10-K 1 f10kvfc123113.htm FORM 10-K FOR YEAR ENDING 12/31/2012 f10kvfc123113.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

Commission file number 0-50765

VILLAGE BANK AND TRUST FINANCIAL CORP.
(Exact name of registrant as specified in its charter)

Virginia
  
16-1694602
(State or other jurisdiction of
  
(I.R.S. Employer
incorporation or organization)
  
Identification No.)
     
15521 Midlothian Turnpike, Suite 200, Midlothian, Virginia
23113
(Address of principal executive offices)
(Zip Code)
     
Issuer’s telephone number 804-897-3900

Securities registered under Section 12(b) of the Exchange Act:

Title of each class
Name of each exchange on which registered
Common Stock, $4.00 par value
The Nasdaq Stock Market

Securities registered under Section 12(g) of the Exchange Act:
None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ¨ Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. [  ]

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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.  Yesx  No¨ 

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form10-K or any amendment to this Form 10-K.[  ]

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

Large Accelerated Filer ¨
Accelerated Filer ¨
Non-Accelerated Filer ¨ (Do not check if smaller reporting company)
Smaller Reporting Company x

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

The aggregate market value of common stock held by non-affiliates of the registrant as of the last business day of the Registrant’s most recent completed second fiscal quarter was approximately $5,315,000.

The number of shares of common stock outstanding as of March 1, 2013 was 4,251,795.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement to be used in conjunction with the 2013 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.
 
 

Village Bank and Trust Financial Corp.
Form 10-K


   
 
3
  
   
  30  
   
   
   
           
   
     
       
     
     
       
   
     
       
   
   
           
   
   
   
     
       
     
       
   
           
   
   
           
 






The disclosures set forth in this item are qualified by ITEM 1A. RISK FACTORS and the section captioned “Caution About Forward-Looking Statements” and other cautionary statements set forth elsewhere in this report.

General

Village Bank and Trust Financial Corp. (“Company”, ”we”, “our”) was incorporated in January 2003 and was organized under the laws of the Commonwealth of Virginia as a bank holding company whose activities consist of investment in its wholly-owned subsidiary, Village Bank (the “Bank”).  The Bank opened to the public on December 13, 1999 as a traditional community bank offering deposit and loan services to individuals and businesses in the Richmond, Virginia metropolitan area.  During 2003, the Company acquired or formed three wholly owned subsidiaries of the Bank, Village Bank Mortgage Corporation (“Village Bank Mortgage”), a full service mortgage banking company, Village Insurance Agency, Inc. (“Village Insurance”), a full service property and casualty insurance agency, and Village Financial Services Corporation (“Village Financial Services”), a financial services company.  Currently, Village Insurance and Village Financial Services have no ongoing operations.  In addition we provide investment services through a separate division of the Bank, Village Investment Services.

The Company is the holding company of and successor to the Bank.  Effective April 30, 2004, the Company acquired all of the outstanding stock of the Bank in a statutory share exchange transaction.  In the transaction, the shares of the Bank’s common stock were exchanged for shares of the Company’s common stock, par value $4.00 per share (“Common Stock”), on a one-for-one basis.  As a result, the Bank became a wholly-owned subsidiary of the Company, the Company became the holding company for the Bank and the shareholders of the Bank became shareholders of the Company.

We offer a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, and commercial, real estate and consumer loans.  In addition we provide investment services through a separate division of the Bank, Village Investment Services.  We are a community-oriented and locally managed financial institution focusing on providing a high level of responsive and personalized services to our customers, delivered in the context of a strong direct relationship with our customers.  We conduct our operations from our main office/corporate headquarters location in Chesterfield County, and we have fourteen branch offices.

During the first quarter of 2013, we expect to complete the sale of one of our branches located in Chesterfield County to StellarOne Bank.  StellarOne Bank will acquire deposits of approximately $21.5 million, loans of $12.2 million and real estate of $1.7 million from Village Bank. The purchase price represents a 3.5% premium on the deposits, par value on the loan portfolio and book value for the real estate.


Business Strategy

Our current business strategies include the following:

 
·
To be a full service financial services provider enabling us to establish and maintain relationships with our customers.

 
·
To reduce the level of our nonperforming assets.  Nonperforming assets, consisting of nonaccrual loans and real estate acquired through foreclosure, reached record highs in 2012 and continue to have a negative effect on profitability.  We have committed significant resources to reduce the level of nonperforming assets.

 
 
·
To comply with the requirements agreed to with our regulatory authorities.
 
o  
The Bank has entered into an agreement with the Federal Deposit Insurance Corporation and the Virginia Bureau of Financial Institutions, agreeing among other matters to: (1) improve its credit risk exposure; (2) comply with regulatory capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital ratios; and (3) not grow its assets more than 10% per year.  This agreement is more fully discussed later in this Annual Report.

o  
In addition, the Company also entered into a Written Agreement with the Federal Reserve Bank of Richmond (the “Reserve Bank”).  Pursuant to this Written Agreement, the Company agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans to maintain sufficient capital and correct any violations of section 23A of the Federal Reserve Act and Regulation W.  In addition, the Company will submit a written statement of its planned sources and uses of cash for debt service, operation expenses, and other purposes. The Company also has agreed that it will not, without prior regulatory approval:
§  
pay or declare any dividends;
§  
take any other form of payment representing a reduction in capital from the Bank;
§  
make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities;
§  
incur, increase, repay, or guarantee any debt;
§  
purchase or redeem any shares of its stock.
 
 
·
To reduce our total assets and liabilities.  At the beginning of 2012, our business strategy included efforts to reduce our total assets and liabilities due to a continued depressed economy as well as capital limitations at the time.  These efforts resulted in declines of approximately $72 million in total assets and approximately $60 million in total liabilities in 2012.  With the sale of a branch in the first quarter of 2013, we expect to further reduce our total assets and liabilities by approximately $22 million.  This strategy helped strengthen our regulatory capital ratios in 2012.  While we do not anticipate significant growth in 2013, we will not continue our efforts to reduce total assets and liabilities.

 
·
To attract commercial and retail customers by providing the breadth of products offered by larger banks while maintaining the quick response and personal service of a community bank.  We will continue to look for opportunities to expand our products and services.  We have established a diverse product line, including commercial, mortgage and consumer loans as well as a full array of deposit products and services.

Our officers, employees and the directors live and work in our market area.  We believe that the existing and future banking market in our community represents an opportunity for locally owned and locally managed community banks.  In view of the continuing trend in the financial services industry toward consolidation into larger, statewide, regional and national institutions, the market exists for the personal and customized financial services that an independent, locally owned bank with local decision making can offer.  With the flexibility of our smaller size and through an emphasis on relationship banking, including personal attention and service, we can be more responsive to the individual needs of our customers than our larger competitors.  As a community oriented and locally managed institution, we make most of our loans in our community and can tailor our services to meet the banking and financial needs of our customers who live and do business in our market.


 
Location and Market Area

Our overall strategy is to become the premier financial institution serving the Richmond metropolitan area.  We recognized early on that to be successful with this strategy, we needed to grow aggressively, expanding our branch network to reach the most people possible.  Initially, we focused our operations in Chesterfield County, Virginia, which, despite its potential for business development and population growth, has been underserved by community banks.  Chesterfield’s resources are very favorable for businesses seeking a profitable and stable environment.  The county offers superb commercial and industrial sites, an educated work force, well-designed and developed infrastructure and a competitive tax structure.  Chesterfield has been awarded the U.S. Senate Gold Medallion for Productivity and Quality.  The county has the highest bond rating from three rating agencies - Standard and Poors, Moody’s and Fitch.

Once we established a strong banking presence in the Chesterfield County market with eight branches, we continued the implementation of our strategy by expanding our franchise into other counties in the Richmond Metropolitan area.  In addition to Chesterfield County, we have now opened three branches in both Hanover and Henrico Counties and one in Powhatan County; all three along with Chesterfield have seen strong population growth in recent years.  Our mortgage company has experienced a significant increase in loan production as a result of the addition of a loan production office in Northern Virginia.

As a result of the depressed economic conditions over the past several years, our more recent strategy has been to curtail growth and reduce total assets and liabilities to strengthen our capital ratios.  This strategy resulted in declines in total assets and liabilities in 2012.  While we do not anticipate significant growth in 2013, we will not continue our efforts to reduce total assets and liabilities.

At December 31, 2012, we had fourteen full service banking offices, which were staffed by 56 full-time employees.  Our senior staff averages more than 25 years of professional or banking experience.  Our principal office, which houses our executive officers and loan department, was opened in August 2008 and is located at 15521 Midlothian Turnpike, Midlothian, Virginia 23113.  Our main telephone number is (804) 897-3900.

Historically the Richmond Metropolitan area has been a favorable market for us to provide banking services.  However, with the depressed economy that started in late 2008, this market area was negatively impacted by the decline in the housing market, especially in Chesterfield County where residential housing has been an economic driver in the past.  Because a substantial part of our loan portfolio is collateralized by residential real estate primarily in Chesterfield County, this decline in the housing market has had a negative impact on our asset quality.  The result has been a substantial increase in nonperforming assets, and in turn, a negative impact on profitability.  See further discussion of nonperforming assets under Asset Quality in Management’s Discussion and Analysis of Financial Condition and Results of Operations following.

Banking Services

We receive deposits, make consumer and commercial loans, and provide other services customarily offered by a commercial banking institution, such as business and personal checking and savings accounts, drive-up windows, and 24-hour automated teller machines.  We have not applied for permission to establish a trust department and offer trust services.  We are not a member of the Federal Reserve System.  Our deposits are insured under the Federal Deposit Insurance Act to the limits provided thereunder.

We offer a full range of short-to-medium term commercial and personal loans.  Commercial loans include both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements) and purchase of equipment and machinery.  Consumer loans include secured and unsecured loans for financing automobiles, home improvements, education and personal investments.  We also originate fixed and variable rate mortgage loans and real estate construction and acquisition loans.  Residential loans originated by our mortgage company are usually sold in the secondary mortgage market.

 
Our lending activities are subject to a variety of lending limits imposed by federal and state law.  While differing limits apply in certain circumstances based on the type of loan or the nature of the borrower (including the borrower’s relationship to the bank), in general, for loans that are not secured by readily marketable or other permissible collateral, we are subject to a loans-to-one borrower limit of an amount equal to 15% of our capital and surplus.  We may voluntarily choose to impose a policy limit on loans to a single borrower that is less than the legal lending limit.  We are a member of the Community Bankers’ Bank and may participate out portions of loans when loan amounts exceed our legal lending limits or internal lending policies.

Lending Activities

Our primary focus is on making loans to small businesses and consumers in our local market area.  In addition, we also provide a select range of real estate finance services.  Our primary lending activities are principally directed to our market area.

Loan Portfolio.  The net loan portfolio was $344,890,000 at December 31, 2012, which compares to $412,567,000 at December 31, 2011.  The Company continued to see a decline in loan levels in 2012, with a decline of 16.4% compared to a decline of 7.6% in 2011.  The declines in loans in 2012 and 2011 were a direct result of the prolonged economic downturn and our decision to increase capital ratios to meet regulatory requirements.  With the anticipated sale of a branch in the first quarter of 2013 which will include the sale of approximately $12.2 million in loans, we do not intend to allow our loan level to continue to decline in 2013; however, this will be influenced by the availability of quality loans and economic conditions.  Our loan customers are generally located in the Richmond metropolitan area.

Commercial Real Estate Lending.  We finance commercial real estate for our clients and commercial real estate loans represent the largest segment of our loan portfolio.  This segment of our loan portfolio has been the largest segment since 2004 due to the significant real estate opportunities in our market area.  We generally will finance owner-occupied commercial real estate at an 80% loan-to-value ratio or less.  In many cases our loan-to-value ratio is less than 80%, which provides us with a higher level of collateral security.  Our underwriting policies and procedures focus on the borrower’s ability to repay the loan as well as assessment of the underlying real estate.  Risks inherent in managing a commercial real estate loan portfolio relate to sudden or gradual drops in property values as well as changes in the economic climate.  We attempt to mitigate those risks by carefully underwriting loans of this type as well as following appropriate loan-to-value standards.  Commercial real estate loans (generally owner occupied) at December 31, 2012 were $157,884,000, or 44.5% of the total loan portfolio.

Residential Mortgage Lending.  We make permanent residential mortgage loans for inclusion in the loan portfolio.  We seek to retain in our portfolio variable rate loans secured by one-to-four-family residences.  However, the majority of permanent residential loans are made by the Bank’s subsidiary, Village Bank Mortgage, which sells them to investors in the secondary mortgage market on a pre-sold basis.  Given the low fixed rate residential loan market in recent years, this allows us to offer this service to our customers without retaining a significant low rate residential loan portfolio which would be detrimental to earnings as interest rates increase.  We originate both conforming and non-conforming single-family loans.

Before we make a loan we evaluate both the borrower’s ability to make principal and interest payments and the value of the property that will secure the loan.  We make first mortgage loans in amounts up to 90% of the appraised value of the underlying real estate.  We retain some second mortgage loans secured by property in our market area, as long as the loan-to-value ratio combined with the first mortgage does not exceed 90%.  For conventional loans in excess of 80% loan-to-value, private mortgage insurance is required.

Our current one-to-four-family residential adjustable rate mortgage loans have interest rates that adjust annually after a fixed period of 1, 3 and 5 years, generally in accordance with the rates on comparable U.S. Treasury bills plus a margin.  Our adjustable rate mortgage loans generally limit
 
 
interest rate increases to 2% each rate adjustment period and have an established ceiling rate at the time the loans are made of up to 6% over the original interest rate.  There are risks resulting from increased costs to a borrower as a result of the periodic repricing mechanisms of these loans.  Despite the benefits of adjustable rate mortgage loans to our asset/liability management, they pose additional risks, primarily because as interest rates rise; the underlying payments by the borrowers rise, increasing the potential for default.  At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.  At December 31, 2012, $115,827,000, or 32.7% of our loan portfolio, consisted of residential mortgage loans.

Real Estate Construction Lending.  This segment of our loan portfolio is predominantly residential in nature and comprised of loans with short duration, meaning maturities of twelve months or less.  Residential houses under construction and the underlying land for which the loan was obtained secure the construction loans.  Construction lending entails significant risks compared with residential mortgage lending.  These risks involve larger loan balances concentrated with single borrowers with funds advanced upon the security of the land and home under construction, which is estimated prior to the completion of the home.  Thus it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios.  To mitigate these risks we generally limit loan amounts to 80% of appraised values on pre-sold homes and 75% on speculative homes, and obtain first lien positions on the property taken as security.  Additionally, we offer real estate construction financing to individuals who have demonstrated the ability to obtain a permanent loan.  At December 31, 2012, construction loans totaled $44,055,000, or 12.4% of the total loan portfolio.

Commercial Business Lending.  Our commercial business lending consists of lines of credit, revolving credit facilities, term loans, equipment loans, stand-by letters of credit and unsecured loans.  Commercial loans are written for any business purpose including the financing of plant and equipment, carrying accounts receivable, general working capital, contract administration and acquisition activities.  Our client base is diverse, and we do not have a concentration of loans in any specific industry segment.  Commercial business loans are generally secured by accounts receivable, equipment, inventory and other collateral such as marketable securities, cash value of life insurance, and time deposits.  Commercial business loans have a higher degree of risk than residential mortgage loans, but have higher yields.  To manage these risks, we generally obtain appropriate collateral and personal guarantees from the borrower’s principal owners and monitor the financial condition of business borrowers.  The availability of funds for the repayment of commercial business loans may substantially depend on the success of the business itself.  Further, the collateral for commercial business loans may depreciate over time and cannot be appraised with as much precision as residential real estate.  All commercial loans we make have recourse under the terms of a promissory note.  At December 31, 2012, commercial loans totaled $34,384,000, or 9.7% of the total loan portfolio.

Consumer Installment Lending.  We offer various types of secured and unsecured consumer loans.  We make consumer loans primarily for personal, family or household purposes as a convenience to our customer base since these loans are not the primary focus of our lending activities.  Our general guideline is that a consumer’s total debt service should not exceed 40% of the consumer’s gross income.  Our underwriting standards for consumer loans include making a determination of the applicant’s payment history on other debts and an assessment of his or her ability to meet existing obligations and payments on the proposed loan.  The stability of an applicant’s monthly income may be determined by verification of gross monthly income from primary employment and additionally from any verifiable secondary income.  Consumer loans totaled $2,761,000 at December 31, 2011, which was 1.1% of the total loan portfolio.

Loan Commitments and Contingent Liabilities.  In the normal course of business, the Company makes various commitments and incurs certain contingent liabilities which are disclosed in the footnotes of our annual financial statements, including commitments to extend credit.  At December 31, 2012, undisbursed credit lines, standby letters of credit and commitments to extend credit totaled $64,110,000.

 
Credit Policies and Administration.  We have a comprehensive lending policy, which includes stringent underwriting standards for all types of loans.  Our lending staff follows pricing guidelines established periodically by our management team.  In an effort to manage risk, all credit decisions in excess of the officers’ lending authority must be approved prior to funding by a management loan committee and/or a board of directors-level loan committee.  Any loans above $5,000,000 require full board of directors’ approval.  Management believes that it employs experienced lending officers, secures appropriate collateral and carefully monitors the financial conditions of our borrowers and the concentration of such loans in the portfolio.

In addition to the normal repayment risks, all loans in our portfolio are subject to the state of the economy and the related effects on the borrower and/or the real estate market.  Generally, longer-term loans have periodic interest rate adjustments and/or call provisions.  Our senior management monitors the loan portfolio closely to ensure that past due loans are minimized and that potential problem loans are swiftly dealt with.  In addition to the internal business processes employed in the credit administration area, the Company utilizes an outside consulting firm to review the loan portfolio.  Results of the report are used to validate our internal loan ratings and to provide independent commentary on specific loans and loan administration activities.

Lending Limit.  As of December 31, 2012, our legal lending limit for loans to one borrower was approximately $5,500,000.  However, we generally will not extend credit to any one individual or entity in excess of $5,000,000, and, as noted above, any amount over that must be approved by the full Board of Directors.

Investments and Funding

We balance our liquidity needs based on loan and deposit growth via the investment portfolio, purchased federal funds, and Federal Home Loan Bank advances.  It is our goal to provide adequate liquidity to support our loan growth.  Should we have excess liquidity, investments are used to generate earnings.  In the event deposit growth does not fully support our loan growth, a combination of investment sales, federal funds and Federal Home Loan Bank advances will be used to augment our funding position.

Our investment portfolio is actively monitored and is classified as “available for sale.”  Under such a classification, investment instruments may be sold as deemed appropriate by management.  On a monthly basis, the investment portfolio is marked to market via equity as required by generally accepted accounting principles.  Additionally, we use the investment portfolio to balance our asset and liability position.  We will invest in fixed rate or floating rate instruments as necessary to reduce our interest rate risk exposure.

For securities classified as available-for-sale securities, we evaluate whether a decline in fair value below the amortized cost basis is other than temporary.  If the decline in fair value is judged to be other than temporary, the cost basis of the individual security is written down to fair value as a new cost basis and the amount of the write-down is included in earnings.  There were no securities at December 31, 2012 where a decline in market value was considered other than temporary.

Asset and Liability Management

Our Asset Liability Management Committee (ALCO), composed of senior managers of the Bank, manages the Bank’s assets and liabilities and strives to provide a stable, optimized net interest income and margin, adequate liquidity and ultimately a suitable after-tax return on assets and return on equity. ALCO conducts these management functions within the framework of written policies that the Bank’s board of directors has adopted.  ALCO works to maintain an acceptable position between rate sensitive assets and rate sensitive liabilities.  The board of directors oversees the ALCO function on an ongoing basis.

 
 
Competition

We encounter strong competition from other local commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other financial institutions.  A number of these competitors are well-established.  Competition for loans is keen, and pricing is important.  Most of our competitors have substantially greater resources and higher lending limits than ours and offer certain services, such as extensive and established branch networks and trust services, which we do not provide at the present time.  Deposit competition also is strong, and we may have to pay higher interest rates to attract deposits.  Nationwide banking institutions and their branches have increased competition in our markets, and federal legislation adopted in 1999 allows non-banking companies, such as insurance and investment firms, to establish or acquire banks.

The greater Richmond metropolitan market has experienced several significant mergers or acquisitions involving all four regional banks formerly headquartered in central Virginia over the past fifteen years.  Additionally, other larger banks from outside Virginia have acquired local banks.  We believe that the Company can capitalize on such merger activity and attract customers from those who are dissatisfied with the acquired banks.

At June 30, 2012, the latest date such information is available from the FDIC, the Bank’s deposit market share in Chesterfield County was 7.26%, 5.30% in Hanover County,  0.61% in the Richmond MSA and 0.13% in Henrico County.

Regulation

We are subject to extensive regulation by certain federal and state agencies and receive periodic examinations by those regulatory authorities.  As a consequence, our business is affected by state and federal legislation and regulations.

General. The discussion below is only a summary of the principal laws and regulations that comprise the regulatory framework applicable to us.  The descriptions of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, do not purport to be complete and are qualified in their entirety by reference to applicable laws and regulations.  In recent years, regulatory compliance by financial institutions such as ours has placed a significant burden on us both in costs and employee time commitment.

Bank Holding Company.  The Company is a bank holding company under the federal Bank Holding Company Act of 1956, as amended, and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and Virginia Bureau of Financial Institutions (the “BFI”).  As a bank holding company, the Company is required to furnish to the Federal Reserve annual and quarterly reports of its operations and such additional information as the Federal Reserve may require.  The Federal Reserve, Federal Deposit Insurance Corporation (the “FDIC”) and BFI also may conduct examinations of the Company and/or its subsidiary bank.

Bank Regulation.  As a Virginia-chartered bank that is not a member of the Federal Reserve System, the Bank is subject to regulation, supervision and examination by the BFI and the FDIC.  Federal and state law also specify the activities in which we may engage, the investments we may make and the aggregate amount of loans that may be granted to one borrower.  Various consumer and compliance laws and regulations also affect our operations.  Earnings are affected by general economic conditions, management policies and the legislative and governmental actions of various regulatory authorities, including those referred to above.  The following description summarizes some of the laws to which we are subject.  The BFI and the FDIC conduct regular examinations, reviewing such matters as the overall safety and soundness of the institution, the adequacy of loan loss reserves, quality of loans and investments, management practices, compliance with laws, and other aspects of our operations.  In addition to these regular examinations, we must furnish the FDIC and BFI with periodic reports containing a full and accurate statement of our affairs. Supervision, regulation and examination of banks by these agencies are intended primarily for the protection of depositors rather than shareholders.
 

Consent Order.  In February 2012, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (“Consent Agreement”) with the FDIC and the BFI (the “Supervisory Authorities”), and the Supervisory Authorities have issued the related Consent Order (the “Order”) effective February 3, 2012.  The description of the Consent Agreement and the Order set forth below:

Management. The Order requires that the Bank have and retain qualified management, including at a minimum a chief executive officer, senior lending officer and chief operating officer, with qualifications and experience commensurate with their assigned duties and responsibilities within 90 days from the effective date of the order.  Within 30 days of the effective date of the Order, the Bank must retain a bank consultant to develop a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management for the Bank.  Within 30 days from receipt of the consultant’s management report, the Bank must formulate a written management plan that incorporates the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a timeframe for completing each action.

Capital Requirements. Within 90 days from the effective date of the Order and during the life of the Order, the Bank must have Tier 1 capital equal to or greater than 8 percent of its total assets, and total risk-based capital equal to or greater than 11 percent of the Bank’s total risk-weighted assets.  Within 90 days from the effective date of the Order, the Bank must submit a written capital plan to the Supervisory Authorities.  The capital plan must include a contingency plan in the event that the Bank fails to maintain the minimum capital ratios required in the Order, submit a capital plan that is acceptable to the Supervisory Authorities, or implement or adhere to the capital plan.

Charge-offs. The Order requires the Bank to eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” and 50 percent of those classified “Doubtful”.  If an asset is classified “Doubtful”, the Bank may, in the alternative, charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment.  The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, “loss” or “doubtful” and is uncollected.  The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.”  These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.

Asset Growth. While the Order is in effect, the Bank must notify the Supervisory Authorities at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition.  The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from the Supervisory Authorities.

Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of the Supervisory Authorities.  In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior written approval of the Supervisory Authorities.

Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits.  These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area.  An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.

Written Plans and Other Material Terms. Under the terms of the Order, the Bank is required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:

 
—
Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management
 
 
—
Plan to reduce assets of $250,000 or greater classified “doubtful” and “substandard”
 
 
—
Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions
 
 
—
Effective internal loan review and grading system
 
 
—
Policy for managing the Bank’s other real estate
 
 
—
Business/strategic plan covering the overall operation of the Bank
 
 
—
Plan and comprehensive budget for all categories of income and expense for the year 2011
 
 
—
Policy and procedures for managing interest rate risk
 
 
—
Assessment of the Bank’s information technology function
 

Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities.  The Bank must also establish a board committee to monitor and coordinate compliance with the Order.
The Order will remain in effect until modified or terminated by the Supervisory Authorities.

While subject to the Consent Order, we expect that our management and board of directors will be required to focus considerable time and attention on taking corrective actions to comply with the terms.  In addition, certain provisions of the Consent Order described above could adversely impact the Company’s businesses and results of operations.

Written Agreement.  In June 2012, the Company entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (“Reserve Bank”).  Under the terms of the Written Agreement, the Company agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans to maintain sufficient capital and correct any violations of section 23A of the Federal Reserve Act and Regulation W.  In addition, the Company will submit a written statement of its planned sources and uses of cash for debt service, operation expenses, and other purposes.

The Company also has agreed that it will not, without prior regulatory approval:
 
·
pay or declare any dividends;
 
·
take any other form of payment representing a reduction in Bank’s capital;
 
·
make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities;
 
·
incur, increase or guarantee any debt;
 
·
purchase or deem any shares of its stock.
 
 
 
Since entering into the Order and the Written Agreement, the Company has taken the following steps, among other things, to comply with their terms:

 
·
The board of directors has established two committees that meet at least monthly.  The Regulatory Oversight Committee to monitor and coordinate compliance with the Order and the Written Agreement and any other related regulatory matters that may arise, and the Asset Quality Committee to oversee management’s progress in reducing the Bank’s classified assets.
 
·
The board of directors retained a bank consultant that developed a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management for the Bank.  Based on the results of this written analysis and assessment, the Bank formulated a written management plan that incorporates the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a timeframe for completing each action which was submitted to the Supervisory Authorities.
 
·
We have established a Problem Assets Group headed by a newly hired member of senior management with extensive experience with problem loan workouts which has developed a plan to reduce our nonperforming assets.  This group has also established a plan to manage foreclosed real estate.
 
·
We have revised our lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions.  This policy was also revised to provide for an effective internal loan review and grading system.
 
·
We have prepared a comprehensive budget and strategic plan covering the overall operation of the Bank which has been submitted to the Supervisory Authorities.
 
·
Prepared and submitted a plan to correct any violations of section 23A of the Federal Reserve Act and Regulation W to the Reserve Bank.

The Dodd-Frank Wall Street Reform and Consumer Protection Act.  In July 2010, the Dodd-Frank Act Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law, incorporating numerous financial institution regulatory reforms.  Many of these reforms are yet to be implemented through regulations to be adopted by various federal banking and securities regulatory agencies.  The following discussion describes the material elements of the regulatory framework that currently apply.  The Dodd-Frank Act implements far-reaching reforms of major elements of the financial landscape, particularly for larger financial institutions.  Many of its provisions do not directly impact community-based institutions like the Bank.  For instance, provisions that regulate derivative transactions and limit derivatives trading activity of federally-insured institutions, enhance supervision of “systemically significant” institutions, impose new regulatory authority over hedge funds, limit proprietary trading by banks, and phase-out the eligibility of trust preferred securities for Tier 1 capital are among the provisions that do not directly impact the Bank either because of exemptions for institutions below a certain asset size or because of the nature of  the Bank’s operations.  Provisions that do impact the Bank include the following:

 
·
FDIC Assessments. The Dodd-Frank Act changes the assessment base for federal deposit insurance from the amount of insured deposits to average consolidated total assets less its average tangible equity.  In addition, it increases the minimum size of the Deposit Insurance Fund (“DIF”) and eliminates its ceiling, with the burden of the increase in the minimum size on institutions with more than $10 billion in assets.
 
·
Deposit Insurance.  The Dodd-Frank Act makes permanent the $250,000 limit for federal deposit insurance and temporarily provided unlimited federal deposit insurance until December 31, 2012 for non-interest-bearing demand transaction accounts at all insured depository institutions.
 
·
Interest on Demand Deposits.  The Dodd- Frank Act also provides that, effective one year after the date of enactment, depository institutions may pay interest on demand deposits, including business transaction and other accounts.
 
·
Consumer Financial Protection Bureau.  The Dodd-Frank Act centralizes responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing federal consumer protection laws, although banks below $10 billion in assets will continue to be examined and supervised for compliance with these laws by their federal bank regulator.
 
 
 
·
Mortgage Lending.  New requirements are imposed on mortgage lending, including new minimum underwriting standards, prohibitions on certain yield-spread compensation to mortgage originators, special consumer protections for mortgage loans that do not meet certain provision qualifications, prohibitions and limitations on certain mortgage terms and various new mandated disclosures to mortgage borrowers.
 
·
Holding Company Capital Levels.  Bank regulators are required to establish minimum capital levels for holding companies that are at least as stringent as those currently applicable to banks.  In addition, all trust preferred securities issued after May 19, 2010 will be counted as Tier 2 capital, but the Company’s currently outstanding trust preferred securities will continue to qualify as Tier 1 capital.
 
·
De Novo Interstate Branching.  National and state banks are permitted to establish de novo interstate branches outside of their home state, and bank holding companies and banks must be well-capitalized and well managed in order to acquire banks located outside their home state.
 
·
Transactions with Affiliates. The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.
 
·
Transactions with Insiders. Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.
 
·
Corporate Governance.  The Dodd-Frank Act includes corporate governance revisions that apply to all public companies, not just financial institutions, including with regard to executive compensation and proxy access to shareholders.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, and their impact on the Company or the financial industry is difficult to predict before such regulations are adopted. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits and interchange fees could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.

Insurance of Accounts, Assessments and Regulation by the FDIC.  Our deposits are insured by the FDIC up to the limits set forth under applicable law, currently $250,000.  We are subject to the deposit insurance assessments of the Deposit Insurance Fund (DIF).  The amount of the assessment is a function of the institution’s risk category, of which there are four, and its assessment base.  An institution’s risk category is determined according to its supervisory ratings and capital levels and is used to determine the institution’s assessment rate.  Beginning April 1, 2011, the assessment base is an institution’s average consolidated total assets less its average tangible equity.

The FDIC is authorized to prohibit any DIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund.  Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance if the institution has no tangible capital.  If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent
 
 
withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC.  We are aware of no existing circumstances that could result in termination of our deposit insurance.

Payment of Dividends.  We are a legal entity separate and distinct from the Bank and our other subsidiaries.  Virtually all of our cash revenues will result from dividends paid to us by the Bank, which is subject to laws and regulations that limit the amount of dividends that it can pay. Under Virginia law, a bank may not declare a dividend in excess of its accumulated retained earnings without BFI approval.  As of December 31, 2012, the Bank did not have any accumulated retained earnings.  In addition, the Bank may not declare or pay any dividend if, after making the dividend, the bank would be "undercapitalized," as defined in FDIC regulations.

The FDIC and the state have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. Both the state and the FDIC have indicated that paying dividends that deplete a bank's capital base to an inadequate level would be an unsound and unsafe banking practice.

In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividend policies. Regulators have indicated that holding companies should generally pay dividends only if the organization's net income available to common shareholders over the past year has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the organization's capital needs, asset quality and overall financial condition.  In addition, the Federal Reserve has issued guidelines that bank holding companies should inform and consult with the Federal Reserve in advance of declaring or paying a dividend that exceeds earnings for the period (e.g., quarter) for which the dividend is being paid or that could result in a material adverse change to the organization’s capital structure.

The Company is currently subject to a Written Agreement with the Reserve Bank pursuant to which the Company must obtain the prior written approval of the Reserve Bank to declare or pay any dividends on its common stock or preferred stock, take dividends or any other form of payment representing a reduction in capital from the Bank or make any payments on its trust preferred securities.

The Bank is currently subject to a Consent Order with the FDIC and the BFI pursuant to which also requires the Bank to obtain prior written regulatory approval to declare or pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction of capital.

Capital Adequacy.  Both the Company and the Bank are required to comply with the capital adequacy standards established by the Federal Reserve, in the case of the Company, and the FDIC, in the case of the Bank.  The Federal Reserve has established a risk-based and a leverage measure of capital adequacy for bank holding companies.  The Bank is also subject to risk-based and leverage capital requirements adopted by the FDIC, which are substantially similar to those adopted by the Federal Reserve for bank holding companies.  Under the risk-based capital requirements, we and our bank subsidiary are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%.  At least half of the total capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings, qualifying perpetual preferred stock and minority interests in common equity accounts of consolidated subsidiaries, less certain intangibles.  The remainder may consist of “Tier 2 Capital”, which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance and pretax net unrealized holding gains on certain equity securities.  In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations.  Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  In summary, the capital measures used by the federal banking regulators are:
 

 
 
·
Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital (which includes common shareholders’ equity, trust preferred securities, minority interests and qualifying preferred stock, less goodwill and other adjustments)  and Tier 2 Capital (which includes preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets and other adjustments) as a percentage of total risk-weighted assets,

 
·
Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets), and

 
·
Leverage ratio (Tier 1 capital divided by adjusted average total assets).

Under these regulations, a bank will be:

 
·
“well capitalized” if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a leverage ratio of 5% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure,

 
·
“adequately capitalized” if it has a Total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater, and a leverage ratio of 4% or greater (or 3% in certain circumstances) and is not well capitalized,

 
·
“undercapitalized” if it has a Total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4% (or 3% in certain circumstances), or a leverage ratio of less than 4% (or 3% in certain circumstances),

 
·
“significantly undercapitalized” if it has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%, or

 
·
“critically undercapitalized” if its tangible equity is equal to or less than 2% of tangible assets.

In addition, the FDIC may require banks to maintain capital at levels higher than those required by general regulatory requirements.

Proposed Changes in Capital Requirements

In June 2012, the Federal Reserve, the FDIC and the OCC jointly issued proposed rules that would revise the risk-based and leverage capital requirements and the method for calculating risk-weighted assets to be consistent with the agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”).

Among other things, the proposed rules establish a new common equity tier 1 (“CET1”) minimum capital requirement, introduce a “capital conservation buffer” and raise minimum risk-based capital requirements.  Basel III establishes the CET1 to risk-weighted assets to 4.5%, and a capital conservation buffer of an additional 2.5%, raising the target CET1 to risk-weighted assets ratio to 7%.  It requires banks to maintain a minimum ratio of Tier 1 capital to risk weighted assets of at least 6.0%, plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%.  Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%.  Institutions that do not maintain the required capital buffer would be subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses
 
 
to senior executive management.  Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity standards.  Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as tier 1 capital would be phased out over a ten-year period.

The proposed rules also introduce new methodologies for determining risk-weighted assets, including higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property.  The proposed rules also require unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposed rules indicate that the final rule would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019.  However, the regulatory agencies have recently indicated that, due to the volume of public comments received, the final rule would not be in effect on January 1, 2013 and implementation has been delayed indefinitely.

Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution (like those contained in the Bank’s Consent Order with the FDIC and BFI) could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements.

Additionally, the Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to banks in the three “undercapitalized” categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. The federal banking agencies have specified by regulation the relevant capital level for each category.

An institution that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized is required to submit an acceptable capital restoration plan to its appropriate federal banking agency.  A bank holding company must guarantee that a subsidiary depository institution meets its capital restoration plan, subject to various limitations.  The controlling holding company’s obligation to fund a capital restoration plan is limited to the lesser of 5% of an undercapitalized subsidiary’s assets or the amount required to meet regulatory capital requirements.  An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.  The regulations also establish procedures for downgrading an institution and a lower capital category based on supervisory factors other than capital.  As of December 31, 2012, the Bank met the ratio requirements to be classified as a well capitalized financial institution.  However, as a result of the Order, the Bank currently is classified as adequately capitalized.

The Dodd-Frank Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which may result in more stringent capital requirements for insured depository institutions and their holding companies.  Under the Collins Amendment to the Dodd-Frank Act, federal regulators were directed to establish minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis.  These minimum requirements can’t be less than the generally applicable leverage and risk-based capital requirements established for insured
 
 
depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of the date that the Dodd-Frank Act was enacted.  These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions.  The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets.  Trust preferred securities issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013.  The Collins Amendment did not exclude preferred stock issued to the U.S. Treasury through the TARP Capital Purchase Program from Tier 1 capital treatment. Accordingly, the Company’s trust preferred securities and preferred stock issued to the U.S. Treasury through the TARP Capital Purchase Program will continue to qualify as Tier 1 capital.

In February 2012, the Bank entered into the Consent Order with the Supervisory Authorities which provided that, within 90 days from the date of the order and during the life of the order, the Bank must have a leverage ratio equal to or greater than 8% of its total assets, and total risk-based capital equal to or greater than 11% of the Bank’s total risk-weighted assets.  At December 31, 2012, the Bank’s Tier 1 risk-based capital ratio was 8.77%, its total risk-based capital ratio was 10.04% and its leverage ratio was 6.52%, compared to 8.98%, 10.26% and 6.46% at December 31, 2011, respectively.  The Bank has submitted a Capital Plan to the Supervisory Authorities which provides for compliance with the capital requirements in the Consent Order by the end of 2014, but as of the date of this report, the Supervisory Authorities have not approved the Capital Plan.  More information concerning our regulatory ratios at December 31, 2012 is included in Note 13 to the “Notes to Consolidated Financial Statements” included elsewhere in this Annual Report on Form 10-K.

Restrictions on Transactions with Affiliates.  Both the Company and the Bank are subject to the provisions of Section 23A of the Federal Reserve Act.  Section 23A places limits on the amount of:

 
·
A bank’s loans or extensions of credit, including purchases of assets subject to an agreement to repurchase, to affiliates;
 
·
A bank’s investment in affiliates;
 
·
Assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve;
 
·
The amount of loans or extensions of credit to third parties collateralized by the securities or debt obligations of affiliates;
 
·
Transactions involving the borrowing or lending of securities and any derivative transaction that results in credit exposure to an affiliate; and
 
·
A bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements.  The Bank must also comply with other provisions designed to avoid acquiring low-quality assets from its affiliates.

The Company and the Bank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

On September 30, 2010, the Company sold its headquarters building at the Watkins Centre to the Bank.  This transaction allowed us to repay the outstanding mortgage loan on the building resulting in a reduction of our interest expense and improvement in earnings on a consolidated basis.  The Federal Reserve Bank has determined that the sale of the headquarters building from the Company to the Bank was not permitted under Section 23A of the Federal Reserve Act as the amount of the transaction exceeded 10% of the Bank’s capital stock and surplus.  As a result, the Federal Reserve
 
 
Bank has directed the Company to take corrective action.  The Company has taken and continues to take active steps to correct this violation including offering the building for sale.  However, the Company has not been successful in these efforts and continues to update the Federal Reserve Bank on such efforts.

The Bank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders and their related interests.  These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

The Dodd-Frank Act also provides that an insured depository institution may not purchase an asset from, or sell an asset to a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties, and (2) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the insured institution, it has been approved in advance by a majority of the institution’s non-interested directors.

Support of Subsidiary Institutions. Under the Dodd-Frank Act, and previously under Federal Reserve policy, we are required to act as a source of financial strength for our bank subsidiary, Village Bank, and to commit resources to support the Bank.  This support can be required at times when it would not be in the best interest of our shareholders or creditors to provide it.  In the unlikely event of our bankruptcy, any commitment by us to a federal bank regulatory agency to maintain the capital of the Bank would be assumed by the bankruptcy trustee and entitled to a priority of payment.  On December 31, 2012, the Company made a capital contribution of $1.5 million to the Bank to improve its capital ratios.
 
Incentive Compensation Policies and Restrictions.  In July 2010, the federal banking agencies issued guidance which applies to all banking organizations supervised by the agencies (thereby including both the Company and the Bank). Pursuant to the guidance, to be consistent with safety and soundness principles, a banking organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance risk and reward; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive compensation. At December 31, 2012, we had not been made aware of any instances of non-compliance with this guidance.

Emergency Economic Stabilization Act of 2008.  In response to unprecedented market turmoil during the third quarter of 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted on October 3, 2008.  EESA authorized the U.S. Treasury to provide up to $700 billion to support the financial services industry.  Pursuant to the EESA, the U.S. Treasury was initially authorized to use $350 billion for the Troubled Asset Relief Program (“TARP”), of which the U.S. Treasury allocated $250 billion to the TARP Capital Purchase Program.

On May 1, 2009, the Company issued preferred stock and a warrant to purchase its common stock to the U.S. Treasury pursuant to the TARP Capital Purchase Program.  The amount of capital raised in that transaction was $14.7 million, approximately three percent of the Company’s risk-weighted assets.  No dividends may be paid on common stock unless dividends have been paid on the preferred stock.  The preferred stock does not have voting rights other than the right to vote as a class on the issuance of any preferred stock ranking senior, any change in its terms or any merger, exchange or similar transaction that would adversely affect its rights.  The U.S. Treasury’s preferred stock will also have the right to elect two directors if dividends have not been paid for six periods.  The Company filed a registration statement on Form S-3 covering the warrant as required under the terms of the TARP investment, on May 29, 2009.  The registration statement was declared effective by the SEC on June 16, 2009.
 

 
In June 2012 the Treasury asked to allow an observer at the Company’s meetings of its board of directors.  The observer started attending board meetings in August 2012.  The Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth missed dividend payment.  The Company has deferred seven dividend payments as of December 31, 2012. However, Treasury has not indicated that it will nominate two directors to the board of directors.

In addition, as long as any obligation remains outstanding to the U.S. Treasury under the TARP Capital Purchase Program, the Company and the Bank must comply in all respects with the executive compensation and corporate governance standards under EESA and the rules and regulations thereunder.  In compliance with such requirements, each of our senior executive officers agreed in writing to accept the compensation standards under the TARP Capital Purchase Program and thereby cap or eliminate some of their contractual or legal rights.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance, accounting and reporting measures for companies, like the Company, that have securities registered under the Securities Exchange Act of 1934.  Specifically, the Sarbanes-Oxley Act and the various regulations promulgated under the Act, established, among other things: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (iv) increased disclosure and reporting obligations for the reporting company and their directors and executive officers, including accelerated reporting of stock transactions and a prohibition on trading during pension blackout periods; and (v) a range of new and increased civil and criminal penalties for fraud and other violations of the securities laws.  In addition, Sarbanes-Oxley required stock exchanges, such as NASDAQ, to institute additional requirements relating to corporate governance in their listing rules.

Section 404 of the Sarbanes-Oxley Act requires the Company to include in its Annual Report on Form 10-K a report by management.  Management’s internal control report must, among other things, set forth management’s assessment of the effectiveness of the Company’s internal control over financial reporting.

USA Patriot Act. The USA Patriot Act became effective on October 26, 2001 and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Among other provisions, the USA Patriot Act permits financial institutions, upon providing notice to the United States Treasury, to share information with one another in order to better identify and report to the federal government activities that may involve money laundering or terrorists’ activities. The USA Patriot Act is considered a significant banking law in terms of information disclosure regarding certain customer transactions. Certain provisions of the USA Patriot Act impose the obligation to establish anti-money laundering programs, including the development of a customer identification program, and the screening of all customers against any government lists of known or suspected terrorists. Although it does create a reporting obligation and compliance costs, the USA Patriot Act has not materially affected the Bank’s products, services or other business activities.

Reporting Terrorist Activities. The Office of Foreign Assets Control (OFAC), which is a division of the Department of the Treasury, is responsible for helping to insure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress.  OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify the FBI. The Bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications. The Bank actively checks high-risk OFAC areas such as new accounts, wire transfers and customer files. The Bank performs these checks utilizing software, which is updated each time a modification is made to the lists provided by OFAC and other agencies of Specially Designated Nationals and Blocked Persons.

 
Other Safety and Soundness Regulations.  There are a number of obligations and restrictions imposed on depository institutions by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event the depository institution becomes in danger of default or is in default.  The Federal banking agencies also have broad powers under current Federal law to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institution in question is well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized, as defined by the law.  Federal regulatory authorities also have broad enforcement powers over us, including the power to impose fines and other civil and criminal penalties, and to appoint a receiver in order to conserve the assets of any such institution for the benefit of depositors and other creditors.  At December 31, 2012, Village Bank met the ratio requirements to be classified as a well capitalized financial institution.  However, as a result of the Order, Village Bank currently is classified as adequately capitalized.

Loans-to-One Borrower. Under applicable laws and regulations the amount of loans and extensions of credit which may be extended by a bank to any one borrower, including related entities, generally may not exceed 15 percent of the sum of the capital, surplus, and loan loss reserve of the institution.

Community Reinvestment.  The requirements of the Community Reinvestment Act (“CRA”) are applicable to the Company.  The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions.  A financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to 12 assessment factors.  These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility.
 
Economic and Monetary Policies.  Our operations are affected not only by general economic conditions, but also by the economic and monetary policies of various regulatory authorities.  In particular, the Federal Reserve regulates money, credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits.  Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Employees

As of December 31, 2012, the Company and its subsidiaries had a total of 191 full-time employees and 14 part-time employees.  None of the Company’s employees are covered by a collective bargaining agreement.  The Company considers its relations with its employees to be good.

Control by Certain Shareholders

The Company has one shareholder who owns 8.34% of its outstanding Common Stock.  As a group, the Board of Directors and the Company’s Executive Officers control 17.10% of the outstanding Common Stock of the Company as of February 15, 2013.  Accordingly, such persons, if they were to act in concert, would not have majority control of the Bank and would not have the ability to approve certain fundamental corporate transactions or the election of the Board of Directors.
 
 
Additional Information

The Company files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission.  You may read and copy any reports, statements and other information we file at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the operations of the Public Reference Room. Our SEC filings are also available on the SEC’s Internet site (http://www.sec.gov).

The Company’s common stock trades under the symbol “VBFC” on the Nasdaq Capital Market.

The Company’s Internet address is www.villagebank.com.  At that address, we make available, free of charge, the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act (see “Investor Relations” section of website), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

In addition, we will provide, at no cost, paper or electronic copies of our reports and other filings made with the SEC (except for exhibits). Requests should be directed to C. Harril Whitehurst, Jr., Chief Financial Officer, Village Bank and Trust Financial Corp., PO Box 330, Midlothian, VA 23113.

The information on the websites listed above is not and should not be considered to be part of this annual report on Form 10-K and is not incorporated by reference in this document.


An investment in the Company’s common stock is subject to risks inherent to the Company’s business, including the material risks and uncertainties that are described below.  Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report.  The risks and uncertainties described below are not the only ones facing the Company.  Additional risks and uncertainties that management is not aware of or focused on, or that management currently deems immaterial, may also impair the Company’s business operations.  This report is qualified in its entirety by these risk factors.  If any of the following risks adversely affect the Company’s business, financial condition or results of operations, the value of the Company’s common stock could decline significantly and you could lose all or part of your investment.

We are subject to agreements with our regulators, which will require us to dedicate a significant amount of resources and which could otherwise adversely affect us.

In February 2012, the Bank entered into a Consent Order with the FDIC and the BFI.  Among other things, the Consent Order requires us to develop and submit plans to reduce and improve our loan portfolio, reducing our commercial real estate concentration, maintain an appropriate allowance for loan losses, review our management performance, and correct certain violations of law.  In addition, the Consent Order requires us to limit asset growth to no more than 10% per year and maintain certain capital ratios higher than those required to be considered “well capitalized.”  The Company has also agreed not to declare or pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction of capital without prior regulatory approval.

In June 2012, the Company entered into a Written Agreement with the Reserve Bank.  Under the terms of the Written Agreement, the Company agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans to maintain sufficient capital and correct any violations of section 23A of the Federal Reserve Act and Regulation W.  In addition, the Company will submit a written statement of its planned sources and uses of cash for debt service, operation expenses, and other purposes.
 
 
While subject to these agreements, we expect that our management and board of directors will be required to focus considerable time and attention on taking corrective actions to comply with the terms.  In addition, certain provisions of these agreements described above could adversely impact the Company’s businesses and results of operations.

There also is no guarantee that we will successfully address our regulators’ concerns in the agreements or that we will be able to comply with them.  If we do not comply with these regulatory agreements, we could be subject to the assessment of civil monetary penalties, further regulatory sanctions and/or other regulatory enforcement actions.

The Company’s business has been adversely affected by conditions in the financial markets and economic conditions generally, and could be further impacted by continued stagnation.

From December 2007 through June 2009, the U.S. economy was in recession.  Business activity across a wide range of industries and regions in the U.S. was greatly reduced.  Although economic conditions have begun to improve, certain sectors, such as real estate, remain weak and unemployment remains high.  Local governments and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets.  Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions.  These failures, as well as potential future failures, have had a significant negative impact on the capitalization level of the Deposit Insurance Fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.  Such conditions have adversely affected the credit quality of the Company’s loans, and the Company’s results of operations and financial condition.  The Company’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services the Company offers, is highly dependent upon the business environment in the markets where the Company operates.  If economic conditions do not improve, our financial condition and results of operations could be adversely impacted.

Improvements in economic indicators disproportionately affecting the financial services industry may lag improvements in the general economy.

Should the stabilization of the U.S. economy lead to a general economic recovery, the improvement of certain economic indicators, such as unemployment and real estate asset values and rents, may nevertheless continue to lag behind the overall economy.  These economic indicators typically affect certain industries, such as real estate and financial services, more significantly.  For example, improvements in commercial real estate fundamentals typically lag broad economic recovery by 12 to 18 months.  The Company’s clients include entities active in these industries.  Furthermore, financial services companies with a substantial lending business are dependent upon the ability of their borrowers to make debt service payments on loans.  Should unemployment or real estate asset values fail to recover for an extended period of time, the Company could be adversely affected.

Our mortgage banking revenue is cyclical and is sensitive to the level of interest rates, changes in economic conditions, decreased economic activity, and slowdowns in the housing market, any of which could adversely impact our profits.

Our mortgage banking operations have experienced a significant increase in loan production, including through the addition of a loan production office in Northern Virginia, and have become a large portion of our revenues.  Maintaining this revenue stream is dependent upon our ability to originate loans and sell them to investors at or near current volumes.  Loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions.  Recently, revenues from mortgage banking have increased due to our expansion; however, a significant portion of this increase is also due to a lowering interest rate environment that resulted in a high volume of mortgage loan refinancing activity, which may not continue at its recent pace. Loan production levels may also suffer if we experience a slowdown in the local housing market or tightening credit conditions. Any sustained period of decreased activity caused by fewer refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect our mortgage originations and, consequently, could significantly reduce our income from mortgage banking activities. As a result, these conditions would also adversely affect our results of operations.
 
 
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain cases where we have originated loans and sold them to investors, we may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would also adversely affect our results of operations.

Our results of operations are significantly affected by the ability of our borrowers to repay their loans.

A significant source of risk is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements.  Most of the Company’s loans are secured but some loans are unsecured.  With respect to the secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans.  Collateral values may be adversely affected by changes in economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, widespread disease, terrorist activity, environmental contamination and other external events.  In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a loan is adequately collateralized when it is not.  The Company has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss.  During the recessionary economy the last four years, we have sustained significant loan losses that have resulted in operating losses.  These loan losses were the result of borrowers’ inability to repay coupled with a decline in the value of the collateral, primarily real estate.  In the fourth quarter of 2012, we did not have to provide for any loan losses which resulted in a return to profitability.  While we are encouraged by this decline in the provision for loan losses, overall asset quality continues to be a concern as there continues to be uncertainty in the economy and the level of nonperforming assets remains significant.

As of December 31, 2012, approximately 67% of the Company’s loan portfolio consisted of commercial and industrial, construction and commercial real estate loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans.  These types of loans are also typically larger than residential real estate loans and consumer loans.  Because the Company’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans.  An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.  Further, if repurchase and indemnity demands with respect to the Company’s loan portfolio increase, its liquidity, results of operations and financial condition will be adversely affected.

The Company’s allowance for loan losses may be insufficient.

The Company maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans.  The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio.

The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio.  The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity
 
 
and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  Continuing deterioration of economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Company’s control, may require an increase in the allowance for loan losses.  In addition, bank regulatory agencies periodically review the Company’s allowance for loan losses and have required an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  Further, if charge-offs in future periods exceed the allowance for loan losses, the Company will need additional provisions to increase the allowance for loan losses.  Any increases in the allowance for loan losses will result in a decrease in net income and, possibly capital, and may have a material adverse effect on the Company’s financial condition and results of operations.

Changes in interest rates may have an adverse effect on the Company’s profitability.

The operations of financial institutions such as the Company are dependent to a large degree on net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings.  An institution’s net interest income is significantly affected by market rates of interest that in turn are affected by prevailing economic conditions, by the fiscal and monetary policies of the federal government and by the policies of various regulatory agencies.  The Federal Reserve Board (FRB) regulates the national money supply in order to manage recessionary and inflationary pressures.  In doing so, the FRB may use techniques such as engaging in open market transactions of U.S. Government securities, changing the discount rate and changing reserve requirements against bank deposits.  The use of these techniques may also affect interest rates charged on loans and paid on deposits.  The interest rate environment, which includes both the level of interest rates and the shape of the U.S. Treasury yield curve, has a significant impact on net interest income.  Like all financial institutions, the Company’s balance sheet is affected by fluctuations in interest rates.  Volatility in interest rates can also result in disintermediation, which is the flow of deposits away from financial institutions into direct investments, such as US Government and corporate securities and other investment vehicles, including mutual funds, which, because of the absence of federal insurance premiums and reserve requirements, generally pay higher rates of return than bank deposit products.  See “Item 7: Management’s Discussion of Financial Condition and Results of Operations” and “Item 7A: Quantitative and Qualitative Disclosure about Market Risk”.

An inability to improve our regulatory capital position could adversely affect our operations.

Federal regulatory agencies are required by law to adopt regulations defining five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.  As of December 31, 2012 the Bank exceeded applicable thresholds to be considered well capitalized; however, as a result of our Consent Order with the FDIC and BFI, the Bank currently is considered adequately capitalized.  Until we are no longer subject to the capital directives contained in the Consent Order and become well capitalized for regulatory capital purposes, we cannot renew or accept brokered deposits without prior regulatory approval and we may not offer interest rates on our deposit accounts that are significantly higher than the average rates in our market area.  As a result, it may be more difficult for us to attract new deposits as our existing brokered deposits mature and do not rollover and to retain or increase non-brokered deposits.  If we are not able to attract new deposits, our ability to fund our loan portfolio may be adversely affected.  As a result of being adequately capitalized, we also could be subject to more frequent examinations by FDIC, restrictions on new branches and other potential limitations.  In addition, we will pay higher insurance premiums to the FDIC, which will reduce our earnings.

In addition, federal law establishes mandatory and discretionary restrictions on insured depository institutions that fail to remain at least adequately capitalized, which could include: submissions and implementations of capital plans, restrictions on payment of dividends and certain management fees, increased supervisory monitoring, restrictions as to asset growth, and branching and new business lines without regulatory approval.
 
 
The Company may have to rely on dividends from the Bank.

The Company is a separate and distinct legal entity from its subsidiary bank.  Although the Company has never received any dividends from the Bank, it is entitled to receive dividends in accordance with federal and state regulations.  These federal and state regulations limit the amount of dividends that the Bank may pay to the Company.  In the event the Bank is unable to pay dividends to the Company, the Company may not be able to service debt, pay obligations or pay dividends on the Company’s common stock.  The inability of the Company to receive dividends from the Bank could have a material adverse effect on the Company’s business, financial condition and results of operations.
 
Declines in value may adversely impact the investment portfolio.

We have not realized any non-cash, other-than-temporary impairment charges during 2012 as a result of reductions in fair value below original cost of any investments in our investment portfolio.  However, we could be required to record future impairment charges on our investment securities if they suffer any declines in value that are considered other-than-temporary.  Considerations used to determine other-than-temporary impairment status to individual holdings include the length of time the stock has remained in an unrealized loss position, and the percentage of unrealized loss compared to the carrying cost of the stock, dividend reduction or suspension, market analyst reviews and expectations, and other pertinent news that would affect expectations for recovery or further decline.

The Company may not be able to meet the cash flow requirements of its depositors and borrowers or meet its operating cash needs.

Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost.  The liquidity of the Company is used to service its debt.  The liquidity of the Bank is used to make loans and leases and to repay deposit liabilities as they become due or are demanded by customers.  Liquidity policies and limits are established by the board of directors.  The overall liquidity position of the Company and the Bank are regularly monitored to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity.  Funding sources include Federal funds purchased, securities sold under repurchase agreements and non-core deposits. The Bank is a member of the Federal Home Loan Bank of Atlanta, which provides funding through advances to members that are collateralized with mortgage-related assets.

If the Company is unable to access any of these funding sources when needed, we might be unable to meet customers’ needs, which could adversely impact our financial condition, results of operations, cash flows, and level of regulatory-qualifying capital

Negative perceptions associated with the Company’s continued participation in the U.S. Treasury’s Capital Purchase Program may adversely affect its ability to retain customers, attract investors and compete for new business opportunities.

A number of financial institutions which participated in the TARP Capital Purchase Program (“CPP”) have received approval from the U.S. Treasury to exit the program.  These institutions have, or are in the process of, repurchasing the preferred stock and repurchasing or auctioning the warrant issued to the U.S. Treasury as part of the program.  The Company has not yet requested regulatory approval to repurchase the preferred stock and warrant from the U.S. Treasury.  In order to repurchase one or both securities, in whole or in part, the Company must establish that it has satisfied all of the conditions to repurchase and must obtain the approval of the U.S. Treasury and the consent of the FDIC.  There can be no assurance that the Company will be able to repurchase these securities from the U.S. Treasury.  The Company’s customers, employees and counterparties in its current and future business relationships may draw negative implications regarding the strength of the Company as a financial institution based on its continued participation in the program following the exit of one or more of its competitors or other financial institutions.  Any such negative perceptions may impair the Company’s ability to effectively compete with other financial institutions for business or to retain high performing employees.  If this were to occur, the Company’s business, financial condition and results of operations may be adversely affected, perhaps materially.
 
 
Government measures to regulate the financial industry, including the Dodd-Frank Act, subject us to increased regulation and could adversely affect us.

As a financial institution, we are heavily regulated at the state and federal levels.  As a result of the financial crisis and related global economic downturn that began in 2007, we have faced, and expect to continue to face, increased public and legislative scrutiny as well as stricter and more comprehensive regulation of our financial services practices.  In July 2010, the Dodd-Frank Act was signed into law.  The Dodd-Frank Act includes significant changes in the financial regulatory landscape and will impact all financial institutions, including the Company and the Bank.  Many of the provisions of the Dodd-Frank Act have begun to be or will be implemented over the next several years and will be subject both to further rulemaking and the discretion of applicable regulatory bodies.  Because the ultimate impact of the Dodd-Frank Act will depend on future regulatory rulemaking and interpretation, we cannot predict the full effect of this legislation on our businesses, financial condition or results of operations.  Among other things, the Dodd-Frank Act and the regulations implemented thereunder could limit debit card interchange fees, increase FDIC assessments, impose new requirements on mortgage lending, and establish more stringent capital requirements on bank holding companies.  As a result of these and other provisions in the Dodd-Frank Act, we could experience additional costs, as well as limitations on the products and services we offer and on our ability to efficiently pursue business opportunities, which may adversely affect our businesses, financial condition or results of operations.

Holders of the TARP preferred stock may, under certain circumstances, have the right to elect two directors to our board of directors.

As of December 31, 2012, we have not made payment of dividends on the TARP preferred stock for seven quarterly dividend periods.  In the event that we fail to pay dividends on the TARP preferred stock for an aggregate of six quarterly dividend periods or more (whether or not consecutive), the authorized number of directors then constituting our board of directors will be increased by two.  Holders of the TARP preferred stock, together with the holders of any outstanding parity stock with like voting rights, voting as a single class, will be entitled to elect the two additional members of our board of directors at the next annual meeting (or at a special meeting called for the purpose of electing these directors prior to the next annual meeting) and at each subsequent annual meeting until all accrued and unpaid dividends for all past dividend periods have been paid in full.

In June 2012 the Treasury asked to allow an observer at the Company’s meetings of its board of directors.  The observer started attending board meetings in August 2012.  The Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth missed dividend payment.  The Company has deferred seven dividend payments as of December 31, 2012. However, Treasury has not indicated that it will nominate two directors to the board of directors.

We are subject to executive compensation restrictions because of our participation in the CPP, which could limit our ability to recruit and retain executives.

As a participant in the CPP, we are subject to TARP rules and standards governing executive compensation and corporate governance, which generally apply to our Chief Executive Officer, Chief Financial Officer and the next three most highly compensated employees (together, our “senior executive officers”), as well as a number of other employees.  The standards include (i) a requirement to recover any bonus payment to senior executive officers and certain other employees if payment was based on materially inaccurate financial statements or performance metric criteria; (ii) a prohibition on making any golden parachute payments to senior executive officers and certain other employees; (iii) a prohibition on paying or accruing any bonus payment to our most highly compensated employee, subject to limited exceptions; (iv) a prohibition on maintaining any plan for senior executive officers that encourage such officers to take unnecessary and excessive risks that threaten the Company’s value; (v) a prohibition on maintaining any employee compensation plan that encourages the manipulation of reported earnings to enhance the compensation of any employee; and (vi) a prohibition on providing tax gross-ups to senior executive officers and other employees.  These restrictions and standards could limit our ability to recruit and retain executives.  If we lose the services of our key personnel, or are unable to attract additional qualified personnel, our operations may be disrupted and our businesses, financial condition and results of operations may be adversely impacted.
 
 
The soundness of other financial institutions could adversely affect us.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. There is no assurance that any such losses would not materially and adversely affect our results of operations.

Changes in economic conditions and related uncertainties may have an adverse affect on the Company’s profitability.

Commercial banking is affected, directly and indirectly, by local, domestic, and international economic and political conditions, and by governmental monetary and fiscal policies.  Conditions such as inflation, recession, unemployment, volatile interest rates, tight money supply, real estate values, international conflicts and other factors beyond the Company’s control may adversely affect the potential profitability of the Company.  Any future rises in interest rates, while increasing the income yield on the Company’s earnings assets, may adversely affect loan demand and the cost of funds and, consequently, the profitability of the Company.  Any future decreases in interest rates may adversely affect the Company’s profitability because such decreases may reduce the amounts that the Company may earn on its assets.  A continued recessionary climate could result in the delinquency of outstanding loans. Management does not expect any one particular factor to have a material effect on the Company’s results of operations.  However, downtrends in several areas, including real estate, construction and consumer spending, could have a material adverse impact on the Company’s profitability.

The supervision and regulation to which the Company is subject can be a competitive disadvantage.

The operations of the Company and the Bank are heavily regulated and will be affected by present and future legislation and by the policies established from time to time by various federal and state regulatory authorities.  In particular, the monetary policies of the Federal Reserve have had a significant effect on the operating results of banks in the past, and are expected to continue to do so in the future.  Among the instruments of monetary policy used by the Federal Reserve to implement its objectives are changes in the discount rate charged on bank borrowings and changes in the reserve requirements on bank deposits.  It is not possible to predict what changes, if any, will be made to the monetary policies of the Federal Reserve or to existing federal and state legislation or the effect that such changes may have on the future business and earnings prospects of the Company.

The Company is subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies.

During the past several years, significant legislative attention has been focused on the regulation and deregulation of the financial services industry.  Non-bank financial institutions, such as securities brokerage firms, insurance companies and money market funds, have been permitted to engage in activities that compete directly with traditional bank business.

 
The competition the Company faces is increasing and may reduce our customer base and negatively impact the Company’s results of operations.

There is significant competition among banks in the market areas served by the Company.  In addition, as a result of deregulation of the financial industry, the Bank also competes with other providers of financial services such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, the mutual funds industry, full service brokerage firms and discount brokerage firms, some of which are subject to less extensive regulations than the Company with respect to the products and services they provide.  Some of the Company’s competitors have greater resources than the Corporation and, as a result, may have higher lending limits and may offer other services not offered by our Company.  See “Item 1: Business — Competition.”

Our deposit insurance premium could be substantially higher in the future which would have an adverse effect on our future earnings.

The FDIC insures deposits at FDIC-insured financial institutions, including Village Bank.  The FDIC charges the insured financial institutions premiums to maintain the Deposit Insurance Fund at a certain level.  Current economic conditions have increased bank failures and expectations for further failures, which may result in the FDIC making more payments from the Deposit Insurance Fund and, in connection therewith, raising deposit premiums.  In addition, the deposit insurance limit on FDIC deposit insurance coverage generally has increased to $250,000, which may result in even larger losses to the Deposit Insurance Fund.  These developments and our financial condition have caused an increase to our assessment, and the FDIC may be required to made additional increases to the assessment rates and levy additional special assessments on us.  Higher assessments increase our non-interest expense.

In February 2011, the FDIC finalized a rule that increases premiums paid by insured institutions and makes other changes to the assessment system.  The Company is generally unable to control the amount of premiums that it is required to pay for FDIC insurance.  If there are additional bank or financial institution failures the Company may be required to pay even higher FDIC premiums than the recently increased levels.  Any future increases or required prepayments of FDIC insurance premiums may adversely impact its earnings.

Concern of customers over deposit insurance may cause a decrease in deposits.

With the continuing news about bank failures, customers are increasingly concerned about the extent to which their deposits are insured by the FDIC.  Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with us is fully insured.  Decreases in deposits may adversely affect our liquidity, funding sources and costs and net income.

Fluctuations in the stock market could negatively affect the value of the Company’s common stock.

The Company’s common stock trades under the symbol “VBFC” on the Nasdaq Capital Market. There can be no assurance that a regular and active market for the Common Stock will develop in the foreseeable future.  See “Item 5: Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities.”  Investors in the shares of common stock may, therefore, be required to assume the risk of their investment for an indefinite period of time.  Current lack of investor confidence in large banks may keep investors away from the banking sector as a whole, causing unjustified deterioration in the trading prices of community banks such as the Company.

 
If the Company fails to maintain an effective system of internal controls, it may not be able to accurately report its financial results or prevent fraud.  As a result, current and potential shareholders could lose confidence in the Company’s financial reporting, which could harm its business and the trading price of its common stock.

The Company has established a process to document and evaluate its internal controls over financial reporting in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations, which require annual management assessments of the effectiveness of the Company’s internal controls over financial reporting.  In this regard, management has dedicated internal resources, engaged outside consultants and adopted a detailed work plan to (i) assess and document the adequacy of internal controls over financial reporting, (ii) take steps to improve control processes, where appropriate, (iii) validate through testing that controls are functioning as documented and (iv) implement a continuous reporting and improvement process for internal control over financial reporting.  The Company’s efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the related regulations regarding the Company’s assessment of its internal controls over financial reporting.  The Company’s management and audit committee have given the Company’s compliance with Section 404 a high priority.  The Company cannot be certain that these measures will ensure that the Company implements and maintains adequate controls over its financial processes and reporting in the future.  Any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm the Company’s operating results or cause the Company to fail to meet its reporting obligations.  If the Company fails to correct any issues in the design or operating effectiveness of internal controls over financial reporting or fails to prevent fraud, current and potential shareholders could lose confidence in the Company’s financial reporting, which could harm its business and the trading price of its common stock.

The Company is subject to a variety of operational risks, including reputational risk, legal and compliance risk, and the risk of fraud or theft by employees or outsiders.

The Company is exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, and unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.  Negative public opinion can result from its actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions and from actions taken by government regulators and community organizations in response to those activities.  Negative public opinion can adversely affect its ability to attract and keep customers and can expose the Company to litigation and regulatory action.

Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified.  The Company’s necessary dependence upon automated systems to record and process its transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect.  The Company also may be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability.  The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as the Company is) and to the risk that its (or its vendors’) business continuity and data security systems prove to be inadequate.  The occurrence of any of these risks could result in a diminished ability of the Company to operate its business, potential liability to clients, reputational damage and regulatory intervention, which could adversely affect its business, financial condition and results of operations, perhaps materially.



The Company relies on other companies to provide key components of its business infrastructure.

Third parties provide key components of the Company’s business infrastructure, for example, system support, and Internet connections and network access.  While the Company has selected these third party vendors carefully, it does not control their actions.  Any problems caused by these third parties, including those resulting from their failure to provide services for any reason or their poor performance of services, could adversely affect its ability to deliver products and services to its customers and otherwise conduct its business.  Replacing these third party vendors could also entail significant delay and expense.

 

None.



Our executive and administrative offices are owned by the Bank and are located at 15521 Midlothian Turnpike, Midlothian, Virginia 23113 in Chesterfield County where an 80,000 square foot corporate headquarters and operations center was opened in August 2008.  The Bank currently occupies approximately forty percent of the space, which includes a full service branch location.  The Bank leases the other portions to unrelated parties.  In addition to the branch, the Bank’s wholly-owned subsidiary, Village Bank Mortgage Corporation, also leases space in the building.

In addition to the branch in the corporate headquarters and operations center, the Bank owns 9 full service branch buildings including the land on those buildings and leases an additional four full service branch buildings.  Eight of our branch offices are located in Chesterfield County, with three branch offices in Hanover County, two in Henrico County and one in Powhatan County.

Our properties are maintained in good operating condition and are suitable and adequate for our operational needs.



In the course of its operations, the Company may become a party to legal proceedings.  There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.



None





Market Information

Shares of the Company’s common stock trade on the Nasdaq Capital Market under the symbol “VBFC”.  The high and low prices of shares of the Company’s common stock for the periods indicated were as follows:
 
2011
  
High
    
Low
  
1st quarter
   $ 4.00     $ 1.54  
2nd quarter
     3.19       2.00  
3rd quarter
     2.98       1.63  
4th quarter
     2.40       1.13  
2012
                
1st quarter
   $ 2.75     $ 1.17  
2nd quarter
     2.14       1.20  
3rd quarter
     1.46       0.82  
4th quarter
     1.45       0.61  
 
Dividends

The Company has not paid any dividends on its common stock.  We intend to retain all of our earnings to finance the Company’s operations and we do not anticipate paying cash dividends for the foreseeable future.  Any decision made by the Board of Directors to declare dividends in the future will depend on the Company’s future earnings, capital requirements, financial condition and other factors deemed relevant by the Board.  Banking regulations limit the amount of cash dividends that may be paid without prior approval of the Bank’s regulatory agencies.  Such dividends are limited to the Bank’s accumulated retained earnings.  The Federal Reserve has issued guidelines that bank holding companies should inform and consult with the Federal Reserve in advance of declaring or paying a dividend that exceeds earnings for the period (e.g. .quarter) for which the dividend is being paid or that could result in a material adverse charge to the organization’s capital structure.  In addition, for as long as the U.S. Treasury holds shares of our preferred stock, the consent of the U.S. Treasury will be required prior to the payment of any dividends on our common stock.

We also are subject to a Written Agreement with the Federal Reserve Bank of Richmond that we will not pay dividends on our preferred stock, including our Series A preferred Stock, trust preferred securities or common stock without the prior consent of the FDIC and the BFI.  Supervisory guidance from the Federal Reserve indicates that Capital Purchase Program recipients that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments, including trust preferred, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries.  The Company has agreed not to declare or pay any dividends on common stock or preferred stock, including the TARP preferred, or make any payments on its trust preferred securities without prior regulatory approval.

In addition, we are subject to a Consent Order with the FDIC and the BFI that the Bank will not pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction of capital without regulatory approval.


The Company has deferred interest payments on the junior subordinated debt securities of $663,379 at December 31, 2012.  Although we elected to defer payment of the interest due, the amount has been accrued and is included in interest expense.

As required by the Federal Reserve Bank of Richmond, the Company notified the U.S. Treasury in May 2011 that the Company was going to defer the payment of the quarterly cash dividend of $184,225 due on May 16, 2011, and subsequent quarterly payments, on the Fixed Rate Cumulative Perpetual Preferred Stock, Series A.  The total arrearage on such preferred stock as of December 31, 2012 is $1,381,688.

Holders

At March 14, 2013, there were approximately 1,669 holders of record of Common Stock.

For information concerning the Company’s Equity Compensation Plans, see “Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”.

Recent Sales of Unregistered Securities

None

Purchases of Equity Securities

The Company did not repurchase any of its Common Stock during the fourth quarter of 2012.

Performance Graph

The following graph shows the yearly percentage change in the Company’s cumulative total shareholder return on its common stock from December 31, 2007 to December 31, 2012 compared with the NASDAQ Composite Index and peer group indexes based on asset size.
 

   
Period Ending
  
Index
12/31/07
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
Village Bank and Trust Financial Corp.
100.00
42.06
21.80
13.93
11.68
8.88
NASDAQ Composite
100.00
60.02
87.24
103.08
102.26
120.42
SNL Bank $500M-$1B
100.00
64.08
61.03
66.62
58.61
75.14



The following consolidated selected financial data is derived from the Company’s audited financial statements for the five years ended December 31, 2012.  This information should be read in conjunction with the following Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated statements and notes thereto.

   
Year Ended December 31,
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
Balance Sheet Data
                              
At year-end
                              
Assets
   $ 510,087,372     $ 581,704,319     $ 591,779,215     $ 601,993,355     $ 572,407,993  
Loans, net of unearned income
     355,698,089       428,638,491       453,866,801       467,568,547       470,722,286  
Investment securities
     25,154,046       30,163,292       53,597,174       54,857,211       24,300,962  
Goodwill
     -       -       -       -       7,422,141  
Deposits
     436,322,962       485,521,052       499,012,193       498,285,124       466,232,043  
Borrowings
     41,615,811       52,292,661       41,679,430       52,593,521       57,726,898  
Stockholders' equity
     24,964,801       36,247,642       48,320,194       47,848,091       46,162,574  
Number of shares outstanding
     4,251,795       4,243,378       4,238,416       4,230,628       4,229,372  
                                         
Average for the year
                                        
Assets
     532,767,166       609,974,864       603,760,108       600,034,107       442,604,327  
Stockholders' equity
     32,214,113       49,912,896       49,801,210       56,089,455       31,067,165  
Weighted average shares outstanding
     4,251,194       4,243,025       4,237,735       4,230,462       3,013,175  
                                         
Income Statement Data
                                        
Interest income
   $ 23,699,263     $ 27,980,498     $ 30,181,838     $ 33,195,973     $ 29,072,146  
Interest expense
     5,996,960       8,345,903       10,885,413       16,407,679       15,969,783  
Net interest income
     17,702,303       19,634,595       19,296,425       16,788,294       13,102,363  
Provision for loan losses
     9,095,000       18,764,295       4,842,000       13,220,000       2,005,633  
Noninterest income
     13,339,298       10,843,781       10,990,667       8,285,100       4,184,727  
Goodwill impairment
     -       -       -       7,422,141       -  
Noninterest expense
     28,290,744       23,961,075       23,303,156       20,915,735       14,572,271  
Income tax expense (benefit)
     4,054,857       (426,872 )     711,627       (3,879,386 )     241,097  
Net income (loss)
     (10,399,000 )     (11,820,122 )     1,430,309       (12,605,096 )     468,089  
Preferred stock dividends and
                                        
amortization of discount
     878,971       882,882       881,402       590,151       -  
Net income (loss) available to
                                        
common shareholders
   $ (11,277,971 )   $ (12,703,004 )   $ 548,907     $ (13,195,247 )   $ 468,089  
                                         
Per Share Data
                                        
Earnings (loss) per share - basic
   $ (2.65 )   $ (2.99 )   $ 0.13     $ (3.12 )   $ 0.16  
Earnings (loss) per share - diluted
   $ (2.65 )   $ (2.99 )   $ 0.13     $ (3.12 )   $ 0.16  
Book value at year-end
   $ 2.28     $ 4.92     $ 7.87     $ 7.81     $ 10.91  
                                         
Performance Ratios
                                        
Return on average assets
     (1.95 )%     (1.94 )%     0.24 %     (2.10 )%     0.11 %
Return on average equity
     (32.28 )%     (23.68 )%     2.87 %     (22.47 )%     1.51 %
Net interest margin(1)
     3.78 %     3.59 %     3.57 %     3.13 %     3.27 %
Efficiency(2)
     91.14 %     78.62 %     76.94 %     83.42 %     84.30 %
Loans to deposits
     81.52 %     88.28 %     90.95 %     93.84 %     100.96 %
Equity to assets
     4.89 %     6.23 %     8.17 %     7.95 %     8.06 %
                                         
Asset Quality Ratios
                                        
ALLL to loans at year-end
     3.04 %     3.75 %     1.61 %     2.25 %     1.29 %
ALLL to nonaccrual loans
     42.21 %     33.41 %     35.98 %     40.61 %     71.05 %
Nonperforming assets to total assets
     8.98 %     9.85 %     5.47 %     6.17 %     2.00 %
Nonperforming loans to total loans
     12.88 %     13.36 %     7.13 %     7.95 %     2.43 %
Net charge-offs to average loans
     3.64 %     2.27 %     1.74 %     1.83 %     0.49 %
                                         
(1) Net interest margin is computed by dividing net interest income for the period by average interest earning assets.
  
(2) Efficiency ratio is computed by dividing noninterest expense by the sum of net interest income and noninterest income. The goodwill impairment write-off is excluded in 2009 from noninterest expense.
  
 


The following discussion is intended to assist readers in understanding and evaluating the financial condition, changes in financial condition and the results of operations of the Company, consisting of the parent company and its wholly-owned subsidiary, the Bank. This discussion should be read in conjunction with the consolidated financial statements and other financial information contained elsewhere in this report.

Caution About Forward-Looking Statements

In addition to historical information, this report may contain forward-looking statements.  For this purpose, any statement, that is not a statement of historical fact may be deemed to be a forward-looking statement.  These forward-looking statements may include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy and financial and other goals.  Forward-looking statements often use words such as “believes,” “expects,” “plans,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends” or other words of similar meaning.  You can also identify them by the fact that they do not relate strictly to historical or current facts.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to:
 
·
the inability of the Bank to comply with the requirements of agreements with its regulators;
 
·
the inability to reduce nonperforming assets consisting of nonaccrual loans and foreclosed real estate;
 
·
our inability to improve our regulatory capital position;
 
·
the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;
 
·
changes in assumptions underlying the establishment of allowances for loan losses, and other estimates;
 
·
changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;
 
·
risks inherent in making loans such as repayment risks and fluctuating collateral values;
 
·
changes in operations of Village Bank Mortgage Corporation as a result of the activity in the residential real estate market;
 
·
legislative and regulatory changes, including the Dodd-Frank Wall Street Reform and Consumer Protection Act and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;
 
·
exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;
 
·
the effects of future economic, business and market conditions;
 
·
governmental monetary and fiscal policies;
 
·
changes in accounting policies, rules and practices;
 
·
maintaining capital levels adequate to remain adequately capitalized;
 
·
reliance on our management team, including our ability to attract and retain key personnel;
 
·
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
 
 
 
·
demand, development and acceptance of new products and services;
 
·
problems with technology utilized by us;
 
·
changing trends in customer profiles and behavior; and
 
·
other factors described from time to time in our reports filed with the SEC.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements.  Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made.  In addition, past results of operations are not necessarily indicative of future results.

General

The Company’s primary source of earnings is net interest income, and its principal market risk exposure is interest rate risk.  The Company is not able to predict market interest rate fluctuations and its asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on the Company’s results of operations and financial condition.

Although we endeavor to minimize the credit risk inherent in the Company’s loan portfolio, we must necessarily make various assumptions and judgments about the collectability of the loan portfolio based on our experience and evaluation of economic conditions.  If such assumptions or judgments prove to be incorrect, the current allowance for loan losses may not be sufficient to cover loan losses and additions to the allowance may be necessary, which would have a negative impact on net income.  Over the last three years, the Company has recorded record provisions for loan losses due primarily to decline in the performance of loans collateralized by real estate located in its principal market area.

There is intense competition in all areas in which the Company conducts its business. The Company competes with banks and other financial institutions, including savings banks, finance companies, and credit unions.  Many of these competitors have substantially greater resources and lending limits and provide a wider array of banking services.  To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies.  Competition is based on a number of factors, including prices, interest rates, services, availability of products and geographic location.

At the beginning of 2012, our business strategy included efforts to reduce our total assets and liabilities due to a continued depressed economy as well as capital limitations at the time.  These efforts resulted in declines of approximately $72 million in total assets and approximately $60 million in total liabilities in 2012.  With the sale of a branch in the first quarter of 2013, we expect to further reduce our total assets and liabilities by approximately $22 million.  This strategy helped strengthen our regulatory capital ratios in 2012.  While we do not anticipate significant growth in 2013, we will not continue our efforts to reduce total assets and liabilities.

In light of the asset growth restriction in the Consent Order and the Company's current weakened financial position, the Company does not anticipate undertaking growth via acquisition or de novo branching during the foreseeable future.

Results of Operations

The following presents management’s discussion and analysis of the financial condition of the Company at December 31, 2012 and 2011, and results of operations for the Company for the years ended December 31, 2012, 2011 and 2010.  This discussion should be read in conjunction with the Company’s audited Financial Statements and the notes thereto appearing elsewhere in this Annual Report.
 

Income Statement Analysis

Summary

We recorded a net loss of $(10,399,000) and a net loss available to common shareholders of $(11,278,000), or $(2.65) per fully diluted share in 2012, compared to a net loss of $(11,820,000) and a net loss available to common shareholders of $(12,703,000), or $(2.99) per fully diluted share, in 2011, and net income of $1,430,000 and net income available to common shareholders of $549,000, or $0.13 per fully diluted share, in 2010.  The most significant factor affecting earnings in the last three years has been costs associated with loan defaults – the provision for loan losses and expenses related to foreclosed real estate.  The impact these costs have had on our operations is illustrated in the following table which adjusts pretax earnings for gains and losses on sales of assets other than loan sales by the mortgage company as well as the effect of problem assets.  Such adjusted earnings is not a measurement under accounting principles generally accepted in the United States (“GAAP”) and is not intended to be a substitute for our income statement prepared in accordance with GAAP..

`
  
Year Ended December 31,
  
   
2012
    
2011
    
2010
  
                   
Pretax income (loss) - GAAP
   $ (6,344,143 )   $ (12,246,995 )   $ 2,141,936  
Less
                        
     Gain on securities
     1,010,381       1,217,554       768,551  
     Gain (loss) on sale of assets
     -       (407 )     243,566  
      1,010,381       1,217,147       1,012,117  
Add
                        
    Provision for loan losses
     9,095,000       18,764,295       4,842,000  
    OREO expenses
     4,700,853       1,413,961       1,693,524  
      13,795,853       20,178,256       6,535,524  
                         
Pretax income as adjusted
     6,441,329       6,714,114       7,665,343  
Income tax expense
     2,190,052       2,282,799       2,606,217  
                         
Net income as adjusted
   $ 4,251,277     $ 4,431,315     $ 5,059,126  


The decline of $180,000 in net income as adjusted in 2012 was not significant, however some of the changes in income and expense are worthy of note.  Interest income decreased by approximately $4,281,000 as a result of a decrease in loans of $72,961,000, from $427,871,000 at December 31, 2011 to $354,910,000 at December 31, 2012.  Interest expense decreased by approximately $2,349,000 as a result of a decline in deposits of $49,200,000, from $485,521,000 at December 31, 2011 to $436,323,000 at December 31, 2012.  These declines resulted in a decline of $1,932,000 in net interest income which is a result of a balance sheet reduction plan adopted by the Company in 2012 that focused on the reduction of nonperforming assets and higher risk-weighted assets.  This decline was partially offset by the increase in the mortgage company’s profitability in 2012.

The $628,000 decrease in net income as adjusted in 2011 was primarily attributable to a decline in the profitability of our mortgage company of $514,000 as its mortgage loan production declined by $47 million in 2011.

Net interest income

Net interest income, which represents the difference between interest earned on interest-earning assets and interest incurred on interest-bearing liabilities, is the Company’s primary source of earnings.  Net interest income can be affected by changes in market interest rates as well as the level and composition of assets, liabilities and shareholders’ equity.  
 
 
Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.  The net yield on interest-earning assets (“net interest margin”) is calculated by dividing tax equivalent net interest income by average interest-earning assets.  Generally, the net interest margin will exceed the net interest spread because a portion of interest-earning assets are funded by various noninterest-bearing sources, principally noninterest-bearing deposits and shareholders’ equity.

Net interest income decreased to $17,702,000 in 2012 from $19,635,000 in 2011 and $19,296,000 in 2010.  Yields on average interest-earning assets declined from 5.11% in 2011 to 5.06% in 2012 resulting in a decline in interest income of $857,000, and the amount of average interest-earning assets declined by $79,473,000 resulting in a decline in interest income of $3,424,000.  This decline in yields on average interest-earning assets is a result of a strategic shift by management in the makeup of our average interest-earning assets, from loans to investment securities and federal funds sold, primarily to increase liquidity.  Yields on loans are generally higher than yields on more liquid assets such as investment securities and federal funds sold.  Additionally, an increase in nonaccrual loans has had a negative effect on asset yields.  Nonaccrual loans averaged $47.5 million in 2012 compared to $25.8 million in 2011.  Rates paid on average interest-bearing liabilities declined from 1.68% in 2011 to 1.38% in 2012 resulting in a decline in interest expense of $1,242,000.  Reducing our cost of funds has been strategic focus of management the last four years which has been aided by the historic low short-term interest rates by the Federal Reserve.

The increase in net interest income in 2011 of $339,000 is not significant however, changes to the components of net interest income are worthy of note.  Yields on average interest-earning assets declined from 5.59% in 2010 to 5.11% in 2011 resulting in a decline in interest income of $1,049,000, and the amount of average interest-earning assets declined by $7,145,000 resulting in a decline in interest income of $1,152,000.  This decline in yields on average interest-earning assets is a result of a strategic shift by management in the makeup of our average interest-earning assets, from loans to investment securities and federal funds sold, primarily to increase liquidity.  Yields on loans are generally higher than yields on more liquid assets such as investment securities and federal funds sold.  Additionally, an increase in nonaccrual loans had a negative effect on asset yields.  Rates paid on average interest-bearing liabilities declined from 2.15% in 2010 to 1.68% in 2011 resulting in a decline in interest expense of $1,750,000.

As previously noted, lost interest on nonaccrual loans has also had an effect on net interest income the last three years as reflected in the following schedule:

   
Actual
    
Lost Interest
    
Adjusted
  
         
Yield
    
on Nonaccrual
          
Yield
  
   
Amount
    
Rate
    
Loans
    
Amount
    
Rate
  
2012
                              
Interest income
   $ 23,699,263       5.06 %   $ 1,592,328     $ 25,291,591       5.40 %
Interest expense
     5,996,960       1.38 %     -       5,996,960       1.38 %
                                         
Net interest income
   $ 17,702,303       3.68 %   $ 1,592,328     $ 19,294,631       4.02 %
                                         
2011
                                        
Interest income
   $ 27,980,498       5.11 %   $ 2,377,204     $ 30,357,702       5.54 %
Interest expense
     8,345,903       1.68 %     -       8,345,903       1.68 %
                                         
Net interest income
   $ 19,634,595       3.43 %   $ 2,377,204     $ 22,011,799       3.86 %
                                         
2010
                                        
Interest income
   $ 30,181,838       5.59 %   $ 1,241,757     $ 31,423,595       5.81 %
Interest expense
     10,885,413       2.15 %     -       10,885,413       2.15 %
                                         
Net interest income
   $ 19,296,425       3.44 %   $ 1,241,757     $ 20,538,182       3.66 %
                                         
                                         
                                         


Our interest spread (average yield on interest-earning assets less average rate in interest-bearing liabilities) was reduced by .34% (34 basis points) in 2012, by .43% (43 basis points) in 2011, and by .22% (22 basis points) in 2010 as a result of lost interest on nonaccrual loans.

Average interest-earning assets and average interest-bearing liabilities decreased by 14.5% and 12.7 %, respectively, due to our business strategy to reduce our total assets and liabilities discussed previously.

The following table illustrates average balances of total interest-earning assets and total interest-bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, shareholders' equity and related income, expense and corresponding weighted-average yields and rates.  The average balances used in these tables and other statistical data were calculated using daily average balances.  We have no tax exempt assets for the periods presented.

Average Balance Sheets
  
(In thousands)
  
                                                       
   
Year Ended December 31, 2012
    
Year Ended December 31, 2011
    
Year Ended December 31, 2010
  
         
Interest
                
Interest
                
Interest
        
   
Average
    
Income/
    
Yield
    
Average
    
Income/
    
Yield
    
Average
    
Income/
    
Yield
  
   
Balance
    
Expense
    
Rate
    
Balance
    
Expense
    
Rate
    
Balance
    
Expense
    
Rate
  
Loans
                                                      
Commercial
   $ 36,764     $ 2,152       5.85 %   $ 37,734     $ 2,253       5.97 %   $ 37,421     $ 2,337       6.25 %
Real estate - residential
     141,600       7,064       4.99 %     143,047       8,333       5.83 %     154,091       9,188       5.96 %
Real estate - commercial
     166,951       10,235       6.13 %     169,300       10,942       6.46 %     174,337       11,426       6.55 %
Real estate - construction
     46,267       2,704       5.84 %     86,497       4,265       4.93 %     92,190       4,939       5.36 %
Consumer
     3,098       170       5.49 %     4,863       272       5.59 %     5,326       357       6.70 %
Gross loans
     394,680       22,325       5.66 %     441,441       26,065       5.90 %     463,365       28,247       6.10 %
Investment securities
     31,524       700       2.22 %     53,834       1,309       2.43 %     36,066       1,087       3.01 %
Loans held for sale
     16,279       615       3.78 %     10,733       516       4.81 %     16,820       793       4.71 %
Federal funds and other
     25,597       59       0.23 %     41,545       91       0.22 %     24,157       55       0.23 %
Total interest earning assets
     468,080       23,699       5.06 %     547,553       27,981       5.11 %     540,408       30,182       5.59 %
Allowance for loan losses
     (12,934 )                     (9,267 )                     (9,722 )                
Cash and due from banks
     14,304                       10,317                       13,103                  
Premises and equipment, net
     26,323                       27,265                       27,630                  
Other assets
     36,994                       34,107                       32,341                  
Total assets
   $ 532,767                     $ 609,975                     $ 603,760                  
                                                                         
Interest bearing deposits
                                                                        
Interest checking
     43,037       148       0.34 %     37,377       229       0.61 %     34,521       336       0.97 %
Money market
     67,887       266       0.39 %     86,860       578       0.67 %     98,762       1,077       1.09 %
Savings
     17,953       88       0.49 %     12,656       85       0.67 %     10,081       80       0.79 %
Certificates
     260,383       4,430       1.70 %     310,634       6,273       2.02 %     315,205       7,604       2.41 %
Total deposits
     389,260       4,932       1.27 %     447,527       7,165       1.60 %     458,569       9,097       1.98 %
Borrowings
                                                                        
Long-tern debt - trust
                                                                        
preferred securities
     8,764       404       4.61 %     8,764       353       4.03 %     8,764       346       3.95 %
FHLB advances
     31,538       651       2.06 %     36,824       810       2.20 %     28,425       864       3.04 %
Other borrowings
     5,100       10       0.20 %     5,009       18       0.36 %     11,473       578       5.04 %
Total interest bearing liabilities
     434,662       5,997       1.38 %     498,124       8,346       1.68 %     507,231       10,885       2.15 %
Noninterest bearing deposits
     60,440                       59,011                       44,495                  
Other liabilities
     5,451                       3,927                       2,233                  
Total liabilities
     500,553                       561,062                       553,959                  
Equity capital
     32,214                       48,913                       49,801                  
Total liabilities and capital
   $ 532,767                     $ 609,975                     $ 603,760                  
                                                                         
Net interest income before
                                                                        
provision for loan losses
           $ 17,702                     $ 19,635                     $ 19,297          
Interest spread - average yield
                                                                        
on interest earning assets,
                                                                        
less average rate on
                                                                        
interest bearing liabilities
                     3.68 %                     3.43 %                     3.44 %
Net interest margin
                                                                        
(net interest income
                                                                        
expressed as a percentage
                                                                        
of average earning assets)
                     3.78 %                     3.59 %                     3.57 %

Interest income and interest expense are affected by changes in both average interest rates and average volumes of interest-earning assets and interest-bearing liabilities.  The following table analyzes changes in net interest income attributable to changes in the volume of interest-sensitive assets and liabilities compared to changes in interest rates.  Nonaccrual loans are included in average loans outstanding. The changes in interest due to both rate and volume have been allocated to changes due to volume and changes due to rate in proportion to the relationship of the absolute dollar amounts of the changes in each.

Rate/Volume Analysis
  
(In thousands)
  
                                     
   
2012 vs. 2011
    
2011 vs. 2010
  
   
Increase (Decrease)
    
Increase (Decrease)
  
   
Due to Changes in
    
Due to Changes in
  
   
Volume
    
Rate
    
Total
    
Volume
    
Rate
    
Total
  
Interest income
                                    
Loans
   $ (2,883 )   $ (759 )   $ (3,642 )   $ (1,555 )   $ (904 )   $ (2,459 )
Investment securities
     (504 )     (104 )     (608 )     365       (143 )     222  
Fed funds sold and other
     (37 )     6       (31 )     38       (2 )     36  
Total interest income
     (3,424 )     (857 )     (4,281 )     (1,152 )     (1,049 )     (2,201 )
                                                 
Interest expense
                                                
Deposits
                                                
Interest checking
     43       (124 )     (81 )     32       (138 )     (106 )
Money market accounts
     (108 )     (204 )     (312 )     (117 )     (381 )     (498 )
Savings accounts
     8       (5 )     3       13       (8 )     5  
Certificates of deposit
     (934 )     (909 )     (1,843 )     (109 )     (1,224 )     (1,333 )
Total deposits
     (991 )     (1,242 )     (2,233 )     (181 )     (1,751 )     (1,932 )
Borrowings
                                                
Long-term debt
     -       51       51       -       7       7  
FHLB Advances
     (111 )     (48 )     (159 )     (833 )     779       (54 )
Other borrowings
     (8 )     -       (8 )     (560 )     -       (560 )
Total interest expense
     (1,110 )     (1,239 )     (2,349 )     (1,574 )     (964 )     (2,539 )
                                                 
Net interest income
   $ (2,313 )   $ 381     $ (1,932 )   $ 423     $ (85 )   $ 338  
                                                 
Note: the combined effect on interest due to changes in both volume and rate, which cannot be separately identified, has been allocated proportionately to the change due to volume and the change due to rate.
  
 
Provision for loan losses

The amount of the loan loss provision is determined by an evaluation of the level of loans outstanding, the level of non-performing loans, historical loan loss experience, delinquency trends, underlying collateral values, the amount of actual losses charged to the reserve in a given period and assessment of present and anticipated economic conditions.

The level of the allowance reflects changes in the size of the portfolio or in any of its components as well as management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, and political and regulatory conditions.  Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off.  While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

 
Profitability has been negatively impacted by historic provisions for loan losses the last three years.  The provision for loan losses decreased to $9,095,000 in 2012 from $18,764,000 in 2011, but was higher than the $4,842,000 recorded in 2010.  Although the provision for loan losses declined significantly in 2012 from that in 2011, it was still very high by historical standards reflecting the continued depressed economic conditions.  However, we did experience some improvement in asset quality in 2012.  The significant increase in the provision for loan losses in 2011 compared to 2010 reflected management’s determination that continuing depressed market conditions in 2011 as well as some financial difficulties experienced by some of our more significant borrowers warranted the addition of a significant provision for loan losses.  Although we believe that the allowance for loan losses of $10,808,000 at December 31, 2012, which represents 3.04% of loans outstanding, is adequate to absorb potential losses in the Company’s loan portfolio at that date, we can make no assurance that significant provisions for loan losses will not be necessary in the future.

Noninterest income

Noninterest income includes service charges and fees on deposit accounts, fee income related to loan origination, and gains and losses on sale of mortgage loans and securities held for sale.  Over the last three years the most significant noninterest income item has been gain on loan sales generated by Village Bank Mortgage, representing 63% in 2010, 60% in 2011 and 64% in 2012 of total noninterest income.  Noninterest income amounted to $10,991,000 in 2010, $10,844,000 in 2011 and $13,339,000 in 2012.

The increase in noninterest income in 2012 of $2,495,000 is primarily attributable to an increase in gain on sale of loans of $2,039,000,  The increased gain on sale of loans resulted from an increase in loan production by our mortgage company, from $238 million in 2011 to $304 million in 2012.

The decrease in noninterest income in 2011 of $147,000 is primarily attributable to a decrease in gain on sale of loans of $481,000.  The decreased gain on sale of loans resulted from a decrease in loan production by our mortgage company from $285 million in 2010 to $238 million in 2011.

Noninterest expense

Noninterest expense includes all expenses of the Company with the exception of interest expense on deposits and borrowings, provision for loan losses and income taxes.  Some of the primary components of noninterest expense are salaries and benefits, occupancy and equipment costs and expenses related to foreclosed real estate.  Over the last three years, the most significant noninterest expense item has been salaries and benefits, representing 53%, 53% and 47% of noninterest expense in 2010, 2011 and 2012, respectively.  Noninterest expense increased from $23,303,000 in 2010, to $23,961,000 in 2011 and to $28,291,000 in 2012.

The increase in noninterest expense of $4,330,000 in 2012 resulted primarily from increases in other real estate owned expenses of $3,287,000 as well as salaries and benefits of $662,000.

The increase in noninterest expense of $658,000 in 2011 resulted primarily from increases in salaries and benefits of $288,000, audit and accounting expense of $206,000 and occupancy expense of $181,000.

Income taxes

Certain items of income and expense are reported in different periods for financial reporting and tax return purposes.  The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit.  Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate

Applicable income tax expense on the 2012 loss amounted to $4,055,000, compared to a tax benefit on the 2011 loss of $426,000, resulting in an effective tax rate of 3.49%, and an income tax expense $712,000 or 33.2% in 2010.  The income tax expense in 2012 is primarily a result of the increase in the valuation allowance related to the deferred tax asset.
 
 
The net deferred tax asset is included in other assets on the balance sheet.  Accounting Standards Codification Topic 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  Management considers both positive and negative evidence and analyzes changes in near-term market conditions as well as other factors which may impact future operating results.  In making such judgments, significant weight is given to evidence that can be objectively verified.  The deferred tax assets are analyzed quarterly for changes affecting realization.  Management determined that as of December 31, 2012, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance on its net deferred tax asset of approximately $10,158,000 representing 100% of the net deferred tax asset at that date.  The net operating losses available to offset future taxable income amounted to $5,286,000 at December 31, 2012 and expire through 2031.

Commercial banking organizations conducting business in Virginia are not subject to Virginia income taxes.  Instead, they are subject to a franchise tax based on bank capital.  The Bank recorded a franchise tax expense of $163,000, $328,000 and $358,000 for 2012, 2011 and 2010, respectively.

Balance Sheet Analysis

Investment securities

At December 31, 2012 and 2011, all of our investment securities were classified as available-for-sale.  Investment securities classified as available for sale may be sold in the future, prior to maturity. These securities are carried at fair value.  Net aggregate unrealized gains or losses on these securities are included, net of taxes, as a component of shareholders’ equity.  Given the generally high credit quality of the portfolio, management expects to realize all of its investment upon market recovery or, the maturity of such instruments, and thus believes that any impairment in value is interest rate related and therefore temporary.  Available for sale securities included net unrealized losses of $109,000 at December 31, 2012 and net unrealized gains of $145,000 at December 31, 2011.  As of December 31, 2012, management does not have the intent to sell any of the securities classified as available for sale and which have unrealized losses and believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.

Sales and calls of investment securities decreased from $102,116,000 in 2011 to $76,167,000 in 2012.  This decrease was attributable to calls on higher interest rate securities as well as sales of securities to realize gains in value at December 31, 2011.

 
The following table presents the composition of our investment portfolio at the dates indicated.
 
Investment Securities Available-for-Sale
  
(Dollars in thousands)
  
                                     
               
Gross
    
Gross
    
Estimated
        
   
Par
    
Amortized
    
Unrealized
    
Unrealized
    
Fair
    
Average
  
   
Value
    
Cost
    
Gains
    
Losses
    
Value
    
Yield
  
December 31, 2012
                                    
                                     
US Government Agencies
                                    
More than ten years
     10,500       11,394       (15 )     8       11,387       2.27 %
      10,500       11,394       (15 )     8       11,387       2.27 %
Mortgage-backed securities
                                                
More than ten years
     1,744       1,830       (2 )     1       1,829       0.97 %
Total
     1,744       1,830       (2 )     1       1,829       0.97 %
                                                 
Municipals
                                                
One to five years
     1,000       1,100       (22 )     -       1,078       3.25 %
Five to ten years
     3,500       4,031       (47 )     -       3,984       2.29 %
More than ten years
     5,280       6,908       (42 )     10       6,876       2.70 %
Total
     9,780       12,039       (111 )     10       11,938       2.61 %
                                                 
                                                 
Total investment securities
   $ 22,024     $ 25,263     $ (128 )   $ 19     $ 25,154       2.34 %
                                                 
December 31, 2011
                                                
                                                 
US Government Agencies
                                                
More than ten years
   $ 2,000     $ 2,000     $ 1     $ -     $ 2,001       3.81 %
                                                 
Mortgage-backed securities
                                                
One to five years
     11       11       -       -       11       0.01 %
More than ten years
     19,870       20,621       220       (49 )     20,792       1.83 %
Total
     19,881       20,632       220       (49 )     20,803       1.83 %
                                                 
Other investments
                                                
More than ten years
     7,356       7,386       -       (27 )     7,359       0.55 %
                                                 
Total investment securities
   $ 29,237     $ 30,018     $ 221     $ (76 )   $ 30,163       1.65 %
                                                 
December 31, 2010
                                                
US Treasuries
                                                
One to five years
   $ 28,000     $ 28,017     $ -     $ -     $ 28,017       0.22 %
                                                 
US Government Agencies
                                                
Five to ten years
     3,000       3,000       -       (111 )     2,889       2.00 %
                                                 
Mortgage-backed securities
                                                
One to five years
     686       703       31       (10 )     724       4.90 %
More than ten years
     14,410       14,796       91       (58 )     14,829       2.86 %
Total
     15,096       15,499       122       (68 )     15,553       2.95 %
                                                 
Municipals
                                                
More than ten years
     6,000       6,060       -       (337 )     5,723       4.69 %
                                                 
Other investments
                                                
More than ten years
     1,418       1,418       -       (3 )     1,415       0.69 %
                                                 
Total investment securities
   $ 53,514     $ 53,994     $ 122     $ (519 )   $ 53,597       1.60 %


Loans

A management objective is to improve the quality of the loan portfolio.  The Company seeks to achieve this objective by maintaining rigorous underwriting standards coupled with regular evaluation of the creditworthiness of and the designation of lending limits for each borrower.  The portfolio strategies include seeking industry and loan size diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar.  Additionally, as a significant amount of the loan losses we have experienced over the last four years is attributable to construction and land development loans, our strategy has been to reduce this type of lending.

The Company’s real estate loan portfolios, which represent approximately 89% of all loans, are secured by mortgages on real property located principally in the Commonwealth of Virginia.  Sources of repayment are from the borrower’s operating profits, cash flows and liquidation of pledged collateral.  The Company’s commercial loan portfolio represents approximately 10% of all loans.  Loans in this category are typically made to individuals, small and medium-sized businesses and range between $250,000 and $2.5 million.  Based on underwriting standards, commercial and industrial loans may be secured in whole or in part by collateral such as liquid assets, accounts receivable, equipment, inventory, and real property.  The collateral securing any loan may depend on the type of loan and may vary in value based on market conditions.  The remainder of our loan portfolio is in consumer loans which represent 1% of the total.

The following tables present the composition of our loan portfolio at the dates indicated and maturities of selected loans at December 31, 2012.

Loan Portfolio, Net
  
(In thousands)
  
                               
   
December 31,
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
                               
Construction and land development
                              
Residential
   $ 2,845     $ 7,906     $ 11,030     $ 22,456     $ 36,260  
Commercial
     41,210       72,621       79,743       95,672       108,821  
Total construction and land development
     44,055       80,527       90,773       118,128       145,081  
Commercial real estate
                                        
Farmland
     2,581       2,465       1,829       1,679       1,433  
Commercial real estate - owner occupied
     92,773       105,592       99,614       86,538       70,944  
Commercial real estate - non-owner occupied
     54,551       54,059       62,422       61,341       70,321  
Multifamily
     7,979       6,680       9,362       11,943       9,398  
Total commercial real estate
     157,884       168,796       173,227       161,501       152,096  
Consumer real estate
                                        
Home equity lines
     25,521       30,687       35,482       38,815       41,776  
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     80,788       93,219       97,359       88,058       67,790  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     9,517       12,042       13,806       12,228       11,454  
Total consumer real estate
     115,826       135,948       146,647       139,101       121,020  
Commercial and industrial loans
                                        
(except those secured by real estate)
     34,384       37,734       37,228       41,201       44,748  
Consumer and other
     2,761       4,865       5,368       7,429       7,973  
                                         
Total loans
     354,910       427,870       453,243       467,360       470,918  
Deferred loan cost (unearned income), net
     788       768       624       209       (196 )
Less:  Allowance for loan losses
     (10,808 )     (16,071 )     (7,312 )     (10,522 )     (6,059 )
                                         
Total loans, net
   $ 344,890     $ 412,567     $ 446,555     $ 457,047     $ 464,663  
                                         

 
Maturities of Selected Loans
  
December 31, 2012
  
(In thousands)
  
                                                 
                                                 
         
Fixed Rate
    
Variable Rate
        
   
Within
    
1 to 5
    
After
          
1 to 5
    
After
          
Total
  
   
1 Year
    
Years
    
5 Years
    
Total
    
Years
    
5 Years
    
Total
    
Maturities
  
Construction and land development
                                                
Residential
   $ 1,739     $ 672     $ -     $ 672     $ 196     $ 238     $ 434     $ 2,845  
Commercial
     15,684       9,972       1,368       11,340       3,804       10,382       14,186       41,210  
Total construction and land development
     17,423       10,644       1,368       12,012       4,000       10,620       14,620       44,055  
Commercial real estate
                                                                
Farmland
     1,244       63       989       1,052       -       285       285       2,581  
Commercial real estate - owner occupied
     11,513       9,798       23,375       33,173       5,612       42,475       48,087       92,773  
Commercial real estate - non-owner occupied
     5,943       10,458       6,663       17,121       -       31,487       31,487       54,551  
Multifamily
     2,436       852       -       852       -       4,691       4,691       7,979  
Total commercial real estate
     21,136       21,171       31,027       52,198       5,612       78,938       84,550       157,884  
Consumer real estate
                                                             -  
Home equity lines
     1,042       -       9,975       9,975       798       13,706       14,504       25,521  
Secured by 1-4 family residential,
                                                                
secured by first deeds of trust
     9,205       13,299       7,094       20,393       1,434       49,756       51,190       80,788  
Secured by 1-4 family residential,
                                                                
secured by second deeds of trust
     1,086       1,790       3,803       5,593       156       2,682       2,838       9,517  
Total consumer real estate
     11,333       15,089       20,872       35,961       2,388       66,144       68,532       115,826  
Commercial and industrial loans
                                                                
(except those secured by real estate)
     12,123       14,334       5,512       19,846       768       1,647       2,415       34,384  
Consumer and other
     532       1,605       197       1,802       79       348       427       2,761  
                                                                 
Total
   $ 62,547     $ 62,843     $ 58,976     $ 121,819     $ 12,847     $ 157,697     $ 170,544     $ 354,910  
                                                                 
 
The Company assigns risk rating classifications to its loans.  These risk ratings are divided into the following groups:

 
·
Risk rated 1 to 4 loans are considered of sufficient quality to preclude and adverse rating.  1-4 assets generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral;
 
·
Risk rated 5 loans are defined as having potential weaknesses that deserve management’s close attention;
 
·
Risk rated 6 loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledge, if any, and;
 
·
Risk rated 7 loans have all the weaknesses inherent in substandard loans, with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Loans are considered impaired when, based on current information and events it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments.  Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans.  If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.  Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Allowance for loan losses

We monitor and maintain an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  We maintain policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

 
The allowance reflects management’s best estimate of probable losses within the existing loan portfolio and of the risk inherent in various components of the loan portfolio, including loans identified as impaired as required by FASB Codification Topic 310: Receivables.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.

Loans are grouped by similar characteristics, including the type of loan, the assigned loan classification and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon historical net charge-off rates, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans is adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to our allowance for loan losses as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  We recognize the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the financial statements.

The allowance for loan losses was $10,808,000, $16,071,000 and $7,312,000 at December 31, 2012, 2011 and 2010, respectively.  The ratio of the allowance for loan losses to gross loans was 3.04% at December 31, 2012, 3.75% at December 31, 2011, and 1.61% December 31, 2010.  The allowance for loan losses as a percentage of net loans decreased in 2012 to 3.04% primarily as a result of significant charge-offs recognized during the year for which specific provisions for loan losses had been previously provided.  The increase in the allowance for loan losses in 2011 was primarily a result of a decline in asset quality caused by the continued recessionary economy.  We believe the amount of the allowance for loan losses at December 31, 2012 is adequate to absorb the losses that can reasonably be anticipated from the loan portfolio at that date.

 
The following table presents an analysis of the changes in the allowance for loan losses for the periods indicated.

Analysis of Allowance for Loan Losses
  
(Dollars in thousands)
  
   
Year Ended December 31,
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
                               
Beginning balance
   $ 16,071     $ 7,312     $ 10,522     $ 6,059     $ 3,469  
Provision for loan losses
     9,095       18,764       4,842       13,220       2,006  
Charge-offs
                                        
Construction and land development
                                        
Residential
     (797 )     (66 )     (1,408 )     (541 )     (1,475 )
Commercial
     (5,645 )     (4,293 )     (3,659 )     (5,021 )     (96 )
Commercial real estate
                                        
Commercial real estate - owner occupied
     (961 )     (150 )     (200 )     -       (15 )
Commercial real estate - non-owner occupied
     (431 )     (343 )     (453 )     (99 )     (80 )
Multifamily
     (10 )     (83 )     (1,228 )     -       -  
Consumer real estate
                                        
Home equity lines
     (884 )     (1,232 )     (99 )     (122 )     (85 )
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     (3,220 )     (1,129 )     (758 )     (242 )     -  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     (663 )     (363 )     (187 )     (72 )     (22 )
Commercial and industrial loans
                                        
(except those secured by real estate)
     (1,880 )     (2,160 )     (183 )     (1,781 )     (468 )
Consumer and other
     (408 )     (249 )     (191 )     (889 )     (2 )
Total charge-offs
     (14,899 )     (10,068 )     (8,366 )     (8,767 )     (2,243 )
Recoveries
                                        
Construction and land development
                                        
Residential
     45       9       106       -       395  
Commercial
     14       10       81       3       -  
Commercial real estate
                                        
Commercial real estate - owner occupied
     200       -       -       -       9  
Commercial real estate - non-owner occupied
     -       -       121       -       -  
Consumer real estate
                                        
Home equity lines
     13       3       2       -       -  
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     86       36       -       -       -  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     21       -       -       -       -  
Commercial and industrial loans
                                        
(except those secured by real estate)
     155       3       2       -       -  
Consumer and other
     7       2       2       7       19  
Total recoveries
     541       63       314       10       423  
Net charge-offs
     (14,358 )     (10,005 )     (8,052 )     (8,757 )     (1,820 )
                                         
Ending balance
   $ 10,808     $ 16,071     $ 7,312     $ 10,522     $ 3,655  
                                         
Loans outstanding at end of period(1)
   $ 355,698     $ 428,639     $ 453,867     $ 467,569     $ 470,722  
Ratio of allowance for loan losses as
                                        
a percent of loans outstanding at
                                        
end of year
     3.04 %     3.75 %     1.61 %     2.25 %     0.78 %
                                         
Average loans outstanding for the period(1)
   $ 394,680     $ 441,441     $ 463,365     $ 477,359     $ 374,221  
Ratio of net charge-offs to average loans
                                        
outstanding for the year
     3.64 %     2.27 %     1.74 %     1.83 %     0.49 %
                                         
(1) Loans are net of unearned income.
                                        


Charge-offs increased from $10,068,000 in 2011 to $14,358,000 in 2012.  Charge-offs continue to be primarily attributable to loans for real estate acquisition, development and construction in Chesterfield County, our primary lending market.  In addition, charge-offs related to 1-4 residential real estate loans increased significantly in 2012 and is related primarily to investor residential properties in Chesterfield County.  The elevated charge-off levels experienced in the last three years warrant the heightened level of provisioning and justify management’s use of a higher historical charge-off factor when considering the losses currently inherent in the loan portfolio during the calculation of the allowance for loan losses.

We have allocated the allowance for loan losses according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within each of the categories of loans.  The allocation of the allowance as shown in the table below should not be interpreted as an indication that losses in future years will occur in the same proportions or that the allocation indicates future loss trends.  Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since the total allowance is a general allowance applicable to the entire portfolio.

Allocation of the Allowance for Loan Losses
  
(In thousands)
  
                                                             
   
December 31, 2012
    
December 31, 2011
    
December 31, 2010
    
December 31, 2009
    
December 31, 2008
  
   
Total
    
%
    
Total
    
%
    
Total
    
%
    
Total
    
%
    
Total
    
%
  
                                                             
Construction and land development
                                                            
Residential
   $ 495       4.6 %   $ 705       4.4 %   $ 294       4.0 %   $ 119       1.1 %   $ 256       4.2 %
Commercial
     4,612       42.6 %     6,798       42.3 %     2,832       38.7 %     1,073       10.2 %     2,344       38.7 %
Commercial real estate
                                                                                
Commercial real estate - owner occupied
 1,359       12.6 %     1,496       9.3 %     78       1.1 %     3,340       31.7 %     1,045       17.2 %
Commercial real estate - non-owner occupied
 817       7.6 %     1,549       9.6 %     21       0.3 %     1,343       12.8 %     426       7.0 %
Multifamily
     23       0.2 %     407       2.5 %     -       0.0 %     -       0.0 %     -          
Consumer real estate
                                                                                
Home equity lines
     658       6.1 %     860       5.4 %     642       8.8 %     863       8.2 %     330       5.4 %
Secured by 1-4 family residential,
                                                                                
secured by first deeds of trust
     1,358       12.6 %     1,881       11.7 %     1,403       19.2 %     1,918       18.2 %     733       12.1 %
Secured by 1-4 family residential,
                                                                                
secured by second deeds of trust
     223       2.1 %     397       2.5 %     297       4.1 %     416       4.0 %     159       2.6 %
Commercial and industrial loans
     1,162       10.7 %     1,657       10.3 %     1,316       18.0 %     1,367       13.0 %     671       11.1 %
(except those secured by real estate)
                                                                                
Consumer and other
     101       0.9 %     321       2.0 %     429       5.8 %     83       0.8 %     95       1.7 %
                                                                                 
Total
   $ 10,808       100.0 %   $ 16,071       100.0 %   $ 7,312       100.0 %   $ 10,522       100.0 %   $ 6,059       100.0 %
                                                                                 
 
Construction and land development loans receive the largest allocation of the allowance for loan losses as this type of loan represents the most risk of loss.  For the last four years with the recessionary economy, charge-offs have increased significantly with the largest amounts related to construction and land development loans which represented 43%, 43% and 61% of total charge-offs for 2012, 2011 and 2010, respectively.



Asset quality

The following table summarizes asset quality information at the dates indicated.

Asset Quality
  
(Dollars in thousands)
  
                               
   
December 31,
  
   
2012
    
2011
    
2010
    
2009
    
2008
  
                               
Nonaccrual loans
   $ 25,605     $ 48,097     $ 20,324     $ 25,913     $ 8,528  
Foreclosed properties
     20,204       9,177       12,028       11,279       2,932  
Total nonperforming assets
   $ 45,809     $ 57,274     $ 32,352     $ 37,192     $ 11,460  
                                         
Restructured loans
                                        
(not included in nonaccrual loans above)
   $ 38,820     $ 37,001     $ 21,695     $ 15,289     $ -  
                                         
Loans past due 90 days and still accruing
                                        
(not included in nonaccrual loans above)
   $ 115     $ 1,172     $ 315     $ 4,787     $ 6,197  
                                         
Nonperforming assets to loans at end of year(1)
     12.9 %     13.4 %     7.1 %     8.0 %     2.4 %
                                         
Nonperforming assets to total assets
     9.0 %     9.8 %     5.5 %     6.2 %     2.0 %
                                         
Allowance for loan losses to nonaccrual loans
     42.2 %     33.4 %     36.0 %     40.6 %     71.0 %
                                         
(1) Loans are net of unearned income.
                          
 
The following table presents an analysis of the changes in nonperforming assets for 2012.

Nonperforming Assets
  
(In thousands)
  
                   
                   
   
Nonaccrual
    
Foreclosed
        
   
Loans
    
Properties
    
Total
  
                   
Balance December 31, 2011
   $ 48,097     $ 9,177     $ 57,274  
Additions, net
     29,523       177       29,700  
Transfers
     (21,675 )     21,675       -  
Repayments
     (15,118 )     -       (15,118 )
Charge-offs
     (15,222 )     (3,338 )     (18,560 )
Sales
     -       (7,487 )     (7,487 )
                         
Balance December 31, 2012
   $ 25,605     $ 20,204     $ 45,809  


The decrease in nonaccrual loans during 2012 was a result of management’s efforts to resolve nonperforming assets.  In early 2012, we formed a special assets group within the Bank to focus solely on the resolution of nonperforming assets.  We hired a Senior Vice President with significant problem loan workout experience to head this group.  Even with $29.5 million of new nonaccrual loans during the year, we were able to reduce nonperforming assets by $11.5 million, or 20%.

Interest is accrued on outstanding loan principal balances, unless the Company considers collection to be doubtful.  Commercial and unsecured consumer loans are designated as non-accrual when the Company considers collection of expected principal and interest doubtful.  Mortgage loans and most other types of consumer loans past due 90 days or more may remain on accrual status if management determines that concern over our ability to collect principal and interest is not significant.  When loans are placed in non-accrual status, previously accrued and unpaid interest is
 
 
reversed against interest income in the current period and interest is subsequently recognized only to the extent cash is received.  Interest accruals are resumed on such loans only when in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest.

Of the total nonaccrual loans of $25,605,000 at December 31, 2012 that were considered impaired, 15 loans totaling $4,648,000 had specific allowances for loan losses totaling $1,338,000.  This compares to $48,097,000 in nonaccrual loans at December 31, 2011 of which 47 loans totaling $20,034,000 had specific allowances for loan losses of $5,034,000.

Cumulative interest income that would have been recorded had nonaccrual loans been performing would have been $1,592,000, $2,377,000 and $1,242,000 for 2012, 2011 and 2010, respectively.  Three loans totaling $115,000 at December 31, 2012 were past due 90 days or more and interest was still being accrued as such amounts were considered collectible.

Other real estate owned consists of assets acquired through or in lieu of foreclosure.  $15,089,000 of the $20,204,000 other real estate owned at December 31, 2012 relates to loans previously classified as construction loans.

Deposits

The following table gives the composition of our deposits at the dates indicated (dollars in thousands).

Deposits
  
(In thousands)
  
                                     
   
December 31, 2012
    
December 31, 2011
    
December 31, 2010
  
   
Amount
    
%
    
Amount
    
%
    
Amount
    
%
  
                                     
Demand accounts
   $ 57,049       13.1 %   $ 66,535       13.7 %   $ 41,036       8.2 %
Interest checking accounts
     45,861       10.5 %     40,237       8.3 %     33,292       6.7 %
Money market accounts
     66,007       15.1 %     75,488       15.5 %     90,156       18.1 %
Savings accounts
     20,922       4.8 %     15,166       3.1 %     10,538       2.1 %
Time deposits of $100,000 and over
     113,332       26.0 %     129,436       26.7 %     140,847       28.2 %
Other time deposits
     133,151       30.5 %     158,659       32.7 %     183,143       36.7 %
                                                 
Total
   $ 436,322       100.0 %   $ 485,521       100.0 %   $ 499,012       100.0 %
                                                 

Total deposits decreased by 10.1% and 2.8% in 2012 and 2011, respectively, and increased by 0.1% 2010.  The decline in deposits in 2012 was a result of our strategy to reduce our assets and liabilities discussed previously.  In reducing deposits, we targeted higher cost deposits to reduce our overall cost of funds.  Lower cost transactional deposit accounts (demand, interest checking, money market and savings accounts) increased to 43.5% of total deposits compared to 40.6% at December 31, 2011.  As our branch network has increased and is more convenient to a larger segment of our target customer base, we have experienced a move to a higher percentage of our deposits in checking accounts.

The variety of deposit accounts offered by the Company has allowed us to be competitive in obtaining funds and has allowed us to respond with flexibility to, although not to eliminate, the threat of disintermediation (the flow of funds away from depository institutions such as banking institutions into direct investment vehicles such as government and corporate securities).  Our ability to attract and retain deposits, and our cost of funds, has been, and will continue to be, significantly affected by money market conditions.

The following table is a schedule of average balances and average rates paid for each deposit category for the periods presented (dollars in thousands).

   
Year Ended December 31,
  
   
2012
    
2011
    
2010
  
Account Type
  
Amount
    
Rate
    
Amount
    
Rate
    
Amount
    
Rate
  
                                     
Noninterest-bearing demand accounts
   $ 60,440           $ 59,011           $ 44,495        
Interest-bearing deposits
                                          
Interest checking accounts
     43,037       0.34 %     37,377       0.61 %     34,521       0.97 %
Money market accounts
     67,887       0.39 %     86,859       0.67 %     98,762       1.09 %
Savings accounts
     17,953       0.49 %     12,656       0.67 %     10,081       0.80 %
Time deposits of $100,000 and over
     104,475       1.71 %     122,442       1.98 %     112,260       2.50 %
Other time deposits
     155,908       1.70 %     188,193       2.04 %     202,945       2.36 %
Total interest-bearing deposits
     389,260       1.27 %     447,527       1.60 %     458,569       1.98 %
                                                 
Total average deposits
   $ 449,700             $ 506,538             $ 503,064          
                                                 
 
With short-term interest rates remaining at historic lows throughout 2012, we were able to significantly reduce the interest rates paid on deposits, particularly on longer term certificates of deposit, as higher rate certificates of deposit matured in 2012.

The following table is a schedule of maturities for time deposits of $100,000 or more at December 31, 2012 (in thousands).

Due within three months
   $ 9,624  
Due after three months through six months
     5,339  
Due after six months through twelve months
     21,818  
Over twelve months
     76,551  
         
    $ 113,332  

The Dodd-Frank Act permanently raises the current standard maximum deposit insurance amount to $250,000. The FDIC insurance coverage limit applies per depositor, per insured depository institution for each account ownership category.

Borrowings

We utilize borrowings to supplement deposits when they are available at a lower overall cost to us or they can be invested at a positive rate of return.

As a member of the Federal Home Loan Bank of Atlanta (“FHLB”), the Bank is required to own capital stock in the FHLB and is authorized to apply for borrowings from the FHLB.  Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities.  The FHLB may prescribe the acceptable uses to which the advances may be put, as well as on the size of the advances and repayment provisions.  Borrowings from the FHLB were $28,000,000 and $37,750,000 at December 31, 2012 and 2011 respectively.  The FHLB advances are secured by the pledge of residential mortgage loans.  Available borrowings at December 31, 2012 were approximately $256,000 based on currently pledged collateral; however, with additional pledges, the Company could be granted up to 15% of assets in advances.

Federal funds purchased represent unsecured borrowings from other banks and generally mature daily.  We did not have any purchased federal funds at December 31, 2012 or 2011.

Other borrowings decreased by $927,000 from $5,779,000 at December 31, 2011 to $4,852,000 at December 31, 2012.  These borrowings represent business checking accounts that bear interest and are secured by pledged securities.

 
Off-balance sheet arrangements

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve elements of credit risk and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual amount of these instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  Unless noted otherwise, the Company does not require collateral or other security to support financial instruments with credit risk.

At December 31, 2012, the Company had outstanding the following approximate off-balance-sheet financial instruments whose contract amounts represent credit risk (in thousands):

   
Contract
    
Contract
  
   
Amount
    
Amount
  
   
2012
    
2011
  
             
Undisbursed credit lines
   $ 35,780     $ 40,661  
Commitments to extend or originate credit
     25,016       18,214  
Standby letter of credit
     3,314       3,719  
                 
Total commitments to extend credit
   $ 64,110     $ 62,594  


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Capital resources

Stockholders’ equity at December 31, 2012 was $24,965,000, compared to $36,248,000 at December 31, 2011 and $48,320,000 at December 31, 2010.  On May 1, 2009, the Company received a $14,738,000 investment by the United States Department of the Treasury under its Capital Purchase Program (the TARP Program).  The TARP Program is a voluntary program designed to provide capital for healthy banks to improve the flow of funds from banks to their customers.  Under the TARP Program, the Company issued to the Treasury $14,738,000 of preferred stock and warrants to purchase 499,030 shares of the Company’s common stock at a purchase price of $4.43 per share. The preferred stock issued by the Company under the TARP Capital Purchase Program carries a 5% dividend until May 1, 2014, and 9% thereafter, unless the shares are redeemed by the Company.  The $11,283,000 decrease in equity in 2012 is primarily due to the loss from operations of $10,399,000.  The decrease in equity in 2011 of $12,072,000 is primarily due to the loss from operations of $11,820,000.

During the first quarter of 2005, the Company issued $5.2 million in Trust Preferred Capital Notes to increase its regulatory capital and to help fund its expected growth in 2005.  During the third quarter of 2007, the Company issued $3.6 million in Trust Preferred Capital Notes to partially fund the construction of an 80,000 square foot headquarters building completed in July 2008.  The Trust
 
 
Preferred Capital Notes may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion.  See Note 15 of the Notes to Consolidated Financial Statements for a more detailed discussion of the Trust Preferred Capital Notes.

The Company is currently prohibited by its Written Agreement with the Reserve Bank from making dividend or interest payments on the TARP program preferred stock or trust preferred capital notes without prior regulatory approval.  In addition, the Consent Order with the FDIC and BFI provides that the Bank will not pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction of capital, without regulatory approval.  At December 31, 2012, the aggregate amount of all of the Company’s total accrued but deferred dividend payments on TARP was $1,382,000 and interest payments on trust preferred capital notes was $663,379.

In June 2012 as a result of the unpaid dividends, Treasury requested that an observer appointed by Treasury be allowed to attend the Company’s meetings of its board of directors.  The observer started attending board meetings in August 2012.  Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth deferred dividend payment.  The Company has deferred seven dividend payments as of December 31, 2012.  However, Treasury has not indicated at this time it will nominate two directors to our board.

The Company is currently evaluating potential sources of additional capital, with the objective to become compliant with the capital requirements of the Consent Order as soon as practically possible.  In addition, the Company is considering various alternatives for the repayment of the preferred stock issued under the TARP Program.   However, no assurance can be given that sources of new capital will be received.




The following table presents the composition of regulatory capital and the capital ratios for the Company at the dates indicated (dollars in thousands).

   
December 31,
  
   
2012
    
2011
    
2010
  
                   
Tier 1 capital
                  
Preferred stock
   $ 59     $ 59     $ 59  
Common stock
     17,007       16,974       16,954  
Additional paid-in capital
     40,705       40,732       40,634  
Retained earnings (deficit)
     (33,174 )     (21,896 )     (9,193 )
Warrant Surplus
     732       732       732  
Discount on preferred stock
     (199 )     (346 )     (492 )
Qualifying trust preferred securities
     8,199       8,764       8,764  
Less intangible assets
     (393 )     (491 )     (589 )
Disallowed Deferred tax asset
     -       (2,125 )     -  
Total equity
     32,936       42,403       56,869  
Total Tier 1 capital
     32,936       42,403       56,869  
                         
Tier 2 capital
                        
Qualifying trust preferred securities
     565       -       -  
Allowance for loan losses
     4,795       5,629       5,900  
Total Tier 2 capital
     5,360       5,629       5,900  
                         
Total risk-based capital
     38,296       48,032       62,769  
                         
Risk-weighted assets
   $ 377,572     $ 439,873     $ 470,662  
                         
Average assets
   $ 505,046     $ 578,330     $ 596,765  
                         
Capital ratios
                        
Leverage ratio (Tier 1 capital to
                        
average assets)
     6.53 %     7.33 %     9.53 %
Tier 1 capital to risk-weighted assets
     8.72 %     9.64 %     12.08 %
Total capital to risk-weighted assets
     10.14 %     10.92 %     13.34 %
Equity to total assets
     4.89 %     6.23 %     8.17 %





The following table presents the composition of regulatory capital and the capital ratios for the Bank at the dates indicated (dollars in thousands).

   
December 31,
  
   
2012
    
2011
    
2010
  
                   
Tier 1 capital
                  
Common stock
     6,849       6,849       6,849  
Additional paid-in capital
     55,406       53,899       53,781  
Retained earnings (deficit)
     (28,925 )     (20,436 )     (9,890 )
Less intangible assets
     (393 )     (491 )     (589 )
Disallowed Deferred tax asset
     -       (846 )     -  
Total equity
     32,937       38,975       50,151  
Total Tier 1 capital
     32,937       38,975       50,151  
                         
Tier 2 capital
                        
Allowance for loan losses
     4,769       5,555       5,862  
Total Tier 2 capital
     4,769       5,555       5,862  
                         
Total risk-based capital
     37,706       44,530       56,013  
                         
Risk-weighted assets
   $ 375,451     $ 433,892     $ 467,532  
                         
Average assets
   $ 505,150     $ 603,758     $ 579,440  
                         
Capital ratios
                        
Leverage ratio (Tier 1 capital to
                        
average assets)
     6.52 %     6.46 %     8.66 %
Tier 1 capital to risk-weighted assets
     8.77 %     8.98 %     10.73 %
Total capital to risk-weighted assets
     10.04 %     10.26 %     11.98 %
Equity to total assets
     6.55 %     7.02 %     8.56 %

Federal regulatory agencies are required by law to adopt regulations defining five capital tiers: well capitalized, adequately capitalized, under capitalized, significantly under capitalized, and critically under capitalized.  The Bank met the ratio requirements to be categorized as a “well capitalized” institution as of December 31, 2012, 2011 and 2010. However, due to the minimum capital ratios required by the Consent Order, the Bank currently is considered adequately capitalized.  The Consent Order requires the Bank to maintain a leverage ratio of at least 8% and a total capital to risk-weighted assets ratio of at least 11%.  At December 31, 2012, the Bank’s leverage ratio was 6.52% and the total capital to risk-weighted assets ratio was 10.04%.  As required by the Consent Order the Bank has provided a capital plan to the FDIC and BFI that demonstrates how the Bank will come into compliance with the required minimum capital ratios set forth in the Consent Order.  When capital falls below the “well capitalized” requirement, consequences can include: new branch approval could be withheld; more frequent examinations by the FDIC; brokered deposits cannot be renewed without a waiver from the FDIC; and other potential limitations as described in FDIC Rules and Regulations sections 337.6 and 303, and FDIC Act section 29.  In addition, the FDIC insurance assessment increases when an institution falls below the “well capitalized” classification.

Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities.  Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day
 
 
cash flow requirements while maximizing profits.  Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made.  However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

At December 31, 2012 and 2011, our liquid assets, consisting of cash, cash equivalents and investment securities available-for-sale, totaled $66,285,000 and $92,949,000, or 13.0% and 15.9% of total assets, respectively.  Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner.  However, approximately $8,622,000 of these securities are pledged against borrowings.  Therefore, the related borrowings would need to be repaid prior to the securities being sold in order for these securities to be converted to cash.

Our holdings of liquid assets plus the ability to maintain and expand our deposit base and borrowing capabilities serve as our principal sources of liquidity.  We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, and from additional borrowings.  In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities.  We maintain two federal funds lines of credit with correspondent banks totaling $22 million for which there were no borrowings against the lines at December 31, 2012.

We are also a member of the Federal Home Loan Bank of Atlanta (FHLB), from which applications for borrowings can be made.  The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the bank be pledged to secure any advances from the FHLB.  The unused borrowing capacity currently available from the FHLB at December 31, 2012 was $256,000, based on the Bank's qualifying mortgages available to secure any future borrowings.  However, we are able to pledge additional securities to the FHLB in order to increase our available borrowing capacity. Liquidity provides us with the ability to meet normal deposit withdrawals, while also providing for the credit needs of customers.  We are committed to maintaining liquidity at a level sufficient to protect depositors, provide for reasonable growth, and fully comply with all regulatory requirements.

At December 31, 2012, we had commitments to originate $64,110,000 of loans.  Fixed commitments to incur capital expenditures were less than $25,000 at December 31, 2012.  Certificates of deposit scheduled to mature or reprice in the 12-month period ending December 31, 2013 total $92,279,000.  We believe that a significant portion of such deposits will remain with us.  We further believe that deposit growth, loan repayments and other sources of funds will be adequate to meet our foreseeable short-term and long-term liquidity needs.

Interest Rate Sensitivity

An important element of asset/liability management is the monitoring of our sensitivity to interest rate movements.  In order to measure the effects of interest rates on our net interest income, management takes into consideration the expected cash flows from the securities and loan portfolios and the expected magnitude of the repricing of specific asset and liability categories.  We evaluate interest sensitivity risk and then formulate guidelines to manage this risk based on management’s outlook regarding the economy, forecasted interest rate movements and other business factors.  Our goal is to maximize and stabilize the net interest margin by limiting exposure to interest rate changes.

Contractual principal repayments of loans do not necessarily reflect the actual term of our loan portfolio.  The average lives of mortgage loans are substantially less than their contractual terms because of loan prepayments and because of enforcement of due-on-sale clauses, which gives us the right to declare a loan immediately due and payable in the event, among other things, the borrower sells the real property subject to the mortgage and the loan is not repaid.  In addition, certain borrowers increase their equity in the security property by making payments in excess of those required under the terms of the mortgage.

 
The sale of fixed rate loans is intended to protect us from precipitous changes in the general level of interest rates. The valuation of adjustable rate mortgage loans is not as directly dependent on the level of interest rates as is the value of fixed rate loans.  As with other investments, we regularly monitor the appropriateness of the level of adjustable rate mortgage loans in our portfolio and may decide from time to time to sell such loans and reinvest the proceeds in other adjustable rate investments.

The data in the following table reflects repricing or expected maturities of various assets and liabilities at December 31, 2012.  The gap analysis represents the difference between interest-sensitive assets and liabilities in a specific time interval.  Interest sensitivity gap analysis presents a position that existed at one particular point in time, and assumes that assets and liabilities with similar repricing characteristics will reprice at the same time and to the same degree.

Village Bank and Trust Financial Corp.
  
Interest Rate Sensitivity GAP Analysis
  
December 31, 2012
  
(In thousands)
  
                                     
                                     
   
Within 3
    
3 to 6
    
6 to 12
    
13 to 36
    
More than
        
   
Months
    
Months
    
Months
    
Months
    
36 Months
    
Total
  
Interest Rate Sensitive Assets
                                    
Loans (1)
                                    
Fixed rate
   $ 16,670     $ 4,664     $ 14,314     $ 30,263     $ 77,713     $ 143,624  
Variable rate
     51,527       6,870       20,806       32,872       99,211       211,286  
Investment securities
     -       -               -       24,154       24,154  
Loans held for sale
     24,188       -       -       -       -       24,188  
Federal funds sold
     39,186       -       -       -       -       39,186  
                                                 
Total rate sensitive assets
     131,571       11,534       35,120       63,135       201,078       442,438  
Cumulative rate sensitive assets
     131,571       143,105       178,225       241,360       442,438          
                                                 
Interest Rate Sensitive Liabilities
                                                
Interest checking
     -       -       -       45,861       -       45,861  
Money market accounts
     66,007       -       -       -       -       66,007  
Savings
     -       -       -       20,922       -       20,922  
Certificates of deposit
     25,522       14,157       52,600       92,076       62,129       246,484  
FHLB advances
     1,000       4,000       5,000       18,000       -       28,000  
Trust Preferred Securities
     -       -       -               8,764       8,764  
Other borrowings
     4,852       -       -       -       -       4,852  
                                                 
Total rate sensitive liabilities
     97,381       18,157       57,600       176,859       70,893       420,890  
Cumulative rate sensitive liabilities
     97,381       115,538       173,138       349,997       420,890          
                                                 
Rate sensitivity gap for period
   $ 34,190     $ (6,623 )   $ (22,480 )   $ (113,724 )   $ 130,185     $ 21,548  
Cumulative rate sensitivity gap
   $ 34,190     $ 27,567     $ 5,087     $ (108,637 )   $ 21,548          
                                                 
Ratio of cumulative gap to total assets
     6.7 %     5.4 %     1.0 %     (21.3 )%     4.2 %        
Ratio of cumulative rate sensitive
                                                
assets to cumulative rate sensitive
                                                
liabilities
     135.1 %     123.9 %     102.9 %     69.0 %     105.1 %        
Ratio of cumulative gap to cumulative
                                                
rate sensitive assets
     26.0 %     19.3 %     2.9 %     (45.0 )%     4.9 %        
                                                 
                                                 
                                                 
(1) Includes nonaccrual loans of approximately $26,025,000, which are spread throughout the categories.
                  

At December 31, 2012, our balance sheet is asset sensitive for the next twelve months, meaning that our assets reprice more quickly than our liabilities during that period, and liability sensitive for the next thirteen to thirty-six months, meaning that our liabilities will reprice more quickly than our assets during that period and asset sensitive after thirty-six months with a ratio of cumulative gap to total assets ranging from a positive gap of 6.7% for the first three months to a negative gap of (21.3)% for the thirteen to thirty-six month period.  A negative gap can adversely affect earnings in periods of increasing interest rates.  Given the Federal Reserve’s recent announcement that it will
 
 
maintain short-term interest rates at current levels until the end of 2014, we do not expect interest rates to increase for the foreseeable future.  However, we believe our balance sheet should be asset sensitive and, accordingly, we have adopted pricing policies to lengthen the maturities/repricing of our liabilities relative to the maturities/pricing of our assets.

Critical Accounting Policies

General

The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry.  The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities, and amounts reported for revenues, expenses and related disclosures.  Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.

The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, real estate acquired in settlement of loans, goodwill and income taxes.  The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations.  Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 of the Notes to Consolidated Financial Statements.

The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions, and judgments.

Allowance for loan losses

We monitor and maintain an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  We maintain policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

The allowance reflects management’s best estimate of probable losses within the existing loan portfolio and of the risk inherent in various components of the loan portfolio, including loans identified as impaired as required by FASB Codification Topic 310: Receivables.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.

Loans are grouped by similar characteristics, including the type of loan, the assigned loan classification and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon historical net charge-off rates, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans is adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

 
The amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to our allowance for loan losses as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  We recognize the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the financial statements.

Troubled debt restructurings

A loan is accounted for as a troubled debt restructuring if we, for economic or legal reasons, grant a concession to a borrower considered to be experiencing financial difficulties that we would not otherwise consider.  A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or balance of the loan, a reduction of accrued interest, an extension of the maturity date or renewal of the loan at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions.  Troubled debt restructurings can be in either accrual or nonaccrual status.  Nonaccrual troubled debt restructurings are included in nonperforming loans.  Accruing troubled debt restructurings are generally excluded from nonperforming loans as it is considered probable that all contractual principal and interest due under the restructured terms will be collected.  Troubled debt restructurings generally remain categorized as nonperforming loans and leases until a six-month payment history has been maintained.

In accordance with current accounting guidance, loans modified as troubled debt restructurings are, by definition, considered to be impaired loans.  Impairment for these loans is measured on a loan-by-loan basis similar to other impaired loans as described above under Allowance for loan losses.  Certain loans modified as troubled debt restructurings may have been previously measured for impairment under a general allowance methodology (i.e., pooling), thus at the time the loan is modified as a troubled debt restructuring the allowance will be impacted by the difference between the results of these two measurement methodologies.  Loans modified as troubled debt restructurings that subsequently default are factored into the determination of the allowance in the same manner as other defaulted loans.

Real estate acquired in settlement of loans

Real estate acquired in settlement of loans represent properties acquired through foreclosure or physical possession.  Write-downs to fair value of foreclosed assets at the time of transfer are charged to allowance for loan losses.  Subsequent to foreclosure, the Company periodically evaluates the value of foreclosed assets held for sale and records an impairment charge for any subsequent declines in fair value less selling costs.  Subsequent declines in value are charged to operations.  Fair value is based on an assessment of information available at the end of a reporting period and depends upon a number of factors, including historical experience, economic conditions, and issues specific to individual properties.  The evaluation of these factors involves subjective estimates and judgments that may change.

Income taxes

The Company uses the asset and liability method of accounting for income taxes.  Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary
 
 
differences are expected to be recovered or settled.  If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance may be established.  Management considers the determination of this valuation allowance to be a critical accounting policy due to the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income.  These judgments and estimates are reviewed on a continual basis as regulatory and business factors change.  A valuation allowance for deferred tax assets may be required if the amounts of taxes recoverable through loss carry backs decline, or if management projects lower levels of future taxable income.  Management determined that as of December 31, 2012 and December 31, 2011, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance of $10,158,000 (representing 100% of the deferred tax asset at that date) and $3,929,000 on its net deferred tax asset, respectively.

New accounting standards

In February 2013, the Financial Accounting Standards Board (FASB) issued ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which is intended to improve the reporting of reclassifications out of accumulated other comprehensive income.  The ASU requires an entity to report, either on the face of the income statement or in the notes to the financial statements, the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in the income statement if the amount being reclassified is required to be reclassified in its entirety to net income.  For other amounts that are not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other required disclosures that provide additional detail about those amounts.  This ASU is effective prospectively in the first quarter of 2013, and is not expected to have a material effect on the Company’s consolidated financial statements.
 
In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income ("ASU 2011-05"). ASU 2011-05 requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity.ASU 2011-05 became effective for the Company on January 1, 2012. In connection with the application of ASU 2011-05, the Company's financial statements now include separate statements of comprehensive income.
 
In May 2011, the FASB issued ASU No. 2011-04,  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The Company adopted ASU 2011-04, which generally aligns the principles of fair value measurements with International Financial Reporting Standards (IFRSs), in its consolidated financial statements in the first quarter 2012. The provisions of ASU 2011-04 clarify the application of existing fair value measurement requirements, and expand the disclosure requirements for fair value measurements. The increased provisions of ASU 2011-04 did not have a material effect on the Company’s consolidated financial statements.
 
In April 2011, the FASB issued ASU 2011-02, A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  This update to codification topic 310 provides guidance for what constitutes a concession and whether a debtor is experiencing financial difficulties. The amendments in this update were effective for the Company on July 1, 2011, with retrospective application from January 1, 2011. This update did not have a material effect on the Company’s consolidated financial statements.

 
Impact of inflation and changing prices

The Company’s financial statements included herein have been prepared in accordance with generally accepted accounting principles in the United States, which require the Company to measure financial position and operating results primarily in terms of historical dollars.  Changes in the relative value of money due to inflation or recession are generally not considered.  The primary effect of inflation on the operations of the Company is reflected in increased operating costs.  In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate.  While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate.  Interest rates are highly sensitive to many factors that are beyond the control of the Company, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.



The consolidated financial statements and related footnotes of the Company are presented following.




Report of Independent Registered Public Accounting Firm


Board of Directors
Village Bank and Trust Financial Corp.
Midlothian, Virginia


We have audited the accompanying consolidated balance sheets of Village Bank and Trust Financial Corp. and Subsidiary as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2012.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting.  Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Village Bank and Trust Financial Corp. and Subsidiary as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.





BDO USA, LLP


Richmond, Virginia
March 26, 2013







 
Village Bank and Trust Financial Corp. and Subsidiary
  
Consolidated Balance Sheets
  
December 31, 2012 and 2011
  
             
             
   
2012
    
2011
  
Assets
            
Cash and due from banks
   $ 13,945,105     $ 55,557,541  
Federal funds sold
     39,185,837       7,228,475  
Total cash and cash equivalents
     53,130,942       62,786,016  
Investment securities available for sale
     25,154,046       30,163,292  
Loans held for sale
     24,188,384       16,168,405  
Loans
                
Outstandings
     354,910,266       427,870,716  
Allowance for loan losses
     (10,807,827 )     (16,071,424 )
Deferred fees and costs
     787,823       767,775  
      344,890,262       412,567,067  
Premises and equipment, net
     25,815,342       26,826,524  
Accrued interest receivable
     1,676,518       2,046,524  
Bank owned life insurance
     6,575,018       6,065,305  
Other real estate owned
     20,203,691       9,177,167  
Other assets
     8,453,169       15,904,019  
                 
    $ 510,087,372     $ 581,704,319  
                 
Liabilities and Stockholders' Equity
                
Liabilities
                
Deposits
                
Noninterest bearing demand
   $ 57,049,348     $ 66,534,956  
Interest bearing
     379,273,614       418,986,096  
Total deposits
     436,322,962       485,521,052  
Federal Home Loan Bank advances
     28,000,000       37,750,000  
Long-term debt - trust preferred securities
     8,764,000       8,764,000  
Other borrowings
     4,851,811       5,778,661  
Accrued interest payable
     911,635       592,283  
Other liabilities
     6,272,163       7,050,681  
Total liabilities
     485,122,571       545,456,677  
                 
Stockholders' equity
                
Preferred stock, $4 par value, $1,000 liquidation preference,
                
  1,000,000 shares authorized, 14,738 shares issued and outstanding
     58,952       58,952  
Common stock, $4 par value - 10,000,000 shares authorized;
                
  4,251,795 shares issued and outstanding at December 31, 2012
                
  4,243,378 shares issued and outstanding at December 31, 2011
     17,007,180       16,973,512  
Additional paid-in capital
     40,705,257       40,732,178  
Retained earnings (deficit)
     (33,173,525 )     (21,895,557 )
Common stock warrant
     732,479       732,479  
Discount on preferred stock
     (198,993 )     (346,473 )
Accumulated other comprehensive loss
     (166,549 )     (7,449 )
Total stockholders' equity
     24,964,801       36,247,642  
                 
    $ 510,087,372     $ 581,704,319  
                 
See accompanying notes to consolidated financial statements.
                
                 
 
 
Village Bank and Trust Financial Corp. and Subsidiary
  
Consolidated Statements of Operations
  
Years Ended December 31, 2012, 2011 and 2010
  
                   
                   
   
2012
    
2011
    
2010
  
Interest income
                  
Loans
   $ 22,939,321     $ 26,580,965     $ 29,040,137  
Investment securities
     700,509       1,308,727       1,086,963  
Federal funds sold
     59,433       90,806       54,738  
Total interest income
     23,699,263       27,980,498       30,181,838  
                         
Interest expense
                        
Deposits
     4,931,645       7,165,169       9,097,177  
Borrowed funds
     1,065,315       1,180,734       1,788,236  
Total interest expense
     5,996,960       8,345,903       10,885,413  
                         
Net interest income
     17,702,303       19,634,595       19,296,425  
Provision for loan losses
     9,095,000       18,764,295       4,842,000  
Net interest income after provision
                        
for loan losses
     8,607,303       870,300       14,454,425  
                         
Noninterest income
                        
Service charges and fees
     2,258,694       1,942,721       1,865,190  
Gain on sale of loans
     8,561,773       6,522,848       7,003,873  
Gain (loss) on sale of assets
     -       (407 )     243,566  
Gain on sale of investment securities
     1,010,381       1,217,554       768,551  
Rental income
     794,285       706,078       464,792  
Other
     714,165       454,987       644,695  
Total noninterest income
     13,339,298       10,843,781       10,990,667  
                         
Noninterest expense
                        
Salaries and benefits
     13,287,588       12,625,396       12,337,065  
Occupancy
     2,212,863       2,112,072       1,931,334  
Equipment
     806,940       891,412       847,536  
Supplies
     431,208       428,011       501,928  
Professional and outside services
     2,778,829       2,425,347       2,028,225  
Advertising and marketing
     225,104       416,963       492,423  
Expenses related to foreclosed real estate
     4,700,853       1,413,961       1,693,524  
FDIC insurance premium
     1,204,098       1,002,226       1,168,830  
Other operating expense
     2,643,261       2,645,687       2,302,291  
Total noninterest expense
     28,290,744       23,961,075       23,303,156  
                         
Net income (loss) before income taxes
     (6,344,143 )     (12,246,994 )     2,141,936  
Income tax expense (benefit)
     4,054,857       (426,872 )     711,627  
                         
Net income (loss)
     (10,399,000 )     (11,820,122 )     1,430,309  
                         
Preferred stock dividends and
                        
amortization of discount
     878,971       882,882       881,402  
Net income (loss) available to
                        
common shareholders
   $ (11,277,971 )   $ (12,703,004 )   $ 548,907  
                         
                         
Earnings (loss) per share, basic
   $ (2.65 )   $ (2.99 )   $ 0.13  
Earnings (loss) per share, diluted
   $ (2.65 )   $ (2.99 )   $ 0.13  
                         
See accompanying notes to consolidated financial statements.
                  




Village Bank and Trust Financial Corp. and Subsidiary
  
Consolidated Statements of Changes in Comprehensive Income (Loss)
  
Years Ended December 31, 2012, 2011 and 2010
  
                                     
   
2012
    
2011
  
         
Tax
                
Tax
        
         
Expense
                
Expense
        
   
Amount
    
(Benefit)
    
Total
    
Amount
    
(Benefit)
    
Total
  
                                     
Net Income
   $ (6,344,143 )   $ 4,054,857     $ (10,399,000 )   $ (12,246,994 )   $ (426,872 )   $ (11,820,122 )
                                                 
Other comprehensive income:
                                                
Unrealized holding gains arising during the period
     756,320       257,149       499,171       1,759,137       598,106       1,161,031  
Reclassification adjustment for gains realized in income
     (1,010,381 )     (343,530 )     (666,851 )     (1,217,554 )     (413,968 )     (803,586 )
Minimum pension adjustment
     13,000       4,420       8,580       13,000       4,420       8,580  
Total other comprehensive income
     (241,061 )     (81,961 )     (159,100 )     554,583       188,558       366,025  
                                                 
        Total comprehensive income
   $ (6,585,204 )   $ 3,972,896     $ (10,558,100 )   $ (11,692,411 )   $ (238,314 )   $ (11,454,097 )
                                                 
      2010                           
           
Tax
                                  
           
Expense
                                  
   
Amount
    
(Benefit)
    
Total
                          
                                                 
Net Income
   $ 2,141,936     $ 711,627     $ 1,430,309                          
                                                 
Other comprehensive income:
                                                
Unrealized holding gains arising during the period
     274,840       93,445       181,395                          
Reclassification adjustment for gains realized in income
     (768,551 )     (261,307 )     (507,244 )                        
Minimum pension adjustment
     13,000       4,420       8,580                          
Total other comprehensive income
     (480,711 )     (163,442 )     (317,269 )                        
                                                 
        Total comprehensive income
   $ 1,661,225     $ 548,185     $ 1,113,040                          
                                                 
See accompanying notes to consolidated financial statements
                                          
 

 
Village Bank and Trust Financial Corp. and Subsidiary
  
Consolidated Statements of Stockholders' Equity
  
Years Ended December 31, 2012, 2011 and 2010
  
                                               
                                     
Accumulated
        
             
Additional
    
Retained
          
Discount on
    
Other
        
 
Preferred
    
Common
    
Paid-in
    
Earnings
          
Preferred
    
Comprehensive
        
 
Stock
    
Stock
    
Capital
    
(Deficit)
    
Warrant
    
Stock
    
Income (loss)
    
Total
  
                                               
Balance, December 31, 2009
 $ 58,952     $ 16,922,512     $ 40,568,771     $ (9,741,459 )   $ 732,479     $ (636,959 )   $ (56,205 )   $ 47,848,091  
Amortization of preferred stock
                                                   -       -  
discount
   -       -       -       (144,503 )     -       144,503               -  
Preferred stock dividend
   -       -       -       (736,899 )     -       -       -       (736,899 )
Issuance of common stock
   -       31,152       (31,152 )     -       -       -       -          
Stock based compensation
   -       -       95,962       -       -       -       -       95,962  
Minimum pension adjustment
                                                              
(net of income taxes of $2,917)
   -       -       -       -       -       -       8,580       8,580  
Net income
   -       -       -       1,430,309                       -       1,430,309  
Change in unrealized gain on
                                                              
investment securities available-for-sale,
                                                              
net of reclassification and tax effect
   -       -       -       -       -       -       (325,849 )     (325,849 )
                                                               
Balance, December 31, 2010
 $ 58,952     $ 16,953,664     $ 40,633,581     $ (9,192,552 )   $ 732,479     $ (492,456 )   $ (373,474 )   $ 48,320,194  
Amortization of preferred stock
                                                   -       -  
discount
   -       -       -       (145,983 )     -       145,983               -  
Preferred stock dividend
   -       -       -       (736,900 )     -       -       -       (736,900 )
Issuance of common stock
   -       19,848       (19,848 )     -       -       -       -       -  
Stock based compensation
   -       -       118,445       -       -       -       -       118,445  
Minimum pension adjustment
                                                              
(net of income taxes of $2,917)
   -       -       -       -       -       -       8,580       8,580  
Net loss
   -       -       -       (11,820,122 )     -       -       -       (11,820,122 )
Change in unrealized gain on
                                                              
investment securities available-for-sale,
                                                              
net of reclassification and tax effect
   -       -       -       -       -       -       357,445       357,445  
                                                               
Balance, December 31, 2011
 $ 58,952     $ 16,973,512     $ 40,732,178     $ (21,895,557 )   $ 732,479     $ (346,473 )   $ (7,449 )   $ 36,247,642  
Amortization of preferred stock
                                                   -       -  
discount
   -       -       -       (147,480 )     -       147,480               -  
Preferred stock dividend
   -       -       -       (731,488 )     -       -       -       (731,488 )
Issuance of common stock
   -       33,668       (33,668 )     -       -       -       -       -  
Stock based compensation
   -       -       6,747       -       -       -       -       6,747  
Minimum pension adjustment
                                                              
(net of income taxes of $2,917)
   -       -       -       -       -       -       8,580       8,580  
Net loss
   -       -       -       (10,399,000 )     -       -       -       (10,399,000 )
Change in unrealized gain on
                                                              
investment securities available-for-sale,
                                                              
net of reclassification and tax effect
   -       -       -       -       -       -       (167,680 )     (167,680 )
                                                               
Balance, December 31, 2012
 $ 58,952     $ 17,007,180     $ 40,705,257     $ (33,173,525 )   $ 732,479     $ (198,993 )   $ (166,549 )   $ 24,964,801  
                                                               
                                                               
See accompanying notes to consolidated financial statements.
                                                  
 

 
Village Bank and Trust Financial Corp. and Subsidiary
  
Consolidated Statements of Cash Flows
  
Years Ended December 31, 2012, 2011 and 2010
  
                   
   
2012
    
2011
    
2010
  
Cash Flows from Operating Activities
                  
Net income (loss)
   $ (10,399,000 )   $ (11,820,122 )   $ 1,430,309  
Adjustments to reconcile net income (loss) to net
                        
cash provided by (used in) operating activities:
                        
Depreciation and amortization
     1,366,014       1,418,393       1,308,770  
Deferred income taxes
     (2,300,383 )     (4,139,276 )     (3,718,495 )
Valuation allowance
     6,229,268       3,928,886       -  
Provision for loan losses
     9,095,000       18,764,295       4,842,000  
Write-down of other real estate owned
     622,710       571,331       294,000  
Gain on securities sold
     (1,010,381 )     (1,217,149 )     (768,551 )
Gain on loans sold
     (8,561,773 )     (6,522,848 )     (7,003,873 )
Gain on sale of premises and equipment
     -       407       (242,936 )
Loss on sale of other real estate owned
     240,598       266,729       96,595  
Stock compensation expense
     6,747       118,445       95,962  
Proceeds from sale of mortgage loans
     304,856,690       248,108,754       279,387,475  
Origination of mortgage loans for sale
     (304,314,896 )     (237,882,524 )     (284,749,137 )
Amortization of premiums and accretion of discounts on securities, net
     330,550       169,804       416,619  
Decrease in interest receivable
     370,006       300,687       1,019,507  
Increase in bank owned life insurance
     (509,713 )     (193,540 )     (440,763 )
(Increase) decrease  in other assets
     3,616,926       (3,810,873 )     5,882,742  
Increase (decrease) in interest payable
     319,352       187,481       (96,268 )
Increase (decrease) in other liabilities
     (1,510,004 )     4,135,410       (402,954 )
Net cash provided by (used in)  operating activities
     (1,552,289 )     12,384,290       (2,648,998 )
                         
Cash Flows from Investing Activities
                        
Purchases of available for sale securities
     (70,732,098 )     (80,991,271 )     (52,283,980 )
Proceeds from the sale or calls of available for sale securities
     76,167,114       102,116,301       51,122,666  
Proceeds from maturities and principal payments of  available for sale securities
     -       3,897,780       2,279,573  
Net decrease (increase) in loans
     39,411,245       11,442,522       (1,448,154 )
Proceeds from sale of other real estate owned
     7,280,728       5,794,090       5,957,507  
Purchases of premises and equipment
     (354,834 )     (807,872 )     (1,081,523 )
Proceeds from sale of premises and equipment
     -       -       377,321  
Net cash provided by investing activities
     51,772,155       41,451,550       4,923,410  
                         
Cash Flows from Financing Activities
                        
Net increase (decrease) in deposits
     (49,198,090 )     (13,491,141 )     727,069  
Net increase (decrease) in Federal Home Loan Bank Advances
     (9,750,000 )     9,000,000       (250,000 )
Net increase (decrease) in other borrowings
     (926,850 )     1,613,231       (10,664,091 )
Dividends on preferred stock
     -       (184,225 )     (736,899 )
Net cash used in financing activities
     (59,874,940 )     (3,062,135 )     (10,923,921 )
                         
Net increase (decrease) in cash and cash equivalents
     (9,655,074 )     50,773,705       (8,649,509 )
Cash and cash equivalents, beginning of period
     62,786,016       12,012,311       20,661,820  
                         
Cash and cash equivalents, end of period
   $ 53,130,942     $ 62,786,016     $ 12,012,311  
                         
Supplemental Schedule of Non Cash Activities
                        
Real estate owned assets acquired in settlement of loans
   $ 19,170,560     $ 3,781,206     $ 7,097,681  
Dividends on preferred stock accrued
   $ 731,488     $ 552,674     $ -  
                         
See accompanying notes to consolidated financial statements.
                        



Village Bank and Trust Financial Corp. and Subsidiary
Notes to Consolidated Financial Statements
Years Ended December 31, 2012, 2011 and 2010


Note 1.                      Summary of Significant Accounting Policies

The accounting and reporting policies of Village Bank and Trust Financial Corp. and subsidiary (the “Company”) conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry.  The following is a description of the more significant of those policies:

Business
The Company is the holding company of Village Bank (the ”Bank”).  The Bank opened to the public on December 13, 1999 as a traditional community bank offering deposit and loan services to individuals and businesses in the Richmond, Virginia metropolitan area.  The Bank has formed three wholly owned subsidiaries, Village Bank Mortgage Corporation (“Village Mortgage”), a full service mortgage banking company, Village Insurance Agency, Inc. (“Village Insurance”), a full service property and casualty insurance agency, and Village Financial Services Corporation (“Village Financial Services”), a financial services company.  Through these subsidiaries, the Bank provides a broad array of financial services to its customers.

On October 14, 2008, the Company acquired River City Bank pursuant to an Agreement and Plan of Reorganization and Merger, and its operations were merged into the Bank’s.

The Bank is subject to regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.  As a consequence of the extensive regulation of commercial banking activities, the Bank’s business is susceptible to being affected by state and federal legislation and regulations.

The majority of the Company’s real estate loans are collateralized by properties in markets in the Richmond, Virginia metropolitan area.  Accordingly, the ultimate collectability of those loans collateralized by real estate is particularly susceptible to changes in market conditions in the Richmond area.

Basis of presentation and consolidation
The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s subsidiaries.  All material intercompany balances and transactions have been eliminated in consolidation.
 
Use of estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the dates of the statements of financial condition and revenues and expenses during the reporting period.  Actual results could differ significantly from those estimates.  A material estimate that is particularly susceptible to significant change in the near term relates to the determination of the allowance for loan losses and the related provision.

Investment securities
At the time of purchase, debt securities are classified into the following categories: held-to-maturity, available-for-sale or trading.  Debt securities that the Company has both the positive intent and ability to hold to maturity are classified as held-to-maturity.  Held-to-maturity securities are stated at amortized cost adjusted for amortization of premiums and accretion of discounts on purchase using a method that approximates the effective interest method.  Investments classified as trading or
 
 
available-for-sale are stated at fair value.  Changes in fair value of trading investments are included in current earnings while changes in fair value of available-for-sale investments are excluded from current earnings and reported, net of taxes, as a separate component of other comprehensive income.  Presently, the Company does not maintain a portfolio of trading securities or held to maturity.

The fair value of investment securities held-to-maturity and available-for-sale is estimated based on quoted prices for similar assets determined by bid quotations received from independent pricing services.  Declines in the fair value of securities below their amortized cost that are other than temporary are reflected in earnings or other comprehensive income, as appropriate. For those debt securities whose fair value is less than their amortized cost basis, we consider our intent to sell the security, whether it is more likely than not that we will be required to sell the security before recovery and if we do not expect to recover the entire amortized cost basis of the security.  In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer’s financial condition.

Interest income is recognized when earned.  Realized gains and losses for securities classified as available-for-sale and held-to-maturity are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

Loans held for sale
The Company, through the Bank’s mortgage banking subsidiary, Village Bank Mortgage, originates residential mortgage loans for sale in the secondary market.  Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value on an aggregate basis as determined by outstanding commitments from investors.  Upon entering into a commitment to originate a loan, the Company locks in the loan and rate with an investor and commits to deliver the loan if settlement occurs on a best efforts basis, thus limiting interest rate risk. Certain additional risks exist that the investor fails to meet its purchase obligation, however, based on historical performance and the size and nature of the investors the Company does not expect them to fail to meet their obligation.  Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

Residential mortgage loans held for sale are sold to the permanent investor with the mortgage servicing rights released.  Gains or losses on sales of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold.  Gains on the sale of loans totaling approximately $8,562,000, $6,523,000 and $7,004,000 were realized during the years ended December 31, 2012, 2011 and 2010, respectively.

Once a residential mortgage loan is sold to a permanent investor, the Company has no further involvement or retained interest in the loan.  There are limited circumstances in which the permanent investor can contractually require the Company to repurchase the loan.  The Company makes no provision for any such recourse related to loans sold as history has shown repurchase of loans under these circumstances has been remote.

The Company, through the Bank’s mortgage banking subsidiary, Village Bank Mortgage, enters into commitments to originate residential mortgage loans in which the interest rate on the loan is determined prior to funding, termed rate lock commitments.  Such rate lock commitments on mortgage loans to be sold in the secondary market are considered to be derivatives.  The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 45 days.  The Company protects itself from changes in interest rates during this period by requiring a firm purchase agreement from a permanent investor before a loan can be closed.  As a result, the Company is not exposed to losses nor will it realize gains or losses related to its rate lock commitments due to changes in interest rates.
 
 
The fair value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets.  The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close.  Due to high correlation between rate lock commitments and best efforts contracts, no significant gains or losses have occurred on the rate lock commitments

At December 31, 2012, Village Bank Mortgage Company, (VBMC) had rate lock commitments to originate mortgage loans aggregating $25.0 million and loans held for sale of $24.2 million.  VBMC has entered into corresponding commitments with third party investors to sell loans of approximately $49.2 million.  Under the best efforts contractual relationship with these investors, VBMC is obligated to sell the loans, and the investor is obligated to purchase the loans, only if the loans close.  No other obligation exists.  As a result of these best efforts contractual relationships with these investors VBMC is not exposed to losses, nor will it realize gains, related to its rate lock commitments due to changes in interest rates.

Transfers of financial assets
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered.  Control over transferred assets is deemed to be surrendered when: (1) the assets have been isolated from the Bank and put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.  Our transfers of financial assets are limited to commercial loan participations sold, which were insignificant for 2012, 2011 and 2010, and the sale of residential mortgage loans in the secondary market; the extent of which are disclosed in the Consolidated Statements of Cash Flows.

Loans
Loans are stated at the principal amount outstanding, net of unearned income.  Loan origination fees and certain direct loan origination costs are deferred and amortized to interest income over the life of the loan as an adjustment to the loan’s yield over the term of the loan.

Interest is accrued on outstanding principal balances, unless the Company considers collection to be doubtful.  Commercial and unsecured consumer loans are designated as non-accrual when payment is delinquent 90 days or at the point which the Company considers collection doubtful, if earlier.  Mortgage loans and most other types of consumer loans past due 90 days or more may remain on accrual status if management determines that such amounts are collectible.  When loans are placed in non-accrual status, previously accrued and unpaid interest is reversed against interest income in the current period and interest is subsequently recognized only to the extent cash is received as long as the remaining recorded investment in the loan is deemed fully collectible.  Loans may be placed back on accrual status when, in the opinion of management, the circumstances warrant such action such as a history of timely payments subsequent to being placed on nonaccrual status, additional collateral is obtained or the borrowers cash flows improve.

Standby letters of credit are written conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  The total contract amount of standby letters of credit, whose contract amount represent credit risk was $3,314,000 at December 31, 2012 and $3,719,000 at December 31, 2011.

Allowance for loan losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is probable.  Subsequent recoveries, if any, are credited to the allowance.

 
The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible.  Management’s judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as changes in the nature and volume of the loan portfolio, current economic conditions which may affect a borrower’s ability to repay, overall portfolio quality, and review of specific potential losses.  This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of general and specific components.  The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.  The specific component relates to loans that we have concluded, based on the value of collateral, guarantees and any other pertinent factors, have known losses.  For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Troubled debt restructurings
A loan or lease is accounted for as a troubled debt restructuring if we, for economic or legal reasons related to the borrower’s financial condition, grant a significant concession to the borrower that we would not otherwise consider.   A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan or lease, or a modification of terms such as a reduction of the stated interest rate or balance of the loan or lease, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions.  Troubled debt restructurings generally remain categorized as nonperforming loans and leases until a six-month payment history has been maintained.

In accordance with current accounting guidance, loans modified as troubled debt restructurings are, by definition, considered to be impaired loans.  Impairment for these loans is measured on a loan-by-loan basis similar to other impaired loans as described above under Allowance for loan losses.  Certain loans modified as troubled debt restructurings may have been previously measured for impairment under a general allowance methodology (i.e., pooling), thus at the time the loan is modified as a troubled debt restructuring the allowance will be impacted by the difference between the results of these two measurement methodologies.  Loans modified as troubled debt restructurings that subsequently default are factored into the determination of the allowance in the same manner as other defaulted loans.
 
 
Real estate acquired in settlement of loans
Real estate acquired through or in lieu of foreclosure is initially recorded at estimated fair value less estimated selling costs.  Subsequent to the date of acquisition, it is carried at the lower of cost or fair value, adjusted for net selling costs.  Fair values of real estate owned are reviewed regularly and write downs are recorded when it is determined that the carrying value of real estate exceeds the fair value less estimated costs to sell.  Costs relating to the development and improvement of such property are capitalized when appropriate, whereas those costs relating to holding the property are expensed.

Premises and equipment
Land is carried at cost.  Premises and equipment are carried at cost less accumulated depreciation and amortization.  Depreciation of buildings and improvements is computed using the straight-line method over the estimated useful lives of the assets of 39 years.  Depreciation of equipment is computed using the straight-line method over the estimated useful lives of the assets ranging from 3 to 7 years.  Amortization of premises (leasehold improvements) is computed using the straight-line method over the term of the lease or estimated lives of the improvements, whichever is shorter.

Income taxes
Deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.  The primary temporary differences are the allowance for loan losses and depreciation and amortization.  The effect on recorded deferred income taxes of a change in tax laws or rates is recognized in income in the period that includes the enactment date.  To the extent that available evidence about the future raises doubt about the realization of a deferred income tax asset, a valuation allowance is established.  A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.  The Company has not identified any material uncertain tax positions.

Consolidated statements of cash flows
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, due from banks (including cash items in process of collection), interest-bearing deposits with banks and federal funds sold.  Generally, federal funds are purchased and sold for one-day periods.  Cash flows from loans originated by the Bank and deposits are reported net.  The Company paid interest of $5,678,000, $8,158,000 and $10,982,000 in 2012, 2011, and 2010, respectively.  The Company did not pay income taxes in 2012, 2011 and 2010.  The Company received a refund of $290,000 in 2010 related to taxes paid in 2009.

Comprehensive income
Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners.  Total comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss).  The Company’s other comprehensive income (loss) and accumulated other comprehensive income (loss) are comprised of unrealized gains and losses on investment securities available for sale and amortization of the unfunded pension liability.  At December 31, 2012 the accumulated other comprehensive income was comprised of unrealized losses on securities available for sale of $72,222 and unfunded pension liability of $94,327.  At December 31, 2011 the accumulated other comprehensive income was comprised of unrealized gains on securities available for sale of $95,458 and unfunded pension liability of $102,907.

Earnings per common share
Basic earnings (loss) per common share represent net income available to common stockholders, which represents net income (loss) less dividends paid or payable to preferred stock shareholders, divided by the weighted-average number of common shares outstanding during the period.  For diluted earnings per common share, net income available to common shareholders is divided by the
 
 
weighted average number of common shares issued and outstanding for each period plus amounts representing the dilutive effect of stock options and warrants, as well as any adjustment to income that would result from the assumed issuance.  The effects of stock options and warrants are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive.  Stock options and warrants are antidilutive if the underlying average market price of the stock that can be purchased for the period is less than the exercise price of the option or warrant.  Potential common shares that may be issued by the Company relate solely to outstanding stock options and warrants and are determined using the treasury stock method.

Stock incentive plan
The Company’s shareholders approved the Company’s 2000 stock incentive plan which authorizes the issuance of up to 455,000 shares of common stock (increased from 255,000 shares by amendment to the Incentive Plan approved by the Company’s shareholders) to assist the Company in recruiting and retaining key personnel.  The incentive plan includes issuances of stock options and awards of 444,590 common shares.  The expiration date on options granted is ten years with a three year vesting schedule.  See Note 14 for more information on the stock incentive plan.

Fair values of financial instruments
The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are independent, knowledgeable, able to transact and willing to transact.  See Note 18 for the methods and assumptions the Bank uses in estimating fair values of financial instruments:

New accounting pronouncements
In February 2013, the Financial Accounting Standards Board (FASB) issued ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which is intended to improve the reporting of reclassifications out of accumulated other comprehensive income.  The ASU requires an entity to report, either on the face of the income statement or in the notes to the financial statements, the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in the income statement if the amount being reclassified is required to be reclassified in its entirety to net income.  For other amounts that are not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other required disclosures that provide additional detail about those amounts.  This ASU is effective prospectively in the first quarter of 2013, and is not expected to have a material effect on the Company’s consolidated financial statements.
 
In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income ("ASU 2011-05"). ASU 2011-05 requires an entity to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of equity.  ASU 2011-05 became effective for the Company on January 1, 2012. In connection with the application of ASU 2011-05, the Company's financial statements now include separate statements of comprehensive income.
 
In May 2011, the FASB issued ASU No. 2011-04,  Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The Company adopted ASU 2011-04, which generally aligns the principles of fair value measurements with International Financial Reporting Standards (IFRSs), in its consolidated financial statements in the first quarter 2012. The provisions of ASU 2011-04 clarify the application of existing fair value measurement requirements, and expand the disclosure requirements for fair value measurements. The increased provisions of ASU 2011-04 did not have a material effect on the Company’s consolidated financial statements.
 
 
In April 2011, the FASB issued ASU 2011-02, A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring.  This update to codification topic 310 provides guidance for what constitutes a concession and whether a debtor is experiencing financial difficulties. The amendments in this update were effective for the Company on July 1, 2011, with retrospective application from January 1, 2011. This update did not have a material effect on the Company’s consolidated financial statements.

Note 2.                      Investment securities available-for-sale

The amortized cost and estimated fair value of investment securities available-for-sale as of December 31, 2012 and 2011 are as follows:

         
Gross
    
Gross
        
   
Amortized
    
Unrealized
    
Unrealized
    
Estimated
  
   
Cost
    
Gains
    
Losses
    
Fair Value
  
                         
December 31, 2012
                        
U.S. Government agencies
   $ 11,394,373     $ 7,831     $ (14,730 )   $ 11,387,474  
Mortgage-backed securities
     1,829,871       1,057       (2,674 )     1,828,254  
Municipals
     12,039,229       9,900       (110,811 )     11,938,318  
                                 
Total
   $ 25,263,473     $ 18,788     $ (128,215 )   $ 25,154,046  
                                 
December 31, 2011
                                
U.S. Government agencies
   $ 2,000,000     $ 733     $ -     $ 2,000,733  
Mortgage-backed securities
     20,632,756       220,322       (49,005 )     20,804,073  
Small Business Administration
     7,385,903       -       (27,417 )     7,358,486  
                                 
Total
   $ 30,018,659     $ 221,055     $ (76,422 )   $ 30,163,292  
 
Investment securities with book values of approximately $8,622,000 and $9,612,000 at December 31, 2012 and 2011, respectively, were pledged to secure municipal deposits.

Gross realized gains and losses pertaining to available for sale securities are detailed as follows for the years ending December 31, 2012, 2011 and 2010:

   
December 31,
  
   
2012
    
2011
    
2010
  
                   
Gross realized gains
   $ 1,037,262     $ 1,232,584     $ 773,826  
Gross realized losses
     (26,881 )     (15,030 )     (5,275 )
                         
    $ 1,010,381     $ 1,217,554     $ 768,551  


Investment securities available for sale that have an unrealized loss position at December 31, 2012 and December 31, 2011 are detailed below (in thousands):

   
Securities in a Loss
    
Securities in a Loss
              
   
Position for Less Than
    
Position for More Than
              
   
12 Months
    
12 Months
    
Total
  
   
Fair
    
Unrealized
    
Fair Value
    
Unrealized
    
Fair
    
Unrealized
  
   
Value
    
Losses
    
(Loss)
    
Losses
    
Value
    
Losses
  
December 31, 2012
      
US Treasuries
   $ 4,378     $ (15 )   $ -     $ -     $ 4,378     $ (15 )
Municipals
     8,064       (111 )     -       -       8,064       (111 )
Mortgage-backed securities
     167       (2 )     -       -       167       (2 )
                                                 
Total
   $ 12,609     $ (128 )   $ -     $ -     $ 12,609     $ (128 )
                                                 
December 31, 2011
                                                
US Treasuries
   $ 7,358     $ (27 )   $ -     $ -     $ 7,358     $ (27 )
Mortgage-backed securities
     10,221       (47 )     205       (2 )     10,426       (49 )
                                                 
Total
   $ 17,579     $ (74 )   $ 205     $ (2 )   $ 17,784     $ (76 )
 
Management does not believe that any individual unrealized loss as of December 31, 2012 is other than a temporary impairment.  These unrealized losses are primarily attributable to changes in interest rates.  As of December 31, 2012, management does not have the intent to sell any of the securities classified as available for sale and management believes that it is more likely than not that the Company will not have to sell any such securities before a recovery of cost.

The amortized cost and estimated fair value of investment securities available-for-sale as of December 31, 2012, by contractual maturity, are as follows:

   
Amortized
    
Estimated
  
   
Cost
    
Fair Value
  
             
One to five years
   $ 1,099,599     $ 1,077,830  
Five to ten years
     4,031,118       3,984,060  
More than ten years
     20,132,756       20,092,156  
                 
Total
   $ 25,263,473     $ 25,154,046  


 
Note 3.                      Loans

Loans classified by type as of December 31, 2012 and 2011 are as follows:

   
2012
    
2011
  
Construction and land development
            
Residential
   $ 2,845,594     $ 7,906,465  
Commercial
     41,209,831       72,620,537  
    Total construction and land development
     44,055,425       80,527,002  
Commercial real estate
                
Farmland
     2,581,297       2,464,981  
Commercial real estate - owner occupied
     92,772,532       105,592,148  
Commercial real estate - non-owner occupied
     54,550,817       54,059,149  
Multifamily
     7,978,389       6,679,328  
    Total commercial real estate
     157,883,035       168,795,606  
Consumer real estate
                
Home equity lines
     25,521,397       30,687,226  
Secured by 1-4 family residential,
                
secured by first deeds of trust
     80,788,425       93,218,798  
Secured by 1-4 family residential,
                
secured by second deeds of trust
     9,517,245       12,042,063  
   Total consumer real estate
     115,827,067       135,948,087  
Commercial and industrial loans
                
(except those secured by real estate)
     34,384,117       37,734,516  
Consumer and other
     2,760,622       4,865,505  
                 
Total Loans
     354,910,266       427,870,716  
Deferred loan cost (unearned income), net
     787,823       767,775  
Less:  Allowance for loan losses
     (10,807,827 )     (16,071,424 )
                 
    $ 344,890,262     $ 412,567,067  
                 
 
Gross loans pledged as collateral with the FHLB as part of their lending arrangements with the Company totaled $52,409,000 and $38,750,000 as of December 31, 2012 and 2011, respectively.

The following is a summary of loans directly or indirectly with executive officers or directors of the Company for the years ended December 31, 2012 and 2011:

   
2012
    
2011
  
             
Beginning balance
   $ 9,386,429     $ 11,108,283  
Additions
     5,536,015       3,221,846  
Reductions
     (6,329,752 )     (4,943,700 )
                 
Ending balance
   $ 8,592,692     $ 9,386,429  


Executive officers and directors also had unused credit lines totaling $1,185,000 and $1,752,000 at December 31, 2012 and 2011, respectively.  All loans and credit lines to executive officers and directors were made in the ordinary course of business at the Company’s normal credit terms, including interest rate and collateralization prevailing at the time for comparable transactions with other persons.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.  Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions.  Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due as long as the remaining recorded investment in the loan is deemed fully collectible.  When interest accrual is discontinued, all unpaid
 
 
accrued interest is reversed.  Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due.  Loans are returned to accrual status when all principal and interest amounts contractually due are brought to current and future payments are reasonably assured.

Year-end nonaccrual loans segregated by type as of December 31, 2012 and 2011 are as follows:

   
2012
    
2011
  
Construction and land development
            
Residential
   $ -     $ 1,219,385  
Commercial
     4,956,865       18,700,805  
    Total construction and land development
     4,956,865       19,920,190  
Commercial real estate
                
Farmland
     1,049,489       -  
Commercial real estate - owner occupied
     4,817,596       10,363,447  
Commercial real estate - non-owner occupied
     2,406,255       4,953,216  
Multifamily
     -       -  
    Total commercial real estate
     8,273,340       15,316,663  
Consumer real estate
                
Home equity lines
     1,939,020       1,061,753  
Secured by 1-4 family residential,
                
secured by first deeds of trust
     8,410,338       9,637,818  
Secured by 1-4 family residential,
                
secured by second deeds of trust
     940,150       503,780  
   Total consumer real estate
     11,289,508       11,203,351  
Commercial and industrial loans
                
(except those secured by real estate)
     1,035,173       1,246,437  
Consumer and other
     50,415       410,407  
                 
Total
   $ 25,605,301     $ 48,097,048  



The Company assigns risk rating classifications to its loans.  These risk ratings are divided into the following groups:

 
·
Risk rated 1 to 4 loans are considered of sufficient quality to preclude an adverse rating.  1-4 assets generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral;
 
·
Risk rated 5 loans are defined as having potential weaknesses that deserve management’s close attention;
 
·
Risk rated 6 loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any, and;
 
·
Risk rated 7 loans have all the weaknesses inherent in substandard loans, with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.
 

 
 
The following tables provide information on the risk rating of loans at the dates indicated:

   
December 31, 2012
  
   
Risk Rated
    
Risk Rated
    
Risk Rated
    
Risk Rated
    
Total
  
      1-4       5       6       7    
Loans
  
                                       
Construction and land development
                                      
Residential
   $ 2,173,885     $ 671,709     $ -     $ -     $ 2,845,594  
Commercial
     17,638,646       7,496,950       16,074,235       -       41,209,831  
    Total construction and land development
     19,812,531       8,168,659       16,074,235       -       44,055,425  
Commercial real estate
                                        
Farmland
     1,531,808               1,049,489       -       2,581,297  
Commercial real estate - owner occupied
     63,772,277       19,273,229       9,727,026       -       92,772,532  
Commercial real estate - non-owner occupied
     24,199,053       15,671,633       14,170,546       509,585       54,550,817  
Multifamily
     5,438,427       1,739,283       800,679       -       7,978,389  
    Total commercial real estate
     94,941,565       36,684,145       25,747,740       509,585       157,883,035  
Consumer real estate
                                        
Home equity lines
     20,180,206       2,015,248       3,325,943       -       25,521,397  
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     49,659,724       11,235,261       19,893,440       -       80,788,425  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     7,385,394       342,770       1,789,081       -       9,517,245  
   Total consumer real estate
     77,225,324       13,593,279       25,008,464       -       115,827,067  
Commercial and industrial loans
                                        
(except those secured by real estate)
     26,712,028       2,590,735       5,081,354       -       34,384,117  
Consumer and other
     2,446,304       261,140       53,178       -       2,760,622  
                                         
Total loans
   $ 221,137,752     $ 61,297,958     $ 71,964,971     $ 509,585     $ 354,910,266  
                                         
                                         
   
December 31, 2011
  
                                         
   
Risk Rated
    
Risk Rated
    
Risk Rated
    
Risk Rated
    
Total
  
      1-4       5       6       7    
Loans
  
                                         
Construction and land development:
                                        
Residential
   $ 4,943,061     $ -     $ 2,963,404     $ -     $ 7,906,465  
Commercial
     44,315,474       -       28,305,063       -       72,620,537  
    Total construction and land development
     49,258,535       -       31,268,467       -       80,527,002  
                                         
Commercial real estate:
                                        
Farmland
     2,464,981       -       -       -       2,464,981  
Commercial real estate - owner occupied
     46,958,816       16,352,920       42,280,412       -       105,592,148  
Commercial real estate - non-owner occupied
     37,581,904       3,036,887       13,440,358       -       54,059,149  
Multifamily
     5,511,882       -       1,167,446       -       6,679,328  
    Total commercial real estate
     92,517,583       19,389,807       56,888,216       -       168,795,606  
                                         
Consumer real estate:
                                        
Home equity lines
     26,403,850       1,373,002       2,910,374       -       30,687,226  
Secured by 1-4 family residential, secured by first deeds of trust
     80,670,887       6,052,128       6,495,783       -       93,218,798  
Secured by 1-4 family residential, secured by second deeds of trust
     9,960,928       706,484       1,374,651       -       12,042,063  
   Total consumer real estate
     117,035,665       8,131,614       10,780,808       -       135,948,087  
                                         
Commercial and industrial loans (except those secured by real estate)
     31,322,834       4,289,037       2,122,645       -       37,734,516  
                                         
Consumer and other
     3,508,768       384,387       972,350       -       4,865,505  
                                         
Total Loans
   $ 293,643,385     $ 32,194,845     $ 102,032,486     $ -     $ 427,870,716  
                                         
 

The following table presents the aging of the recorded investment in past due loans and leases as of the dates indicated.

December 31, 2012
  
                                       
Recorded
  
               
Greater
                      
Investment >
  
   
30-59 Days
    
60-89 Days
    
Than
    
Total Past
          
Total
    
90 Days and
  
   
Past Due
    
Past Due
    
90 Days
    
Due
    
Current
    
Loans
    
Accruing
  
                                           
Construction and land development
                                          
Residential
   $ -     $ -     $ -     $ -     $ 2,845,594     $ 2,845,594     $ -  
Commercial
     76,351       10,709       -       87,060       41,122,771       41,209,831       -  
Total construction and land development
     76,351       10,709       -     $ 87,060     $ 43,968,365     $ 44,055,425       -  
Commercial real estate
                                                        
Farmland
     -       -       -       -       2,581,297       2,581,297       -  
Commercial real estate - owner occupied
     708,278       377,563       -       1,085,841       91,686,691       92,772,532       -  
Commercial real estate - non-owner occupied
     1,094,906       714,655       -       1,809,561       52,741,256       54,550,817       -  
Multifamily
     -       -       -       -       7,978,389       7,978,389       -  
Total commercial real estate
     1,803,184       1,092,218       -       2,895,402       154,987,633       157,883,035       -  
Consumer real estate
                                                        
Home equity lines
     110,614       24,746       16,130       151,490       25,369,907       25,521,397       16,130  
Secured by 1-4 family residential,
                                                        
secured by first deeds of trust
     645,807       1,507,073       -       2,152,880       78,635,545       80,788,425       -  
Secured by 1-4 family residential,
                                                        
secured by second deeds of trust
     157,816       50,016       50,000       257,832       9,259,413       9,517,245       50,000  
Total consumer real estate
     914,237       1,581,835       66,130       2,562,202       113,264,865       115,827,067       66,130  
Commercial and industrial loans
                                                        
(except those secured by real estate)
     40,171       31,057       49,139       120,367       34,263,750       34,384,117       49,139  
Consumer and other
     4,286       36,030       -       40,316       2,720,306       2,760,622       -  
                                                         
Total loans
   $ 2,838,229     $ 2,751,849     $ 115,269     $ 5,705,347     $ 349,204,919     $ 354,910,266     $ 115,269  
 
 
 
December 31, 2011
  
                                       
Recorded
  
               
Greater
                      
Investment >
  
   
30-59 Days
    
60-89 Days
    
Than
    
Total Past
          
Total
    
90 Days and
  
   
Past Due
    
Past Due
    
90 Days
    
Due
    
Current
    
Loans
    
Accruing
  
                                           
Construction and land development
                                          
Residential
   $ 575,200     $ 251,799     $ -     $ 826,999     $ 7,079,466     $ 7,906,465     $ -  
Commercial
     1,367,360       408,000       36,770       1,812,130       70,808,407       72,620,537       36,770  
Total construction and land development
     1,942,560       659,799       36,770     $ 2,639,129     $ 77,887,873     $ 80,527,002       36,770  
Commercial real estate
                                                        
Farmland
     -       -       -       -       2,464,981       2,464,981       -  
Commercial real estate - owner occupied
     598,006       36,972       -       634,978       104,957,170       105,592,148       -  
Commercial real estate - non-owner occupied
     55,709       673,561       -       729,270       53,329,879       54,059,149       -  
Multifamily
     111,571       255,196       -       366,767       6,312,561       6,679,328       -  
Total commercial real estate
     765,286       965,729       -       1,731,015       167,064,591       168,795,606       -  
Consumer real estate
                                                        
Home equity lines
     323,349       99,494       299,783       722,626       29,964,600       30,687,226       299,783  
Secured by 1-4 family residential,
                                                        
secured by first deeds of trust
     985,116       1,572,973       624,740       3,182,829       90,035,969       93,218,798       624,740  
Secured by 1-4 family residential,
                                                        
secured by second deeds of trust
     12,673       132,928       156,026       301,627       11,740,436       12,042,063       156,026  
Total consumer real estate
     1,321,138       1,805,395       1,080,549       4,207,082       131,741,005       135,948,087       1,080,549  
Commercial and industrial loans
     46,392       3,313       54,918       104,623       37,629,893       37,734,516       54,918  
(except those secured by real estate)
                                                        
Consumer and other
     59,697       3,176       -       62,873       4,802,632       4,865,505       -  
                                                         
Total loans
   $ 4,135,073     $ 3,437,412     $ 1,172,237     $ 8,744,722     $ 419,125,994     $ 427,870,716     $ 1,172,237  
 
 
 
Loans are considered impaired when, based on current information and events it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans.  If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.  Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.  Impaired loans, or portions thereof, are charged off when deemed uncollectible.  Impaired loans are set forth in the following table as of the dates indicated.
 

 
   
December 31, 2012
  
                   
         
Unpaid
        
   
Recorded
    
Principal
    
Related
  
   
Investment
    
Balance
    
Allowance
  
                   
With no related allowance recorded
                  
                   
Construction and land development
                  
Residential
   $ -     $ -     $ -  
Commercial
     8,254,440       13,625,670       -  
    Total construction and land development
     8,254,440       13,625,670       -  
Commercial real estate
                        
Farmland
     1,049,489       1,049,489       -  
Commercial real estate - owner occupied
     8,250,071       8,715,684       -  
Commercial real estate - non-owner occupied
     13,777,787       14,124,016       -  
Multifamily
     2,825,274       2,825,274       -  
    Total commercial real estate
     25,902,621       26,714,463       -  
Consumer real estate
                        
Home equity lines
     1,939,020       1,938,005       -  
Secured by 1-4 family residential, secured by first deeds of trust
     10,686,435       10,928,024       -  
Secured by 1-4 family residential, secured by second deeds of trust
     601,805       861,158       -  
   Total consumer real estate
     13,227,260       13,727,187       -  
Commercial and industrial loans (except those secured by real estate)
     858,136       1,421,196       -  
Consumer and other
     50,415       50,390       -  
    $ 48,292,872     $ 55,538,906     $ -  
                         
With an allowance recorded
                        
                         
Construction and land development:
                        
Residential
   $ -     $ -     $ -  
Commercial
     430,828       430,828       62,643  
    Total construction and land development
     430,828       430,828       62,643  
Commercial real estate:
                        
Farmland
                        
Commercial real estate - owner occupied
     2,940,647       3,261,584       663,330  
Commercial real estate - non-owner occupied
     1,434,195       1,434,195       508,704  
Multifamily
     -       -       -  
    Total commercial real estate
     4,374,842       4,695,779       1,172,034  
Consumer real estate:
                        
Home equity lines
     -       -       -  
Secured by 1-4 family residential, secured by first deeds of trust
     1,155,027       1,155,027       20,896  
Secured by 1-4 family residential, secured by second deeds of trust
     338,345       386,629       43,456  
   Total consumer real estate
     1,493,372       1,541,656       64,352  
Commercial and industrial loans (except those secured by real estate)
     182,840       182,840       39,243  
Consumer and other
     -       -       -  
    $ 6,481,882     $ 6,851,103     $ 1,338,272  
                         
Total
                        
Construction and land development
                        
Residential
   $ -     $ -     $ -  
Commercial
     8,685,268       14,056,498       62,643  
    Total construction and land development
     8,685,268       14,056,498       62,643  
Commercial real estate
                        
Farmland
     1,049,489       1,049,489       -  
Commercial real estate - owner occupied
     11,190,718       11,977,268       663,330  
Commercial real estate - non-owner occupied
     15,211,982       15,558,211       508,704  
Multifamily
     2,825,274       2,825,274       -  
    Total commercial real estate
     30,277,463       31,410,242       1,172,034  
Consumer real estate
                        
Home equity lines
     1,939,020       1,938,005       -  
Secured by 1-4 family residential, secured by first deeds of trust
     11,841,462       12,083,051       20,896  
Secured by 1-4 family residential, secured by second deeds of trust
     940,150       1,247,787       43,456  
   Total consumer real estate
     14,720,632       15,268,843       64,352  
Commercial and industrial loans (except those secured by real estate)
     1,040,976       1,604,036       39,243  
Consumer and other
     50,415       50,390       -  
    $ 54,774,754     $ 62,390,009     $ 1,338,272  
                         
                         
                         


   
December 31, 2011
  
         
Unpaid
        
   
Recorded
    
Principal
    
Related
  
   
Investment
    
Balance
    
Allowance
  
                   
With no related allowance recorded
                  
Construction and land development
                  
Residential
   $ 624,651     $ 712,243     $ -  
Commercial
     9,722,132       11,094,408       -  
Total
     10,346,783       11,806,651       -  
Commercial real estate
                        
Commercial real estate - owner occupied
     6,414,362       6,414,362       -  
Commercial real estate - non-owner occupied
     7,146,531       7,146,531       -  
Multifamily
     2,019,675       2,019,675       -  
Total
     15,580,568       15,580,568       -  
Consumer real estate
                        
Home equity lines
     702,338       702,338       -  
Secured by 1-4 family residential, secured by first deeds of trust
     6,319,837       6,792,837       -  
Secured by 1-4 family residential, secured by second deeds of trust
     336,257       336,257       -  
Total
     7,358,432       7,831,432       -  
Commercial and industrial loans (except those secured by real estate)
     1,194,913       1,494,913       -  
Consumer and other
     143,241       143,241       -  
    $ 34,623,937     $ 36,856,805     $ -  
                         
With an allowance recorded
                        
Construction and land development
                        
Residential
   $ 587,235     $ 587,235     $ 320,250  
Commercial
     14,885,541       15,785,541       3,913,820  
Total
     15,472,776       16,372,776       4,234,070  
Commercial real estate
                        
Commercial real estate - owner occupied
     9,508,393       9,652,393       2,031,740  
Commercial real estate - non-owner occupied
     1,719,690       1,719,690       450,000  
Multifamily
     -       -       -  
Total
     11,228,083       11,372,083       2,481,740  
Consumer real estate
                        
Home equity lines
     756,892       756,892       233,606  
Secured by 1-4 family residential, secured by first deeds of trust
     4,224,325       4,749,325       1,007,155  
Secured by 1-4 family residential, secured by second deeds of trust
     167,523       167,523       119,524  
Total
     5,148,740       5,673,740       1,360,285  
Commercial and industrial loans (except those secured by real estate)
     818,597       818,597       452,773  
Consumer and other
     267,166       267,166       266,178  
    $ 32,935,362     $ 34,504,362     $ 8,795,046  
                         
Total
                        
Construction and land development
                        
Residential
   $ 1,211,886     $ 1,299,478     $ 320,250  
Commercial
     24,607,673       26,879,949       3,913,820  
Total
     25,819,559       28,179,427       4,234,070  
Commercial real estate
                        
Commercial real estate - owner occupied
     15,922,755       16,066,755       2,031,740  
Commercial real estate - non-owner occupied
     8,866,221       8,866,221       450,000  
Multifamily
     2,019,675       2,019,675       -  
Total
     26,808,651       26,952,651       2,481,740  
Consumer real estate
                        
Home equity lines
     1,459,230       1,459,230       233,606  
Secured by 1-4 family residential, secured by first deeds of trust
     10,544,162       11,542,162       1,007,155  
Secured by 1-4 family residential, secured by second deeds of trust
     503,780       503,780       119,524  
Total
     12,507,172       13,505,172       1,360,285  
Commercial and industrial loans (except those secured by real estate)
     2,013,510       2,313,510       452,773  
Consumer and other
     410,407       410,407       266,178  
    $ 67,559,299     $ 71,361,167     $ 8,795,046  
                         
 
 
The following is a summary of average recorded investment in impaired loans with and without a valuation allowance and interest income recognized on those loans for periods indicated:
 
   
December 31,
  
   
2012
    
2011
  
   
Average
    
Interest
    
Average
    
Interest
  
   
Recorded
    
Income
    
Recorded
    
Income
  
   
Investment
    
Recognized
    
Investment
    
Recognized
  
                         
With no related allowance recorded
                        
Construction and land development
                        
Residential
   $ -     $ -     $ 822,020     $ -  
Commercial
     9,163,986       290,828       12,878,320       214,171  
Total
     9,163,986       290,828       13,700,340       214,171  
Commercial real estate
                                
Farmland
     1,049,489       18,255               -  
Commercial real estate - owner occupied
     8,777,660       637,208       2,310,893       25,969  
Commercial real estate - non-owner occupied
     8,822,895       375,498       2,574,670       273,829  
Multifamily
     637,029       41,775       -          
Total
     19,287,073       1,072,736       4,885,563       299,798  
Consumer real estate
                                
Home equity lines
     1,591,647       85,821       -       -  
Secured by 1-4 family residential, secured by first deeds of trust
     10,392,272       334,883       9,863,066       38,660  
Secured by 1-4 family residential, secured by second deeds of trust
     609,757       27,128       634,249       -  
Total
     12,593,676       447,832       10,497,315       38,660  
Commercial and industrial loans (except those secured by real estate)
     897,078       50,259       1,064,936       216  
Consumer and other
     57,530       3,435       100,456       204  
    $ 41,999,343     $ 1,865,090     $ 30,248,610     $ 553,049  
                                 
With an allowance recorded
                                
Construction and land development
                                
Residential
   $ -     $ -     $ 323,736     $ -  
Commercial
     453,702       1,373       7,769,670       425,892  
Total
     453,702       1,373       8,093,406       425,892  
Commercial real estate
                                
Farmland
                                
Commercial real estate - owner occupied
     3,116,022       30,003       2,495,259       111,132  
Commercial real estate - non-owner occupied
     1,446,983       -       475,287       142,216  
Multifamily
     -       -       -       -  
Total
     4,563,005       30,003       2,970,546       253,348  
Consumer real estate
                                
Home equity lines
     -               684,504          
Secured by 1-4 family residential, secured by first deeds of trust
     1,171,653       50,691       1,388,472          
Secured by 1-4 family residential, secured by second deeds of trust
     349,192       4,151       91,516          
Total
     1,520,845       54,842       2,164,492       -  
Commercial and industrial loans (except those secured by real estate)
     191,625       2,628       782,036          
Consumer and other
     -       -       191,974       -  
    $ 6,729,177     $ 88,846     $ 14,202,454     $ 679,240  
                                 
Total
                                
Construction and land development
                                
Residential
   $ -     $ -     $ 1,145,756     $ -  
Commercial
     9,617,688       292,201       20,647,990       640,063  
Total
     9,617,688       292,201       21,793,746       640,063  
Commercial real estate
                                
Farmland
     1,049,489       18,255       -       -  
Commercial real estate - owner occupied
     11,893,682       667,211       4,806,152       137,101  
Commercial real estate - non-owner occupied
     10,269,878       375,498       3,049,957       416,045  
Multifamily
     637,029       41,775       -       -  
Total
     23,850,078       1,102,739       7,856,109       553,146  
Consumer real estate
                                
Home equity lines
     1,591,647       85,821       684,504       -  
Secured by 1-4 family residential, secured by first deeds of trust
     11,563,925       385,574       11,251,538       38,660  
Secured by 1-4 family residential, secured by second deeds of trust
     958,949       31,279       725,765       -  
Total
     14,114,521       502,674       12,661,807       38,660  
Commercial and industrial loans (except those secured by real estate)
     1,088,703       52,887       1,846,972       216  
Consumer and other
     57,530       3,435       292,430       204  
    $ 48,728,520     $ 1,953,936     $ 44,451,064     $ 1,232,289  

As of December 31, 2012, 2011 and 2010, the Company had impaired loans of $25,605,301, $48,097,048 and $20,323,887, respectively, which were on nonaccrual status.  These loans had valuation allowances of $1,338,000, $5,034,000 and $305,000 as of December 31, 2012, 2011 and 2010, respectively.  Cumulative interest income that would have been recorded had nonaccrual loans been performing would have been $1,592,000, $2,377,000 and $1,242,000 for 2012, 2011 and 2010, respectively.

 
Included in impaired loans are loans classified as troubled debt restructurings (TDRs).  A modification of a loan’s terms constitutes a TDR if the creditor grants a concession to the borrower for economic or legal reasons related to the borrowers financial difficulties that it would not otherwise consider.  For loans classified as impaired TDRs, the Company further evaluates the loans as performing or nonperforming.  If, at the time of restructure, the loan is not considered nonaccrual, it will be classified as performing.  TDRs originally classified as nonperforming are able to be reclassified as performing if, subsequent to restructure, they experience six months of payment performance according to the restructured terms.  The following table provides certain information concerning TDRs as of December 31, 2012.

                     
Specific
  
                     
Valuation
  
   
Total
    
Performing
    
Nonaccrual
    
Allowance
  
                         
Construction and land development
                        
Commercial
   $ 6,116,248     $ 3,728,403     $ 2,387,845     $ -  
Total construction and land development
     6,116,248       3,728,403       2,387,845       -  
Commercial real estate
                                
Commercial real estate - owner occupied
     8,881,257       6,373,122       2,508,135       3,321  
Commercial real estate - non-owner occupied
     13,266,992       12,805,727       461,265       -  
Multifamily
     2,825,274       2,825,274       -       -  
Total commercial real estate
     24,973,523       22,004,123       2,969,400       3,321  
Consumer real estate
                                
Home equity lines
     -       -       -       -  
Secured by 1-4 family residential,
                                
secured by first deeds of trust
     7,011,329       3,431,124       3,580,205       15,633  
Secured by 1-4 family residential,
                                
secured by second deeds of trust
     338,344       -       338,344       43,456  
Total consumer real estate
     7,349,673       3,431,124       3,918,549       59,089  
Commercial and industrial loans
                                
(except those secured by real estate)
     380,427       5,803       374,624       39,243  
                                 
Total
   $ 38,819,871     $ 29,169,453     $ 9,650,418     $ 101,653  
                                 
Number of loans
     73       46       27       7  

The following table provides information about TDRs identified during the indicated periods.


   
December 31, 2012
    
December 31, 2011
  
         
Pre-
    
Post-
          
Pre-
    
Post-
  
         
Modification
    
Modification
          
Modification
    
Modification
  
   
Number of
    
Recorded
    
Recorded
    
Number of
    
Recorded
    
Recorded
  
   
Loans
    
Balance
    
Balance
    
Loans
    
Balance
    
Balance
  
                                     
Construction and land development
                                    
Commercial
     6     $ 653,612     $ 653,612       11     $ 6,604,400     $ 6,604,400  
Total construction and land development
     6       653,612       653,612       11       6,604,400       6,604,400  
Commercial real estate
                                             -  
Farmland
             -       -                       -  
Commercial real estate - owner occupied
     1       522,715       522,715       9       9,748,062       9,748,062  
Commercial real estate - non-owner occupied
     6       2,102,231       2,102,231       5       4,031,868       4,031,868  
Total commercial real estate
     7       2,624,946       2,624,946       14       13,779,930       13,779,930  
Consumer real estate
                                                
Secured by 1-4 family residential,
                                                
secured by first deeds of trust
     25       5,570,245       5,570,245       2       1,422,772       1,422,772  
Secured by 1-4 family residential,
                                                
secured by second deeds of trust
     1       338,344       338,344               -       -  
Total consumer real estate
     26       5,908,589       5,908,589       2       1,422,772       1,422,772  
Commercial and industrial loans
                                                
(except those secured by real estate)
     1       117,813       117,813       3       159,073       159,073  
Consumer and other
     -       -       -       1       128,419       128,419  
                                                 
Total
     40     $ 9,304,960     $ 9,304,960       31     $ 21,966,175     $ 21,966,175  



The following table provides information about defaults on TDRs for the year ended December 31, 2012.

   
Number of
    
Recorded
  
   
Loans
    
Balance
  
             
Construction and land development
            
Commercial
     8     $ 2,387,845  
Total construction and land development
     8       2,387,845  
Commercial real estate
                
Commercial real estate - owner occupied
     2       2,053,276  
Commercial real estate - non-owner occupied
     1       461,265  
Total commercial real estate
     3       2,514,541  
Consumer real estate
                
Secured by 1-4 family residential,
                
secured by first deeds of trust
     8       3,302,827  
Secured by 1-4 family residential,
                
secured by second deeds of trust
     1       338,344  
Total consumer real estate
     9       3,641,171  
Commercial and industrial loans
                
(except those secured by real estate)
     4       257,136  
                 
Total
     24     $ 8,800,693  




Note 4.                      Allowance for loan losses

Activity in the allowance for loan losses was as follows for the periods indicated.

   
Beginning
    
Provision for
                
Ending
  
   
Balance
    
Loan Losses
    
Charge-offs
    
Recoveries
    
Balance
  
Year Ended December 31, 2012
                              
Construction and land development
                              
Residential
   $ 704,728     $ 542,067     $ (797,286 )   $ 45,233     $ 494,742  
Commercial
     6,798,177       3,444,160       (5,645,064 )     14,137       4,611,410  
Commercial real estate
                                        
Farmland
     -       -       -       -       -  
Commercial real estate - owner occupied
     1,496,466       623,552       (961,155 )     200,000       1,358,863  
Commercial real estate - non-owner occupied
     1,548,899       (300,898 )     (431,354 )     205       816,852  
Multifamily
     406,635       (373,238 )     (9,963 )     -       23,434  
Consumer real estate
                                        
Home equity lines
     860,307       668,614       (883,848 )     13,062       658,135  
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     1,881,470       2,610,905       (3,220,072 )     85,799       1,358,102  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     397,504       468,192       (663,135 )     20,746       223,307  
Commercial and industrial loans
                                        
(except those secured by real estate)
     1,655,713       1,230,555       (1,879,517 )     154,903       1,161,654  
Consumer and other
     321,525       181,091       (408,302 )     7,014       101,328  
                                         
Total
   $ 16,071,424     $ 9,095,000     $ (14,899,696 )   $ 541,099     $ 10,807,827  
                                         
Year Ended December 31, 2011
                                        
Construction and land development
                                        
Residential
   $ 293,841     $ 467,187     $ (65,500 )   $ 9,200     $ 704,728  
Commercial
     2,832,119       8,249,320       (4,293,262 )     10,000       6,798,177  
Commercial real estate
                                        
Farmland
     -       -       -       -       -  
Commercial real estate - owner occupied
     78,445       1,568,052       (150,031 )     -       1,496,466  
Commercial real estate - non-owner occupied
     20,477       1,871,804       (343,382 )     -       1,548,899  
Multifamily
     -       489,136       (82,501 )     -       406,635  
Consumer real estate
                                        
Home equity lines
     641,975       1,447,272       (1,232,153 )     3,213       860,307  
Secured by 1-4 family residential,
                                        
secured by first deeds of trust
     1,403,207       1,571,813       (1,129,509 )     35,959       1,881,470  
Secured by 1-4 family residential,
                                        
secured by second deeds of trust
     297,401       462,634       (362,531 )     -       397,504  
Commercial and industrial loans
                                        
(except those secured by real estate)
     1,315,582       2,496,729       (2,159,668 )     3,070       1,655,713  
Consumer and other
     428,665       140,349       (249,526 )     2,037       321,525  
                                         
Total
   $ 7,311,712     $ 18,764,296     $ (10,068,063 )   $ 63,479     $ 16,071,424  
 

 
Loans were evaluated for impairment as follows for the periods indicated.
 

 
   
Individually
    
Collectively
    
Total
  
Year Ended December 31, 2012
                  
Construction and land development
                  
Residential
   $ 1,247,709     $ 1,597,885     $ 2,845,594  
Commercial
     27,351,857       13,857,974       41,209,831  
Commercial real estate
                        
Farmland
     1,391,501       1,189,796       2,581,297  
Commercial real estate - owner occupied
     67,167,587       25,604,945       92,772,532  
Commercial real estate - non-owner occupied
     41,801,577       12,749,240       54,550,817  
Multifamily
     6,461,639       1,516,750       7,978,389  
Consumer real estate
                        
Home equity lines
     2,185,040       23,336,357       25,521,397  
Secured by 1-4 family residential,
                        
secured by first deeds of trust
     15,526,551       65,261,874       80,788,425  
Secured by 1-4 family residential,
                        
secured by second deeds of trust
     557,600       8,959,645       9,517,245  
Commercial and industrial loans
                        
(except those secured by real estate)
     15,101,291       19,282,826       34,384,117  
Consumer and other
     -       2,760,622       2,760,622  
                         
Total
   $ 178,792,352     $ 176,117,914     $ 354,910,266  
                         
Year Ended December 31, 2011
                        
Construction and land development
                        
Residential
   $ 1,831,478     $ 6,074,987     $ 7,906,465  
Commercial
     30,292,460       42,328,077       72,620,537  
Commercial real estate
                        
Farmland
     -       2,464,981       2,464,981  
Commercial real estate - owner occupied
     91,008,321       14,583,827       105,592,148  
Commercial real estate - non-owner occupied
     45,529,918       8,529,231       54,059,149  
Multifamily
     5,625,490       1,053,838       6,679,328  
Consumer real estate
                        
Home equity lines
     4,314,190       26,373,036       30,687,226  
Secured by 1-4 family residential,
                        
secured by first deeds of trust
     13,105,245       80,113,553       93,218,798  
Secured by 1-4 family residential,
                        
secured by second deeds of trust
     1,692,944       10,349,119       12,042,063  
Commercial and industrial loans
                        
(except those secured by real estate)
     14,343,224       23,391,292       37,734,516  
Consumer and other
     3,501,524       1,363,981       4,865,505  
                         
Total
   $ 211,244,794     $ 216,625,922     $ 427,870,716  



Note 5.                      Premises and equipment

The following is a summary of premises and equipment as of December 31, 2012 and 2011:

   
2012
    
2011
  
             
Land
   $ 6,190,561     $ 6,190,561  
Buildings and improvements
     20,385,517       20,371,382  
Furniture, fixtures and equipment
     7,585,491       7,431,892  
Total premises and equipment
     34,161,569       33,993,835  
Less: Accumulated depreciation and amortization
     (8,346,227 )     (7,167,311 )
                 
Premises and equipment, net
   $ 25,815,342     $ 26,826,524  


Depreciation and amortization of premises and equipment for 2012, 2011 and 2010 amounted to $1,366,000, $1,418,000 and $1,309,000 respectively.

Note 6.                      Investment in bank owned life insurance

The Bank is owner and designated beneficiary on life insurance policies in the face amount of $13,101,000 covering certain of its directors and executive officers.  The earnings from these policies are used to offset expenses related to retirement plans.  The cash surrender value of these policies at December 31, 2012 and 2011 was $6,575,000 and $6,065,000, respectively.

Note 7.                      Deposits

Deposits as of December 31, 2012 and 2011 were as follows:

   
2012
    
2011
  
             
Demand accounts
   $ 57,049,348     $ 66,534,956  
Interest checking accounts
     45,861,199       40,237,146  
Money market accounts
     66,007,160       75,487,907  
Savings accounts
     20,922,112       15,166,012  
Time deposits of $100,000 and over
     113,332,481       129,436,270  
Other time deposits
     133,150,662       158,658,761  
                 
Total
   $ 436,322,962     $ 485,521,052  



The following are the scheduled maturities of time deposits as of December 31, 2012:

         
Greater than
        
   
Less Than
    
or Equal to
        
Year Ending December 31,
   $100,000     $100,000    
Total
  
                       
2013
   $ 55,488,066     $ 36,781,241     $ 92,269,307  
2014
     28,380,294       31,124,916       59,505,210  
2015
     17,279,506       15,300,934       32,580,440  
2016
     18,320,271       18,867,037       37,187,308  
2017
     13,682,525       11,258,353       24,940,878  
                         
    $ 133,150,662     $ 113,332,481     $ 246,483,143  


Deposits held at the Company by related parties, which include officers, directors, greater than 5% shareholders and companies in which directors of the Board have a significant ownership interest, approximated $6,310,000 and $18,508,000 at December 31, 2012 and 2011, respectively.

 
Note 8.                      Borrowings

The Company uses both short-term and long-term borrowings to supplement deposits when they are available at a lower overall cost to the Company or they can be invested at a positive rate of return.

As a member of the Federal Home Loan Bank of Atlanta, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances from the FHLB.  The Company held $2,122,000 in FHLB stock at December 31, 2012 and $2,647,000 at December 31, 2011 which is held at cost and included in other assets.  Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities.  The FHLB may prescribe the acceptable uses to which the advances may be put, as well as on the size of the advances and repayment provisions.  The FHLB borrowings are secured by the pledge of U.S. Government agency securities, FHLB stock and qualified single family first mortgage loans.  The Company had FHLB advances of approximately $28 million at December 31, 2012 maturing through 2016.  At December 31, 2011 $38 million of advances were outstanding.

At December 31, 2012, the contractual maturities of the advances are as follows (in thousands):

Due in 2013
   $ 10,000  
Due in 2014
     8,000  
Due in 2015
     8,000  
Due in 2016
     2,000  
         
    $ 28,000  


The Company uses federal funds purchased and repurchase agreements for short-term borrowing needs.  Federal funds purchased represent unsecured borrowings from other banks and generally mature daily.  Securities sold under agreements to repurchase are classified as borrowings and generally mature within one to four days from the transaction date.  Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction.  The Company may be required to provide additional collateral based on the fair value of the underlying securities.

The Company also has securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the date sold.  The carrying value of these repurchase agreements was $4,851,811 and $5,778,661 at December 31, 2012 and 2011, respectively.

Information related to borrowings as of December 31, 2012 and 2011 is as follows:

   
2012
    
2011
  
             
Maximum outstanding during the year
            
FHLB advances
   $ 37,750,000     $ 37,750,000  
Balance outstanding at end of year
                
FHLB advances
     28,000,000       37,750,000  
Average amount outstanding during the year
                
FHLB advances
     31,537,568       36,823,973  
Average interest rate during the year
                
FHLB advances
     2.06 %     2.20 %
Average interest rate at end of year
                
FHLB advances
     2.19 %     2.10 %



Note 9.                      Income taxes

The following summarizes the tax effects of temporary differences which comprise net deferred tax assets and liabilities at December 31, 2012, 2011 and 2010:


   
2012
    
2011
    
2010
  
Deferred tax assets
                  
Net operating loss carryforward
   $ 4,786,458     $ 1,541,937     $ 1,558,313  
Allowance for loan losses
     3,674,661       5,464,284       2,485,982  
Unrealized loss on available-for-sale securities
     37,206       -       134,963  
Interest on nonaccrual loans
     541,392       808,249       -  
Expenses and writedowns related to foreclosed
                        
property
     2,318,413       758,073       -  
Gain on disposal of fixed assets
     52,885       -       -  
Merger stock options replacement
     134,200       134,200       134,200  
Stock compensation
     122,728       98,733       82,089  
Employee benefits
     378,831       283,398       172,322  
Pension expense
     48,615       53,031       57,447  
Goodwill
     85,908       101,528       117,148  
                         
Total deferred tax assets
     12,181,296       9,243,433       4,742,464  
                         
Deferred tax liabilities
                        
Depreciation
     955,198       830,146       597,977  
Unrealized gain on available-for-sale securities
     -       49,175       -  
Loss on disposal of foreclosed real estate
     919,719       276,629       -  
Loss on disposal of fixed assets
     -       12,541       106,741  
Amortization of intangibles
     167,305       235,889       311,055  
Goodwill
     -       -       -  
Other, net
     (19,080 )     (18,719 )     8,196  
                         
Total deferred tax liabilities
     2,023,142       1,385,661       1,023,969  
                         
Less valuation allowance
     10,158,154       3,928,886       -  
                         
Net deferred tax asset
   $ -     $ 3,928,886     $ 3,718,495  


The net deferred tax asset is included in other assets on the consolidated balance sheet.  Accounting Standards Codification Topic 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard.  Management considers both positive and negative evidence and analyzes changes in near-term market conditions as well as other factors which may impact future operating results.  In making such judgments, significant weight is given to evidence that can be objectively verified.  The deferred tax assets are analyzed quarterly for changes affecting realization.  Management determined that as of December 31, 2011, the objective negative evidence represented by the Company’s recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance on its net deferred tax asset.  The net operating losses available to offset future taxable income amounted to $5,286,000 at December 31, 2012 and expire through 2030; $1,200,000 is subject to a limitation by IRS section 382 to $908,000 per year.

 
The income tax expense (benefit) charged to operations for the years ended December 31, 2012, 2011 and 2010 consists of the following:

   
2012
    
2011
    
2010
  
                   
Current tax expense (benefit)
   $ -     $ 64,000     $ -  
Deferred tax expense (benefit)
     (2,174,411 )     (4,419,758 )     711,627  
Valuation allowance change
     6,229,268       3,928,886       -  
                         
Provision (benefit) for income taxes
   $ 4,054,857     $ (426,872 )   $ 711,627  
 
A reconciliation of income taxes computed at the federal statutory income tax rate to total income taxes is as follows for the years ended December 31, 2012, 2011 and 2010:
 
   
2012
    
2011
    
2010
  
                   
Net income (loss) before income taxes
   $ (6,344,143 )   $ (12,246,994 )   $ 2,141,936  
                         
                         
Computed "expected" tax expense (benefit)
   $ (2,157,009 )   $ (4,163,978 )   $ 728,257  
Change in valuation allowance
     6,229,268       3,928,886       -  
Cash surrender value of life insurance
     (64,907 )     (65,804 )     (68,866 )
Nondeductible expenses
     13,867       15,899       14,862  
Stock compensation ISO expense
     891       6,982       7,372  
Other
     32,746       (148,857 )     30,001  
                         
Provision (benefit) for income taxes
   $ 4,054,857     $ (426,872 )   $ 711,627  
 
Commercial banking organizations conducting business in Virginia are not subject to Virginia income taxes.  Instead, they are subject to a franchise tax based on bank capital.  The Company recorded franchise tax expense of $163,000, $328,000 and $358,000 for 2012, 2011 and 2010, respectively, which is included in other operating expenses.

Note 10.                      Earnings (loss) per share

The following table presents the basic and diluted earnings per share computations:

   
Year Ended December 31,
  
   
2012
    
2011
    
2010
  
Numerator
                  
Net income (loss) - basic and diluted
   $ (10,399,000 )   $ (11,820,122 )   $ 1,430,309  
Preferred stock dividend and accretion
     878,971       882,882       881,402  
Net income (loss) available to common
                        
shareholders
   $ (11,277,971 )   $ (12,703,004 )   $ 548,907  
                         
Denominator
                        
Weighted average shares outstanding - basic
     4,252,206       4,243,025       4,237,735  
Dilutive effect of common stock options and
                        
      restricted stock awards
     -       -       -  
                         
Weighted average shares outstanding - diluted
     4,252,206       4,243,025       4,237,735  
                         
Earnings (loss) per share - basic and diluted
                        
Earnings (loss) per share - basic
   $ (2.65 )   $ (2.99 )   $ 0.13  
Effect of dilutive common stock options
     -       -       -  
                         
Earnings (loss) per share - diluted
   $ (2.65 )   $ (2.99 )   $ 0.13  


Outstanding options and warrants to purchase common stock and restricted stock awards (see Notes 13 and 14) were considered in the computation of diluted earnings per share for the years presented.  Stock options for 256,130, 264,980 and 310,205 shares of common stock were not included in computing diluted earnings per share in 2012, 2011 and 2010, respectively, because their effects were anti-dilutive. Warrants for 499,030 of common stock were not included in computing earnings per share in 2012, 2011 and 2010, because their effects were also anti-dilutive.  Restricted stock awards for 10,302 and 4,458 were not included in computing diluted earnings per share in 2011 and 2010, respectively, because their effects were anti-dilutive.

Note 11.                      Lease commitments

Certain premises and equipment are leased under various operating leases.  Total rent expense charged to operations was $367,000, $369,000 and $480,000 in 2012, 2011 and 2010, respectively.  At December 31, 2012, the minimum total rental commitment under such non-cancelable operating leases was as follows:

2013
   $ 274,000  
2014
     284,000  
2015
     294,000  
2016
     220,000  
2017
     208,000  
Thereafter
     220,000  
 
Note 12.                      Commitments and contingencies

Off-balance-sheet risk – The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of the amounts recognized in the financial statements.  The contract amounts of these instruments reflect the extent of involvement that the Company has in particular classes of instruments.

The Company’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, and to potential credit loss associated with letters of credit issued, is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and conditional obligations as it does for loans and other such on-balance sheet instruments.

At December 31, 2012 and 2011, the Company had outstanding the following approximate off-balance-sheet financial instruments whose contract amounts represent credit risk:

   
Contract
    
Contract
  
   
Amount
    
Amount
  
   
2012
    
2011
  
             
Undisbursed credit lines
   $ 35,780,000     $ 40,661,000  
Commitments to extend or originate credit
     25,016,000       18,214,000  
Standby letter of credit
     3,314,000       3,719,000  
                 
Total commitments to extend credit
   $ 64,110,000     $ 62,594,000  


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee.  Historically, many commitments expire without being drawn upon; therefore, the total commitment amounts shown in the above table
 
 
are not necessarily indicative of future cash requirements.  The Company evaluates each customer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, as deemed necessary by the Company upon extension of credit is based on management’s credit evaluation of the customer.  Collateral held varies but may include personal or income-producing commercial real estate, accounts receivable, inventory and equipment.

Concentrations of credit risk – All of the Company’s loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area.  Although the Company is building a diversified loan portfolio, a substantial portion of its clients’ ability to honor contracts is reliant upon the economic stability of the Richmond, Virginia area, including the real estate markets in the area.  The concentrations of credit by type of loan are set forth in Note 3.  The distribution of commitments to extend credit approximates the distribution of loans outstanding.

Consent Order – In February 2012, the Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (“Consent Agreement”) with the Federal Deposit Insurance Corporation and the Virginia Bureau of Financial Institutions (the “Supervisory Authorities”), and the Supervisory Authorities have issued the related Consent Order (the “Order”) effective February 3, 2012.  The description of the Consent Agreement and the Order is set forth below:

Management. The Order requires that the Bank have and retain qualified management, including at a minimum a chief executive officer, senior lending officer and chief operating officer, with qualifications and experience commensurate with their assigned duties and responsibilities within 90 days from the effective date of the order.  Within 30 days of the effective date of the Order, the Bank must retain a bank consultant to develop a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management for the Bank.  Within 30 days from receipt of the consultant’s management report, the Bank must formulate a written management plan that incorporates the findings of the management report, a plan of action in response to each recommendation contained in the management report, and a timeframe for completing each action.

Capital Requirements. Within 90 days from the effective date of the Order and during the life of the Order, the Bank must have Tier 1 capital equal to or greater than 8 percent of its total assets, and total risk-based capital equal to or greater than 11 percent of the Bank’s total risk-weighted assets.  Within 90 days from the effective date of the Order, the Bank must submit a written capital plan to the Supervisory Authorities.  The capital plan must include a contingency plan in the event that the Bank fails to maintain the minimum capital ratios required in the Order, submit a capital plan that is acceptable to the Supervisory Authorities, or implement or adhere to the capital plan.

Charge-offs. The Order requires the Bank to eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” and 50 percent of those classified “Doubtful”.  If an asset is classified “Doubtful”, the Bank may, in the alternative, charge off the amount that is considered uncollectible in accordance with the Bank’s written analysis of loan or lease impairment.  The Order also prevents the Bank from extending, directly or indirectly, any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, on whole or in part, “loss” or “doubtful” and is uncollected.  The Bank may not extend, directly or indirectly, any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been classified “substandard.”  These limitations do not apply if the Bank’s failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.

Asset Growth. While the Order is in effect, the Bank must notify the Supervisory Authorities at least 60 days prior to undertaking asset growth that exceeds 10% or more per year or initiating material changes in asset or liability composition.  The Bank’s asset growth cannot result in noncompliance with the capital maintenance provisions of the Order unless the Bank receives prior written approval from the Supervisory Authorities.

Restriction on Dividends and Other Payments. While the Order is in effect, the Bank cannot declare or pay dividends, pay bonuses, or pay any form of payment outside the ordinary course of business resulting in a reduction of capital without the prior written approval of the Supervisory Authorities.  In addition, the Bank cannot make any distributions of interest, principal, or other sums on subordinated debentures without prior written approval of the Supervisory Authorities.

Brokered Deposits. The Order provides that the Bank may not accept, renew, or roll over any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits.  These regulations prohibit undercapitalized institutions from accepting, renewing, or rolling over any brokered deposits and also prohibit undercapitalized institutions from soliciting deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in the institution’s market area. An “adequately capitalized” institution may not accept, renew, or roll over brokered deposits unless it has applied for and been granted a waiver by the FDIC.

Written Plans and Other Material Terms. Under the terms of the Order, the Bank is required to prepare and submit the following written plans or reports to the FDIC and the Commissioner:
     
 
·Plan to improve liquidity, contingency funding, interest rate risk, and asset liability management
     
 
·Plan to reduce assets of $250,000 or greater classified “doubtful” and “substandard”
     
 
·Revised lending and collection policy to provide effective guidance and control over the Bank’s lending and credit administration functions

     
·Effective internal loan review and grading system
 
     
·Policy for managing the Bank’s other real estate
 
     
·Business/strategic plan covering the overall operation of the Bank
 
     
·Plan and comprehensive budget for all categories of income and expense for the year 2011
 
     
·Policy and procedures for managing interest rate risk
 
     
·Assessment of the Bank’s information technology function
 
Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities. The Bank must also establish a board committee to monitor and coordinate compliance with the Order.

The Order will remain in effect until modified or terminated by the Supervisory Authorities.

While subject to the Consent Order, our management and board of directors have focused considerable time and attention on taking corrective actions to comply with the terms.  In addition, certain provisions of the Consent Order described above could adversely impact the Company’s businesses and results of operations.

Written Agreement – In June 2012, the Company entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of Richmond (“Reserve Bank”).  Under the terms of the Written Agreement, the Company agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans to maintain sufficient capital and correct any violations of section 23A of the Federal Reserve Act and Regulation W.  In addition, the Company will submit a written statement of its planned sources and uses of cash for debt service, operation expenses, and other purposes.

 
The Company also has agreed that it will not, without prior regulatory approval:
 
·
pay or declare any dividends;
 
·
take any other form of payment representing a reduction in Bank’s capital;
 
·
make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities;
 
·
incur, increase or guarantee any debt;
 
·
purchase or deem any shares of its stock.

Since entering into the Order and the Written Agreement, the Company has taken numerous steps to comply with the terms of the consent order.

Note 13.                      Stockholders’ equity and regulatory matters

On May 1, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008 (“EESA”), the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 14,738 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $4.00 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 499,029 shares of the Company’s common stock at an initial exercise price of $4.43 per share, subject to certain anti-dilution and other adjustments, for an aggregate purchase price of $14,738,000 in cash.  The fair value of the preferred stock was estimated using discounted cash flow methodology at an assumed market equivalent rate of 13%, with 20 quarterly payments over a five year period, and was determined to be $10,208,000.  The fair value of the warrant was estimated using the Black-Scholes option pricing model, with assumptions of 25% volatility, a risk-free rate of 2.03%, a yield of 6.162% and an estimated life of 5 years, and was determined to be $534,000.  The aggregate fair value for both the preferred stock and common stock warrants was determined to be $10,742,000 with 95% of the aggregate attributable to the preferred stock and 5% attributable to the common stock warrant.  Therefore, the $14,738,000 issuance was allocated with $14,006,000 being assigned to the preferred stock and $732,000 being allocated to the common stock warrant.  The difference between the $14,738,000 face value of the preferred stock and the amount allocated of $14,006,000 to the preferred stock is being accreted as a discount on the preferred stock using the effective interest rate method over five years.

The Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% until May 1, 2014 and 9% thereafter, unless the shares are redeemed by the Company.  The Preferred Stock is generally non-voting, other than on certain matters that could adversely affect the Preferred Stock.

The Warrant was immediately exercisable.  The Warrant provides for the adjustment of the exercise price and the number of shares of common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of common stock, and upon certain issuances of common stock at or below a specified price relative to the then-current market price of common stock.  The Warrant expires ten years from the issuance date.  Pursuant to the Purchase Agreement, the Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant.

As required by the Federal Reserve Bank of Richmond, the Company notified the U.S. Treasury in May 2011 that the Company was going to defer the payment of the quarterly cash dividend of $184,225 due on May 16, 2011, and subsequent quarterly payments, on the Fixed Rate Cumulative Perpetual Preferred Stock, Series A.  The total arrearage on such preferred stock as of December 31, 2012 is $1,381,688.  This amount has been accrued for and is included in other liabilities in the consolidated balance sheet.
 
 
In June 2012 the Treasury asked to allow an observer at the Company’s meetings of its board of directors.  The observer started attending board meetings in August 2012.  The Treasury has the contractual right to nominate up to two members to the board of directors upon the Company’s sixth missed dividend payment.  The Company has deferred six dividend payments as of December 31, 2012. However, Treasury has not indicated that it will nominate two directors to the board of directors.

The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements.  Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures are established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets, and of Tier 1 Capital to average assets (the Leverage ratio).

Federal regulatory agencies are required by law to adopt regulations defining five capital tiers: well capitalized, adequately capitalized, under capitalized, significantly under capitalized, and critically under capitalized. The Bank met the ratio criteria to be categorized as a “well capitalized” institution as of December 31, 2012, 2011 and 2010. However, due to the Consent Order the Bank is currently considered adequately capitalized.  In addition, the Consent Order requires the Bank to maintain a leverage ratio of at least 8% and a total capital to risk-weighted assets ratio of at least 11%.  At December 31, 2012, the Banks leverage ratio was 6.52% and the total capital to risk-weighted assets ratio was 10.04%.  As required by the Consent Order, the Bank has provided a capital plan to the FDIC and BFI that demonstrates how the Bank will come into compliance with the required minimum capital ratios set forth in the Consent Order.  When capital falls fellow the “well capitalized” requirement, consequences can include:  new branch approval could be withheld, more frequent examinations by the FDIC; brokered deposits cannot be renewed without a waiver from the FDIC; and other potential limitation as described in FDIC Rules and Regulations sections 337.6 and 303, and FDIC Act section 29.  In addition, the FDIC insurance assessment increases when an institution falls below the “well capitalized” classification.
 
 
The capital amounts and ratios at December 31, 2012 and 2011 for the Company and the Bank are presented in the table below:

               
For Capital
              
   
Actual
    
Adequacy Purposes
    
To be Well Capitalized (1)
  
   
Amount
    
Ratio
    
Amount
    
Ratio
    
Amount
    
Ratio
  
                                     
December 31, 2012
                                    
Total capital (to risk-
                                    
weighted assets)
                                    
Consolidated
   $ 38,296,000       10.14 %   $ 30,206,000       8.00 %   $ 37,757,000       10.00 %
Village Bank
     37,705,000       10.04 %     30,036,000       8.00 %     37,545,000       10.00 %
                                                 
Tier 1 capital (to risk-
                                                
weighted assets)
                                                
Consolidated
     32,936,000       8.72 %     15,103,000       4.00 %     22,654,000       6.00 %
Village Bank
     32,936,000       8.77 %     15,018,000       4.00 %     22,527,000       6.00 %
                                                 
Leverage ratio (Tier 1
                                                
capital to average
                                                
assets)
                                                
Consolidated
     32,936,000       6.53 %     20,186,000       4.00 %     25,233,000       5.00 %
Village Bank
     32,936,000       6.52 %     20,206,000       4.00 %     25,257,000       5.00 %
                                                 
December 31, 2011
                                                
Total capital (to risk-
                                                
weighted assets)
                                                
Consolidated
   $ 48,033,000       10.92 %   $ 35,190,000       8.00 %   $ 43,987,000       10.00 %
Village Bank
     44,530,000       10.26 %     34,711,000       8.00 %     43,389,000       10.00 %
                                                 
Tier 1 capital (to risk-
                                                
weighted assets)
                                                
Consolidated
     42,404,000       9.64 %     17,595,000       4.00 %     26,392,000       6.00 %
Village Bank
     38,975,000       8.98 %     17,356,000       4.00 %     26,033,000       6.00 %
                                                 
Leverage ratio (Tier 1
                                                
capital to average
                                                
assets)
                                                
Consolidated
     42,404,000       7.33 %     23,029,000       4.00 %     28,786,000       5.00 %
Village Bank
     38,975,000       6.46 %     24,150,000       4.00 %     30,188,000       5.00 %
                                                 

 
(1)
As a result of the consent order, the Bank is not considered well capitalized even though it meets the ratio requirements to be classified as such.  The consent order requires the total capital to risk-weighted assets to be at least 11% and the leverage ratio to be at least 8%.


The Company is currently prohibited by its Written Agreement with the Reserve Bank from making dividend or interest payments on the TARP program preferred stock or trust preferred capital notes without prior regulatory approval.  In addition, the Consent Order with the FDIC and BFI provides that the Bank will not pay any dividends, pay bonuses or make any other form of payment outside the ordinary course of business resulting in a reduction of capital, without regulatory approval.  At December 31, 2012, the Company’s total accrued but deferred payments on TARP dividends was $1,382,000 and interest payments on trust preferred capital notes was $663,379.  Although we elected to defer payment of the interest due, the amounts have been accrued in the consolidated balance sheet and included in interest expense in the consolidated statement of operations.

Note 14.                      Stock incentive plan

In accordance with accounting standards the Company measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions).  That cost is recognized over the period during which an employee is required to provide service in exchange for the award rather than disclosed in the financial statements.

 
The following table summarizes options outstanding under the stock incentive plan at the indicated dates:

   
Year Ended December 31,
  
   
2012
    
2011
  
         
Weighted
                      
Weighted
              
         
Average
                      
Average
              
         
Exercise
    
Fair Value
    
Intrinsic
          
Exercise
    
Fair Value
    
Intrinsic
  
   
Options
    
Price
    
Per Share
    
Value
    
Options
    
Price
    
Per Share
    
Value
  
                                                 
Options outstanding,
                                                
beginning of period
     264,980     $ 9.48     $ 4.70             310,205     $ 9.48     $ 4.73        
Granted
     5,000       1.00       1.08             -       -       -        
Forfeited
     (14,350 )     8.02       4.34             (45,225 )     8.50       4.88        
Exercised
     -       -       -             -       -       -        
Options outstanding,
                                                            
end of period
     255,630     $ 9.57     $ 4.65     $ -       264,980     $ 9.48     $ 4.70     $ -  
Options exercisable,
                                                                
end of period
     250,630                               261,980                          
                                                                 
                                                                 
                                                                 
   
Year Ended December 31,
                                  
     2010                                   
           
Weighted
                                                  
           
Average
                                                  
           
Exercise
    
Fair Value
    
Intrinsic
                                  
   
Options
    
Price
    
Per Share
    
Value
                                  
                                                                 
Options outstanding,
                                                                
beginning of period
     336,005     $ 9.58     $ 4.75                                          
Granted
     -       -       -                                          
Forfeited
     (25,800 )     10.77       5.02                                          
Exercised
     -       -       -                                          
Options outstanding,
                                                                
end of period
     310,205     $ 9.48     $ 4.73     $ -                                  
Options exercisable,
                                                                
end of period
     291,350                                                          


The fair value of each option granted is estimated on the date of grant using the Black-Sholes option pricing model with the following assumptions used for grants for the years indicated:

   
Year Ended
  
   
December 31, 2012
  
       
Risk-free interest rate
     1.82 %
Dividend yield
     0 %
Expected weighted average term
  
7 years
Volatility
     50 %


The following table summarizes information about stock options outstanding at December 31, 2012:

     
Outstanding
    
Exercisable
  
           
Weighted
                    
           
Average
                    
           
Remaining
    
Weighted
          
Weighted
  
           
Years of
    
Average
          
Average
  
Range of
    
Number of
    
Contractual
    
Exercise
    
Number of
    
Exercise
  
Exercise Prices
    
Options
    
Life
    
Price
    
Options
    
Price
  
                                 
$1.00-$6.00       69,355       3.3     $ 5.64       64,355     $ 5.64  
$7.68 - $9.24       12,000       0.1     $ 8.51       12,000       8.51  
$11.20 - $13.96       174,275       3.4       11.50       174,275       11.50  
                                             
          255,630       3.20       9.77       250,630       9.85  
 

During the first quarter of 2009, we granted to certain officers 26,592 restricted shares of common stock with a weighted average fair market value of $4.60 at the date of grant.  These restricted stock awards have three-year graded vesting.  Prior to vesting, these shares are subject to forfeiture to us without consideration upon termination of employment under certain circumstances.  The remaining balance of restricted stock has been issued as of December 31, 2012.  The total number of shares underlying non-vested restricted stock and performance share awards was 896 at December 31, 2011.

The fair value of the stock is calculated under the same methodology as stock options and the expense is recognized over the vesting period.  Unamortized stock-based compensation related to nonvested share based compensation arrangements granted under the Incentive Plan as of December 31, 2012 and 2011 was $2,492 and $6,344, respectively.  The time based unamortized compensation of $2,492 is expected to be recognized over a weighted average period of 2.58 years.  There were no forfeitures of restricted stock awards in 2012 and 2011.

Stock-based compensation expense was $6,747, $118,445 and $95,962 for the years ended December 31, 2012, 2011 and 2010, respectively.

Note 15.                      Trust preferred securities

During the first quarter of 2005, Southern Community Financial Capital Trust I, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On February 24, 2005, $5.2 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities have a LIBOR-indexed floating rate of interest (three-month LIBOR plus 2.15%) which adjusts, and is payable, quarterly. The interest rate was 2.46% and 2.71% at December 31, 2012 and 2011, respectively.  The securities were redeemable at par beginning on March 15, 2010 and each quarter after such date until the securities mature on March 15, 2035.  No amounts have been redeemed at December 31, 2012 and there are no plans to do so.  The principal asset of the Trust is $5.2 million of the Company’s junior subordinated debt securities with like maturities and like interest rates to the Trust Preferred Capital Notes.

During the third quarter of 2007, Village Financial Statutory Trust II, a wholly –owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On September 20, 2007, $3.6 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities have a five year fixed interest rate of 6.29% payable quarterly, converting after five years to a LIBOR-indexed floating rate of interest (three-month LIBOR plus 1.4%) which adjusts and is also payable quarterly.  The securities may be redeemed at par at any time commencing in December 2012 until the securities mature in 2037.  The principal asset of the Trust is $3.6 million of the Company’s junior subordinated securities with like maturities and like interest rates to the Trust Preferred Capital Notes.
 
 
The Trust Preferred Capital Notes may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion.  The portion of the Trust Preferred Capital Notes not considered as Tier 1 capital may be included in Tier 2 capital.
 
The obligations of the Company with respect to the issuance of the Trust Preferred Capital Notes constitute a full and unconditional guarantee by the Company of the Trust’s obligations with respect to the Trust Preferred Capital Notes.  Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Trust Preferred Capital Notes and require a deferral of common dividends.  In consideration of our agreements with our regulators, which require regulatory approval to make interest payments on these securities, the Company has deferred an aggregate of $663,379 in interest payments on the junior subordinated debt securities as of December 31, 2012.  The Company has been deferring interest payments since June 2011.  Although we elected to defer payment of the interest due, the amounts has been accrued in the consolidated balance sheet and included in interest expense in the consolidated statement of operations.

Note 16.                      Retirement plans

401K Plan:  The Bank provides a qualified 401K plan to all eligible employees which is administered through the Virginia Bankers Association Benefits Corporation.  Employees are eligible to participate in the plan after three months of employment.  Eligible employees may, subject to statutory limitations, contribute a portion of their salary to the plan through payroll deduction.  Due to the recent economic conditions the Bank ceased its matching program in 2009.  Prior to 2009 the Bank provided a matching contribution of $.50 for every $1.00 the participant contributes up to the first 4% of their salary.  Participants are fully vested in their own contributions and vest equally over three years of service in the Bank’s matching contributions.

Supplemental Executive Retirement Plan:  The Bank established the Village Bank Supplemental Executive Retirement Plan (the “SERP”) on January 1, 2005 to provide supplemental retirement income to certain executive officers as designated by the Personnel Committee and approved by the Board of Directors.  The SERP is an unfunded employee pension plan under the provisions of ERISA.  An eligible employee, once designated by the Committee and approved by the Board of Directors in writing to participate in the SERP, becomes a participant in the SERP 60 days following such approval (unless an earlier participation date is approved).  There are currently five executive officers who participate in the SERP.  The retirement benefit to be received by a participant is determined by the Committee and approved by the Board of Directors and is payable in equal monthly installments over a 15 year period, commencing on the first day of the month following a participant’s retirement or termination of employment, provided the participant has been employed by the Bank for a minimum of 10 years (6 years in the case of one participant).  The Personnel Committee, in its sole discretion, may choose to treat a participant who has experienced a termination of employment on or after attaining age 65 but prior to completing his service requirement as having completed his service requirement.  At December 31, 2012 and 2011, the Bank’s liability under the SERP was $1,205,921 and $1,078,342, respectively, and expense for the years ended December 31, 2012, 2011 and 2010 was to $140,575, $166,571 and $160,124, respectively.  The increase in cash surrender value of the BOLI related to the participants was $190,902, $193,540 and $440,763 for the years ended December 31, 2012, 2011 and 2010, respectively.

Directors’ Deferral Plan:  The Bank established the Village Bank Outside Directors Deferral Plan (the “Directors Deferral Plan”) on January 1, 2005 under which non-employee Directors of Village Bank have the opportunity to defer receipt of all or a portion of certain compensation until retirement or departure from the Board of Directors.  Deferral of compensation under the Directors Deferral Plan is voluntary by non-employee Directors and to participate in the plan a director must file a deferral election as provided in the plan.  A Director shall become an active participant with respect to a plan year (as defined in the plan) only if he is expected to have compensation during the plan year and he timely files a deferral election.  A separate account is established for each participant in
 
 
the plan and each account shall, in addition to compensation deferred at the election of the participant, be credited with interest on the balance of the account, the rate of such interest to be established by the Board of Directors in its sole discretion at the beginning of each plan year.  At December 31, 2012 and 2011, the Bank’s liability under the Directors Deferral Plan was $795,736 and $612,475, respectively, and expense for the years ended December 31, 2012, 2011 and 2010 was $181,419, $153,090 and $91,973, respectively.

Note 17.         Fair Value

Effective January 1, 2008, the Company adopted the provisions of FASB Codification Topic 820: Fair Value Measurements which defines fair value, establishes a framework for measuring fair value under U.S GAAP, and expands disclosures about fair value measurements.

FASB Codification Topic 820: Fair Value Measurements and Disclosures establishes a hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.  The fair values hierarchy is as follows:

 
·
Level 1 Inputs— Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 
·
Level 2 Inputs — Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 
·
Level 3 Inputs - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods to determine the fair value of each type of financial instrument:

Securities: Fair values for securities available-for-sale are obtained from an independent pricing service.  The prices are not adjusted.  The independent pricing service uses industry-standard models to price U.S. Government agency obligations and mortgage backed securities that consider various assumptions, including time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures.  Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating.  Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace (Levels 1 and 2).

Impaired loans: The fair values of impaired loans are measured for impairment using the fair value of the collateral for collateral-dependent loans on a nonrecurring basis.  Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable.  The vast majority of the Company’s collateral is real estate.  The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2).  However, if the collateral is a house or building in the process of construction or when economic or other circumstances dictate a need to obtain an updated appraisal of the property, then a Level 3 valuation is considered to measure the fair value.  The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data.  Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3).  Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
 
 
Real estate owned: Real estate owned assets are adjusted to fair value upon transfer of the loans to foreclosed assets.  Subsequently, real estate owned assets are carried at fair value less costs to sell. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets measured at fair value under Topic 820 on a recurring and non-recurring basis are summarized below:

   
Fair Value Measurement
  
   
at December 31, 2012 Using
  
   
(In thousands)
  
         
Quoted Prices
              
         
in Active
    
Other
    
Significant
  
         
Markets for
    
Observable
    
Unobservable
  
   
Carrying
    
Identical Assets
    
Inputs
    
Inputs
  
   
Value
    
(Level 1)
    
(Level 2)
    
(Level 3)
  
Financial Assets - Recurring
                        
US Government Agencies
   $ 11,387     $ 5,000     $ 6,387     $ -  
MBS
     1,829       -       1,829       -  
Municipals
     11,938       2,918       9,020       -  
Residential loans held for sale
     24,188       -       24,188       -  
                                 
Financial Assets - Non-Recurring
                                
Impaired loans
     54,775       -       47,016       7,759  
Real estate owned
     20,204       -       18,675       1,529  
                                 
                                 

   
Fair Value Measurement
  
   
at December 31, 2011 Using
  
   
(In thousands)
  
         
Quoted Prices
              
         
in Active
    
Other
    
Significant
  
         
Markets for
    
Observable
    
Unobservable
  
   
Carrying
    
Identical Assets
    
Inputs
    
Inputs
  
   
Value
    
(Level 1)
    
(Level 2)
    
(Level 3)
  
Financial Assets - Recurring
                        
US Government Agencies
   $ 2,001     $ -     $ 2,001     $ -  
MBS
     20,803       2,849       17,954       -  
Small Business Administration
     7,359       7,359       -       -  
Residential loans held for sale
     16,168       -       16,168       -  
                                 
Financial Assets - Non-Recurring
                                
Impaired loans
     64,655       -       51,868       12,787  
Real estate owned
     9,177       -       874       8,303  

 
The following table presents the changes in the Level 3 fair value category for the years ended December 31, 2012 and 2011.

   
Impaired
    
Real Estate
        
   
Loans
    
Owned
    
Total Assets
  
   
(In thousands)
  
                   
                   
Balance at December 31, 2010
   $ 7,944     $ 12,028     $ 19,972  
Total realized and unrealized gains (losses)
                        
Included in earnings
     -       267       267  
Included in other comprehensive income
     -       -       -  
Net transfers in and/or out of Level 3
     56,711       (3,118 )     53,593  
                         
Balance at December 31, 2011
     64,655       9,177       73,832  
                         
Total realized and unrealized gains (losses)
                        
Included in earnings
     -       241       241  
Included in other comprehensive income
     -       -       -  
Net transfers in and/or out of Level 3
     (56,896 )     (7,889 )     (64,785 )
                         
Balance at December 31, 2012
   $ 7,759     $ 1,529     $ 9,288  



In general, fair value of securities is based upon quoted market prices, where available.  If such quoted market prices are not available, fair value is based upon market prices determined by an outside, independent entity that primarily uses as inputs, observable market-based parameters.  Fair value of loans held for sale is based upon internally developed models that primarily use as inputs, observable market-based parameters.  Valuation adjustments may be made to ensure that financial instruments are recorded at fair value.  These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters.  Any such valuation adjustments are applied consistently over time.  The Company valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.  While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.  Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and or quarter valuation process.

Cash and cash equivalents – The carrying amount of cash and cash equivalents approximates fair value.

Investment securities – The fair value of investment securities held-to-maturity and available-for-sale is estimated based on quoted prices for similar assets or liabilities determined by bid quotations received from independent pricing services.  The carrying amount of other investments approximates fair value.

Loans – For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.  For all other loans, fair values are calculated by discounting the contractual cash flows using estimated market discount rates which reflect the credit and interest rate risk inherent in the loans, or by using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Deposits – The fair value of deposits with no stated maturity, such as demand, interest checking and money market, and savings accounts, is equal to the amount payable on demand at year-end.  The fair value of certificates of deposit is based on the discounted value of contractual cash flows using the rates currently offered for deposits of similar remaining maturities.

 
Borrowings – The fair value of borrowings is based on the discounted value of contractual cash flows using the rates currently offered for borrowings of similar remaining maturities.

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

     
December 31,
    
December 31,
  
     
2012
    
2011
  
 
Level in Fair
                        
 
Value
  
Carrying
    
Estimated
    
Carrying
    
Estimated
  
 
Hierarchy
  
Value
    
Fair Value
    
Value
    
Fair Value
  
                           
Financial assets
                          
Cash
Level 1
   $ 13,945,105     $ 13,945,105     $ 55,557,541     $ 55,557,541  
Cash equivalents
Level 2
     39,185,837       39,185,837       7,228,475       7,228,475  
Investment securities available for sale
Level 1
     7,918,420       7,918,420       10,207,805       10,207,805  
Investment securities available for sale
Level 2
     17,235,626       17,235,626       19,955,487       19,955,487  
Federal Home Loan Bank stock
Level 2
     2,121,900       2,121,900       2,647,000       2,647,000  
Loans held for sale
Level 2
     24,188,384       24,188,384       16,168,405       16,168,405  
Loans
Level 2
     290,115,508       293,170,670       353,186,646       353,349,981  
Impaired loans
Level 2
     47,016,065       47,016,065       51,867,625       51,867,625  
Impaired loans
Level 3
     7,758,689       7,758,689       12,787,473       12,787,473  
Other real estate owned
Level 2
     18,675,164       18,675,164       874,246       874,246  
Other real estate owned
Level 3
     1,528,527       1,528,527       8,302,921       8,302,921  
Bank owned life insurance
Level 3
     6,575,018       6,575,018       6,065,305       6,065,305  
Accrued interest receivable
Level 2
     1,676,518       1,676,518       2,046,524       2,046,524  
                                   
Financial liabilities
                                  
Deposits
Level 2
     436,322,962       437,644,329       485,521,052       487,915,609  
FHLB borrowings
Level 2
     28,000,000       28,424,029       37,750,000       37,963,672  
Trust preferred securities
Level 2
     8,764,000       7,537,040       8,764,000       7,537,040  
Other borrowings
Level 2
     4,851,811       4,851,811       5,778,661       5,778,661  
Accrued interest payable
Level 2
     911,635       911,635       592,283       592,283  




Note 18.                      Parent corporation only financial statements

Village Bank and Trust Financial Corp.
  
(Parent Corporation Only)
  
Balance Sheet
  
             
             
   
December 31,
    
December 31,
  
   
2012
    
2011
  
Assets
            
Cash and due from banks
   $ 595,267     $ 2,181,281  
Investment in subsidiaries
     33,162,750       40,304,299  
Investment in special purpose subsidiary
     264,000       264,000  
Premises and equipment, net
     1,774,252       1,783,432  
Prepaid expenses and other assets
     56,904       5,071,426  
                 
    $ 35,853,173     $ 49,604,438  
                 
Liabilities and Stockholders' Equity
                
Liabilities
                
Balance due to nonbank subsidiaries
   $ 8,764,000     $ 8,764,000  
Payable to subsidiary
     -       -  
Other liabilities
     2,124,372       4,592,796  
Total liabilities
     10,888,372       13,356,796  
                 
Stockholders' equity
                
Preferred stock
     58,952       58,952  
Warrant surplus
     732,479       732,479  
Discount on preferred stock
     (198,993 )     (346,473 )
      592,438       444,958  
Surplus related to PS (CPP)
     14,679,048       14,679,048  
Additional paid-in capital
     26,026,209       26,053,130  
      40,705,257       40,732,178  
Common stock
     17,007,180       16,973,512  
Retained earnings (deficit)
     (33,173,525 )     (21,895,557 )
Accumulated other comprehensive
             -  
  Income (loss)
     (166,549 )     (7,449 )
Total stockholders' equity
     24,964,801       36,247,642  
                 
    $ 35,853,173     $ 49,604,438  
                 








Village Bank and Trust Financial Corp.
  
(Parent Corporation Only)
  
Statement of Operations
  
Years Ended December 31, 2012, 2011 and 2010
  
                   
                   
   
2012
    
2011
    
2010
  
                   
Interest income
                  
Village Bank money market
   $ 7,923     $ 20,897     $ 2,554  
                         
Interest expense
                        
Interest on trust preferred securities
     403,997       353,108       -  
                         
Net interest (loss), income
     (396,074 )     (332,211 )     2,554  
                         
Noninterest income
                        
Rental income
     -       -       871,600  
Other income
     -       -       25,872  
Total noninterest income
     -       -       897,472  
                         
Expenses
                        
Interest
                     910,009  
Occupancy
                     565,463  
Equipment
     7,134       20,148       25,119  
Advertising and marketing
     -       -       1,078  
Supplies
     49,924       16,000       48,825  
Legal
     -       -       4,795  
Other outside services
     19,965       11,316       66,820  
Insurance
     -       -       12,431  
Other
     25,212       27,024       28,958  
Total expenses
     102,235       74,488       1,663,498  
                         
Net loss before undistributed equity in subsidiary
     (498,309 )     (406,699 )     (763,472 )
                         
Undistributed equity in subsidiary
     (8,489,198 )     (10,546,079 )     1,917,569  
                         
Net income before income tax benefit
     (8,987,507 )     (10,952,778 )     1,154,097  
Income tax benefit
     1,411,493       867,344       (276,212 )
                         
Net income (loss)
   $ (10,399,000 )   $ (11,820,122 )   $ 1,430,309  
                         
Total comprehensive income
   $ (10,558,100 )   $ (11,454,097 )   $ 1,113,040  




Village Bank and Trust Financial Corp.
  
(Parent Corporation Only)
  
Statement of Cash Flows
  
Years Ended December 31, 2012, 2011 and 2010
  
                   
                   
   
2012
    
2011
    
2010
  
Cash Flows from Operating Activities
                  
Net loss
   $ (10,399,000 )   $ (11,820,122 )   $ 1,430,309  
Adjustments to reconcile net income to net cash
                        
provided by operating activities
                        
Depreciation and amortization
     9,180       16,366       14,525  
Undistributed earnings of subsidiary
     8,489,198       10,546,079       (1,917,569 )
(Increase) decrease in other assets
     5,014,522       (703,922 )     1,847,606  
Increase (decrease) in other liabilities
     (2,468,426 )     601,180       (553,518 )
Net cash provided by operations
     645,474       (1,360,419 )     821,363  
                         
                         
Cash Flows from Investing Activities
                        
Payments for investments in and advances to subsidiaries
     (1,500,000 )     -       -  
Proceeds from sale of premises and equipment
     -       -       12,750,000  
Net cash provided by operations
     (1,500,000 )     -       12,750,000  
                         
                         
Cash Flows from Financing Activities
                        
Net increase (decrease) in other borrowings
                     (11,943,873 )
Dividends on preferred stock
     (731,488 )     (184,225 )     (736,899 )
Net cash provided by operations
     (731,488 )     (184,225 )     (12,680,772 )
                         
Net increase (decrease) in cash
     (1,586,014 )     (1,544,644 )     890,591  
Cash, beginning of period
     2,181,281       3,725,925       2,835,344  
                         
Cash, end of period
   $ 595,267     $ 2,181,281     $ 3,725,935  
                         
                         



Note 19.                      Selected quarterly financial data (unaudited)

Condensed quarterly financial data is shown as follows:

   
First
    
Second
    
Third
    
Fourth
  
   
Quarter
    
Quarter
    
Quarter
    
Quarter
  
2012
                        
Interest income
   $ 6,070,489     $ 5,841,080     $ 5,667,181     $ 6,120,513  
Interest expense
     1,649,888       1,489,600       1,450,807       1,406,665  
Net interest income before
                                
provision for loan losses
     4,420,601       4,351,480       4,216,374       4,713,848  
Provision for loan losses
     1,735,000       6,660,000       700,000       -  
Gain on sale of loans
     1,750,663       2,191,229       2,394,138       2,225,743  
Fees and other noninterest
                                
income
     984,391       943,900       1,634,744       1,214,490  
Noninterest expenses
     6,821,035       6,680,967       7,751,018       7,037,724  
Income tax (benefit)
     -       3,881,914       161,315       11,628  
Net income (loss)
     (1,400,380 )     (9,736,272 )     (367,077 )     1,104,729  
Earnings per share
                                
Basic
   $ (0.38 )   $ (2.33 )   $ (0.14 )   $ 0.20  
Diluted
   $ (0.38 )   $ (2.33 )   $ (0.14 )   $ 0.20  
                                 
2011
                                
Interest income
   $ 7,359,417     $ 7,140,700     $ 6,962,527     $ 6,517,854  
Interest expense
     2,321,567       2,202,478       1,999,984       1,821,874  
Net interest income before
                                
provision for loan losses
     5,037,850       4,938,222       4,962,543       4,695,980  
Provision for loan losses
     1,003,000       900,000       9,507,884       7,353,411  
Gain on sale of loans
     1,372,678       1,636,240       1,724,730       1,789,200  
Fees and other noninterest
                                
income
     682,530       769,625       925,650       1,943,128  
Noninterest expenses
     5,897,938       6,054,949       6,021,320       5,986,869  
Income tax (benefit)
     109,400       132,306       (2,671,536 )     2,002,957  
Net income (loss)
     82,720       256,832       (5,244,745 )     (6,914,929 )
Earnings per share
                                
Basic
   $ (0.03 )   $ 0.01     $ (1.29 )   $ (1.68 )
Diluted
   $ (0.03 )   $ 0.01     $ (1.29 )   $ (1.68 )






None.



Disclosure Controls and Procedures. The Company, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that as of December 31, 2012, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and regulations and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that the Company’s disclosure controls and procedures will detect or uncover every situation involving the failure of persons within the Company or its subsidiaries to disclose material information otherwise required to be set forth in the Company’s periodic reports.
 
Management’s Report on Internal Control over Financial Reporting. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934.  The Company’s internal control over financial reporting is designed to provide reasonable assurance to the Company’s management and board of directors regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
 
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012.  In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework.  Based on our assessment, we believe that, as of December 31, 2012, the Company’s internal control over financial reporting was effective based on those criteria.

Changes in Internal Control Over Financial Reporting.  There has been no change in the Company’s internal control over financial reporting during the fourth quarter of the fiscal year ended December 31, 2012 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.



Report on Management’s Assessment of Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting.  Internal control is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.  Management regularly monitors its internal control over financial reporting and takes appropriate action to correct any deficiencies that may be identified.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Further, because of changes in conditions, internal control effectiveness may vary over time.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

   
/s/  Thomas W. Winfree
  
President and Chief Executive Officer
   
   
/s/  C. Harril Whitehurst, Jr.
  
Senior Vice President and Chief Financial Officer
   
   
March 26, 2013
  
Date



None.





The information required to be disclosed in this Item 10 is contained in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders and is incorporated herein by reference.



The information required to be disclosed in this Item 11 is contained in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders and is incorporated herein by reference.



The information required to be disclosed in this Item 12 is contained in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders and is incorporated herein by reference.



The information required to be disclosed in this Item 13 is contained in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders and is incorporated herein by reference.



The information required to be disclosed in this Item 14 is contained in the Company’s Proxy Statement for the 2013 Annual Meeting of Shareholders and is incorporated herein by reference.








(a)(1) Financial Statements
The following consolidated financial statements and reports are included in Part II, Item 8, of this report on Form 10K.

Report of Independent Registered Public Accounting Firm (BDO Seidman)
Consolidated Balance Sheets – December 31, 2012 and 2011
Consolidated Statements of Income – Years Ended December 31, 2012, 2011 and 2010 Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income – Years
Ended December 31, 2012, 2011 and 2010
Consolidated Statements of Cash Flows – Years Ended December 31, 2012, 2011 and 2010
Notes to Consolidated Financial Statements

(a)(2) Financial Statement Schedules
All schedules are omitted since they are not required, are not applicable, or the required information is shown in the consolidated financial statements or notes thereto.

(a)(3) Exhibits
The following exhibits are filed as part of this Form 10-K and this list includes the Exhibit Index.
 
 
Exhibit
  
Number
Description
   
3.1
Articles of Incorporation of Village Bank and Trust Financial Corp. restated in electronic format only as of May 18, 2005.
   
3.2
Articles of Amendment to the Company’s Articles of Incorporation, designating the terms of the Fixed Rate Cumulative Perpetual Preferred Stock, Series A, incorporated by reference to Exhibit 3.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009
   
3.3
Bylaws of Village Bank and Trust Financial Corp., incorporated by reference to Exhibit 3.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on December 10, 2007.
   
4.1
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A, incorporated by reference to Exhibit 4.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
4.2
Warrant to Purchase Shares of Common Stock, dated May 1, 2009, incorporated by reference to Exhibit 4.2 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.1
Incentive Plan, as amended and restated May 23, 2006, incorporated by reference to Exhibit 10.1 of the Quarterly Report on Form 10-QSB for the period ended June 30, 2006.*
   
10.2
Executive Employment Agreement, effective as of April 1, 2001, between Thomas W. Winfree and Southern Community Bank & Trust, incorporated by reference to Exhibit 10.4 of the Annual Report on Form 10-KSB for the year ended December 31, 2004.*
 
 
10.3
Form of Incentive Stock Option Agreement, incorporated by reference to Exhibit 10.5 of the Annual Report on Form 10-KSB for the year ended December 31, 2004.*
   
10.4
Form of Non-Employee Director Non-Qualified Stock Option Agreement, incorporated by reference to Exhibit 10.6 of the Annual Report on Form 10-KSB for the year ended December 31, 2004. *
   
10.5
Letter Agreement, dated as of May 1, 2009, by and between Village Bank and Trust Financial Corp. and the United States Department of the Treasury, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.6
Side Letter Agreement, dated as of May 1, 2009, by and between Village Bank and Trust Financial Crop. and the United States Department of the Treasury, incorporated by reference to Exhibit 10.2 of the Current Report of Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.7
Form of Senior Executive Officer Waiver, incorporated by reference to Exhibit 10.3 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.*
   
10.8
Form of Senior Executive Officer Consent Letter, incorporated by reference to Exhibit 10.4 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.*
   
10.9
Outside Directors Deferral Plan, dated January 1, 2005, incorporated by reference to Exhibit 10.9 of the Annual Report on Form 10-K for the year ended December 31, 2010.*
   
10.10
Supplemental Executive Retirement Plan, dated January 1, 2005, incorporated by reference to Exhibit 10.10 of the Annual Report on Form 10-K for the year ended December 31, 2010.*
   
10.11
Stipulation and Consent to the Issuance of a Consent Order, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2012.
   
10.12
Consent Order, incorporated by reference to Exhibit 10.2 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2012.
 
   
10.13 Written Agreement by and between Village Bank and Trust Financial Corp. and the Federal Reserve Bank of Richmond, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on July 2, 2012.
   
21
Subsidiaries of Village Bank and Trust Financial Corp.
   
23.1
Consent of Independent Registered Public Accounting Firm.
   
 
 
31.1
Section 302 Certification by Chief Executive Officer.
   
31.2
Section 302 Certification by Chief Financial Officer.
   
32
Section 906 Certification.
   
99.1
TARP Certification by Chief Executive Officer.
   
99.2
TARP Certification by Chief Financial Officer.
   
101
The following materials from the Village Bank and Trust Financial Crop.  Annual Report on Form 10-K for the year ended December 31, 2012 formatted in eXtensible Business Reporting (XBRL) (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Changes in Comprehensive Income (Loss), (iv) Consolidated Statements of Stockholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Condensed Consolidated Financial Statements
   
* Management contracts and compensatory plans and arrangements.




Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
VILLAGE BANK AND TRUST FINANCIAL CORP.
       
       
       
Date:  March 26, 2013
By:
 /s/ Thomas W. Winfree
  
 
 
Thomas W. Winfree
  
 
 
President and Chief Executive Officer

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature
 
 
Title
Date
 
/s/ Thomas W. Winfree
President and Chief Executive
March 26, 2013
Thomas W. Winfree
 
 
Officer and Director
(Principal Executive Officer)
  
/s/ C. Harril Whitehurst, Jr.
Senior Vice President and Chief
March 26, 2013
C. Harril Whitehurst, Jr.
 
 
Financial Officer (Principal Financial and Accounting Officer)
  
/s/ R.T. Avery, III
Director
March 26, 2013
R.T. Avery, III
 
 
    
/s/ Donald J. Balzer, Jr.
Director and
March 26, 2013
Donald J. Balzer, Jr.
 
 
Vice Chairman of the Board
 
  
/s/ Craig D. Bell
Director and
March 26, 2013
Craig D. Bell
 
 
Chairman of the Board
 
  
/s/ William B. Chandler
Director
March 26, 2013
William B. Chandler
 
 
    
/s/ R. Calvert Esleeck, Jr.
Director
March 26, 2013
R. Calvert Esleeck, Jr.
 
 
    
/s/ George R. Whittemore
Director
March 26, 2013
George R. Whittemore
 
 
    
/s/ Michael L Toalson
Director
March 26, 2013
Michael L. Toalson
    

Signature
 
 
Title
Date
 
/s/ O. Woodland Hogg, Jr.
 
Director
 
March 26, 2013
O. Woodland Hogg, Jr.
 
 
    
/s/ Michael A. Katzen
Director
March 26, 2013
Michael A. Katzen
 
 
    
/s/ Charles E. Walton
Director
March 26, 2013
Charles E. Walton
 
 
    
/s/ John T. Wash, Sr.
Director
March 26, 2013
John T. Wash, Sr.
    










EXHIBIT LIST

Exhibit
  
Number
Description
   
3.1
Articles of Incorporation of Village Bank and Trust Financial Corp. restated in electronic format only as of May 18, 2005.
   
3.2
Articles of Amendment to the Company’s Articles of Incorporation, designating the terms of the Fixed Rate Cumulative Perpetual Preferred Stock, Series A, incorporated by reference to Exhibit 3.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009
   
3.3
Bylaws of Village Bank and Trust Financial Corp., incorporated by reference to Exhibit 3.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on December 10, 2007.
   
4.1
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A, incorporated by reference to Exhibit 4.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
4.2
Warrant to Purchase Shares of Common Stock, dated May 1, 2009, incorporated by reference to Exhibit 4.2 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.1
Incentive Plan, as amended and restated May 23, 2006, incorporated by reference to Exhibit 10.1 of the Quarterly Report on Form 10-QSB for the period ended June 30, 2006.*
   
10.2
Executive Employment Agreement, effective as of April 1, 2001, between Thomas W. Winfree and Southern Community Bank & Trust, incorporated by reference to Exhibit 10.4 of the Annual Report on Form 10-KSB for the year ended December 31, 2004.*
   
10.3
Form of Incentive Stock Option Agreement, incorporated by reference to Exhibit 10.5 of the Annual Report on Form 10-KSB for the year ended December 31, 2004.*
   
10.4
Form of Non-Employee Director Non-Qualified Stock Option Agreement, incorporated by reference to Exhibit 10.6 of the Annual Report on Form 10-KSB for the year ended December 31, 2004. *
   
10.5
Letter Agreement, dated as of May 1, 2009, by and between Village Bank and Trust Financial Corp. and the United States Department of the Treasury, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.6
Side Letter Agreement, dated as of May 1, 2009, by and between Village Bank and Trust Financial Crop. and the United States Department of the Treasury, incorporated by reference to Exhibit 10.2 of the Current Report of Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.
   
10.7
Form of Senior Executive Officer Waiver, incorporated by reference to Exhibit 10.3 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.*
 
 
   
10.8
Form of Senior Executive Officer Consent Letter, incorporated by reference to Exhibit 10.4 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on May 6, 2009.*
   
10.9
Outside Directors Deferral Plan, dated January 1, 2005, incorporated by reference to Exhibit 10.9 of the Annual Report on Form 10-K for the year ended December 31, 2010.*
   
10.10
Supplemental Executive Retirement Plan, dated January 1, 2005, incorporated by reference to Exhibit 10.10 of the Annual Report on Form 10-K for the year ended December 31, 2010.*
   
10.11
Stipulation and Consent to the Issuance of a Consent Order, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2012.
   
10.12
Consent Order, incorporated by reference to Exhibit 10.2 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on February 9, 2012.
 
10.13 Written Agreement by and between Village Bank and Trust Financial Corp. and the Federal Reserve Bank of Richmond, incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed with the Securities and Exchange Commission on July 2, 2012.
   
21
Subsidiaries of Village Bank and Trust Financial Corp.
   
23.1
Consent of Independent Registered Public Accounting Firm.
 
31.1
Section 302 Certification by Chief Executive Officer.
   
31.2
Section 302 Certification by Chief Financial Officer.
   
32
Section 906 Certification.
   
99.1
TARP Certification by Chief Executive Officer.
   
99.2
TARP Certification by Chief Financial Officer.
   
101
The following materials from the Village Bank and Trust Financial Crop.  Annual Report on Form 10-K for the year ended December 31, 2012 formatted in eXtensible Business Reporting (XBRL) (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Changes in Comprehensive Income (Loss), (iv) Consolidated Statements of Stockholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Condensed Consolidated Financial Statements
   
* Management contracts and compensatory plans and arrangements.