f10qafnc033111.htm



 

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 


FORM 10-Q/A
Amendment No. 1
 

 

 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2011
 
or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
 
Commission File Number: 0-23976
 

 

 
(Exact name of registrant as specified in its charter)
 

 

 
     
Virginia
 
54-1232965
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
   
112 West King Street, Strasburg, Virginia
 
22657
(Address of principal executive offices)
 
(Zip Code)
 
(540) 465-9121
(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  x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
             
Large accelerated filer
 
¨
  
Accelerated filer
 
¨
       
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
  
Smaller reporting company
 
x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of May 13, 2011, 2,952,303 shares of common stock, par value $1.25 per share, of the registrant were outstanding.
 
 



 
 

 


 
EXPLANATORY NOTE
 
First National Corporation (the “Company”) hereby amends its Quarterly Report on Form 10-Q for the period ended March 31, 2011 as set forth in this Quarterly Report on Form 10-Q/A (Amendment No. 1) (the “Amendment”).  The original filing, as well as Exhibits 31.1 and 32.1, were signed by the Company's previous Interim Chief Executive Officer.  The Amendment is being filed solely for the purpose of providing a revised Signatures page and new Exhibits 31.1 and 32.1, signed by the Company's new President and Chief Executive Officer, who was appointed May 9, 2011.
 
 
No other information in the Form 10-Q for the period ended March 31, 2011 is being amended by the Amendment. For convenience, the entire Quarterly Report on Form 10-Q for the period ended March 31, 2011 has been re-filed in this Amendment. Pursuant to SEC Rule 12b-15, in connection with this filing, we have also re-filed Exhibits 31.2 and 32.2.
 

 
 

 
TABLE OF CONTENTS
 
             
 
  
 
  
Page
 
     
 
  
  
     
     
Item 1.
  
  
     
     
 
  
  
 
3
  
     
 
  
  
 
4
  
     
 
  
  
 
5
  
     
 
  
  
 
7
  
     
 
  
  
 
8
  
     
Item 2.
  
  
 
21
  
     
Item 3.
  
  
 
31
  
     
Item 4.
  
  
 
32
  
     
 
  
  
     
     
Item 1.
  
  
 
32
  
     
Item 1A.
  
  
 
32
  
     
Item 2.
  
  
 
32
  
     
Item 3.
  
  
 
32
  
     
Item 4.
  
  
 
32
  
     
Item 5.
  
  
 
32
  
     
Item 6.
  
  
 
32
  
 
 
 
 
2

 
 
PART I – FINANCIAL INFORMATION
 
Item 1. Financial Statements
 
FIRST NATIONAL CORPORATION
Consolidated Balance Sheets
(in thousands, except share and per share data)
 
 
 

 
                 
 
  
(unaudited)
March 31,
2011
 
  
December 31,
2010
 
Assets
  
     
  
     
Cash and due from banks
  
$
7,329
  
  
$
5,048
  
Interest-bearing deposits in banks
  
 
14,912
  
  
 
10,949
  
Federal funds sold
  
 
15,000
  
  
 
7,500
  
Securities available for sale, at fair value
  
 
66,660
  
  
 
60,420
  
Restricted securities, at cost
  
 
3,153
  
  
 
3,153
  
Loans held for sale
  
 
150
  
  
 
271
  
Loans, net of allowance for loan losses, 2011, $13,168, 2010, $16,036
  
 
413,148
  
  
 
418,994
  
Other real estate owned, net of valuation allowance, 2011, $3,026, 2010, $3,341
  
 
5,428
  
  
 
3,961
  
Premises and equipment, net
  
 
20,020
  
  
 
20,302
  
Interest receivable
  
 
1,632
  
  
 
1,667
  
Other assets
  
 
12,803
  
  
 
12,364
  
 
  
     
  
     
Total assets
  
$
560,235
  
  
$
544,629
  
 
  
     
  
     
     
Liabilities and Shareholders’ Equity
  
     
  
     
     
Liabilities
  
     
  
     
Deposits:
  
     
  
     
Noninterest-bearing demand deposits
  
$
82,226
  
  
$
78,964
  
Savings and interest-bearing demand deposits
  
 
185,076
  
  
 
178,685
  
Time deposits
  
 
210,421
  
  
 
205,851
  
 
  
     
  
     
Total deposits
  
$
477,723
  
  
$
463,500
  
Other borrowings
  
 
20,117
  
  
 
20,122
  
Company obligated mandatorily redeemable capital securities
  
 
9,279
  
  
 
9,279
  
Accrued expenses and other liabilities
  
 
3,937
  
  
 
3,230
  
Commitments and contingencies
  
 
—  
  
  
 
—  
  
 
  
     
  
     
Total liabilities
  
$
511,056
  
  
$
496,131
  
 
  
     
  
     
     
Shareholders’ Equity
  
     
  
     
Preferred stock, $1,000 liquidation preference; 14,595 shares issued and outstanding
  
$
14,160
  
  
$
14,127
  
Common stock, par value $1.25 per share; authorized 8,000,000 shares; issued and outstanding, 2011, 2,952,303 shares, 2010, 2,948,901 shares
  
 
3,690
  
  
 
3,686
  
Surplus
  
 
1,614
  
  
 
1,582
  
Retained earnings
  
 
29,454
  
  
 
28,969
  
Accumulated other comprehensive income, net
  
 
261
  
  
 
134
  
 
  
     
  
     
Total shareholders’ equity
  
$
49,179
  
  
$
48,498
  
 
  
     
  
     
     
Total liabilities and shareholders’ equity
  
$
560,235
  
  
$
544,629
  
 
  
     
  
     
 
See Notes to Consolidated Financial Statements
 
 
 
3

 
FIRST NATIONAL CORPORATION
Consolidated Statements of Income
Three months ended March 31, 2011 and 2010
(in thousands, except per share data)
 
 
 

 
                 
 
  
(unaudited)
March 31,
2011
 
  
(unaudited)
March 31,
2010
 
Interest and Dividend Income
  
     
  
     
Interest and fees on loans
  
$
5,833
  
  
$
6,260
  
Interest on federal funds sold
  
 
7
  
  
 
—  
  
Interest on deposits in banks
  
 
7
  
  
 
2
  
Interest and dividends on securities available for sale:
  
     
  
     
Taxable interest
  
 
451
  
  
 
468
  
Tax-exempt interest
  
 
123
  
  
 
145
  
Dividends
  
 
17
  
  
 
12
  
 
  
     
  
     
Total interest and dividend income
  
$
6,438
  
  
$
6,887
  
 
  
     
  
     
     
Interest Expense
  
     
  
     
Interest on deposits
  
$
1,303
  
  
$
1,676
  
Interest on federal funds purchased
  
 
—  
  
  
 
5
  
Interest on company obligated mandatorily redeemable capital securities
  
 
109
  
  
 
108
  
Interest on other borrowings
  
 
91
  
  
 
149
  
 
  
     
  
     
Total interest expense
  
$
1,503
  
  
$
1,938
  
 
  
     
  
     
     
Net interest income
  
$
4,935
  
  
$
4,949
  
Provision for loan losses
  
 
270
  
  
 
411
  
 
  
     
  
     
Net interest income after provision for loan losses
  
$
4,665
  
  
$
4,538
  
 
  
     
  
     
     
Noninterest Income
  
     
  
     
Service charges on deposit accounts
  
$
501
  
  
$
609
  
ATM and check card fees
  
 
371
  
  
 
314
  
Trust and investment advisory fees
  
 
342
  
  
 
310
  
Fees for other customer services
  
 
73
  
  
 
73
  
Gains on sale of loans
  
 
47
  
  
 
40
  
Gains on sale of securities available for sale
  
 
—  
  
  
 
2
  
Net losses on sale of other real estate owned
  
 
—  
  
  
 
(52
Other operating income
  
 
6
  
  
 
25
  
 
  
     
  
     
Total noninterest income
  
$
1,340
  
  
$
1,321
  
 
  
     
  
     
     
Noninterest Expense
  
     
  
     
Salaries and employee benefits
  
$
2,288
  
  
$
2,227
  
Occupancy
  
 
341
  
  
 
344
  
Equipment
  
 
325
  
  
 
348
  
Marketing
  
 
105
  
  
 
124
  
Stationery and supplies
  
 
79
  
  
 
97
  
Legal and professional fees
  
 
201
  
  
 
226
  
ATM and check card fees
  
 
171
  
  
 
177
  
FDIC assessment
  
 
190
  
  
 
187
  
Bank franchise tax
  
 
105
  
  
 
100
  
Provision for other real estate owned
  
 
130
  
  
 
—  
  
Other real estate owned expense
  
 
126
  
  
 
66
  
Telecommunications expense
  
 
90
  
  
 
64
  
Other operating expense
  
 
404
  
  
 
437
  
 
  
     
  
     
Total noninterest expense
  
$
4,555
  
  
$
4,397
  
 
  
     
  
     
     
Income before income taxes
  
$
1,450
  
  
$
1,462
  
Income tax provision
  
 
447
  
  
 
447
  
 
  
     
  
     
Net income
  
$
1,003
  
  
$
1,015
  
 
  
     
  
     
     
Effective dividend on preferred stock
  
 
223
  
  
 
221
  
 
  
     
  
     
     
Net income available to common shareholders
  
$
780
  
  
$
794
  
 
  
     
  
     
     
Earnings per common share, basic and diluted
  
$
0.26
  
  
$
0.27
  
 
  
     
  
     
 
See Notes to Consolidated Financial Statements
 
 
 
4

 
FIRST NATIONAL CORPORATION
Consolidated Statements of Cash Flows
Three months ended March 31, 2011 and 2010
(in thousands)
 
 
 

 
                 
 
  
(unaudited)
March 31,
2011
   
(unaudited)
March 31,
2010
 
Cash Flows from Operating Activities
  
             
Net income
  
$
1,003
  
 
$
1,015
  
Adjustments to reconcile net income to net cash provided by operating activities:
  
             
Depreciation and amortization
  
 
298
  
   
318
  
Origination of loans held for sale
  
 
(3,170
   
(2,838
Proceeds from sale of loans held for sale
  
 
3,338
  
   
2,963
  
Gains on sale of loans held for sale
  
 
(47
   
(40
Provision for loan losses
  
 
270
  
   
411
  
Provision for other real estate owned
  
 
130
  
   
—  
  
Gains on sale of securities available for sale, net
  
 
—  
  
   
(2
Losses on sale of other real estate owned, net
  
 
—  
  
   
52
  
Accretion of security discounts
  
 
(10
   
(10
Amortization of security premiums
  
 
114
  
   
92
  
Shares acquired by leveraged ESOP
  
 
—  
  
   
34
  
Changes in assets and liabilities:
  
             
(Increase) decrease in interest receivable
  
 
35
  
   
(10
Increase in other assets
  
 
(439
   
(148
Increase (decrease) in accrued expenses and other liabilities
  
 
542
  
   
(527
 
  
             
Net cash provided by operating activities
  
$
2,064
  
 
$
1,310
  
 
  
             
     
Cash Flows from Investing Activities
  
             
Proceeds from maturities, calls, and principal payments of securities available for sale
  
$
2,733
  
 
$
2,679
  
Purchase of securities available for sale
  
 
(8,885
   
—  
  
Increase in federal funds sold
  
 
(7,500
   
(2,220
Purchase of premises and equipment
  
 
(16
   
(37
Proceeds from sale of other real estate owned
  
 
182
  
   
756
  
Net (increase) decrease in loans
  
 
3,897
  
   
(626
 
  
             
Net cash used in investing activities
  
$
(9,589
 
$
(552
 
  
             
     
Cash Flows from Financing Activities
  
             
Net increase in demand deposits and savings accounts
  
$
9,653
  
 
$
4,043
  
Net increase (decrease) in time deposits
  
 
4,570
  
   
(11,782
Proceeds from other borrowings
  
 
10,000
  
   
23,600
  
Principal payments on other borrowings
  
 
(10,005
   
(23,639
Cash dividends paid on common stock
Cash dividends paid on preferred stock
  
 
(259
(190
   
(356
(190
Shares issued to leveraged ESOP
  
 
—  
  
   
(26
 
  
             
Net cash provided by (used in) financing activities
  
$
13,769
  
 
$
(8,350
 
  
             
     
Increase (decrease) in cash and cash equivalents
  
$
6,244
  
 
$
(6,488
     
Cash and Cash Equivalents
  
             
Beginning
  
$
15,997
  
 
$
14,977
  
 
  
             
Ending
  
$
22,241
  
 
$
8,489
  
 
  
             
 
See Notes to Consolidated Financial Statements
 
 
 
5

 
FIRST NATIONAL CORPORATION
Consolidated Statements of Cash Flows
(Continued)
Three months ended March 31, 2011 and 2010
(in thousands)
 
 
 

 
                 
 
  
(unaudited)
March 31,
2011
 
  
(unaudited)
March 31,
2010
 
Supplemental Disclosures of Cash Flow Information
  
     
  
     
Cash payments for:
  
     
  
     
Interest
  
$
1,514
  
  
$
2,028
  
 
  
     
  
     
Income taxes
  
$
—  
  
  
$
1,446
  
 
  
     
  
     
     
Supplemental Disclosures of Noncash Investing and Financing Activities
  
     
  
     
Unrealized gain on securities available for sale
  
$
192
  
  
$
294
  
 
  
     
  
     
     
Transfer from loans to other real estate owned
  
$
2,292
  
  
$
1,101
  
 
  
     
  
     
     
Loan originated from sale of other real estate owned
  
$
640
  
  
$
—  
  
 
  
     
  
     
     
Issuance of common stock, dividend reinvestment plan
  
$
36
  
  
$
54
  
 
  
     
  
     
 
See Notes to Consolidated Financial Statements
 
 
 
6

 
FIRST NATIONAL CORPORATION
Consolidated Statements of Changes in Shareholders’ Equity
Three months ended March 31, 2011 and 2010
(in thousands, except share and per share data)
(unaudited)
 
 
 

 
                                                                 
 
  
Preferred
Stock
 
  
Common
Stock
 
  
Surplus
   
Retained
Earnings
   
Unearned
ESOP
Shares
   
Accumulated
Other
Comprehensive
Income
 
  
Comprehensive
Income
   
Total
 
Balance, December 31, 2009
  
$
13,998
  
  
$
3,664
  
  
$
1,418
  
 
$
35,104
  
 
$
(42
 
$
665
  
  
       
$
54,807
  
Comprehensive income:
  
     
  
     
  
                             
  
             
Net income
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
1,015
  
   
—  
  
   
—  
  
  
$
1,015
  
   
1,015
  
Other comprehensive income, net of tax:
  
     
  
     
  
                             
  
             
Unrealized holding gains arising during the period (net of tax, $101)
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
—  
  
   
—  
  
   
—  
  
  
 
195
  
   
—  
  
Reclassification adjustment (net of tax, $1)
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
—  
  
   
—  
  
   
—  
  
  
 
(1
   
—  
  
 
  
     
  
     
  
                             
  
             
Other comprehensive income (net of tax, $100)
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
—  
  
   
—  
  
   
194
  
  
$
194
  
   
194
  
 
  
     
  
     
  
                             
  
             
Total comprehensive income
  
     
  
     
  
                             
  
$
1,209
  
       
 
  
     
  
     
  
                             
  
             
Shares acquired by leveraged ESOP
  
 
—  
  
  
 
—  
  
  
 
(26
   
—  
  
   
34
  
   
—  
  
  
         
8
  
Cash dividends on common stock ($0.14 per share)
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
(410
   
—  
  
   
—  
  
  
         
(410
Issuance of 5,210 shares common stock, dividend reinvestment plan
  
 
—  
  
  
 
7
  
  
 
47
  
   
—  
  
   
—  
  
   
—  
  
  
         
54
  
Cash dividends on preferred stock
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
(190
   
—  
  
   
—  
  
  
         
(190
Accretion on preferred stock discount
  
 
31
  
  
 
—  
  
  
 
—  
  
   
(31
   
—  
  
   
—  
  
  
         
—  
  
 
  
     
  
     
  
                             
  
             
Balance, March 31, 2010
  
$
14,029
  
  
$
3,671
  
  
$
1,439
  
 
$
35,488
  
 
$
(8
 
$
859
  
  
       
$
55,478
  
 
  
     
  
     
  
                             
  
             
 
 
 

 
                                                                 
 
  
Preferred
Stock
 
  
Common
Stock
 
  
Surplus
 
  
Retained
Earnings
   
Unearned
ESOP
Shares
 
  
Accumulated
Other
Comprehensive
Income
 
  
Comprehensive
Income
 
  
Total
 
Balance, December 31, 2010
  
$
14,127
  
  
$
3,686
  
  
$
1,582
  
  
$
28,969
  
 
$
—  
  
  
$
134
  
  
     
  
$
48,498
  
Comprehensive income:
  
     
  
     
  
     
  
             
  
     
  
     
  
     
Net income
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
1,003
  
   
—  
  
  
 
—  
  
  
$
1,003
  
  
 
1,003
  
Other comprehensive income, net of tax:
  
     
  
     
  
     
  
             
  
     
  
     
  
     
Unrealized holding gains arising during the period (net of tax, $65)
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
   
—  
  
  
 
127
  
  
 
127
  
  
 
127
  
 
  
     
  
     
  
     
  
             
  
     
  
     
  
     
Total comprehensive income
  
     
  
     
  
     
  
             
  
     
  
$
1,130
  
  
     
 
  
     
  
     
  
     
  
             
  
     
  
     
  
     
Cash dividends on common stock ($0.10 per share)
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
(295
   
—  
  
  
 
—  
  
  
     
  
 
(295
Issuance of 3,402 shares common stock, dividend reinvestment plan
  
 
—  
  
  
 
4
  
  
 
32
  
  
 
—  
  
   
—  
  
  
 
—  
  
  
     
  
 
36
  
Cash dividends on preferred stock
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
(190
   
—  
  
  
 
—  
  
  
     
  
 
(190
Accretion on preferred stock discount
  
 
33
  
  
 
—  
  
  
 
—  
  
  
 
(33
   
—  
  
  
 
—  
  
  
     
  
 
—  
  
 
  
     
  
     
  
     
  
             
  
     
  
     
  
     
Balance, March 31, 2011
  
$
14,160
  
  
$
3,690
  
  
$
1,614
  
  
$
29,454
  
 
$
—  
  
  
$
261
  
  
     
  
$
49,179
  
 
  
     
  
     
  
     
  
             
  
     
  
     
  
     
 
See Notes to Consolidated Financial Statements
 
 
 
7

 
FIRST NATIONAL CORPORATION
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
Note 1. General
 
The accompanying unaudited consolidated financial statements of First National Corporation (the Company) and its subsidiaries, including First Bank (the Bank), have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications of a normal and recurring nature considered necessary to present fairly the financial positions at March 31, 2011 and December 31, 2010, the results of operations for the three months ended March 31, 2011 and 2010 and cash flows and changes in shareholders’ equity for the three months ended March 31, 2011 and 2010. The statements should be read in conjunction with the consolidated financial statements and related notes included in the Annual Report on Form 10-K for the year ended December 31, 2010. Operating results for the three month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.
 
Note 2. Securities
 
The Company invests in U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate equity securities and restricted securities. Restricted securities include required equity investments in certain correspondent banks which have no readily determinable market value. Amortized costs and fair values of securities available for sale at March 31, 2011 and December 31, 2010 were as follows:
 
                                 
 
  
(in thousands)
March 31, 2011
 
 
  
Amortized
Cost
 
  
Gross
Unrealized
Gains
 
  
Gross
Unrealized
(Losses)
   
Fair
Value
 
U.S. agency and mortgage-backed securities
  
$
51,904
  
  
$
1,475
  
  
$
(153
 
$
53,226
  
Obligations of states and political subdivisions
  
 
13,061
  
  
 
338
  
  
 
(153
   
13,246
  
Corporate equity securities
  
 
23
  
  
 
165
  
  
 
—  
  
   
188
  
 
  
     
  
     
  
             
 
  
$
64,988
  
  
$
1,978
  
  
$
(306
 
$
66,660
  
 
  
     
  
     
  
             
   
 
  
(in thousands)
December 31, 2010
 
 
  
Amortized
Cost
 
  
Gross
Unrealized
Gains
 
  
Gross
Unrealized
(Losses)
   
Fair
Value
 
U.S. agency and mortgage-backed securities
  
$
45,627
  
  
$
1,508
  
  
$
(211
 
$
46,924
  
Obligations of states and political subdivisions
  
 
13,290
  
  
 
225
  
  
 
(214
   
13,301
  
Corporate equity securities
  
 
23
  
  
 
172
  
  
 
—  
  
   
195
  
 
  
     
  
     
  
             
 
  
$
58,940
  
  
$
1,905
  
  
$
(425
 
$
60,420
  
 
  
     
  
     
  
             
 
At March 31, 2011 and December 31, 2010, investments in an unrealized loss position that were temporarily impaired were as follows:
 
                                                 
 
  
(in thousands)
March 31, 2011
 
 
  
Less than 12 months
   
12 months or more
   
Total
 
 
  
Fair Value
 
  
Unrealized
(Loss)
   
Fair Value
 
  
Unrealized
(Loss)
   
Fair Value
 
  
Unrealized
(Loss)
 
U.S. agency and mortgage-backed securities
  
$
13,004
  
  
$
(153
 
$
—  
  
  
$
—  
  
 
$
13,004
  
  
$
(153
Obligations of states and political subdivisions
  
 
1,300
  
  
 
(104
   
929
  
  
 
(49
   
2,229
  
  
 
(153
 
  
     
  
             
  
             
  
     
 
  
$
14,304
  
  
$
(257
 
$
929
  
  
$
(49
 
$
15,233
  
  
$
(306
 
  
     
  
             
  
             
  
     
 
 
8

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
                                                 
 
  
(in thousands)
 
 
  
December 31, 2010
 
 
  
Less than 12 months
   
12 months or more
   
Total
 
 
  
Fair Value
 
  
Unrealized
(Loss)
   
Fair Value
 
  
Unrealized
(Loss)
   
Fair Value
 
  
Unrealized
(Loss)
 
U.S. agency and mortgage-backed securities
  
$
11,286
  
  
$
(211
 
$
—  
  
  
$
—  
  
 
$
11,286
  
  
$
(211
Obligations of states and political subdivisions
  
 
2,923
  
  
 
(128
   
893
  
  
 
(86
   
3,816
  
  
 
(214
 
  
     
  
             
  
             
  
     
 
  
$
14,209
  
  
$
(339
 
$
893
  
  
$
(86
 
$
15,102
  
  
$
(425
 
  
     
  
             
  
             
  
     
 
The tables above provide information about securities that have been in an unrealized loss position for less than twelve consecutive months and securities that have been in an unrealized loss position for twelve consecutive months or more. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Impairment is considered to be other-than temporary if the Company (1) intends to sell the security, (2) more likely than not will be required to sell the security before recovering its cost, or (3) does not expect to recover the security’s entire amortized cost basis. Presently, the Company does not intend to sell any of these securities, will not be required to sell these securities, and expects to recover the entire amortized cost of all the securities.
 
At March 31, 2011, there were eight U.S. agency and mortgage-backed securities and four obligations of state and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio is considered investment grade. The weighted-average re-pricing term of the portfolio was 3.8 years at March 31, 2011.
 
The Company’s investment in FHLB stock totaled $2.3 million at March 31, 2011. FHLB stock is generally viewed as a long-term investment and as a restricted security, which is carried at cost, because there is a minimal market for the stock. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider this investment to be other-than-temporarily impaired at March 31, 2011, and no impairment has been recognized. FHLB stock is shown in restricted securities on the balance sheet and is not part of the available for sale securities portfolio.
 
Note 3. Loans
 
Loans at March 31, 2011 and December 31, 2010 are summarized as follows:
 
                 
 
  
(in thousands)
 
 
  
March 31,
2011
 
  
December 31,
2010
 
Real estate loans:
  
     
  
     
Construction
  
$
50,655
  
  
$
52,591
  
Secured by 1-4 family residential
  
 
120,863
  
  
 
121,506
  
Other real estate loans
  
 
202,208
  
  
 
207,371
  
Commercial and industrial loans
  
 
39,659
  
  
 
40,683
  
Consumer loans
  
 
12,931
  
  
 
12,879
  
 
  
     
  
     
Total loans
  
$
426,316
  
  
$
435,030
  
Allowance for loan losses
  
 
13,168
  
  
 
16,036
  
 
  
     
  
     
Loans, net
  
$
413,148
  
  
$
418,994
  
 
  
     
  
     
 
Consumer loans included $128 thousand and $231 thousand of demand deposit overdrafts at March 31, 2011 and December 31, 2010, respectively.
 
The Company has a credit concentration of loans secured by real estate. These loans totaled $373.7 million, or 88% of total loans, and $381.5 million, or 88% of total loans, at March 31, 2011 and December 31, 2010, respectively. Although the Company believes that its underwriting standards are generally conservative, the ability of its borrowers to meet their mortgage obligations may be impacted by local economic conditions.
 
The Company has a concentration of credit risk within the loan portfolio involving loans secured by hotels. This concentration totaled $42.5 million at March 31, 2011, representing 86% of total equity and 10% of total loans. At December 31, 2010, this concentration totaled $41.6 million representing 86% of total equity and 10% of total loans. These loans are included in other real estate loans in the above table. The Company experienced no loan losses related to this concentration of credit risk during the three month period ended March 31, 2011 and charged down $147 thousand related to these loans during the year ended December 31, 2010.
 
 
 
9

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The following table provides a summary of loan classes and an aging of past due loans as of March 31, 2011 and December 31, 2010:
 
                                                                 
 
  
March 31, 2011
(in thousands)
 
 
  
30-59 Days
Past Due
 
  
60-89
Days
Past Due
 
  
> 90 Days
Past Due
 
  
Total
Past Due
 
  
Current
 
  
Total
Loans
 
  
Nonaccrual
loans
 
  
90 Days or
More Past
Due and
Accruing
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Construction
  
$
555
  
  
$
190
  
  
$
3,345
  
  
$
4,090
  
  
$
46,565
  
  
$
50,655
  
  
$
3,172
  
  
$
173
  
1-4 family residential
  
 
2,014
  
  
 
440
  
  
 
74
  
  
 
2,528
  
  
 
118,335
  
  
 
120,863
  
  
 
784
  
  
 
—  
  
Other real estate loans
  
 
1,535
  
  
 
551
  
  
 
6,202
  
  
 
8,288
  
  
 
193,920
  
  
 
202,208
  
  
 
7,032
  
  
 
1,481
  
Commercial and industrial
  
 
689
  
  
 
504
  
  
 
—  
  
  
 
1,193
  
  
 
38,466
  
  
 
39,659
  
  
 
23
  
  
 
—  
  
Consumer
  
 
85
  
  
 
16
  
  
 
5
  
  
 
106
  
  
 
12,825
  
  
 
12,931
  
  
 
5
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Total
  
$
4,878
  
  
$
1,701
  
  
$
9,626
  
  
$
16,205
  
  
$
410,111
  
  
$
426,316
  
  
$
11,016
  
  
$
1,654
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
 
                                                                 
 
  
December 31, 2010
(in thousands)
 
 
  
30-59 Days
Past Due
 
  
60-89
Days
Past Due
 
  
> 90 Days
Past Due
 
  
Total
Past Due
 
  
Current
 
  
Total Loans
 
  
Nonaccrual
loans
 
  
90 Days or
More Past
Due and
Accruing
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Construction
  
$
525
  
  
$
—  
  
  
$
3,665
  
  
$
4,190
  
  
$
48,401
  
  
$
52,591
  
  
$
5,780
  
  
$
—  
  
1-4 family residential
  
 
2,642
  
  
 
178
  
  
 
315
  
  
 
3,135
  
  
 
118,371
  
  
 
121,506
  
  
 
628
  
  
 
315
  
Other real estate loans
  
 
10,225
  
  
 
3,475
  
  
 
751
  
  
 
14,451
  
  
 
192,920
  
  
 
207,371
  
  
 
4,407
  
  
 
283
  
Commercial and industrial
  
 
1,033
  
  
 
3
  
  
 
—  
  
  
 
1,036
  
  
 
39,647
  
  
 
40,683
  
  
 
—  
  
  
 
—  
  
Consumer
  
 
168
  
  
 
10
  
  
 
1
  
  
 
179
  
  
 
12,700
  
  
 
12,879
  
  
 
2
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Total
  
$
14,593
  
  
$
3,666
  
  
$
4,732
  
  
$
22,991
  
  
$
412,039
  
  
$
435,030
  
  
$
10,817
  
  
$
598
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
  
     
 
Credit Quality Indicators
 
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to the risk grading of specified classes of loans.
 
The Company utilizes a risk grading matrix to assign a rating to each of its loans. The loan ratings are summarized into the following categories: pass, special mention, substandard, doubtful and loss. Pass rated loans include all risk rated credits other than those included in special mention, substandard or doubtful. Loans classified as loss are charged-off. Loan officers assign risk grades to loans at origination and as renewals arise. The Bank’s Credit Administration department reviews risk grades for accuracy on a quarterly basis and as delinquency issues arise. In addition, a certain amount of loans are reviewed each year through the Company’s internal and external loan review process. A description of the general characteristics of the loan grading categories is as follows:
 
Special Mention – Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the Bank’s credit position at some future date.
 
Substandard – Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation in full of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
Doubtful – Loans classified as doubtful have all the weakness inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The Company considers all doubtful loans to be impaired and places the loan on nonaccrual status.
 
 
 
10

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The following tables provide an analysis of the credit risk profile of each loan class as of March 31, 2011 and December 31, 2010:
 
                                         
 
  
March 31, 2011
(in thousands)
 
 
  
Pass
 
  
Special
Mention
 
  
Substandard
 
  
Doubtful
 
  
Total
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
Construction
  
$
20,546
  
  
$
8,453
  
  
$
19,588
  
  
$
2,068
  
  
$
50,655
  
Secured by 1-4 family residential
  
 
103,939
  
  
 
5,573
  
  
 
11,183
  
  
 
168
  
  
 
120,863
  
Other real estate loans
  
 
145,160
  
  
 
13,617
  
  
 
38,649
  
  
 
4,782
  
  
 
202,208
  
Commercial and industrial
  
 
33,879
  
  
 
4,004
  
  
 
1,753
  
  
 
23
  
  
 
39,659
  
Consumer
  
 
12,840
  
  
 
85
  
  
 
6
  
  
 
—  
  
  
 
12,931
  
 
  
     
  
     
  
     
  
     
  
     
Total
  
$
316,364
  
  
$
31,732
  
  
$
71,179
  
  
$
7,041
  
  
$
426,316
  
 
  
     
  
     
  
     
  
     
  
     
   
 
  
December 31, 2010
(in thousands)
 
 
  
Pass
 
  
Special
Mention
 
  
Substandard
 
  
Doubtful
 
  
Total
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
Construction
  
$
21,212
  
  
$
5,237
  
  
$
21,471
  
  
$
4,671
  
  
$
52,591
  
Secured by 1-4 family residential
  
 
106,722
  
  
 
4,435
  
  
 
10,349
  
  
 
—  
  
  
 
121,506
  
Other real estate loans
  
 
143,874
  
  
 
17,915
  
  
 
43,443
  
  
 
2,139
  
  
 
207,371
  
Commercial and industrial
  
 
34,619
  
  
 
4,033
  
  
 
2,031
  
  
 
—  
  
  
 
40,683
  
Consumer
  
 
12,864
  
  
 
13
  
  
 
1
  
  
 
1
  
  
 
12,879
  
 
  
     
  
     
  
     
  
     
  
     
Total
  
$
319,291
  
  
$
31,633
  
  
$
77,295
  
  
$
6,811
  
  
$
435,030
  
 
  
     
  
     
  
     
  
     
  
     
 
Note 4. Allowance for Loan Losses
 
Transactions in the allowance for loan losses for the three months ended March 31, 2011 and 2010 and for the year ended December 31, 2010 were as follows:
 
                         
 
  
(in thousands)
 
 
  
March 31,
2011
   
December 31,
2010
   
March 31,
2010
 
Balance at beginning of year
  
$
16,036
  
 
$
7,106
  
 
$
7,106
  
Provision charged to operating expense
  
 
270
  
   
11,731
  
   
411
  
Loan recoveries
  
 
87
  
   
261
  
   
80
  
Loan charge-offs
  
 
(3,225
   
(3,062
   
(432
 
  
                     
Balance at end of period
  
$
13,168
  
 
$
16,036
  
 
$
7,165
  
 
  
                     
 
 
 
11

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The following tables present, as of March 31, 2011 and December 31, 2010, the total allowance for loan losses, the allowance by impairment methodology and loans by impairment methodology.
 
                                                 
 
  
March 31, 2010
 
 
  
(in thousands)
 
 
  
Commercial
and
Industrial
 
  
Other Real
Estate
   
Construction
   
Secured by
1-4 Family
Residential
   
Consumer
Loans
   
Total
 
Allowance for loan losses:
  
     
  
                                     
Beginning Balance, December 31, 2010
  
$
858
  
  
$
9,187
  
 
$
4,050
  
 
$
1,681
  
 
$
260
  
 
$
16,036
  
Charge-offs
  
 
—  
  
  
 
(349
   
(2,556
   
(235
   
(85
   
(3,225
Recoveries
  
 
—  
  
  
 
—  
  
   
—  
  
   
—  
  
   
87
  
   
87
  
Provision for loan losses
  
 
16
  
  
 
176
  
   
32
  
   
41
  
   
5
  
   
270
  
 
  
     
  
                                     
Ending Balance, March 31, 2011
  
$
874
  
  
$
9,014
  
 
$
1,526
  
 
$
1,487
  
 
$
267
  
 
$
13,168
  
 
  
     
  
                                     
             
Ending Balance:
  
     
  
                                     
Individually evaluated for impairment
  
 
23
  
  
 
4,917
  
   
485
  
   
612
  
   
—  
  
   
6,037
  
Collectively evaluated for impairment
  
 
851
  
  
 
4,097
  
   
1,041
  
   
875
  
   
267
  
   
7,131
  
             
Loans:
  
     
  
                                     
Ending Balance
  
$
39,659
  
  
$
202,208
  
 
$
50,655
  
 
$
120,863
  
 
$
12,931
  
 
$
426,316
  
             
Individually evaluated for impairment
  
 
39
  
  
 
25,979
  
   
5,847
  
   
6,331
  
   
—  
  
   
38,196
  
Collectively evaluated for impairment
  
 
39,620
  
  
 
176,229
  
   
44,808
  
   
114,532
  
   
12,931
  
   
388,120
  
   
 
  
December 31, 2010
 
 
  
(in thousands)
 
 
  
Commercial
and
Industrial
 
  
Other Real
Estate
   
Construction
   
Secured by
1-4 Family
Residential
   
Consumer
Loans
   
Total
 
Allowance for loan losses:
  
     
  
                                     
Ending Balance
  
$
858
  
  
$
9,187
  
 
$
4,050
  
 
$
1,681
  
 
$
260
  
 
$
16,036
  
             
Ending Balance:
  
     
  
                                     
Individually evaluated for impairment
  
 
36
  
  
 
5,020
  
   
3,006
  
   
536
  
   
—  
  
   
8,597
  
Collectively evaluated for impairment
  
 
822
  
  
 
4,167
  
   
1,044
  
   
1,145
  
   
260
  
   
7,439
  
             
Loans:
  
     
  
                                     
Ending Balance
  
 
40,683
  
  
 
207,371
  
   
52,591
  
   
121,506
  
   
12,879
  
   
435,030
  
             
Ending Balance:
  
     
  
                                     
Individually evaluated for impairment
  
 
48
  
  
 
28,426
  
   
9,709
  
   
5,682
  
   
—  
  
   
43,865
  
Collectively evaluated for impairment
  
 
40,635
  
  
 
178,945
  
   
42,882
  
   
115,824
  
   
12,879
  
   
391,165
  
 
 
 
12

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
Impaired loans and the related allowance at March 31, 2011 and December 31, 2010, were as follows:
 
                                                         
 
  
March 31, 2011
(in thousands)
 
 
  
Unpaid
Principal
Balance
 
  
Recorded
Investment
with No
Allowance
 
  
Recorded
Investment
with
Allowance
 
  
Total
Recorded
Investment
 
  
Related
Allowance
 
  
Average
Recorded
Investment
 
  
Interest
Income
Recognized
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Construction
  
$
7,860
  
  
$
3,380
  
  
$
2,467
  
  
$
5,847
  
  
$
485
  
  
$
8,792
  
  
$
38
  
Secured by 1-4 family
  
 
6,353
  
  
 
3,450
  
  
 
2,881
  
  
 
6,331
  
  
 
612
  
  
 
6,124
  
  
 
62
  
Other real estate loans
  
 
26,491
  
  
 
9,606
  
  
 
16,373
  
  
 
25,979
  
  
 
4,917
  
  
 
27,529
  
  
 
240
  
Commercial and industrial
  
 
39
  
  
 
17
  
  
 
22
  
  
 
39
  
  
 
23
  
  
 
54
  
  
 
—  
  
Consumer
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Total
  
$
40,744
  
  
$
16,453
  
  
$
21,743
  
  
$
38,196
  
  
$
6,037
  
  
$
42,500
  
  
$
340
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
 
                                                         
 
  
December 31, 2010
(in thousands)
 
 
  
Unpaid
Principal
Balance
 
  
Recorded
Investment
with No
Allowance
 
  
Recorded
Investment
with
Allowance
 
  
Total
Recorded
Investment
 
  
Related
Allowance
 
  
Average
Recorded
Investment
 
  
Interest
Income
Recognized
 
Real estate loans:
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Construction
  
$
10,440
  
  
$
1,217
  
  
$
8,492
  
  
$
9,709
  
  
$
3,006
  
  
$
2,920
  
  
$
374
  
Secured by 1-4 family
  
 
5,701
  
  
 
595
  
  
 
5,087
  
  
 
5,682
  
  
 
536
  
  
 
795
  
  
 
222
  
Other real estate loans
  
 
29,480
  
  
 
7,904
  
  
 
20,522
  
  
 
28,426
  
  
 
5,020
  
  
 
18,432
  
  
 
1,345
  
Commercial and industrial
  
 
48
  
  
 
—  
  
  
 
48
  
  
 
48
  
  
 
36
  
  
 
163
  
  
 
4
  
Consumer
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
Total
  
$
45,669
  
  
$
9,716
  
  
$
34,149
  
  
$
43,865
  
  
$
8,597
  
  
$
22,310
  
  
$
1,945
  
 
  
     
  
     
  
     
  
     
  
     
  
     
  
     
 
The “Recorded Investment” amounts in the table above represent the outstanding principal balance on each loan represented in the table. The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged off on each loan and/or payments that have been applied towards principal on nonaccrual loans.
 
During the first quarter of 2011, the Bank adjusted its allowance for loan losses methodology by expanding the historical loss period that is applied to the general component of the allowance from one year to three years. The Company decreased the loss history to one year after significant deterioration in economic conditions in 2008. Since then, the Company has been operating in a stable market and has determined that a three-year loss history is more appropriate to reflect a reasonable loss inherent in the loan portfolio. For further information on the Company’s allowance for loan losses methodology, see the “Allowance for Loan Losses” section included in Part I, Item 2 of this Form 10-Q.
 
Note 5. Other Borrowings
 
The Bank had unused lines of credit totaling $126.2 million available with non-affiliated banks at March 31, 2011. This amount primarily consists of a blanket floating lien agreement with the Federal Home Loan Bank of Atlanta (FHLB) under which the Bank can borrow up to 19% of its total assets.
 
At March 31, 2011, the Bank had borrowings from the FHLB system totaling $20.0 million which mature through March 28, 2013. The interest rate on these notes payable ranged from 0.36% to 1.91% and the weighted average rate was 0.97%. The Bank had collateral pledged on these borrowings, including real estate loans totaling $63.1 million and FHLB stock with a book value of $2.3 million.
 
At March 31, 2011, the Bank had a $117 thousand note payable, secured by a deed of trust, which requires monthly payments of $2 thousand and matures January 3, 2016. The fixed interest rate on this loan is 4.00%.
 
 
 
13

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
Note 6. Capital Requirements
 
A comparison of the capital of the Company and the Bank at March 31, 2011 and December 31, 2010 with the minimum regulatory guidelines were as follows:
 
                                                 
 
  
Actual
   
(dollars in thousands)
   
Minimum
To Be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
 
  
   
 
  
 
Minimum Capital
Requirement
   
 
  
   
 
  
   
 
  
Amount
 
  
Ratio
   
Amount
 
  
Ratio
   
Amount
 
  
Ratio
 
March 31, 2011:
  
     
  
             
  
             
  
     
             
Total Capital (to Risk
Weighted Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
63,648
  
  
 
14.40
 
$
35,368
  
  
 
8.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
63,014
  
  
 
14.29
 
$
35,280
  
  
 
8.00
 
$
 44,100
  
  
 
10.00
Tier 1 Capital (to Risk
Weighted Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
58,027
  
  
 
13.13
 
$
17,684
  
  
 
4.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
57,407
  
  
 
13.02
 
$
17,640
  
  
 
4.00
 
$
26,460
  
  
 
6.00
             
Tier 1 Capital (to
Average Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
58,027
  
  
 
10.50
 
$
22,111
  
  
 
4.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
57,407
  
  
 
10.40
 
$
22,090
  
  
 
4.00
 
$
27,612
  
  
 
5.00
             
December 31, 2010:
  
     
  
             
  
             
  
     
             
Total Capital (to Risk
Weighted Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
63,163
  
  
 
14.18
 
$
35,624
  
  
 
8.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
62,550
  
  
 
14.06
 
$
35,584
  
  
 
8.00
 
$
44,480
  
  
 
10.00
Tier 1 Capital (to Risk
Weighted Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
57,467
  
  
 
12.91
 
$
17,812
  
  
 
4.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
56,861
  
  
 
12.78
 
$
17,792
  
  
 
4.00
 
$
26,688
  
  
 
6.00
             
Tier 1 Capital (to
Average Assets):
  
     
  
             
  
             
  
     
Consolidated
  
$
57,467
  
  
 
10.54
 
$
21,810
  
  
 
4.00
   
N/A
  
  
 
N/A
  
First Bank
  
$
56,861
  
  
 
10.40
 
$
21,859
  
  
 
4.00
 
$
27,324
  
  
 
5.00
 
Note 7. Company Obligated Mandatorily Redeemable Capital Securities
 
On June 8, 2004, First National (VA) Statutory Trust II (Trust II), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities. On June 17, 2004, $5.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at March 31, 2011 was 2.91%. The securities have a mandatory redemption date of June 17, 2034, and were subject to varying call provisions that began September 17, 2009. The principal asset of Trust II is $5.2 million of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company.
 
On July 24, 2006, First National (VA) Statutory Trust III (Trust III), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities. On July 31, 2006, $4.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a fixed rate of interest of 7.26% until July 31, 2011. The securities then have a LIBOR-indexed floating rate of interest. The securities have a mandatory redemption date of October 1, 2036, and are subject to varying call provisions beginning October 1, 2011. The principal asset of Trust III is $4.1 million of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company.
 
 
 
14

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
 
While these securities are debt obligations of the Company, they are included in capital for regulatory capital ratio calculations. Under present regulations, the trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. At March 31, 2011, the total amount of trust preferred securities issued by the Trusts was included in the Company’s Tier 1 capital.
 
Note 8. Benefit Plans
 
The Bank has a noncontributory, defined benefit pension plan for all full-time employees over 21 years of age with at least one year of credited service and hired prior to May 1, 2011. Benefits are generally based upon years of service and average compensation for the five highest-paid consecutive years of service. The Bank’s funding practice has been to make at least the minimum required annual contribution permitted by the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended.
 
Components of the net periodic benefit cost of the plan for the three months ended March 31, 2011 and 2010 were as follows:
 
                 
 
  
(in thousands)
 
 
  
For the three months
ended March 31,
 
 
  
2011
   
2010
 
Service cost
  
$
90
  
 
$
77
  
Interest cost
  
 
76
  
   
71
  
Expected return on plan assets
  
 
(85
   
(78
Amortization of prior service cost
  
 
1
  
   
1
  
Amortization of net obligation at transition
  
 
—  
  
   
(1
Amortization of net loss
  
 
9
  
   
5
  
 
  
             
Net periodic benefit cost
  
$
91
  
 
$
75
  
 
  
             
 
The Company previously disclosed in its consolidated financial statements in its Annual Report on Form 10-K for the year ended December 31, 2010, that it expected to contribute $366 thousand to its pension plan for the 2011 plan year. The Company is planning to make the contribution for the 2011 plan year during the fourth quarter of 2011.
 
In addition to the defined benefit pension plan, the Company maintains a 401(k) plan and an employee stock ownership plan (ESOP) for eligible employees. The Bank also maintains a Split Dollar Life Insurance Plan that provides life insurance coverage to insurable directors. See Note 11 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for additional information about the Company’s benefit plans.
 
Note 9. Earnings per Common Share
 
Basic earnings per common share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. There are no potential common shares that would have a dilutive effect. Shares not committed to be released under the Company’s leveraged ESOP are not considered to be outstanding. See Note 11 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 for additional information about the Company’s leveraged ESOP. The average number of common shares outstanding used to calculate basic and diluted earnings per common share were 2,949,166 and 2,932,879 for the three months ended March 31, 2011 and 2010, respectively.
 
Note 10. Fair Value Measurements
 
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurement and Disclosures” topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, fair value estimates may not be realized in an immediate settlement of the instrument.
 
 
 
15

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
 
In accordance with this guidance, the Company groups its assets and liabilities generally measured 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 on quoted prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.
   
Level 2 –
  
Valuation is based on inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on quoted prices for similar assets and liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
   
Level 3 –
  
Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires a significant management judgment or estimation.
 
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
 
The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:
 
Securities available for sale
 
Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that considers observable market data (Level 2).
 
The following tables present the balances of financial assets measured at fair value on a recurring basis as of March 31, 2011 and December 31, 2010.
 
                                 
 
  
   
  
Fair Value Measurements at March 31, 2011
(in thousands)
 
 
Description
 
  
Balance as of
March 31,
2011
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Securities available for sale
  
     
  
     
  
     
  
     
U.S. agency and mortgage-backed securities
  
$
53,226
  
  
$
—  
  
  
$
53,226
  
  
$
—  
  
Obligations of states and political subdivisions
  
 
13,246
  
  
 
—  
  
  
 
13,246
  
  
 
—  
  
Corporate equity securities
  
 
188
  
  
 
188
  
  
 
—  
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
 
  
$
66,660
  
  
$
188
  
  
$
66,472
  
  
$
—  
  
 
  
     
  
     
  
     
  
     
 
 
 
16

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
                                 
 
  
   
  
Fair Value Measurements at December 31, 2010
(in thousands)
 
 
Description
 
  
Balance as of
December 31,
2010
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Securities available for sale
  
     
  
     
  
     
  
     
U.S. agency and mortgage-backed securities
  
$
46,924
  
  
$
—  
  
  
$
46,924
  
  
$
—  
  
Obligations of states and political subdivisions
  
 
13,301
  
  
 
—  
  
  
 
13,301
  
  
 
—  
  
Corporate equity securities
  
 
195
  
  
 
195
  
  
 
—  
  
  
 
—  
  
 
  
     
  
     
  
     
  
     
 
  
$
60,420
  
  
$
195
  
  
$
60,225
  
  
$
—  
  
 
  
     
  
     
  
     
  
     
Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
 
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
 
Loans held for sale
 
Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the three months ended March 31, 2011.
 
Impaired Loans
 
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans or the present value of expected future cash flows. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
 
Other real estate owned
 
Loans are transferred to other real estate owned when the collateral securing them is foreclosed on or acquired through a deed in lieu of foreclosure. The measurement of loss associated with other real estate owned is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. If there is a contract for the sale of a property, and management reasonably believes the contract will be executed, fair value is based on the sale price in that contract (Level 1). Lacking such a contract, the value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. Any fair value adjustments to other real estate owned are recorded in the period incurred and expensed against current earnings.
 
 
 
17

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The following tables summarize the Company’s financial assets that were measured at fair value on a nonrecurring basis during the periods:
 
                                 
 
  
   
  
Carrying Value at March 31, 2011
(in thousands)
 
 
Description
 
  
Balance as of
March 31,
2011
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Impaired loans
  
$
15,706
  
  
$
—  
  
  
$
15,418
  
  
$
288
  
 
  
     
  
     
  
     
  
     
     
 
  
   
  
Carrying Value at December 31, 2010
(in thousands)
 
 
Description
 
  
Balance as of
December 31,
2010
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Impaired loans
  
$
25,552
  
  
$
—  
  
  
$
17,584
  
  
$
7,968
  
 
  
     
  
     
  
     
  
     
 
The following tables summarize the Company’s nonfinancial assets that were measured at fair value on a nonrecurring basis during the periods.
 
                                 
 
  
   
  
Carrying Value at March 31, 2011
(in thousands)
 
 
Description
 
  
Balance as of
March 31,
2011
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Other real estate owned
  
$
5,428
  
  
$
—  
  
  
$
5,428
  
  
$
—  
  
 
  
     
  
     
  
     
  
     
     
 
  
   
  
Carrying Value at December 31, 2010
(in thousands)
 
 
Description
 
  
Balance as of
December 31,
2010
 
  
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
  
Significant
Other
Observable
Inputs
(Level 2)
 
  
Significant
Unobservable
Inputs
(Level 3)
 
         
Assets
  
     
  
     
  
     
  
     
Other real estate owned
  
$
 3,961
  
  
$
—  
  
  
$
 3,961
  
  
$
—  
  
 
  
     
  
     
  
     
  
     
 
 
 
18

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
Accounting guidance requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The methodologies for other financial assets and financial liabilities are discussed below:
 
Cash and Cash Equivalents
 
The carrying amounts of cash and short-term instruments approximate fair values.
 
Loans
 
For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for all other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.
 
Deposit Liabilities
 
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.
 
Accrued Interest
 
The carrying amounts of accrued interest approximate fair value.
 
Borrowings
 
The carrying amounts of federal funds purchased and other short-term borrowings maturing within ninety days approximate their fair values. Fair values of all other borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
 
Commitments and Unfunded Credits
 
The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.
 
The fair value of stand-by letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At March 31, 2011 and December 31, 2010, fair value of loan commitments and standby letters of credit was immaterial.
 
The estimated fair values of the Company’s financial instruments at March 31, 2011 and December 31, 2010 were as follows:
 
                                 
 
  
(in thousands)
 
 
  
March 31, 2011
 
  
December 31, 2010
 
 
  
Carrying
Amount
 
  
Fair
Value
 
  
Carrying
Amount
 
  
Fair
Value
 
         
Financial Assets
  
     
  
     
  
     
  
     
Cash and short-term investments
  
$
37,241
  
  
$
37,241
  
  
$
23,497
  
  
$
23,497
  
Securities
  
 
66,660
  
  
 
66,660
  
  
 
60,420
  
  
 
60,420
  
Loans, net
  
 
413,148
  
  
 
413,955
  
  
 
418,994
  
  
 
420,011
  
Loans held for sale
  
 
150
  
  
 
150
  
  
 
271
  
  
 
271
  
Accrued interest receivable
  
 
1,632
  
  
 
1,632
  
  
 
1,667
  
  
 
1,667
  
         
Financial Liabilities
  
     
  
     
  
     
  
     
Deposits
  
$
477,723
  
  
$
442,709
  
  
$
463,500
  
  
$
433,300
  
Other borrowings
  
 
20,117
  
  
 
20,325
  
  
 
20,122
  
  
 
20,400
  
Company obligated mandatorily redeemable capital securities
  
 
9,279
  
  
 
9,279
  
  
 
9,279
  
  
 
9,279
  
Accrued interest payable
  
 
540
  
  
 
540
  
  
 
551
  
  
 
551
  
 
 
19

 
Notes to Consolidated Financial Statements
(unaudited)
 
 
 

 
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities and borrowing wholesale funding with terms that mitigate the Company’s overall interest rate risk.
 
Note 11. Capital Purchase Program
 
On March 13, 2009, the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the Purchase Agreement) with the Treasury Department, pursuant to which the Company sold (i) 13,900 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $1.25 per share and liquidation preference $1,000 per share (the Preferred Stock) and (ii) a warrant (the Warrant) to purchase 695 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the Warrant Preferred Stock), at an exercise price of $1.25 per share, for an aggregate purchase price of $13.9 million in cash. The Treasury immediately exercised the Warrant and, after net settlement, received 695 shares of the Company’s Warrant Preferred Stock, which has a liquidation preference amount of $1,000 per share. Closing of the sale occurred on March 13, 2009 and increased Tier 1 and total capital by $13.9 million. The Preferred Stock pays cumulative dividends at a rate of 5% per annum for the first five years, and thereafter at a rate of 9% per annum. The Warrant Preferred Stock pays cumulative dividends at a rate of 9% per annum from the date of issuance. The discount on the Preferred Stock is amortized over a five year period using the constant effective yield method.
 
Note 12. Subsequent Events
 
The Company evaluated subsequent events that have occurred after the balance sheet date, but before the financial statements were issued. There are two types of subsequent events (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, and (2) nonrecognized, or those that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.
 
Based on the evaluation, the Company did not identify any recognized or nonrecognized subsequent events that would have required adjustment to or disclosure in the financial statements.
 
 
20

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Cautionary Statement Regarding Forward-Looking Statements
 
The Company makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
 
 
 
the Company may be adversely affected by economic conditions in the market area;
 
 
 
risks inherent in the loan portfolio such as repayment risks, fluctuating collateral values and concentrations;
 
 
 
the adequacy of the allowance for loan losses related to changes in general economic and business conditions in the market area;
 
 
 
successful management of credit risk including certain concentrations in loans secured by real estate or to certain industry;
 
 
 
the adequacy of the valuation allowance for other real estate owned related to changes in economic conditions and local real estate activity;
 
 
 
the reliance on secondary sources, such as Federal Home Loan Bank advances, sales of securities and loans, federal funds lines of credit from correspondent banks and out-of-market time deposits, to meet liquidity needs;
 
 
 
the ability to raise capital as needed;
 
 
 
the successful management of interest rate risk;
 
 
 
potential impact on the Company of legislation;
 
 
 
difficult market conditions in the Company’s industry; and
 
 
 
other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2010.
 
Because of these uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition and results of operations of the Company for the three month period ended March 31, 2011 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2010. The results of operations for the three month period ended March 31, 2011 may not be indicative of the results to be achieved for the year.
 
Executive Overview
 
The Company
 
First National Corporation (the Company) is the bank holding company of:
 
 
 
First Bank (the Bank). The Bank owns:
 
 
 
First Bank Financial Services, Inc.
 
 
 
Shen-Valley Land Holdings, LLC
 
 
 
First National (VA) Statutory Trust I (Trust I)
 
 
 
First National (VA) Statutory Trust II (Trust II)
 
 
 
First National (VA) Statutory Trust III (Trust III)
 
First Bank Financial Services, Inc. invests in partnerships that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities.
 
Products, Services, Customers and Locations
 
The Bank’s primary market area is located within the northern Shenandoah Valley region of Virginia, including Shenandoah County, Warren County, Frederick County and the City of Winchester. Within the market area there are various types of industry including medical and professional services, manufacturing, retail and higher education. Customers include individuals, small and medium-sized businesses, local governmental entities and non-profit organizations.
 
The Bank provides loan, deposit, investment, trust and asset management and other products and services in the northern Shenandoah Valley region of Virginia. Loan products and services include personal loans, residential mortgages, home equity loans and commercial loans. Deposit products and services include checking, savings, NOW accounts, money market accounts, IRA accounts, certificates of deposit and cash management accounts. The Bank offers other services, including internet banking, mobile banking, remote deposit capture and other traditional banking services.
 
The Bank’s Trust and Asset Management Department offers a variety of trust and asset management services including estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, estate settlement and benefit plans. The Bank offers financial planning and brokerage services for its customers through its investment division, First Financial Advisors.
 
 
 
21

 
The Bank’s products and services are provided through 10 branch offices, 31 ATMs and its website, www.therespowerinone.com. The Bank operates six of its offices under the “Financial Center” concept. A Financial Center offers all of the Bank’s financial services at one location. This concept allows loan, deposit, trust and investment advisory personnel to be readily available to serve customers throughout the Bank’s market area. The location and general character of these properties is further described in Part I, Item 2 of Form 10-K for the year ended December 31, 2010.
 
Revenue Sources and Expense Factors
 
The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 75% to 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on loans and deposits and fees earned from other services. The Bank generates fee income from other services that include trust and investment advisory services and through the origination and sale of residential mortgages.
 
The provision for loan losses and noninterest expense are the two major expense categories. The provision is determined by factors that include loan growth, asset quality, net charge-offs and economic conditions. Changing economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs and ultimately the required provision for loan losses. The largest component of noninterest expense for the three month period ended March 31, 2011 was salaries and employee benefits, comprising 50% of noninterest expenses, followed by occupancy and equipment expense, comprising 15% of noninterest expenses.
 
Quarterly Performance
 
First quarter 2011 earnings of $1.0 million were consistent with the same quarter of 2010. After the effective dividend on preferred stock, net income available to common shareholders was $780 thousand, or $0.26 per basic and diluted share compared to $794 thousand, or $0.27 per basic and diluted share, for the same period in 2010. Net interest income and noninterest income were relatively unchanged, while noninterest expense increased 4% when comparing the two periods. Return on assets and return on equity were 0.74% and 8.31%, respectively, for the first quarter of 2011 compared to 0.75% and 7.45% for the same quarter in 2010.
 
Comparing the quarter ended March 31, 2011 to the same period in 2010, net interest income remained relatively unchanged at $4.9 million. The net interest margin was 12 basis points lower and average interest-earning assets were $13.2 million higher when comparing the two periods. The net interest margin was 3.89% for the first quarter of 2011, compared to 4.01% for the same period in 2010. The decline in the margin resulted from a change in the earning asset mix.
 
The provision for loan losses totaled $270 thousand in the first quarter of 2011 compared to $411 thousand for the same period in 2010. Net charge-offs were $3.1 million for the first quarter of 2011 compared to $352 thousand for the same period in 2010. The allowance for loan losses totaled $13.2 million or 3.09% of total loans at March 31, 2011, compared to $7.2 million or 1.62% of total loans at March 31, 2010. Management regularly evaluates the loan portfolio, economic conditions and other factors to determine an appropriate allowance for loan losses. As a result of those evaluations, management believes the allowance for loan losses was adequate at March 31, 2011.
 
Noninterest income totaled $1.3 million for the first quarter of 2011, which was consistent with the same quarter of 2010. A decrease in overdraft fee income was offset by increases in ATM, check card and trust and investment advisory fees. Noninterest expense was slightly higher for the first quarter of 2011 when compared to the same quarter of 2010, primarily due to the provision for other real estate owned.
 
Management Outlook
 
The Company expects that there will not be a significant change in net interest income, noninterest income or noninterest expense (excluding the provision for OREO) for the remainder of the year when compared to first quarter results. Net interest income is expected to be relatively unchanged as the net interest margin and average earning asset balances are projected to remain stable. The Company is not planning for economic conditions to improve significantly in the local market, which should result in low loan demand and deposit growth. As a result, the earning asset mix is expected to change as loan balances continue decreasing while balances of securities increase. Even though net interest margin pressure is expected from this change in the earning asset mix, the Company plans to reallocate investments from interest-bearing deposits in banks and federal funds sold to investment securities, which will lessen the impact of the mix change. In addition, interest-bearing liabilities are expected to re-price slightly lower throughout the year which should also alleviate margin pressure.
 
Noninterest income and noninterest expense levels are not expected to change significantly for the remainder of the year, when compared to first quarter results. Higher levels of ATM and check card fee income, and trust and advisory fee income are expected to continue offsetting lower levels of income from service charges on deposit accounts.
 
Management believes that the allowance for loan losses provides prudent coverage of the risks in the loan portfolio, and that the carrying value of other real estate owned reflects current market conditions. However, the amount of provision for loan losses and provision for other real estate owned will be influenced by collateral values and economic conditions, among other factors. In addition, gains or losses that may occur from the sale of other real estate owned will be impacted by changes in market values.
 
 
22

 
Non-GAAP Financial Measures
 
The Company measures the net interest margin as an indicator of profitability. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax-equivalent net interest income is considered in the calculation of this ratio. Tax-equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for 2011 and 2010 is 34%. The reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.
 
                 
 
  
Reconciliation of Net Interest
Income to Tax-Equivalent Net
Interest Income
(in thousands)
 
 
  
For the three months ended
 
 
  
March 31,
2011
 
  
March 31,
2010
 
     
GAAP measures:
  
     
  
     
Interest income - loans
  
$
5,833
  
  
$
6,260
  
Interest income - investments and other
  
 
605
  
  
 
627
  
Interest expense - deposits
  
 
1,303
  
  
 
1,676
  
Interest expense - other borrowings
  
 
91
  
  
 
149
  
Interest expense - other
  
 
109
  
  
 
113
  
 
  
     
  
     
Total net interest income
  
$
4,935
  
  
$
4,949
  
 
  
     
  
     
Non-GAAP measures:
  
     
  
     
Tax benefit realized on non-taxable interest income - loans
  
$
13
  
  
$
10
  
Tax benefit realized on non-taxable interest income - municipal securities
  
 
63
  
  
 
74
  
 
  
     
  
     
Total tax benefit realized on non-taxable interest income
  
$
76
  
  
$
84
  
 
  
     
  
     
Total tax-equivalent net interest income
  
$
5,011
  
  
$
5,033
  
 
  
     
  
     
 
Critical Accounting Policies
 
General
 
The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Bank uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change. For further information about the Bank’s loans and the allowance for loan losses, see Notes 3 and 4 to consolidated financial statements, included in Item 1 of this Form 10-Q.
 
Presented below is a discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.
 
Allowance for Loan Losses
 
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4.
 
The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
 
The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on
 
 
 
23

 
evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revisions as more information becomes available. The evaluation also considers the following risk characteristics of each loan portfolio:
 
 
 
Residential mortgage loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.
 
 
 
Real estate construction loans carry risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may, at any point in time, be less than the principal amount of the loan; Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure unrelated to the project.
 
 
 
Commercial real estate and commercial and industrial loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much precision.
 
 
 
Consumer loans carry risk associated with the continued credit-worthiness of the borrower and the value of the collateral (i.e., rapidly depreciating assets such as automobiles), or lack thereof. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy.
 
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when appropriate.
 
The general component relates to loans that are not considered impaired. These unimpaired loans are segregated by loan type and allowance factors are assigned by management based on a three-year loss history, delinquencies, national and local economic trends, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan segment. The general component recognizes potential losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor.
 
Lending Policies
 
General
 
The principal risk associated with each of the categories of loans in the Bank’s portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased, depending on prevailing economic conditions. The risk associated with real estate mortgage loans, commercial and consumer loans varies, based on economic conditions, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.
 
In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve secured loans up to $1.5 million and unsecured loans up to $1.2 million. The Management Loan Committee consists of the Chief Executive Officer (CEO), Executive Vice President (EVP) – Loan Administration and the Senior Vice President (SVP) – Credit Administration. The Board Loan Committee approves all loans which exceed the authority of the Management Loan Committee. The Board Loan Committee consists of five non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews loans that have been charged-off. It also reviews the loan watch list, concentrations of credit and other management reports. The Board Loan Committee meets on a monthly basis and the Chairman of the Committee then reports to the Board of Directors.
 
Residential loan originations are primarily generated by Bank loan officer solicitations, referrals by real estate professionals and customers. Commercial loans and commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment and credit history of the applicant. Information is also obtained to evaluate cash flow available for debt service. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines as well as the guidelines issued by the purchasers of loans, depending on the type of loan involved. Real estate collateral is appraised by independent appraisers who have been pre-approved by the Board Loan Committee.
 
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year. This is performed to ensure reasonableness of collateral valuations. The Company also obtains an independent review of the loan portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.
 
 
24

 
In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities that are disclosed but not reflected in its financial statements, including commitments to extend credit. At March 31, 2011, commitments to extend credit, stand-by letters of credit and rate lock commitments totaled $57.1 million.
 
Commercial Business Lending
 
Commercial business loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as real estate. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. At March 31, 2011 and December 31, 2010, commercial loans not secured by real estate totaled $37.3 million or 9% of total loans and $37.4 million, or 9% of total loans, respectively.
 
Commercial Real Estate Lending
 
Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, hotels, small shopping centers, farms and churches. At March 31, 2011, commercial real estate loans totaled $202.2 million or 47% of the Bank’s total loans, as compared to $207.4 million, or 48%, at December 31, 2010. In its underwriting of commercial real estate, the Bank may lend, under federal regulation, up to 85% of the secured property’s appraised value, although the Bank’s loan to original appraised value ratio on such properties is typically 80% or less. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios and the borrower’s creditworthiness, prior credit history and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and carefully evaluates the location and environmental condition of the real estate collateral. To further mitigate risk, the Company monitors loan concentrations within the commercial real estate portfolio, including hotel loans, which totaled $42.5 million, or 10%, of the Bank’s total loans at March 31, 2011 compared to $41.6 million, or 10%, of total loans at December 31, 2010.
 
Construction Lending
 
The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. Construction and land development loans outstanding at March 31, 2011 and December 31, 2010, were $50.7 million, or 12% of total loans, and $52.6 million, or 12% of total loans, respectively. The majority of these loans have an average life of approximately one year and re-price monthly as key rates change. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction lending is attributable to the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of appraised value, in addition to analyzing the creditworthiness of its borrowers. The Bank typically obtains a first lien on the property as security for its construction loans, requires personal guarantees from the borrower’s principal owners, and monitors the progress of the construction project during the draw period.
 
Residential Real Estate Lending
 
Residential lending activity may be generated by Bank loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. Typically, the Bank originates all fixed rate mortgage loans with the intent to sell to correspondent lenders. Depending on the financial goals of the Company, the Bank occasionally originates and retains these loans. At March 31, 2011, $120.9 million, or 28%, of total loans consisted of residential real estate loans as compared to $121.5 million, or 28%, at December 31, 2010.
 
 
 
25

 
In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, where applicable, flood insurance. Flood determination letters with life of loan tracking are obtained on all federally related transactions with improvements serving as security for the transaction. The Bank does require escrows for real estate taxes and insurance for secondary market loans.
 
The Company does not participate in sub-prime lending practices so issues in the residential mortgage market from sub-prime lending are not expected to have a direct impact on earnings. Nevertheless, the Company is subject to risks associated with general economic and business conditions in its market area, as well as the condition of the regional residential mortgage market, each of which has been impacted by sub-prime lending and related issues.
 
Consumer Lending
 
The Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans and installment and demand loans. Consumer loans, including deposit overdraft balances, totaled $12.9 million, or 3% of total loans for each period ending March 31, 2011 and December 31, 2010. Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
 
The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the collateral in relation to the proposed loan amount.
 
Results of Operations
 
General
 
Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings and trust preferred securities. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts; fees charged for other customer services, including trust and investment advisory services; gains and losses from the sale of assets, including loans held for sale, securities, premises and equipment and other real estate owned; general and administrative expenses; and income tax expense.
 
Net income totaled $1.0 million for the quarter ended March 31, 2011. After the effective dividend on preferred stock, net income available to common shareholders was $780 thousand, or $0.26 per basic and diluted share compared to $794 thousand, or $0.27 per basic and diluted share, for the same period in 2010. Net interest income and noninterest income were relatively unchanged, while noninterest expense increased 4% when comparing the two periods. Return on assets and return on equity were 0.74% and 8.31%, respectively, for the first quarter of 2011 compared to 0.75% and 7.45% for the same quarter in 2010.
 
Net Interest Income
 
Comparing the quarter ended March 31, 2011 to the same quarter in 2010, net interest income remained relatively unchanged at $4.9 million. The net interest margin decreased 12 basis points and average interest-earning assets increased $13.2 million when comparing the two periods. The net interest margin was 3.89% for the first quarter of 2011, compared to 4.01% for the same period in 2010. The decline in the margin was a result of a change in the earning asset mix. Loan balances were lower and cash, due from banks, federal funds sold and securities balances were higher in the first quarter of 2011 when compared to the same quarter in 2010.
 
The Company expects that there will not be a significant change in net interest income for the remainder of the year when compared to first quarter results. Net interest income is expected to be relatively unchanged as the net interest margin and average earning asset balances are projected to remain stable. The Company is not planning for economic conditions to improve significantly in the local market, which should result in low loan demand and deposit growth. As a result, the earning asset mix is expected to change as loan balances continue decreasing while balances of securities increase. Even though the Company expects net interest margin pressure from this change in the earning asset mix, the Company plans to reallocate investments from interest-bearing deposits in banks and federal funds sold to investment securities, which will lessen the impact of the mix change. In addition, interest-bearing liabilities are expected to re-price slightly lower throughout the year which should also alleviate margin pressure.
 
 
 
26

 
Provision for Loan Losses
 
The provision for loan losses totaled $270 thousand in the first quarter of 2011 compared to $411 thousand for the same period in 2010. Net charge-offs were $3.1 million for the first quarter of 2011 compared to $352 thousand for the same period in 2010. The allowance for loan losses totaled $13.2 million or 3.09% of total loans at March 31, 2011, compared to $7.2 million or 1.62% of total loans at March 31, 2010.
 
Management believes that the allowance for loan losses provides prudent coverage of the risks in the loan portfolio. However, the amount of provision for loan losses will be influenced by collateral values and economic conditions, among other factors.
 
Noninterest Income
 
Noninterest income totaled $1.3 million for the first quarter of 2011, which was consistent with the same quarter of 2010. Trust and investment advisory fees increased $32 thousand, or 10%, to $342 thousand for the first quarter of 2011 compared to $310 thousand for the same quarter of 2010. In addition, ATM and check card fees increased $57 thousand, or 18%, to $371 thousand for the first quarter of 2011, compared to $314 thousand for the same period in 2010. This was related to an increase in ATM and check card transactions during the quarter. Service charges on deposit accounts decreased $108 thousand, or 18%, to $501 thousand for the first quarter of 2011 compared to $609 thousand for the same quarter of 2010.
 
Noninterest income levels are not expected to change significantly for the remainder of the year, when compared to first quarter results. Higher levels of ATM and check card fee income, and trust and advisory fee income are expected to continue offsetting lower levels of income from service charges on deposit accounts.
 
Noninterest Expense
 
Noninterest expense increased $158 thousand, or 4%, to $4.6 million for the first quarter of 2011 compared to $4.4 million for the same period in 2010. The slight increase in noninterest expense was primarily due to the provision for other real estate owned.
 
The Company expects no significant change in noninterest expense, excluding provision for other real estate owned, for the remainder of 2011. Management believes that the carrying value of other real estate owned reflects current market conditions. However, the amount of provision for other real estate owned will be influenced by collateral values and economic conditions, among other factors. In addition, gains or losses that may occur from the sale of other real estate owned may be impacted by changes in market values.
 
Income Taxes
 
The Company’s income tax provision differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three month period ended March 31, 2011 and 2010. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income. A more detailed discussion of the Company’s tax calculation is contained in Note 9 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
Financial Condition
 
General
 
Total assets were $560.2 million at March 31, 2011 compared to $544.6 million at December 31, 2010. The Company’s trust and investment advisory group had assets under management of $216.8 million at March 31, 2011 compared to $205.5 million at December 31, 2010. Assets managed by the trust and investment advisory group are not held on the Company’s balance sheet.
 
The Company is not planning for economic conditions to improve significantly in the local market, which should result in low loan demand and deposit growth. As a result, the earning asset mix is expected to change as loan balances continue decreasing while balances of securities increase.
 
Loans
 
The Company, through its banking subsidiary, grants mortgage, commercial and consumer loans to customers. The bank segments its loan portfolio into real estate loans, commercial loans, and consumer loans. Real estate loans are further divided into the following classes: Construction; 1-4 family residential; and Other Real Estate Loans. Descriptions of the Company’s loan classes are as follows:
 
Commercial Loans: Commercial loans are typically secured with non-real estate commercial property. The Company makes commercial loans primarily to businesses located within our market area.
 
Real Estate Loans – Construction: The Company originates construction loans for the acquisition and development of land and construction of condominiums, townhomes, and one-to-four family residences.
 
Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one to four family homes. Typically, the Bank originates fixed rate mortgage loans with the intent to sell to correspondent lenders. Depending on the financial goals of the Company, the Bank occasionally originates and retains these loans.
 
 
27

 
Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, hotels, small shopping centers, farms and churches.
 
Consumer Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans and lines of credit.
 
A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the northern Shenandoah Valley region of Virginia. The ability of the Bank’s debtors to honor their contracts is subject to the real estate and general economic conditions in this area.
 
The Company has a credit concentration in mortgage loans on real estate. These loans totaled $373.7 million, or 88% of total loans at March 31, 2011 and $381.5 million, or 88% of total loans at December 31, 2010. Although the Company believes that its underwriting standards are generally conservative, the ability of its borrowers to meet their mortgage obligations is influenced by local economic conditions.
 
The Company has a concentration of credit risk within the loan portfolio involving loans secured by hotels. This concentration totaled $42.5 million at March 31, 2011, representing 86% of total equity and 10% of total loans. At December 31, 2010, this concentration totaled $41.6 million representing 86% of total shareholders’ equity and 10% of total loans. These loans are included in other real estate loans in the table found in Note 3 of the notes to consolidated financial statements of this Form 10-Q. The Company experienced no loan losses related to this concentration of credit risk during the three month period ended March 31, 2011 and charged down $147 thousand during the year ended December 31, 2010. The Company analyzes this concentration by performing interest rate and vacancy rate stress tests on a quarterly basis. In addition, occupancy reports are evaluated monthly to identify performance trend lines.
 
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
 
A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on nonaccrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. For those loans that are carried on nonaccrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.
 
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
Any unsecured loan that is over 120 days past due is charged-off in full. Any secured loan that is 120 days delinquent and is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.
 
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management’s policy is to evaluate substandard and doubtful loans greater than $500 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer, residential and certain small commercial loans that are less than $500 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below.
 
In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on nonaccrual status at the time of the TDR, the loan will remain on nonaccrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $3.0 million and $14.4 million classified as TDRs as of March 31, 2011 and December 31, 2010, respectively.
 
 
 
28

 
Asset Quality
 
Management classifies as nonperforming assets non-accrual loans and other real estate owned (OREO). OREO represents real property taken by the Bank either through foreclosure or through a deed in lieu thereof from the borrower. OREO is recorded at the lower of cost or market, less estimated selling costs, and is actively marketed by the Bank through brokerage channels. The Bank had $5.4 million in OREO, net of the valuation allowance, at March 31, 2011 and $4.0 million at December 31, 2010. The valuation allowance for other real estate owned totaled $3.0 million at March 31, 2011 and $3.3 million at December 31, 2010.
 
Nonperforming assets were $16.4 million at March 31, 2011, $14.8 million at December 31, 2010 and $15.1 million at March 31, 2010, representing 2.94%, 2.71% and 2.77% of total assets, respectively. Nonperforming assets included $11.0 million in nonaccrual loans and $5.4 million in OREO, net of the valuation allowance at March 31, 2011.
 
The higher levels of nonperforming assets in 2011 and 2010 were primarily attributable to weaker local economic conditions that negatively impacted the ability of certain borrowers to service debt. Borrowers that have not been able to meet their debt requirements are primarily business customers involved in retail operations and residential real estate development. At March 31, 2011, 50% of nonperforming assets related to commercial real estate loans, 43% related to residential development loans and 7% related to residential real estate loans. Nonperforming assets could increase due to other potential problem loans identified by management. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $61.8 million and $73.3 million at March 31, 2011 and December 31, 2010, respectively. Other potential problem loans totaled $73.3 million at December 31, 2010. The amount of other potential problem loans in future periods will be dependent on economic conditions.
 
The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $13.2 million at March 31, 2011 and $16.0 million at December 31, 2010, representing 3.09% and 3.69% of total loans, respectively. The Company began utilizing the allowance for loan losses in the first quarter of 2011 to charge-down balances of loans that had been assigned specific reserves in the fourth quarter of 2010.
 
Impaired loans totaled $38.2 million and $43.9 million at March 31, 2011 and December 31, 2010, respectively. The related allowance for loan losses provided for these loans totaled $6.0 million and $8.6 million at March 31, 2011 and December 31, 2010, respectively. The average recorded investment in impaired loans during the three months ended March 31, 2011 and the year ended December 31, 2010 was $42.5 million and $22.3 million, respectively. Included in the impaired loans total at March 31, 2011 are loans classified as TDRs totaling $3.0 million. These loans represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of March 31, 2011, these TDRs were performing under the restructured terms and were not considered nonperforming assets.
 
Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the economic assumptions underlying management’s estimates and judgments, adverse developments in the economy, on a national basis or in the Company’s market area, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies” above.
 
Securities
 
Securities at March 31, 2011 were $66.7 million, an increase of $6.3 million, or 10%, from $60.4 million at December 31, 2010. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions and corporate equity securities. As of March 31, 2011, neither the Company nor the Bank held any derivative financial instruments in its respective investment security portfolios.
 
Deposits
 
Deposits were $477.7 million at March 31, 2011, an increase of 3% from $463.5 million at December 31, 2010. Savings and interest-bearing demand deposits increased $6.4 million or 4% to $185.1 million at March 31, 2011 compared to $178.7 million at December 31, 2010. Time deposits, which include brokered deposits, increased $4.6 million or 2% during the first three months of 2011 to $210.4 million compared to $205.9 million at December 31, 2010. Non-interest bearing demand deposits increased $3.3 million or 4% to $82.2 million during the first three months of 2011 from $79.0 million at December 31, 2010.
 
 
 
29

 
Liquidity
 
Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities and loans maturing within one year as liquid assets. As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.
 
At March 31, 2011, cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, loans maturing within one year, and expected maturities, calls and principal repayments from the securities portfolio within one year totaled $155.8 million. At March 31, 2011, 28% or $118.2 million of the loan portfolio would mature within one year. Non-deposit sources of available funds totaled $126.2 million at March 31, 2011, which included $86.2 million available from FHLB, $40.0 million of unsecured federal funds lines of credit with other correspondent banks and $3.9 million available through the Federal Reserve Discount Window. During the first three months of 2011, other borrowing activity included repayment of a fixed rate advance from FHLB totaling $10.0 million and borrowing Daily Rate Credit advances as an alternative to purchasing federal funds.
 
Capital Resources
 
The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.
 
The Board of Governors of the Federal Reserve System has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.00%, of which at least 4.00% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The Company had a ratio of total capital to risk-weighted assets of 14.41% at March 31, 2011 and a ratio of Tier 1 capital to risk-weighted assets of 13.14%. Both of these exceed the capital requirements adopted by the federal regulatory agencies.
 
On March 13, 2009, the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the Purchase Agreement) with the Treasury Department, pursuant to which the Company sold (i) 13,900 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $1.25 per share and liquidation preference $1,000 per share (the Preferred Stock) and (ii) a warrant (the Warrant) to purchase 695 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series B (the Warrant Preferred Stock), at an exercise price of $1.25 per share, for an aggregate purchase price of $13.9 million in cash. The Treasury immediately exercised the Warrant and, after net settlement, received 695 shares of the Company’s Warrant Preferred Stock, which has a liquidation preference amount of $1,000 per share. Closing of the sale occurred on March 13, 2009 and increased Tier 1 and total capital by $13.9 million. The Preferred Stock pays cumulative dividends at a rate of 5% per annum for the first five years, and thereafter at a rate of 9% per annum. The Warrant Preferred Stock pays cumulative dividends at a rate of 9% per annum from the date of issuance.
 
Contractual Obligations
 
There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
Off-Balance Sheet Arrangements
 
The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.
 
Commitments to extend credit, which amounted to $50.6 million at March 31, 2011, and $53.5 million at December 31, 2010, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.
 
Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and might not be drawn upon to the total extent to which the Bank is committed.
 
 
 
30

 
Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At March 31, 2011 and December 31, 2010, the Bank had $6.5 million and $6.9 million in outstanding standby letters of credit, respectively.
 
At March 31, 2011 and December 31, 2010, the Company had no locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.
 
Recent Accounting Pronouncements
 
In January 2010, the Financial Accounting Standards Board (FASB) issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
 
In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosure guidance will significantly expand the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements. The extensive new disclosures of information as of the end of a reporting period became effective for both interim and annual reporting periods ending on or after December 15, 2010. Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance rollforward and modification disclosures were required for periods beginning on or after December 15, 2010. The Company has included the required disclosures in its consolidated financial statements.
 
In March 2011, the SEC issued Staff Accounting Bulletin (SAB) 114. This SAB revises or rescinds portions of the interpretive guidance included in the codification of the Staff Accounting Bulletin Series. This update is intended to make the relevant interpretive guidance consistent with current authoritative accounting guidance issued as a part of the FASB’s Codification. The principal changes involve revision or removal of accounting guidance references and other conforming changes to ensure consistency of referencing through the SAB Series. The effective date for SAB 114 is March 28, 2011. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
 
In April 2011, the FASB issued ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The amendments in this ASU clarify the guidance on a creditor’s evaluation of whether it has granted a concession to a debtor. They also clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty. The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011. Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, an entity may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company is currently assessing the impact that ASU 2011-02 will have on its consolidated financial statements.
 
The SEC has issued Final Rule No. 33-9002, “Interactive Data to Improve Financial Reporting”, which requires companies to submit financial statements in XBRL (extensible business reporting language) format with their SEC filings on a phased-in schedule. Large accelerated filers and foreign large accelerated filers using U.S. GAAP were required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2010. All remaining filers are required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2011. The Company plans to comply with this Rule with the filing of the June 30, 2011 Form 10-Q.
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk
 
Not required.
 
 
 
31

 
Item 4. Controls and Procedures
 
The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods required by the SEC. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of March 31, 2011 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.
 
The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
 
PART II – OTHER INFORMATION
 
Item 1. Legal Proceedings
 
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which the Company is a party or to which the property of the Company is subject.
 
Item 1A. Risk Factors
 
Not required.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
None
 
Item 3. Defaults upon Senior Securities
 
None
 
Item 4. Removed and Reserved
 
None
 
Item 5. Other Information
 
None
 
Item 6. Exhibits
 
The following documents are attached hereto as Exhibits:
 
     
  3.1
  
Bylaws of First National Corporation (as restated in electronic format as of January 28, 2011, incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on January 28, 2011.
   
31.1
  
Certification of Chief Executive Officer, Section 302 Certification
   
31.2
  
Certification of Chief Financial Officer, Section 302 Certification
   
32.1
  
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
   
32.2
  
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
 
 
32

 
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.
 
FIRST NATIONAL CORPORATION
(Registrant)
 
         
/s/ Scott C. Harvard
     
May 16, 2011
 
Scott C. Harvard
     
Date
President and Chief Executive Officer
       
     
/s/ M. Shane Bell
 
     
May 16, 2011
 
M. Shane Bell
     
Date
Executive Vice President and Chief Financial Officer
       
 
 
 
33

 
EXHIBIT INDEX
 
     
 
Number
 
  
 
Document
 
   
  3.1
  
Bylaws of First National Corporation (as restated in electronic format as of January 28, 2011, incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on January 28, 2011.
   
31.1
  
Certification of Chief Executive Officer, Section 302 Certification
   
31.2
  
Certification of Chief Financial Officer, Section 302 Certification
   
32.1
  
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
   
32.2
  
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
 
34