Edgar Filing: SIERRA BANCORP

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2012

Commission file number: 000-33063

Sierra Bancorp

(Exact name of Registrant as specified in its charter)

	California	33-0937517
	(State of Incorporation)	(IRS Employer Identification No)

86 North Main Street, Porterville, California	93257
(Address of principal executive offices)	(Zip Code)

(559) 782-4900

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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 R No £

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes R 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.

Large accelerated filer £	Accelerated filer R
Non-accelerated filer £ (Do not check if a smaller reporting company)	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 R

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

Common stock, no par value, 14,106,889 shares outstanding as of October 31, 2012

FORM 10-Q

Table of Contents

	Page
Part I - Financial Information	1
Item 1. Financial Statements (Unaudited)	1
Consolidated Balance Sheets	1
Consolidated Statements of Income	2
Consolidated Statements of Comprehensive Income	3
Consolidated Statements of Cash Flows	4
Notes to Unaudited Consolidated Financial Statements	5

Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations	28
Forward-Looking Statements	28
Critical Accounting Policies	28
Overview of the Results of Operations and Financial Condition	29
Earnings Performance	31
Net Interest Income and Net Interest Margin	31
Provision for Loan and Lease Losses	36
Non-interest Revenue and Operating Expense	37
Provision for Income Taxes	40
Balance Sheet Analysis	40
Earning Assets	40
Investments	40
Loan Portfolio	41
Nonperforming Assets	43
Allowance for Loan and Lease Losses	45
Off-Balance Sheet Arrangements	47
Other Assets	47
Deposits and Interest-Bearing Liabilities	48
Deposits	48
Other Interest-Bearing Liabilities	50
Non-Interest Bearing Liabilities	50
Liquidity and Market Risk Management	50
Capital Resources	53

Item 3. Qualitative & Quantitative Disclosures about Market Risk	54

Item 4. Controls and Procedures	54

Part II - Other Information	55
Item 1. - Legal Proceedings	55
Item 1A. - Risk Factors	55
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds	55
Item 3. - Defaults upon Senior Securities	55
Item 4. - (Removed and Reserved)	55
Item 5. - Other Information	55
Item 6. - Exhibits	56

Signatures	57

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

SIERRA BANCORP

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

	September 30, 2012			December 31, 2011
	(unaudited)			(audited)
ASSETS
Cash and due from banks	$	41,744		$	42,805
Interest-bearing deposits in banks		3,351			20,231
Total Cash & Cash Equivalents		45,095			63,036
Investment securities available for sale		414,635			406,471
Loans held for sale		618			1,354
Loans and leases:
Gross loans and leases		847,130			757,591
Allowance for loan and lease losses		(12,806	)		(17,283	)
Deferred loan and lease fees, net		926			621
Net Loans and Leases		835,250			740,929
Premises and equipment, net		22,218			20,721
Operating leases, net		268			384
Foreclosed assets		19,835			15,364
Goodwill		5,544			5,544
Other assets		79,839			81,602
TOTAL ASSETS	$	1,423,302		$	1,335,405

LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	323,184		$	300,045
Interest bearing		822,669			786,223
Total Deposits		1,145,853			1,086,268
Federal funds purchased and repurchase agreements		3,634			3,037
Short-term borrowings		47,900			17,120
Long-term borrowings		5,000			15,000
Junior subordinated debentures		30,928			30,928
Other liabilities		15,514			14,488
TOTAL LIABILITIES		1,248,829			1,166,841
SHAREHOLDERS' EQUITY
Common stock, no par value; 24,000,000 shares
authorized; 14,103,849 and 14,101,609 shares issued
and outstanding at September 30, 2012 and
December 31, 2011, respectively		64,344			64,321
Additional paid in capital		2,364			2,221
Retained earnings		101,877			98,174
Accumulated other comprehensive income		5,888			3,848
TOTAL SHAREHOLDERS' EQUITY		174,473			168,564

TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	1,423,302		$	1,335,405

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data, unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012		2011
Interest income:
Interest and fees on loans	$	11,954		$	11,780	$	34,251	$	35,480
Interest on investment securities:
Taxable		1,523			2,420		5,159		6,621
Tax-exempt		700			716		2,052		2,153
Interest on federal funds sold and interest-bearing deposits		15			23		51		56
Total interest income		14,192			14,939		41,513		44,310

Interest expense:
Interest on deposits		796			1,063		2,490		3,279
Interest on short-term borrowings		23			7		41		46
Interest on long-term borrowings		51			143		231		425
Interest on mandatorily redeemable trust preferred securities		193			179		586		540
Total interest expense		1,063			1,392		3,348		4,290

Net Interest Income		13,129			13,547		38,165		40,020

Provision for loan losses		4,700			3,000		10,610		9,600

Net Interest Income after Provision for Loan Losses		8,429			10,547		27,555		30,420

Non-interest revenue:
Service charges on deposit accounts		2,525			2,439		7,229		7,140
Gains on investment securities available-for-sale		90			-		161		-
Other income, net		1,281			930		4,831		3,278
Total other operating income		3,896			3,369		12,221		10,418

Other operating expense:
Salaries and employee benefits		5,278			4,849		15,855		15,760
Occupancy expense		1,669			1,787		4,721		4,987
Other		4,064			3,932		13,059		13,078
Total other operating expenses		11,011			10,568		33,635		33,825

Income before income taxes		1,314			3,348		6,141		7,013

Provision for income taxes		(321	)		822		54		774

Net Income	$	1,635		$	2,526	$	6,087	$	6,239

PER SHARE DATA
Book value	$	12.37		$	11.97	$	12.37	$	11.97
Cash dividends	$	0.06		$	0.06	$	0.18	$	0.18
Earnings per share basic	$	0.12		$	0.18	$	0.43	$	0.45
Earnings per share diluted	$	0.12		$	0.18	$	0.43	$	0.44
Average shares outstanding, basic		14,103,543			14,051,614		14,102,880		14,015,583
Average shares outstanding, diluted		14,138,682			14,097,368		14,114,962		14,081,936

Total shareholder Equity (in thousands)	$	174,473		$	168,325	$	174,473	$	168,325
Shares outstanding		14,103,849			14,062,259		14,103,849		14,062,259
Dividends Paid	$	846,193		$	842,800	$	2,538,482	$	2,521,643

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2012			2011		2012			2011

Net Income	$	1,635		$	2,526	$	6,087		$	6,239
Other comprehensive income, before tax:
Unrealized gains on securities:
Unrealized holding gains arising during period		1,926			1,838		3,635			7,127
Less: reclassification adjustment for gains included in net income		(90	)		-		(161	)		-
Other comprehensive income, before tax		1,836			1,838		3,474			7,127
Income tax expense related to items of other comprehensive income, net of tax		(756	)		765		(1,434	)		2,928
Other comprehensive income		1,080			1,073		2,040			4,199

Comprehensive income	$	2,715		$	3,599	$	8,127		$	10,438

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands, unaudited)

	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities:
Net income	$	6,087		$	6,239
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on investment of securities		(161	)		-
Gain on sales of loans		(139	)		(93	)
Loss (Gain) on disposal of fixed assets		10			(12	)
Loss on sale on foreclosed assets		709			569
Writedowns on foreclosed assets		1,610			1,656
Share-based compensation expense		183			166
Provision for loan losses		10,610			9,600
Depreciation and amortization		1,813			1,971
Net amortization on securities premiums and discounts		6,214			4,031
Increase in unearned net loan fees		(304	)		(291	)
Increase in cash surrender value of life insurance policies		(30	)		(5,538	)
Proceeds from sales of loans portfolio		5,717			3,440
Net (Increase) Decrease in loans held-for-sale		(4,842	)		59
(Increase) Decrease in interest receivable and other assets		(677	)		1,362
Increase (Decrease) in other liabilities		1,179			(389	)
Net Decrease in FHLB Stock		670			996
Deferred Income Tax Provision (Benefit)		318			(105	)
Excess tax (provision) benefit from equity based compensation		(39	)		4
Net cash provided by operating activities		28,928			23,665

Cash flows from investing activities:
Maturities of securities available for sale		1,080			2,664
Proceeds from sales/calls of securities available for sale		11,319			3,119
Purchases of securities available for sale		(99,084	)		(154,229	)
Principal pay downs on securities available for sale		75,953			53,430
Net (Increase) Decrease in loans receivable, net		(125,316	)		28,709
Purchases of premises and equipment, net		(3,204	)		(830	)
Proceeds from sales of foreclosed assets		13,898			4,681
Net cash used in investing activities		(125,354	)		(62,456	)

Cash flows from financing activities:
Increase in deposits		59,585			41,345
Increase in borrowed funds		20,780			10,350
Increase in repurchase agreements		597			4,633
Cash dividends paid		(2,538	)		(2,522	)
Repurchases of common stock		-			(23	)
Stock options exercised		22			672
Excess tax provision (benefit) from equity based compensation		39			(4	)
Net cash provided by financing activities		78,485			54,451

(Decrease) Increase in cash and due from banks		(17,941	)		15,660

Cash and Cash Equivalents
Beginning of period		63,036			42,645
End of period	$	45,095		$	58,305

The accompanying notes are an integral part of these consolidated financial statements

Sierra Bancorp

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2012

Note 1 – The Business of Sierra Bancorp

Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. At the present time, the Company’s only other direct subsidiaries are Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities (TRUPS). Pursuant to the Financial Accounting Standards Board’s (FASB’s) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the financial statements of the Company. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

The Bank is a California state-chartered bank headquartered in Porterville, California, that offers a full range of retail and commercial banking services to communities in the central and southern sections of the San Joaquin Valley. Our branch footprint stretches from Fresno on the north to Bakersfield on the south, and on the southern end extends east through the Tehachapi plateau and into the northwestern tip of the Mojave Desert. The Bank was incorporated in September 1977 and opened for business in January 1978, and in the ensuing years has grown to be the largest independent bank headquartered in the South San Joaquin Valley. Our growth has primarily been organic, but includes the acquisition of Sierra National Bank in 2000. We currently operate 25 full service branch offices throughout our geographic footprint, as well as an internet branch which provides the ability to open deposit accounts online. The Bank’s most recent branch expansion activity includes a new branch which opened for business in the city of Selma in February 2011, and the relocation of our Clovis branch to a larger facility in a more convenient location in the third quarter of 2012. In addition to our full-service branches, the Bank has an agricultural credit division with lending staff domiciled in Porterville, Bakersfield and Visalia, an SBA lending unit located at our corporate headquarters, and offsite ATM’s at six different non-branch locations. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts.

Note 2 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (GAAP) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such period. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. In preparing the accompanying consolidated financial statements, management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2011 have been reclassified to be consistent with the reporting for 2012. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, as filed with the Securities and Exchange Commission.

Note 3 – Current Accounting Developments

In September 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-08, Intangibles—Goodwill and Other (Topic 350) - Testing Goodwill for Impairment. The objective of ASU 2011-08 is to simplify how entities test goodwill for impairment. Topic 350 requires an entity to test goodwill for impairment on at least an annual basis, by comparing the fair value of a reporting unit with its carrying amount, including goodwill (step one). If the fair value of a reporting unit is less than its carrying amount, then the second step of the test must be performed to measure the amount of the impairment loss, if any. Pursuant to ASU 2011-08, an entity will not be required to calculate the fair value of a reporting unit and perform step one unless, after assessing qualitative factors, the entity determines that it is more likely than not that its fair value is less than its carrying amount. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. This update is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of ASU 2011-08 did not have an impact on the Company’s financial statements, as the Company has not been required to perform the second step of the goodwill impairment test since the first step has, to date, determined that the fair value of the reporting unit, Bank of the Sierra, is greater than its carrying amount.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income. Current U.S. generally accepted accounting principles allow reporting entities several alternatives for displaying other comprehensive income and its components in financial statements, and ASU 2011-05 is intended to improve the consistency of this reporting issue. The amendments in this ASU require all non-owner changes in stockholders’ equity to be presented either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. Furthermore, the entity is required to present, on the face of the financial statements, adjustments for items that are reclassified from other comprehensive income to net income in the statements, where the components of net income and the components of other comprehensive income are presented. The amendments in the ASU do not change the following: 1) items that must be reported in other comprehensive income; 2) when an item of other comprehensive income must be reclassified to net income; 3) the option to present components of other comprehensive income either net of related tax effects or before related tax effects; or, 4) how earnings per share is calculated or presented. The amendments in ASU 2011-05 should be applied retrospectively. For public entities, such as the Company, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company’s adoption of this ASU impacted our presentation of comprehensive income, but not the calculation of such.

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, to substantially converge the fair value measurement and disclosure guidance in U.S. GAAP with International Financial Reporting Standards (“IFRS”). The amended guidance changes several aspects of current fair value measurement guidance, including the following provisions: 1) the application of the concepts of “highest and best use” and “valuation premise”; 2) the introduction of an option to measure groups of offsetting assets and liabilities on a net basis; 3) the incorporation of certain premiums and discounts in fair value measurements; and, 4) the measurement of the fair value of certain instruments classified in shareholders’ equity. In addition, the amended guidance includes several new fair value disclosure requirements, including, among other things, information about valuation techniques and unobservable inputs used in Level 3 fair value measurements and a narrative description of Level 3 measurements’ sensitivity to changes in unobservable inputs. For public entities such as the Company, the provisions of ASU 2011-04 are effective for interim and annual periods beginning after December 15, 2011, and are to be applied prospectively. The implementation of ASU 2011-04 enhanced our footnote disclosures, but did not change fair value measurements for any of the Company’s assets or liabilities carried at fair value and thus did not impact the Company’s statements of income and condition.

Note 4 – Supplemental Disclosure of Cash Flow Information

During the nine months ended September 30, 2012 and 2011, cash paid for interest due on interest-bearing liabilities was $3.087 million and $3.991 million, respectively. There was no cash paid for income taxes during the nine months ended September 30, 2012, and $1.643 million for the same time frame in 2011. Assets totaling $20.724 million and $4.663 million were acquired in settlement of loans for the nine months ended September 30, 2012 and September 30, 2011, respectively. We received $10.134 million in cash from the sale of foreclosed assets during the first nine months of 2012 relative to $2.779 million during the first nine months of 2011, which represents sales proceeds less loans extended to finance such sales totaling $3.735 million for the first nine months of 2012 and $1.506 million for the first nine months of 2011.

Note 5 – Share Based Compensation

The 2007 Stock Incentive Plan (the “2007 Plan”) was adopted by the Company in 2007. Our 1998 Stock Option Plan (the “1998 Plan”) was concurrently terminated, although options to purchase 171,550 shares that were granted prior to the termination of the 1998 Plan were still outstanding as of September 30, 2012 and remain unaffected by the termination. The 2007 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors of the Company. The 2007 Plan also provides for the potential issuance of restricted stock awards to these same classes of eligible participants, on such terms and conditions as are established at the discretion of the Board of Directors or the Compensation Committee. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although options have been granted since the inception of the plan and the number remaining available for grant as of September 30, 2012 was 911,640. The dilutive impact of stock options outstanding is discussed below in Note 6, Earnings per Share. No restricted stock awards have been issued by the Company.

Pursuant to FASB’s standards on stock compensation, the value of each option granted is reflected in our income statement as share-based compensation expense or directors’ expense, by amortizing it over the vesting period of such option or by expensing it as of the grant date for immediately vested options. The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense. Under the multiple option approach, an employee’s options for each vesting period are separately valued and amortized. This appears to be the preferred method for option grants with multiple vesting periods, which is the case for most options granted by the Company. A pre-tax charge of $61,000 was reflected in the Company’s income statement during the third quarter of 2012 and $48,000 was charged during the third quarter of 2011, as expense related to stock options. For the first nine months, the charges amounted to $183,000 in 2012 and $166,000 in 2011.

Note 6 – Earnings per Share

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 14,103,543 weighted average shares outstanding during the third quarter of 2012, and 14,051,614 during the third quarter of 2011. There were 14,102,880 weighted average shares outstanding during the first nine months of 2012, and 14,015,583 during the first nine months of 2011.

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of “in-the-money” stock options. The dilutive effect of options outstanding was calculated using the treasury stock method, excluding anti-dilutive shares and adjusting for unamortized expense and windfall tax benefits. For the third quarter and first nine months of 2012, the dilutive effect of options outstanding calculated under the treasury stock method totaled 35,139 and 12,082, respectively, which were added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share. Likewise, for the third quarter and first nine months of 2011 shares totaling 45,754 and 66,353, respectively, were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.

Note 7 – Comprehensive Income

Comprehensive income, as presented in the Consolidated Statements of Comprehensive Income, includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Gains or losses on investment securities that were realized and included in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from comprehensive income of the current period.

Note 8 – Financial Instruments with Off-Balance-Sheet Risk

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business, in order to meet the financing needs of its customers. Those financial instruments consist of commitments to extend credit, and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

	September 30, 2012		December 31, 2011
Commitments to extend credit	$	239,849	$	154,323
Standby letters of credit	$	6,059	$	11,113
Commercial letters of credit	$	8,543	$	8,991

Commitments to extend credit consist primarily of the following: Unfunded home equity lines of credit; commercial real estate construction loans, which are established under standard underwriting guidelines and policies and are secured by deeds of trust, with disbursements made over the course of construction; commercial revolving lines of credit, which have a high degree of industry diversification; the unused portions of mortgage warehouse lines of credit; and the unused portions of formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, while commercial letters of credit represent the Company’s commitment to pay a third party on behalf of a customer upon fulfillment of contractual requirements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.

The Company is also utilizing a $74 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits. The letter of credit is backed by specific loans which are pledged to the Federal Home Loan Bank by the Company.

Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose the estimated fair value of financial instruments for which it is practicable to estimate fair values. In addition to those footnote disclosure requirements, FASB’s standard on investments requires that our debt securities, which are classified as available for sale, and our equity securities that have readily determinable fair values, be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. While the fair value option outlined under FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, we have not elected the fair value option for any additional financial assets or liabilities.

Fair value measurements and disclosure standards also establish a framework for measuring fair value. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, they establish a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standards describe three levels of inputs that may be used to measure fair value:

Level 1: 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: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would likely consider in pricing an asset or liability.

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in any estimates. Because no market exists for a significant portion of the Company’s financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments disclosed at September 30, 2012 and December 31, 2011:

Cash and cash equivalents and short-term borrowings: For cash and cash equivalents and short-term borrowings, the carrying amount is estimated to be fair value.

Investment securities: The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.

Loans and leases: For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values. Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value.

Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are thus not relevant for reporting purposes. If available-for-sale loans stay on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

Collateral dependent impaired loans: Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the original loan agreement, and the carrying value has been written down to the fair value of the loan. The carrying value is equivalent to the fair value of the collateral, net of expected disposition costs where applicable, for collateral-dependent loans.

Cash surrender value of life insurance policies: The fair values are based on net cash surrender values at each reporting date.

Investments in, and capital commitments to, limited partnerships: The fair values of our investments in WNC Institutional Tax Credit Fund Limited Partnerships and any other limited partnerships are estimated using quarterly indications of value provided by the general partner. The fair values of undisbursed capital commitments are assumed to be the same as their book values.

Other investments: Certain long-term investments for which no secondary market exists are carried at cost, and the carrying amount for those investments approximates their estimated fair value.

Deposits: Fair values for demand deposits and other non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.

Short-term borrowings: The carrying amounts approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Long-term borrowings: The fair values of the Company’s long-term borrowings are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Subordinated debentures: The fair values of subordinated debentures are determined based on the current market value for like instruments of a similar maturity and structure.

Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would approximate fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

Estimated fair values for the Company’s financial instruments at the periods noted are as follows:

Fair Value of Financial Instruments
(dollars in thousands, unaudited)	September 30, 2012
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
			(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	45,095	$	45,095	$	-	$	-	$	45,095
Investment securities available for sale		414,635		1,911		412,724		-		414,635
Loans and leases, net		823,850		-		867,484		-		867,484
Collateral dependent impaired loans		11,401		-		9,044		-		9,044
Loans held-for-sale		618		618		-		-		618
Cash surrender value of life insurance policies		37,687		-		37,687		-		37,687
Other investments		6,370		-		6,370		-		6,370
Investment in Limited Partnership		10,537		-		10,537		-		10,537
Accrued interest receivable		5,228		-		5,228		-		5,228

Financial Liabilities:
Deposits:
Noninterest-bearing	$	323,184	$	323,184	$	-	$	-	$	323,184
Interest-bearing		822,669		-		745,132		-		745,132
Fed Funds Purchased and Repurchase Agreements		3,634		-		3,634		-		3,634
Short-term borrowings		47,900		-		47,900		-		47,900
Long-term borrowings		5,000		-		5,084		-		5,084
Subordinated debentures		30,928		-		12,141		-		12,141
Limited partnership capital commitment		1,138		-		1,138		-		1,138
Accrued Interest Payable		252		-		252		-		252

	Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	239,849
Standby letters of credit		6,059
Commercial lines of credit		8,543

	December 31, 2011
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
			(Dollars in thousands)
Financial Assets:
Cash and cash equivalents	$	63,036	$	63,036	$	-	$	-	$	63,036
Investment securities available for sale		406,471		1,347		405,124		-		406,471
Loans and leases, net		726,302		-		771,192		-		771,192
Collateral dependent impaired loans		14,627		-		11,016		285		11,301
Loans held-for-sale		1,354		1,354		-		-		1,354
Cash surrender value of life insurance policies		37,657		-		37,657		-		37,657
Other Investments		7,040		-		7,040		-		7,040
Investment in Limited Partnership		9,927		-		9,927		-		9,927
Accrued Interest Receivable		5,368		-		5,368		-		5,368

Financial Liabilities:
Deposits:
Noninterest-bearing	$	300,045	$	300,045	$	-	$	-	$	300,045
Interest-bearing		786,223		-		702,270		-		702,270
Fed Funds Purchased and Repurchase Agreements		3,037		-		3,037		-		3,037
Short-term borrowings		17,120		-		17,120		-		17,120
Long-term borrowings		15,000		-		15,000		-		15,000
Subordinated debentures		30,928		-		12,262		-		12,262
Limited partnership capital commitment		353		-		353		-		353
Accrued Interest Payable		514		-		514		-		514

	Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	154,323
Standby letters of credit		11,113
Commercial lines of credit		8,991

For each financial asset category that was actually reported at fair value at September 30, 2012 and December 31, 2011, the Company used the following methods and significant assumptions:

Investment Securities: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the their relationship to other benchmark quoted securities.

Impaired loans: Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the contractual terms of the original loan agreement, and the carrying value has been written down to the fair value of the loan. The carrying value is equivalent to the fair value of the collateral, net of expected disposition costs where applicable, for collateral-dependent loans.

Foreclosed assets: Repossessed real estate (OREO) and other assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and for all other assets fair value is represented by the estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

Assets reported at fair value on a recurring basis are summarized below:

Fair Value Measurements - Recurring
(dollars in thousands, unaudited)
	Fair Value Measurements at September 30, 2012, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total		Realized Gain/(Loss)
Investment Securities
U.S. Government agencies	$	-	$	1,134	$	-	$	1,134	$	-
Obligations of states and political subdivisions		-		80,963		-		80,963		-
U.S. Government agencies collateralized by mortgage obligations		-		330,627		-		330,627		-
Other Securities		1,911		-		-		1,911		-

Total available-for-sale securities	$	1,911	$	412,724	$	-	$	414,635	$	-

	Fair Value Measurements at December 31, 2011, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total		Realized Gain/(Loss)
Investment Securities
U.S. Government agencies	$	-	$	2,026	$	-	$	2,026	$	-
Obligations of states and political subdivisions		-		71,340		-		71,340		-
U.S. Government agencies collateralized by mortgage obligations		-		331,758		-		331,758		-
Other Securities		1,347		-		-		1,347		(1,370	)

Total available-for-sale securities	$	1,347	$	405,124	$	-	$	406,471	$	(1,370	)

Assets reported at fair value on a nonrecurring basis are summarized below:

Fair Value Measurements - Nonrecurring
(dollars in thousands, unaudited)
	Fair Value Measurements at September 30, 2012, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral Dependent Impaired Loans	$	-	$	9,044	$	-	$	9,044
Foreclosed Assets	$	-	$	19,835	$	-	$	19,835

	Fair Value Measurements at December 31, 2011, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral Dependent Impaired Loans	$	-	$	11,016	$	285	$	11,301
Foreclosed Assets	$	-	$	14,777	$	587	$	15,364

The table above only includes impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances, and specific loss reserves associated with those balances, is included in Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

The unobservable inputs are based on management’s best estimates of appropriate discounts in arriving at fair market value. Significant increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, a change in either direction of actual loss rates would have a directionally opposite change in the calculation of the fair value of impaired unsecured loans.

Note 10 – Investments

Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity. The Company’s available-for-sale investment securities totaled $415 million at September 30, 2012, and $406 million at December 31, 2011.

Amortized Cost And Estimated Fair Value

The amortized cost and estimated fair value of investment securities available-for-sale are as follows

(Dollars in thousands, unaudited):

	September 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

U.S. Government agencies	$	1,129	$	5	$	-		$	1,134
Obligations of state and political subdivisions		76,558		4,480		(75	)		80,963
U.S. Government agencies collateralized by mortgage obligations		325,605		5,763		(741	)		330,627
Equity Securities		1,336		575		-			1,911
	$	404,628	$	10,823	$	(816	)	$	414,635

	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

U.S. Government agencies	$	2,008	$	18	$	-		$	2,026
Obligations of state and political subdivisions		67,851		3,634		(145	)		71,340
U.S. Government agencies collateralized by mortgage obligations		328,751		4,467		(1,460	)		331,758
Equity Securities		1,336		11		-			1,347
	$	399,946	$	8,130	$	(1,605	)	$	406,471

At September 30, 2012 and December 31, 2011, the Company had 76 securities and 80 securities, respectively, with unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the associated unrealized losses are other than temporary. Information pertaining to our investment securities with unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous loss position, is disclosed in the table below.

Investment Portfolio - Unrealized Losses
(dollars in thousands, unaudited)	September 30, 2012
	Less than Twelve Months					Over Twelve Months
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value

U.S. Government Agencies	$	-		$	-	$	-		$	-
Obligations of State and Political Subdivisions		(75	)		5,881		-			-
U.S. Government agencies collateralized by mortgage obligations		(591	)		90,344		(150	)		14,363
TOTAL	$	(666	)	$	96,225	$	(150	)	$	14,363

	December 31, 2011
	Less than Twelve Months					Over Twelve Months
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value

Obligations of State and Political Subdivisions	$	(26	)	$	1,735	$	(119	)	$	1,978
U.S. Government agencies collateralized by mortgage obligations		(1,432	)		144,953		(28	)		949
TOTAL	$	(1,458	)	$	146,688	$	(147	)	$	2,927

Note 11 – Credit Quality and Nonperforming Assets

Credit Quality Classifications

The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company uses the following definitions of risk classifications:

Pass: Loans listed as pass include larger non-homogeneous loans not meeting the risk rating definitions below and smaller, homogeneous loans that are not assessed on an individual basis.

Special Mention: Loans classified as special mention have potential issues that deserve the close attention of management. If left uncorrected, those potential weaknesses could eventually diminish the prospects for full repayment of principal and interest according to the contractual terms of the loan agreement, or could result in deterioration of the Company’s credit position at some future date.

Substandard: Loans classified as substandard have at least one clear and well-defined weakness which could jeopardize the ultimate recoverability of all principal and interest, such as a borrower displaying a highly leveraged position, unfavorable financial operating results and/or trends, uncertain repayment sources or a deteriorated financial condition.

Impaired: A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all nonperforming loans, loans classified as restructured troubled debt, and certain other loans that are still being maintained on accrual status. If the Bank grants a concession to a borrower in financial difficulty, the loan falls into the category of a troubled debt restructuring (TDR). A TDR may be nonperforming or performing, depending on its accrual status and the demonstrated ability of the borrower to comply with restructured terms.

Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:

Credit Quality Classifications
(dollars in thousands, unaudited)
	September 30, 2012
	Pass		Special Mention		Substandard		Impaired		Total
Real Estate:
1-4 Family residential construction	$	2,004	$	3,450	$	-	$	1,558	$	7,012
Other construction/Land		19,771		3,191		3,693		8,289		34,944
1-4 Family - closed-end		75,048		6,487		736		19,329		101,600
Equity Lines		58,527		23		1,931		1,411		61,892
Multi-family residential		4,590		611		-		-		5,201
Commercial real estate - owner occupied		137,460		21,838		5,786		10,083		175,167
Commercial real estate - non-owner occupied		64,770		7,642		540		18,863		91,815
Farmland		55,523		916		3,552		1,943		61,934
Total Real Estate		417,693		44,158		16,238		61,476		539,565

Agricultural		19,915		30		25		999		20,969
Commercial and Industrial		221,773		4,166		2,973		2,242		231,154
Small Business Administration		14,511		1,671		624		3,422		20,228
Direct finance leases		4,515		38		-		190		4,743
Consumer loans		25,254		603		224		4,390		30,471
Total Gross Loans and Leases	$	703,661	$	50,666	$	20,084	$	72,719	$	847,130

	December 31, 2011
	Pass		Special Mention		Substandard		Impaired		Total
Real Estate:
1-4 Family residential construction	$	4,240	$	2,004	$	-	$	2,244	$	8,488
Other construction/Land		18,185		8,873		1,015		11,987		40,060
1-4 Family - closed-end		75,765		7,574		1,354		20,260		104,953
Equity Lines		62,867		456		1,795		1,379		66,497
Multi-family residential		4,620		618		-		2,941		8,179
Commercial real estate - owner occupied		141,245		23,289		8,878		9,658		183,070
Commercial real estate - non-owner occupied		64,746		7,463		4,514		29,120		105,843
Farmland		47,719		1,878		3,626		6,919		60,142
Total Real Estate		419,387		52,155		21,182		84,508		577,232

Agricultural		15,477		1,574		27		-		17,078
Commercial and Industrial		83,780		7,529		3,078		5,021		99,408
Small Business Administration		16,251		-		852		3,903		21,006
Direct finance leases		6,089		63		-		591		6,743
Consumer loans		30,004		1,006		808		4,306		36,124
Total Gross Loans and Leases	$	570,988	$	62,327	$	25,947	$	98,329	$	757,591

Past Due and Nonperforming Assets

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and other real estate owned (“OREO”). OREO consists of properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt exists with regard to the ability of the Company to collect all principal and interest on a loan or lease. At that point, we stop accruing interest on the loan or lease in question, and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status, even if interest is still being received, unless the asset is both well secured and in the process of collection. An aging of the Company’s loan balances, by number of days past due as of the indicated dates, is presented in the following tables:

Loan Portfolio Aging
(dollars in thousands, unaudited)
	September 30, 2012
	30-59 Days Past Due		60-89 Days Past Due		90 Days Or More Past Due		Total Past Due		Current		Total Financing Receivables		Non-Accrual Loans⁽¹⁾
Real Estate:
1-4 Family residential construction	$	1,558	$	-	$	-	$	1,558	$	5,454	$	7,012	$	1,558
Other construction/Land		689		-		572		1,261		33,683		34,944		1,349
1-4 Family - closed-end		1,294		173		1,466		2,933		98,667		101,600		5,590
Equity Lines		24		290		66		380		61,512		61,892		732
Multi-family residential		-		-		-		-		5,201		5,201		-
Commercial real estate - owner occupied		594		734		1,845		3,173		171,994		175,167		6,409
Commercial real estate - non-owner occupied		-		22		711		733		91,082		91,815		5,193
Farmland		232		-		-		232		61,702		61,934		1,943
Total Real Estate		4,391		1,219		4,660		10,270		529,295		539,565		22,774

Agricultural		162		-		-		162		20,807		20,969		999
Commercial and Industrial		1,060		219		292		1,571		229,583		231,154		1,307
Small Business Administration		854		845		1,701		3,400		16,828		20,228		2,331
Direct finance leases		38		-		190		228		4,515		4,743		190
Consumer loans		354		69		111		534		29,937		30,471		1,253
Total Gross Loans and Leases	$	6,859	$	2,352	$	6,954	$	16,165	$	830,965	$	847,130	$	28,854

⁽¹⁾ Included in Total Financing Receivables

	December 31, 2011
	30-59 Days Past Due		60-89 Days Past Due		90 Days Or More Past Due⁽²⁾		Total Past Due		Current		Total Financing Receivables		Non-Accrual Loans⁽¹⁾

Real Estate:
1-4 Family residential construction	$	-	$	-	$	-	$	-	$	8,488	$	8,488	$	2,244
Other construction/Land		1,354		-		1,417		2,771		37,289		40,060		4,083
1-4 Family - closed-end		1,777		1,835		1,661		5,273		99,680		104,953		7,605
Equity Lines		253		511		640		1,404		65,093		66,497		1,309
Multi-family residential		-		-		2,941		2,941		5,238		8,179		2,941
Commercial real estate - owner occupied		3,070		1,038		5,581		9,689		173,381		183,070		7,086
Commercial real estate - non-owner occupied		1,031		577		7,128		8,736		97,107		105,843		13,958
Farmland		6,436		-		188		6,624		53,518		60,142		6,919
Total Real Estate		13,921		3,961		19,556		37,438		539,794		577,232		46,145

Agricultural		-		-		-		-		17,078		17,078		-
Commercial and Industrial		701		386		3,160		4,247		95,161		99,408		3,778
Small Business Administration		828		917		2,715		4,460		16,546		21,006		3,452
Direct finance leases		63		-		591		654		6,089		6,743		591
Consumer loans		520		619		838		1,977		34,147		36,124		2,144
Total Gross Loans and Leases	$	16,033	$	5,883	$	26,860	$	48,776	$	708,815	$	757,591	$	56,110

⁽¹⁾ Included in Total Financing Receivables

⁽²⁾ Includes Small Business Administration loans over 90 days past due and still accruing in the amount of $48,000.

Troubled Debt Restructurings

A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring (“TDR”), if the modification constitutes a concession. At September 30, 2012, the Company had a total of $50.7 million in TDR’s, including $13.8 million in TDR’s that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. TDR’s may have the TDR designation removed in the calendar year following the restructuring, if the loan is in compliance with all modified terms and is yielding a market rate of interest. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to the terms of the restructured agreement.

The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDR’s which were modified during the noted periods, by type of concession:

Troubled Debt Restructurings, by Type of Loan Modification

(dollars in thousands, unaudited)

	For the Nine Months Ended September 30, 2012
	Rate Modification		Term Modification		Interest Only Modification		Rate & Term Modification		Rate & Interest Only Modification		Term & Interest Only Modification		Rate, Term & Interest Only Modification		Total
Trouble Debt Restructurings
Real Estate:
Other construction/Land	$	-	$	158	$	-	$	309	$	-	$	-	$	-	$	467
1-4 family - closed-end		-		228		-		41		-		222		-		491
Equity Lines		-		29		-		-		-		-		-		29
Commercial real estate - owner occupied		-		2,305		-		1,184		-		-		-		3,489
Commercial real estate - non owner occupied		-		328		-		60		-		-		-		388
Total Real Estate Loans		-		3,048		-		1,594		-		222		-		4,864
Agricultural Products		-		-		-		-		-		-		-		-
Commercial and Industrial		-		251		-		531		-		-		-		782
Consumer loans		-		1,042		-		225		-		-		47		1,314
Small Business Administration Loans		-		200		-		475		-		-		-		675
	$	-	$	4,541	$	-	$	2,825	$	-	$	222	$	47	$	7,635

	For the Year Ended December 31, 2011
	Rate Modification		Term Modification		Interest Only Modification		Rate & Term Modification		Rate & Interest Only Modification		Term & Interest Only Modification		Rate, Term & Interest Only Modification		Total
Trouble Debt Restructurings
Real Estate:
Other construction/Land	$	-	$	555	$	-	$	754	$	-	$	6,188	$	-	$	7,497
1-4 family - closed-end		-		6,419		-		151		561		48		421		7,600
Equity Lines		-		71		426		-		78		-		-		575
Commercial real estate - owner occupied		-		1,893		1,231		297		542		-		-		3,963
Commercial real estate - non owner occupied		7,400		-		-		1,069		6,420		-		-		14,889
Total Real Estate Loans		7,400		8,938		1,657		2,271		7,601		6,236		421		34,524
Agricultural Products		-		-		-		-		-		-		12		12
Commercial and Industrial		19		342		23		1,188		-		384		-		1,956
Consumer loans		278		495		-		2,069		282		-		85		3,209
Small Business Administration Loans		-		621		106		46		-		-		-		773
	$	7,697	$	10,396	$	1,786	$	5,574	$	7,883	$	6,620	$	518	$	40,474

The following tables present, by class, additional details related to loans classified as TDR’s during the three-month and nine-month periods ended September 30, 2012, including the recorded investment in the loan both before and after modification and balances that were modified during those periods:

Troubled Debt Restructurings
(dollars in thousands, unaudited)
	For the Three Months Ended September 30, 2012
			Pre- Modification		Post- Modification
	Number of Loans		Outstanding Recorded Investment		Outstanding Recorded Investment		Reserve Difference⁽¹⁾			Reserve
Real Estate:
Other Construction/Land		4	$	361	$	355	$	(153	)	$	9
1-4 family - closed-end		2		159		159		(7	)		11
Equity Lines		0		-		-		-			-
Commercial real estate- owner occupied		3		889		889		15			360
Commercial real estate- non-owner occupied		1		60		60		-			1
Total Real Estate Loans				1,469		1,463		(145	)		381

Agricultural products		0		-		-		-			-
Commercial and Industrial		7		389		382		(80	)		7
Consumer loans		13		459		455		41			62
Small Business Administration Loans		1		200		200		6			50
			$	2,517	$	2,500	$	(178	)	$	500

⁽¹⁾ This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

	For the Nine Months Ended September 30, 2012
			Pre- Modification		Post- Modification
	Number of Loans		Outstanding Recorded Investment		Outstanding Recorded Investment		Reserve Difference⁽¹⁾			Reserve
Real Estate:
Other Construction/Land		6	$	472	$	467	$	(143	)	$	20
1-4 family - closed-end		5		503		491		20			57
Equity Lines		1		29		29		13			29
Commercial real estate- owner occupied		6		3,489		3,489		(57	)		411
Commercial real estate- non-owner occupied		3		390		388		(45	)		8
Total Real Estate Loans				4,883		4,864		(212	)		525

Agricultural products		0		-		-		-			-
Commercial and Industrial		14		796		782		(107	)		79
Consumer loans		27		1,320		1,314		(167	)		207
Small Business Administration Loans		2		668		675		8			169
			$	7,667	$	7,635	$	(478	)	$	980

The table below summarizes TDR’s that defaulted during the period noted, and any charge-offs on those TDR’s resulting from such default.

Troubled Debt Restructurings⁽¹⁾
(dollars in thousands, unaudited)
	Subsequent default three months ended September 30, 2012
	Number of Loans		Recorded Investment		Charge-Offs
Real Estate:
Other Construction/Land		0	$	-	$	-
1-4 family - closed-end		1		222		-
Equity Lines		0		-		-
Commercial real estate- owner occupied		1		332		-
Commercial real estate- non owner occupied		0		-		-
Total Real Estate Loans				554		-

Agricultural products		0		-		-
Commercial and Industrial		1		66		66
Consumer Loans		0		-		-
Small Business Administration Loans		0		-		-
			$	620	$	66

	Subsequent default nine months ended September 30, 2012
	Number of Loans		Recorded Investment		Charge-Offs
Real Estate:
Other Construction/Land		0	$	-	$	-
1-4 family - closed-end		1		222		-
Equity Lines		0		-		-
Commercial real estate- owner occupied		1		332		-
Commercial real estate- non owner occupied		0		-		-
Total Real Estate Loans				554		-

Agricultural products		0		-		-
Commercial and Industrial		2		175		175
Consumer Loans		0		-		-
Small Business Administration Loans		0		-		-
			$	729	$	175

⁽¹⁾ Troubled Debt Restructurings within the previous 12 months for which there was a payment default in the periods noted.

Note 12 – Allowance for Loan and Lease Losses

The allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it at least quarterly. Pursuant to that methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary. The following tables disclose the unpaid principal balance, recorded investment (including accrued interest), average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDR’s, totaling $3.131 million at September 30, 2012 and $3.635 million at December 31, 2011.

Impaired Loans	September 30, 2012
(dollars in thousands, unaudited)	Unpaid Principal Balance⁽¹⁾		Recorded Investment⁽²⁾		Related Allowance		Average Recorded Investment		Interest Income Recognized⁽³⁾
With an Allowance Recorded
Real Estate:
1-4 family residential construction	$	-	$	-	$	-	$	-	$	-
Other Construction/Land		1,432		1,432		435		1,451		24
1-4 Family - closed-end		10,197		10,197		1,150		10,236		256
Equity Lines		1,087		1,087		483		1,089		7
Multifamily residential		-		-		-		-		-
Commercial real estate- owner occupied		3,452		3,451		628		3,475		74
Commercial real estate- non-owner occupied		6,882		6,883		545		7,380		241
Farmland		91		91		3		95		-
Total Real Estate		23,141		23,141		3,244		23,726		602
Agricultural		1,363		999		2		945		-
Commercial and Industrial		2,277		2,242		571		2,334		35
Small Business Administration		2,559		2,559		768		2,559		37
Direct finance leases		190		190		92		190		-
Consumer loans		4,418		4,390		951		4,502		134
		33,948		33,521		5,628		34,256		808
With no Related Allowance Recorded
Real Estate:
1-4 family residential construction	$	4,350	$	1,558	$	-	$	1,579	$	-
Other Construction/Land		7,510		6,857		-		6,894		244
1-4 Family - closed-end		9,423		9,132		-		9,178		87
Equity Lines		324		324		-		330		1
Multifamily residential		-		-		-		-		-
Commercial real estate- owner occupied		7,554		6,632		-		6,867		66
Commercial real estate- non-owner occupied		12,135		11,980		-		12,107		493
Farmland		1,852		1,852		-		1,861		-
Total Real Estate		43,148		38,335		-		38,816		891
Agricultural		-		-		-		-		-
Commercial and Industrial		-		-		-		-		-
Small Business Administration		863		863		-		863		-
Direct finance leases		-		-		-		-		-
Consumer loans		-		-		-		6		-
		44,011		39,198		-		39,685		891
Total	$	77,959	$	72,719	$	5,628	$	73,941	$	1,699

⁽¹⁾Contractual principal balance due from customer.

⁽²⁾Principal balance on Company's books, less any direct charge offs.

⁽³⁾Interest income is recognized on performing balances on a regular accrual basis.

Impaired Loans	December 31, 2011
(dollars in thousands, unaudited)	Unpaid Principal Balance⁽¹⁾		Recorded Investment⁽²⁾		Related Allowance		Average Recorded Investment		Interest Income Recognized⁽³⁾
With an Allowance Recorded
Real Estate:
1-4 family residential construction	$	188	$	188	$	13	$	188	$	-
Other Construction/Land		3,477		2,906		735		2,925		89
1-4 Family - closed-end		8,086		8,057		821		8,071		222
Equity Lines		1,072		1,072		243		1,069		-
Multifamily residential		2,941		2,941		850		2,950		-
Commercial RE- owner occupied		3,628		3,628		834		3,645		24
Commercial RE- non-owner occupied		17,454		17,454		1,733		17,842		274
Farmland		-		-		-		-		-
Total Real Estate		36,846		36,246		5,229		36,690		609
Agriculture		-		-		-		-		-
Commercial and Industrial		4,135		4,106		1,481		4,197		24
Small Business Administration		3,902		3,903		1,212		3,903		2
Direct finance leases		591		591		291		591		-
Consumer loans		3,896		3,858		541		3,920		56
		49,370		48,704		8,754		49,301		691
With no Related Allowance Recorded
Real Estate:
1-4 family residential construction	$	4,784	$	2,056	$	-	$	2,069	$	-
Other Construction/Land		11,740		9,081		-		9,326		193
1-4 Family - closed-end		12,467		12,203		-		12,250		101
Equity Lines		307		307		-		318		-
Multifamily residential		-		-		-		-		-
Commercial RE- owner occupied		6,049		6,030		-		6,136		17
Commercial RE- non-owner occupied		11,818		11,666		-		12,033		190
Farmland		7,468		6,919		-		6,956		-
Total Real Estate		54,633		48,262		-		49,088		501
Agriculture		-		-		-		-		-
Commercial and Industrial		916		915		-		965		11
Small Business Administration		-		-		-		-		-
Direct finance leases		-		-		-		-		-
Consumer loans		448		448		-		462		11
		55,997		49,625		-		50,515		523
Total	$	105,367	$	98,329	$	8,754	$	99,816	$	1,214

⁽¹⁾Contractual principal balance due from customer

⁽²⁾Principal balance on Company's books, less any direct charge offs.

⁽³⁾Interest income is recognized on performing balances on a regular accrual basis

Similar but condensed information as of the dates noted is provided in the following table:

Impaired Loans
(dollars in thousands, unaudited)
	September 30, 2012		December 31, 2011

Impaired loans without a valuation allowance	$	39,198	$	49,625
Impaired loans with a valuation allowance		33,521		48,704
Total impaired loans ⁽¹⁾	$	72,719	$	98,329
Valuation allowance related to impaired loans	$	5,628	$	8,754
Total non-accrual loans	$	28,854	$	56,110
Total loans past-due ninety days or more and still accruing	$	-	$	48

⁽¹⁾ Principal balance on Company's books less any direct charge-off

The specific loss allowance for an impaired loan represents the difference between the face value of the loan and either its current appraised value less estimated disposition costs, or its net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition where applicable, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal was not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required, and adjusts the specific loss allowance, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired. Current appraisals were available for 83% of the Company’s impaired real estate loan balances at September 30, 2012. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

Our methodology also provides that a “general” allowance be established for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the state of the agricultural industry and other key industries in the Central San Joaquin Valley. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $7.2 million at September 30, 2012.

During the nine months ended September 30, 2012 we adjusted certain qualitative factors used in determining our allowance for loan and lease losses pursuant to our assessment that default risk in non-impaired loans is declining, and further refined the methodology for determining proxy loss rates that are incorporated into the model when there is insufficient data to utilize the Bank’s own historical loan rates. Other than those adjustments, there have been no material changes implemented in 2012 to the methodology used to determine our allowance for loan and lease losses. As we add new products and expand our geographic coverage, and as the economic environment changes, we expect to continue to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the Company’s external auditors, the FDIC, and the California DFI review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity. The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:

Allowance for Credit Losses and Recorded Investment in Financing Receivables

(dollars in thousands, unaudited)

	For the Three Months Ended September 30, 2012
	Real Estate			Agricultural Products			Commercial and Industrial			Small Business Administration			Direct Finance Leases			Consumer			Total

Allowance for credit losses:
Beginning Balance	$	7,926		$	18		$	2,919		$	1,165		$	212		$	1,623		$	13,863
Charge-offs		(3,778	)		(634	)		(675	)		(335	)		-			(526	)		(5,948	)
Recoveries		33			-			70			35			-			53			191
Provision		2,423			629			550			79			(17	)		1,036			4,700

Ending Balance	$	6,604		$	13		$	2,864		$	944		$	195		$	2,186		$	12,806

	For the Nine Months Ended September 30, 2012
	Real Estate			Agricultural Products			Commercial and Industrial			Small Business Administration			Direct Finance Leases			Consumer			Total

Allowance for credit losses:
Beginning Balance	$	8,260		$	19		$	4,638		$	1,447		$	311		$	2,608		$	17,283
Charge-offs		(9,179	)		(634	)		(3,215	)		(753	)		(198	)		(1,873	)		(15,852	)
Recoveries		222			-			262			82			-			199			765
Provision		7,301			628			1,179			168			82			1,252			10,610

Ending Balance	$	6,604		$	13		$	2,864		$	944		$	195		$	2,186		$	12,806

Reserves:
Specific	$	3,244		$	2		$	571		$	768		$	92		$	951		$	5,628
General		3,360			11			2,293			176			103			1,235			7,178

Ending Balance	$	6,604		$	13		$	2,864		$	944		$	195		$	2,186		$	12,806

Loans evaluated for impairment:
Individually	$	61,476		$	999		$	2,242		$	3,422		$	190		$	4,390		$	72,719
Collectively		478,089			19,970			228,912			16,806			4,553			26,081			774,411

Ending Balance	$	539,565		$	20,969		$	231,154		$	20,228		$	4,743		$	30,471		$	847,130

	For the Year Ended December 31, 2011
	Real Estate			Agricultural Products			Commercial and Industrial			Small Business Administration			Direct Finance Leases			Consumer			Total

Allowance for credit losses:
Beginning Balance	$	10,143		$	62		$	6,379		$	1,274		$	284		$	2,996		$	21,138
Charge-offs		(10,596	)		-			(3,407	)		(148	)		(82	)		(2,754	)		(16,987	)
Recoveries		418			-			323			71			57			263			1,132
Provision		8,295			(43	)		1,343			250			52			2,103			12,000

Ending Balance	$	8,260		$	19		$	4,638		$	1,447		$	311		$	2,608		$	17,283

Reserves:
Specific	$	5,229		$	-		$	1,481		$	1,212		$	291		$	541		$	8,754
General		3,031			19			3,157			235			20			2,067			8,529

Ending Balance	$	8,260		$	19		$	4,638		$	1,447		$	311		$	2,608		$	17,283

Loans evaluated for impairment:
Individually	$	84,508		$	-		$	5,021		$	3,903		$	591		$	4,306		$	98,329
Collectively		492,724			17,078			94,387			17,103			6,152			31,818			659,262

Ending Balance	$	577,232		$	17,078		$	99,408		$	21,006		$	6,743		$	36,124		$	757,591

Note 13 – Recent Developments

On June 12, 2012, banking regulators issued a notice of proposed rulemaking outlining potential new regulatory capital guidelines which conform to Basel III requirements. While there is lingering uncertainty with regard to exemptions that might apply to community banks, if ultimately adopted as proposed the new rules would, among other things:

add a new regulatory capital component referred to as “common equity tier 1 capital”, and establish threshold ratios for this new component (e.g., 6.5% to be “well-capitalized”);

impose a new “capital conservation buffer” of at least 2.5% of risk-weighted assets to be added to common equity tier 1 capital, and limit dividend payments, share buybacks, and certain discretionary bonus payments to executive officers if the capital conservation buffer is not achieved;

provide a phase-out period for the inclusion of trust-preferred securities as tier 1 capital (although TRUPS would reportedly still be includible in tier 2 capital);

require us to include accumulated other comprehensive income (AOCI) in tier 1 capital, which could significantly increase capital volatility;

impose additional constraints on the inclusion of minority interests, mortgage servicing assets, and deferred tax assets in regulatory capital;

adjust risk-weightings for certain assets, such as the assignment of a risk weighting of 150% to certain acquisition/development and construction loans, a risk weighting of 150% for loans that are more than 90-days past due or are on non-accrual status, and risk weightings for residential mortgages based on loan-to-value ratios and certain other loan characteristics; and

increase minimum required ratios over a phase-in period, and increase the threshold for a “well-capitalized” classification for the Tier 1 Risk-Based Capital Ratio from 6% to 8%.

The largest impact on the consolidated Company would likely come from the exclusion of $30 million in TRUPS from tier 1 capital. Other potential changes that could materially affect us include the additional constraints on the inclusion of deferred tax assets in capital, increased risk weightings for nonperforming loans and acquisition/development loans, and the inclusion of accumulated other comprehensive income in regulatory capital. The inclusion of AOCI would benefit us as long as we have a net unrealized gain on securities, but would lower our regulatory capital ratios if interest rates increase and our unrealized gain becomes an unrealized loss.

The aggregate effect of these regulatory changes on Sierra Bancorp and Bank of the Sierra cannot yet be determined with any degree of certainty, but our preliminary estimates indicate that if the changes are implemented and when they become fully phased-in they could have a material impact on our Tier 1 Leverage Ratio and our consolidated Tier 1 Risk-Based Capital Ratio. Nevertheless, given our current level of capital we should be well-positioned to absorb the impact of Basel III without constraining our organic growth plans, although no assurance can be provided in that regard.

PART I - FINANCIAL INFORMATION

ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the potential future financial performance of the Company. They include, but are not limited to, further deterioration in economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and net credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; the Company’s ability to secure buyers for foreclosed properties; declines in the market value of available-for-sale securities that could result if interest rates change substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of branch expansion; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and various other assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the Company’s allowance for loan and lease losses, as explained in detail in Note 12 to the consolidated financial statements and the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, which is discussed in Note 11 to the consolidated financial statements and in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; income taxes, especially with regard to the ability of the Company to recover deferred tax assets, as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; goodwill, which is evaluated annually for impairment based on the fair value of the Company as discussed in the “Other Assets” section of this discussion and analysis; and equity-based compensation, which is discussed in greater detail in Note 5 to the consolidated financial statements. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to those areas.

OVERVIEW OF THE RESULTS OF OPERATIONS

AND FINANCIAL CONDITION

results of operations Summary

Third quarter 2012 compared to Third quarter 2011

Net income for the quarter ended September 30, 2012 was $1.635 million, representing a decline of $891,000, or 35%, relative to net income of $2.526 million for the quarter ended September 30, 2011. Basic and diluted earnings per share for the third quarter of 2012 were $0.12, compared to $0.18 basic and diluted earnings per share for the third quarter of 2011. The Company’s annualized return on average equity was 3.74% and annualized return on average assets was 0.46% for the quarter ended September 30, 2012, compared to a return on equity of 6.00% and return on assets of 0.74% for the quarter ended September 30, 2011. The primary drivers behind the variance in third quarter net income are as follows:

Net interest income was down $418,000, or 3%, due to a 29 basis point drop in the Company’s net interest margin that was partially offset by a $44 million increase in average interest-earning assets. Factors contributing to the negative variance in the net interest margin include a shift from real estate and consumer loan balances into lower-yielding commercial loan balances, and lower loan yields resulting from increased competition for quality loans. However, those unfavorable factors were partially offset by a $15 million drop in the average balance of nonperforming loans, sizeable increases in the average balances of non-interest bearing demand deposits and equity, a shift in average interest-bearing deposit balances from higher-cost time deposits into lower-cost non-maturity deposits, and a drop in deposit rates due to the general lack of competitive pressures.

The Company’s loan loss provision was increased by $1.7 million, or 57%. The $4.7 million loan loss provision in the third quarter of 2012 was used to provide specific reserves for newly-impaired loans, replenish reserves subsequent to charge-offs, and establish general reserves for net growth in loan balances.

Total non-interest revenue increased by $527,000, or 16%, due in large part to an increase in income on bank-owned life insurance (BOLI) associated with deferred compensation plans, which was partially offset by higher net losses on the sale of OREO in the third quarter of 2012.

Total operating expense increased by $443,000, or 4%. The largest variances in operating expense include increases in deferred compensation accruals for officers and directors (related to the increase in BOLI income discussed above), lower marketing costs related to the timing of payments, a drop in expenses associated with OREO, higher regulatory assessments due to accrual adjustments made in the third quarter of 2011, an increase in fraud losses on debit cards, and lower occupancy costs resulting in part from the purchase of our headquarters office building in the fourth quarter of 2011.

The Company had a tax benefit of $321,000 in the third quarter of 2012, relative to a tax provision of $822,000 in the third quarter of 2011 which was 25% of pre-tax income. The negative tax provisioning rate for the third quarter of 2012 is primarily the result of lower taxable income relative to the Company’s available tax credits, and was impacted further by a sizeable increase in tax-exempt BOLI income for that quarter.

First Nine months 2012 compared to First Nine months 2011

Net income for the first nine months of 2012 was $6.087 million, representing a decline of $152,000, or 2%, relative to net income of $6.239 million for the first nine months of 2011. Basic and diluted earnings per share for the first nine months of 2012 were $0.43, compared to $0.45 basic earnings per share and $0.44 diluted earnings per share for the first nine months of 2011. The Company’s annualized return on average equity was 4.73% and annualized return on average assets was 0.59% for the nine months ended September 30, 2012, compared to a return on equity of 5.09% and return on assets of 0.63% for the nine months ended September 30, 2011. The primary drivers behind the variance in year-to-date net income are as follows:

Net interest income declined $1.855 million, or 5%, due to a 35 basis point drop in the Company’s net interest margin partially offset by a $33 million increase in average interest-earning assets. Factors contributing to the negative variance in the net interest margin include a proportionately small increase in average loans relative to the increase in lower-yielding investments, a shift from real estate and consumer loan balances into lower-yielding commercial loan balances, and lower loan yields resulting from increased competition for quality loans. However, as with the quarterly comparison, those unfavorable factors were partially offset by a drop in the average balance of nonperforming loans, sizeable increases in the average balances of non-interest bearing demand deposits and equity, a shift in average interest-bearing deposit balances from higher-cost time deposits into lower-cost non-maturity deposits, and a drop in deposit rates due to the general lack of competitive pressures.

The Company’s loan loss provision was increased by $1.010 million, or 11%. As with the quarter, the $10.610 million loan loss provision for the year-to-date period was used to provide specific reserves for newly-impaired loans, replenish reserves subsequent to charge-offs, and establish general reserves for net growth in loan balances.

Total non-interest revenue increased by $1.803 million, or 17%, due in large measure to an increase in BOLI income associated with deferred compensation plans, and accrual adjustments which caused a drop in expenses associated with low-income housing tax credit investments and other limited partnerships (those expenses are accounted for as a reduction in income). Debit card interchange income was also up for the year-to-date comparison, and we had $161,000 in gains on the sale of investments during the first nine months of 2012. Another favorable variance came from risk-adjusted fees on certain deposits accounts which were implemented in the fourth quarter of 2011, although that increase was offset to a great extent by a drop in fee income on returned item and overdraft charges.

Total operating expense declined by $190,000, or 1%. Favorable variances in operating expense include lower marketing costs related to the timing of payments, a drop in occupancy expense, lower regulatory assessments, and declining OREO costs. Unfavorable variances include higher deferred compensation accruals for officers and directors (related to the increase in BOLI income discussed above), higher data processing costs due to $181,000 in non-recurring vendor credits received in the first quarter of 2011, higher telecommunications expense, and higher debit card losses caused by a surge in fraud-related incidents in the third quarter of 2012.

Because of the tax benefit recorded in the third quarter of 2012, the Company’s provision for income taxes dropped for the year-to-date period to only $54,000, or less than 1% of pre-tax income. The Company’s tax provision was $774,000 for the first nine months of 2011, which equates to 11% of pre-tax income.

Financial Condition Summary

September 30, 2012 relative to December 31, 2011

The most significant characteristics of, and changes in, the Company’s balance sheet during the first nine months of 2012 are outlined below:

The Company’s assets totaled $1.423 billion at September 30, 2012, an increase of $88 million, or 7%, relative to total assets of $1.335 billion at December 31, 2011. Total assets increased due mainly to growth in loans, comprised primarily of an increase in balances outstanding on mortgage warehouse lines that was partially offset by a $27 million drop in nonperforming loans.

Total nonperforming assets fell by $23 million, or 32%, to $49 million at September 30, 2012 from $71 million at December 31, 2011. In addition to nonperforming assets, the Company had $37 million in performing troubled debt restructurings (TDR’s) as of September 30, 2012, a slight increase relative to year-end 2011.

The Company’s allowance for loan and lease losses was $12.8 million as of September 30, 2012, a decline of over $4 million, or 26%, relative to year-end 2011. The drop was due to write-downs on certain impaired collateral-dependent loans against previously-established specific reserves, which did not directly lead to the need for reserve replenishment, as well as a reduction in general reserves consistent with the Company’s improvement in asset quality. Net loans charged off against the allowance totaled $15.087 million in the first nine months of 2012 relative to net charge-offs of $10.246 million in the first nine months of 2011. Because of the decline in the overall allowance and the increase in total loans, the allowance fell to 1.51% of total loans at September 30, 2012 from 2.28% at December 31, 2011.

Total deposits increased by $60 million, or 5%. Core non-maturity deposits increased by $47 million, or 7%, including sizeable increases in non-interest bearing demand deposits, interest-bearing transaction accounts, and savings deposits. The only non-maturity deposit category that declined was money market deposits, which were down $4 million, or 5%, for the first nine months of 2012. Customer time deposits, including reciprocal deposits obtained via the Certificate of Deposit Account Registry Service (CDARS), increased by $12 million, or 4%.

Despite strong growth in deposits, additional funding was obtained for loan growth via borrowings from the Federal Home Loan Bank, which increased by $21 million.

Total capital increased by $6 million, or 4%, to $174 million at September 30, 2012, but risk-based capital ratios declined since capital was leveraged for organic loan growth. Our consolidated total risk-based capital ratio fell to 19.96% at September 30, 2012 from 21.72% at year-end 2011. Our tier one risk-based capital ratio was 18.70% and our tier one leverage ratio was 13.50% at September 30, 2012.

EARNINGS PERFORMANCE

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is non-interest income, which consists mainly of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net interest income AND NET INTEREST MARGIN

For the third quarter of 2012 relative to the third quarter of 2011 net interest income declined by $418,000, or 3%. For the year-to-date comparison, net interest income declined by $1.855 million, or 5%. The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volume of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income can also be impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and by the recovery of interest on loans that have been on non-accrual and are either sold or returned to accrual status.

The following tables show the average balance of each significant balance sheet category, and the amount of interest income or interest expense associated with each applicable category, for the noted periods. The tables also display the calculated yields on each major component of the Company’s investment and loan portfolios, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin.

Average Balances and Rates	For the Three Months							For the Three Months
(dollars in thousands, except per share data)	Ended September 30, 2012							Ended September 30, 2011
	Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾			Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾
Assets
Investments:
Federal funds sold/Due from time	$	22,858	$	15		0.26	%	$	35,763	$	23		0.25	%
Taxable		335,979		1,513		1.76	%		340,428		2,420		2.78	%
Non-taxable		81,521		700		5.09	%		74,630		716		5.69	%
Equity		1,840		10		2.13	%		1,564		-		0.00	%
Total Investments		442,198		2,238		2.30	%		452,385		3,159		3.05	%

Loans and Leases:⁽⁴⁾
Agricultural		17,905		232		5.15	%		14,455		162		4.45	%
Commercial		201,435		2,662		5.26	%		101,487		1,465		5.73	%
Real Estate		527,474		8,402		6.34	%		550,405		9,093		6.55	%
Consumer		30,239		605		7.96	%		38,658		971		9.97	%
Direct Financing Leases		3,983		53		5.29	%		6,240		89		5.66	%
Nonperforming Loans		32,926		-		0.00	%		48,267		-		0.00	%
Total Loans and Leases		813,962		11,954		5.84	%		759,512		11,780		6.15	%
Total Interest Earning Assets⁽⁵⁾		1,256,160		14,192		4.61	%		1,211,897		14,939		5.01	%
Other Earning Assets		6,389							7,528
Non-Earning Assets		143,075							131,936
Total Assets	$	1,405,624						$	1,351,361

Liabilities and Shareholders' Equity
Interest Bearing Deposits:
Demand Deposits	$	67,331	$	60		0.35	%	$	28,206	$	58		0.82	%
NOW		194,628		123		0.25	%		181,317		203		0.44	%
Savings Accounts		109,070		61		0.22	%		88,388		53		0.24	%
Money Market		79,184		32		0.16	%		130,938		85		0.26	%
CDAR's		18,768		16		0.34	%		43,912		58		0.52	%
Certificates of Deposit<$100,000		112,412		157		0.56	%		136,079		244		0.71	%
Certificates of Deposit>$100,000		225,905		297		0.52	%		207,012		311		0.60	%
Brokered Deposits		15,000		50		1.33	%		15,000		51		1.35	%
Total Interest Bearing Deposits		822,298		796		0.39	%		830,852		1,063		0.51	%
Borrowed Funds:
Federal Funds Purchased		-		-		0.00	%		1		-		0.00	%
Repurchase Agreements		5,434		8		0.59	%		4,842		7		0.57	%
Short Term Borrowings		24,019		15		0.25	%		638		-		0.00	%
Long Term Borrowings		5,000		51		4.06	%		15,000		143		3.78	%
TRUPS		30,928		193		2.48	%		30,928		179		2.30	%
Total Borrowed Funds		65,381		267		1.62	%		51,409		329		2.54	%
Total Interest Bearing Liabilities		887,679		1,063		0.48	%		882,261		1,392		0.63	%
Non-interest Bearing Demand Deposits		327,368							285,114
Other Liabilities		16,513							16,821
Shareholders' Equity		174,064							167,165
Total Liabilities and Shareholders' Equity	$	1,405,624						$	1,351,361

Interest Income/Interest Earning Assets						4.61	%						5.01	%
Interest Expense/Interest Earning Assets						0.34	%						0.46	%
Net Interest Income and Margin⁽⁶⁾			$	13,129		4.27	%			$	13,547		4.56	%

⁽¹⁾

Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

⁽²⁾

Yields and net interest margin have been computed on a tax equivalent basis utilizing a 34% effective tax rate.

⁽³⁾

Annualized

⁽⁴⁾

Loan costs have been included in the calculation of interest income. Loan costs were approximately $(81) thousand and $94 thousand for the quarters ended September 30, 2012 and 2011.

Loans are gross of the allowance for possible loan losses.

⁽⁵⁾

Non-accrual loans have been included in total loans for purposes of total earning assets.

⁽⁶⁾

Net interest margin represents net interest income as a percentage of average interest-earning assets.

Average Balances and Rates	For the Nine Months							For the Nine Months
(dollars in thousands, except per share data)	Ended September 30, 2012							Ended September 30, 2011
	Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾			Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾
Assets
Investments:
Federal funds sold/Due from time	$	26,694	$	51		0.25	%	$	29,447	$	56		0.25	%
Taxable		339,873		5,116		1.98	%		310,225		6,621		2.81	%
Non-taxable		77,146		2,052		5.30	%		73,290		2,153		5.87	%
Equity		1,698		43		3.33	%		1,570		-		0.00	%
Total Investments		445,411		7,262		2.45	%		414,532		8,830		3.16	%

Loans and Leases:⁽⁴⁾
Agricultural		15,985		547		4.57	%		13,485		493		4.89	%
Commercial		150,343		6,157		5.47	%		103,557		4,585		5.92	%
Real Estate		528,233		25,326		6.40	%		558,791		27,233		6.52	%
Consumer		31,674		2,042		8.61	%		41,237		2,861		9.28	%
Direct Financing Leases		4,416		179		5.41	%		7,096		308		5.80	%
Nonperforming Loans		44,744		-		0.00	%		48,813		-		0.00	%
Total Loans and Leases		775,395		34,251		5.90	%		772,979		35,480		6.14	%
Total Interest Earning Assets⁽⁵⁾		1,220,806		41,513		4.66	%		1,187,511		44,310		5.11	%
Other Earning Assets		6,650							7,916
Non-Earning Assets		141,799