
Purchased credit-impaired		216		-		1		445		-		394		3		289		36		1,384
Total	$	1,801	$	343	$	1,420	$	4,375	$	4	$	661	$	1,314	$	807	$	122	$	10,847
Recorded Investment in Loans:
Individually evaluated for impairment	$	988	$	1,949	$	3,859	$	2,575	$	156	$	3,367	$	1,853	$	-	$	66	$	14,813
Collectively evaluated for impairment		117,661		232,136		293,227		92,309		3,217		139,791		145,085		43,360		21,309		1,088,095
		118,649		234,085		297,086		94,884		3,373		143,158		146,938		43,360		21,375		1,102,908
Purchased credit-impaired		6,124		39,958		71,470		34,270		148		37,037		1,748		9,309		1,521		201,585
Total	$	124,773	$	274,043	$	368,556	$	129,154	$	3,521	$	180,195	$	148,686	$	52,669	$	22,896	$	1,304,493
At December 31, 2012
Allowance for Loan Losses:
Individually evaluated for impairment	$	115	$	-	$	-	$	-	$	-	$	249	$	351	$	-	$	-	$	715
Collectively evaluated for impairment		734		496		1,102		4,157		8		205		1,112		1,046		49		8,909
		849		496		1,102		4,157		8		454		1,463		1,046		49		9,624
Purchased credit-impaired		225		-		-		542		-		200		-		-		-		967
Total	$	1,074	$	496	$	1,102	$	4,699	$	8	$	654	$	1,463	$	1,046	$	49	$	10,591
Recorded Investment in Loans:
Individually evaluated for impairment	$	607	$	2,337	$	4,243	$	4,855	$	168	$	3,463	$	1,925	$	71	$	73	$	17,742
Collectively evaluated for impairment		111,202		252,154		281,755		96,265		4,718		144,586		159,751		41,476		13,385		1,105,292
		111,809		254,491		285,998		101,120		4,886		148,049		161,676		41,547		13,458		1,123,034
Purchased credit-impaired		7,323		44,925		85,959		39,541		742		40,483		1,949		11,265		2,095		234,282
Total	$	119,132	$	299,416	$	371,957	$	140,661	$	5,628	$	188,532	$	163,625	$	52,812	$	15,553	$	1,357,316

17

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The Company’s allowance for loan loss methodology includes four components, as described below:

1)          Specific Reserve Component. Specific reserves represent the current impairment estimate on specific loans, for which it is probable that the Company will be unable to collect all amounts due according to contractual terms based on current information and events. Impairment measurement reflects only a deterioration of credit quality and not changes in market rates that may cause a change in the fair value of the impaired loan. The amount of impairment may be measured in one of three ways, including (i) calculating the present value of expected future cash flows, discounted at the loan’s interest rate implicit in the original document and deducting estimated selling costs, if any; (ii) observing quoted market prices for identical or similar instruments traded in active markets, or employing model-based valuation techniques for which all significant assumptions are observable in the market; and (iii) determining the fair value of collateral, which is utilized for both collateral dependent loans and for loans when foreclosure is probable.

Impaired loans with a balance less than or equal to $150 thousand are viewed in two groups: those which have experienced charge-offs and those recorded at legal balance. Those loans which have experienced charge-offs have no additional reserve applied unless specifically calculated at a point in time when the loan balance exceeded $150 thousand. Those loans recorded at their legal balance are based on a pooled probability of default and loss given default calculation.

2)          Quantitative Reserve Component. Quantitative reserves represent the current loss contingency estimate on pools of loans, which is an estimate of the amount for which it is probable that the Company will be unable to collect all amounts due on homogeneous groups of loans according to contractual terms should one or more events occur, excluding those loans specifically identified above. During the fourth quarter of 2011, the Company introduced two enhancements to this component of the allowance. Management completed its previously disclosed project to collect and evaluate internal loan loss data and now incorporates the Company’s historical loss experience in this component. Previously, given the Company’s limited operating history, this component of the allowance for loan losses was based on the historical loss experience of comparable institutions. Second, the methodology now segregates loans by product type. 

This component of the allowance for loan losses is based on the historical loss experience of the Company. This loss experience is collected quarterly by evaluating internal loss data. The estimated historical loss rates are grouped by loan product type. The Company utilizes average historical losses to represent management’s estimate of losses inherent in that portfolio. The historical look back period is estimated by loan type and the Company applies the appropriate historical loss period which best reflects the inherent loss in the portfolio considering prevailing market conditions. A minimum reserve is utilized when the Company has insufficient internal loss history. Minimums are determined by analyzing Federal Reserve Bank charge-off data for all insured federal- and state-chartered commercial banks. In determining the quantitative reserve component at June 30, 2013, management utilized the following look back periods:

18

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

i.	15 quarter – Commercial & industrial and AC&D
ii.	12 quarter – CRE-investor income producing, residential mortgage, and HELOCs

 iii. 10 quarter – Residential construction

 iv. Minimum – CRE-owner-occupied, other commercial and other consumer

At December 31, 2012, management utilized the following look back periods:

 i. 12 quarter – AC&D, residential mortgage and residential construction

 ii. 8 quarter – Commercial & industrial, CRE-owner-occupied, CRE-investor income producing, and HELOCs

iii. Minimum –Other commercial and other consumer

In all cases, except residential construction, the changes in look back periods are the result of sufficient build up in loss histories to support a longer period. The residential construction look back period was shortened in the first quarter of 2013 to better present the current estimate of risk and loss in the portfolio. In the second quarter of 2013, management extended the look back period in the residential construction portfolio to 10 quarters to continue to present an estimated risk and loss consistent with its expectations. These changes in methodology did not have a material impact on the estimated allowance at June 30, 2013.

3)          Qualitative Reserve Component. Qualitative reserves represent an estimate of the amount for which it is probable that environmental or other relevant factors will cause the aforementioned loss contingency estimate to differ from the Company’s historical loss experience or other assumptions. During the second quarter of 2012, the Company refined its allowance methodology to eliminate the use of traditional risk grade factors as a forward-looking qualitative indicator, which had been introduced during the fourth quarter of 2011, and instead focuses directly on five specific environmental factors. These five factors include portfolio trends, portfolio concentrations, economic and market conditions, changes in lending practices and other factors. Management believes these refinements simplify application of the qualitative component of the allowance methodology. Each of the factors, except other factors, can range from 0.00% (not applicable) to 0.15% (very high). Other factors are reviewed on a situational basis and are adjusted in 5 basis point increments, up or down, with a maximum of 0.50%. Details of the five environmental factors for inclusion in the allowance methodology are as follows:

i. Portfolio trends, which may relate to such factors as type or level of loan origination activity, changes in asset quality (i.e., past due, special mention, non-performing) and/or changes in collateral values;

ii. Portfolio concentrations, which may relate to individual borrowers and/or guarantors, geographic regions, industry sectors, loan types and/or other factors;

iii. Economic and market trends, which may relate to trends and/or levels of gross domestic production, unemployment, bankruptcies, foreclosures, housing starts, housing prices, equity prices, competitor activities and/or other factors;

19

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

	iv.	Changes in lending practices, which may relate to changes in credit policies, procedures, systems or staff; and
	v.	Other factors, which is intended to capture environmental factors not specifically identified above.
	In addition, qualitative reserves on purchased performing loans are based on the Company’s judgment around the timing difference expected to occur between accretion of the fair market value credit adjustment and realization of actual loans losses.
4)	Reserve on Purchased-Credit Impaired Loans.In determining the acquisition date fair value of PCI loans, and in subsequent accounting, the Company generally aggregates purchased loans into pools of loans with common risk characteristics. Expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable. Subsequent to the acquisition date, significant increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses. In pools where impairment has already been recognized, an increase in cash flows will result in a reversal of prior impairment. Management analyzes these acquired loan pools using various assessments of risk to determine and calculate an expected loss. The expected loss is derived using an estimate of a loss given default based upon the collateral type and/or specific review by loan officers of loans generally greater than $1.0 million, and the probability of default that was determined based upon management’s review of the loan portfolio. Trends are reviewed in terms of traditional credit metrics such as accrual status, past due status, and weighted-average grade of the loans within each of the accounting pools. In addition, the relationship between the change in the unpaid principal balance and change in the fair value mark is assessed to correlate the directional consistency of the expected loss for each pool.
	This analysis resulted in net impairment for the three- and six-months ended June 30, 2013 of $372 thousand and $808 thousand, respectively. Additionally, in both periods approximately $297 thousand is attributable to covered loans under FDIC loss share agreements. These covered loan impairments were a function of an increase in expected losses and as a result, the FDIC indemnification asset was increased. See Note 6 – FDIC Loss Share Agreements for further discussion. These impairments are spread among several pools and reporting segments. A full breakdown of the net impairment or recovery is detailed in the allowance by segment table above for the three- and six-months ended June 30, 2013. There was a $254 thousand impairment of a residential mortgage pool that is reflected in the allowance by segment table above for the three and six months ended June 30, 2012.

The Company evaluates and estimates off-balance sheet credit exposure at the same time it estimates credit losses for loans by a similar process. These estimated credit losses are not recorded as part of the allowance for loan losses, but are recorded to a separate liability account by a charge to income, if material. Loan commitments, unused lines of credit and standby letters of credit make up the off-balance sheet items reviewed for potential credit losses. At June 30, 2013 and December 31, 2012, $125 thousand was recorded as an other liability for off-balance sheet credit exposure.

20

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

  Credit Quality Indicators-The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company's primary credit quality indicator is an internal credit risk rating system that categorizes loans into pass, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes that comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes that comprise the consumer portfolio segment.

The following are the definitions of the Company's credit quality indicators:

Pass:	Loans in classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Purchased performing and PCI loans that were recorded at estimated fair value on the acquisition date are generally assigned a “pass” loan grade because their net financial statement value is based on the present value of expected cash flows. Management believes there is a low likelihood of loss related to those loans that are considered pass.
Special Mention:	Loans in classes that comprise the commercial and consumer portfolio segments that have potential weaknesses that deserve management's close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. Management believes there is a moderate likelihood of some loss related to those loans that are considered special mention.
Classified:	Loans in the classes that comprise the commercial portfolio segment that are inadequately protected by the sound worth and paying capacity of the borrower or of the collateral pledged, if any. Management believes that there is a distinct possibility that the Company will sustain some loss if the deficiencies related to classified loans are not corrected in a timely manner.

The Company's credit quality indicators are periodically updated on a case-by-case basis. The following tables present the recorded investment in the Company's loans as of June 30, 2013 and December 31, 2012, by loan class and by credit quality indicator.

21

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

	As of June 30, 2013
(dollars in thousands)	Commercial and Industrial		CRE-Owner Occupied		CRE-Investor Income Producing		AC&D		Other Commercial		Total Commercial
Pass	$	123,625	$	268,761	$	362,129	$	120,421	$	3,365	$	878,301
Special mention		150		2,351		1,969		5,702		-		10,172
Classified		998		2,931		4,458		3,031		156		11,574
Total	$	124,773	$	274,043	$	368,556	$	129,154	$	3,521	$	900,047

	Residential Mortgage		Home Equity Lines of Credit		Residential Construction		Other Loans to Individuals		Total Consumer
Pass	$	176,406	$	143,458	$	52,323	$	22,354	$	394,541
Special mention		2,324		1,251		181		374		4,130
Classified		1,465		3,977		165		168		5,775
Total	$	180,195	$	148,686	$	52,669	$	22,896	$	404,446
Total Loans									$	1,304,493

	As of December 31, 2012
(dollars in thousands)	Commercial and Industrial		CRE-Owner Occupied		CRE-Investor Income Producing		AC&D		Other Commercial		Total Commercial
Pass	$	115,907	$	292,418	$	361,212	$	126,167	$	5,460	$	901,164
Special mention		173		3,804		5,564		9,252		-		18,793
Classified		3,052		3,194		5,181		5,242		168		16,837
Total	$	119,132	$	299,416	$	371,957	$	140,661	$	5,628	$	936,794

	Residential Mortgage		Home Equity Lines of Credit		Residential Construction		Other Loans to Individuals		Total Consumer
Pass	$	185,686	$	158,335	$	52,612	$	15,444	$	412,077
Special mention		1,115		2,599		-		78		3,792
Classified		1,731		2,691		200		31		4,653
Total	$	188,532	$	163,625	$	52,812	$	15,553	$	420,522
Total Loans									$	1,357,316

22

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Aging Analysis of Accruing and Non-Accruing Loans -The Company considers a loan to be past due or delinquent when the terms of the contractual obligation are not met by the borrower. PCI loans are included as a single category in the table below as management believes, regardless of their age, there is a lower likelihood of aggregate loss related to these loan pools. Additionally, PCI loans are discounted to allow for the accretion of income on a level yield basis over the life of the loan based on expected cash flows. Regardless of accruing status, the associated discount on these loan pools results in income recognition. The following table presents, by class, an aging analysis of the Company’s accruing and non-accruing loans as of June 30, 2013 and December 31, 2012.

	30-59 Days Past Due		60-89 Days Past Due		Past Due 90 Days or More		PCI Loans		Current		Total Loans
As of June 30, 2013	(dollars in thousands)
Commercial:
Commercial and industrial	$	571	$	124	$	100	$	6,124	$	117,854	$	124,773
CRE - owner-occupied		-		186		183		39,958		233,716		274,043
CRE - investor income producing		302		30		150		71,470		296,604		368,556
AC&D		291		-		563		34,270		94,030		129,154
Other commercial		-		-		-		148		3,373		3,521
Total commercial loans		1,164		340		996		151,970		745,577		900,047
Consumer:
Residential mortgage		1,298		151		625		37,037		141,084		180,195
Home equity lines of credit		561		1,262		755		1,748		144,360		148,686
Residential construction		54		139		42		9,309		43,125		52,669
Other loans to individuals		13		12		1		1,521		21,349		22,896
Total consumer loans		1,926		1,564		1,423		49,615		349,918		404,446
Total loans	$	3,090	$	1,904	$	2,419	$	201,585	$	1,095,495	$	1,304,493
As of December 31, 2012
Commercial:
Commercial and industrial	$	1,316	$	83	$	230	$	7,323	$	110,180	$	119,132
CRE - owner-occupied		48		1,903		113		44,925		252,427		299,416
CRE - investor income producing		224		27		366		85,959		285,381		371,957
AC&D		-		699		1,428		39,541		98,993		140,661
Other commercial		-		-		168		742		4,718		5,628
Total commercial loans		1,588		2,712		2,305		178,490		751,699		936,794
Consumer:
Residential mortgage		18		196		499		40,483		147,336		188,532
Home equity lines of credit		590		-		1,094		1,949		159,992		163,625
Residential construction		-		-		71		11,265		41,476		52,812
Other loans to individuals		36		4		-		2,095		13,418		15,553
Total consumer loans		644		200		1,664		55,792		362,222		420,522
Total loans	$	2,232	$	2,912	$	3,969	$	234,282	$	1,113,921	$	1,357,316

  Impaired Loans - All classes of loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impaired loans may include all classes of nonaccrual loans and loans modified in a troubled debt restructuring (“TDR”). If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the rate implicit in the original loan agreement or at the fair value of collateral if repayment is expected solely from the collateral. Additionally, a portion of the Company’s qualitative factors accounts for potential impairment on loans generally less than $150 thousand. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

23

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

During the three- and six-months ended June 30, 2013, the Company’s quarterly cash flow analyses indicated that net impairment of $372 thousand and $808 thousand was present in several of the Company’s PCI loan pools. This net impairment is spread among almost all the loan segments presented in the table above. As a result of changes in cash flows, increases and decreases, certain segments saw reversals of previously recognized impairment.

The following tables do not include information regarding impairment of the Company's PCI loans. At December 31, 2012, the Company’s quarterly cash flow analyses indicated that three of fourteen PCI loan pools were impaired. This analysis resulted in $225 thousand net impairment in a commercial pool, $542 thousand net impairment in an AC&D pool and $200 thousand net impairment of a residential mortgage pool at December 31, 2012. There was no impairment of PCI loans for the first quarter of 2012. For the three- and six-months ended June 30, 2012, the quarterly cash flow analysis indicated one of the Company’s PCI loan pools was deemed impaired. This pool has a current recorded investment of $3.0 million, a current unpaid principal balance of $3.2 million, and impairment of $254 thousand. Additionally, this pool had an average recorded investment of $1.0 million and $502 thousand for the three- and six-month periods ended June 30, 2012 and the Company recognized interest income of $14 thousand for both the three- and six-month periods ended June 30, 2012. 

The table below presents impaired loans, by class, and the corresponding allowance for loan losses at June 30, 2013 and December 31, 2012:

24

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

	June 30, 2013						December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance For Loan Losses		Recorded Investment		Unpaid Principal Balance		Related Allowance For Loan Losses
	(dollars in thousands)
Impaired Loans with No RelatedAllowance Recorded:
Commercial:
Commercial and industrial	$	213	$	847	$	-	$	377	$	1,170	$	-
CRE - owner-occupied		1,949		3,233		-		2,337		2,675		-
CRE - investor income producing		180		3,553		-		4,243		4,424		-
AC&D		2,325		8,442		-		4,855		9,306		-
Other commercial		156		197		-		168		172		-
Total commercial loans		4,823		16,272		-		11,980		17,747		-
Consumer:
Residential mortgage		2,136		2,571		-		2,252		2,363		-
Home equity lines of credit		1,243		3,691		-		1,419		2,439		-
Residential construction		-		266		-		71		551		-
Other loans to individuals		63		94		-		73		75		-
Total consumer loans		3,442		6,622		-		3,815		5,428		-
Total impaired loans with no relatedallowance recorded	$	8,265	$	22,894	$	-	$	15,795	$	23,175	$	-
Impaired Loans with anAllowance Recorded:
Commercial:
Commercial and industrial	$	775	$	1,327	$	321	$	230	$	230	$	115
CRE - owner-occupied		-		-		-		-		-		-
CRE - investor income producing		3,679		3,682		203		-		-		-
AC&D		250		250		64		-		-		-
Other commercial		-		-		-		-		-		-
Total commercial loans		4,704		5,259		588		230		230		115
Consumer:
Residential mortgage		1,231		1,293		130		1,211		1,250		249
Home equity lines of credit		610		651		261		506		707		351
Residential construction		-		-		-		-		-		-
Other loans to individuals		3		5		-		-		-		-
Total consumer loans		1,844		1,949		391		1,717		1,957		600
Total impaired loans with anallowance recorded	$	6,548	$	7,208	$	979	$	1,947	$	2,187	$	715
Total Impaired Loans:
Commercial:
Commercial and industrial	$	988	$	2,174	$	321	$	607	$	1,400	$	115
CRE - owner-occupied		1,949		3,233		-		2,337		2,675		-
CRE - investor income producing		3,859		7,235		203		4,243		4,424		-
AC&D		2,575		8,692		64		4,855		9,306		-
Other commercial		156		197		-		168		172		-
Total commercial loans		9,527		21,531		588		12,210		17,977		115
Consumer:
Residential mortgage		3,367		3,864		130		3,463		3,613		249
Home equity lines of credit		1,853		4,342		261		1,925		3,146		351
Residential construction		-		266		-		71		551		-
Other loans to individuals		66		99		-		73		75		-
Total consumer loans		5,286		8,571		391		5,532		7,385		600
Total impaired loans	$	14,813	$	30,102	$	979	$	17,742	$	25,362	$	715

25

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The average recorded investment and interest income recognized on impaired loans, by class, for the three and six months ended June 30, 2013 and June 30, 2012 is shown in the table below.

	Three Months Ended June 30,								Six Months Ended June 30,
	2013				2012				2013				2012
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(dollars in thousands)
Impaired Loans with No RelatedAllowance Recorded:
Commercial:
Commercial and industrial	$	297	$	-	$	1,125	$	-	$	476	$	-	$	1,081	$	-
CRE - owner-occupied		2,135		-		317		5		1,602		-		319		12
CRE - investor income producing		224		106		3,496		-		2,471		123		2,561		-
AC&D		2,936		-		8,929		9		5,250		-		9,328		30
Other commercial		160		-		43		-		162		-		21		-
Total commercial loans		5,752		106		13,910		14		9,961		123		13,310		42
Consumer:
Residential mortgage		2,247		14		684		-		1,626		31		588		-
Home equity lines of credit		1,315		-		772		-		1,129		-		761		-
Residential construction		1		-		127		-		56		-		117		-
Other loans to individuals		66		1		7		2		70		2		8		2
Total consumer loans		3,629		15		1,590		2		2,881		33		1,474		2
Total impaired loans with no relatedallowance recorded	$	9,381	$	121	$	15,500	$	16	$	12,842	$	156	$	14,784	$	44
Impaired Loans with anAllowance Recorded:
Commercial:
Commercial and industrial	$	1,010	$	-	$	123	$	-	$	521	$	1	$	124	$	-
CRE - owner-occupied		-		-		61		-		12		-		32		-
CRE - investor income producing		3,644		38		364		-		1,531		75		364		-
AC&D		125		-		903		-		341		-		861		-
Other commercial		-		-		-		-		-		-		-		-
Total commercial loans		4,779		38		1,451		-		2,405		76		1,381		-
Consumer:
Residential mortgage		1,216		6		14		7		1,220		16		7		16
Home equity lines of credit		654		1		318		-		489		2		318		-
Residential construction		-		-		-		-		-		-		-		-
Other loans to individuals		2		-		-		-		-		-		-		-
Total consumer loans		1,872		7		332		7		1,709		18		325		16
Total impaired loans with anallowance recorded	$	6,651	$	45	$	1,783	$	7	$	4,114	$	94	$	1,706	$	16
Total Impaired Loans:
Commercial:
Commercial and industrial	$	1,307	$	-	$	1,248	$	-	$	997	$	1	$	1,205	$	-
CRE - owner-occupied		2,135		-		378		5		1,614		-		351		12
CRE - investor income producing		3,868		144		3,860		-		4,002		198		2,925		-
AC&D		3,061		-		9,832		9		5,591		-		10,189		30
Other commercial		160		-		43		-		162		-		21		-
Total commercial loans		10,531		144		15,361		14		12,366		199		14,691		42
Consumer:
Residential mortgage		3,463		20		698		7		2,846		47		595		16
Home equity lines of credit		1,969		1		1,090		-		1,618		2		1,079		-
Residential construction		1		-		127		-		56		-		117		-
Other loans to individuals		68		1		7		2		70		2		8		2
Total consumer loans		5,501		22		1,922		9		4,590		51		1,799		18
Total impaired loans	$	16,032	$	166	$	17,283	$	23	$	16,956	$	250	$	16,490	$	60

26

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

During the three and six months ended June 30, 2013, the Company recognized $166 thousand and $250 thousand, respectively, in interest income with respect to impaired loans, primarily accruing TDRs, within the period the loans were impaired. During the three and six months ended June 30, 2012, the Company recognized $23 thousand and $60 thousand, respectively, with respect to impaired loans.

Nonaccrual and Past Due Loans -It is the general policy of the Company to place a loan on nonaccrual status when there is probable loss or when there is reasonable doubt that all principal will be collected, or when it is over 90 days past due. At June 30, 2013, there was $196 thousand in loans past due 90 days or more and accruing interest. These loans are being evaluated for collectability at June 30, 2013. At December 31, 2012, there was a $77 thousand loan past due 90 days or more and accruing interest. The recorded investment in nonaccrual loans at June 30, 2013 and December 31, 2012 follows:

	June 30, 2013		December 31, 2012
	(dollars in thousands)
Commercial:
Commercial and industrial	$	967	$	607
CRE - owner-occupied		1,949		1,996
CRE - investor income producing		214		633
AC&D		876		3,872
Other commercial		156		168
Total commercial loans		4,162		7,276
Consumer:
Residential mortgage		865		1,096
Home equity lines of credit		1,801		1,925
Residential construction		-		71
Other loans to individuals		4		6
Total consumer loans		2,670		3,098
Total nonaccrual loans	$	6,832	$	10,374

Purchased Credit-Impaired Loans–PCI loans had an unpaid principal balance of $239.3 million and $278.2 million and a carrying value of $201.6 million and $234.3 million at June 30, 2013 and December 31, 2012, respectively. PCI loans represented 10.2% and 11.5% of total assets at June 30, 2013 and December 31, 2012, respectively. Determining the fair value of the PCI loans at acquisition required the Company to estimate cash flows expected to result from those loans and to discount those cash flows at appropriate rates of interest. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans and is called the accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and is called the nonaccretable difference. In accordance with GAAP, there was no carry-over of previously established allowance for loan losses from acquired companies.

27

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

In conjunction with the Citizens South acquisition, the PCI loan portfolio was accounted for at fair value as follows (dollars in thousands):

	October 1, 2012
Contractual principal and interest at acquisition	$	294,283
Nonaccretable difference		(47,941	)
Expected cash flows at acquisition		246,342
Accretable yield		(37,724	)
Basis in PCI loans at acquisition - estimated fair value	$	208,618

 

In conjunction with the acquisition of Community Capital Corporation (“Community Capital”) in 2011, the PCI loan portfolio was accounted for at fair value as follows (dollars in thousands):

	November 1, 2011
Contractual principal and interest at acquisition	$	146,843
Nonaccretable difference		(61,145	)
Expected cash flows at acquisition		85,698
Accretable yield		(14,424	)
Basis in PCI loans at acquisition - estimated fair value	$	71,274

A summary of changes in the accretable yield for PCI loans for the six months ended June 30, 2013 and 2012 follows (dollars in thousands):

	Six Months Ended June 30,
	2013			2012
Accretable yield, beginning of period	$	42,734		$	14,264
Addition from the Community Capital acquisition		-			136
Interest income		(7,610	)		(2,239	)
Reclassification of nonaccretable difference due toimprovement in expected cash flows		5,746			5,077
Other changes, net		1,378			(642	)
Accretable yield, end of period	$	42,248		$	16,596

  Troubled Debt Restructuring -In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a TDR. Management strives to identify borrowers in financial difficulty early and work with them to modify to more affordable terms. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. All loan modifications are made on a case-by-case basis.

28

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The Company had allocated $251 thousand and $54 thousand, respectively, of specific reserves to customers whose loan terms have been modified in a TDR as of June 30, 2013 and December 31, 2012. As of June 30, 2013, the Company had 17 TDR loans totaling $8.1 million, of which $0.3 million are nonaccrual loans. As of December 31, 2012, the Company had 18 TDR loans totaling $10.2 million, of which $2.8 million were nonaccrual loans.

The following tables represent a breakdown of the types of concessions made by loan class for the 12 months ended June 30, 2013. There were no new TDRs identified for the twelve months ended June 30, 2012.

	For the 12 months ended June 30, 2013
(dollars in thousands)	Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Below market interest rate
CRE - investor income producing		1	$	3,610	$	3,610
Residential mortgage		1		43		43
Total		2		3,653		3,653
Extended payment terms
AC&D		1		962		962
		1		962		962
Total		3	$	4,615	$	4,615

 

There were no loans that were modified as TDRs within the 12 months ended June 30, 2013 and for which there was a payment default during the three months or six months ended June 30, 2013. The following table presents loans that were modified as TDRs within the 12 months ended June 30, 2012 and for which there was a payment default during the three or six months ended June 30, 2012 (dollars in thousands):

	Three months ended June 30, 2012				Six months ended June 30, 2012
	Number of loans		Recorded Investment		Number of loans		Recorded Investment
Below market interest rate
Residential mortgage		-	$	-		1	$	323
Total		-	$	-		1	$	323

29

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The Company does not deem a TDR to be successful until it has been re-established as an accruing loan. The following table presents the successes and failures of the types of modifications indicated within the 12 months ended June 30, 2013 and 2012 (dollars in thousands):

Twelve Months Ended June 30, 2013
	Paid in full				Paying as restructured				Nonaccrual				Foreclosure/Default
	Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment
Below market interest rate		2	$	164		2	$	3,647		-	$	-		-	$	-
Extended payment terms		1	$	329		1		249		-		-		-		-
Total		3	$	493		3	$	3,896		-	$	-		-	$	-

Twelve Months Ended June 30, 2012
	Paid in full				Paying as restructured				Nonaccrual				Foreclosure/Default
	Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment
Below market interest rate		-	$	-		-	$	-		1	$	323		-	$	-
Extended payment terms		-		-		2		423		2		497		-		-
Total		-	$	-		2	$	423		3	$	820		-	$	-

    Related Party Loans–From time to time, the Company engages in loan transactions with its directors, executive officers and their related interests (collectively referred to as “related parties”). Such loans are made in the ordinary course of business and on substantially the same terms and collateral as those for comparable transactions prevailing at the time and do not involve more than the normal risk of collectability or present other unfavorable features. A summary of activity in loans to related parties is as follows (dollars in thousands):

Loans to Directors, Executive Officers and Their Related Interests

	Six Months Ended June 30,
	2013			2012
Beginning balance	$	4,184		$	3,998
Disbursements		2,923			209
Repayments		(1,803	)		(340	)
Ending balance	$	5,304		$	3,867

At June 30, 2013 and December 31, 2012, the Company had pre-approved but unused lines of credit totaling $3.8 million and $1.8 million, respectively, to related parties.

30

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 6 – FDIC Loss Share Agreements

   In connection with the Citizens South acquisition, the Bank assumed two purchase and assumption agreements with the FDIC that cover approximately $85.1 million of loans (the “covered loans”) and $6.5 million of OREO (the “covered OREO”) at June 30, 2013. Citizens South acquired these assets in prior transactions with the FDIC.

Within the first purchase and assumption agreement are two loss share agreements, which originated in April 2011, related to Citizens South’s acquisition of New Horizons Bank, a Georgia state-chartered bank headquartered in East Ellijay, Georgia. The first loss share agreement covers certain residential loans and OREO for a period of ten years. The other loss-share agreement covers all remaining covered assets for a period of five years. Pursuant to the terms of these loss-share agreements, the FDIC is obligated to reimburse the Bank for 80% of all eligible losses, which begins with the first dollar of loss occurred, and certain collection and disposition expenses with respect to covered assets. The Bank has a corresponding obligation to reimburse the FDIC for 80% of eligible recoveries with respect to covered assets for a period of ten years for residential properties and eight years for all other covered assets. At June 30, 2013, the Bank recorded an estimated receivable from the FDIC for $5.9 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.

Within the second purchase and assumption agreement are two loss share agreements, which originated in March 2010, related to Citizen South’s acquisition of Bank of Hiawassee, a Georgia state-chartered bank headquartered in Hiawassee, Georgia. Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million. The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans, five years for losses on all other loans and eight years for recoveries on all other loans. At June 30, 2013, the Bank recorded an estimated receivable from the FDIC for $9.0 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.

      The following table provides changes in the receivable from the FDIC for the six months ended June 30, 2013:

FDIC Loss Share Receivable

Balance, beginning of period	$	18,697
Increase in expected losses on loans		297
Additional losses to OREO		232
Reimbursable expenses (income)		429
Amortization discounts and premiums, net		(38	)
Reimbursements from the FDIC		(5,236	)
Other changes, net		467
Balance, end of period	$	14,848

The FDIC receivable for loss share agreements is measured separately from the related covered assets and is recorded at carrying value. At June 30, 2013, the projected cash flows related to the FDIC receivable for losses on covered loans and assets were approximately $15.7 million. At December 31, 2012, the projected cash flows related to the FDIC receivable for a loss on covered loans and assets was approximately $19.6 million.

In relation to the FDIC indemnification asset is an expected "true-up" with the FDIC related to the loss share agreements above. The loss share agreements between the Bank and the FDIC with respect to New Horizons Bank and Bank of Hiawassee each contain a provision that obligates us to make a "true-up" payment to the FDIC if the realized losses of each of these acquired banks are less than expected. This amount is determined each reporting period. At June 30, 2013, the present value “true-up” amount was estimated to be approximately $5.0 million at the end of the loss share agreements. At December 31, 2012, the “true-up” amount was estimated to be approximately $4.9 million at the end of the loss share agreements. These amounts are recorded in other liabilities on the balance sheet. The actual payment will be determined at the end of the term of the loss sharing agreements and is based on the negative bid, expected losses, intrinsic loss estimate, and assets covered under the loss share agreements.

31

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 7 – Other Real Estate Owned

      The Company owned $16.3 million and $25.1 million in OREO at June 30, 2013 and December 31, 2012, respectively. In 2012, the Company acquired $16.1 million in OREO through the merger with Citizens South. Approximately $6.5 million of this OREO is covered under the loss share agreements with the FDIC. Transactions in OREO for the three and six months ended June 30, 2013 and 2012 are summarized below (dollars in thousands):

	Three months ended						Six months ended
	June 30, 2013			June 30, 2012			June 30, 2013			June 30, 2012
Beginning balance	$	21,251		$	16,674		$	25,073		$	14,403
Additions		1,122			1,778			4,279			6,178
Sales		(5,306	)		(2,914	)		(12,057	)		(4,795	)
Writedowns		(784	)		(794	)		(1,012	)		(1,042	)
Ending balance	$	16,283		$	14,744		$	16,283		$	14,744

Note 8 – Income Taxes

Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of deferred tax assets (“DTAs”) and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, the Company records a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements.

As of June 30, 2013 and December 31, 2012, the Company had a net DTA in the amount of approximately $42.3 million and $41.8 million, respectively. The increase is a function of the change in the unrealized gain position of the Company’s securities to an unrealized loss position at June 30, 2013. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If the Company’s forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Based on the weight of available evidence, the Company has determined, as of June 30, 2013 and December 31, 2012, that it is more likely than not that it will be able to fully realize the existing DTA and therefore considers it appropriate not to establish a DTA valuation allowance at either June 30, 2013 or December 31, 2012.

      The Company considers all available evidence, positive and negative, to determine whether a DTA valuation allowance is appropriate. In conducting the DTA analysis, the Company currently believes it is essential to differentiate between the unique characteristics of each industry or business. In particular, characteristics such as business model, level of capital and reserves held by financial institutions and their ability to absorb potential losses are important distinctions to be considered for bank holding companies, such as the Company.

32

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Negative Evidence. The Company considered the following five areas of potential negative evidence identified in ASC 740 as part of its DTA analysis:

1.  Rolling twelve-quarter cumulative loss. 

The Bank commenced operations in late 2006, attained profitability in the third quarter of 2008 and remained profitable through the second quarter of 2010 before its business was materially impacted by the recent economic downturn. As a result, the Bank moved into a rolling twelve-quarter cumulative pre-tax loss position during the third quarter of 2010. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. However, the Company evaluates the circumstances behind those losses and considers them in the context of the current economic environment and the significant changes it has made to address the circumstances underlying the losses.

As of June 30, 2013, the Company’s three-year cumulative pre-tax loss position was $9.2 million and was driven, in large part, by rolling twelve-quarter cumulative provision expenses of $26.6 million. The Company’s three-year cumulative pre-tax loss position was $19.6 million and $25.4 million at December 31, 2012 and 2011, respectively. This high level of provision expense reflects the negative impact on the Company’s loan portfolio from the effects of the extended economic downturn. The risk of loan loss is inherent to the banking industry. The Company considered the special circumstances of the economic environment of the last few years, which led to these high historical provision levels and currently believes they are unlikely to be repeated going forward, given changes in the Company’s lending practices, business strategy, risk tolerance, capital levels and operating practices.

Based on current internal loss data analysis, approximately 75% of rolling twelve-quarter cumulative net charge-offs are associated with construction & development (“C&D”, which includes both commercial AC&D and residential construction) lending (which was impacted the most by the economic downturn). Prior to the Bank’s public offering in August 2010, the Bank had allowed an excessive concentration to build in C&D exposures, which peaked at $159 million, or 43% of total loans, in the fourth quarter of 2008. In the second quarter of 2010, C&D exposures were $124 million, or 31% of total loans. Following the public offering, the Company reconstituted its executive management team with significant new hires, immediately curtailed originating new residential C&D exposures and significantly tightened standards for all other types of C&D lending. These changes reflect both the Company’s new business strategies and risk tolerance, which include building a more diversified loan portfolio both by geography and product type. As of June 30, 2013, C&D exposures were 15% of total loans, or $196.1 million.

The Company has also significantly strengthened its lending practices including the additions of a new chief risk officer, chief credit officer, head of special assets, manager of credit underwriting and additional credit underwriters. The Company currently believes it has remediated many of the circumstances that led to the rolling twelve-quarter cumulative pre-tax loss position and currently does not expect these losses to continue in the future.

2.  History of operating loss or tax credit carry forwards expiring unused. 

The Company has no history of operating loss or tax carry forwards expiring unused.

3.  Unsettled circumstances that, if unfavorably unresolved, would adversely affect future operations and profit levels on a continuing basis in future years. 

The Company is not currently aware of any unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years.

4.  Carryback or carry forward period that is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business. 

Approximately $7.7 million, or 18%, of the DTA existing at June 30, 2013 related to net operating loss carry forwards that do not expire until December 31, 2033, leaving over eighteen years for recognition. Approximately $14.4 million, or 34%, of the DTA existing at December 31, 2012 related to net operating loss carry forwards with availability for application out as far as 20 years.

33

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Positive Evidence. The Company considered the following sources of future taxable income identified in ASC 740 as positive evidence to weigh against the negative evidence described above.

1. Future reversals of existing taxable temporary differences and carry forwards.

The Company’s largest future reversals relate to its PCI loans and allowance for loan losses, which represented $32.0 million and $3.7 million, respectively, of the DTA at June 30, 2013. Current tax, accounting and regulatory treatment of the allowance generally results in substantial taxable temporary differences for financial institutions engaged in lending activities. The following is a brief description of the Company’s current expectations regarding recognition or reversal of the major components of the allowance:

●  Specific reserves, which totaled $1.0 million at June 30, 2013, relate to identified impairments and are based on individual loan-collectability analyses. The Company currently estimates that specific reserves will generally reverse within two quarters of establishment, and currently believes these reserves are very unlikely to remain unaddressed after four quarters of establishment. To be conservative, specific reserves are currently assumed to reverse within one year.

●  Quantitative and qualitative reserves on the non-acquired portfolio, which totaled $8.1 million at June 30, 2013, are based on model-driven estimates of inherent loss content in the performing loan portfolio based on historical loss rates by loan product type. The Company currently estimates that these reserves will generally reverse within six to eight quarters of establishment. However, the Company currently estimates that the average life of the underlying loan pool is approximately three years; therefore, all quantitative reserves are currently assumed to reverse within approximately three years.

●  Qualitative reserves on purchased performing loans, which totaled $380 thousand at June 30, 2013, are based on the Company’s judgment around the timing difference expected to occur between accretion of the fair market value credit adjustment and realization of actual loans losses. The Company currently estimates that the average life of the underlying loan pool is approximately three years and these reserves are currently assumed to reverse within that time.

●  Quantitative reserves on PCI loans, which totaled $1.4 million at June 30, 2013, are determined in connection with the quarterly cash flows analyses for this portion of the acquired loan book. The Company compares the initial expected cash flows to the new remaining expected cash flows. Increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses. The Company currently estimates that the average life of the underlying loan pool is approximately three years and these reserves are currently assumed to reverse within that time.

Given these assumptions, the Company currently expects the full allowance-driven component of its DTA to reverse within approximately three years, meaning either (i) the Company will generate sufficient taxable income to fully utilize these reversals through reduced tax payments or (ii) these reversals will shift to net operating loss carry forwards with an expected 20-year life, which would be utilized as the Company generates sufficient taxable income over that period.

2. Taxable income in carryback year(s).

34

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Approximately $14.4 million, or 40%, of the estimated DTA at December 31, 2012 related to net operating loss carry forwards with expected expiration dates out over 18 years. Approximately $7.7 million, or 18%, of the estimated DTA at June 30, 2013 related to net operating loss carryforwards, with expected expiration dates out as long as 20 years. Management currently believes that the Company will generate sufficient taxable income to fully utilize these net operating losses before expiration.

3. Future taxable income, exclusive of reversing temporary differences and carry forwards.

Projecting future taxable income requires estimates and judgments about future events that may be predictable, but that are less certain than past events that can be objectively measured. In projecting future taxable income, the Company considered the significant change in its strategy that occurred in mid-2010, from previously growing organically at a moderate pace to creating a regional community bank through a combination of mergers and acquisitions and accelerated organic growth. This transition was facilitated by the completion of the public offering in August 2010 and the addition of new executive management and additional independent board members. The Company is focused on long-term results and has taken actions to achieve this objective, including:

●  Addressing legacy problem assets, particularly C&D-related exposures, to move more rapidly through the cycle;

●  Consummating the merger with Community Capital;

●  Consummating the merger with Citizens South and expanding its market into Georgia;

●  Hiring experienced bankers and openingde novo offices in three new markets (Charleston, South Carolina, the Upstate and Midlands areas of South Carolina and the Research Triangle region of North Carolina);

●  Hiring bankers to begin a new asset-based lending line of business;

●  Significantly strengthening the leadership team with the addition of a new chief credit officer, head of special assets, head of managerial reporting, chief accounting officer and other positions; and

●  Maintaining significant excess capital to support both the above-mentioned organic and acquisition-related growth initiatives.

The progress already made indicates that the change in business plan is well on track to achieve its intended objectives. Management presents, generally on a monthly basis, a financial forecast to the board of directors that incorporates current assumptions and timelines regarding the Company’s baseline activities, including assumptions regarding loan and deposit growth. These assumptions and timelines are periodically evaluated both in terms of their historical trends and absolute levels. Under each scenario, the Company currently expects its pre-tax profitability to build to levels sufficient to fully absorb the existing DTA.

4. Tax-planning strategies that could, if necessary, be implemented.

As provided by ASC 740, the Company considers certain prudent and feasible tax-planning strategies that, if implemented, could prevent an operating loss or tax credit carry forward from expiring unused and could result in realization of the existing DTA. The Company currently expects that these tax-planning strategies could generate pre-tax profitability at levels sufficient to fully absorb the existing DTA. The Company has no present intention to implement such strategies.

Based on the weight of available evidence, including the continued improvement in earnings, the Company has determined that it is more likely than not that it will be able to fully realize the existing DTA. Specifically, the negative evidence is tempered by the unusual and temporary circumstances created by the recent significant economic downturn and significant changes in the Company’s lending practices, management, capital levels, growth strategy, risk tolerance, and operating practices. The implementation of such changes has already led to improved asset quality measures since the fourth quarter of 2010. Further, the positive evidence currently indicates that the Company has opportunities through various means to generate income at a sufficient enough level to fully absorb the DTA.

35

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Management will continue to evaluate the carrying value of the Company’s DTA on a quarterly basis, in accordance with ASC 740, and will determine any need for a valuation allowance based upon circumstances and expectations then in existence.

Note 9 - Per Share Results

Basic earnings per share represent income available to common shareholders divided by the weighted-average number of shares outstanding during the year. Diluted earnings per share reflect additional shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate solely to outstanding stock options and restricted stock (non-vested shares), and are determined using the treasury stock method. Under the treasury stock method, the number of incremental shares is determined by assuming the issuance of stock for the outstanding stock options reduced by the number of shares assumed to be repurchased from the issuance proceeds, using the average market price for the year of the Company's stock. Weighted-average shares for the basic and diluted EPS calculations have been reduced by the average number of unvested restricted shares.

Weighted-Average Shares for Earnings Per Share Calculation

	Three Months Ended June 30				Six Months Ended June 30
	2013		2012		2013		2012
Weighted-average number of commonshares outstanding		44,143,301		32,120,367		44,078,262		32,097,867
Effect of dilutive stock options and restricted shares		61,280		35		59,233		33
Weighted-average number of commonshares and dilutive potential commonshares outstanding		44,204,581		32,120,402		44,137,495		32,097,900

There were 2,760,090 outstanding stock options that were anti-dilutive for the three-month period ended June 30, 2013 and 2,790,090 for the six-month period ended June 30, 2013. For the three- and six-month periods ended June 30, 2012, 2,154,189 outstanding stock options were anti-dilutive. In all periods, the anti-dilution was due to the exercise prices exceeding the market price for the period.

There were 554,400 and 568,260 outstanding restricted shares that were anti-dilutive for each of the three- and six-month periods ended June 30, 2013, due to the vesting price exceeding the average market price for the periods, which were omitted from the calculation. For the three- and six-month periods ended June 30, 2012, 631,260 outstanding restricted shares were anti-dilutive. Of these shares, 554,400 restricted shares had performance conditions, which will vest one-third each when the Company’s share price achieves, for 30 consecutive trading days, $8.125, $9.10 and $10.40, respectively.

Note 10 – Preferred Stock

In connection with the Citizens South acquisition, the Company issued 20,500 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”) upon conversion of Citizens South’s preferred stock that previously was issued to the Treasury pursuant to a Securities Purchase Agreement between Citizens South and the Treasury in connection with Citizens South’s participation in the SBLF. The Series C Preferred Stock has a liquidation value of $1,000 per share and is entitled to receive non-cumulative dividends payable quarterly, on each January 1, April 1, July 1 and October 1. The dividend rate, which is calculated on the aggregate liquidation amount, was initially set at 4.84% per annum (with respect to the Citizens South preferred stock) based on the level of “Qualified Small Business Lending”, or “QSBL” (as defined in the Company’s Articles of Incorporation, as amended). The dividend rate for future dividend periods will be set based on the “Percentage Change in QSBL” (as defined in the Articles of Incorporation, as amended) between each dividend period and the “Baseline” QSBL level. Such dividend rate may vary from 1% per annum to 5% per annum for the second through tenth dividend periods (or through December 31, 2013). For the eleventh through the first half of the nineteenth dividend periods (or through March 21, 2016), the dividend rate will be fixed at between 1% and 7% per annum, based on the “Percentage Change in QSBL” at the end of the ninth dividend period. If the Series C Preferred Stock remains outstanding for more than 4 ½ years, the dividend rate will be fixed at 9%. Prior to that time, in general, the dividend rate decreases as the level of the Bank’s QSBL increases. The dividend rate as of June 30, 2013 was 3.19%.

36

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Under the terms of the Series C Preferred Stock, the Company may pay a dividend on its common stock or other stock junior to the Series C Preferred Stock, or repurchase shares of any such class or series of stock, if, after payment of such dividend, the dollar amount of the Company's Tier 1 Capital would be at least 90% of the Tier 1 Capital, existing immediately after the Treasury investment, excluding any subsequent net charge-offs and any redemption of the Series C Preferred Stock. Beginning on January 1, 2014, this threshold will be reduced by 10% for each one percent increase in the Company’s QSBL over the “Baseline” QSBL. In addition, under the terms of the Series C Preferred Stock, the Company cannot repurchase common stock or pay dividends with respect to the common stock for a specified period following a failure to declare and pay dividends on the Series C Preferred Stock.

The Series C Preferred Stock does not have general voting rights. The Company may redeem the shares of Series C Preferred Stock, in whole or in part, at any time at a redemption price equal to the sum of the liquidation amount per share and the per share amount of any unpaid dividends for the then-current dividend period, subject to any required prior approval by the Company’s primary federal banking regulator. Pursuant to the Securities Purchase Agreement, the Treasury (and any successor holder) has certain rights to require the Series C Preferred Stock to be registered for resale under the Securities Act of 1933, as amended.

Note 11 - Commitments and Contingencies

In the normal course of business, there are various outstanding commitments and contingent liabilities, such as commitments to extend credit, which are not reflected in the accompanying unaudited condensed consolidated financial statements. At June 30, 2013, we had $267.0 million of pre-approved but unused lines of credit, $3.5 million of standby letters of credit and $4.1 million of commercial letters of credit. At December 31, 2012, we had $251.9 million of pre-approved but unused lines of credit, $3.9 million of standby letters of credit and $5.6 million of commercial letters of credit. In management’s opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity.

37

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 12 - Derivative Financial Instruments and Hedging Activities

As of June 30, 2013, the Company maintained two loan swaps accounted for as fair value hedges in accordance with ASC 815. The aggregate original notional amount of these loan swaps was $6.2 million. These derivative instruments are used to protect the Company from interest rate risk caused by changes in the LIBOR curve in relation to certain designated fixed rate loans and are accounted for as fair value hedges. The derivative instruments are used to convert these fixed rate loans to an effective floating rate. If the LIBOR rate is below the stated fixed rate of the loan for a given period, the Company will owe the floating rate payer the notional amount times the difference between LIBOR and the stated fixed rate. If LIBOR is above the stated rate for any given period during the term of the contract, the Company will receive payments based on the notional amount times the difference between LIBOR and the stated fixed rate. These derivative instruments are carried at a fair market value of $(297) thousand and $(453) thousand at June 30, 2013 and December 31, 2012, respectively, and are included in other liabilities. The loans being hedged are also recorded at fair value. These fair value hedges had no indications of ineffectiveness for any of the periods presented. The Company recorded interest expense on these loan swaps of $39 thousand and $0.1 million in each of the three and six months ended June 30, 2013, and $0.1 million and $0.2 million in each of the three and six months ended June 30, 2012.

The following table presents information on the individual loan swaps at June 30, 2013:

Individual Loan Swap Information

(Dollars in thousands)

Original Notional Amount		Current Notional Amount		Termination Date	Fixed Rate		Floating Rate	Floating Rate Payer Spread
$	2,555	$	2,460	10/15/15		5.50%	USD-LIBOR-BBA		2.88	%
	3,595		3,333	04/27/17		5.25%	USD-LIBOR-BBA		2.73	%
$	6,150	$	5,793

38

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 13 - Fair Value Measurements

The Company is required to disclose the estimated fair value of financial instruments, both assets and liabilities on and off the balance sheet, for which it is practicable to estimate fair value. These fair value estimates are made at each balance sheet date, based on relevant market information and information about the financial instruments. Fair value estimates are intended to represent the price at which an asset could be sold or the price for which a liability could be settled in an orderly transaction between market participants at the measurement date. However, given there is no active market or observable market transactions for many of the Company’s financial instruments, the Company has made estimates of many of these fair values which are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimated values. The methodologies used for estimating the fair value of financial assets and financial liabilities are discussed below:

Cash and Cash Equivalents

Cash and cash equivalents, which are comprised of cash and due from banks, interest-bearing balances at banks and Federal funds sold, approximate their fair value.

39

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Investment Securities

Fair value for investment securities is based on the quoted market price if such information is available. If a quoted market price is not available, fair values are based on quoted market prices of comparable instruments.

Nonmarketable Equity Securities

Cost is a reasonable estimate of fair value for nonmarketable equity securities because no quoted market prices are available and the securities are not readily marketable. The carrying amount is adjusted for any permanent declines in value.

Loans, Net of Allowance and Loans Held for Sale

For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Further adjustments are made to reflect current market conditions. There is no discount for liquidity included in the expected cash flow assumptions.

FDIC Indemnification Asset

The fair values for the FDIC indemnification asset are estimated based on discounted future cash flows using current discount rates.

Accrued Interest Receivable

The carrying amount is a reasonable estimate of fair value.

Deposits

The fair value of deposits that have no stated maturities, including demand deposits, savings, money market and NOW accounts, is the amount payable on demand at the reporting date. The fair value of deposits that have stated maturity dates, primarily time deposits, is estimated by discounting expected cash flows using the rates currently offered for instruments of similar remaining maturities.

Borrowings

The fair values of short-term and long-term borrowings are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collateral requirements.

Subordinated Debentures

The fair value of fixed rate subordinated debentures is estimated using a discounted cash flow calculation that applies the Company’s current borrowing rate. The carrying amounts of variable rate borrowings are reasonable estimates of fair value because they can reprice frequently.

Contingent Payable

The carrying amount is a reasonable estimate of fair value.

Accrued Interest Payable

The carrying amount is a reasonable estimate of fair value.

Derivative Instruments

Derivative instruments, including interest rate swaps and swap fair value hedges, are recorded at fair value on a recurring basis. Fair value measurement is based on discounted cash flow models. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.

40

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Financial Instruments with Off-Balance Sheet Risk

With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale and derivative instruments are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record other assets at fair value on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1 Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2 Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include the use of option pricing models, discounted cash flow models and similar techniques.

41

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, at June 30, 2013 and December 31, 2012 are as follows:

 

Financial Instruments Carrying Amounts and Estimated Fair Values

					Fair Value Measurements
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2013:
Financial assets:
Cash and cash equivalents	$	112,710	$	112,710	$	112,710	$	-	$	-
Investment securities		329,720		329,720		-		329,311		409
Nonmarketable equity securities		5,905		5,905		-		5,905		-
Loans held for sale		10,985		10,985		-		10,985		-
Loans, net of allowance		1,293,812		1,267,051		-		6,090		1,260,961
FDIC indemnification asset		14,848		15,651		-		-		15,651
Accrued interest receivable		3,961		3,961		-		-		3,961
Financial liabilities:
Deposits with no stated maturity		1,009,037		1,009,037		-		1,009,037		-
Deposits with stated maturities		584,068		584,485		-		584,485		-
Swap fair value hedge		297		297		-		297		-
Borrowings		78,988		78,858		-		78,858		-
Contingent payable		3,003		3,003		-		3,003		-
Accrued interest payable		449		449		-		449		-
December 31, 2012:
Financial assets:
Cash and cash equivalents	$	184,142	$	184,142	$	184,142	$	-	$	-
Investment securities		245,571		245,571		-		245,156		415
Nonmarketable equity securities		7,422		7,422		-		7,422		-
Loans held for sale		14,147		14,147		-		14,147		-
Loans, net of allowance		1,346,116		1,332,683		-		11,390		1,321,293
FDIC indemnification asset		18,697		18,697		-		-		18,697
Accrued interest receivable		3,821		3,821				-		3,821
Financial liabilities:						-		-		-
Deposits with no stated maturity		1,002,258		1,002,258		-		1,002,258		-
Deposits with stated maturities		629,746		631,289		-		631,289		-
Swap fair value hedge		453		453		-		453		-
Borrowings		101,716		101,307		-		101,307		-
Contingent payable		3,003		3,003		-		3,003		-
Accrued interest payable		516		516		-		516		-

42

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

Investment Securities Available-for-Sale

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government-sponsored entities, municipal bonds and corporate debt securities that are valued using quoted prices for similar instruments in active markets. Securities classified as Level 3 include a corporate debt security in a less liquid market whose value is determined by reference to the going rate of a similar debt security if it were to enter the market at period end. The derived market value requires significant management judgment and is further substantiated by discounted cash flow methodologies.

Derivative Instruments

Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company uses a third party to measure the fair value on a recurring basis. The Company classifies derivative instruments held or issued for risk management purposes as Level 2. As of June 30, 2013 and December 31, 2012, the Company’s derivative instruments consist of swap fair value hedges.

Loans

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures it for the estimated impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, a loan’s observable market price and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value exceeds the recorded investments in such loans. Impaired loans where a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. The Company records the impaired loans as nonrecurring Level 3.

At June 30, 2013 and December 31, 2012, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. The Company recorded the six loans involved in fair value hedges at fair market value on a recurring basis. The Company does not record other loans at fair value on a recurring basis.

Loans held for sale

Loans held for sale are adjusted to lower of cost or market upon transfer from the loan portfolio to loans held for sale. Subsequently, loans held for sale are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral, management’s estimation of the value of the collateral or commitments on hand from investors within the secondary market for loans with similar characteristics. The fair value adjustments for loans held for sale are recorded as recurring Level 2.

Other real estate owned

OREO is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value less costs to sell. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. The Company records the OREO as nonrecurring Level 3.

43

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents, by level, the recorded amount of assets and liabilities at June 30, 2013 and December 31, 2012 measured at fair value on a recurring basis:

	Fair Value on a Recurring Basis
Description	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Assets/Liabilities at Fair Value
	(Dollars in thousands)
June 30, 2013
U.S. Government agencies	$	-	$	567		$	-	$	567
Municipal securities		-		16,962			-		16,962
Residential agency mortgage-backed securities		-		97,247			-		97,247
Commercial mortgage-backed securities		-		60,870			-		60,870
All other debt securities				153,666			409		154,075
Fair value loans		-		6,090			-		6,090
Swap fair value hedge		-		(297	)		-		(297	)
December 31, 2012
U.S. Government agencies	$	-	$	583		$	-	$	583
Municipal securities		-		17,986			-		17,986
Residential agency mortgage-backed securities		-		159,113			-		159,113
All other debt securities		-		67,474			415		67,889
Fair value loans		-		11,390			-		11,390
Swap fair value hedge		-		(453	)		-		(453	)

There were no transfers between valuation levels for any accounts. If different valuation techniques are deemed necessary, the Company would consider those transfers to occur at the end of the period that the accounts are valued.

The Company classifies its corporate debt security as a Level 3 asset. A valuation of the corporate debt security is performed using a discounted cash flow method at a rate of  10.25%. Valuation techniques are consistent with techniques used in prior periods. The following are reconciliations of the beginning and ending balances for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and six months ended June 30, 2013 and 2012. The ending balances for Level 3 assets at June 30, 2013 remained unchanged from December 31, 2012 at $0.4 million.

 

Level 3 Assets Reconciliation

	Three Months Ended June					Six Months Ended June
	2013			2012		2013			2012
	(dollars in thousands)
Corporate and Other Securities:
Balance, beginning of period	$	415		$	407	$	415		$	405
(Increase) decrease in unrealized loss		(6	)		1		(6	)		3
Balance, end of period	$	409		$	408	$	409		$	408

44

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets. Processes are in place for overseeing the valuation procedures for Level 3 measurements of OREO and impaired loans. The assets are reviewed on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. Discounts are based on asset type and valuation source; deviations from the standard are documented. The discounts are periodically reviewed to determine they remain appropriate. Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets.

Discounts range from 0% to 60% depending on the nature of the assets and source of value. Real estate is valued based on appraisals or evaluations, discounted by 8% at a minimum with higher discounts for property in poor condition or property with characteristics that may make it more difficult to market. Commercial loans secured by receivables or non-real estate collateral are generally valued using the discounted cash flow method. Inputs are determined on a borrower-by-borrower basis.

Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are reviewed quarterly and estimated using customized discounting criteria and appraisals.

Other real estate owned is based on the lower of the cost or fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. Fair values are reviewed quarterly and new appraisals are obtained annually.

The table below presents the carrying value of assets at June 30, 2013 and December 31, 2012 measured at fair value on a nonrecurring basis:

Fair Value on a Nonrecurring Basis

Description	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Assets/ (Liabilities) at Fair Value
	(Dollars in thousands)
June 30, 2013
OREO	$	-	$	-	$	3,535	$	3,535
Impaired loans:
Commercial and industrial		-		-		454		454
CRE - investor income producing		-		-		3,476		3,476
AC&D						186		186
Residential mortgage		-		-		1,102		1,102
Home equity lines of credit		-		-		197		197
Other loans to individuals						2		2
December 31, 2012
OREO	$	-	$	-	$	25,390	$	25,390
Impaired loans:
Commercial and industrial		-		-		115		115
Residential mortgage		-		-		962		962
Home equity lines of credit		-		-		155		155

45

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a nonrecurring basis at June 30, 2013.

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Range of Inputs
OREO	$	3,535	Appraisals	Discount to reflect currentmarket conditions	0%	-	55%
Impaired loans		4,623	Discounted cash flows	Percent of total contractual cash flows not expected to be collected	0%	-	50%
		496	Probability of default model	Discount to reflect probability of and loss given default		16%
		298	Collateral basedmeasurements	Discount to reflect current market conditions and ultimate collectability	0%	-	60%
	$	8,952

In accordance with accounting for foreclosed property, the carrying value of OREO is periodically reviewed and written down to fair value and any loss is included in earnings. During the three months ended June 30, 2013, OREO with a carrying value of $4.7 million was written down by $784 thousand to $4 million. During the six months ended June 30, 2013, OREO with a carrying value of $6.5 million was written down by $884 thousand to $5.5 million. During the three months ended June 30, 2012, OREO with a carrying value of $4.7 million was written down by $752 thousand to $4 million. During the six months ended June 30, 2012, OREO with a carrying value of $6.5 million was written down by $1.0 million to $5.5 million.

There were no transfers between valuation levels for any accounts for the three and six months ended June 30, 2013 and 2012. If different valuation techniques are deemed necessary, we would consider those transfers to occur at the end of the period that the accounts are valued.

46

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 14 – Shareholders’ Equity

Share-Based Plans

Pursuant to the Park Sterling Corporation 2010 Long-Term Incentive Plan (the “LTIP”), the Company may grant share-based compensation to employees and non-employee directors in the form of stock options, restricted stock or other stock-based awards. Share-based compensation expense is measured based on the fair value of the award at the date of grant and is charged to earnings on a straight-line basis over the requisite service period, which is currently up to seven years. The fair value of stock options is estimated at the date of grant using a Black-Scholes option-pricing model and related assumptions and expensed over each option’s vesting period. The amortization of share-based compensation reflects estimated forfeitures, adjusted for actual forfeiture experience. The fair value of restricted stock awards subject to share price performance vesting requirements is estimated using a Monte Carlo simulation and related estimated assumptions for volatility and a risk free interest rate. The fair value of restricted stock awards, not subject to share price performance, is estimated at the date of the grant based on the grant date closing stock price. As of June 30, 2013, there were 107,160 shares available for future grant under the LTIP.

As a result of the Citizens South merger, the Company assumed the Citizens South Bank 1999 Stock Option Plan (the “1999 Citizens South Plan”), the Citizens South Banking Corporation 2003 Stock Option Plan (the “2003 Citizens South Plan”) and the Citizens South Banking Corporation 2008 Equity Incentive Plan ( the “2008 Citizens South Plan”), each of which has been renamed as a Park Sterling Corporation plan, and the obligations of awards outstanding under the plans at the effective date of the merger.

47

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Under the 2008 Citizens South Plan, the Company may grant future non-qualified stock options and stock appreciation rights (“SARs”) to eligible employees and directors of, or service providers to, the Company or the Bank who were not employees or directors of or service providers to the Company or the Bank at the effective time of the merger. At June 30, 2013, there were options to purchase 241,631 shares of Common Stock outstanding and 94,571 shares remaining available for future grants under the 2008 Citizens South Plan.

The 1999 Citizens South Plan and the 2003 Citizens South Plan are no longer active plans and no future awards can be granted thereunder. As of June 30, 2013, there were options to purchase 2,190 shares of Common Stock outstanding under the 1999 Citizens South Plan and options to purchase 721,595 shares of Common Stock outstanding under the 2003 Citizens South Plan. 

The exercise price of each option under these plans is not less than the market price of the Company’s Common Stock on the date of the grant. The exercise price of all options outstanding at June 30, 2013 under these plans ranges from $3.04 to $15.45 and the average exercise price was $7.82. The Company funds the option shares from authorized but unissued shares. The Company does not typically purchase shares to fulfill the obligations of the stock benefit plans. Options granted become exercisable in accordance with the plans’ vesting schedules that are generally three years. In connection with the retirement of certain directors following the Bank’s public offering, vesting of their director options previously awarded in December 2007 was accelerated from December 2010 to August 2010 at their original exercise price of $13.23 per share. All unexercised options expire ten years after the date of the grant.

Additional information regarding the Company’s share-based plans is presented in Note 19 – Employee and Director Benefit Plans to the 2012 Audited Financial Statements.

Activity in the Company’s share-based plans is summarized in the following table:

				Outstanding Options									Nonvested Restricted Shares
	Available for Future Grants			Number Outstanding			Weighted Average Exercise Price		Weighted Average Contractual Term (Years)		Intrinsic Value		Number Outstanding			Weighted Average Grant Date Fair Value		Aggregate Intrinsic Value
At December 31, 2012		390,236			3,119,692		$	7.84		5.27	$	-		646,260		$	4.01	$	3,379,940
Expiration of 2003 Citizens South Plan		(88,917	)		-			-		-		-		-			-		-
Options Granted		-			-			-		-		-		-			-		-
Restricted Shares Granted		(141,500	)		-			-		-		-		141,500			5.57		836,265
Restricted Shares Vested		-			-			-		-		-		(21,000	)		4.68		124,113
Exercised		-			(312	)		3.22		-		-		-			-		-
Expired and forfeited		41,912			(41,912	)		9.19		-		-		(16,860	)		4.20		99,643
At June 30, 2013		201,731			3,077,468		$	7.82		4.80	$	337,538		749,900		$	4.28	$	4,431,907
Exercisable at June 30, 2013					2,569,789		$	8.12		4.31

At June 30, 2013, unrecognized compensation cost related to nonvested stock options of $0.2 million is expected to be recognized over a weighted-average period of 0.24 years. Total compensation expense for stock options was $321 thousand and $323 thousand for the three months ended June 30, 2013 and 2012, respectively, and $644 thousand and $646 thousand for the six months ended June 30, 2013 and 2012, respectively.

At June 30, 2013, unrecognized compensation cost related to nonvested restricted shares of $1.6 million is expected to be recognized over a weighted-average period of 1.33 years. Total compensation expense for restricted shares was $217 thousand and $185 thousand for the three months ended June 30, 2013 and 2012, respectively, and $419 thousand and $345 thousand for the six months ended June 30, 2013 and 2012, respectively.

48

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)  

Note 15 – Subsequent Event

Dividend Declaration

On July 26, 2013, the Company announced that its Board of Directors has approved the initiation of a quarterly cash dividend to its common shareholders and has declared an initial quarterly dividend of $0.02 per common share, payable on August 20, 2013 to all shareholders of record as of the close of business on August 6, 2013.

49

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains, and Park Sterling Corporation (the “Company”) and its management may make, certain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by the fact that they do not relate strictly to historical or current facts and often use words such as “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” “goal,” “target” and similar expressions. These forward-looking statements express management’s current expectations or forecasts of future events, results and conditions, including financial and other estimates and expectations regarding the merger with Citizens South Banking Corporation (“Citizens South”); the general business strategy of engaging in bank mergers, organic growth, branch openings and closings, expansion or addition of product capabilities, expected footprint of the banking franchise and anticipated asset size; anticipated loan growth; changes in loan mix and deposit mix; capital and liquidity levels; net interest income; provision expense, noninterest income and noninterest expenses; credit trends and conditions, including loan losses, allowance for loan loss, charge-offs, delinquency trends and nonperforming asset levels; net interest margin trends and the impact of the acquired portfolio fair value mark; the amount, timing and prices of share repurchases; the initiation of a common stock dividend and possible redemption of the Series C Preferred Stock; and other similar matters. These forward-looking statements are not guarantees of future results or performance and by their nature involve certain risks and uncertainties that are based on management’s beliefs and assumptions and on the information available to management at the time that these disclosures were prepared. Actual outcomes and results may differ materially from those expressed in, or implied by, any of these forward-looking statements.

You should not place undue reliance on any forward-looking statement and should consider all of the following uncertainties and risks, as well as those more fully discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the Securities and Exchange Commission (“SEC”) on March 15, 2013 (the “2012 Form 10-K”) and in any of the Company’s subsequent filings with the SEC: failure to realize synergies and other financial benefits from the Citizens South merger within the expected time frames; increases in expected costs or decreases in expected savings or difficulties related to integration of the merger; inability to identify and successfully negotiate and complete additional combinations with potential merger partners or to successfully integrate such businesses into the Company, including the Company’s ability to adequately estimate or to realize the benefits and cost savings from and limit any unexpected liabilities acquired as a result of any such business combination; the effects of negative or soft economic conditions or a “double-dip” recession, including stress in the commercial real estate markets or delay or failure of recovery in the residential real estate markets; the impact of deterioration of the United States credit standing; changes in consumer and investor confidence and the related impact on financial markets and institutions; changes in interest rates; failure of assumptions underlying the establishment of allowances for loan losses; deterioration in the credit quality of the loan portfolio or in the value of the collateral securing those loans; deterioration in the value of securities held in the investment securities portfolio; fluctuations in the market price of the common stock, regulatory, legal and contractual requirements, other uses of capital, the Company’s financial performance, market conditions generally or future actions by the board of directors, in each case impacting repurchases of common stock, declaration of dividends or redemption of preferred stock; legal and regulatory developments including changes in the federal risk-based capital rules; increased competition from both banks and nonbanks; changes in accounting standards, rules and interpretations, inaccurate estimates or assumptions in accounting, including acquisition accounting fair market value assumptions and accounting for purchased credit-impaired loans, and the impact on the Company’s financial statements; and management’s ability to effectively manage credit risk, market risk, operational risk, legal risk, and regulatory and compliance risk.

Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any forward-looking statement to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made.

50

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

The purpose of this discussion and analysis is to focus on significant changes in our financial condition as of and results of operations during the three- and six-month periods ended June 30, 2013. This discussion and analysis highlights and supplements information contained elsewhere in this Quarterly Report on Form 10-Q, particularly the preceding unaudited condensed consolidated financial statements and accompanying notes (the “Unaudited Financial Statements”).

Executive Overview

Park Sterling Corporation (the “Company”) reported net income available to common shareholders of $6.7 million, or $0.15 per share, for the six months ended June 30, 2013 compared to net income available to common shareholders of $2.4 million, or $0.07 per share, for the six months ended June 30, 2012. The increase resulted primarily from increased earning assets, higher net interest margin and higher noninterest income associated with the merger with Citizens South Banking Corporation (“Citizens South”), which was completed on October 1, 2012, combined with continued organic growth.     

The Company also announced that its Board of Directors approved the initiation of a quarterly cash dividend to its common shareholders and has declared an initial quarterly dividend of $0.02 per common share, payable on August 20, 2013 to all shareholders of record as of the close of business on August 6, 2013. This is the first cash dividend paid to common shareholders in the Company’s history. Future dividends will be subject to Board approval.

Asset quality continued to improve in the second quarter and remains a point of strength for the Company. Nonperforming loans decreased $3.0 million, or 17%, to $14.8 million at June 30, 2013, or 1.13% of total loans, compared to $17.8 million at December 31, 2012, or 1.31% of total loans. Nonperforming assets decreased $11.8 million, or 28%, to $31.1 million at June 30, 2013, or 1.58% of total assets, compared to $42.9 million at December 31, 2012, or 2.11% of total assets. Nonperforming assets include $6.5 million of covered other real estate owned (“OREO”) for which the Company expects certain losses to be reimbursed under the FDIC loss share agreements.

Total assets decreased $59.9 million, or 3%, to $1.97 billion at June 30, 2013 compared to total assets of $2.03 billion at December 31, 2012. Cash and equivalents decreased $71.4 million, or 39%, to $112.7 million during the first six months of 2013. Securities increased $82.6 million, or 33%, to $335.6 million. Total loans, which exclude loans held for sale, decreased $52.0 million, or 4%, to $1.3 billion, including a $16.5 million, or 16%, reduction in covered loans. Overall, less attractive acquired purchased credit-impaired (“PCI”) loans, of which covered loans are a component, decreased $32.7 million, or 14%, to $201.6 million while acquired performing loans decreased $120.9 million, or 20%, to $493.7 million. The Company’s metropolitan markets, which include Charlotte, Raleigh and Wilmington, North Carolina and Greenville and Charleston, South Carolina, reported a $12.3 million, or 9% annualized, increase in total loans to $544.9 million (before acquisition accounting fair market value adjustments). The Company’s origination activity remains somewhat tempered by aggressive competition with respect to term structure and interest rates, as well as by continued general softness in the economy.

Total deposits decreased $38.9 million, or 2%, to $1.59 billion at June 30, 2013 compared to total deposits of $1.63 billion at December 31, 2012 due to repricing strategies and management electing not to renew maturing brokered time deposits. Total borrowings decreased $22.7 million, or 22%, to $79.0 million at June 30, 2013 compared to $101.7 million at December 31, 2012, due to a reduction in Federal Home Loan Bank (“FHLB”) advances and short-term borrowings. Total shareholders’ equity increased $1.4 million, or 1%, to $277.1 million at June 30, 2013 compared to $275.7 million at December 31, 2012, driven by a $5.98million swing in other comprehensive income resulting from fair value changes in available for sale securities offset by net income and share-based compensation activity. The Company’s ratio of equity to assets was 14.04% at June 30, 2013 compared to 13.56% at December 31, 2012. The Company’s ratio of tangible common equity to tangible assets increased to 11.48% at June 30, 2013 from 11.05% at December 31, 2012. Both ratios increased as a result of the increase in equity and decrease in total assets. Similarly, the Tier 1 leverage ratio increased to 11.91% at June 30, 2013 from 11.25% at December 31, 2012. Tangible common equity and tangible assets, and related ratios, are non-GAAP financial measures. For reconciliations to the most comparable GAAP measure, see “Non-GAAP Financial Measures” below.

51

Business Overview

The Company, a North Carolina corporation, was formed in October 2010 to serve as the holding company for Park Sterling Bank (the “Bank”) and is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Bank was incorporated in September 2006 as a North Carolina-chartered commercial nonmember bank. On January 1, 2011, the Company acquired all of the outstanding common stock of the Bank in exchange for shares of the Company’s Common Stock, on a one-for-one basis, in a statutory share exchange transaction effected under North Carolina law pursuant to which the Company became the bank holding company for the Bank. Prior to January 1, 2011, the Company conducted no operations other than obtaining regulatory approval for the holding company reorganization.

Consistent with our growth strategy, during 2011 the Bank opened a full-service branch in Charleston, South Carolina and loan production offices in Raleigh, North Carolina and Greenville, South Carolina, and subsequently opened full-service branches in Greenville and Raleigh in the first quarter of 2012. The Bank currently anticipates that it will open additional branch offices and/or loan production offices in its target markets in the future.

As part of our growth strategy, the Company acquired Community Capital Corporation (“Community Capital”) in November 2011. The aggregate merger consideration consisted of 4,024,269 shares of Common Stock and approximately $13.3 million in cash. The final transaction value was approximately $28.8 million based on the $3.85 per share closing price of the Common Stock on October 31, 2011

In addition, in October 2012, the Company acquired Citizens South, the parent company of Citizens South Bank. As a result of the merger of Citizens South into the Company, Citizens South Bank, which operated 20 branches in North Carolina, South Carolina and Georgia, became a wholly-owned subsidiary of the Company and thereafter was merged into the Bank. The aggregate merger consideration consisted of 11,857,226 shares of Common Stock and $24.3 million in cash. The final transaction value was approximately $82.9 million based on the $4.94 per share closing price of the Common Stock on September 28, 2012. In addition, in connection with the merger, the preferred stock previously issued by Citizens South to the United States Department of the Treasury (the “Treasury”) in connection with Citizens South’s participation in the Small Business Lending Fund (“SBLF”) was converted into 20,500 shares of a substantially identical newly created series of our preferred stock, Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”). Citizens South contributed approximately $929.5 million in total assets, $683.4 million in total loans (including loans held for sale), $30.3 million in goodwill and intangibles, and $828.3 million in total deposits to the Company, after acquisition accounting fair market value adjustments.

The Company provides a full array of retail and commercial banking services, including wealth management, through its offices located in North Carolina, South Carolina, and Georgia. Our objective since inception has been to provide the strength and product diversity of a larger bank and the service and relationship attention that characterizes a community bank.

Non-GAAP Financial Measures

In addition to traditional measures, management uses tangible assets, tangible common equity, adjusted allowance for loan losses to loans, adjusted non interest expenses and adjusted net interest margin, and related ratios and per-share measures, each of which is a non-GAAP financial measure. Management uses (i) tangible assets and tangible common equity (which exclude goodwill and other intangibles from equity and assets) and related ratios to evaluate the adequacy of shareholders' equity and to facilitate comparisons with peers; (ii) adjusted allowance for loan losses (which includes acquisition accounting fair market value adjustments related to acquired loans) and related ratios to evaluate both its asset quality and asset quality trends, and to facilitate comparisons with peers; and (iii) adjusted noninterest expense (which excludes merger-related expenses and gain on sale of securities, as applicable) and adjusted net interest margin (which excludes accelerated mark accretion) to evaluate its core earnings and to facilitate comparisons with peers.

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The following table presents these non-GAAP financial measures and provides a reconciliation of these non-GAAP measures to the most directly comparable GAAP measure reported in the unaudited condensed consolidated financial statements:

Reconciliation of Non-GAAP Financial Measures
	June 30,			December 31,
	2013			2012
	(Unaudited)			(Unaudited)
	(dollars in thousands)
Tangible common equity to tangible assets
Total assets (as reported)	$	1,972,923		$	2,032,794
Less: intangible assets		(33,860	)		(34,375	)
Tangible assets	$	1,939,063		$	1,998,419
Total equity (as reported)	$	277,057		$	275,702
Less: preferred stock		(20,500	)		(20,500	)
intangible assets		(33,860	)		(34,375	)
Tangible common equity	$	222,697		$	220,827
Tangible common equity		222,697			220,827
Divided by: tangible assets		1,939,063			1,998,419
Tangible common equity to tangible assets		11.48	%		11.05	%
Total equity to total assets		14.04	%		13.56	%
Adjusted allowance for loan losses
Allowance for loan losses (as reported)	$	10,847		$	10,591
Plus: acquisition accounting FMV adjustments to acquired loans		44,179			53,719
Adjusted allowance for loan losses	$	55,026		$	64,310
Divided by: total loans (excluding LHFS)		1,304,659			1,356,707
Adjusted allowance for loan losses to total loans		4.22	%		4.74	%
Allowance for loan losses to total loans		0.83	%		0.78	%
	Three months ended						Six months ended
	June 30,			June 30,			June 30,			June 30,
	2013			2012			2013			2012
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
	(dollars in thousands)
Adjusted net interest margin
Net interest income (as reported)	$	18,671		$	10,100		$	36,407		$	21,819
Less: accelerated mark accretion		(560	)		(277	)		(560	)		(1,746	)
Adjusted net interest income		18,111			9,823			35,847			20,073
Divided by: average earning assets		1,742,312			1,012,570			1,737,276			1,013,165
Multiplied by: annualization factor		4.01			4.02			2.02			2.01
Adjusted net interest margin		4.17	%		3.90	%		4.16	%		3.98	%
Net interest margin		4.30	%		4.01	%		4.23	%		4.33	%
Adjusted noninterest expense
Noninterest expense (as reported)	$	16,922		$	10,835		$	32,953		$	21,838
Less: merger-related expenses		(822	)		(434	)		(1,658	)		(1,364	)
Adjusted noninterest expense	$	16,100		$	10,401		$	31,295		$	20,474

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Recent Accounting Pronouncements

See Note 2 to the Unaudited Financial Statements for a description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.

Critical Accounting Policies and Estimates

In the preparation of our financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States (“GAAP”) and in accordance with general practices within the banking industry. Our significant accounting policies are described in Note 2 – Summary of Significant Accounting Policies to the Company’s audited consolidated financial statements and accompanying notes (the “2012 Audited Financial Statements”) included in the 2012 Form 10-K. While all of these policies are important to understanding our financial statements, certain accounting policies described below involve significant judgment and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and assumptions that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

Purchased Credit-Impaired Loans.Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered credit impaired. Evidence of credit quality deterioration as of the purchase date may include statistics such as internal risk grade, past due and nonaccrual status, recent borrower credit scores and recent loan-to-value (“LTV”) percentages. PCI loans are initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, the associated allowance for credit losses related to these loans is not carried over at the acquisition date. We estimated the cash flows expected to be collected at acquisition using specific credit review of certain loans, quantitative credit risk, interest rate risk and prepayment risk models, and qualitative economic and environmental assessments, each of which incorporated our best estimate of current key relevant factors, such as property values, default rates, loss severity and prepayment speeds.

Under the accounting guidance for PCI loans, the excess of cash flows expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan, or pool of loans, in situations where there is a reasonable expectation about the timing and amount of cash flows to be collected. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is available to absorb future charge-offs.

In addition, subsequent to acquisition, we periodically evaluate our estimate of cash flows expected to be collected. These evaluations, performed quarterly, require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. In the current economic environment, estimates of cash flows for PCI loans require significant judgment given the impact of home price and property value changes, changing loss severities, prepayment speeds and other relevant factors. Decreases in the expected cash flows will generally result in a charge to the provision for credit losses resulting in an increase to the allowance for loan losses. Significant increases in the expected cash flows will generally result in an increase in interest income over the remaining life of the loan, or pool of loans. In pools where impairment has already been recognized, an increase in cash flows will result in a reversal of prior impairment.Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.

PCI loans currently represent loans acquired from Community Capital and Citizens South that were deemed credit impaired. PCI loans that were classified as nonperforming loans by Community Capital or Citizens South are no longer classified as nonperforming so long as, at acquisition and quarterly re-estimation periods, we believe we will fully collect the new carrying value of these loans. It is important to note that judgment regarding the timing and amount of cash flows to be collected is required to classify PCI loans as performing, even if the loan is contractually past due.

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Allowance for Loan Losses.The allowance for loan losses is based upon management's ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic and market conditions, independent loan reviews performed periodically by third parties, portfolio trends and concentrations, delinquency information, management's internal review of the loan portfolio, internal historical loss rates and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management's assessment of their differing inherent loss characteristics, the entire allowance for losses on loans, other than the portions related to PCI loans and specific reserves on impaired loans, is available to absorb further loan losses in any segment. Additional information regarding our policies and methodology used to estimate the allowance for possible loan losses is presented in Note 5 – Loans and Allowance for Loan Losses to the 2012 Audited Financial Statements, and Note 5 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements included in this Form 10-Q.

Income Taxes.Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of deferred tax assets (“DTAs”) and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, we record a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements.

As of June 30, 2013 and December 31, 2012, we had a net DTA in the amount of approximately $42.3 million and $42.6 million, respectively. We evaluate the carrying amount of our DTA quarterly in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If our forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Based on the weight of available evidence, including the continued improvement in earnings, we have determined that it is more likely than not that we will be able to fully realize the existing DTA. Accordingly, we consider it appropriate not to establish a DTA valuation allowance at either June 30, 2013 or December 31, 2012.

Additional information regarding our income taxes, including the methodology used to determine the need for a valuation allowance for the existing DTA, if any, is presented in Note 8 —Income Taxes to the Unaudited Financial Statements.

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Financial Condition at June 30, 2013 and December 31, 2012

Total assets of $1.97 billion at June 30, 2013 decreased $59.9 million from total assets of $2.03 billion at December 31, 2012. During the six months ended June 30, 2013, cash, interest-earning balances and Federal funds sold decreased $71.4 million, or 38.8%, loans decreased $52.3 million, or 3.9%, and non-marketable equity securities decreased $1.5 million, or 20%, while investment securities available-for-sale increased $84.1 million, or 34.3%. These decreases resulted from the redeployment of funds into the securities portfolio, which totaled $329.7 million at June 30, 2013, and to reduce higher-priced deposits.

Total liabilities of $1.7 billion at June 30, 2013 were relatively unchanged compared to $1.8 billion at December 31, 2012. Total deposits decreased $38.9 million, or 2.4% and total borrowings decreased $22.7 million, or 22.3%, during the first six months of 2013. Total borrowings included $6.9 million in Tier 2-eligible subordinated debt at June 30, 2013 and December 31, 2012, and $14.9 million and $14.7 million of Tier 1-eligible subordinated debt (after acquisition accounting fair market value adjustments) at June 30, 2013 and December 31, 2012, respectively.

Total shareholders’ equity increased $1.4 million, or 0.5%, during the first half of 2013 to $277.1 million at June 30, 2013. This increase was the result of net income before preferred dividends for the six months ended June 30, 2013 of $7.1 million, and $1.0 million of net share-based compensation expense, offset by a $6.4 million decrease in accumulated other comprehensive income from unrealized securities losses and $353 thousand of preferred stock dividends.

The following table presents selected ratios for the Company for the six months ended June 30, 2013 and 2012 and for the year ended December 31, 2012:

Selected Ratios
	Six months ended June 30, (annualized)		Twelve months ended December 31,
	2013	2012	2012
Return on Average Assets	0.68%	0.43%	0.32%
Return on Average Equity	4.82%	2.50%	1.99%
Period End Equity to Total Assets	14.04%	17.35%	13.56%
Tangible Common Equity to Tangible Assets*	11.48%	17.02%	11.05%

*Non-GAAP financial measure. See “Reconciliation of Non-GAAP Financial Measures”

Investments and Other Interest-earning Assets

Investment securities increased $84.1 million, or 34.2%, to $329.7 million at June 30, 2013, from $245.6 million at December 31, 2012. Purchases of investment securities available-for-sale were $143.6 million for the six months ended June 30, 2013. Proceeds from the sales, calls, and maturities of investment securities available-for-sale totaled $49.0 million for the six months ended June 30, 2013. Our investment portfolio consists of U.S. government agency securities, small business administration pools, residential agency and commercial mortgage-backed securities, collateralized agency mortgage-backed securities, municipal securities and other debt instruments. At June 30, 2013, our investment portfolio had a net unrealized loss of $5.1 million compared to a $5.1 million net unrealized gain at December 31, 2012 due to movements in market rates. There were no securities with an unrealized loss deemed to be other than temporary at June 30, 2013 or December 31, 2012.

At June 30, 2013, we had $0.5 million in federal funds sold, $100.3 million in deposits with the Federal Reserve Bank and $0.05 million in interest-bearing deposits with other FDIC-insured financial institutions. This compares with $46.0 in federal funds sold, $89.7 million in deposits with the Federal Reserve Bank and $11.7 million in interest-bearing deposits at other FDIC-insured financial institutions at December 31, 2012.

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Loans

We consider asset quality to be of primary importance, and employ seasoned credit professionals and documented processes to ensure effective oversight of credit approvals and asset quality monitoring. Our internal loan policy is reviewed by our board of directors’ Loan and Risk Committee on an annual basis and our underwriting guidelines are reviewed and updated on a periodic basis. A formal loan review process is maintained both to ensure adherence to lending policies and to ensure accurate loan grading and is reviewed by our board of directors twice annually. Since inception, we have promoted the separation of loan underwriting from the loan production staff through our credit department. Currently, credit administration analysts are responsible for underwriting and assigning proper risk grades for all loans with an individual, or relationship, exposure in excess of $500 thousand. Underwriting is completed on standardized forms including a loan approval form and separate credit memorandum. The credit memorandum includes a summary of the loan's structure and a detailed analysis of loan purpose, borrower strength (including individual and global cash flow worksheets), repayment sources and, when applicable, collateral positions and guarantor strength. The credit memorandum further identifies exceptions to policy and/or regulatory limits, total exposure, internal risk grades and other relevant credit information. Loans are approved or denied by varying levels of signature authority based on total customer relationship exposure, with a minimum requirement of at least two authorized signatures. A management-level loan committee is responsible for approving all credits in excess of the chief credit officer’s lending authority, which was increased in March 2013 from $1 million to $3 million.

Our loan underwriting policy contains LTV limits that are at or below levels required under regulatory guidance, when such guidance is available, including limitations for non-real estate collateral, such as accounts receivable, inventory and marketable securities. When applicable, we compare LTV with loan-to-cost guidelines and ultimately limit loan amounts to the lower of the two ratios. We also consider FICO scores and strive to uphold a high standard when extending loans to individuals. LTV limits have been selectively reduced in response to the recent economic cycle. In particular, loans collateralized with 1-4 family properties have seen a reduction in their maximum LTV. We have not underwritten any subprime, hybrid, no-documentation or low-documentation products.

All residential acquisition, construction and development (“AC&D”) loans, whether related to commercial or consumer borrowers, are subject to policies, guidelines and procedures specifically designed to properly identify, monitor and mitigate the risk associated with these loans. Loan officers receive and review a cost budget from the borrower at the time an AC&D loan is originated. Loan draws are monitored against the budgeted line items during the development period in order to identify potential cost overruns. Individual draw requests are verified through review of supporting invoices as well as site inspections performed by an external inspector. Additional periodic site inspections are performed by loan officers at times that do not coincide with draw requests in order to keep abreast of ongoing project conditions. Our exposure to AC&D loans has declined significantly since inception of the Bank and current loan origination is focused in 1 – 4 family residential construction for pre-sold homes. Concentrations as a percent of capital are reported to the board of directors on a quarterly basis. Market conditions for AC&D loans improved in 2012 due to increasing new home sales in our primary markets. As of June 30, 2013, approximately 7% of our AC&D loan portfolio, commercial and consumer, falls under the watch list.

Our second mortgage exposure is primarily attributable to our home equity lines of credit (“HELOC”) portfolio, which totaled approximately $149 million as of June 30, 2013, of which approximately 76% is secured by second mortgages and approximately 24% is secured by first mortgages.

All loans are assigned an internal risk grade and are reviewed continuously for payment performance and updated through annual portfolio reviews. Loans on the Bank’s watch list are monitored through quarterly watch meetings and monthly impairment meetings. Classified loans are generally managed by a dedicated special asset team who is experienced in various loan rehabilitation and work out practices. Special asset loans are generally managed with a least-loss strategy.

At June 30, 2013, total loans, net of deferred fees and costs, decreased $52.0 million compared to December 31, 2012. This decline was driven by a $33 million decline in acquired PCI loans. The composition of the portfolio remained unchanged from December 31, 2012 with commercial loans representing 69% of the total loan portfolio and consumer loans representing 31% of the total loan portfolio at June 30, 2013.

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Asset Quality and Allowance for Loan Losses

The allowance for loan losses is based upon management's ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic and market conditions, independent loan reviews performed periodically by third parties, portfolio trends and concentrations, delinquency information, management's internal review of the loan portfolio, internal historical loss rates and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management's assessment of their differing inherent loss characteristics, the entire allowance for losses on loans, other than that portion related to PCI loans, is available to absorb further loan losses in any segment. 

Our Allowance for Loan Losses Committee (the “Allowance Committee”) is responsible for overseeing our allowance and works with our chief executive officer, senior financial officers, senior risk management officers and the Audit Committee of the board of directors in developing and achieving our allowance methodology and practices. The Company’s allowance for loan loss methodology includes four components – specific reserves, quantitative reserves, qualitative reserves and qualitative reserves on PCI loans. We introduced certain enhancements to our allowance methodology during the fourth quarter of 2011, and further refinements were implemented during the second quarter of 2012. Additional information about the four components and our policies and methodology used to estimate the allowance for loan losses are presented in Note 5 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements.

The following table provides a breakdown of the components of our allowance for loan losses by loan segment and its contribution to the allowance at June 30, 2013:

Allowance Allocation by Component 

	Specific Reserve					Quantitative Reserve					Qualitative Reserve					PCI Reserve
	$		% of Total Allowance			$		% of Total Allowance			$		% of Total Allowance			$		% of Total Allowance
	(dollars in thousands)
Commercial:
Commercial and industrial	$	321		2.96	%	$	1,083		9.98	%	$	181		1.67	%	$	216		1.99	%
CRE - owner-occupied		-		0.00	%		278		2.56	%		65		0.60	%		-		0.00	%
CRE - investor income producing		203		1.87	%		1,029		9.49	%		187		1.72	%		1		0.01	%
AC&D		64		0.59	%		3,765		34.71	%		101		0.93	%		445		4.10	%
Other commercial		-		0.00	%		3		0.03	%		1		0.01	%		-		0.00	%
Consumer:									0.00	%
Residential mortgage		130		1.20	%		92		0.85	%		45		0.41	%		394		3.63	%
Home equity lines of credit		261		2.41	%		805		7.42	%		245		2.26	%		3		0.03	%
Residential construction		-		0.00	%		439		4.05	%		79		0.73	%		289		2.66	%
Other loans to individuals		-		0.00	%		74		0.68	%		12		0.11	%		36		0.33	%
	$	979		9.03	%	$	7,568		69.77	%	$	916		8.44	%	$	1,384		12.76	%

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The allowance for loan losses is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The ratio of the allowance for loan losses to total loans was 0.83% and 0.78% at June 30, 2013 and December 31, 2012, respectively. The increase from December is the result of higher levels of specific reserves on loans reviewed for impairment and deemed impaired and additional PCI impairment in the first six months of 2013. The ratio of the adjusted allowance for loan losses to total loans, which includes the remaining acquisition accounting fair market value adjustments for acquired loans, was 4.22% at June 30, 2013 and 4.73% at December 31, 2012. In accordance with GAAP, loans acquired from both Community Capital and Citizens South were adjusted to reflect estimated fair market value at consummation and the associated allowance for loan losses was eliminated. Adjusted allowance for loan losses to loans is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

While management believes that it uses the best information available to determine the allowance for loan losses, and that its allowance for loan losses is maintained at a level appropriate in light of the risk inherent in our loan portfolio based on an assessment of various factors affecting the loan portfolio, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. The allowance for loan losses to total loans may increase if our loan portfolio deteriorates due to economic conditions or other factors.

We evaluate and estimate off-balance sheet credit exposure at the same time we estimate credit losses for loans by a similar process, including an estimate of commitment usage levels. These estimated credit losses are not recorded as part of the allowance for loan losses, but are recorded to a separate liability account by a charge to income, if material. Loan commitments, unused lines of credit and standby letters of credit make up the off-balance sheet items reviewed for potential credit losses. At June 30, 2013 and December 31, 2012, $125 thousand was recorded as an other liability for off-balance sheet credit exposure.

Nonperforming Assets

Nonperforming assets, which consist of nonaccrual loans, accruing TDRs, accruing loans for which payments are 90 days or more past due, nonaccrual loans held for sale and OREO, totaled $31.1 million at June 30, 2013 compared to $42.9 million at December 31, 2012. OREO, in particular, declined $8.8 million as a result of successful dispositions. Nonperforming loans, which consist of nonaccrual loans, accruing TDRs and accruing loans for which payments are 90 days or more past due, decreased $3.0 million, or 17%, to $14.8 million, or 1.13% of total loans and OREO at June 30, 2013, compared to $17.8 million, or 1.31% of total loans at December 31, 2012.

It is our general policy to place a loan on nonaccrual status when it is over 90 days past due and there is reasonable doubt that all principal and interest will be collected. Nonaccrual loans decreased $3.5 million, or 34%, in the first half of 2013 from $10.4 million at December 31, 2012. Nonaccrual TDRs are included in the nonaccrual loan amounts noted. At June 30, 2013, nonaccrual TDR loans were $0.3 million and had no recorded allowance. At December 31, 2012, nonaccrual TDR loans were $2.8 million and had no recorded allowance. Accruing TDRs totaled $7.8 million and $7.4 million at June 30, 2013 and December 31, 2012, respectively.

We grade loans with an internal risk grade scale of 10 through 90, with grades 10 through 50 representing “pass” loans, grade 60 representing “special mention” and grades 70 and higher representing “classified” credit grades, respectively. Loans are reviewed on a regular basis internally, and at least twice annually by an external loan review group, to ensure loans are graded appropriately. Credits are reviewed for past due trends, declining cash flows, significant decline in collateral value, weakened guarantor financial strength, management concerns, market conditions and other factors that could jeopardize the repayment performance of the loan. Documentation deficiencies including collateral perfection and outdated or inadequate financial information are also considered in grading loans.

All loans graded 60 or worse are included on our list of “watch loans,” which represent potential problem loans, and are updated and reported to both management and the Loan and Risk Committee of the board of directors quarterly. Additionally, the watch list committee may review other loans with more favorable ratings if there are concerns that the loan may become a problem. Impairment analyses are performed on all loans graded “substandard” (risk grade of 70 or worse) and selected other loans as deemed appropriate. At June 30, 2013, we maintained watch loans totaling $31.7 million compared to $44.4 million at December 31, 2012. Approximately $8 million and $9 million of the watch loans at June 30, 2013 and December 31, 2012, respectively, were acquired loans. The future level of watch loans cannot be predicted, but rather will be determined by several factors, including overall economic conditions in the markets served.

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At June 30, 2013, OREO totaled $16.3 million, all of which is recorded at values based on our most recent appraisals. Included in that total is $6.5 million of OREO covered under FDIC loss share agreements assumed by the Bank in connection with the Citizens South merger. At December 31, 2012, OREO totaled $25.1 million, all of which is recorded at values based on our most recent appraisals. Included in that total is $6.6 million of OREO covered under the FDIC loss share agreements.

Deposits and Other Borrowings

We offer a broad range of deposit instruments, including personal and business checking accounts, individual retirement accounts, business and personal money market accounts and certificates of deposit at competitive interest rates. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. We regularly evaluate the internal cost of funds, survey rates offered by competing institutions, review cash flow requirements for lending and liquidity and execute rate changes when deemed appropriate.

Total deposits at June 30, 2013 were $1.59 billion, a decrease of $38.9 million, or 2.4%, from December 31, 2012. Noninterest bearing demand deposits increased $21.8 million, or 8.9%, and represented 16% of total deposits at June 30, 2013. Money market, NOW and savings deposits decreased $15.0 million, or 2.0%, primarily as a result of a decrease in rates paid to depositors during the first six months of 2013. Non-brokered time deposits decreased $33.1 million, or 6.4%. Finally, brokered deposits decreased $12.6 million, or 11.4%. The decreases in time deposits are due to normal runoff as well as management’s decision to keep rates unchanged in an effort to de-lever as a result of increased liquidity during the period. The following is a summary of deposits at June 30, 2013 and December 31, 2012 (dollars in thousands):

	June 30,		December 31,
	2013		2012
Noninterest bearing demand deposits	$	265,246	$	243,495
Interest-bearing demand deposits		287,934		323,037
Money market deposits		407,273		388,809
Savings		48,584		46,917
Brokered deposits		98,436		111,049
Time deposits		485,632		518,697
Total deposits	$	1,593,105	$	1,632,004

Total borrowings decreased $22.7 million, or 22.3%, to $79.0 million at June 30, 2013 compared to $101.7 million at December 31, 2012. Total borrowings at December 31, 2012 included $15.0 million of short-term FHLB advances used for year-end liquidity needs. These borrowings were repaid in January 2013. Borrowings at June 30, 2013 include $14.9 million (after acquisition accounting fair market value adjustments) of Tier 1-eligible subordinated debt and $6.9 million of Tier 2-eligible subordinated debt.

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Results of Operations

The following table summarizes components of net income and the changes in those components for the three and six months ended June 30, 2013 and 2012:

Condensed Consolidated Statements of Income

	Three Months Ended June 30,										Six Months Ended June 30,
	2013		2012		Change						2013		2012		Change
	(Unaudited)				$			%			(Unaudited)				$			%
	(Dollars in thousands)										(Dollars in thousands)
Gross interest income	$	20,144	$	11,642	$	8,502			73.0	%	$	39,467	$	25,039	$	14,428			57.6	%
Gross interest expense		1,473		1,542		(69	)		-4.5	%		3,060		3,220		(160	)		-5.0	%
Net interest income		18,671		10,100		8,571			84.9	%		36,407		21,819		14,588			66.9	%
Provision for loan losses		75		899		(824	)		-91.7	%		384		1,022		(638	)		-62.4	%
Noninterest income		4,106		2,563		1,543			60.2	%		7,674		4,518		3,156			69.9	%
Noninterest expense		16,922		10,835		6,087			56.2	%		32,953		21,838		11,115			50.9	%
Net income before taxes		5,780		929		4,851			522.2	%		10,744		3,477		7,267			209.0	%
Income tax expense		1,968		251		1,717			684.1	%		3,692		1,076		2,616			243.1	%
Net income		3,812		678		3,134			462.2	%		7,052		2,401		4,651			193.7	%
Preferred dividends		302		-		302			100.0	%		353		-		353			100.0	%
Net income to common shareholders	$	3,510	$	678	$	2,832			417.7	%	$	6,699	$	2,401	$	4,298			179.0	%

Net Income to common shareholders.Net income to common shareholders for the three months ended June 30, 2013 was $3.5 million compared to $0.7 million for the same period in 2012. Net income available to common shareholders for the six months ended June 30, 2012, was $6.7 million compared to $2.4 million for the same period in 2012. The increases in net income in both the three and six month periods were the result of increased earning assets, higher net interest margin and higher noninterest income associated with the merger with Citizens South, combined with continued organic growth offset, in the six month period, by the accelerated accretion of income associated with the acquired loan portfolio.

Annualized return on average assets improved during the six-month period ended June 30, 2013 to 0.68% from 0.43% for the same period in 2012. Annualized return on average equity also improved from 2.50% for the six-month period ended June 30, 2012, to 4.82% for the same period in 2013.

Net Interest Income.Our largest source of earnings is net interest income, which is the difference between interest income on interest-earning assets and interest paid on deposits and other interest-bearing liabilities. The primary factors that affect net interest income are changes in volume and yields of earning assets and interest-bearing liabilities, which are affected, in part, by management's responses to changes in interest rates through asset/liability management. Net interest income increased to $18.7 million for the three-month period ended June 30, 2013 from $10.1 million for the same period in 2012. During the six-month period ended June 30, 2013, net interest income was $36.4 million as compared to $21.8 million in 2012, an increase of $14.6 million, or 66.9%. These increases are driven by the merger with Citizens South on October 1, 2012.

Net interest income for the three-month and six-month periods ended June 30, 2013 also includes $0.6 million of accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments for purchased performing loans, as accounted for under the contractual cash flow method of accounting. The three-month and six-month periods ended June 30, 2012 include $0.3 million and $1.7 million, respectively, of accelerated accretion. This accelerated accretion, which was not anticipated at the time of the acquisition, resulted from a combination of (i) borrowers repaying loans faster than required by their contractual terms; and (ii) customer driven restructuring related to loan rates and/or terms which effectively result in a new loan under the contractual cash flow method of accounting. In both instances, the remaining acquisition accounting fair value marks associated with the loan are fully accreted into interest income.

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Our net interest margin increased from 4.01% in the three-month period ended June 30, 2012 to 4.30% in the corresponding period in 2013. The increase in net interest margin reflects the inclusion of the Citizens South loan portfolio, increased accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments and reduced funding costs due, primarily, to lower pricing on interest bearing deposits. Our net interest margin decreased from 4.33% in the six-month period ended June 30, 2012 to 4.23% in the corresponding period in 2013. This decrease in net interest margin reflects the decreased accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments and reduced funding costs due, primarily, to lower pricing on interest bearing deposits.

Our adjusted net interest margin, which excludes the accelerated accretion discussed above, for the three-month periods ended June 30, 2013 and 2012 were 4.17% and 3.90%, respectively. For the six-month periods ended June 30, 2013 and 2012, our adjusted net interest margin was 4.16% and 3.98%, respectively. Adjusted net interest margin is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

Total average interest-earning assets increased by $729.7 million, or 72%, to $1.7 billion for the three months ended June 30, 2013 from $1.1 billion for the same period in the previous year. Total average interest-earning assets increased by $724.1 million, or 71%, to $1.7 billion for the six months ended June 30, 2013 from $1.0 billion for the same period in the previous year. This increase was driven primarily by the addition of Citizens South assets following the merger on October 1, 2012.

Average balances of total interest-bearing liabilities increased in the three-month period ended June 30, 2013, with average total interest-bearing deposit balances increasing by $648.2 million, or 85%, to $1.4 billion from $758.5 million for the same period in 2012. Average brokered deposits for the three months ended

June 30, 2013 decreased by $45.0 million from the corresponding period in 2012. Average interest-bearing liabilities increased $654.3 million, or 85%, in the first six months of 2013 from $768.9 million for the same period in 2012 to $1.4 million. Average brokered deposits for the six months ended June 30, 2013 decreased by $41.5 million from the corresponding period in 2012. The increases in interest-bearing deposits are a result of the acquisition of Citizens South; the decreases in brokered deposits is a function of management electing not to renew maturing certificates in an effort to reduce reliance on brokered deposits.

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The following tables summarize net interest income and average yields and rates paid for the periods indicated (dollars in thousands):

Average Balance Sheets and Net Interest Analysis

	For the Three Months Ended June 30,
	2013								2012
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Interest-earning assets:
Loans, including fees (1)(2)	$	1,337,318		$	18,805		5.64	%	$	729,163		$	10,416		5.75	%
Federal funds sold		12,330			7		0.23	%		26,438			15		0.23	%
Taxable investment securities		284,775			1,068		1.50	%		210,435			969		1.84	%
Tax-exempt investment securities		17,583			195		4.44	%		17,693			186		4.21	%
Other interest-earning assets		90,306			69		0.31	%		28,841			56		0.78	%
Total interest-earning assets		1,742,312			20,144		4.64	%		1,012,570			11,642		4.62	%
Allowance for loan losses		(11,736	)							(9,135	)
Cash and due from banks		14,315								15,023
Premises and equipment		57,292								24,470
Other assets		165,553								84,103
Total assets	$	1,967,736							$	1,127,031
Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand	$	285,697		$	62		0.09	%	$	83,927		$	69		0.33	%
Savings and money market		445,158			317		0.29	%		240,370			264		0.44	%
Time deposits - core		493,995			313		0.25	%		217,837			378		0.70	%
Time deposits - brokered		102,716			215		0.84	%		147,685			342		0.93	%
Total interest-bearing deposits		1,327,566			907		0.27	%		689,819			1,053		0.61	%
Federal Home Loan Bank advances		55,000			137		1.00	%		55,000			148		1.08	%
Other borrowings		24,187			429		7.11	%		13,685			341		10.02	%
Total borrowed funds		79,187			566		2.87	%		68,685			489		2.86	%
Total interest-bearing liabilities		1,406,753			1,473		0.42	%		758,504			1,542		0.82	%
Net interest rate spread					18,671		4.22	%					10,100		3.81	%
Noninterest-bearing demand deposits		256,383								160,744
Other liabilities		22,589								13,438
Shareholders' equity		282,011								194,345
Total liabilities and shareholders' equity	$	1,967,736							$	1,127,031
Net interest margin							4.30	%							4.01	%

(1) Average loan balances include nonaccrual loans.

(2) Interest income and yields include accretion from acquisition accounting adjustments associated with acquired loans.

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Average Balance Sheets and Net Interest Analysis

	For the Six Months Ended June 30,
	2013								2012
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Interest-earning assets:
Loans, including fees (1)(2)	$	1,341,937		$	36,945		5.55	%	$	737,798		$	22,526		6.14	%
Federal funds sold		29,112			24		0.17	%		19,777			23		0.23	%
Taxable investment securities		264,947			1,934		1.46	%		212,451			1,989		1.87	%
Tax-exempt investment securities		17,739			385		4.34	%		17,758			371		4.18	%
Other interest-earning assets		83,541			179		0.43	%		25,381			130		1.03	%
Total interest-earning assets		1,737,276			39,467		4.58	%		1,013,165			25,039		4.97	%
Allowance for loan losses		(11,726	)							(9,484	)
Cash and due from banks		22,172								15,563
Premises and equipment		57,340								24,489
Other assets		167,804								85,417
Total assets	$	1,972,866							$	1,129,150
Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand	$	294,887		$	153		0.10	%	$	81,249		$	96		0.24	%
Savings and money market		440,576			633		0.29	%		243,548			563		0.46	%
Time deposits - core		500,214			658		0.27	%		226,667			768		0.68	%
Time deposits - brokered		105,034			477		0.92	%		146,548			773		1.06	%
Total interest-bearing deposits		1,340,711			1,921		0.29	%		698,012			2,200		0.63	%
Federal Home Loan Bank advances		55,083			274		1.00	%		56,648			309		1.10	%
Other borrowings		27,462			865		6.35	%		14,275			711		10.02	%
Total borrowed funds		82,545			1,139		2.78	%		70,923			1,020		2.89	%
Total interest-bearing liabilities		1,423,256			3,060		0.43	%		768,935			3,220		0.84	%
Net interest rate spread					36,407		4.15	%					21,819		4.13	%
Noninterest-bearing demand deposits		248,370								152,755
Other liabilities		20,858								13,942
Shareholders' equity		280,382								193,518
Total liabilities and shareholders' equity	$	1,972,866							$	1,129,150
Net interest margin							4.23	%							4.33	%

(1) Average loan balances include nonaccrual loans.

(2) Interest income and yields include accretion from acquisition accounting adjustments associated with acquired loans.

Provision for Loan Losses. Our provision for loan losses decreased $824 thousand, or 91.7%, to $75 thousand during the three months ended June 30, 2013, from $899 thousand during the corresponding period in 2012. For the six months ended June 30, 2013, our provision decreased $638 thousand, or 62.4%, to $384 thousand from $1.0 million during the corresponding period in 2012. The decrease in provision, in all periods presented, is a result of both a reduction in outstanding loans and improvement in the quality of our loans in addition to a $297,000 benefit attributable to FDIC loss share agreements assumed from Citizens South caused by an increase in expected loss in those acquired loans. Generally, these additional losses are reflected as a provision for loan losses, and offset with an increase in the FDIC indemnification asset for those acquired loans covered by FDIC loss share agreements.

Included in the provision for loan losses for the three and six months ended June 30, 2013 was net impairment charges of $0.3 million and $0.8 million, respectively, associated with PCI loan pools. For the three and six months ended June 30, 2012, a net impairment charge of $0.2 million was recognized.

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We had $0.2 million in net charge-offs during the three months ended June 30, 2013 compared to $1.0 million during the corresponding period in 2012. Year to date net charge-offs in 2013 were $0.4 million compared to $1.7 million during the first six months of 2012.

Noninterest Income. The following table presents components of noninterest income for the three and six months ended June 30, 2013 and 2012:

Noninterest Income

	Three months ended June 30,										Six months ended June 30,
	2013		2012		Change						2013		2012		Change
	(Unaudited)							%			(Unaudited)							%
	(Dollars in thousands)
Service charges on deposit accounts	$	616	$	299	$	317			106.0	%	$	1,380	$	613	$	767			125.1	%
Income from fiduciary activities		731		661		70			10.6	%		1,439		1,260		179			14.2	%
Gain on sale of securities available for sale		104		489		(385	)		-78.7	%		104		489		(385	)		-78.7	%
Bankcard services income		830		223		607			272.2	%		1,428		451		977			216.6	%
Mortgage banking income		977		540		437			80.9	%		1,945		1,001		944			94.3	%
Income from bank-owned life insurance		528		260		268			103.1	%		909		519		390			75.1	%
Other noninterest income		320		91		229			251.6	%		469		185		284			153.5	%
Total noninterest income	$	4,106	$	2,563	$	1,543			60.2	%	$	7,674	$	4,518	$	3,156			69.9	%

As a result of the mergers with Community Capital in November 2011 and Citizens South in October 2012, noninterest income has become a key component of our earnings. Noninterest income increased $1.5 million to $4.1 million for the three months ended June 30, 2013 from $2.6 million for the three months ended June 30, 2012. Noninterest income increased $3.2 million to $7.7 million for the six months ended June 30, 2013 from $4.5 million for the six months ended June 30, 2012. In both periods, the results are due to (i) an increase in service charges on deposit accounts associated with expanded retail and commercial banking activities; (ii) an increase in income from fiduciary activities associated with new asset management, investment brokerage and trust services; (iii) an increase associated with expanded ATM and card services, and (iv) gains on sales of loans associated with new mortgage brokerage activities. In addition, income from bank-owned life insurance increased in both periods primarily as a result of the bank-owned life insurance acquired from Citizens South.

Noninterest Expense. The level of noninterest expense substantially affects our profitability. Total noninterest expense was $16.9 million for the three months ended June 30, 2013, an increase of 56.2% from $10.8 million for the corresponding period in 2012. Total noninterest expense was $33.0 million for the six months ended June 30, 2013, an increase of 50.9% from $11.1 million for the corresponding period in 2012. The increase in both periods was due to the inclusion of results from the Citizens South merger.

Excluding merger-related expenses of $822 thousand and $434 thousand for the three-month periods ended June 30, 2013 and 2012, respectively, noninterest expense increased $5.7 million for the three months ended June 30, 2013 compared to the corresponding period in 2012. Excluding merger-related expenses of $1.7 million and $1.4 million for the six-month periods ended June 30, 2013 and 2012, respectively, noninterest expense increased $10.8 million for the six months ended June 30, 2013 compared to the corresponding period in 2012. Adjusted noninterest expense, which excludes merger-related expenses, is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

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The following table presents components of noninterest expense for the three and six months ended June 30, 2013 and 2012:

Noninterest Expense

	Three months ended June 30,											Six months ended June 30,
	2013			2012		Change						2013			2012		Change
	(Unaudited)					$			%			(Unaudited)					$			%
	(Dollars in thousands)
Salaries and employee benefits	$	8,800		$	5,871	$	2,929			49.9	%	$	17,578		$	11,995	$	5,583			46.5	%
Occupancy and equipment		1,980			910		1,070			117.6	%		3,888			1,730		2,158			124.7	%
Advertising and promotion		150			108		42			38.9	%		370			269		101			37.5	%
Legal and professional fees		861			614		247			40.2	%		1,754			926		828			89.4	%
Deposit charges and FDIC insurance		409			250		159			63.6	%		896			541		355			65.6	%
Data processing and outside service fees		1,640			696		944			135.6	%		3,293			2,045		1,248			61.0	%
Communication fees		448			196		252			128.6	%		880			428		452			105.6	%
Core deposit intangible amortization		257			102		155			152.0	%		514			204		310			152.0	%
Net cost (earnings) of operation of other real estate owned		(36	)		809		(845	)		-104.4	%		(464	)		1,331		(1,795	)		-134.9	%
Loan and collection expense		679			295		384			130.2	%		1,005			539		466			86.5	%
Postage and supplies		298			124		174			140.3	%		627			320		307			95.9	%
Other tax expense		127			70		57			81.4	%		303			139		164			118.0	%
Other noninterest expense		1,309			790		519			65.7	%		2,309			1,371		938			68.4	%
Total noninterest expense	$	16,922		$	10,835	$	6,087			56.2	%	$	32,953		$	21,838	$	11,115			50.9	%

 

As a result of the merger with Citizens South on October 1, 2012, expenses in almost all categories increased for both the three and six-month periods ended June 30, 2013. The following discussion highlights specific areas but does not intend to represent all variances.

Salaries and employee benefits expenses increased $2.9 million, or 49.9%, to $8.8 million in the three months ended June 30, 2013 compared to $5.9 million in the comparable period of 2012. Salaries and employee benefits expenses increased $5.6 million, or 46.5%, to $17.6 million in the six months ended June 30, 2013 compared to $12.0 million in the comparable period of 2012. These increases are primarily due to the increase in number of employees resulting from the Citizens South merger.

Occupancy and equipment expenses increased $1.1 million, or 117.6%, to $1.9 million in the second quarter of 2013, compared to $910 thousand in the comparable period of 2012. Occupancy and equipment expenses increased $2.2 million, or 124.7%, to $3.9 million in the first half of 2013, compared to $1.7 million in the comparable period of 2012. The increase is primarily due to the acquisition of property in connection with the merger with Citizens South.

Legal and professional fees increased $247 thousand, or 40.2%, to $861 thousand in the second quarter of 2013, compared to $614 thousand in the comparable period of 2012. Legal and professional fees increased $828 thousand, or 89.4%, to $1.8 million in the first half of 2013, compared to $926 thousand in the comparable period of 2012. Merger-related expenses included in these results for the second quarters of 2013 and 2012 were $223 thousand and $419 thousand, respectively. Merger-related expenses included in the results for the six-months ended June 30, 2013 and 2012 were $503 thousand and $643 thousand, respectively. The increase is primarily due to fees associated with the mergers with Citizens South and Community Capital related to merger integration as well as core systems integration.

We realized a net gain on operation of other real estate during the second quarter of 2013 of $36 thousand. This represents a decrease of $845 thousand, or 104.4%, when compared to the comparable period of 2012. We realized a net gain on operation of other real estate during the six months ended June 30, 2013 of $464 thousand compared to a net cost of $1.3 million for the comparable period in 2012. We have sold over 150 properties during the first six months of 2013 at a net gain of approximately $1.4 million compared to 42 properties in the first six months of 2012 at a net gain of approximately $159 thousand.

Income Taxes. We generate non-taxable income from tax-exempt investment securities and loans as well as bank-owned life insurance. Accordingly, the level of such income in relation to income before taxes affects our effective tax rate. For the three months ended June 30, 2013, we recognized income tax expense of $2.0 million compared to an income tax expense of $0.3 million for the same period in 2012. The effective tax rate for the three months ended June 30, 2013 is 34.05% compared to 27.02% for the same period in 2012. For the six months ended June 30, 2013, we recognized income tax expense of $3.7 million compared to an income tax expense of $1.1 million for the same period in 2012. The effective tax rate for the six months ended June 30, 2013 is 34.36% compared to 30.95% for the same period in 2012. The change in the effective tax rate was due to the amount of tax-exempt income and nondeductible merger-related expenses relative to the size of pre-tax income. A tax benefit is recorded if non-taxable income exceeds income before taxes, resulting in a reduction of total income subject to income taxes.

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Liquidity and Capital Resources

Liquidity refers to the ability to manage future cash flows to meet the needs of depositors and borrowers and to fund operations. We strive to maintain sufficient liquidity to fund future loan demand and to satisfy fluctuations in deposit levels. This is achieved primarily in the form of available lines of credit from various correspondent banks, the FHLB, the Federal Reserve Discount Window and through our investment portfolio. In addition, we may have short-term investments at our primary correspondent bank in the form of Federal funds sold. Liquidity is governed by an asset/liability policy approved by the board of directors and administered by an internal Senior Management Risk Committee (the “Senior Risk Committee”). The Senior Risk Committee reports monthly asset/liability-related matters to the Loan and Risk Committee of the board of directors.

Our internal liquidity ratio (total liquid assets, or cash and cash equivalents, divided by deposits and short-term liabilities) at June 30, 2013 was 23.9% compared to 22.0% at December 31, 2012. Both ratios exceeded our minimum internal target of 10%. In addition, at June 30, 2013, we had $247.4 million of credit available from the FHLB, $146.9 million from the Federal Reserve Discount Window, and available lines totaling $70.0 million from correspondent banks.

At June 30, 2013, we had $267.0 million of pre-approved but unused lines of credit, $3.5 million of standby letters of credit and $4.1 million of commercial letters of credit. In management’s opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity.

Our capital position is reflected in our shareholders’ equity, subject to certain adjustments for regulatory purposes. Shareholders’ equity, or capital, is a measure of our net worth, soundness and viability. We continue to remain in a well-capitalized position. Shareholders’ equity on June 30, 2013 was $277.1 million compared to the December 31, 2012 balance of $275.7 million. The $1.4 million increase was the result of net income before preferred dividends for the six months ended June 30, 2013 of $7.1 million, and $1.0 million of net share-based compensation expense, offset by a $6.4 million decrease in accumulated other comprehensive income from unrealized securities losses and $353 thousand of preferred stock dividends.

Risk-based capital regulations adopted by the Federal Reserve Board and the FDIC require bank holding companies and banks to achieve and maintain specified ratios of capital to risk-weighted assets. The risk based capital rules are designed to measure “Tier 1” capital (currently consisting generally of common shareholders’ equity, a limited amount of qualifying perpetual preferred stock and trust preferred securities, and minority interests in consolidated subsidiaries, net of goodwill and other intangible assets, deferred tax assets in excess of certain thresholds and certain other items) and total capital (consisting of Tier 1 capital and Tier 2 capital, which generally includes certain preferred stock, mandatorily convertible debt securities and term subordinated debt) in relation to the credit risk of both on- and off-balance sheet items. Under the existing guidelines, one of four risk weights is applied to the different on-balance sheet items. Off-balance sheet items, such as loan commitments, are also subject to risk weighting after conversion to balance sheet equivalent amounts. Under current regulations, all banks must maintain a minimum total capital to total risk weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital. These guidelines also specify that banks that are experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels. At June 30, 2013, the Company and the Bank both satisfied their minimum regulatory capital requirements and each was “well capitalized” within the meaning of Federal regulatory requirements.

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Capital Ratios

							Regulatory Minimums
							For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Actions Provisions
	June 30, 2013			December 31, 2012			Ratio			Ratio
Park Sterling Corporation
Tier 1 capital	$	225,388		$	219,060
Tier 2 capital		17,742			17,611
Total capital	$	243,130		$	236,671
Risk-weighted assets	$	1,399,273		$	1,451,532
Average assets for Tier 1	$	1,894,989		$	1,947,156
Risk-based capital ratios
Tier 1 capital		16.11	%		15.09	%		4.00	%		6.00	%
Total capital		17.38	%		16.30	%		8.00	%		10.00	%
Tier 1 leverage ratio		11.89	%		11.25	%		4.00	%		5.00	%
Park Sterling Bank
Tier 1 capital	$	199,899		$	193,018
Tier 2 capital		17,742			17,611
Total capital	$	217,641		$	210,629
Risk-weighted assets	$	1,394,843		$	1,446,233
Average assets for Tier 1	$	1,877,861		$	1,913,420
Risk-based capital ratios
Tier 1 capital		14.33	%		13.35	%		4.00	%		6.00	%
Total capital		15.60	%		14.56	%		8.00	%		10.00	%
Tier 1 leverage ratio		10.65	%		10.09	%		4.00	%		5.00	%

The Bank has committed to its regulators to maintain a Tier 1 leverage ratio, calculated as Tier 1 capital to average assets, of at least 10.00% for the three years following the Bank’s public offering. This commitment expires August 18, 2013. In addition, the Company currently is evaluating the possible redemption of its $20.5 million of Series C Preferred Stock which was assumed in the merger with Citizens South, subject to applicable regulatory and Board of Director approvals.

In July 2013, the federal banking regulatory agencies approved final regulatory capital rules applicable to U.S. banking organizations (the “Final Rules”) which will replace the existing general risk-based capital and related rules, broadly revising the basic definitions and elements of regulatory capital and making substantial changes to the credit risk weightings for banking and trading book assets. The new regulatory capital rules establish the benchmark capital rules and capital floors that are generally applicable to U.S. banks under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and make the capital rules consistent with heightened international capital standards known as Basel III. These new capital standards will apply to all banks, regardless of size, and to all bank holding companies with consolidated assets greater than $500 million. 

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Under the Final Rules, tier 1 capital will consist of two components: common equity tier 1 capital and additional tier 1 capital. Total tier 1 capital, plus tier 2 capital, will constitute total risk-based capital. The required minimum ratios will be (i) common equity tier 1 risk-based capital ratio of 4.5%; (ii) tier 1 risk-based capital ratio of 6%; (iii) total risk-based capital ratio of 8%; and (iv) tier 1 leverage ratio of average consolidated assets of 4%. Advanced approaches banking organizations (those organizations with either total assets of $250 billion or more, or with foreign exposure of $10 billion or more) also will be subject to a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The Final Rules also incorporate these changes in regulatory capital into the prompt corrective action framework, under which the thresholds for “adequately capitalized” banking organizations will be equal to the new minimum capital requirements. Under this framework, in order to be considered “well capitalized”, insured depository institutions will be required to maintain a tier 1 leverage ratio of 5%, a common equity tier 1 risk-based capital measure of 6.5%, a tier 1 risked-based capital ratio of 8% and a total risk-based capital ratio of 10%.

The Final Rules also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. Advanced approaches organizations also will be subject to a countercyclical capital buffer. Failure to satisfy the capital buffer requirements would result in increasingly stringent limitations on various types of capital distributions, including dividends, share buybacks and discretionary payments on tier 1 instruments, and discretionary bonus payments.

The Final Rules reflect changes from the June 2012 proposals that minimize the impact of the revised capital regulations on community banks. In particular, banking organizations with less than $15 billion in total assets (including the Company and the Bank) will not be subject to the phase-out of non-qualifying tier 1 capital instruments, such as trust preferred securities (“TruPS”), that were issued and outstanding prior to May 19, 2010. In addition, non-advanced approaches banking organizations will have a one-time option to exclude certain components of accumulated other comprehensive income from inclusion in regulatory capital, comparable to treatment under the current capital rules. The Final Rules also retain the existing treatment for residential mortgage exposures in the current risk-based capital rules, rather than adopt the proposed changes that would have required banking organizations to determine the risk weights based on a complex categorization and loan-to-value assessment.

Although the Final Rules alleviate some of the concerns of community banks with the capital standards as originally proposed, the new capital standards will impose significant changes on the definition of capital, including the inability to include instruments such as TruPS in tier 1 capital going forward and new constraints on the inclusion of minority interests, mortgage servicing assets, deferred tax assets and certain investments in the capital of unconsolidated financial institutions. In addition, the Final Rules increase the risk-weights of various assets, including certain high volatility commercial real estate and past due asset exposures.

Non-advanced approaches banking organizations, including the Company and the Bank, must begin compliance with the new minimum capital ratios and the standardized approach for risk-weighted assets as of January 1, 2015, and the revised definitions of regulatory capital and the revised regulatory capital deductions and adjustments will be phased in over time for such organizations beginning as of that date. The capital conservation buffer will be phased in for all banking organizations beginning January 1, 2016.

Management is currently assessing the impact of the Final Rules to its regulatory capital ratios but does not expect these changes to result in a material difference.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

In the ordinary course of operations, we enter into certain contractual obligations. Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment.

Information about our off-balance sheet risk exposure is presented in Note 16 of the 2012 Audited Financial Statements. As part of ongoing business, we have not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (“SPE”s), which generally are established for facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of June 30, 2013, we were not involved in any unconsolidated SPE transactions.

Impact of Inflation and Changing Prices

As a financial institution, we have an asset and liability make-up that is distinctly different from that of an entity with substantial investments in plant and inventory because the major portions of a commercial bank’s assets are monetary in nature. As a result, our performance may be significantly influenced by changes in interest rates. Although the banking industry and we are more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor that may influence interest rates. However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses and the cost of supplies and outside services tend to increase more during periods of high inflation.

Interest Rate Sensitivity

The Senior Risk Committee actively evaluates and manages interest rate risk using a process developed by the Company. The Senior Risk Committee is also responsible for approving our asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing our interest rate sensitivity position.

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The primary measures that management uses to evaluate short-term interest rate risk include (i) cumulative gap summary, which measures potential changes in cash flows should interest rates rise or fall; (ii) net interest income at risk, which projects the impact of different interest rate scenarios on net interest income over one-year and two-year time horizons; and (iii) economic value of equity at risk, which measures potential long-term risk in the balance sheet by valuing our assets and liabilities at “market” under different interest rate scenarios.

These measures have historically been calculated under a simulation model prepared by an independent correspondent bank assuming incremental 100 basis point shocks (or immediate shifts) in interest rates up to a total increase or decrease of 300 basis points. These simulations estimate the impact that various changes in the overall level of interest rates over a one- and two-year time horizon have on net interest income. The results help us develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates and balance sheet management strategies. We believe that the assumptions are reasonable, both individually and in the aggregate. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. The overall interest rate risk management process is subject to annual review by an outside professional services firm to ascertain its effectiveness as required by Federal regulations.

Our current guidelines for risk management call for preventive measures if a 300 basis point shock, or immediate increase or decrease, would affect net interest income by more than 30.0% over the next twelve months. We currently operate well within these guidelines. However, the current interest rate environment creates an unusual scenario; specifically, our earnings may be negatively impacted by either a significant increase or decrease in short-term interest rates. As of June 30, 2013, based on the results of this simulation model, which assumed a static environment with no contemplated asset growth, we could expect net interest income to decrease by approximately 4.8% over twelve months if short-term interest rates immediately decreased by 300 basis points, which is unlikely based on current rate levels. This decrease results from our cost of interest-bearing liabilities, which was 0.43% for the six months ended June 30, 2013, being unable to fully benefit from a 300 basis point decline in rates, while our yield on interest-earning assets, which was 4.58% for the period, could suffer from the full decline. Concurrently, if short-term interest rates increased by 300 basis points, net interest income could be expected to decrease by approximately 8.7% over twelve months given that we are currently in a slight liability-sensitive position. As of December 31, 2012, based on the results of this simulation model, which assumed a dynamic environment with contemplated asset growth, we expected net interest income to decrease by approximately 3% over twelve months if short-term interest rates immediately decreased by 300 basis points, which was unlikely based on the rate levels at that time. Conversely, if short term interest rates increased by 300 basis points, net interest income was expected to decrease by approximately 3% over twelve months.

As of June 30, 2013, we maintained two loan swaps accounted for as fair value hedges. The aggregate original notional amount of these swaps was $6.2 million. These derivative instruments are used to protect us from interest rate risk caused by changes in the LIBOR curve in relation to certain designated fixed rate loans. These derivative instruments are carried at a fair market value of $(297) thousand and $(453) thousand at June 30, 2013 and December 31, 2012, respectively. We recorded interest expense on these loan swaps of $39 thousand and $0.1 million in each of the three and six months ended June 30, 2013, and $0.1 million and $0.2 million in each of the three and six months ended June 30, 2012.

For fair value hedges, ASC Topic 815 requires that the method selected for assessing hedge effectiveness must be reasonable, be defined at the inception of the hedging relationship and be applied consistently throughout the hedging relationship. The Company uses the dollar-offset method for assessing effectiveness using the cumulative approach. The dollar-offset method compares the fair value of the hedging derivative with the fair value of the hedged exposure. The cumulative approach involves comparing the cumulative changes in the hedging derivative’s fair value to the cumulative changes in the hedged exposure’s fair value. The calculation of dollar offset is the change in clean fair value of hedging derivative, divided by the change in fair value of the hedged exposure attributable to changes in the LIBOR curve. To the extent that the cumulative change in fair value of the hedging derivative offsets from 80% to 125% of the cumulative change in fair value of the hedged exposure, the hedge will be deemed effective. The change in fair value of the hedging derivative and the change in fair value of the hedged exposure are recorded in earnings. Any hedge ineffectiveness is also reflected in current earnings.

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Prime rate swaps (pay floating, received fixed) are recorded on the balance sheet in other assets or liabilities at fair market value. Loan swaps (pay fixed, receive floating) are carried at fair market value and are included in loans. Changes in fair value of the hedged loans have been completely offset by the fair value changes in the derivatives, which are in contra asset accounts included in loans.

See Note 17 – Derivative Financial Instruments and Hedging Activities of the 2012 Audited Financial Statements and Note 12 – Derivative Financial Instruments and Hedging Activities of the Unaudited Financial Statements for further discussion on our derivative financial instruments and hedging activities.

Financial institutions are subject to interest rate risk to the degree that their interest-bearing liabilities, primarily deposits, mature or reprice more or less frequently, or on a different basis, than their interest-earning assets, primarily loans and investment securities. The match between the scheduled repricing and maturities of our interest-earning assets and liabilities within defined periods is referred to as “gap” analysis. At June 30, 2013, our cumulative one year gap was $(140.2) million, or –7.1% of total assets, indicating a net liability-sensitive position. Our cumulative one year gap at December 31, 2012 was $(10.0) million, or -0.5% of total assets.

The following table reflects our rate sensitive assets and liabilities by maturity as of June 30, 2013. Variable rate loans are shown in the category of due “within three months” because they reprice with changes in the prime lending rate. Fixed rate loans are presented assuming the entire loan matures on the final due date, although payments are actually made at regular intervals and are not reflected in this schedule.

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Interest Rate Gap Sensitivity

	Within			Three			One Year
	Three			Months to			to Five			After
	Months			One Year			Years			Five Years		Total
	(Dollars in thousands)
At June 30, 2013:
Interest-earning assets:
Interest-bearing deposits	$	100,469		$	-		$	-		$	-	$	100,469
Federal funds sold		495			-			-			-		495
Securities		29,151			50,666			104,623			151,185		335,625
Loans and loans held for sale		503,152			200,271			504,844			107,377		1,315,644
Total interest-earning assets		633,267			250,937			609,467			258,562		1,752,233
Interest-bearing liabilities:
Demand deposits		57,587			-			131,626			98,720		287,933
MMDA and savings		455,858			-			-			-		455,858
Time deposits		121,460			333,196			129,412			-		584,068
Short term borrowings		2,176			-			-			-		2,176
Long term borrowings		49,917			-			20,000			6,895		76,812
Total interest-bearing liabilities		686,998			333,196			281,038			105,615		1,406,847
Derivatives		6,150			-			(6,150	)		-		-
Interest sensitivity gap	$	(47,581	)	$	(82,259	)	$	322,279		$	152,947	$	345,386
Cumulative interest sensitivity gap	$	(47,581	)	$	(129,840	)	$	192,439		$	345,386
Percentage of total assets					-6.58	%
At December 31, 2012:
Interest-earning assets:
Interest-bearing deposits	$	101,431		$	-		$	-		$	-	$	101,431
Federal funds sold		45,995			-			-			-		45,995
Securities		19,608			31,765			97,089			104,531		252,993
Loans and loans held for sale		519,789			268,764			492,638			89,663		1,370,854
Total interest-earning assets		686,823			300,529			589,727			194,194		1,771,273
Interest-bearing liabilities:
Demand deposits		53,274			-			121,769			146,842		321,885
MMDA and savings		437,951			-			-			-		437,951
Time deposits		152,722			284,894			190,408			649		628,673
Short term borrowings		10,143			-			-			-		10,143
Long term borrowings		64,678			-			20,000			6,895		91,573
Total interest-bearing liabilities		718,768			284,894			332,177			154,386		1,490,225
Derivatives		10,415			(4,265	)		(6,150	)		-		-
Interest sensitivity gap	$	(21,530	)	$	11,370		$	251,400		$	39,808	$	281,048
Cumulative interest sensitivity gap	$	(21,530	)	$	(10,160	)	$	241,240		$	281,048
Percentage of total assets					-0.50	%

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Item 3.   Quantitative and Qualitative Disclosures about Market Risk.

See “Interest Rate Sensitivity” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 2 for disclosures about market risk.

Item 4.   Controls and Procedures 

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, the management of the Company, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of such date.

Changes in Internal Control Over Financial Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the second fiscal quarter of 2013 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1.    Legal Proceedings 

In the ordinary course of business, the Company may be a party to various legal proceedings from time to time. There are no material pending legal proceedings to which the Company is a party or of which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on its business, operating results or financial condition.

Item 1A  Risk Factors 

There have been no material changes in risk factors previously disclosed in the Company’s 2012 Form 10-K.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds 

The following table provides information regarding the Company’s purchases of common stock during the three months ended June 30, 2013:

Period	(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
Repurchases from April 1, 2013through April 30, 2013		-	$	-		-		2,197,000
Repurchases from May 1, 2013through May 31, 2013		-		-		-		2,197,000
Repurchases from June 1, 2013through June 30, 2013		-		-		-		2,197,000
Total		-	$	-		-		2,197,000

(1) On November 2, 2012, we announced a program which expires on December 31, 2014 to repurchase up to 2,200,000 of our common shares from time to time, depending on market conditions and other factors.

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The Company’s ability to pay dividends is subject to the provisions of the Series C Preferred Stock described in Note 10 - Preferred Stock, in addition to the various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums.

During the three months ended June 30, 2013,the Company did not have any unregistered sales of equity securities.

Item 3. Defaults Upon Senior Securities 

Not applicable.

Item 4. Mine Safety Disclosures 

Not applicable.

Item 5. Other Information 

Not applicable.

Item 6. Exhibits 

The following documents are filed or furnished as exhibits to this report:

Exhibit Number	Description of Exhibits
3.1	Articles of Incorporation of the Company, as amended, incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q (File No. 001-35032) filed November 9, 2012
3.2	Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012; (ii) Condensed Consolidated Statements of Income for the three and six months ended June 30, 2013 and 2012; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2013 and 2012; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2013 and 2012; (v) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012; and (vi) Notes to Condensed Consolidated Financial Statements*

*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

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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.

		PARK STERLING CORPORATION
Date: August 8, 2013	By:	/s/ James C. Cherry
		James C. Cherry
		Chief Executive Officer (authorized officer)
Date: August 8, 2013	By:	/s/ David L. Gaines
		David L. Gaines
		Chief Financial Officer

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Exhibit Index

Exhibit Number	Description of Exhibits
3.1	Articles of Incorporation of the Company, as amended, incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q (File No. 001-35032) filed November 9, 2012
3.2	Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012; (ii) Condensed Consolidated Statements of Income for the three and six months ended June 30, 2013 and 2012; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2013 and 2012; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2013 and 2012; (v) Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012; and (vi) Notes to Condensed Consolidated Financial Statements*

*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934