Edgar Filing: First Federal of Northern Michigan Bancorp, Inc.

Unassociated Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2011

¨	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___________________________ to ___________________________

Commission File Number 000-31957

FIRST FEDERAL OF NORTHERN MICHIGAN BANCORP, INC.

(Exact name of registrant as specified in its charter)

Maryland		32-0135202
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

100 S. Second Avenue, Alpena, Michigan 49707

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (989) 356-9041

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

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

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

Large accelerated filer ¨		Accelerated filer ¨
Non-accelerated filer ¨		Smaller reporting company x
(Do not check if a smaller reporting company)

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

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

Common Stock, Par Value $0.01		Outstanding at August 10, 2011
(Title of Class)		2,884,049 shares

FIRST FEDERAL OF NORTHERN MICHIGAN BANCORP, INC.

FORM 10-Q

Quarter Ended June 30, 2011

INDEX

	PAGE
PART I – FINANCIAL INFORMATION
ITEM 1 - UNAUDITED FINANCIAL STATEMENTS
Consolidated Balance Sheet at June 30, 2011 and December 31, 2010	3
Consolidated Statements of Income for the Three and Six Months Ended June 30, 2011 and June 30, 2010	4
Consolidated Statement of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2011	5
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and June 30, 2010	6
Notes to Unaudited Consolidated Financial Statements	7

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	25

ITEM 3 – QUANTITATIVE AND QUALITIATIVE DISCLOSURES ABOUT MARKET RISK	32

ITEM 4 - CONTROLS AND PROCEDURES	32

Part II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS	33
ITEM 1A - RISK FACTORS	33
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	33
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES	33
ITEM 4 - (REMOVED AND RESERVED)	33
ITEM 5 - OTHER INFORMATION	33
ITEM 6 - EXHIBITS	33
Section 302 Certifications
Section 906 Certifications

When used in this Form 10-Q or future filings by First Federal of Northern Michigan Bancorp, Inc. (the “Company”) with the Securities and Exchange Commission ("SEC"), in the Company's press releases or other public or stockholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases "would be," "will allow," "intends to," "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project," or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995.

The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including regional and national economic conditions, changes in levels of market interest rates, credit and other risks of lending and investment activities and competitive and regulatory factors, could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from those anticipated or projected.

The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

First Federal of Northern Michigan Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheet

	June 30, 2011			December 31, 2010
	(Unaudited)
ASSETS
Cash and cash equivalents:
Cash on hand and due from banks	$	3,951,713		$	1,889,999
Overnight deposits with FHLB		34,756			72,658
Total cash and cash equivalents		3,986,469			1,962,657
Securities AFS		47,671,712			35,301,238
Securities HTM		2,485,000			2,520,000
Loans held for sale		550,613			-
Loans receivable, net of allowance for loan losses of $2,190,949 and $2,831,332 as of June 30, 2011 and December 31, 2010, respectively		144,825,894			157,143,918
Foreclosed real estate and other repossessed assets		4,625,417			2,818,343
Federal Home Loan Bank stock, at cost		3,266,100			3,775,400
Premises and equipment		5,924,907			6,026,793
Accrued interest receivable		1,158,565			1,230,938
Intangible assets		481,081			627,306
Prepaid FDIC premiums		852,890			967,143
Deferred tax asset		471,751			659,194
Other assets		2,623,837			2,700,034
Total assets	$	218,924,236		$	215,732,964

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits	$	156,110,486		$	155,465,896
Advances from borrowers for taxes and insurance		370,215			130,030
Federal Home Loan Bank Advances		32,000,000			29,000,000
REPO Sweep Accounts		4,847,231			6,172,362
Accrued expenses and other liabilities		1,530,196			1,728,735

Total liabilities		194,858,128			192,497,023

Stockholders' equity:
Common stock ($0.01 par value 20,000,000 shares authorized 3,191,799 shares issued)		31,918			31,918
Additional paid-in capital		23,851,341			23,822,152
Retained earnings		2,661,488			2,238,064
Treasury stock at cost (307,750 shares)		(2,963,918	)		(2,963,918	)
Unearned compensation		(556	)		(38,382	)
Accumulated other comprehensive income		485,835			146,107
Total stockholders' equity		24,066,108			23,235,941

Total liabilities and stockholders' equity	$	218,924,236		$	215,732,964

See accompanying notes to consolidated financial statements.

First Federal of Northern Michigan Bancorp, Inc. and Subsidiaries

Consolidated Statement of Income

	For the Three Months						For the Six Months
	Ended June 30,						Ended June 30,
	2011			2010			2011			2010
	(Unaudited)						(Unaudited)
Interest income:
Interest and fees on loans	$	2,317,197		$	2,552,986		$	4,590,517		$	5,093,399
Interest and dividends on investments
Taxable		134,402			106,843			229,217			239,406
Tax-exempt		40,011			58,455			80,339			111,267
Interest on mortgage-backed securities		199,702			165,313			383,068			321,846
Total interest income		2,691,312			2,883,597			5,283,141			5,765,918

Interest expense:
Interest on deposits		407,875			601,733			845,128			1,239,557
Interest on borrowings		172,681			298,657			340,755			617,239
Total interest expense		580,556			900,390			1,185,883			1,856,796

Net interest income		2,110,756			1,983,207			4,097,258			3,909,122
Provision for loan losses		(19,238	)		594,840			48,120			605,928
Net interest income after provision for loan losses		2,129,994			1,388,367			4,049,138			3,303,194

Non-interest income:
Service charges and other fees		181,228			199,340			345,719			403,514
Mortgage banking activities		182,463			315,223			418,446			563,315
Gain on sale of investments		-			447,387			-			496,817
Net gain (loss) on sale of premises and equipment, real estate owned and other repossessed assets		(37,756	)		42,691			(46,431	)		53,867
Other		67,048			260,723			124,601			326,336
Total non-interest income		392,983			1,265,364			842,335			1,843,849

Non-interest expense:
Compensation and employee benefits		1,159,252			1,194,299			2,328,188			2,365,241
FDIC Insurance Premiums		51,170			94,348			122,387			188,548
Advertising		33,817			36,103			56,838			55,992
Occupancy		267,652			288,237			537,694			600,813
Amortization of intangible assets		73,112			73,112			146,225			146,225
Service bureau charges		79,292			86,114			155,498			165,696
Professional services		133,570			149,091			221,147			252,202
Other		462,389			515,103			900,072			850,786
Total non-interest expense		2,260,254			2,436,407			4,468,049			4,625,503

Income before income tax benefit		262,723			217,324			423,424			521,540
Income tax benefit		-			(101,913	)		-			-

Net Income	$	262,723		$	319,237		$	423,424		$	521,540

Per share data:
Net income per share
Basic	$	0.09		$	0.11		$	0.15		$	0.18
Diluted	$	0.09		$	0.11		$	0.15		$	0.18
Weighted average number of shares outstanding
Basic and diluted		2,884,049			2,884,249			2,884,049			2,884,249
Dividends per common share	$	-		$	-		$	-		$	-
See accompanying notes to consolidated financial statements.

First Federal of Northern Michigan Bancorp Inc. and Subsidiaries

Consolidated Statement of Changes in Stockholders' Equity (Unaudited)

													Accumulated
						Additional							Other
	Common		Treasury			Paid-in		Unearned			Retained		Comprehensive
	Stock		Stock			Capital		Compensation			Earnings		Income		Total

Balance at December 31, 2010	$	31,918	$	(2,963,918	)	$	23,822,152	$	(38,382	)	$	2,238,064	$	146,107	$	23,235,941

Treasury Stock at Cost		-		-			-		-			-		-		-

Stock-based compensation		-		-			29,189		37,826			-		-		67,015

Net income for the period		-		-			-		-			423,424		-		423,424

Change in unrealized gain:
on available-for-sale securities (net of tax of $175,011)		-		-			-		-			-		339,728		339,728

Total comprehensive income		-		-			-		-			-		-		763,152

Balance at June 30, 2011	$	31,918	$	(2,963,918	)	$	23,851,341	$	(556	)	$	2,661,488	$	485,835	$	24,066,108

See accompanying notes to the consolidated financial statements.

First Federal of Northern Michigan Bancorp, Inc. and Subsidiaries
Consolidated Statement of Cash Flows
	For Six Months Ended
	June 30,
	2011			2010
	(Unaudited)
Cash Flows from Operating Activities:
Net income	$	423,424		$	521,540
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		360,115			410,565
Provision for loan loss		48,120			605,928
Amortization and accretion on securities		133,688			60,794
Gain on sale of investment securities		-			(496,817	)
Stock-based compensation		67,015			109,429
Gain on sale of loans held for sale		(162,421	)		(225,014	)
Originations of loans held for sale		(11,516,189	)		(17,133,098	)
Proceeds from sale of loans held for sale		11,127,997			16,639,206
Gain on sale of fixed assets		(990	)		(9,423	)
Net change in
Accrued interest receivable		72,373			132,706
Other assets		568,753			867,161
Prepaid FDIC insurance premiums		114,253			179,338
Deferred income tax expense (benefit)		187,443			(84,193	)
Accrued expenses and other liabilities		(198,539	)		194,306

Net cash provided by operating activities		1,225,042			1,772,428

Cash Flows from Investing Activities:
Net decrease in loans (loans originated, net of principal payments)		9,795,262			6,787,517
Proceeds from maturity and sale of available-for-sale securities		3,374,182			19,558,755
Proceeds from sale of property and equipment		1,480			30,874
Purchase of securities		(15,328,604	)		(18,604,083	)
Purchase of premises and equipment		(112,494	)		(11,086	)
Proceeds from sale of Federal Home Loan Bank Stock		509,300			-
Net cash (used for) provided by investing activities		(1,760,874	)		7,761,977

Cash Flows from Financing Activities:
Net increase/(decrease) in deposits		644,590			(273,222	)
Net decrease in Repo Sweep accounts		(1,325,131	)		(162,167	)
Net increase in advances from borrowers		240,185			268,295
Advances from Federal Home Loan Bank and notes payable		7,350,000			11,925,000
Repayments of Federal Home Loan Bank advances and notes payable		(4,350,000	)		(18,955,927	)
Net cash provided by (used for) financing activities		2,559,644			(7,198,021	)

Net increase in cash and cash equivalents		2,023,812			2,336,384
Cash and cash equivalents at beginning of period		1,962,657			3,099,058
Cash and cash equivalents at end of period	$	3,986,469		$	5,435,442

Supplemental disclosure of cash flow information:
Cash paid during the period for
Interest	$	1,203,998		$	1,929,931
Income taxes		-			-
Transfers of loans to foreclosed real estate and repossessed assets		2,474,642			208,902

See accompanying notes to the consolidated financial statements.

FIRST FEDERAL OF NORTHERN MICHIGAN BANCORP, INC.

AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1—BASIS OF FINANCIAL STATEMENT PRESENTATION

The accompanying unaudited condensed consolidated interim financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements are not included herein. The interim financial statements should be read in conjunction with the financial statements of First Federal of Northern Michigan Bancorp, Inc. and Subsidiaries and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010.

All adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of financial position, results of operations and cash flows, have been made. The results of operations for the three and six months ended June 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

Note 2— PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of First Federal of Northern Michigan Bancorp, Inc., First Federal of Northern Michigan, and the Bank’s wholly owned subsidiaries, Financial Services & Mortgage Corporation (“FSMC”) and FFNM Agency, Inc. FSMC invests in real estate, which includes leasing, selling, developing, and maintaining real estate properties. The main activity of FFNM Agency is to collect the stream of income associated with the sale of the Blue Cross/Blue Shield override to the Grotenhuis Group (as discussed further below). All significant intercompany balances and transactions have been eliminated in the consolidation.

Note 3—SECURITIES

Investment securities have been classified according to management’s intent. The carrying value and estimated fair value of securities are as follows:

	June 30, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Market Value
	(in thousands)
Securities Available for Sale
U.S. Government and agency obligations	$	14,396	$	85	$	-			14,481
Municipal obligations		7,976		288		-			8,264
Mortgage-backed securities		24,562		372		(8	)		24,926
Equity securities		2		-		(1	)		1

Total	$	46,936	$	745	$	(9	)	$	47,672

Securities Held to Maturity
Municipal obligations	$	2,485	$	159	$	(1	)	$	2,643

	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Market Value
	(in thousands)
Securities Available for Sale
U.S. Government and agency obligations	$	4,518	$	44	$	-			4,562
Municipal obligations		4,875		171		-			5,046
Mortgage-backed securities		25,684		83		(75	)		25,692
Equity securities		3		-		(2	)		1

Total	$	35,080	$	298	$	(77	)	$	35,301

Securities Held to Maturity
Municipal obligations	$	2,520	$	90	$	(15	)	$	2,595

The amortized cost and estimated market value of securities at June 30, 2011, by contract maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities with no specified maturity date are separately stated.

	June 30, 2011
	Amortized Cost		Market Value
	(in thousands)
Available For Sale:
Due in one year or less	$	1,557	$	1,561
Due after one year through five years		13,871		14,030
Due in five year through ten years		6,528		6,671
Due after ten years		416		483

Subtotal		22,372		22,745

Equity securities		2		1
Mortgage-backed securities		24,562		24,926

Total	$	46,936	$	47,672

Held To Maturity:
Due in one year or less	$	90	$	91
Due after one year through five years		395		424
Due in five year through ten years		645		695
Due after ten years		1,355		1,433

Total	$	2,485	$	2,643

At June 30, 2011 and December 31, 2010, securities with a carrying value of $35,833,000 and $34,981,000, respectively, were pledged to secure certain deposit accounts, FHLB advances and our line of credit at the Federal Reserve.

Gross proceeds from the sale of securities for the six-months ended June 30, 2011 and 2010 were $0 and $10,354,000, respectively, resulting in gross gains of $0 and $497,000, respectively and gross losses of $0 and $0, respectively.

The following is a summary of temporarily impaired investments that have been impaired for less than and more than twelve months as of June 30, 2011 and December 31, 2010:

	June 30, 2011
			Gross Unrealized Losses					Gross Unrealized Losses
	Fair Value		<12 months			Fair Value		> 12 months
	(in thousands)
Available For Sale:
U.S. Government and agency obligations	$	-	$	-		$	-	$	-
Municipal obligations		-		-			-		-
Mortgage-backed securities		1,658		(8	)		-		-
Equity securities		-		-			2		(1	)

Total	$	1,658	$	(8	)	$	2	$	(1	)

Held to Maturity:
Municipal obligations	$	-	$	-		$	29	$	(1	)

	December 31, 2010
			Gross Unrealized Losses					Gross Unrealized Losses
	Fair Value		<12 months			Fair Value		> 12 months
	(in thousands)
Available For Sale:
U.S. Government and agency obligations	$	-	$	-		$	-	$	-
Municipal obligations		-		-			-		-
Mortgage-backed securities		12,626		(75	)		-		-
Equity securities		3		(2	)		-		-

Total	$	12,629	$	(77	)	$	-	$	-

Held to Maturity:
Municipal obligations	$	382	$	(13	)	$	28	$	(2	)

The unrealized losses on the securities held in the portfolio are not considered other than temporary and have not been recognized into income. This decision is based on the Company’s ability and intent to hold any potentially impaired security until maturity. The performance of the security is based on the contractual terms of the agreement, the extent of the impairment and the financial condition and credit quality of the issuer. The decline in market value is considered temporary and a result of changes in interest rates and other market variables.

Note 4—LOANS

The following table sets forth the composition of our loan portfolio by loan type at the dates indicated.

	At June 30,			At December 31,
	2011			2010
	(in thousands)
Real estate loans:
Residential mortgage	$	65,060		$	71,697
Commercial loans:
Secured by real estate		57,465			61,010
Other		8,208			8,848
Total commercial loans		65,673			69,858

Consumer loans:
Secured by real estate		15,056			16,547
Other		1,474			2,118

Total consumer loans		16,530			18,665
Total gross loans	$	147,263		$	160,220
Less:
Net deferred loan fees		(246	)		(245	)
Allowance for loan losses		(2,191	)		(2,831	)

Total loans, net	$	144,826		$	157,144

The following table illustrates the contractual aging of the recorded investment in past due loans by class of loans as of June 30, 2011 and December 31, 2010:

As of June 30, 2011
													Recorded
													Investment > 90
	30 - 59 Days		60 - 89 Days		Greater than 90		Total				Total Financing		Days and
	Past Due		Past Due		Days		Past Due		Current		Receivables		Accruing

Commercial Real Estate:
Commercial Real Estate - construction	$	-	$	-	$	290	$	290	$	70	$	360	$	-
Commercial Real Estate - other		447		-		514		961		56,144		57,105		-
Commercial - non real estate		-		-		-		-		8,208		8,208		-

Consumer:
Consumer - Real Estate		272		112		158		542		14,514		15,056		-
Consumer - Other		17		13		1		31		1,443		1,474		1

Residential:
Residential		2,935		1,191		2,771		6,897		58,163		65,060		340
Total	$	3,671	$	1,316	$	3,734	$	8,721	$	138,542	$	147,263	$	341

As of December 31, 2010
													Recorded
													Investment > 90
	30 - 59 Days		60 - 89 Days		Greater than 90		Total				Total Financing		Days and
	Past Due		Past Due		Days		Past Due		Current		Receivables		Accruing

Commercial Real Estate:
Commercial Real Estate - construction	$	-	$	-	$	1,772	$	1,772	$	1,498	$	3,270	$	-
Commercial Real Estate - other		891		488		784		2,163		55,577		57,740		82
Commercial - non real estate		-		6		-		6		8,842		8,848		-

Consumer:
Consumer - Real Estate		650		108		205		963		15,584		16,547		-
Consumer - Other		27		14		2		43		2,075		2,118		2

Residential:
Residential		3,919		2,056		2,434		8,409		63,288		71,697		282
Total	$	5,487	$	2,672	$	5,197	$	13,356	$	146,864	$	160,220	$	366

The Bank uses an eight tier risk rating system to grade its commercial loans. The grade of a loan may change during the life of the loans. The risk ratings are described as follows:

Risk Grade 1 (Excellent) - Prime loans based on liquid collateral, with adequate margin or supported by strong financial statements. Probability of serious financial deterioration is unlikely. High liquidity, minimum risk, strong ratios, and low handling costs are common to these loans. This classification also includes all loans secured by certificates of deposit or cash equivalents.

Risk Grade 2 (Good) - Desirable loans of somewhat less stature than Grade 1, but with strong financial statements. Probability of serious financial deterioration is unlikely. These loans possess a sound repayment source (and/or a secondary source). These loans represent less than the normal degree of risk associated with the type of financing contemplated.

Risk Grade 3 (Satisfactory) - Satisfactory loans of average risk – may have some minor deficiency or vulnerability to changing economic conditions, but still fully collectible. There may be some minor weakness but with offsetting features or other support readily available. These loans present a normal degree of risk associated with the type of financing. Actual and projected indicators and market conditions provide satisfactory assurance that the credit shall perform in accordance with agreed terms.

Risk Grade 4 (Acceptable) - Loans considered satisfactory, but which are of slightly “below average” credit risk due to financial weaknesses or uncertainty. The loans warrant a somewhat higher than average level of monitoring to insure that weaknesses do not advance. The level of risk is considered acceptable and within normal underwriting guidelines, so long as the loan is given the proper level of management supervision.

Risk Grade 4.5 (Monitored) - Loans are considered “below average” and monitored more closely due to some credit deficiency that poses additional risk but is not considered adverse to the point of being a “classified” credit. Possible reasons for additional monitoring may include characteristics such as temporary negative debt service coverage due to weak economic conditions, borrower may have experienced recent losses from operations, declining equity and/or increasing leverage, or marginal liquidity that may affect long-term sustainability. Loans of this grade have a higher degree of risk and warrant close monitoring to insure against further deterioration.

In any tables presented subsequently, Risk Grade 4.5 credits are included with Risk Grade 4 credits.

Risk Grade 5 (Other Assets Especially Mentioned) (OAEM) - Loans which possess some credit deficiency or potential weakness, which deserve close attention, but which do not yet warrant substandard classification. Such loans pose unwarranted financial risk that, if not corrected, could weaken the loan and increase risk in the future.

Risk Grade 6 (Substandard) - Loans are “substandard” whose full, final collectability does not appear to be a matter of serious doubt, but which nevertheless portray some form of well defined weakness that requires close supervision by Bank management. The noted weaknesses involve more than normal banking risk. One or more of the following characteristics may be exhibited in loans classified Substandard: (1) Loans possess a defined credit weakness and the likelihood that the loan shall be paid from the primary source of repayment is uncertain; (2) Loans are not adequately protected by the current net worth and/or paying capacity of the obligor; (3) primary source of repayment is gone, and the Bank is forced to rely on a secondary source of repayment such as collateral liquidation or guarantees; (4) distinct possibility that the Bank shall sustain some loss if deficiencies are not corrected; (5) unusual courses of action are needed to maintain a high probability of repayment; (6) the borrower is not generating enough cash flow to repay loan principal, however, continues to make interest payments; (7) the Bank is forced into a subordinated or unsecured position due to flaws in documentation; (8) loans have been restructured so that payment schedules, terms, and collateral represent concessions to the borrower when compared to normal loan terms; (9) the Bank is contemplating foreclosure or legal action due to the apparent deterioration in the loan; or (10) there is a significant deterioration in the market conditions and the borrower is highly vulnerable to these conditions.

Grade 7 (Doubtful) - Loans have all the weaknesses of those classified Substandard. Additionally, however, these weaknesses make collection or liquidation in full, based on existing conditions, improbable. Loans in this category are typically not performing in conformance with established terms and conditions. Full repayment is considered “Doubtful”, but extent of loss is not currently determinable.

Risk Grade 8 (Loss) - Loans are considered uncollectible and of such little value, that continuing to carry them as an asset on the Bank’s financial statements is not feasible.

The following table presents the risk category of loans by class of loans based on the most recent analysis performed and the contractual aging as of June 30, 2011 and December 31, 2010:

As of June 30, 2011
	Commercial Real Estate		Commercial Real Estate
Loan Grade	Construction		Other		Commercial

1-2	$	-	$	-	$	2
3		70		13,169		2,793
4		-		30,362		5,049
5		-		5,179		364
6		290		8,395		-
7		-		-		-
8		-		-		-
Total	$	360	$	57,105	$	8,208

As of December 31, 2010

	Commercial Real Estate		Commercial Real Estate
Loan Grade	Construction		Other		Commercial

1-2	$	-	$	-	$	5
3		70		12,411		2,958
4		1,428		33,754		5,631
5		-		3,245		248
6		1,772		8,330		6
7		-		-		-
8		-		-		-
Total	$	3,270	$	57,740	$	8,848

For residential real estate and other consumer credit the Company also evaluates credit quality based on the aging status of the loan and by payment activity. Loans 60 or more days past due are monitored by the collection committee.

The following tables present the risk category of loans by class based on the most recent analysis performed as of June 30, 2011 and December 31, 2010:

As of June 30, 2011			As of December 31, 2010

	Residential			Residential

Grade			Grade

Pass	$	61,774	Pass	$	68,301
Special Mention		-	Special Mention		-
Substandard		3,286	Substandard		3,396
Total	$	65,060	Total	$	71,697

As of June 30, 2011

	Consumer -
	Real Estate		Consumer - Other

Performing	$	14,880	$	1,468
Nonperforming		176		7
Total	$	15,056	$	1,475

As of December 31, 2010

	Consumer -
	Real Estate		Consumer - Other

Performing	$	16,341	$	2,116
Nonperforming		206		2
Total	$	16,547	$	2,118

The following table presents the recorded investment in non-accrual loans by class as of June 30, 2011 and December 31, 2010:

	As of
	June 30, 2011

Commercial Real Estate:
Commercial Real Estate - construction	$	290
Commercial Real Estate - other		514
Commercial		-

Consumer:
Consumer - real estate		176
Consumer - other		6

Residential:
Residential		2,946

Total	$	3,932

	As of
	December 31, 2010

Commercial Real Estate:
Commercial Real Estate - construction	$	1,772
Commercial Real Estate - other		1,148
Commercial		-

Consumer:
Consumer - real estate		206
Consumer - other		-

Residential:
Residential		3,114

Total	$	6,240

The key features of the Company’s loan modifications are determined on a loan-by-loan basis. Generally, our restructurings have related to interest rate reductions and loan term extensions. In the past the Company has granted reductions in interest rates, payment extensions and short-term payment forbearances as a means to maximize collectability of troubled credits. The Company has not forgiven principal to date, although this would be considered if necessary to ensure the long-term collectability of the loan. The Company’s loan modifications are typically short-term in nature, although the Company would consider a long-term modification to ensure the long-term collectability of the credit. In general, a borrower must make at least six consecutive timely payments before the Company would consider a return of a restructured loan to accruing status in accordance with Federal Deposit Insurance Corporation guidelines regarding restoration of credits to accrual status.

The Bank has classified approximately $1,415,000 of its impaired loans as troubled debt restructurings as of June 30, 2011, as noted in the table below:

As of June 30, 2011

			Pre-Modification		Post-Modification
	Number of		Outstanding Recorded		Outstanding Recorded
	Contracts		Investments		Investment

Troubled Debt Restructurings

Commercial Real Estate - Construction		-		-		-
Commercial Real Estate - Other		3		1,488		1,415
Commercial - non real estate		-		-		-
Residential		-		-		-

	Number of
	Contracts		Recorded Investment
Troubled Debt Restructurings
That Subsequently Defaulted

Commercial Real Estate - Construction		-		-
Commercial Real Estate - Other		-		-
Commercial - non real estate		-		-
Residential		-		-

For the majority of the Bank’s impaired loans, the Bank will apply the observable market price methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine observable market price, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated evaluations are received, the Bank may discount the collateral value used.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquency, secured consumer loans are charged down to the value of collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial credits are charged down at 90 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized.

The following table presents loans individually evaluated for impairment by class of loans as of June 30, 2011 and December 31, 2010:

As of June 30, 2011
							Average		Interest
	Unpaid Principal		Recorded		Related		Recorded		Income
	Balance		Investment		Allowance		Investment		Recognized

With no related allowance recorded:
Commercial	$	-	$	-	$	-	$	-	$	-
Commercial Real Estate - Construction		-		-		-		-		-
Commercial Real Estate - Other		60		60		-		60		-
Consumer - Real Estate		68		68		-		70		-
Consumer - Other		6		6		-		7		-
Residential		2,527		2,451		-		2,460		-

With a specific allowance recorded:
Commercial		-		-		-		-		-
Commercial Real Estate - Construction		290		290		150		290		-
Commercial Real Estate - Other		1,236		1,236		245		1,239		-
Consumer - Real Estate		109		108		20		108		-
Consumer - Other		-		-		-		-		-
Residential		495		495		129		494		-

Totals:
Commercial	$	-	$	-	$	-	$	-	$	-
Commercial Real Estate - Construction	$	290	$	290	$	150	$	290	$	-
Commercial Real Estate - Other	$	1,296	$	1,296	$	245	$	1,299	$	-
Consumer - Real Estate	$	177	$	176	$	20	$	178	$	-
Consumer - Other	$	6	$	6	$