U.S. Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

x Quarterly Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2012

¨ Transition Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period ended                                 

Commission File Number    000-33227

Southern Community Financial Corporation

(Exact name of registrant as specified in its charter)

North Carolina	56-2270620
(State or other jurisdiction of	(I.R.S. Employer Identification No.)
incorporation or organization)
4605 Country Club Road
Winston-Salem, North Carolina	27104
(Address of principal executive offices)	(Zip Code)

Registrant's telephone number, including area code (336) 768-8500

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 Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

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

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

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

As of July 31, 2012 (the most recent practicable date), the registrant had outstanding 16,852,525 shares of Common Stock, no par value.

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
	Consolidated Statements of Financial Condition June 30, 2012 and December 31, 2011	22
	Consolidated Statements of Operations Three Months and Six Months Ended June 30, 2012 and 2011	23
	Consolidated Statements of Comprehensive Income (Loss) Three Months and Six Months Ended June 30, 2012 and 2011	24
	Consolidated Statement of Changes in Stockholders’ Equity Six Months Ended June 30, 2012	25
	Consolidated Statements of Cash Flows Six Months Ended June 30, 2012 and 2011	26
	Notes to Consolidated Financial Statements	27
	Selected Financial Data	3
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	4
Item 3 -	Quantitative and Qualitative Disclosures about Market Risk	61
Item 4 -	Controls and Procedures	61
Part II.	Other Information
Item 1A -	Risk Factors	62
Item 6 -	Exhibits	62
Signatures		63

Part I. Financial Information

SElected financial data

	At or for the Quarter Ended									% Change June 30, 2012 from
	June 30,			December 31,			June 30,			December 31,			June 30,
	2012			2011			2011			2011			2011
	(Amounts in thousands, except per share data)
Operating Data:
Interest income	$	15,442		$	16,602		$	18,148			(7	)%		(15	)%
Interest expense		4,772			5,111			5,578			(7	)		(14	)
Net interest income		10,670			11,491			12,570			(7	)		(15	)
Provision for loan losses		2,300			3,400			3,700			(32	)		(38	)
Net interest income after provision for loan losses		8,370			8,091			8,870			3			(6	)
Non-interest income		3,898			4,403			3,534			(11	)		10
Non-interest expense		11,177			11,497			11,255			(3	)		(1	)
Income before income taxes		1,091			997			1,149			9			(5	)
Income tax expense (benefit)		-			-			-			-			-
Net income	$	1,091		$	997		$	1,149			9			(5	)
Effective dividend on preferred stock		645			638			638			1			1
Net income available to common shareholders	$	446		$	359		$	511			24			(13	)
Net Income Per Common Share:
Basic	$	0.03		$	0.02		$	0.03
Diluted		0.03			0.02			0.03
Selected Performance Ratios:
Return on average assets		0.30	%		0.26	%		0.29	%
Return on average equity		4.44	%		4.02	%		5.00	%
Net interest margin (1)		3.15	%		3.22	%		3.43	%
Efficiency ratio (2)		76.72	%		72.34	%		69.89	%
Asset Quality Ratios:
Nonperforming loans to period-end loans		6.01	%		7.13	%		6.42	%
Nonperforming assets to total assets (3)		5.18	%		5.85	%		5.75	%
Net loan charge-offs to average loans outstanding (annualized)		1.52	%		2.29	%		1.46	%
Allowance for loan losses to period-end loans		2.50	%		2.53	%		2.65	%
Allowance for loan losses to nonperforming loans		0.42	X		0.36	X		0.41	X
Capital Ratios:
Total risk-based capital		14.87	%		14.26	%		13.41	%
Tier 1 risk-based capital		12.38	%		11.75	%		10.90	%
Leverage ratio		8.95	%		8.47	%		7.97	%
Equity to assets ratio		6.93	%		6.50	%		6.07	%
Balance Sheet Data (End of Period):
Total assets		1,446,961			1,502,578			1,561,986			(4	)		(7	)
Loans		913,591			950,022			1,038,349			(4	)		(12	)
Deposits		1,126,701			1,183,172			1,247,888			(5	)		(10	)
Short-term borrowings		59,268			33,629			7,353			76			706
Long-term borrowings		147,426			177,514			202,601			(17	)		(27	)
Stockholders’ equity		100,339			97,635			94,740			3			6
Other Data:
Weighted average shares
Basic		16,858,572			16,827,684			16,835,724
Diluted		16,934,115			16,891,910			16,906,810
Period end outstanding shares		16,854,775			16,827,075			16,831,375
Number of banking offices		22			22			22
Number of full-time equivalent employees		286			290			289

(1) Net interest margin is net interest income divided by average interest-earning assets.

(2) Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.

(3) Nonperforming assets consist of nonaccrual loans, restructured loans and foreclosed assets, where applicable.

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

This Quarterly Report on Form 10-Q may contain certain forward-looking statements consisting of estimates with respect to our financial condition, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, technological factors affecting our operations, pricing, products and services, and other factors discussed in our filings with the Securities and Exchange Commission.

Capital Bank Financial Corp. Acquisition

On March 26, 2012, Southern Community Financial Corporation, Winston-Salem, N.C. (“Southern Community”) entered into an Agreement and Plan of Merger (the “Agreement”) with Capital Bank Financial Corp. (“CBF”) and Winston 23 Corporation (“Winston”), a wholly-owned subsidiary of CBF, pursuant to which Southern Community will merge with Winston and become a wholly-owned subsidiary of CBF (the “Merger”). The Agreement and the transactions contemplated by it has been approved by the Board of Directors of both CBF and Southern Community.

Capital Bank Financial Corp. is a national bank holding company that was incorporated in the State of Delaware in 2009. CBF has raised approximately $900 million of equity capital with the goal of creating a regional banking franchise in the southeastern region of the United States. CBF has previously invested in First National of the South, Metro Bank of Dade Country, Turnberry Bank, TIB Financial Corporation, Capital Bank Corporation and Green Bankshares, Inc. CBF is the parent of Capital Bank, N.A., a national banking association with approximately $6.5 billion in total assets and 143 full-service banking offices throughout southern Florida and the Florida Keys, North Carolina, South Carolina, Tennessee and Virginia. CBF is also the parent company of Naples Capital Advisors, Inc., a registered investment advisor.

Subject to the terms and conditions set forth in the Agreement dated March 26, 2012 and as amended on June 25, 2012, each share of Southern Community Common Stock issued and outstanding at the effective time of the Merger will be converted into the right to receive $3.11 in cash, without interest and less any applicable withholding taxes.

Each outstanding option to purchase shares of Southern Community common stock will be vested prior to the Merger and be paid in cash equal to the difference between the exercise price of the option and $3.11 and each share of Southern Community restricted stock will vest immediately prior to the Merger and all restrictions will immediately lapse.

Southern Community shareholders will also be granted one non-transferable contingent value right (“CVR”) per share, with each CVR eligible to receive a cash payment equal to 75% of the excess, if any, of (i) $87 million over (ii) net charge-offs and net realized losses on Southern Community’s legacy loan portfolio and foreclosed assets for a period of five years from the closing date of the Merger, with a maximum payment of $1.30 per CVR. Payout of the CVR will be overseen by a special committee of the CBF Board. Southern Community shareholders may also receive an additional cash payment based on the terms of a potential repurchase by CBF of the securities issued by Southern Community to the United States Department of the Treasury.

Upon the closing of the Merger, Dr. William G. Ward, Sr., the Chairman of Southern Community’s Board of Directors, will join the Board of Directors of both CBF and its subsidiary bank (“Capital Bank”), and James G. Chrysson, the Vice Chairman of the Board of Southern Community, will join the Board of Capital Bank.

The obligations of Southern Community and CBF to consummate the merger are subject to certain conditions, including: (i) approval of the Merger by the shareholders of Southern Community; (ii) receipt of required regulatory approvals (and in CBF’s case, without the imposition of an unduly burdensome regulatory condition); (iii) the absence of any injunction or similar restraint enjoining or making illegal consummation of the Merger or any of the other transactions contemplated by the Agreement; (iv) the continuing material truth and accuracy of representations and warranties made by the parties in the Agreement; and (vi) the performance in all material respects by each of the parties of its covenants under the Agreement. Some of these conditions may be waived by the party for whose benefit they were included in the Agreement. CBF’s obligation to close is subject to certain additional conditions, including the absence of a material adverse effect on Southern Community and the amendment or waiver of certain of Southern Community’s compensation-related agreements.

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The Agreement may be terminated, before or after receipt of shareholder approval, in certain circumstances, including: (i) upon the mutual consent of the parties; (ii) failure to obtain any required regulatory approval; (iii) by either party if the Merger is not consummated on or before September 26, 2012 if such failure is not caused by material breach of the Agreement; (iv) by either party if there is a material breach of the other party’s representations, warranties, or covenants, and the breach or change that is not cured within 30 days following notice by the complaining party to the complaining party’s reasonable satisfaction; (v) by CBF if Southern Community’s Board fails to recommend that shareholders approve the Agreement and the Merger, changes such recommendation or breaches certain non-solicitation covenants with respect to third party proposals; or (vi) by either party if the shareholders of Southern Community fail to approve the Agreement.

Under certain circumstances, Southern Community will be obligated to pay CBF a termination fee of $4 million and reimburse CBF up to $1 million for all expenses incurred by it in connection with the Agreement and the transactions contemplated thereby.

On July 25, 2012, the Board terminated the employment of Messrs. Bauer and Clark effective September 22, 2012. Their employment agreements, which have now been terminated, contained change in control provisions that provided for a lump sum payment equal to three times the sum of the applicable officer’s base salary for the year of the change in control and the incentive compensation paid in the year prior to the change in control. As previously disclosed in Southern Community’s Form 10-K/A, Amendment No. 1 for the year ended December 31, 2011, the following would have been the estimated cost to the Company in the event of a change in control as of January 1, 2012, pursuant to the employment agreements and Salary Continuation Agreements and assuming that the Treasury’s investment in Southern Community was repaid in full, the Company was no longer under regulatory restrictions and not taking into account the amendments contemplated by the merger agreement. On behalf of Messrs. Bauer and Clark, the estimated cost to the Company would have been approximately $2,622,297 and $1,366,220, respectively. As a condition to the closing of the merger, both the amounts and the terms of potential change in control payments under the employment agreements with Messrs. Bauer and Clark were required to be amended. Since neither officer will be an employee of Southern Community at the time of the merger, amendments to their employment agreements will not be required to consummate the merger.

Regulatory Actions and Management’s Compliance Efforts

On February 25, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the North Carolina Commission of Banks (“NCCOB”). Under the terms of the Consent Order among other things, the Bank has agreed to:

· Strengthen Board oversight of the management and operations of the Bank;

· Comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital;

· Formulate and implement a plan to reduce the Bank’s risk exposure in assets classified “Substandard or Doubtful” in the FDIC’s most recent report of examination by 15% in 180 days, 35% in 360 days, 60% in 540 days and 75% in 720 days;

· Within 90 days, implement effective lending and collection policies;

· Not pay cash dividends without the prior written approval of the FDIC and the Commissioner; and

· Neither renew, rollover or accept any brokered deposits without obtaining a waiver from the FDIC.

On June 23, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond under which the Company agreed to, among other things:

· Not, directly or indirectly, do the following without the prior approval of the Federal Reserve:

¾ Declare or pay dividends on its, common or preferred stock;

¾ Make any distributions of interest or principal on trust preferred securities;

¾ Incur, increase or guarantee any debt; and

¾ Purchase or redeem any shares of its stock.

· Formulate and implement a written plan to maintain sufficient capital at the Company on a consolidated basis.

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As previously reported, the Company suspended the payment of quarterly cash dividends on the preferred stock issued to the US Treasury and the Company elected to defer the payment of quarterly scheduled interest payments on both issues of junior subordinated debentures, relating to its outstanding trust preferred securities. The Company continues to account for the obligation for the preferred dividend to the US Treasury and the interest due on the subordinated debentures. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. As of June 30, 2012, the cumulative amount of dividends owed to the US Treasury and the cumulative amount of interest due on the subordinated debentures were $3.9 million and $4.3 million, respectively.

The Bank has already undertaken the following actions, among others, to comply with the Consent Order:

· The Bank has exceeded all minimum capital requirements of the Consent Order.

· As of June 30, 2012, the Bank reduced its risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination by an amount (60%) exceeding its scheduled reduction of 35% by February 2012 and meeting, in advance, its August 2012 scheduled reduction of 60%.

To date, management believes that the Company’s compliance efforts have been satisfactory and within the scheduled time frames. Compliance efforts remain ongoing.

Summary of Second Quarter

Total assets decreased $54.4 million, or 3.6%, during the second quarter as loans continued to decline but at a much slower rate. Investment securities decreased by $89.8 million, or 22.3%, due to the Company’s active management of the investment portfolio. Loans outstanding decreased $17.8 million, or 1.9%, as loan pay downs continued to exceed weak loan demand. The allowance for loan losses decreased $1.2 million, or 5.1%, to $23.0 million during the quarter as the specific allowance requirements decreased $928 thousand to $1.7 million while the volume of impaired loans individually evaluated for impairment decreased $2.0 million. Foreclosed assets decreased $4.1 million as the $831 thousand in writedowns and $6.4 million in foreclosed assets sold exceeded the new foreclosed asset additions during the quarter of $3.1 million. The liquidity from the loan pay downs and sales of investment securities held at the Federal Reserve ended the quarter at an unusually high balance of $101.5 million. Total deposits were $1.13 billion at June 30, 2012, a decrease of $55.1 million, or 4.7%, from the prior quarter end. The decrease in deposits included decreases of $44.5 million in time deposits and $13.7 million in interest bearing transaction accounts while demand deposits increased $3.2 million. This decrease in time deposits consisted of $24.4 million in outflows of maturing brokered deposits and $20.1 million in customer certificates of deposits. Interest bearing transaction accounts also declined with decreases of $11.1 million in NOW accounts, $2.4 million in money market accounts and $214 thousand in savings accounts. The decrease in interest bearing transaction accounts combined with the decrease in higher cost customer certificates of deposit and brokered deposits minimized the two basis point decrease in the net interest margin for the quarter. We expect wholesale funding to continue to decrease as the Company seeks to grow its core deposits and not renew maturing brokered deposits. Borrowings decreased $2.9 million, or 1.4%, from the prior quarter due primarily to decreased customer repurchase agreement activity.

Net interest income decreased $248 thousand, or 2.3%, for the second quarter compared to the first quarter. The interest rate environment remained stable in the second quarter as the Federal Reserve maintained the federal funds target rate consistent with the prior quarter and changes in LIBOR rates were relatively minor. Total interest income decreased $403 thousand, or 2.5%, while the cost of funds decreased $155 thousand, or 3.2%, compared to the previous quarter. The sequential decrease in interest income was attributable to a $15.5 million decrease in average loan balances and a four basis point decline in the earning asset yields due to the shift in the earning asset mix from loans into lower yielding investments and overnight funds. Interest expense declined primarily due to reduced cost of deposits as interest bearing deposit balances dropped significantly and the continued downward repricing of deposits. The net interest margin decreased two basis points to 3.15% compared to 3.17% for the linked quarter and decreased 28 basis points when compared to 3.43% for the second quarter of 2011. Management expects that interest margin compression will continue in the near future due to, among other factors, (i) more competitive pricing for loans, (ii) a continuation of current balance sheet trends in loan portfolio reduction and earning asset mix shift, (iii) a reduction in the investment securities portfolio and corresponding increase in interest bearing balances held at the Federal Reserve and federal funds sold and (iv) less impactful opportunities to reduce the cost of funds due to the low current interest rate structure of deposits.

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The Company’s provision for loan losses of $2.3 million decreased from $2.9 million for the first quarter and decreased from $3.7 million for the second quarter of 2011. Net charge-offs of $3.5 million increased $600 thousand compared to $2.9 million in the first quarter. Annualized net charge-offs increased to 1.52% of average loans in second quarter 2012 from 1.22% of average loans for first quarter and year-over-year from 1.46% of average loans for the second quarter 2011. Nonperforming loans decreased to $55.1 million, or 6.01% of loans, at June 30, 2012 from $57.9 million, or 6.19% of loans, at March 31, 2012. Nonperforming assets decreased to $75.0 million, or 5.18% of total assets, at June 30, 2012 from $81.9 million, or 5.46% of total assets, at March 31, 2011. The allowance for loan losses of $23.0 million at June 30, 2012 represented 2.50% of total loans and 42% coverage of nonperforming loans at current quarter-end compared with 2.58% of total loans and 42% coverage of nonperforming loans at March 31, 2012. We believe the allowance is adequate for losses inherent in the loan portfolio at June 30, 2012.

Non-interest income of $3.9 million increased $466 thousand, or 13.6%, compared to $3.4 million for the prior quarter and increased $364 thousand, or 10.3%, compared to $3.5 million for the second quarter of 2011. The major sequential changes in non-interest income were increases of $601 thousand from gains on sale of investment securities, an increase of $126 thousand in wealth management income and an increase of $93 thousand in derivative activity. These increases were offset by a decrease in Small Business Investment Corporation (SBIC) income of $370 thousand. The year-over-year increase of $364 thousand in non-interest income was primarily due to increased gains on sale of investment securities of $340 thousand and an increase in SBIC income of $177 thousand; partially offsetting these year-over-year increases was a decrease of $218 thousand in service charges on deposit accounts.

Non-interest expense of $11.2 million in the second quarter of 2012 increased $542 thousand, or 5.1%, from the prior quarter and decreased by $78 thousand, or 0.7%, compared with the year ago period. Linked quarter expense increases were primarily due to increases of $225 in foreclosed asset related expenses and $673 thousand in merger related expense offset by increased gains in sales of foreclosed property of $110 thousand and decreases of $73 thousand in debit card rewards expense and $51 thousand in other outside services expense. Non-interest expense decreased $78 thousand year-over-year primarily from decreases in occupancy and equipment of $198 thousand, FDIC deposit insurance of $161 thousand and advertising of $150 thousand which were offset by an increase of $387 thousand in foreclosed asset related expenses.

Financial Condition at June 30, 2012 and December 31, 2011

During the six month period ending June 30, 2012, total assets declined $55.4 million, or 3.7%, to $1.45 billion. The Company continued to emphasize improving the funding mix and reducing brokered deposits during this time of asset shrinkage from slow loan demand. A decrease of $36.4 million in loans and $93.7 million in investment securities was offset by an increase of $78.6 million in interest bearing deposits and overnight funds. Investment securities that matured or were sold during the quarter remained in our interest bearing account at the Federal Reserve instead of being reinvested due to merger related considerations. Demand deposits increased $12.6 million during the six month period, reaching an all-time high of $148.0 million or 13.1% of total deposits. Money market, NOW and savings accounts increased $9.7 million. Time deposits decreased $78.8 million as a result of $60.2 million in brokered deposits not being renewed, while customer time deposits decreased $18.6 million. The decrease in customer time deposits was due to lower retention of maturing certificates of deposits at a time of declining deposit offering rates and the Bank’s less competitive pricing on time deposits.

Total loans decreased $36.4 million, or 3.8%, during the six month period with decreases in the following major categories: $14.7 million, or 8.5%, in consumer loans, $14.5 million, or 3.8%, in commercial real estate loans, $5.6 million, or 12.3%, in residential lots, $3.2 million or 3.4%, in home equity lines, $2.5 million or 2.9% in commercial and industrial loans and $2.3 million in other loans. Commercial lines of credit increased $3.4 million or 7.7% and residential construction increased $3.0 million or 2.9% during the quarter. Loans outstanding decreased during the period as a result of large loan payoffs and continued problem loan remediation although the amount of the decrease was much less than in prior quarters due to some improvement in new loan volume for the quarter. The allowance for loan losses decreased $1.2 million year to date with a provision of $5.2 million and net charge-offs of $6.4 million. Net charge-offs increased in the second quarter to $3.5 million from the first quarter total of $2.9 million while the provision decreased due to factors discussed in the Asset Quality section below. Year to date net charge-offs have decreased to $6.4 million for the current year from $9.9 million for the six month period of 2011. The reduced amount of provision and charge-offs during the second quarter reflected moderating economic conditions and continued improving trends in the Company’s asset quality.

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At June 30, 2012, the Company’s consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.95%, 12.38% and 14.87%, respectively. As of June 30, 2012, the Bank’s leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 9.66%, 13.36% and 14.62%, respectively. Our capital position remains in excess of our required regulatory capital ratios, including the capital requirements pursuant to the Consent Order. See Note 8 to the financial statements for an update on compliance with the Consent Order. Given the current regulatory environment and recent legislation, our regulatory burden could increase with a material impact on the Company and could include requirements for higher regulatory capital levels and various other restrictions. While regulatory capital requirements are considered, the Company also evaluates its capital needs based on other appropriate business considerations on an ongoing basis. Although raising additional capital has been considered and discussed in recent filings, management does not expect to seek additional sources of capital due to the pending merger with Capital Bank. At June 30, 2012, our stockholders’ equity totaled $100.3 million, an increase of $2.7 million compared to December 31, 2011. The increase is primarily the result of $1.9 million in net income and $769 thousand in other comprehensive income.

Results of Operations for the Three Months Ended June 30, 2012 and 2011

Net Income. Our net income from operations of $1.1 million and our net income available to common shareholders of $446 thousand for the three months ended June 30, 2012 decreased $58 thousand and $65 thousand, respectively, from the same three month period in 2011. Net income per share available to common shareholders was $0.03 per share, both basic and diluted, for the three months ended June 30, 2012 which were unchanged in comparison with the same period in 2011. Net interest income for the second quarter of 2012 was $10.7 million, down from $12.6 million, or a decrease of $1.9 million, or 15.1%, compared with the second quarter 2011, primarily due to a $108.6 million decrease in the average balance of interest earning assets. The net interest margin of 3.15% declined 28 basis points from the year ago period. The shift in the mix of earning assets from loans to lower yielding investments and overnight funds and the decreased loan yields due to pricing competition were the main influences on net interest income. The yield on interest earning assets decreased 39 basis points while the cost of funds decreased only nine basis points year-over-year. Due to the current unusually low interest rate environment, management’s ability to continue to reprice downward our deposits to achieve a meaningful reduction in our cost of funds is limited. A positive factor included in net income was the $1.4 million reduction in the provision for loan losses for the period. Non-interest income was $3.9 million during the second quarter of 2012, which represents an increase of 10.3% from non-interest income of $3.5 million reported in the comparable period in 2011. Non-interest expense declined $78 thousand year-over-year.

Net Interest Income. During the three months ended June 30, 2012, our net interest income was $10.7 million, a decrease of $1.9 million, or 15.1%, over the second quarter 2011. Interest income decreased $2.7 million from the reduced level of interest earning assets. This reduction in our interest income exceeded the $806 thousand decrease in interest expense from reduced interest bearing deposit volume and repricing of deposits.

The average yield on interest-earning assets in the second quarter of 2012 decreased 39 basis points to 4.56% compared to the second quarter 2011 due to the decline in yields for investment securities and the shift in mix from loans to lower yielding securities and overnight deposits. The lower interest rate environment has also impacted our funding costs. Deposits, such as money market and NOW accounts, are repriced at the discretion of management while time deposits can only be repriced as they mature. Over the past year, management repriced all of our deposits downward to continue to lower our funding cost while remaining competitive. Given the Bank’s excess liquidity levels and weak loan demand, management has focused on reducing its levels of time deposits and has continued to reprice deposit offering rates downward. Our cost of average interest bearing liabilities for the second quarter of 2012 decreased eight basis points to 1.58% compared to the second quarter of 2011. For the second quarter 2012, our net interest margin of 3.15% decreased 28 basis points from 3.43% for the second quarter of 2011.

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Average Yield/Cost Analysis

The following table contains information relating to the Company’s average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented. The average loan portfolio balances include nonaccrual loans.

	Three Months								Three Months
	Ended June 30, 2012								Ended June 30, 2011
	(Amounts in thousands)
	Average balance			Interest earned/paid		Average yield/cost			Average balance			Interest earned/paid		Average yield/cost
Interest-earning assets:
Loans	$	931,809		$	12,824		5.54	%	$	1,059,527		$	15,003		5.68	%
Investment securities available for sale		352,247			1,914		2.19	%		304,750			2,490		3.28	%
Investment securities held to maturity		51,591			690		5.39	%		52,937			618		4.68	%
Federal funds sold and overnight deposits		26,505			14		0.21	%		53,581			37		0.28	%
Total interest earning assets		1,362,152			15,442		4.56	%		1,470,795			18,148		4.95	%
Other assets		105,434								11,660
Total assets	$	1,467,586							$	1,482,455
Interest-bearing liabilities:
Deposits:
Money market, NOW and savings	$	487,267		$	521		0.43	%	$	497,711		$	731		0.59	%
Time deposits greater than $100K		213,213			604		1.14	%		237,658			583		0.98	%
Other time deposits		301,380			1,383		1.85	%		394,895			1,978		2.01	%
Short-term borrowings		62,252			424		2.75	%		7,037			35		1.99	%
Long-term borrowings		147,440			1,840		5.02	%		210,592			2,251		4.29	%
Total interest bearing liabilities		1,211,552			4,772		1.58	%		1,347,893			5,578		1.66	%
Demand deposits		144,867								132,559
Other liabilities		12,419								9,794
Stockholders' equity		98,748								92,209
Total liabilities and stockholders' equity	$	1,467,586							$	1,582,455
Net interest income and net interest spread				$	10,670		2.98	%				$	12,570		3.29	%
Net interest margin							3.15	%							3.43	%
Ratio of average interest-earning assets to average interest-bearing liabilities		112.43	%							109.12	%

Provision for Loan Losses. The Company recorded a $2.3 million provision for loan losses for the quarter ended June 30, 2012, representing a decrease of $1.4 million from the $3.7 million provision for the second quarter of 2011. The level of provision for the quarter is reflective of the trends in the loan portfolio, including levels of nonperforming loans and other loan portfolio quality measures, and analyses of impaired loans as well as the level of net charge-offs during the period. The year-over-year decrease in the provision was based on management’s analysis and evaluation of the adequacy of the level of the allowance for loan losses. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Asset Quality” below. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 1.52% for the quarter ended June 30, 2012, compared with 1.46% for the quarter ended June 30, 2011.

Non-Interest Income. For the three months ended June 30, 2012, non-interest income increased $364 thousand, or 10.3%, to $3.9 million from $3.5 million for the same period in 2011 primarily as a result of increased gain on sales of investment securities of $340 thousand and SBIC income of $177 thousand. Insufficient fund, or NSF, charges continued their trend, decreasing $178 thousand, based on a reduction in transaction volumes and other service charges, including debit card charges, decreased $40 thousand. Wealth management fees and mortgage banking income increased $36 thousand and $33 thousand, respectively; while income from derivative activities and other non-interest income remained virtually unchanged.

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Non-Interest Expense. For the three months ended June 30, 2012, non-interest expenses decreased $78 thousand or 0.7%, over the same period in 2011. Merger related expenses including investment banker fees, legal fees and CPA fees, which were not present in the second quarter of 2011, were $673 thousand. Expenses related to foreclosed assets continued to be significant including a year-over-year increase in foreclosed property writedowns of $528 thousand offset by reduced other expenses of $141 thousand. Gains on sales of foreclosed assets decreased $25 thousand due to a number of factors including the higher mix of residential lots being sold this year. Reduced legal and professional expenses included savings of $165 thousand in legal fees and $287 thousand in fees on other professional services. The reduced legal fees related to a decreased volume of problem asset remediation litigation and other work. FDIC deposit insurance premiums decreased $161 thousand primarily due to decreased levels of deposits and a change in the basis of the quarterly assessment calculation. Although the premiums decreased year-over year, the premiums remained high as a result of the previously announced Consent Order and will remain at the higher assessment rates until the Consent Order is no longer in effect. Salaries and employees benefits increased $79 thousand from increases in commissions on mortgage and wealth management production, employee insurance costs and payroll taxes. Occupancy and equipment expense decreased $198 thousand which included decreases of $48 thousand in furniture and equipment depreciation, software maintenance of $44 thousand and building repairs of $49 thousand. Other reductions in non-interest expense included, among other things, advertising of $150 thousand, debit card rewards program of $73 thousand and real estate appraisals of $68 thousand.

Provision for Income Taxes. The Company recorded no income tax expense or benefit for the quarter ending June 30, 2012 or for the second quarter 2011. The Company has now used all available net operating loss (NOL) carry backs and now has an NOL carry forward. No income tax expense is expected until income taxes on future earnings exceed the NOL carry forward of approximately $4.7 million.

Results of Operations for the Six Months Ended June 30, 2012 and 2011

Net Income. Our net income after preferred dividends for the six months ended June 30, 2012 was $616 thousand, compared to $23 thousand for the six months ended June 30, 2011. Net interest income decreased $3.8 million, or 15.0%, compared to the 2011 six month period as net interest margin declined 26 basis points due to decreased yields on loans and the shift in mix of earning assets from loans to lower yielding securities and overnight funds while continuing the downward repricing of deposits and borrowings. The provision for loan losses continued to be the most significant factor in improved profitability, decreasing $2.6 million, or 33.3%, compared to the prior year period. Non-interest income increased $893 thousand, or 13.9%, compared to the prior six month period with significant differences between the two periods discussed below. Non-interest expense decreased $926 million, or 4.1%, year-over-year. The largest increase in non-interest expense for the six month period was $673 thousand for merger related expenses; while the largest decrease was in FDIC deposit insurance expense which decreased $543 thousand.

Net Interest Income. During the six months ended June 30, 2012, our net interest income totaled $21.6 million, a year-over-year decrease of $3.8 million, or 15.0%. The primary reasons for this decrease were the $121.4 million reduction in the average balance of earning assets and the shift in the mix of earning assets from loans to lower yielding investment securities and overnight funds. The impact of these two factors was partially mitigated through the downward repricing of deposits and borrowings as well as an improved funding mix as previously mentioned. Our average yield on interest-earning assets decreased 39 basis points to 4.58% for the first six months of 2012 compared to the same period in 2011. Declining rates have also impacted our funding costs for the first six months of 2012, as funding costs decreased nine basis points to 1.59% from 1.68% for the comparable period a year ago. Average interest bearing liabilities decreased $148.7 million, or 10.8%, to $1.36 billion from $1.23 billion for the six month period ended June 2011. Average demand deposits increased $13.0 million, or 10.3%, year-over-year. For the six months ended June 30, 2012, our net interest spread decreased 30 basis points compared to the prior year at 3.29%; while our net interest margin was 3.16% compared to 3.42% for the prior year period.

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Average Yield/Cost Analysis

The following table contains information relating to the Company’s average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. The average loan portfolio balances include non-accrual loans.

	Six Months								Six Months
	Ended June 30, 2012								Ended June 30, 2011
	(Amounts in thousands)
	Average balance			Interest earned/paid		Average yield/cost			Average balance			Interest earned/paid		Average yield/cost
Interest-earning assets:
Loans	$	939,564		$	26,040		5.57	%	$	1,085,468		$	30,516		5.67	%
Investment securities available for sale		358,358			3,951		2.22	%		308,607			5,053		3.30	%
Investment securities held to maturity		49,304			1,267		5.17	%		49,337			1,167		4.77	%
Federal funds sold and over night deposits		26,937			29		0.22	%		52,180			111		0.43	%
Total interest earning assets		1,374,163			31,287		4.58	%		1,495,592			36,847		4.97	%
Other assets		105,213								110,988
Total assets	$	1,479,376							$	1,606,580
Interest-bearing liabilities:
Deposits:
Money market, NOW and savings	$	484,555		$	1,036		0.43	%	$	519,414		$	1,611		0.63	%
Time deposits greater than $100K		215,553			1,210		1.13	%		223,313			1,156		1.04	%
Other time deposits		318,751			2,943		1.86	%		414,487			4,148		2.02	%
Short-term borrowings		61,514			836		2.74	%		15,013			113		1.52	%
Long-term borrowings		148,671			3,674		4.97	%		205,542			4,418		4.33	%
Total interest bearing liabilities		1,229,044			9,699		1.59	%		1,377,769			11,446		1.68	%
Demand deposits		140,198								127,155
Other liabilities		11,809								9,572
Stockholders' equity		98,325								92,084
Total liabilities and stockholders' equity	$	1,479,376							$	1,606,580
Net interest income and net interest spread				$	21,588		2.99	%				$	25,401		3.29	%
Net interest margin							3.16	%							3.42	%
Ratio of average interest-earning assets to average interest-bearing liabilities		111.81	%							108.55	%

Provision for Loan Losses. The Company recorded a $5.2 million provision for loan losses for the six months ended June 30, 2012, representing a decrease of $2.6 million from the $7.8 million provision for the comparable period of 2011. The level of provision for the quarter is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans as well as the level of net charge-offs during the period. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Asset Quality.” On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 1.37% for the six month period ended June 30, 2012, compared with 1.83% for the period ended June 30, 2011.

Non-Interest Income. For the six months ended June 30, 2012, the Company reported non-interest income of $7.3 million compared to $6.4 million for the first six months of 2011, an increase of $893 thousand, or 13.9%. SBIC income improved $725 thousand due to significant investment harvest gains in the current year. Gains from derivative activity increased $687 thousand, or 162.0%, for the period due to consistent activity in the current year compared to a $384 thousand mark to market charge on the ineffective trust preferred interest rate swap which was incurred during the prior year. Mortgage banking income increased $75 thousand, or 13.5%, as new loan origination activity improved during the 2012 period. Investment brokerage income increased $78 thousand during the 2012 period on increased brokerage transaction volume. The year-over-year decrease in service charges on deposits of $344 thousand was primarily attributable to a $346 thousand decrease in NSF fees, reflecting the trend of more customer transactions being completed electronically and fewer checks being written. Gains on sales of investment securities decreased $341 thousand, or 23.2%, year-over-year as management actively managed the investment portfolio and sold investment securities that met certain criteria.

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Non-Interest Expense. For the six months ended June 30, 2012, the Company reported non-interest expense of $21.8 million compared to $22.7 million for the first six months of 2011, a decrease of $926 thousand, or 4.1%. FDIC deposit insurance premiums decreased $543 thousand primarily due to decreased levels of deposits and a change in the basis of the quarterly assessment calculation. Significant expense reductions of $359 thousand were realized in legal fees while other professional fees decreased an additional $486 thousand. Advertising expense decreased $152 thousand due to reduced advertisement of deposit rates. Merger related expenses including investment banker fees, legal fees and CPA fees, which were not present in the prior period, were $673 thousand. Expenses related to foreclosed assets continued to be significant including a year-over-year increase in foreclosed property writedowns of $379 thousand offset by reduced other expenses of $74 thousand. Gains on sales of foreclosed assets decreased $233 thousand due to a number of factors including the higher mix of residential lots being sold this year. Occupancy and equipment expense decreased $342 thousand compared to the prior period of 2011 due to reduced building maintenance, software maintenance and furniture and fixture leases and equipment depreciation. Other non-interest expense decreases for the period included debit card rewards of $78 thousand, contract employee services of $68 thousand, shareholder relations of $38 thousand and real estate appraisals of $32 thousand.

Provision for Income Taxes. The Company recorded no income tax expense or benefit for the six months ended June 30, 2012 or 2011. The Company has now used all available net operating loss (NOL) carry backs and now has a NOL carry forward. No income tax expense or benefit is expected until future earnings exceed the NOL carry forward.

Liquidity and Capital Resources

Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and sufficient levels of capital resources to generate appropriate earnings and to maintain a consistent dividend policy.

Liquidity is defined as our ability to meet anticipated customer demands for funds under credit commitments and deposit withdrawals at a reasonable cost and on a timely basis. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of funds and demands for funds on a daily and weekly basis.

Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, unpledged investments available for sale, loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan Bank, the Federal Reserve and from correspondent banks through overnight federal funds credit lines. In addition to deposit and borrowing withdrawals and maturities, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.

We believe our liquidity is adequate to fund expected loan demand and current deposit and borrowing maturities particularly in light of the expected continued balance sheet shrinkage through loan remediation activities and continued slowdown in loan demand. During the six months ended June 30, 2012, $60.2 million of brokered deposits matured and were repaid. We expect an additional $13.0 million in brokered deposits to mature or be called by December 31, 2012. Under the provisions of the Consent Order, the Bank may not renew rollover or replace these brokered deposits at their call or maturity. Investment securities totaled $313.0 million at June 30, 2012, a decrease of $93.7 million from $406.7 million at December 31, 2011. As of June 30, 2012, there were $119.9 million in unpledged securities collateral. In addition, management has increased our overnight balances at the Federal Reserve Bank to $101.5 million at June 30, 2012 versus our reserve requirement of $5.6 million for the applicable period. Supplementing liquid assets and customer deposits as a source of funding, we have available a line of credit from a correspondent bank to purchase federal funds on a short-term basis of approximately $40.0 million. We also have the credit capacity from the Federal Home Loan Bank of Atlanta (FHLB) to borrow up to $361.1 million as of June 30, 2012 with lendable collateral value of $87.6 million and current outstanding borrowings of $76.5 million. At June 30, 2012, we had funding of $60.0 million in the form of term repurchase agreements with maturities from two to seven years under repurchase lines of credit from various institutions. The repurchases must be and are adequately collateralized. We also had short-term repurchase agreements with total outstanding balances of $24.3 million and $28.6 million at June 30, 2012 and December 31, 2011, respectively, $4.3 million of which were done as accommodations for our deposit customers. In addition to the investment securities, $3.0 million in cash is currently being held as collateral for one short term repurchase agreement. At June 30, 2012, our outstanding commitments to extend credit consisted of loan commitments of $141.5 million and amounts available under home equity credit lines, other credit lines and letters of credit of $85.6 million, $8.4 million and $5.5 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.

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Historically, we relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. Under the Consent Order, as discussed above, the Bank is not permitted to accept, renew or rollover any brokered deposits. During the six months of 2012, brokered deposits decreased $60.2 million as maturing brokered deposits were not renewed. Year-over-year demand deposits increased $20.6 million, or 16.1%. Customer certificates of deposits decreased $29.6 million, or 6.8%, on a year-over-year basis; while money market, savings and NOW accounts decreased $4.8 million, or 1.0%. Customers’ certificates of deposit decreased significantly due to lower retention of maturing certificates of deposit at a time of declining deposit offering rates and the Bank’s less competitive pricing on time deposits. Certificates of deposits represented 36.0% of our total deposits at June 30, 2012, an increase from 34.9% at June 30, 2011.

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval. In February 2011, the Company suspended the payment of quarterly cash dividends to the US Treasury on this cumulative preferred stock. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. Interest on the past due payments is now also being accrued. As of June 30, 2012, the total amount of cumulative dividends and interest owed to the US Treasury was $3.9 million. As part of the merger with Capital Bank, it is expected that the Treasury’s investment in the Company’s preferred stock will be redeemed.

As a condition of the CPP, the Company must obtain consent from the United States Department of the Treasury to repurchase its common stock or to increase its cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. The Company has agreed to certain restrictions on executive compensation, including limitations on amounts payable to certain executives under severance arrangements and change in control provisions of employment contracts and clawback provisions in compensation plans, as part of the CPP. Under the American Recovery and Reinvestment Act of 2009, the Company is limited to using restricted stock as the form of payment to the top five highest compensated executives under any incentive or bonus compensation programs.

Through July 2006, the Company authorized the repurchase of up to 1.9 million shares of its common stock. Through December 5, 2008 (the date of our participation in the CPP), the Company had repurchased 1,858,073 shares at an average price of $6.99 per share under the three plans. During the first six months of 2012, there were no repurchases. Under the provisions of the CPP, the Company may not repurchase any of its common stock without the consent of the United States Treasury as long as the Treasury holds an investment in our preferred stock.

At June 30, 2012, the Company’s consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.95%, 12.38% and 14.87%, respectively, which exceeded the minimum requirements for a “well-capitalized” bank holding company. As of June 30, 2012, the Bank’s leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 9.66%, 13.36% and 14.62%, respectively. The Consent Order, as set forth above, requires the Bank to achieve and maintain minimum capital requirements of 8% Tier 1 (leverage) capital and 11% total risk-based capital. Our capital position remains in excess of our regulatory capital requirements pursuant to the Consent Order. In addition to utilizing balance sheet shrinkage through net loan run-off and the reduction in brokered deposits and ways to improve Bank profitability, the Company has considered various strategies, including: asset sales, plans for capital injections, taking action to restructure the risk weighting of assets, capital raising and strategic partnerships in order to achieve and maintain compliance with the terms of the Consent Order. Due to the pending merger with Capital Bank Financial Corp., management does not expect to seek additional sources of capital. As of June 30, 2012, the parent holding company had $5.5 million in cash available to be invested into the Bank to bolster capital levels.

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Given the current regulatory environment and recent legislation such as the Dodd-Frank Act, our regulatory burden could increase with a material impact on the Company and could include requirements for higher regulatory capital levels and various other restrictions.

On March 24, 2009, the Company announced that its Board of Directors voted to suspend payment of a quarterly cash dividend to common shareholders.

Asset Quality

We consider asset quality to be of primary importance. We employ a formal internal loan review process to ensure adherence to the Board-approved Lending Policy. It is the responsibility of each lending officer to assign an appropriate risk grade to every loan originated. Credit Administration, through the loan review process, validates the accuracy of the initial and any revised risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, it is the loan officer’s responsibility to change the borrower’s risk grade accordingly. Our policy in regard to past due loans normally requires a charge-off to the allowance for loan losses within a reasonable period after collection efforts and a thorough review have been completed. Further collection efforts are then pursued through various means including legal remedies. Loans carried in a nonaccrual status and probable losses are considered in the determination of the allowance for loan losses.

Our financial statements are prepared on the accrual basis of accounting, which means we recognize interest income on loans, unless we place a loan on nonaccrual basis. We account for loans on a nonaccrual basis when we have serious doubts about the collectability of principal or interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. If a borrower brings their loan current, our general policy is to keep this loan in a nonaccrual status until this loan has remained current for six months. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. We record interest on restructured loans at the restructured rates, as collected, when we anticipate that no loss of original principal will occur. Management also considers potential problem loans in the evaluation of the adequacy of the Bank’s allowance for loan losses. Potential problem loans are loans which are currently performing and are not included in nonaccrual or restructured loans as shown above, but about which we have doubts as to the borrower’s ability to comply with present repayment terms. Because these loans are at a heightened risk of becoming past due, reaching nonaccrual status or being restructured, they are being monitored closely.

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Nonperforming Assets

In the tables and discussion below, the credit metrics for the current quarter and their sequential changes are illustrated reflecting: 1) a $2.8 million decrease in nonperforming loans; 2) $7.0 million decrease in nonperforming assets as foreclosed assets decreased $4.2 million returning to a near year end level; 3) a sequential increase in 30-89 delinquencies driven by one loan; 4) a significant decrease in criticized assets (Special Mention, Substandard and Doubtful); and 5) the continued reduction in the higher risk loan segments of aged speculative construction and land acquisition and development loans.

The following is a summary of nonperforming assets at the periods presented:

	June 30,		March 31,		December 31,		September 30,		June 30,
	2012		2012		2011		2011		2011
	(Amounts in thousands)
Nonaccrual loans	$	34,443	$	31,499	$	38,715	$	39,587	$	45,381
Restructured loans - nonaccruing		20,669		26,404		29,333		32,870		21,422
Total nonperforming loans		55,112		57,903		68,048		72,457		66,803
Foreclosed assets		19,873		24,032		19,812		19,114		23,022
Total nonperforming assets	$	74,985	$	81,935	$	87,860	$	91,571	$	89,825
Restructured loans in accruing status not included above	$	24,107	$	24,486	$	24,202	$	22,214	$	15,471

Nonperforming loans decreased to $55.1 million, or 6.01% of total loans, at June 30, 2012 compared to $57.9 million or 6.19% of total loans at March 31, 2012 and $68.0 million, or 7.13% of total loans, at December 31, 2011. This $12.9 million year to date decrease in nonperforming loans is due to the impact of: $6.4 million in net charge-offs $8.3 million in loans foreclosed upon and approximately $4.6 million in loan payoffs and pay downs which more than offset the $16.5 million in new additions to nonperforming loans year to date. Foreclosed assets increased $61 thousand for the first six months as $8.3 million in new foreclosed asset additions was offset by sales of foreclosed properties of $7.0 million and writedowns of $1.3 million. The increase in sales year to date was affected by the sale of three large commercial real estate properties during the second quarter.

The following table sets forth a breakdown of nonperforming loans at the periods presented, by loan segment.

	June 30,		March 31,		December 31,		September 30,		June 30,
Nonperforming loans	2012		2012		2011		2011		2011
	(Amounts in thousands)
Construction	$	13,162	$	12,887	$	12,975	$	16,412	$	13,424
Commercial real estate		17,429		19,234		26,484		31,035		28,730
Commercial and industrial		4,228		3,292		4,977		5,524		3,917
Residential lots		10,056		12,305		12,096		8,717		8,806
Consumer		10,237		10,185		11,516		10,769		11,926
Total nonperforming loans	$	55,112	$	57,903	$	68,048	$	72,457	$	66,803

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The following table sets forth a breakdown, by loan class, of impaired loans that were individually evaluated for loss impairment at June 30, 2012. This table further shows, within each loan class, the evaluation results for those loans requiring a specific valuation allowance and those which did not.

	With Specific Allowance						No Specific Allowance
	Unpaid						Unpaid				Total		Net
	Principal		Recorded		Specific		Principal		Recorded		Recorded		of Specific
	Balance		Investment		Allowance		Balance		Investment		Investment		Allowance
	(Amounts in thousands)
Commercial real estate	$	12,394	$	12,394	$	673	$	30,821	$	20,743	$	33,137	$	32,464
Commercial
Commercial and industrial		815		815		524		4,034		3,086		3,901		3,377
Commercial line of credit		397		397		167		1,070		939		1,336		1,169
Residential real estate
Residential construction		646		646		11		17,466		15,426		16,072		16,061
Residential lot loans		-		-		-		15,075		10,076		10,076		10,076
Raw land		-		-		-		2,716		114		114		114
Home equity lines		1,007		1,007		250		435		403		1,410		1,160
Consumer loans		2,509		2,282		74		7,081		6,514		8,796		8,722
Total	$	17,768	$	17,541	$	1,699	$	78,698	$	57,301	$	74,842	$	73,143

The recorded investment in loans that were considered individually impaired, including all non-accrual loans and accruing troubled debt restructured loans, was $74.8 million and $87.1 million at June 30, 2012 and December 31, 2011, respectively. At June 30, 2012, the largest non-accrual balance of any one borrower was $8.0 million, with the average balance for the two hundred fourteen non-accrual loans being $258 thousand. Included in the table above, $52.4 million of the total $55.1 million of non-accrual loans and $22.4 million of the total $24.1 million of accruing troubled debt restructured loans were individually evaluated as they exceeded the evaluation scope of $200,000 per loan. The results of the individual evaluations indicated that $2.6 million in non-accrual loans and $14.9 million in accruing troubled debt restructured loans required specific allowances of $1.2 million and $526 thousand, respectively, for an aggregate specific allowance of $1.7 million. In the above table for these impaired loans individually evaluated for loss impairment, the unpaid principal balance represents the amount borrowers owe the Bank; while the recorded investment represents the amount of loans shown on the Bank’s books which are net of amounts charged off to date. For these impaired loans as of June 30, 2012, amounts charged off to date were $21.6 million, or 22.4% of the unpaid principal balances.

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The Company has a small residential mortgage portfolio without the need to utilize government sponsored loan modification programs. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

As illustrated in one of the tables in Note 4 to the financial statements, during the six months ended June 30, 2012, the following concessions were made on 16 loans for $5.2 million (measured as a percentage of loan balances on TDRs):

· Reduced interest rate for 40% (3 loans for $2.0 million);

· Extension of payment terms for 50% (11 loans for $2.6 million); and

· Forgiveness of principal for 10% (2 loans for $531 thousand).

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

Of the total of 86 loans for $36.9 million which were modified as TDRs during the twelve months ended June 30, 2012, there were payment defaults (where the modified loan was past due thirty days or more) of $617 thousand, or 1.7%, during the six months ended June 30, 2012.

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On these TDRs (86 loans for $36.9 million) during the twelve months ended June 30, 2012, the following represents the success or failure of these concessions during the past year:

· 89.5% are paying as restructured;

· 0.3% have been reclassified to nonaccrual;

· 5.3% have defaulted and/or been foreclosed upon; and

· 4.9% have paid in full.

For a further breakdown of the successes and failures of each type of concession/modification, see the table in Note 4 to the financial statements.

In addition to nonperforming loans and accruing TDRs, there were $102.6 million of loans at June 30, 2012 for which management has concerns regarding the ability of the borrowers to meet existing repayment terms, compared with $98.5 million at December 31, 2011. See “Credit Quality Indicators” below for a more detailed disclosure and discussion on the Bank’s distribution of credit risk grade classifications. Potential problem loans are primarily classified as substandard for regulatory purposes and reflect the distinct possibility, but not the probability, that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Although these loans have been identified as potential problem loans, they may never become delinquent, nonperforming or impaired. Additionally, these loans are generally secured by real estate or other assets, thus reducing the total exposure should they become nonperforming. Potential problem loans are considered in the determination of the adequacy of the allowance for loan losses.

The following table sets forth a breakdown of foreclosed assets at the periods presented, by nature of the property.

	June 30,		March 31,		December 31,		September 30,		June 30,
Foreclosed assets	2012		2012		2011		2011		2011
	(Amounts in thousands)
Residential construction, land
development and other land	$	9,210	$	10,452	$	9,854	$	11,617	$	14,360
Commercial construction		-		1,196		1,196		1,196		1,196
1 - 4 family residential properties		1,770		2,126		1,990		2,453		1,245
Nonfarm nonresidential properties		8,893		10,258		6,772		3,808		6,221
Multi-family properties		-		-		-		40		-
Total foreclosed assets	$	19,873	$	24,032	$	19,812	$	19,114	$	23,022

Foreclosed assets decreased $4.2 million, or 17%, sequentially as strong sales of foreclosed properties of $6.4 million and writedowns of $831 thousand exceeded the $3.0 million in new foreclosed asset additions. During the quarter ended June 30, 2012, foreclosed property was affected by the sales of three large commercial real estate properties.

- 17 -

Credit Quality Indicators

We monitor credit risk migration and delinquency trends in the ongoing evaluation and assessment of credit risk exposure in the overall loan portfolio. The following table presents quarterly trends in loan delinquencies, in loans classified substandard or doubtful and in nonperforming loans.

	June 30,					March 31,					December 31,					September 30,					June 30,
	2012					2012					2011					2011					2011
	(Amounts in millions)
	$		% of Total Loans			$		% of Total Loans			$		% of Total Loans			$		% of Total Loans			$		% of Total Loans
Loans delinquencies:
30 - 89 days past due	$	6.2		0.68	%	$	4.5		0.48	%	$	5.2		0.55	%	$	4.5		0.46	%	$	4.3		0.41	%
Loans classified substandard or doubtful	$	180.2		19.64	%	$	176.8		18.90	%	$	185.7		19.46	%	$	205.6		20.72	%	$	210.0		20.19	%
Nonperforming loans	$	55.1		6.01	%	$	57.9		6.19	%	$	68.0		7.13	%	$	72.5		7.30	%	$	66.8		6.42	%

Delinquency is viewed as one of the leading indicators for credit quality. The Company’s 30-89 day past due statistic increased sequentially by $1.7 million to $6.2 million, or 0.68% of total loans, at June 30, 2012. This sequential increase was driven by one loan for $2.9 million which matured during the second quarter and the borrower is in process of putting the underlying property on the market for sale. The borrower is expected to bring this loan current in the near term and keep it current until the property is liquidated and the loan is paid off. Absent this loan, the Company’s 30-89 day delinquency would be $3.3 million, or 0.36% of total loans, at June 30, 2012. The improvement in loan delinquencies is attributable to a continued strong involvement of commercial loan officers and their management in monthly collection efforts.

Another key indicator of credit quality is the distribution of credit risk grade classifications in the loan portfolio and the trends in the movement or migration of these risk grades or classifications. See Note 5 in the financial statements for a description of the Bank’s credit risk grade classifications. The Substandard (Grade 7) and Doubtful (Grade 8) classifications denote adversely classified loans, while the Special Mention (Grade 6) classification may provide an early warning indicator of deterioration in the credit quality of a loan portfolio. The following table is a summary of certain classified loans in our loan portfolio at the dates indicated.

	June 30,					March 31,					December 31,					September 30,					June 30,
	2012					2012					2011					2011					2011
	$		% of Total Loans			$		% of Total Loans			$		% of Total Loans			$		% of Total Loans			$		% of Total Loans
	(Amounts in millions)
Special Mention	$	61.7		6.8	%	$	86.8		9.3	%	$	96.1		10.1	%	$	100.0		10.1	%	$	104.1		10.0	%
Substandard and Doubtful		180.2		19.7	%		176.8		19.0	%		185.7		19.6	%		205.6		20.8	%		210.0		20.2	%
	$	241.9		26.5	%	$	263.6		28.3	%	$	281.8		29.7	%	$	305.6		30.9	%	$	314.1		30.2	%

Criticized loans (consisting of loans classified Special Mention, Substandard and Doubtful) decreased by $21.7 million, or 8%, during the second quarter of 2012 and decreased by $39.9 million, or 14% during the six months ended June 30, 2012. These reductions were due to ongoing loan remediation efforts partially mitigated by portfolio downgrades during the period. The $3.4 million, or 2%, increase in adversely classified loans was the result of downgrades of loans previously classified Special Mention.

- 18 -

The following table contains an indicator of the overall credit quality of each loan class, denoted by the weighted average risk grade, along with a further breakdown of the certain classified loans by loan class at June 30, 2012.

	Weighted
	Average	Special		Substandard and
	Risk Grade	Mention		Doubtful
		(Amounts in thousands)
Commercial real estate	4.91	$	26,778	$	72,947
Commercial
Commercial and industrial	4.83		4,872		19,271
Commercial line of credit	4.55		3,101		5,481
Residential real estate
Residential construction	4.95		8,106		25,858
Residential lots	6.19		3,655		26,474
Raw land	5.14		200		3,168
Home equity lines	3.65		1,251		5,024
Consumer	4.51		13,698		21,974
		$	61,659	$	180,199

Compared with December 31, 2011, the above mentioned weighted average risk grades, within these loan classes and in the aggregate, have not changed significantly.

In addition to the financial strength of each borrower and cash flow characteristics of each project, the repayment of construction and development loans are particularly dependent on the value of the real estate collateral. Repayment of such loans is generally considered subject to greater credit risk than residential mortgage loans. Regardless of the underwriting criteria the Company utilizes, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of the real estate collateral and problems affecting the credit of our borrowers.

Furthermore, we monitor certain performance and credit metrics related to these higher risk loan categories, including the aging of the underlying loans in these categories. As of June 30, 2012, speculative construction loans on our books more than twelve months amounted to $9.9 million, or 30.1%, of the total speculative residential construction loan portfolio of $32.9 million. This aged segment of the speculative residential construction loan portfolio has declined to 30.1% from 37.9% at December 31, 2011. This speculative residential construction portfolio has decreased from $33.3 million at December 31, 2011 and decreased from $37.7 million at June 30, 2011. Land acquisition and development loans on our books for more than twenty-four months at June 30, 2012 amounted to $34.8 million, or 79.5%, of that $43.8 million portfolio. The land acquisition and development portfolio has decreased from $46.0 million as of December 31, 2011 and decreased from $55.8 million as of June 30, 2011.

Analysis of Allowance for Loan Losses

Our allowance for loan losses (“ALLL”) is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off and we reduce our allowance by loans charged off. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors derived from our history of operations. Management is continuing to closely monitor the value of real estate serving as collateral for our loans, especially lots and land under development, due to continued concern that the low level of real estate sales activity will continue to have a negative impact on the value of real estate collateral. In addition, depressed market conditions have adversely impacted, and may continue to adversely impact, the financial condition and liquidity position of certain of our borrowers. Additionally, the value of commercial real estate collateral may come under further pressure from weak economic conditions and prevailing unemployment levels. The methodology and assumptions used to determine the allowance are continually reviewed as to their appropriateness given the most recent losses realized and other factors that influence the estimation process. The model assumptions and resulting allowance level are adjusted accordingly as these factors change.

- 19 -

The ALLL consists of two major components: specific valuation allowances and a general valuation allowance. The Bank’s format for the calculation of ALLL begins with the evaluation of individual loans considered impaired. For the purpose of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be evaluated for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Once a loan is considered individually impaired, it is not included in other troubled loan analysis, even if no specific allowance is considered necessary.

In addition to the evaluation of loans for impairment, we calculate the loan loss exposure on the remaining loans (not evaluated for impairment) by applying the applicable historical loan loss experience of the loan portfolio to provide for probable losses in the loan portfolio through the general valuation allowance. These loss factors are based on an appropriate loss history for each major loan segment more heavily weighted for the most recent twelve months historical loss experience to reflect current market conditions. In addition, we assign additional general allowance requirements utilizing qualitative risk factors related to economic trends (such as the unemployment rate and changes in real estate values) and portfolio trends (such as delinquencies and concentration levels among others) that are pertinent to the underlying risks in each major loan segment in estimating the general valuation allowance. This methodology allows us to focus on the relative risk and the pertinent factors for the major loan segments of the Company. The Company incorporates certain refinements and improvements to its allowance for loan losses methodology from time to time. During 2011 and for the six months ended June 30, 2012, these refinements had a minimal effect on the total allowance for loan losses.

As discussed herein, management has undertaken various initiatives since mid-year 2010 in response to the challenging economic environment, increased nonperforming loans, weakened collateral positions, and increased foreclosed asset levels, including but not limited to:

· Restructuring interest only loan payment terms to require principal repayments;

· Refining the allowance for loan losses methodology to weight current period loss experience more heavily;

· Downgrading renewed and other higher risk loans to a substandard classification;

· Enhancing the internal controls surrounding troubled debt restructured (TDR) loan identification and monitoring;

· Charging off weakened credits;

· Increasing the staffing resources of our Credit Administration function, including problem asset management and loan review;

· Enhancing our internal and external loan review protocol; and

· Increasing the general valuation allowance component of our allowance for loan losses.

- 20 -

The following table shows, an analysis of the allowance for loan losses by loan segment, for the quarter ended June 30, 2012.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
Allowance for credit losses:	(Amounts in thousands)
Beginning balance	$	8,925		$	3,092		$	7,861		$	1,266		$	3,037		$	24,181
Provision		1,410			574			76			34			206			2,300
Charge-offs		(1,802	)		(356	)		(1,597	)		(139	)		(586	)		(4,480	)
Recoveries		321			112			433			7			80			953
Ending balance	$	8,854		$	3,422		$	6,773		$	1,168		$	2,737		$	22,954

The following table shows, by loan segment, an analysis of the allowance for loan losses for the six months ended June 30, 2012.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
Allowance for credit losses:	(Amounts in thousands)
Beginning balance	$	9,076		$	3,036		$	7,258		$	1,412		$	3,383		$	24,165
Provision		2,778			1,390			1,202			(103	)		(67	)		5,200
Charge-offs		(3,529	)		(1,256	)		(2,169	)		(151	)		(943	)		(8,048	)
Recoveries		529			252			482			10			364			1,637
Ending balance	$	8,854		$	3,422		$	6,773		$	1,168		$	2,737		$	22,954

The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur.

	At June 30, 2012					At March 31, 2012					At December 31, 2011					At September 30, 2011
			% of					% of					% of					% of
By Loan Class	Amount		Total ALLL			Amount		Total ALLL			Amount		Total ALLL			Amount		Total ALLL
	(Amounts in thousands)
Commercial real estate	$	8,854		38.6	%	$	8,925		36.9	%	$	9,076		37.6	%	$	8,072		30.6	%
Commercial
Commercial and industrial		2,251		9.8	%		1,741		7.2	%		1,865		7.7	%		2,504		9.5	%
Commercial line of credit		1,171		5.1	%		1,351		5.6	%		1,171		4.8	%		1,047		4.0	%
Residential real estate
Residential Construction		4,187		18.2	%		4,827		20.0	%		4,564		18.9	%		5,559		21.0	%
Residential lots		2,457		10.7	%		2,821		11.7	%		2,595		10.7	%		4,295		16.3	%
Raw land		129		0.6	%		213		0.9	%		99		0.5	%		218		0.8	%
Home equity lines		1,168		5.1	%		1,266		5.2	%		1,412		5.8	%		1,665		6.3	%
Consumer		2,737		11.9	%		3,037		12.5	%		3,383		14.0	%		3,049		11.5	%
	$	22,954		100.0	%	$	24,181		100.0	%	$	24,165		100.0	%	$	26,409		100.0	%

- 21 -

Item 1 - Financial Statements

SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)

	June 30,			December 31,
	2012			2011*
	(Amounts in thousands, except share data)
Assets
Cash and due from banks	$	25,144		$	23,356
Federal funds sold and overnight deposits		101,784			23,198
Investment securities
Available for sale, at fair value		261,944			362,298
Held to maturity, at amortized cost		51,009			44,403
Federal Home Loan Bank stock		5,957			6,842
Loans held for sale		4,032			4,459
Loans		913,591			950,022
Allowance for loan losses		(22,954	)		(24,165	)
Net Loans		890,637			925,857
Premises and equipment, net		37,501			38,315
Foreclosed assets		19,873			19,812
Other assets		49,080			54,038
Total Assets	$	1,446,961		$	1,502,578
Liabilities and Stockholders’ Equity
Deposits
Non-interest bearing demand	$	148,048		$	135,434
Money market, NOW and savings		485,569			475,900
Time		493,084			571,838
Total Deposits		1,126,701			1,183,172
Short-term borrowings		59,268			33,629
Long-term borrowings		147,426			177,514
Other liabilities		13,227			10,628
Total Liabilities		1,346,622			1,404,943
Stockholders’ Equity
Senior cumulative preferred stock (Series A), no par value, 1,000,000 shares authorized; 42,750 shares issued and outstanding at June 30, 2012 and December 31, 2011		42,091			41,870
Common stock, no par value, 30,000,000 shares authorized; issued and outstanding 16,854,775 shares at June 30, 2012  and 16,827,075 shares at December 31, 2011		119,534			119,505
Retained earnings (accumulated deficit)		(62,740	)		(64,425	)
Accumulated other comprehensive income		1,454			685
Total Stockholders’ Equity		100,339			97,635
Total Liabilities and Stockholders' Equity	$	1,446,961		$	1,502,578

* Derived from audited consolidated financial statements

See accompanying notes.

- 22 -

SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
	(Amounts in thousands, except per share and share data)
Interest Income
Loans	$	12,824	$	15,003	$	26,040	$	30,516
Investment securities available for sale		1,914		2,490		3,951		5,053
Investment securities held to maturity		690		618		1,267		1,167
Federal funds sold and overnight deposits		14		37		29		111
Total Interest Income		15,442		18,148		31,287		36,847
Interest Expense
Money market, NOW and savings deposits		521		731		1,036		1,611
Time deposits		1,987		2,561		4,153		5,304
Borrowings		2,264		2,286		4,510		4,531
Total Interest Expense		4,772		5,578		9,699		11,446
Net Interest Income		10,670		12,570		21,588		25,401
Provision for Loan Losses		2,300		3,700		5,200		7,800
Net Interest Income After Provision for Loan Losses		8,370		8,870		16,388		17,601
Non-Interest Income
Service charges and fees on deposit accounts		1,363		1,581		2,725		3,069
Income from mortgage banking activities		324		291		629		554
Investment brokerage and trust fees		356		320		586		508
Gain on sale of investment securities		864		524		1,127		1,468
SBIC income and management fees		300		123		970		245
Other		691		695		1,293		593
Total Non-Interest Income		3,898		3,534		7,330		6,437
Non-Interest Expense
Salaries and employee benefits		4,647		4,568		9,333		9,314
Occupancy and equipment		1,662		1,860		3,302		3,644
FDIC deposit insurance		771		932		1,522		2,065
Foreclosed asset related		1,023		636		1,821		1,515
Merger related expense		673		-		673		-
Other		2,401		3,259		5,161		6,200
Total Non-Interest Expense		11,177		11,255		21,812		22,738
Income Before Income Taxes		1,091		1,149		1,906		1,300
Income Tax (Benefit) Expense		-		-		-		-
Net Income		1,091		1,149		1,906		1,300
Effective Dividend on Preferred Stock		645		638		1,290		1,277
Net Income Available to Common Shareholders	$	446	$	511	$	616	$	23
Net Income Per Common Share
Basic	$	0.03	$	0.03	$	0.04	$	-
Diluted		0.03		0.03		0.04		-
Weighted Average Common Shares Outstanding
Basic		16,858,572		16,835,724		16,849,841		16,829,898
Diluted		16,934,115		16,906,810		16,921,561		16,897,702

See accompanying notes.

- 23 -

SOUTHERN COMMUNITY FINANCIAL CORPORATION

Consolidated STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Amounts in thousands)
Net income	$	1,091		$	1,149		$	1,906		$	1,300
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding gains on available for sale securities		2,296			3,387			3,280			2,798
Tax effect		(885	)		(1,306	)		(1,264	)		(1,079	)
Reclassification of gains recognized in net income		(864	)		(524	)		(1,127	)		(1,468	)
Tax effect		333			202			434			566
Net of tax amount		880			1,759			1,323			817
Cash flow hedging activities:
Unrealized holding (gains) losses on cash flow hedging activities		(850	)		(137	)		(903	)		(150	)
Tax effect		328			52			349			57
Reclassification of (gains) losses recognized in net income, net:
Reclassified into income		-			75			-			534
Tax effect		-			(28	)		-			(206	)
Net of tax amount		(522	)		(38	)		(554	)		235
Total other comprehensive income		358			1,721			769			1,052
Comprehensive income	$	1,449		$	2,870		$	2,675		$	2,352

See accompanying notes.

- 24 -

SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

	Preferred Stock				Common Stock				Retained Earnings			Accumulated Other		Total
	Shares		Amount		Shares		Amount		(Accumulated Deficit)			Comprehensive Income		Stockholders' Equity
					(Amounts in thousands, except share data)
Balance at December 31, 2011		42,750	$	41,870		16,827,075	$	119,505	$	(64,425	)	$	685	$	97,635
Net income		-		-		-		-		1,906			-		1,906
Other comprehensive income, net of tax		-		-		-		-		-			769		769
Stock options exercised including income tax benefit of $0		-		-		200		-		-			-		-
Restricted stock issued		-		-		27,500		26		-			-		26
Stock-based compensation		-		-		-		3		-			-		3
Preferred stock accretion of discount		-		221		-		-		(221	)		-		-
Balance at June 30, 2012		42,750	$	42,091		16,854,775	$	119,534	$	(62,740	)	$	1,454	$	100,339

See accompanying notes.

- 25 -

SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Six Months Ended
	June 30,
	2012			2011
	(Amounts in thousands)
Cash Flows from Operating Activities
Net income	$	1,906		$	1,300
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		2,630			2,156
Provision for loan losses		5,200			7,800
Net proceeds from sales of loans held for sale		28,173			29,164
Originations of loans held for sale		(27,117	)		(24,243	)
Gain from mortgage banking		(629	)		(554	)
Stock-based compensation		29			47
Net increase in cash surrender value of life insurance		(511	)		(542	)
Realized gain on sale of available for sale securities, net		(1,127	)		(1,468	)
Realized loss on sale of premises and equipment		4			-
(Gain) loss on economic hedges		(263	)		424
Deferred income taxes		(830	)		-
Realized gain on sales of foreclosed assets		(258	)		(490	)
Writedowns in carrying values of foreclosed assets		1,291			912
Changes in assets and liabilities:
Decrease in other assets		4,583			4,543
Increase in other liabilities		3,085			1,126
Total Adjustments		14,260			18,875
Net Cash Provided by (Used in) Operating Activities		16,166			20,175
Cash Flows from Investing Activities
(Increase) decrease in federal funds sold		(78,586	)		3,207
Purchase of:
Available-for-sale investment securities		(82,304	)		(136,116	)
Held-to-maturity investment securities		(8,552	)		(7,829	)
Proceeds from maturities and calls of:
Available-for-sale investment securities		22,437			16,825
Held-to-maturity investment securities		2,070			724
Proceeds from sale of:
Available-for-sale investment securities		162,182			124,052
Proceeds from sales of Federal Home Loan Bank stock		885			871
Net decrease in loans		21,740			68,917
Capitalized cost in foreclosed assets		(55	)		(230	)
Purchases of premises and equipment		(526	)		(270	)
Proceeds from disposal of premises and equipment		10			-
Proceeds from sales of foreclosed assets		7,241			7,041
Net Cash Provided by (Used in) Investing Activities		46,542			77,192
Cash Flows from Financing Activities
Net increase (decrease) in transaction accounts and savings accounts		22,283			(75,125	)
Net decrease in time deposits		(78,754	)		(25,406	)
Net decrease in short-term borrowings		(4,361	)		(14,745	)
Proceeds from long-term borrowings		-			20,000
Repayment of long-term borrowings		(88	)		(85	)
Net Cash Provided by (Used in) Financing Activities		(60,920	)		(95,361	)
Net Increase (Decrease) in Cash and Due From Banks		1,788			2,006
Cash and Due From Banks, Beginning of Period		23,356			16,584
Cash and Due From Banks, End of Period	$	25,144		$	18,590
Supplemental Cash Flow Information:
Transfer of loans to foreclosed assets	$	8,280		$	12,941

See accompanying notes.

- 26 -

Southern Community Financial Corporation

Notes to Consolidated Financial Statements (Unaudited)

Note 1 – Basis of Presentation

The consolidated financial statements include the accounts of Southern Community Financial Corporation (the “Company”), and its wholly-owned subsidiary, Southern Community Bank and Trust (the “Bank”). All intercompany transactions and balances have been eliminated in consolidation. In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three-month and six-month periods ended June 30, 2012 and 2011, in conformity with accounting principles generally accepted in the United States of America.

The preparation of the consolidated financial statements and accompanying notes requires management of the Company to make estimates and assumptions relating to reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ significantly from those estimates and assumptions. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. To a lesser extent, significant estimates are also associated with the valuation of securities, intangibles and derivative instruments and determination of stock-based compensation and income tax assets or liabilities. Operating results for the three-month and six-month periods ended June 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.

The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the consolidated financial statements filed as part of the Company’s 2011 annual report on Form 10-K. This quarterly report should be read in conjunction with the annual report.

Per Share Data

Basic and diluted net income per common share is computed based on the weighted average number of shares outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if stock options or warrants were exercised, resulting in the issuance of common stock that then shared in the net income of the Company.

Basic and diluted net income per share have been computed based upon the weighted average number of common shares outstanding or assumed to be outstanding as summarized below.

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Weighted average number of common shares used in computing basic net income per share		16,858,572		16,835,724		16,849,841		16,829,898
Effect of dilutive stock options		75,543		71,086		71,720		67,804
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per share		16,934,115		16,906,810		16,921,561		16,897,702
Net income available to common shareholders (in thousands)	$	446	$	511	$	616	$	23
Basic		0.03		0.03		0.04		-
Diluted		0.03		0.03		0.04		-

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Note 1 – Basis of Presentation (continued)

For the three months ended June 30, 2012 and 2011, net income for determining net income per common share was reported as net income less the dividend on preferred stock. Options and warrants to purchase shares that have been excluded from the determination of diluted earnings per share because they are antidilutive (the exercise price is higher than the current market price) amount to 485,950 and 597,452 shares for the three months ended June 30, 2012 and 2011, respectively, and 485,950 and 597,452 shares for the six months ended June 30, 2012 and 2011, respectively. These options, warrants, unvested shares of restricted stock and all other common stock equivalents were excluded from the determination of diluted earnings per share for the three months ended June 30, 2012 since the exercise price exceeded the average market price for the period.

Recently issued accounting pronouncements

In May 2011, the FASB has issued Accounting Standards Update No. 2011-04, Fair Value Measurement. The purpose of the standard is to clarify and combine fair value measurements and disclosure requirements for accounting principles generally accepted in the U.S. (GAAP) and international financial reporting standards (IFRS). The new standard provides amendments and wording changes used to describe certain requirements for measuring fair value and for disclosing information about fair value measurements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied prospectively to the beginning of the annual period of adoption. The Company adopted this statement during the quarter ended March 31, 2012, which resulted in additional disclosures related to fair value in Notes 11 and 12.

From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements and SEC Staff Accounting Bulletins on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.

Note 2 – Acquisition Agreement with Capital Bank Financial Corp.

On March 26, 2012, the Company entered into an Agreement and Plan of Merger (the “Agreement”) with Capital Bank Financial Corp. (“CBF”) and Winston 23 Corporation (“Winston”), a wholly-owned subsidiary of CBF, pursuant to which Southern Community Financial Corporation (“Southern Community”) will merge with Winston and become a wholly-owned subsidiary of CBF (the “Merger”). The Agreement and the transactions contemplated by it has been approved by the Board of Directors of both CBF and Southern Community.

Capital Bank Financial Corp. is a national bank holding company that was incorporated in the State of Delaware in 2009. CBF has raised approximately $900 million of equity capital with the goal of creating a regional banking franchise in the southeastern region of the United States. CBF has previously invested in First National of the South, Metro Bank of Dade Country, Turnberry Bank, TIB Financial Corporation, Capital Bank Corporation and Green Bankshares, Inc. CBF is the parent of Capital Bank, N.A., a national banking association with approximately $6.5 billion in total assets and 143 full-service banking offices throughout southern Florida and the Florida Keys, North Carolina, South Carolina, Tennessee and Virginia. CBF is also the parent company of Naples Capital Advisors, Inc., a registered investment advisor.

Subject to the terms and conditions set forth in the Agreement dated March 26, 2012 and as amended on June 25, 2012, each share of Southern Community Common Stock issued and outstanding at the effective time of the Merger will be converted into the right to receive $3.11 in cash, without interest and less any applicable withholding taxes.

Each outstanding option to purchase shares of Southern Community common stock will be vested prior to the Merger and be paid in cash equal to the difference between the exercise price of the option and $3.11 and each share of Southern Community restricted stock will vest immediately prior to the Merger and all restrictions will immediately lapse.

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Note 2 – Acquisition Agreement with Capital Bank Financial Corp. (continued)

Southern Community shareholders will also be granted one non-transferable contingent value right (“CVR”) per share, with each CVR eligible to receive a cash payment equal to 75% of the excess, if any, of (i) $87 million over (ii) net charge-offs and net realized losses on Southern Community’s legacy loan portfolio and foreclosed assets for a period of five years from the closing date of the Merger, with a maximum payment of $1.30 per CVR. Payout of the CVR will be overseen by a special committee of the CBF Board. Southern Community shareholders may also receive an additional cash payment based on the terms of a potential repurchase by CBF of the securities issued by Southern Community to the United States Department of the Treasury.

Upon the closing of the Merger, Dr. William G. Ward, Sr., the Chairman of Southern Community’s Board of Directors, will join the Board of Directors of both CBF and its subsidiary bank (“Capital Bank”), and James G. Chrysson, the Vice Chairman of the Board of Southern Community, will join the Board of Capital Bank.

The obligations of Southern Community and CBF to consummate the merger are subject to certain conditions, including: (i) approval of the Merger by the shareholders of Southern Community; (ii) receipt of required regulatory approvals (and in CBF’s case, without the imposition of an unduly burdensome regulatory condition); (iii) the absence of any injunction or similar restraint enjoining or making illegal consummation of the Merger or any of the other transactions contemplated by the Agreement; (iv) the continuing material truth and accuracy of representations and warranties made by the parties in the Agreement; and (vi) the performance in all material respects by each of the parties of its covenants under the Agreement. Some of these conditions may be waived by the party for whose benefit they were included in the Agreement. CBF’s obligation to close is subject to certain additional conditions, including the absence of a material adverse effect on Southern Community and the amendment or waiver of certain of Southern Community’s compensation-related agreements.

The Agreement may be terminated, before or after receipt of shareholder approval, in certain circumstances, including: (i) upon the mutual consent of the parties; (ii) failure to obtain any required regulatory approval; (iii) by either party if the Merger is not consummated on or before September 26, 2012 if such failure is not caused by material breach of the Agreement; (iv) by either party if there is a material breach of the other party’s representations, warranties, or covenants, and the breach or change that is not cured within 30 days following notice by the complaining party to the complaining party’s reasonable satisfaction; (v) by CBF if Southern Community’s Board fails to recommend that shareholders approve the Agreement and the Merger, changes such recommendation or breaches certain non-solicitation covenants with respect to third party proposals; or (vi) by either party if the shareholders of Southern Community fail to approve the Agreement.

Under certain circumstances, Southern Community will be obligated to pay CBF a termination fee of $4 million and reimburse CBF up to $1 million for all expenses incurred by it in connection with the Agreement and the transactions contemplated thereby.

On July 25, 2012, the Board terminated the employment of Messrs. Bauer and Clark effective September 22, 2012. Their employment agreements, which have now been terminated, contained change in control provisions that provided for a lump sum payment equal to three times the sum of the applicable officer’s base salary for the year of the change in control and the incentive compensation paid in the year prior to the change in control. As previously disclosed in Southern Community’s Form 10-K/A, Amendment No. 1 for the year ended December 31, 2011, the following would have been the estimated cost to the Company in the event of a change in control as of January 1, 2012, pursuant to the employment agreements and Salary Continuation Agreements and assuming that the Treasury’s investment in Southern Community was repaid in full, the Company was no longer under regulatory restrictions and not taking into account the amendments contemplated by the merger agreement. On behalf of Messrs. Bauer and Clark, the estimated cost to the Company would have been approximately $2,622,297 and $1,366,220, respectively. As a condition to the closing of the merger, both the amounts and the terms of potential change in control payments under the employment agreements with Messrs. Bauer and Clark were required to be amended. Since neither officer will be an employee of Southern Community at the time of the merger, amendments to their employment agreements will not be required to consummate the merger.

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Note 3 – Investment Securities

The following is a summary of the securities portfolio by major classification at the dates presented.

	June 30, 2012
	Amortized Cost		Gross Unrealized  Gains		Gross Unrealized  Losses		Fair Value
	(Amounts in thousands)
Securities available for sale:
US Government agencies	$	19,681	$	34	$	-	$	19,715
Asset-backed securities
Residential mortgage-backed securities		155,698		2,406		66		158,038
Collateralized mortgage obligations		26,895		392		594		26,693
Small Business Administration loan pools		13,515		430		7		13,938
Student loan pools		8,538		-		62		8,476
Municipals		25,142		2,644		-		27,786
Trust preferred securities		3,250		-		695		2,555
Corporate bonds		4,213		-		469		3,744
Other		1,000		-		1		999
	$	257,932	$	5,906	$	1,894	$	261,944
Securities held to maturity:
Mortgage-backed securities
Residential mortgage-backed securities	$	389	$	26	$	-	$	415
Small Business Administration loan pools		4,655		316		-		4,971
Municipals		31,452		2,833		24		34,261
Trust preferred securities		8,726		-		361		8,365
Corporate bonds		5,787		-		741		5,046
	$	51,009	$	3,175	$	1,126	$	53,058

	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(Amounts in thousands)
Securities available for sale:
US Government agencies	$	34,660	$	69	$	-	$	34,729
Asset-backed securities
Residential mortgage-backed securities		185,838		1,713		245		187,306
Collateralized mortgage obligations		28,089		450		1,447		27,092
Small Business Administration loan pools		67,507		637		76		68,068
Student loan pools		8,903		-		1		8,902
Municipals		26,981		2,239		-		29,220
Trust preferred securities		3,250		-		929		2,321
Corporate Bonds		4,213		-		554		3,659
Other		1,000		1		-		1,001
	$	360,441	$	5,109	$	3,252	$	362,298
Securities held to maturity:
Mortgage-backed securities
Residential mortgage-backed securities	$	474	$	34	$	-	$	508
Small Business Administration loan pools		4,928		230		-		5,158
Municipals		33,214		1,904		1		35,117
Corporate bonds		5,787		-		1,056		4,731
	$	44,403	$	2,168	$	1,057	$	45,514

Residential mortgage-backed securities and collateralized mortgage obligations are primarily government sponsored (GSE) agency issued whose underlying collateral are prime residential mortgage loans. The Company’s municipal securities are composed of geographic concentrations of 97.3% North Carolina, 1.7% of Texas independent school districts and less than 1.0% in other states. As the Company’s investment policy limits the purchase of municipal securities to “A” rated or better, the municipal investment portfolio segment has 98.3% of this portfolio rated “A” or better.

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Note 3 – Investment Securities (continued)

For the second quarter 2012 and 2011, sales of securities available for sale resulted in gross realized gains of $864 thousand and $926 thousand, respectively, and realized losses of none and $402 thousand, respectively for each period. These investment sales generated $100.2 million and $72.4 million in proceeds during these respective periods. For the six months ended June 30, 2012 and 2011, sales of securities available for sale resulted in gross realized gains of $1.2 million and $2.2 million, respectively, and realized losses of $38 thousand and $730 thousand, respectively, for each period. These investment sales generated $162.2 million and $124.1 million in proceeds during these respective periods.

The following table shows the gross unrealized losses and fair values for our investments and length of time that the individual securities have been in a continuous unrealized loss position.

	June 30, 2012
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized losses		Fair Value		Unrealized losses		Fair Value		Unrealized losses
	(Amounts in thousands)
Securities available for sale:
Asset-backed securities
Residential mortgage-backed securities	$	18,036	$	66	$	-	$	-	$	18,036	$	66
Collateralized mortgage obligations		1,506		128		5,602		466		7,108		594
Small Business Administration loan pools		2,544		5		993		2		3,537		7
Student loan pools		8,477		62		-		-		8,477		62
Trust preferred securities		-		-		2,553		695		2,553		695
Corporate bonds		-		-		3,744		469		3,744		469
Other		1,000		1		-		-		1,000		1
Total temporarily impaired  securities	$	31,563	$	262	$	12,892	$	1,632	$	44,455	$	1,894
Securities held to maturity:
Municipals	$	942	$	24	$	-	$	-	$	942	$	24
Trust preferred securities		8,365		361		-		-		8,365		361
Corporate bonds		-		-		5,046		741		5,046		741
Total temporarily impaired  securities	$	9,307	$	385	$	5,046	$	741	$	14,353	$	1,126

	December 31, 2011
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized losses		Fair Value		Unrealized losses		Fair Value		Unrealized losses
	(Amount in thousands)
Securities available for sale:
Asset-backed securities
Residential mortgage-backed securities	$	54,446	$	245	$	-	$	-	$	54,446	$	245
Collateralized mortgage obligations		12,248		1,447		-		-		12,248		1,447
Small Business Administration loan pools		12,309		74		686		2		12,995		76
Student loan pools		8,902		1		-		-		8,902		1
Municipals		6		-		-		-		6		-
Trust preferred securities		-		-		2,321		929		2,321		929
Corporate bonds		-		-		3,659		554		3,659		554
Total temporarily impaired  securities	$	87,911	$	1,767	$	6,666	$	1,485	$	94,577	$	3,252
Securities held to maturity:
Municipals	$	-	$	-	$	967	$	1	$	967	$	1
Corporate bonds		-		-		4,731		1,056		4,731		1,056
Total temporarily impaired  Securities	$	-	$	-	$	5,698	$	1,057	$	5,698	$	1,057

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Note 3 – Investment Securities (continued)

In evaluating investment securities for “other-than-temporary impairment” losses, management considers, among other things, (i) the length of time and the extent to which the investment is in an unrealized loss position, (ii) the financial condition and near term prospects of the issuer, and (iii) the intent and ability of the Company to retain its investment in the issuer for a sufficient period of time to allow for any anticipated recovery of unrealized loss. At June 30, 2012, there were six investment securities with aggregate fair values of $17.9 million in an unrealized loss position for at least twelve months including one trust preferred security valued at $2.6 million with a $695 thousand unrealized loss due to changes in the level of market interest rates. The security has a variable rate based on LIBOR which had declined steadily throughout 2009 and has stabilized during 2010, 2011 and the first six months of 2012. The fair value of this security increased from the prior quarter and the unrealized loss remained significant. Based on the nature of these securities and the continued timely receipt of scheduled payments, we believe the decline in value to be solely due to changes in interest rates and the general economic conditions and not deterioration in their credit quality. We have the intention and ability to hold these securities for a period of time sufficient to allow for their recovery in value or until maturity. The unrealized losses on the securities available for sale are reflected in other comprehensive income.

The amortized cost and fair values of securities available for sale and held to maturity at June 30, 2012 by contractual maturity are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligation.

	Securities Available for Sale				Securities Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Amount in thousands)
US Government Agencies
Due after one but through five years	$	1,000	$	1,001	$	-	$	-
Due after ten years		18,681		18,713		-		-
Municipals
Due within one year		103		103		-		-
Due after one but through five years		444		445		1,318		1,398
Due after five but through ten years		684		717		3,825		4,184
Due after ten years		23,911		26,521		26,309		28,679
Trust preferred securities
Due after ten years		3,250		2,555		8,726		8,365
Corporate bonds
Due after five but through ten years		4,213		3,744		5,787		5,046
Other
Due after five but through ten years		1,000		999		-		-
Asset-backed securities
Residential mortgage-backed securities		155,698		158,038		389		415
Collateralized mortgage obligations		26,895		26,693		-		-
Small Business Administration loan pools		13,515		13,938		4,655		4,971
Student loan pools		8,538		8,477		-		-
	$	257,932	$	261,944	$	51,009	$	53,058

Federal Home Loan Bank Stock

As disclosed separately on our statements of financial condition, the Company has an investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock of $6.0 million and $6.8 million at June 30, 2012 and December 31, 2011 respectively. The Company carries its investment in FHLB at its cost which is the par value of the stock. Based on current borrowings, the FHLB periodically repurchases excess stock from the Company at par value as the stock is not actively traded and does not have a quoted market price. After briefly suspending the payment of dividends, the FHLB paid a quarterly cash dividend to its members for the second quarter of 2009 and each quarter following including the most recent quarter. Management believes that the investment in FHLB stock was not impaired as of June 30, 2012.

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Note 4 – Loans

Following is a summary of loans by loan class:

	At June 30, 2012						At December 31, 2011
				Percent						Percent
	Amount			of Total			Amount			of Total
	(Amounts in thousands)
Commercial real estate	$	372,739			40.8	%	$	387,275			40.8	%
Commercial
Commercial and industrial		82,816			9.1	%		85,321			9.0	%
Commercial line of credit		48,008			5.3	%		44,574			4.7	%
Residential real estate
Residential construction		104,927			11.5	%		101,945			10.7	%
Residential lots		39,607			4.3	%		45,164			4.8	%
Raw land		15,158			1.7	%		17,488			1.8	%
Home equity lines		91,900			10.1	%		95,136			10.0	%
Consumer		158,436			17.4	%		173,119			18.2	%
Subtotal	$	913,591			100	%	$	950,022			100	%
Less: Allowance for loan losses		(22,954	)					(24,165	)
Net Loans	$	890,637					$	925,857

Construction loans are non-revolving extensions of credit secured by real property, the proceeds of which will be used to a) finance the preparation of land for construction of industrial, commercial, residential, or farm buildings; or b) finance the on-site construction of such buildings. Construction loans are approved based on a set of projections regarding cost, time to completion, time to stabilization or sale, and availability of permanent financing. Any one of these projections may vary from actual results. Therefore, construction loans are considered based not only on the expected merits of the project itself, but also on secondary and tertiary repayment sources of the project sponsor, project sponsor expertise and experience and independent evaluation of project viability. Personal guarantees are typically required. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections to ensure that loan commitments remain in-balance with work completed to date and that adequate funds remain available to ensure completion.

Commercial real estate loans are underwritten by evaluating and understanding the borrower’s ability to generate adequate cash flow to repay the subject debt within reasonable terms. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan amounts relative to equity sources of capitalization and higher debt service requirements relative to available cash flow. This heightened degree of financial and operating leverage can expose commercial real estate loans to increased sensitivity to changes in market and economic conditions. Repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Management monitors and evaluates commercial real estate loans based on collateral, geography, and secondary/tertiary sources of repayment of the property sponsors. Management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. Loans secured by owner-occupied properties are generally considered to be less sensitive to real estate market conditions, since the profitability and cash flow of the occupying business are aligned via common ownership.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to generate positive cash flow, operate profitably and prudently expand its business. Underwriting standards are designed to promote relationships to include a full range of loan, deposit, and cash management services. Underwriting processes include thorough examination of the borrower’s market, operating environment, and business model, to assess whether current and projected cash flows can reasonably be expected to present an acceptable source of repayment. Such repayments are generally sensitized with variances of growth/decline, profitability, and operating cycle changes. Secondary repayment sources, including collateral, are assessed. The level of control and monitoring over such secondary repayment sources may be impacted by the strength of the primary repayment source and the financial position of the borrower.

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Note 4 – Loans (continued)

Residential lot loans are extensions of credit secured by developed tracts of land with appropriate entitlements to support construction of single family or multifamily residential buildings. Such loans were historically structured as time or term loans to finance the holding of the lot for future construction. Because the property is neither generating current income nor providing shelter, these loans have proven to be subject to a higher-than-average risk of abandonment. Extensions of credit for acquisition of finished lots are generally assessed based on the outside repayment sources readily available to the borrower in the current underwriting for such loans.

Consumer loans are originated utilizing a centralized approval process staffed by experienced consumer loan administration personnel. Policies and procedures are developed and maintained to ensure compliance with the Company’s risk management objectives and regulatory compliance requirements. This activity, coupled with relatively small loan amounts spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a periodic basis, along with periodic review activity of particular regions and individual lenders. Loans are concentrated in home equity lines of credit and term loans secured by first or second liens on owner-occupied residential real estate.

Home Equity loans are consumer-purpose revolving or term loans secured by 1^st or 2^nd liens on owner-occupied residential real estate. Such loans are underwritten and approved on the same centralized basis as other consumer loans. Appropriate risk management and compliance practices are exercised to ensure that loan-to-value, lien perfection, and compliance risks are addressed and managed within the Bank’s established tolerances. The degree of utilization of revolving commitments within this asset class is reviewed monthly to identify changes in the behavior of this borrowing group.

Commercial lines of credit are underwritten according to the same standards applied to other commercial and industrial loans; with particular focus on the cash flow impact of the borrower’s operating cycle. Based on the risk profile of each borrower, an appropriate level of monitoring and servicing can be applied, such that higher risk categories involve more frequent monitoring and more involved control over the cash proceeds of asset conversion. Lower risk profiles may involve less restrictive controls and lighter servicing intensity.

Raw land loans are those secured by tracts of undeveloped raw land held for personal use or investment. Such properties are expected to be held for a period of not less than twenty-four months with no active development plan. Given the raw nature of the land, these loans are underwritten based on the ability of the borrower to service the indebtedness with sources of income unrelated to the property. Higher cash down payment and lower loan-to-value expectations are applied to such loans.

Loan origination fees and certain direct origination are capitalized and recognized as an adjustment to yield over the life of the related loan. Net unamortized deferred fees less related cost included in the above were $123 thousand at June 30, 2012 and $136 thousand at December 31, 2011.

Loans are placed in a nonaccrual status for all classes of loans when, in management’s opinion, the borrower may be unable to meet payments as they become due or payments are 90 days past due. Loans are returned to an accrual status when the borrower makes timely principal and interest payments for a period of at least six months and has demonstrated the ability to continue making scheduled payments until the loan is repaid in full.

The following is a summary of nonperforming assets at the periods presented:

	June 30,		December 31,		June 30,
	2012		2011		2011
	(Amounts in thousands)
Nonaccrual loans	$	34,443	$	38,715	$	45,381
Restructured loans - nonaccruing		20,669		29,333		21,422
Total nonperforming loans		55,112		68,048		66,803
Foreclosed assets		19,873		19,812		23,022
Total nonperforming assets	$	74,985	$	87,860	$	89,825
Restructured loans in accrual status not included above	$	24,107	$	24,202	$	15,471

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Note 4 – Loans (continued)

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

As illustrated in the table below, during the three months ended June 30, 2012, the following concessions were made on 11 loans for $3.4 million (measured as a percentage of loan balances on TDRs):

· Reduced interest rate for 58% (2 loans for $2.0 million);

· Extension of payment terms for 29% (8 loans for $984 thousand); and

· Forgiveness of principal for 13% (1 loan for $435 thousand).

During the six months ended June 30, 2012, the following concessions were made on 16 loans for $5.2 million (measured as a percentage of loan balances on TDRs):

· Reduced interest rate for 40% (3 loans for $2.0 million);

· Extension of payment terms for 50% (11 loans for $2.6 million); and

· Forgiveness of principal for 10% (2 loans for $531 thousand).

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

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Note 4 – Loans (continued)

The following table presents a breakdown of the types of concessions made by loan class for the three and six months ended June 30, 2012.

	Three months ended June 30, 2012						Six months ended June 30, 2012
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number of		Recorded		Recorded		Number of		Recorded		Recorded
	Loans		Investment		Investment		Loans		Investment		Investment
Below market interest rate
Commercial real estate		1	$	1,957	$	1,957		1	$	1,957	$	1,957
Commercial and industrial		-		-		-		-		-		-
Commercial line of credit		-		-		-				-		-
Residential construction		-		-		-		-		-		-
Home equity lines		1		46		46		1		46		46
Residential lots		-		-		-		-		-		-
Raw land		-		-		-		-		-		-
Consumer		-		-		-		1		42		42
Total		2		2,003		2,003		3		2,045		2,045
Extended payment terms
Commercial real estate		2		414		414		2		414		414
Commercial and industrial		1		30		30		3		737		737
Commercial line of credit		1		74		74		1		74		74
Residential construction		-		-		-		1		902		902
Home equity lines		-		-		-		-		-		-
Residential lots		1		349		349		1		349		349
Raw land		-		-		-		-		-		-
Consumer		3		117		117		3		117		117
Total		8		984		984		11		2,593		2,593
Forgiveness of principal
Commercial real estate		-		-		-		-		-		-
Commercial and industrial		-		-		-		-		-		-
Commercial line of credit		-		-		-		-		-		-
Residential construction		1		435		345		1		435		345
Home equity lines		-		-		-		-		-		-
Residential lots		-		-		-		-		-		-
Raw land		-		-		-		-		-		-
Consumer		-		-		-		1		96		27
Total		1		435		345		2		531		372
Total		11	$	3,422	$	3,332		16	$	5,169	$	5,010

- 36 -

Note 4 – Loans (continued)

During the previous twelve months ended June 30, 2012, the Company modified 86 loans in the amount of $36.9 million. Of this total, there were payment defaults (where the modified loan was past due thirty days or more) of $198 thousand, or 0.5%, and $617 thousand, or 1.7%, respectively, during the three and six months ended June 30, 2012.

The following table presents loans that were modified as troubled debt restructurings within the previous 12 months and for which there was a payment default (past due 30 days or more) during the three and six months ended June 30, 2012.

	Three Months				Six Months
	Ended June 30, 2012				Ended June 30, 2012
	Number of		Recorded		Number of		Recorded
	Loans		Investment		Loans		Investment
Below market interest rate
Commercial real estate		-	$	-		-	$	-
Commercial and industrial		-		-		-		-
Commercial line of credit		-		-		-		-
Residential construction		-		-		-		-
Home equity lines		-		-		-		-
Residential lots		-		-		1		10
Raw land		-		-		-		-
Consumer		-		-		-		-
Total		-		-		1		10
Extended payment terms
Commercial real estate		1		22		2		158
Commercial and industrial		1		4		1		4
Commercial line of credit		-		-		-		-
Residential construction		1		46		1		46
Home equity lines		-		-		-		-
Residential lots		1		43		1		43
Raw land		-		-		-		-
Consumer		2		83		3		356
Total		6		198		8		607
Forgiveness of principal
Total		-		-		-		-
Total		6	$	198		9	$	617

Of the total of 86 loans for $36.9 million which were modified during the twelve months ended June 30, 2012, the following represents their success or failure for the twelve months ended June 30, 2012:

· 89.5% are paying as restructured;

· 0.3% have been reclassified to nonaccrual;

· 5.3% have defaulted and/or foreclosed upon; and

· 4.9% has paid in full.

The following table presents the successes and failures of the types of modifications within the previous 12 months as of June 30, 2012.

	Paid in full				Paying as restructured				Converted to non-accrual				Foreclosure/Default
	Number		Recorded		Number		Recorded		Number		Recorded		Number		Recorded
Amounts in $ thousands	of Loans		Investment		of Loans		Investment		of Loans		Investment		of Loans		Investment
Below market interest rate		1	$	1,500		22	$	16,465		2	$	94		-	$	-
Extended payment terms		1		292		49		13,670		1		30		5		1,969
Forgiveness of principal		-		-		3		1,763		-		-		-		-
Other		-		-		2		1,142		-		-		-		-
Total		2	$	1,792		76	$	33,040		3	$	124		5	$	1,969

- 37 -

Note 4 – Loans (continued)

The following is a summary of the recorded investment in nonaccrual loans and impaired loans segregated by class of loans at the periods presented:

	June 30, 2012				December 31, 2011
	Nonaccrual Loans		Impaired Loans		Nonaccrual Loans		Impaired Loans
	(Amounts in thousands)
Commercial real estate	$	17,429	$	33,137	$	26,484	$	39,297
Commercial and industrial		2,799		3,901		3,548		3,899
Commercial line of credit		1,429		1,337		1,429		1,004
Residential construction		12,921		16,071		11,491		16,619
Home equity lines		2,093		1,410		2,637		1,955
Residential lots		10,056		10,076		12,096		12,095
Raw land		241		114		1,484		1,484
Consumer		8,144		8,796		8,879		10,753
Total	$	55,112	$	74,842	$	68,048	$	87,106

The Company evaluates “impaired” loans, which includes nonperforming loans and accruing troubled debt restructured loans, having risk characteristics that are unique to an individual borrower on a loan-by-loan basis with balances above a specified level. For smaller loans, the allowance is calculated based on the credit grade utilizing historical loss experience and other qualitative factors. Included in the table below, $52.4 million out of the total of $55.1 million of nonperforming loans and $22.4 million out of the total of $24.1 million of accruing troubled debt restructured loans were individually evaluated which required a specific allowance of $1.2 million and $526 thousand, respectively, for a total specific ALLL of $1.7 million. The impaired loans with smaller balances ($2.7 million in nonperforming loans and $1.7 million in accruing troubled debt restructured loans) were collectively evaluated for impairment.

The following is a summary of loans individually or collectively evaluated for impairment, by segment, at June 30, 2012:

	Commercial				Residential
	Real				Real
	Estate		Commercial		Estate		HELOC		Consumer		Total
	(Amounts in thousands)
Ending balance: nonperforming loans individually evaluated for impairment	$	15,983	$	3,655	$	25,093	$	1,410	$	6,254	$	52,395
Accruing troubled debt restructured loans individually evaluated for impairment		17,154		1,583		1,168		-		2,542		22,447
Ending balance: total impaired loans individually evaluated for impairment		33,137		5,238		26,261		1,410		8,796		74,842
Ending balance: collectively  evaluated for impairment		339,602		125,586		133,431		90,490		149,640		838,749
Ending Balance	$	372,739	$	130,824	$	159,692	$	91,900	$	158,436	$	913,591

- 38 -

Note 4 – Loans (continued)

The following is a summary of loans individually or collectively evaluated for impairment, by segment, at December 31, 2011:

	Commercial				Residential
	Real				Real
	Estate		Commercial		Estate		HELOC		Consumer		Total
	(Amounts in thousands)
Ending balance: nonperforming loans individually evaluated for impairment	$	24,822	$	3,889	$	27,238	$	1,955	$	7,209	$	65,113
Accruing troubled debt restructured loans individually evaluated for impairment		14,475		1,014		2,960		-		3,544		21,993
Ending balance: total impaired loans individually evaluated for impairment		39,297		4,903		30,198		1,955		10,753		87,106
Ending balance: collectively   evaluated for impairment		347,978		124,993		134,399		93,180		162,366		862,916
Ending Balance	$	387,275	$	129,896	$	164,597	$	95,135	$	173,119	$	950,022

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at June 30, 2012:

										Quarter		Quarter		Year to Date		Year to Date
	Unpaid		Partial							Average		Interest		Average		Interest
	Principal		Charge Offs			Recorded		Related		Recorded		Income		Recorded		Income
	Balance		To Date			Investment		Allowance		Investment		Recognized		Investment		Recognized
	(Amounts in thousands)
With no related allowance recorded:
Commercial real estate	$	30,821	$	(10,078	)	$	20,743	$	-	$	22,270	$	66	$	23,188	$	204
Commercial
Commercial and industrial		4,034		(948	)		3,086		-		2,860		4		2,449		26
Commercial line of credit		1,070		(131	)		939		-		457		3		501		4
Residential real estate
Residential construction		17,466		(2,040	)		15,426		-		13,567		24		13,039		42
Residential lots		15,075		(4,999	)		10,076		-		7,376		12		7,680		12
Raw land		2,716		(2,602	)		114		-		115		1		117		3
Home equity lines		435		(32	)		403		-		918		-		878
Consumer		7,081		(567	)		6,514		-		7,434		10		7,254		22
Subtotal		78,698		(21,397	)		57,301		-		54,997		120		55,106		313
With an allowance recorded:
Commercial real estate		12,394		-			12,394		673		11,841		147		12,126		294
Commercial
Commercial and industrial		815		-			815		524		792		-		544
Commercial line of credit		397		-			397		167		695		-		571
Residential real estate
Residential construction		646		-			646		11		2,298		4		2,751		7
Residential lots		-		-			-		-		5,710		5		4,825		11
Raw land		-		-			-		-		-		-		272
Home equity lines		1,007					1,007		250		926		-		911
Consumer		2,509		(227	)		2,282		74		2,130		38		2,479		75
Subtotal		17,768		(227	)		17,541		1,699		24,392		194		24,479		387
Summary
Commercial real estate		43,215		(10,078	)		33,137		673		34,111		213		35,314		498
Commercial		6,316		(1,079	)		5,237		691		4,804		7		4,065		30
Residential real estate		35,903		(9,641	)		26,262		11		29,066		46		28,684		75
Home equity lines		1,442		(32	)		1,410		250		1,844		-		1,789		-
Consumer		9,590		(794	)		8,796		74		9,564		48		9,733		97
Grand Totals	$	96,466	$	(21,624	)	$	74,842	$	1,699	$	79,389	$	314	$	79,585	$	700

- 39 -

Note 4 – Loans (continued)

As shown in the above table, the Company has previously taken partial charge-offs of $21.6 million on the $74.8 million in loans individually evaluated for impairment. In addition, the Company has set aside $1.7 million in specific allowance for $17.5 million of these loans.

The recorded investment in loans that were considered and collectively evaluated for impairment at June 30, 2012 and December 31, 2011 totaled $838.7 million and $862.9 million, respectively. The recorded investment in loans that were considered individually impaired at June 30, 2012 and December 31, 2011 totaled $74.8 million and $87.1 million, respectively. At June 30, 2012 and December 31, 2011, the recorded investment in impaired loans requiring a valuation allowance based on individual analysis was $17.5 million and $23.0 million, respectively, with a corresponding valuation allowance of $1.7 million and $1.6 million. No valuation allowance for the other impaired loans was considered necessary as a result of previously recognized partial charge-offs or adequate collateral coverage. No loans with deteriorated credit quality have been acquired by the Company to date.

The average recorded investment in impaired loans for the quarter ended June 30, 2012 and year ended December 31, 2011 was approximately $79.4 million and $84.7 million, respectively. For the three months ended June 30, 2012, the interest income recorded on accruing troubled debt restructured loans that were individually evaluated for impairment was $314 thousand. The interest income foregone for loans in a non-accrual status at June 30, 2012 and 2011 was $700 thousand and $2.1 million, respectively.

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at December 31, 2011:

										Year to Date		Year to Date
	Unpaid		Partial							Average		Interest
	Principal		Charge Offs			Recorded		Related		Recorded		Income
	Balance		To Date			Investment		Allowance		Investment		Recognized
	(Amounts in thousands)
With no related allowance recorded:
Commercial real estate	$	36,251	$	(7,334	)	$	28,917	$	-	$	26,846	$	358
Commercial
Commercial and industrial		4,742		(1,341	)		3,401		-		2,998		76
Commercial line of credit		957		(52	)		905		-		1,427		-
Residential real estate
Residential construction		17,874		(2,443	)		15,431		-		15,241		190
Residential lots		6,853		(2,803	)		4,050		-		10,387		17
Raw land		3,808		(2,324	)		1,484		-		1,467		-
Home equity lines		954		(32	)		922		-		655		-
Consumer		10,501		(1,501	)		9,000		-		5,211		81
Subtotal		81,940		(17,830	)		64,110		-		64,232		722
With an allowance recorded:
Commercial real estate		10,710		(330	)		10,380		655		8,346		420
Commercial
Commercial and industrial		498		-			498		114		1,067		14
Commercial line of credit		99		-			99		99		482		-
Residential real estate
Residential construction		1,348		(160	)		1,188		102		2,602		17
Residential lots		9,080		(1,035	)		8,045		161		3,843		32
Raw land		-		-			-		-		144		-
Home equity lines		1,033		-			1,033		387		1,027		-
Consumer		1,839		(86	)		1,753		90		2,921		80
Subtotal		24,607		(1,611	)		22,996		1,608		20,432		563
Summary
Commercial real estate		46,961		(7,664	)		39,297		655		35,192		778
Commercial		6,296		(1,393	)		4,903		213		5,974		90
Residential real estate		38,963		(8,765	)		30,198		263		33,684		256
Home equity lines		1,987		(32	)		1,955		387		1,682		-
Consumer		12,340		(1,587	)		10,753		90		8,132		161
Grand Totals	$	106,547	$	(19,441	)	$	87,106	$	1,608	$	84,664	$	1,285

- 40 -

Note 4 – Loans (continued)

The following is an aging analysis of past due financing receivables by class at June 30, 2012:

	30-59 Days Past Due			60-89 Days Past Due			Greater than 90 Days (1)			Total Past Due			Current			Total Financing Receivables		Recorded Investment 90 Days or more and Accruing
	(Amounts in thousands)
Commercial real estate	$	902		$	-		$	17,429		$	18,331		$	354,408		$	372,739	$	-
Commercial and industrial		365			-			2,799			3,164			79,652			82,816		-
Commercial line of credit		232			50			1,429			1,711			46,297			48,008		-
Residential construction		-			-			12,921			12,921			92,006			104,927		-
Home equity lines		324			-			2,093			2,417			89,483			91,900		-
Residential lots		229			-			10,056			10,285			29,322			39,607		-
Raw land		-			2,881			241			3,122			12,036			15,158		-
Consumer		1,180			48			8,144			9,372			149,064			158,436		-
Total	$	3,232		$	2,979		$	55,112		$	61,323		$	852,268		$	913,591	$	-
Percentage of total loans		0.35	%		0.33	%		6.03	%		6.71	%		93.29	%

The following is an aging analysis of past due financing receivables by class at December 31, 2011:

	30-59 Days Past Due			60-89 Days Past Due			Greater than 90 Days (1)			Total Past Due			Current			Total Financing Receivables		Recorded Investment 90 Days or more and Accruing
	(Amounts in thousands)
Commercial real estate	$	376		$	265		$	26,484		$	27,125		$	360,150		$	387,275	$	-
Commercial and industrial		308			7			3,548			3,863			81,458			85,321		-
Commercial line of credit		50			35			1,429			1,514			43,060			44,574		-
Residential construction		-			-			11,491			11,491			90,454			101,945		-
Home equity lines		248			171			2,637			3,056			92,080			95,136		-
Residential lots		-			-			12,096			12,096			33,068			45,164		-
Raw land		-			-			1,484			1,484			16,004			17,488		-
Consumer		2,839			932			8,879			12,650			160,469			173,119		-
Total	$	3,821		$	1,410		$	68,048		$	73,279		$	876,743		$	950,022	$	-
Percentage of total loans		0.40	%		0.15	%		7.16	%		7.71	%		92.29	%

(1)  As the Company has no loans past due 90 or more days and still accruing, this category only includes nonaccrual loans.

Note 5 – Allowance for Loan Losses

The following table shows, an analysis of the allowance for loan losses by loan segment, for the quarter ended June 30, 2012.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
	(Amounts in thousands)
Allowance for credit losses:
Beginning balance	$	8,925		$	3,092		$	7,861		$	1,266		$	3,037		$	24,181
Provision		1,410			574			76			34			206			2,300
Charge-offs		(1,802	)		(356	)		(1,597	)		(139	)		(586	)		(4,480	)
Recoveries		321			112			433			7			80			953
Ending balance	$	8,854		$	3,422		$	6,773		$	1,168		$	2,737		$	22,954

- 41 -

Note 5 – Allowance for Loan Losses (continued)

The following table shows, an analysis of the allowance for loan losses by loan segment, for the six months ended June 30, 2012.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
	(Amounts in thousands)
Allowance for credit losses:
Beginning balance	$	9,076		$	3,036		$	7,258		$	1,412		$	3,383		$	24,165
Provision		2,778			1,390			1,202			(103	)		(67	)		5,200
Charge-offs		(3,529	)		(1,256	)		(2,169	)		(151	)		(943	)		(8,048	)
Recoveries		529			252			482			10			364			1,637
Ending balance	$	8,854		$	3,422		$	6,773		$	1,168		$	2,737		$	22,954
For nonperforming loans requiring specific ALLL		201			691			9			272			-		$	1,173
For accruing troubled debt restructured loans requiring specific ALLL		471			-			3			-			52			526
Ending balance: requiring specific ALLL	$	672		$	691		$	12		$	272		$	52		$	1,699
Ending balance: general ALLL	$	8,182		$	2,731		$	6,761		$	896		$	2,685		$	21,255

 The following table shows the breakdown of the allowance for loan losses by component loan segment, for the quarter ended June 30, 2011.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
	(Amounts in thousands)
Allowance for credit losses:
Beginning balance	$	6,262		$	3,593		$	13,097		$	1,759		$	2,953		$	27,664
Provision		2,385			940			273			(320	)		422			3,700
Charge-offs		(2,180	)		(1,064	)		(1,805	)		(100	)		(386	)		(5,535	)
Recoveries		416			199			752			132			183			1,682
Ending balance	$	6,883		$	3,668		$	12,317		$	1,471		$	3,172		$	27,511

- 42 -

Note 5 – Allowance for Loan Losses (continued)

The following table shows, an analysis of the allowance for loan losses by loan segment, for the six months ended June 30, 2011.

	Commercial						Residential
	Real						Real
	Estate			Commercial			Estate			HELOC			Consumer			Total
	(Amounts in thousands)
Allowance for credit losses:
Beginning balance	$	6,703		$	4,154		$	13,534		$	1,493		$	3,696		$	29,580
Provision		3,306			1,068			1,714			484			1,228			7,800
Charge-offs		(4,077	)		(1,829	)		(4,008	)		(641	)		(2,066	)		(12,621	)
Recoveries		951			275			1,077			135			314			2,752
Ending balance	$	6,883		$	3,668		$	12,317		$	1,471		$	3,172		$	27,511
For nonperforming loans requiring specific ALLL		299			348			754			315			438			2,154
For accruing troubled debt restructured loans requiring specific ALLL		118			2			-			-			42			162
Ending balance: requiring specific ALLL	$	417		$	350		$	754		$	315		$	480		$	2,316
Ending balance: general ALLL	$	6,466		$	3,318		$	11,563		$	1,156		$	2,692		$	25,195

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 (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) nonperforming loans (see details above) and (v) the general economic conditions in its market areas.

The Company utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the 9 risk grades is as follows:

· Grades 1, 2 and 3 – Better Than Average Risk – Borrowers assigned any one of these ratings would generally be characterized as representing better than average risk. Access to alternate sources of traditional bank financing is evident; secondary repayment sources are sufficient to protect against the risk of principal or income loss.

· Grade 4 – Average Risk – Borrowers assigned this rating would generally be characterized as representing average risk. Access to alternate sources of traditional bank financing is evident; secondary repayment sources are sufficient to protect against the risk of principal or income loss. Or, the risk attributable to a marginally sufficient primary repayment source is mitigated by liquid collateral in amounts which, discounted for normal fluctuations in market value, are sufficient to protect against the risk of principal or income loss.

· Grade 5 – Acceptable Risk/Watch – Loans where the borrower’s ability to repay from primary (intended) repayment source is not clearly sufficient to ensure performance as contracted; however, the loan is performing as contracted, secondary repayment sources are clearly sufficient to protect against the risk of principal or income loss, and the Bank can reasonably expect that the circumstances causing the repayment concern will be resolved. Access to alternate financing sources exists, but may be limited to institutions specializing in higher risk financing.

· Grade 6 – Special Mention – This would include “Other Assets Especially Mentioned” (OAEM). OAEM are currently protected but potentially weak, they are characterized by undue and unwarranted credit risk but not to the point of justifying a classification of substandard. Potential weakness may weaken the asset or inadequately protect the Bank’s credit position at some future date if not corrected. Evidence that the risk is increasing beyond that at which the loan originally would have been granted. Loans, where adverse economic conditions that develop subsequent to the loan origination that do not jeopardize liquidation of the debt but do increase the level of risk, may also warrant this rating.

- 43 -

Note 5 – Allowance for Loan Losses (continued)

· Grade 7 – Substandard – A substandard loan is inadequately protected by the current net worth and paying capacity of the obligor or by the value of the collateral pledged, if any. There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. Examples include high debt to net worth ratios, declining or negative earnings trends, declining or inadequate liquidity, improper loan structure and questionable repayment sources. Near term improvement is questionable.

· Grade 8 – Doubtful – Loans classified as doubtful have all the weaknesses inherent in loans classified substandard, plus 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. Some loss of principal is expected, however, the amount of such loss cannot be fully determined at this time. Factors such as equity injection, alternative financing, liquidation of assets or the pledging of additional collateral can impact the loan. All loans in this category are to immediately be placed on non-accrual with all payments applied to principal until such time as the potential loss exposure is eliminated.

· Grade 9 – Loss – Loans classified as loss are considered uncollectable and of such little value that there continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be affected in the future.

Loan grades for all commercial loans are established at the origination of the loan. Non-commercial loans are graded as a 4 at origination date as these loans are determined to be “pass graded” loans. These non-commercial loans may subsequently require a different risk grade if the credit department has evaluated the credit and determined it necessary to reclassify the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes public. Credit improvements are evidenced by known factors regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a grade of 1 to 5 are believed to have some inherent losses in the portfolios, but to a lesser extent than the other loan grades. Acceptable or better risk (1 to 5) graded loans might have a zero percent loss based on historical experience and current market trends. The special mention or OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential losses. However, the likelihood of loss is greater than Watch grade because there has been measurable credit deterioration. Loans with a substandard grade are generally loans the Company has individually analyzed for potential impairment. The Doubtful graded loans and the Loss graded loans are to a point that the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off.

- 44 -

Note 5 – Allowance for Loan Losses (continued)

The Company’s allowance for loan losses (“ALLL”) is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off and we reduce our allowance by loans charged off. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors derived from our history of operations. Management is continuing to closely monitor the value of real estate serving as collateral for our loans, especially lots and land under development, due to continued concern that the low level of real estate sales activity will continue to have a negative impact on the value of real estate collateral. In addition, depressed market conditions have adversely impacted, and may continue to adversely impact, the financial condition and liquidity position of certain of our borrowers. Additionally, the value of commercial real estate collateral may come under further pressure from weak economic conditions and prevailing unemployment levels. The methodology and assumptions used to determine the allowance are continually reviewed as to their appropriateness given the most recent losses realized and other factors that influence the estimation process. The model assumptions and resulting allowance level are adjusted accordingly as these factors change. The Company incorporates certain refinements and improvements to its allowance for loan losses methodology from time to time.

The ALLL consists of two major components: specific valuation allowances and a general valuation allowance. The Bank’s format for the calculation of ALLL begins with the evaluation of individual loans considered impaired. For the purpose of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be considered for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Once a loan is considered individually impaired, it is not included in other troubled loan analysis, even if no specific allowance is considered necessary.

In addition to the evaluation of loans for impairment, the Company calculates loan loss exposure on the remaining loans (not evaluated for impairment) by applying the applicable historical loan loss experience of the loan portfolio to provide for probable losses in the loan portfolio through the general valuation allowance. These loss factors are based on an appropriate loss history for each major loan segment more heavily weighted for the most recent twelve months historical loss experience to reflect current market conditions. In addition, the Company assigns additional general allowance requirements utilizing qualitative risk factors related to economic and portfolio trends that are pertinent to the underlying risks in each major loan segment in estimating the general valuation allowance. This methodology allows the Company to focus on the relative risk and the pertinent factors for the major loan segments of the Company.

- 45 -

Note 5 – Allowance for Loan Losses (continued)

The following is a summary of credit exposure segregated by credit risk profile by internally assigned grade by class at June 30, 2012 and December 31, 2011:

	Commercial Real Estate				Commercial and Industrial				Commercial Lines of Credit
	June 30,		December 31,		June 30,		December 31,		June 30,		December 31,
	2012		2011		2012		2011		2012		2011
	(Amounts in thousands)
Acceptable Risk or Better	$	273,013	$	261,287	$	58,673	$	57,563	$	39,426	$	37,883
Special Mention		26,778		49,179		4,872		10,804		3,101		2,796
Substandard		64,840		76,701		19,214		16,526		5,481		3,765
Doubtful		8,108		108		57		428		-		130
Total	$	372,739	$	387,275	$	82,816	$	85,321	$	48,008	$	44,574

	Residential Construction				Home Equity Lines				Consumer
	June 30,		December 31,		June 30,		December 31,		June 30,		December 31,
	2012		2011		2012		2011		2012		2011
	(Amounts in thousands)
Acceptable Risk or Better	$	70,963	$	62,382	$	85,625	$	87,325	$	122,763	$	139,491
Special Mention		8,106		11,212		1,251		2,362		13,698		13,147
Substandard		25,858		28,351		5,024		5,449		21,975		20,481
Total	$	104,927	$	101,945	$	91,900	$	95,136	$	158,436	$	173,119

	Residential Lots				Raw Land
	June 30,		December 31,		June 30,		December 31,
	2012		2011		2012		2011
			(Amounts in thousands)
Acceptable Risk or Better	$	9,478	$	10,451	$	11,790	$	11,807
Special Mention		3,655		5,612		200		976
Substandard		26,474		29,101		3,168		4,705
Total	$	39,607	$	45,164	$	15,158	$	17,488

Note 6 – Borrowings

The following is a summary of our borrowings at June 30, 2012 and December 31, 2011:

	June 30,		December 31,
	2012		2011
	(Amounts in thousands)
Short-term borrowings
FHLB advances	$	35,000	$	5,000
Repurchase agreements		24,268		28,629
	$	59,268	$	33,629
Long-term borrowings
FHLB advances	$	41,549	$	71,637
Term repurchase agreements		60,000		60,000
Jr. subordinated debentures		45,877		45,877
	$	147,426	$	177,514

See Note 8 for discussion on deferral of interest payments on subordinated debentures.

- 46 -

Note 7 – Non-Interest Income and Other Non-Interest Expense

The major components of other non-interest income are as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
	(Amounts in thousands)
Increase in cash surrender value of life insurance	$	257	$	276	$	511	$	542
Gain (loss) and net cash settlement on economic hedges		178		181		263		(424	)
Other		256		238		519		475
	$	691	$	695	$	1,293	$	593

The major components of other non-interest expense are as follows:

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Amounts in thousands)
Postage, printing and office supplies	$	129		$	178		$	294		$	349
Telephone and communication		206			215			422			463
Advertising and promotion		229			378			457			609
Data processing and other outsourced services		204			189			461			360
Professional services		508			962			950			1,795
Debit card expense		218			243			471			459
(Gain) loss on sales of foreclosed assets		(185	)		(210	)		(258	)		(490	)
Other		1,092			1,304			2,364			2,655
	$	2,401		$	3,259		$	5,161		$	6,200

Note 8 – Regulatory Matters

Regulatory Actions and Management’s Compliance Efforts

On February 25, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the North Carolina Commission of Banks (“NCCOB”). Under the terms of the Consent Order among other things, the Bank has agreed to:

· Strengthen Board oversight of the management and operations of the Bank;

· Comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital;

· Formulate and implement a plan to reduce the Bank’s risk exposure in assets classified “Substandard or Doubtful” in the FDIC’s most recent report of examination by 15% in 180 days, 35% in 360 days, 60% in 540 days and 75% in 720 days;

· Within 90 days, implement effective lending and collection policies;

· Not pay cash dividends without the prior written approval of the FDIC and the Commissioner; and

· Neither renew, rollover or accept any brokered deposits without obtaining a waiver from the FDIC.

On June 23, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond under which the Company agreed to, among other things:

· Not, directly or indirectly, do the following without the prior approval of the Federal Reserve:

¾ Declare or pay dividends on its, common or preferred stock;

¾ Make any distributions of interest or principal on trust preferred securities;

¾ Incur, increase or guarantee any debt; and

¾ Purchase or redeem any shares of its stock.

· Formulate and implement a written plan to maintain sufficient capital at the Company on a consolidated basis.

- 47 -

Note 8 – Regulatory Matters (continued)

As previously reported, the Company suspended the payment of quarterly cash dividends on the preferred stock issued to the US Treasury and the Company elected to defer the payment of quarterly scheduled interest payments on both issues of junior subordinated debentures, relating to its outstanding trust preferred securities. The Company continues to account for the obligation for the preferred dividend to the US Treasury and the interest due on the subordinated debentures. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. As of June 30, 2012, the cumulative amount of dividends owed to the US Treasury and the cumulative amount of interest due on the subordinated debentures were $3.9 million and $4.3 million, respectively.

The Bank has already undertaken the following actions, among others, to comply with the Consent Order:

· The Bank has exceeded all minimum capital requirements of the Consent Order.

· As of June 30, 2012, the Bank reduced its risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination by an amount (60%) exceeding its scheduled reduction of 35% by February 2012 and meeting, in advance, its August 2012 scheduled reduction of 60%.

The process of responding to the provisions of the Consent Order is well underway. To date, management believes that the Company’s compliance efforts have been satisfactory and within the scheduled time frames. Compliance efforts remain ongoing.

The Consent Order, as set forth above, requires the Bank to achieve and maintain minimum capital requirements of 8% Tier 1 (leverage) capital and total risk-based capital of 11%. As shown in the table below, the Bank had regulatory capital in excess of the Consent Order requirements as of June 30, 2012.

The minimum capital requirements to be characterized as “well capitalized”, as defined by regulatory guidelines, the capital requirements pursuant to the Consent Order and the Bank’s actual capital ratios were as follows for June 30, 2012: 

				Minimum Regulatory Requirement
				"Well			Pursuant to
Captial ratios	Bank			Capitalized"			Consent Order
Total risk-based		14.62	%		10	%		11	%
Tier 1 risk-based		13.36	%		6	%		N/A
Tier 1 leverage		9.66	%		5	%		8	%

If the Bank fails to comply with the minimum capital levels in the Consent Order, the Bank may be subject to further restrictions, the extent of which is dependent upon the magnitude of noncompliance. A bank may be prohibited from engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the FDIC of a capital restoration plan for the bank. Therefore, failure to maintain adequate capital could have a material adverse effect on operations.

Failure by the Bank to comply with the requirements set forth in the Consent Order may result in further adverse regulatory actions, sanctions, and restrictions on the Bank’s activities, which could have a material adverse effect on the business, future prospects, financial condition or results of operations of the Bank and the Company.

- 48 -

Note 8 – Regulatory Matters (continued)

As a bank holding company subject to regulation by the Federal Reserve, the Company must comply with regulatory capital ratios. Under the June 23, 2011 Written Agreement, there were no minimum regulatory ratios imposed by the Federal Reserve. In the written capital plan submitted to the Federal Reserve in June 2011, the Company set the regulatory well capitalized minimum requirements as its capital targets. As of June 30, 2012, the Company’s capital exceeded the minimum requirements for a “well capitalized” bank holding company. Information regarding the Company’s capital at June 30, 2012 is set forth below:

						Minimum
	Actual					"Well Capitalized"
Captial ratios	Amount		Ratio			Requirements
Total risk-based	$	157,815		14.87	%		10	%
Tier 1 risk-based		131,387		12.38	%		6	%
Tier 1 leverage		131,387		8.95	%		5	%

Note 9 – Cumulative Perpetual Preferred Stock

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million to the United States Treasury in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval.

In February 2011, the Company suspended the payment of quarterly cash dividends to the US Treasury on this preferred stock. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. As of June 30, 2012, the total amount of cumulative dividends and interest owed to the US Treasury was $3.9 million. The Company has now deferred six quarterly payments. If the Company defers more than six quarterly payments to the US Treasury, then the US Treasury will have the right to elect two new board members. Directors elected by the US Treasury may not have the same interests as other shareholders and may desire the Company to take certain actions not supported by other shareholders. There can be no assurances that directors elected to represent the US Treasury would be supportive of our management’s business plans or the interests of other shareholders. Therefore, the election of directors to represent the US Treasury could have a material adverse effect on our business or the direction of its future prospects. As a part of the merger with Capital Bank, it is expected that the Treasury’s investment in the Company’s preferred stock will be redeemed.

As a condition of the CPP, the Company must obtain consent from the United States Department of the Treasury to repurchase its common stock or to increase its cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. Furthermore, the Company has agreed to certain restrictions on executive compensation. Under the American Recovery and Reinvestment Act of 2009, the Company is limited to using restricted stock as the form of payment to the top five highest compensated executives under any incentive compensation programs.

Note 10 - Derivatives

Derivative Financial Instruments

The Company utilizes stand-alone derivative financial instruments, primarily in the form of interest rate swap and option agreements, in its asset/liability management program. These transactions involve both credit and market risk. The Company uses derivative instruments to mitigate exposure to adverse changes in fair value or cash flows of certain assets and liabilities. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

- 49 -

Note 10 – Derivatives (continued)

Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense on the hedged asset or liability. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in accumulated other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods the hedged transaction affects earnings. Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement.

The Company does not enter into derivative financial instruments for speculative or trading purposes. For derivatives that are economic hedges, but are not designated as hedging instruments or otherwise do not qualify for hedge accounting treatment, all changes in fair value are recognized in non-interest income during the period of change. The net cash settlement on these derivatives is included in non-interest income.

The Company is exposed to credit-related losses in the event of nonperformance by the counterparties to these agreements. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures and agreements that specify collateral levels to be maintained by the Company and the counterparties. These collateral levels are based on the credit rating of the counterparties and the value of the derivatives.

The Company currently has ten derivative instrument contracts consisting of one interest rate cap, seven interest rate swaps and two foreign exchange contracts. The primary objective for each of these contracts is to minimize risk, interest rate risk being the primary risk for the interest rate cap and swaps while foreign exchange risk is the primary risk for the foreign exchange contracts. The Company’s strategy is to use derivative contracts to stabilize and improve net interest margin and net interest income currently and in future periods. In order to acquire low cost, long term funding without incurring currency risk, the Company entered into the foreign exchange contract to convert foreign currency denominated certificates of deposit into long term dollar denominated time deposits. The interest rate on the underlying certificates of deposit with an original notional value/amount of $10.0 million is based on a proprietary index (Barclays Intelligent Carry Index USD ER) managed by the counterparty (Barclays Bank). The currency swap is also based on this proprietary index.

The fair value of the Company’s derivative assets and liabilities and their related notional amounts is summarized below.

	June 30, 2012					December 31, 2011
	Fair Value			Notional Amount		Fair Value			Notional Amount
	(Amounts in thousands)
Fair value hedges
Interest rate swaps associated with deposit  activities: Certificate of Deposit contracts	$	420		$	40,000	$	436		$	65,000
Currency Exchange contracts		(344	)		10,000		(457	)		10,000
Trust Preferred contracts		(72	)		10,000		(202	)		10,000
Cash flow hedges
Interest rate swaps associated with borrowing activities: Loan contracts		(895	)		35,000		-			-
Interest rate cap contracts		1			12,500		9			12,500
	$	(890	)	$	107,500	$	(214	)	$	97,500

See Note 11 for additional information on fair values of net derivatives.

- 50 -

Note 10 – Derivatives (continued)

The following table further breaks down the derivative positions of the Company:

	As of June 30, 2012
	Asset Derivatives				Liability Derivatives
	Balance Sheet				Balance Sheet
	Location		Fair Value		Location		Fair Value
	(Amounts in thousands)
Derivatives designated as hedging instruments
Interest rate cap contracts		Other Assets	$	1
Interest rate swap contracts		Other Assets		420		Other Liabilities	$	967
Derivatives not designated as hedging instruments
Interest rate swap contracts				-		Other Liabilities		344
Total derivatives			$	421			$	1,311
Net Derivative Asset (Liability)							$	(890	)

	As of December 31, 2011
	Asset Derivatives				Liability Derivatives
	Balance Sheet				Balance Sheet
	Location		Fair Value		Location		Fair Value
	(Amounts in thousands)
Derivatives designated as hedging instruments
Interest rate cap contracts		Other Assets	$	9
Interest rate swap contracts		Other Assets		436		Other Liabilities	$	202
Derivatives not designated as hedging instruments
Interest rate swap contracts				-		Other Liabilities		457
Total derivatives			$	445			$	659
Net Derivative Asset (Liability)							$	(214	)

- 51 -

Note 10 – Derivatives (continued)

The tables below illustrate the effective portion of the gains (losses) recognized in other comprehensive income and the gains (losses) reclassified from accumulated other comprehensive income into earnings.

For the Three Months Ended June 30, 2012
				Location of Gain or		Amount of Gain or (Loss)
	Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
	Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging	Derivative (Effective			into Income		Income (Effective
Relationships	Portion)			(Effective Portion)		Portion)
				(Amounts in thousands)
Interest rate contracts	$	(850	)		Interest Expense	$	-

For the Six Months Ended June 30, 2012
				Location of Gain or		Amount of Gain or (Loss)
	Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
	Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging	Derivative (Effective			into Income		Income (Effective
Relationships	Portion)			(Effective Portion)		Portion)
				(Amounts in thousands)
Interest rate contracts	$	(903	)		Interest Expense	$	-

For the Three Months Ended June 30, 2011
				Location of Gain or		Amount of Gain or (Loss)
	Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
	Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging	Derivative (Effective			into Income		Income (Effective
Relationships	Portion)			(Effective Portion)		Portion)
				(Amounts in thousands)
Interest rate contracts	$	(62	)		Interest Expense	$	-
		Ineffective Portion					Ineffective Portion
	$	42				$	(75	)

For the Six Months Ended June 30, 2011
				Location of Gain or		Amount of Gain or (Loss)
	Amount of Gain or (Loss)			(Loss) Reclassified from		Reclassified from
	Recognized in OCI on			Accumulated OCI		Accumulated OCI into
Cash Flow Hedging	Derivative (Effective			into Income		Income (Effective
Relationships	Portion)			(Effective Portion)		Portion)
				(Amounts in thousands)
Interest rate contracts	$	(150	)		Interest Expense	$	-
		Ineffective Portion					Ineffective Portion
	$	104				$	534

- 52 -

Note 10 – Derivatives (continued)

Prior to 2011, no gain or loss has been recognized in the income statement due to any ineffective portion of any cash flow hedging relationship. During the first quarter of 2011, the Company recorded a $384 thousand mark to market loss in the income statement on an interest rate swap relating to trust preferred securities. The Company recorded a $70 thousand gain on this swap into non-interest income during the three months ended June 30, 2012. The payment of interest on the trust preferred securities was suspended in February 2011 which resulted in the swap changing its status from effective to ineffective. The change to an ineffective status disqualified the instrument from hedge accounting and required mark to market adjustments to be included in the income statement instead of other comprehensive income as previously recorded.

The tables below show the location and amount of gains (losses) recognized in earnings for fair value hedges, the ineffective portion of cash flow hedges and other economic hedges.

For the Three Months Ended June 30, 2012
	Location of Gain or		Amount of Gain or (Loss)
	(Loss) Recognized in		Recognized in Income on
Description	Income on Derivative		Derivative
			(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other Income (Expense)	$	178
Interest rate contracts - Fair value hedging relationships		Interest Income/(Expense)	$	272

For the Six Months Ended June 30, 2012
	Location of Gain or		Amount of Gain or (Loss)
	(Loss) Recognized in		Recognized in Income on
Description	Income on Derivative		Derivative
			(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other Income (Expense)	$	263
Interest rate contracts - Fair value hedging relationships		Interest Income/(Expense)	$	598

For the Three Months Ended June 30, 2011
	Location of Gain or		Amount of Gain or (Loss)
	(Loss) Recognized in		Recognized in Income on
Description	Income on Derivative		Derivative
			(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other Income (Expense)	$	181
Interest rate contracts - Fair value hedging relationships		Interest Income/(Expense)	$	465

For the Six Months Ended June 30, 2011
	Location of Gain or		Amount of Gain or (Loss)
	(Loss) Recognized in		Recognized in Income on
Description	Income on Derivative		Derivative
			(Amounts in thousands)
Interest rate contracts - Not designated as hedging instruments		Other Income (Expense)	$	(424	)
Interest rate contracts - Fair value hedging relationships		Interest Income/(Expense)	$	993

- 53 -

Note 10 – Derivatives (continued)

The interest rate swap with borrowing activities on trust preferred securities has a maturity date of September 6, 2012. The maturity date for the interest rate cap contract is February 18, 2014. The currency exchange contracts have maturity dates of November 29, 2013 and December 30, 2013. The interest rate swaps on certificates of deposit have maturity dates of September 30, 2030, October 12, 2040 and December 17, 2040. All of these swaps have the ability to be called by the counterparty prior to their maturity date. One interest rate swap on certificates of deposit has passed its call date (September 30, 2011) and is now callable quarterly. Two others have original call dates of October 14, 2014 and November 28, 2014. On April 28, 2012 and May 29, 2012, interest rate swaps on certificates of deposit with notional amounts totaling $25.0 million were called by the counterparty. The related certificates of deposit were also called.

Certain derivative liabilities were collateralized by securities, which are held by the counterparty or in safekeeping by third parties. The fair value of these securities was $2.4 million and $7.3 million at June 30, 2012 and December 31, 2011, respectively. Collateral calls can be required at any time that the market value exposure of the contracts is less than the collateral pledged. The degree of overcollateralization is dependent on the derivative contracts to which the Company is a party.

As part of our banking activities, the Company originates certain residential loans and commits these loans for sale. The commitments to originate residential loans and the sales commitments are freestanding derivative instruments and are generally funded within 90 days. The fair value of these commitments was not significant at June 30, 2012.

In January 2012, the Company entered into $35.0 million notional forward starting interest rate swaps. The purpose of these swaps is to lock in currently low fixed rate funding costs for intermediate term FHLB advances maturing from July 2012 through November 2013. The maturity dates for these three contracts are July 16, 2017, January 3, 2018, and January 11, 2018. The first of the three FHLB loans was not renewed in July 2012 as scheduled due to higher than anticipated liquidity levels and as part of merger strategy. The result of not renewing the advance is a free standing derivative that will be adjusted to market value through the income statement beginning in the third quarter. The valuation of the derivative at the most recent month end was a loss of $118 thousand. The valuation of the instrument will change at each subsequent reporting period based on several factors, most notably changes in interest rates.

Note 11 - Disclosures About Fair Values of Financial Instruments

Financial instruments include cash and due from banks, federal funds sold, investment securities, loans, bank-owned life insurance, deposit accounts and other borrowings, accrued interest and derivatives. Fair value estimates are made at a specific moment in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no active market readily exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and due from banks, federal funds sold and overnight deposits

The carrying amounts for cash and due from banks, federal funds sold and overnight deposits approximate fair value because of the short maturities of those instruments.

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Note 11 - Disclosures About Fair Values of Financial Instruments (continued)

Investment securities

Fair value for investment securities equals quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The Company utilizes a third party pricing service to provide valuations on its securities portfolio. Most of these securities are US government agency debt obligations and agency mortgage-backed securities traded in active markets. The third party valuations are determined based on the characteristics of each security (such as maturity, duration, rating, etc.) and in reference to similar or comparable securities. Due to the nature and methodology of these valuations, the Company considers these fair value measures as Level 2.

Loans

The fair value of commercial and other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For these loans, internal credit risk methodologies are used to adjust values for expected losses. For certain homogeneous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. In addition for residential mortgage loans, internal prepayment risk assumptions are incorporated to adjust contractual cash flows.

Investment in bank-owned life insurance

The carrying value of bank-owned life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer. In assessing the fair value of the cash surrender value of this asset, we evaluate quantitative factors such as the level of death claims on the underlying policies and the impact of aging/actuarial factors.

Deposits

The fair value of demand deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated based on discounting expected cash flows using the rates currently offered for deposits of similar remaining maturities.

Borrowings

As it relates to the Company’s subordinated debentures, a portion of this debt is publicly traded on NASDAQ under the ticker “SCMFO”. The remaining fair values on the subordinated debentures are calculated by reference to the market price of the publicly traded comparable trust preferred securities as an indication of the Company’s credit risk. The remaining fair values of the FHLB advances and repurchase agreements are based on discounting expected cash flows at the current interest rate for debt with the same or similar remaining maturities and collateral requirements.

Accrued interest

The carrying amounts of accrued interest receivable and payable approximate fair value.

Derivative financial instruments

Interest rate swaps and the interest rate option are recorded at fair value on a recurring basis. Fair value measurement is based on discounted cash flow models run by a third-party on a monthly basis. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date using interest rates appropriate for the term structure of the financial instrument hedged and for the counterparty involved. The Company classifies interest rate swaps as Level 2 except for the foreign exchange contracts.

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Note 11 - Disclosures About Fair Values of Financial Instruments (continued)

The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, are as follows at June 30, 2012 and December 31, 2011:

	June 30, 2012
	Carrying			Estimated fair value
	amount			Level 1		Level 2			Level 3
	(Amounts in thousands)
Financial assets:
Cash and due from banks	$	25,144		$	25,144	$	-		$	-
Federal funds sold and overnight deposits		101,784			101,784		-			-
Investment securities available for sale		261,944			-		261,944			-
Investment securities held to maturity		51,009			-		53,058			-
Loans held for sale and loans, net of allowance		894,669			-		-			875,980
Investment in life insurance		31,430			-		-			31,430
Accrued interest receivable		5,081			-		-			5,081
Financial liabilities:
Deposits		1,126,701			-		-			1,130,200
Short-term borrowings		59,268			-		-			61,319
Long-term borrowings		147,426			35,880		9,500			110,836
Accrued interest payable		6,125			-		-			6,125
On-balance sheet derivative financial instruments:
Interest rate swaps		(890	)		-		(546	)		(344	)
Interest rate option		1			-		1			-

	December 31, 2011
	Carrying			Estimated fair value
	amount			Level 1		Level 2		Level 3
	(Amounts in thousands)
Financial assets:
Cash and due from banks	$	23,356		$	23,356	$	-	$	-
Federal funds sold and overnight deposits		23,198			23,198		-		-
Investment securities available for sale		362,298			-		362,298		-
Investment securities held to maturity		44,403			-		45,514		-
Loans held for sale and loans, net of allowance		930,316			-		-		867,438
Investment in life insurance		30,919			-		-		30,919
Accrued interest receivable		5,843			-		-		5,843
Financial liabilities:
Deposits		1,183,172			-		-		1,177,073
Short-term borrowings		33,629			-		-		35,334
Long-term borrowings		177,514			14,352		4,160		143,376
Accrued interest payable		5,219			-		-		5,219
On-balance sheet derivative financial instruments:
Interest rate swaps		(223	)		-		234		(457	)
Interest rate option		9			-		9		-

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Note 12 – Fair Values of Assets and Liabilities

Accounting standards establish a framework for measuring fair value according to GAAP and expands disclosures about fair value measurements. Under these standards, there is a three level fair value hierarchy that is fully described below. The Company reports fair value on a recurring basis for certain financial instruments, most notably for available for sale investment securities and certain derivative instruments. The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis. These include assets that are measured at the lower of cost or market that were recognized at fair value which was below cost at the end of the period. Assets subject to nonrecurring use of fair value measurements could include loans held for sale, impaired loans and foreclosed assets. At June 30, 2012 and December 31, 2011, the Company had certain impaired loans and foreclosed assets that are measured at fair value on a nonrecurring basis.

The Company groups financial assets and financial liabilities 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. These levels are:

· Level 1 – Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. There were no investments held with level 1 valuations.

· Level 2 – Valuations for assets and liabilities traded in less active dealer or broker markets. Level 2 securities include asset-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Valuations are obtained from third party services for similar or comparable assets or liabilities.

· Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or brokered traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

There were no transfers between any of the levels during second quarter 2012. The table below presents the balances of assets and liabilities measured at fair value on a recurring basis.

	June 30, 2012
	Total			Level 1		Level 2			Level 3
	(Amounts in thousands)
Securities available for sale:
US Government agencies	$	19,715		$	-	$	19,715		$	-
Asset-backed securities		207,145			-		207,145			-
Municipals		27,786			-		27,786			-
Trust preferred securities		2,555			-		2,555			-
Common stocks and mutual funds		3,744			-		3,744			-
Other		999			-		999			-
Derivatives
Interest rate swaps		(890	)		-		(546	)		(344	)

	December 31, 2011
	Total			Level 1		Level 2		Level 3
	(Amounts in thousands)
Securities available for sale:
US government agencies	$	34,729		$	-	$	34,729	$	-
Asset-backed securities		291,368			-		291,368		-
Municipals		29,220			-		29,220		-
Trust preferred securities		2,321			-		2,321		-
Corporate bonds		3,659			-		3,659		-
Other		1,001			-		1,001		-
Derivatives
Interest rate swaps		(214	)		-		243		(457	)

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Note 12 – Fair Values of Assets and Liabilities (continued)

Quantitative Information about Level 3 Fair Value Measurements

					Range
	Fair Value at		Valuation	Unobservable	(Weighted
	June 30, 2012		Technique	Input	Average)
	(Amounts in thousands)
Recurring measurements:
Interest rate swaps	(344	)	Discounted cash flow	Discount rate	.5 - 3.75%
Nonrecurring measurements:
Impaired loans	15,857		Discounted appraisals	Appraisal Discounts	15 - 50%
Other real estate owned	19,873		Discounted appraisals	Appraisal Discounts	10% - 90%

The unobservable input used in the fair value measurement of the Company’s interest rate swap agreements is the discount rate. A significant change in the discount rate could result in a significantly different fair value measurement. The discount rate is determined by a third-party valuation provider by obtaining publicly available third party quotes. The only level three derivatives held by the Company are two foreign exchange contracts. The Company entered into the foreign exchange contract to convert foreign currency denominated certificates of deposit into long term dollar denominated time deposits. The interest rate on the underlying certificates of deposit with an original notional value/amount of $10.0 million is based on a proprietary index (Barclays Intelligent Carry Index USD ER) managed by the counterparty (Barclays Bank). The currency swap is also based on this proprietary index. The Company’s asset liability management team periodically reviews the discount rates utilized in determining the fair value of the interest rate swap agreements.

The table below presents a reconciliation for the second quarter of 2012, for all Level 3 assets and liabilities that are measured at fair value on a recurring basis.

	Fair Value Measurements Using Significant Unobservable Inputs
	(Amounts in thousands)
	Net Derivatives
Beginning Balance April 1, 2012	$	(458	)
Total realized and unrealized gains or losses:
Included in earnings		114
Included in other comprehensive income		-
Purchases		-
Issuances		-
Settlements		-
Transfers in and/or out of Level 3		-
Ending Balance	$	(344	)

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Note 12 – Fair Values of Assets and Liabilities (continued)

The table below presents a reconciliation for the six months ended 2012, for all Level 3 assets and liabilities that are measured at fair value on a recurring basis.

	Fair Value Measurements Using Significant Unobservable Inputs
	(Amounts in thousands)
	Net Derivatives
Beginning Balance January 1, 2012	$	(457	)
Total realized and unrealized gains or losses:
Included in earnings		113
Included in other comprehensive income		-
Purchases		-
Issuances		-
Settlements		-
Transfers in and/or out of Level 3		-
Ending Balance	$	(344	)

The Company utilizes a third party pricing service to provide valuations on its securities portfolio. Despite most of these securities being US government agency debt obligations, agency mortgage-backed securities and municipal securities traded in active markets, third party valuations are determined based on the characteristics of a security (such as maturity, duration, rating, etc.) and in reference to similar or comparable securities. Due to the nature and methodology of these valuations, the Company considers these fair value measurements as level 2. No securities were transferred between level 1 and level 2 for the quarter ended June 30, 2012.

The table below presents a reconciliation for the second quarter of 2011, for all Level 3 assets and liabilities that are measured at fair value on a recurring basis.

	Fair Value Measurements Using Significant Unobservable Inputs
	(Amounts in thousands)
	Securities
	Available for Sale		Net Derivatives
Beginning Balance April 1, 2011	$	-	$	(1,085	)
Total realized and unrealized gains or losses:
Included in earnings		-		516
Included in other comprehensive income		-		-
Purchases, issuances and settlements		-		-
Transfers in and/or out of Level 3		-		-
Ending Balance	$	-	$	(569	)

The table below presents a reconciliation for the six months ended 2011, for all Level 3 assets and liabilities that are measured at fair value on a recurring basis.

	Fair Value Measurements Using Significant Unobservable Inputs
	(Amounts in thousands)
	Securities
	Available for Sale			Net Derivatives
Beginning Balance January 1, 2011	$	3,003		$	(679	)
Total realized and unrealized gains or losses:
Included in earnings		537			110
Included in other comprehensive income		-			-
Purchases, issuances and settlements		(3,540	)		-
Transfers in and/or out of Level 3		-			-
Ending Balance	$	-		$	(569	)

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Note 12 – Fair Values of Assets and Liabilities (continued)

The fair value reporting standards allows an entity to make an irrevocable election to measure certain financial instruments at fair value. The changes in fair value from one reporting period to the next period must be reported in the income statement with additional disclosures to identify the effect on net income. The Company continued to account for securities available for sale at fair value as reported in prior years. Derivative activity is also reported at fair value. Securities available for sale and derivative activity are reported on a recurring basis. Upon adoption of the fair value reporting standard, no additional financial assets or liabilities were reported at fair value and there was no material effect on earnings.

The Company records loans in the ordinary course of business and does not record loans at fair value on a recurring basis. Loans are considered impaired when it is determined to be probable that all amounts due under the contractual terms of the loan will not be collected when due. Loans considered individually impaired are evaluated and a specific allowance is established if required based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. A specific allowance is required if the fair value of the expected repayments or the fair value of the collateral is less than the recorded investment in the loan. At June 30, 2012, loans with a book value of $74.8 million were evaluated for impairment. Of this total, $17.7 million required a specific allowance totaling $1.7 million for a net fair value of $15.8 million. The methods used to determine the fair value of these loans were considered level 3. At June 30, 2012, the majority of impaired loans were evaluated based on the fair value of the collateral. The Company records impaired loans as nonrecurring level 3. There have been no changes in valuation techniques for the quarter ended June 30, 2012. Valuation techniques are consistent with techniques used in prior periods.

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less estimated cost to sell on the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management or outside appraisers and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. These valuations generally are based on market comparable sales data for similar type of properties. The range of discounts in these valuations is specific to the nature, type, location, condition and market demand for each property. The methods used to determine the fair value of these foreclosed assets were considered level 3.

The table below presents the balances of assets and liabilities measured at fair value on a nonrecurring basis.

	June 30, 2012
	Total		Level 1		Level 2		Level 3
	(Amounts in thousands)
Impaired loans	$	15,857	$	-	$	-	$	15,857
Foreclosed assets		19,873		-		-		19,873

	December 31, 2011
	Total		Level 1		Level 2		Level 3
	(Amounts in thousands)
Impaired loans	$	21,388	$	-	$	-	$	21,388
Foreclosed assets		19,812		-		-		19,812

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.

The Company’s market risk arises primarily from interest rate risk inherent in its lending, deposit-taking and borrowing activities. The structure of the Company’s loan and liability portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. The Company does not maintain a trading account nor is the Company subject to currency exchange risk or commodity price risk.

In reviewing the needs of our Bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including net interest income simulations and gap analyses. A net interest income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. The results of the most recent analysis indicated that the Company is relatively interest rate neutral. Given the current level of market interest rates, it is not meaningful to use an assumed decrease in interest rates of more than 1%. If interest rates decreased instantaneously by one percentage point, our net interest income over a one-year time frame could decrease by approximately 7.6%. If interest rates increased instantaneously by two percentage points, our net interest income over a one-year time frame could increase by approximately 10.6%.

Item 4. Controls and Procedures

The Company conducted an evaluation, under the supervision and with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2012. The Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2012 at the reasonable assurance level. However, the Company believes that a system of internal controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

During the six months ended June 30, 2012, the Company completed a number of measures to strengthen its credit risk management, including enhancements to credit underwriting and credit approval, more comprehensive procedures to identify and evaluate troubled debt restructurings and a strengthening of the staffing and Board oversight for the Bank’s internal loan review function. As a part of the changes in these processes, there were improvements in the related system of internal controls that enhanced the effectiveness of the Company’s internal controls over financial reporting. The Company reviews its disclosure controls and procedures, which may include its internal control over financial reporting, on an ongoing basis, and may from time to time make changes to ensure that the Company’s systems evolve with its business.

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Part II. OTHER INFORMATION

Item 1A. Risk Factors

An investment in our common stock involves risk. Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-Q and information incorporated by reference in this Form 10-Q, including our consolidated financial statements and related notes. If any of the following risks or other risks which have not been identified or which we may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be harmed. This could cause the price of our stock to decline and shareholders could lose part or all of their investment. This Form 10-Q contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions and expectations. Many factors, including those described below, could cause actual results to differ materially from those discussed in our forward-looking statements.

Risks Related to Holding Southern Community Common Stock

Failure to consummate the acquisition transaction with Capital Bank Financial Corp.

While we intend and expect to meet all of the conditions required to consummate the transaction with Capital Bank Financial Corp., there are certain closing conditions which are beyond our control whose occurrence, or failure, could result in the transaction being terminated. These factors include the failure of Capital Bank Financial Corp. to obtain regulatory approval or the consideration by our Board of a competing offer. Under certain circumstances, the consideration of a competing offer could result in the Company paying significant termination fees and expenses as disclosed in Note 2 to the financial statements. If the transaction with Capital Bank Financial Corp. fails to be consummated, the Company could be obligated to pay additional expenses for the transaction (which could be material and have not yet been expensed). We could also experience material operational disruptions, including a loss of key employees and/or key customer relationships. Failure of the transaction to be consummated could have a material adverse effect on our business, future prospects, financial condition or results of operations and shareholders might not be able to realize a similar value for their shares for some time.

Item 6. Exhibits

(a) Exhibits.

Exhibit 31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)
Exhibit 31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)
Exhibit 32	Section 1350 Certification
Exhibit 101.INS	XBRL Instance Document
Exhibit 101.SCH	XBRL Taxonomy Extension Schema
Exhibit 101.CAL	XBRL Taxonomy Extension Calculation Linkbase
Exhibit 101.DEF	XBRL Taxonomy Extension Definition Linkbase
Exhibit 101.LAB	XBRL Taxonomy Extension Label Linkbase
Exhibit 101.PRE	XBRL Taxonomy Extension Presentation Linkbase

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SIGNATURES

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

	SOUTHERN COMMUNITY FINANCIAL CORPORATION
Date:  August 8, 2012	By:	/s/ James Hastings
		James Hastings
		Interim President and Chief Executive Officer
		(principal executive officer)
Date:  August 8, 2012	By:	/s/ James Hastings
		James Hastings
		Executive Vice President and Chief Financial Officer
		(principal financial and accounting officer)

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