UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
     
 
FORM 10-Q
 
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended:     June 30, 2017
 
OR
 
[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
(Exact name of registrant as specified in its charter)
 
North Carolina
(State or other jurisdiction of incorporation or organization)
 
000-27205
56-2132396
(Commission File No.)
(IRS Employer Identification No.)
 
518 West C Street, Newton, North Carolina
28658
(Address of principal executive offices)
(Zip Code)
 
(828) 464-5620
(Registrant's telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes
X
 
No
 
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 
 
Yes
X
 
No
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of "accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large Accelerate Filer
 
 
Accelerated Filer
X
 
Non-Accelerated Filer
 
 
 
Smaller Reporting Company
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2 of the Exchange Act).
 
Yes
 
 
No
X
 
 
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
5,450,412 shares of common stock, outstanding at July 31, 2017.
 

 
INDEX   
       
PART I.
FINANCIAL INFORMATION
PAGE(S)
       
Item 1.
 
Financial Statements
 
       
   
Consolidated Balance Sheets at June 30, 2017 (Unaudited) and December
 
   
31, 2016 (Audited)
3
       
   
Consolidated Statements of Earnings for the three and six months ended
 
   
June 30, 2017 and 2016 (Unaudited)
4
       
   
Consolidated Statements of Comprehensive Income for the three and six
 
   
months ended June 30, 2017 and 2016 (Unaudited)
5
       
   
Consolidated Statements of Changes in Shareholders'Equity for the six
 
   
months ended June 30, 2017 and 2016 (Unaudited)
6
       
   
Consolidated Statements of Cash Flows for the six months ended June 30,
 
   
2017 and 2016 (Unaudited)
7-8
       
 
 
Notes to Consolidated Financial Statements (Unaudited)
9-24
       
Item 2.
 
Management's Discussion  and Analysis of Financial Condition
 
   
and Results of Operations
25-37
       
Item 3.
 
Quantitative and Qualitative Disclosures About Market Risk
38
       
Item 4T.  
Controls and Procedures
39
       
PART II.
OTHER INFORMATION
 
       
Item 1.
 
Legal Proceedings
40
Item 1A.
 
Risk Factors
40
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
40
Item 3.
 
Defaults upon Senior Securities
40
Item 5.
 
Other Information
40
Item 6.
 
Exhibits
40-42
Signatures 
 
43
Certifications 
 
44-46
 
 
Statements made in this Form 10-Q, other than those concerning historical information, should be considered forward-looking statements pursuant to the safe harbor provisions of the Securities Exchange Act of 1934 and the Private Securities Litigation Act of 1995.  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management and on the information available to management at the time that this Form 10-Q was prepared.  These statements can be identified by the use of words like "expect," "anticipate," "estimate," and "believe," variations of these words and other similar expressions.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  Factors that could cause actual results to differ include, but are not limited to, (1) competition in the markets served by the registrant and its subsidiaries, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environments and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in other filings with the Securities and Exchange Commission, including but not limited to, those described in the registrant's Annual Report on Form 10-K for the year ended December 31, 2016.
 
2

 
PART I.
FINANCIAL INFORMATION
   
Item 1.
Financial Statements
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.      
             
Consolidated Balance Sheets      
             
June 30, 2017 and December 31, 2016      
             
(Dollars in thousands)      
   
June 30,
   
December 31,
 
Assets
 
2017
   
2016
 
   
(Unaudited)
   
(Audited)
 
             
Cash and due from banks, including reserve requirements
 
$
54,100
     
53,613
 
of $8,947 at 6/30/17 and $6,075 at 12/31/16
               
Interest-bearing deposits
   
20,955
     
16,481
 
Cash and cash equivalents
   
75,055
     
70,094
 
                 
Investment securities available for sale
   
241,320
     
249,946
 
Other investments
   
2,680
     
2,635
 
Total securities
   
244,000
     
252,581
 
                 
Mortgage loans held for sale
   
3,513
     
5,709
 
                 
Loans
   
745,038
     
723,811
 
Less allowance for loan losses
   
(7,167
)
   
(7,550
)
Net loans
   
737,871
     
716,261
 
                 
Premises and equipment, net
   
19,385
     
16,452
 
Cash surrender value of life insurance
   
15,351
     
14,952
 
Other real estate
   
-
     
283
 
Accrued interest receivable and other assets
   
11,809
     
11,659
 
Total assets
 
$
1,106,984
     
1,087,991
 
                 
Liabilities and Shareholders' Equity
               
                 
Deposits:
               
Noninterest-bearing demand
 
$
276,614
     
271,851
 
NOW, MMDA & savings
   
483,440
     
477,054
 
Time, $250,000 or more
   
22,462
     
26,771
 
Other time
   
109,969
     
117,242
 
Total deposits
   
892,485
     
892,918
 
                 
Securities sold under agreements to repurchase
   
49,977
     
36,434
 
FHLB borrowings
   
20,000
     
20,000
 
Junior subordinated debentures
   
20,619
     
20,619
 
Accrued interest payable and other liabilities
   
9,971
     
10,592
 
Total liabilities
   
993,052
     
980,563
 
                 
Commitments
               
                 
Shareholders' equity:
               
Series A preferred stock, $1,000 stated value; authorized
               
5,000,000 shares; no shares issued and outstanding
   
-
     
-
 
Common stock, no par value; authorized
               
20,000,000 shares; issued and outstanding 5,448,454 shares
               
at June 30, 2017 and 5,417,800 shares at December 31, 2016
   
45,039
     
44,187
 
Retained earnings
   
63,954
     
60,254
 
Accumulated other comprehensive income
   
4,939
     
2,987
 
Total shareholders' equity
   
113,932
     
107,428
 
                 
Total liabilities and shareholders' equity
 
$
1,106,984
     
1,087,991
 
                 
See accompanying Notes to Consolidated Financial Statements.
               

3

 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.            
                         
Consolidated Statements of Earnings            
                         
Three and Six Months Ended June 30, 2017 and 2016            
                         
(Dollars in thousands, except per share amounts)            
                         
   
Three months ended
   
Six months ended
 
   
June 30,   
   
June 30,  
 
   
2017
   
2016
   
2017
   
2016
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Interest income:
                       
Interest and fees on loans
 
$
8,689
     
7,973
     
16,969
     
15,996
 
Interest on due from banks
   
48
     
18
     
78
     
35
 
Interest on investment securities:
                               
U.S. Government sponsored enterprises
   
613
     
649
     
1,217
     
1,307
 
State and political subdivisions
   
1,067
     
1,118
     
2,151
     
2,245
 
Other
   
44
     
57
     
110
     
137
 
Total interest income
   
10,461
     
9,815
     
20,525
     
19,720
 
                                 
Interest expense:
                               
NOW, MMDA & savings deposits
   
143
     
121
     
275
     
241
 
Time deposits
   
120
     
148
     
248
     
310
 
FHLB borrowings
   
201
     
416
     
393
     
822
 
Junior subordinated debentures
   
145
     
118
     
280
     
231
 
Other
   
13
     
10
     
24
     
18
 
Total interest expense
   
622
     
813
     
1,220
     
1,622
 
                                 
Net interest income
   
9,839
     
9,002
     
19,305
     
18,098
 
                                 
Provision for (reduction of provision for) loan losses
   
49
     
(531
)
   
(187
)
   
(748
)
                                 
Net interest income after provision for loan losses
   
9,790
     
9,533
     
19,492
     
18,846
 
                                 
Non-interest income:
                               
Service charges
   
1,094
     
1,087
     
2,200
     
2,128
 
Other service charges and fees
   
147
     
202
     
302
     
536
 
Gain on sale of securities
   
-
     
324
     
-
     
324
 
Mortgage banking income
   
319
     
292
     
665
     
661
 
Insurance and brokerage commissions
   
179
     
156
     
347
     
314
 
Gain/(loss) on sale and write-down of
                               
other real estate
   
-
     
3
     
(283
)
   
80
 
Miscellaneous
   
1,542
     
1,508
     
2,926
     
2,853
 
Total non-interest income
   
3,281
     
3,572
     
6,157
     
6,896
 
                                 
Non-interest expense:
                               
Salaries and employee benefits
   
4,871
     
4,704
     
10,105
     
9,285
 
Occupancy
   
1,699
     
1,734
     
3,312
     
3,488
 
Professional fees
   
236
     
239
     
485
     
1,174
 
Advertising
   
366
     
148
     
612
     
310
 
Debit card expense
   
268
     
333
     
574
     
599
 
FDIC Insurance
   
87
     
164
     
173
     
335
 
Other
   
1,808
     
1,787
     
3,869
     
3,410
 
Total non-interest expense
   
9,335
     
9,109
     
19,130
     
18,601
 
                                 
Earnings before income taxes
   
3,736
     
3,996
     
6,519
     
7,141
 
                                 
Income tax expense
   
925
     
1,032
     
1,503
     
1,723
 
                                 
Net earnings
 
$
2,811
     
2,964
     
5,016
     
5,418
 
                                 
Basic net earnings per share
 
$
0.52
     
0.54
     
0.92
     
0.98
 
Diluted net earnings per share
 
$
0.51
     
0.53
     
0.91
     
0.97
 
Cash dividends declared per share
 
$
0.12
     
0.10
     
0.24
     
0.18
 
                                 
See accompanying Notes to Consolidated Financial Statements.
                         
 
 
4

 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.            
                         
Consolidated Statements of Comprehensive Income            
                         
Three and Six Months Ended June 30, 2017 and 2016            
 
(Dollars in thousands)            
                         
   
Three months ended
   
Six months ended
 
   
June 30,   
   
June 30,  
 
   
2017
   
2016 
 
2017
   
2016
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Net earnings
 
$
2,811
     
2,964
     
5,016
     
5,418
 
                                 
Other comprehensive income:
                               
Unrealized holding gains on securities
                               
available for sale
   
2,107
     
2,844
     
2,694
     
4,273
 
Reclassification adjustment for gains on
                               
securities available for sale
                               
included in net earnings
   
-
     
(324
)
   
-
     
(324
)
                                 
Total other comprehensive  income,
                               
before income taxes
   
2,107
     
2,520
     
2,694
     
3,949
 
                                 
Income tax expense related to other
                               
comprehensive income:
                               
                                 
Unrealized holding gains on securities
                               
available for sale
   
758
     
1,026
     
742
     
1,566
 
Reclassification adjustment for gains
                               
on securities available for sale
                               
included in net earnings
   
-
     
(126
)
   
-
     
(126
)
                                 
Total income tax expense related to
                               
other comprehensive income
   
758
     
900
     
742
     
1,440
 
                                 
Total other comprehensive income,
                               
net of tax
   
1,349
     
1,620
     
1,952
     
2,509
 
                                 
Total comprehensive income
 
$
4,160
     
4,584
     
6,968
     
7,927
 
                                 
See accompanying Notes to Consolidated Financial Statements.
                         
 
 
5

 
PEOPLES BANCORP OF NORTH CAROLINA, INC.          
                               
Consolidated Statements of Changes in Shareholders' Equity          
                               
Six Months Ended June 30, 2017 and 2016             
                               
(Dollars in thousands)               
                               
                     
Accumulated
       
                     
Other
       
    Common Stock        Retained     Comprehensive        
   
Shares
   
Amount
   
Earnings
   
Income
   
Total
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                               
Balance, December 31, 2016
   
5,417,800
   
$
44,187
     
60,254
     
2,987
     
107,428
 
                                         
Cash dividends declared on
                                       
common stock
   
-
     
-
     
(1,316
)
   
-
     
(1,316
)
Restricted stock units exercised
   
30,654
     
852
     
-
     
-
     
852
 
Net earnings
   
-
     
-
     
5,016
     
-
     
5,016
 
Change in accumulated other
                                       
comprehensive income, net of tax
   
-
     
-
     
-
     
1,952
     
1,952
 
Balance, June 30, 2017
   
5,448,454
   
$
45,039
     
63,954
     
4,939
     
113,932
 
                                         
Balance, December 31, 2015
   
5,510,538
   
$
46,171
     
53,183
     
5,510
     
104,864
 
                                         
Cash dividends declared on
                                       
common stock
   
-
     
-
     
(1,007
)
   
-
     
(1,007
)
Net earnings
   
-
     
-
     
5,418
     
-
     
5,418
 
Change in accumulated other
                                       
comprehensive income, net of tax
   
-
     
-
     
-
     
2,509
     
2,509
 
Balance, June 30, 2016
   
5,510,538
   
$
46,171
     
57,594
     
8,019
     
111,784
 
                                         
See accompanying Notes to Consolidated Financial Statements.
                         
 
6

 

PEOPLES BANCORP OF NORTH CAROLINA, INC.      
             
Consolidated Statements of Cash Flows      
             
Six Months Ended June 30, 2017 and 2016      
             
(Dollars in thousands)      
             
   
2017
   
2016
 
   
(Unaudited)
   
(Unaudited)
 
             
Cash flows from operating activities:
           
Net earnings
 
$
5,016
     
5,418
 
Adjustments to reconcile net earnings to
               
net cash provided by operating activities:
               
Depreciation, amortization and accretion
   
2,506
     
2,862
 
(Reduction)/Provision for loan losses
   
(187
)
   
(748
)
Deferred income taxes
   
(1,122
)
   
(532
)
Gain on sale of investment securities
   
-
     
(324
)
Gain on sale of other real estate
   
-
     
(83
)
Write-down of other real estate
   
283
     
3
 
Loss on sale of premises and equipment
   
32
     
-
 
Restricted stock expense
   
471
     
252
 
Proceeds from sales of mortgage loans held for sale
   
34,845
     
30,099
 
Origination of mortgage loans held for sale
   
(32,649
)
   
(28,974
)
Change in:
               
Cash surrender value of life insurance
   
(399
)
   
(207
)
Other assets
   
230
     
518
 
Other liabilities
   
(240
)
   
630
 
                 
Net cash provided by operating activities
   
8,786
     
8,914
 
                 
Cash flows from investing activities:
               
Purchases of investment securities available for sale
   
(3,138
)
   
(6,686
)
Proceeds from sales, calls and maturities of investment securities
               
available for sale
   
4,285
     
2,774
 
Proceeds from paydowns of investment securities available for sale
   
8,682
     
9,949
 
Purchases of FHLB stock
   
(45
)
   
-
 
FHLB stock redemption
   
-
     
2
 
Net change in loans
   
(21,423
)
   
(13,512
)
Purchases of premises and equipment
   
(3,980
)
   
(444
)
Proceeds from sale of other real estate and repossessions
   
-
     
855
 
                 
Net cash used by investing activities
   
(15,619
)
   
(7,062
)
                 
Cash flows from financing activities:
               
Net change in deposits
   
(433
)
   
9,225
 
Net change in securities sold under agreement to repurchase
   
13,543
     
14,841
 
Proceeds from Fed Funds purchased
   
-
     
8,985
 
Repayments of Fed Funds purchased
   
-
     
(8,995
)
Cash dividends paid on common stock
   
(1,316
)
   
(1,007
)
                 
Net cash provided by financing activities
   
11,794
     
23,049
 
                 
Net change in cash and cash equivalents
   
4,961
     
24,911
 
                 
Cash and cash equivalents at beginning of period
   
70,094
     
39,763
 
                 
Cash and cash equivalents at end of period
 
$
75,055
     
64,674
 
 
7

 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.      
             
Consolidated Statements of Cash Flows, continued      
             
Six Months Ended June 30, 2017 and 2016      
             
(Dollars in thousands)      
             
             
   
2017
   
2016
 
   
(Unaudited)
   
(Unaudited)
 
             
Supplemental disclosures of cash flow information:
           
Cash paid during the period for:
           
Interest
 
$
1,241
     
1,608
 
Income taxes
 
$
40
     
2,851
 
                 
Noncash investing and financing activities:
               
Change in unrealized gain on investment securities
               
 available for sale, net
 
$
1,952
     
2,509
 
Issuance of accrued restricted stock units
 
$
(852
)
   
-
 
Transfers of loans to other real estate and repossessions
 
$
-
     
271
 
                 
See accompanying Notes to Consolidated Financial Statements.
               
 
 
8

 
PEOPLES BANCORP OF NORTH CAROLINA, INC.

Notes to Consolidated Financial Statements (Unaudited)

(1)
    Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank (the "Bank"), along with the Bank's wholly owned subsidiaries, Peoples Investment Services, Inc., Real Estate Advisory Services, Inc. ("REAS"), Community Bank Real Estate Solutions, LLC ("CBRES") and PB Real Estate Holdings, LLC (collectively called the "Company").  All significant intercompany balances and transactions have been eliminated in consolidation.

The Bank operates three banking offices focused on the Latino population that were formerly operated as a division of the Bank under the name Banco de la Gente ("Banco").  These offices are now branded as Bank branches and considered a separate market territory of the Bank as they offer normal and customary banking services as are offered in the Bank's other branches such as the taking of deposits and the making of loans.

The consolidated financial statements in this report (other than the Consolidated Balance Sheet at December 31, 2016) are unaudited.  In the opinion of management, all adjustments (none of which were other than normal accruals) necessary for a fair presentation of the financial position and results of operations for the periods presented have been included.  Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles in the United States ("GAAP").  Actual results could differ from those estimates.

The Company's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition.  Many of the Company's accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of the specific accounting guidance.  A description of the Company's significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company's 2016 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2017 Annual Meeting of Shareholders.

Recently Issued Accounting Pronouncements  
In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, (Topic 842):  Leases.  ASU No. 2016-02 increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.  ASU No. 2016-02 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In June 2016, FASB issued ASU No. 2016-13, (Topic 326):  Measurement of Credit Losses on Financial Instruments.  ASU No. 2016-13 provides guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. ASU No. 2016-13 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019.  The Company is currently evaluating the effect that implementation of the new standard will have on its results of operations, financial position and disclosures.
 
In January 2017, FASB issued ASU No. 2017-01, (Topic 805):  Clarifying the Definition of a Business.  ASU No. 2017-01 adds guidance to assist companies and other reporting organizations with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses.  ASU No. 2017-01 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In January 2017, FASB issued ASU No. 2017-04, (Topic 350):  Simplifying the Test for Goodwill Impairment.  ASU No. 2017-04 provides guidance to simplify the accounting related to goodwill impairment. ASU No. 2017-04 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2019.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.
 
9


In February 2017, FASB issued ASU No. 2017-05, (Subtopic 610-20):  Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets.  ASU No. 2017-05 clarifies the scope of established guidance on nonfinancial asset derecognition (issued as part of the new revenue standard, ASU No. 2014-09, Revenue from Contracts with Customers), as well as the accounting for partial sales of nonfinancial assets.  ASU No. 2017-05 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In March 2017, FASB issued ASU No. 2017-07, (Topic 715):  Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Costs.  ASU No. 2017-07 amended the requirements related to the income statement presentation of the components of net periodic benefit cost for an entity's sponsored defined benefit pension and other postretirement plans.  ASU No. 2017-07 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In March 2017, FASB issued ASU No. 2017-08, (Subtopic 310-20):  Premium Amortization on Purchased Callable Debt Securities.  ASU No. 2017-08 amended the requirements related to the amortization period for certain purchased callable debt securities held at a premium.  ASU No. 2017-08 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

In May 2017, FASB issued ASU No. 2017-09, (Topic 718):  Scope of Modification Accounting.  ASU No. 2017-09 amended the requirements related to changes to the terms or conditions of a share-based payment award.  ASU No. 2017-09 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017.  The adoption of this guidance is not expected to have a material impact on the Company's results of operations, financial position or disclosures.

Other accounting standards that have been issued or proposed by FASB or other standards-setting bodies are not expected to have a material impact on the Company's results of operations, financial position or disclosures.

(2)
    Investment Securities

Investment securities available for sale at June 30, 2017 and December 31, 2016 are as follows:
 
(Dollars in thousands)
                   
 
June 30, 2017         
 
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
Mortgage-backed securities
$
59,302
   
1,257
   
182
   
60,377
U.S. Government
                     
sponsored enterprises
 
39,254
   
402
   
29
   
39,627
State and political subdivisions
 
133,298
   
6,252
   
20
   
139,530
Corporate bonds
 
1,500
   
36
   
-
   
1,536
Trust preferred securities
 
250
   
-
   
-
   
250
Total
$
233,604
   
7,947
   
231
   
241,320
 
10

 
 
(Dollars in thousands)
                   
 
December 31, 2016      
 
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Estimated
Fair Value
Mortgage-backed securities
$
66,654
   
1,221
   
290
   
67,585
U.S. Government
                     
sponsored enterprises
 
38,188
   
308
   
274
   
38,222
State and political subdivisions
 
137,832
   
4,176
   
152
   
141,856
Corporate bonds
 
1,500
   
33
   
-
   
1,533
Trust preferred securities
 
750
   
-
   
-
   
750
Total
$
244,924
   
5,738
   
716
   
249,946
 
The current fair value and associated unrealized losses on investments in securities with unrealized losses at June 30, 2017 and December 31, 2016 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.
 
(Dollars in thousands)
                                 
   
June 30, 2017               
   
Less than 12 Months
   
12 Months or More
   
Total   
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
Mortgage-backed securities
 
$
14,513
     
182
     
-
     
-
     
14,513
     
182
U.S. Government
                                             
sponsored enterprises
   
-
     
-
     
11,567
     
29
     
11,567
     
29
State and political subdivisions
   
1,037
     
4
     
570
     
16
     
1,607
     
20
Total
 
$
15,550
     
186
     
12,137
     
45
     
27,687
     
231
                                               
(Dollars in thousands)
                                             
   
December 31, 2016                    
   
Less than 12 Months
   
12 Months or More
   
Total    
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
   
Fair Value
   
Unrealized
Losses
Mortgage-backed securities
 
$
15,594
     
290
     
-
     
-
     
15,594
     
290
U.S. Government
                                             
sponsored enterprises
   
10,120
     
94
     
9,562
     
180
     
19,682
     
274
State and political subdivisions
   
10,441
     
123
     
561
     
29
     
11,002
     
152
Total
 
$
36,155
     
507
     
10,123
     
209
     
46,278
     
716
 
At June 30, 2017, unrealized losses in the investment securities portfolio relating to debt securities totaled $231,000.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the June 30, 2017 tables above, 3 out of 163 securities issued by state and political subdivisions contained unrealized losses, 15 out of 78 securities issued by U.S. Government sponsored enterprises contained unrealized losses, and no securities issued by corporations contained unrealized losses.  These unrealized losses are considered temporary because of acceptable financial condition and results of operations of entities that issued each security and the repayment sources of principal and interest on U.S. Government sponsored enterprises, including mortgage-backed securities, are government backed.

The amortized cost and estimated fair value of investment securities available for sale at June 30, 2017, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
11

 
 
June 30, 2017
         
(Dollars in thousands)
         
   
Amortized
Cost
   
Estimated
Fair Value
Due within one year
 
$
14,885
     
15,051
Due from one to five years
   
93,690
     
97,862
Due from five to ten years
   
56,040
     
58,093
Due after ten years
   
9,437
     
9,687
Mortgage-backed securities
   
59,302
     
60,377
Trust preferred securities
   
250
     
250
Total
 
$
233,604
     
241,320
 
No securities available for sale were sold during the six months ended June 30, 2017.   Proceeds from sales of securities available for sale during the six months ended June 30, 2016 were $804,000 and resulted in gross gains of $324,000.

Securities with a fair value of approximately $88.4 million and $95.6 million at June 30, 2017 and December 31, 2016, respectively, were pledged to secure public deposits and for other purposes as required by law.

(3)
    Loans

Major classifications of loans at June 30, 2017 and December 31, 2016 are summarized as follows:
 
(Dollars in thousands)
         
   
June 30, 2017
   
December 31, 2016
Real estate loans:
         
Construction and land development
 
$
71,213
     
61,749
Single-family residential
   
240,993
     
240,700
Single-family residential -
             
Banco de la Gente stated income
   
38,875
     
40,189
Commercial
   
243,957
     
247,521
Multifamily and farmland
   
30,125
     
21,047
Total real estate loans
   
625,163
     
611,206
               
Loans not secured by real estate:
             
Commercial loans
   
94,567
     
87,596
Farm loans
   
1,591
     
-
Consumer loans
   
10,099
     
9,832
All other loans
   
13,618
     
15,177
               
Total loans
   
745,038
     
723,811
               
Less allowance for loan losses
   
7,167
     
7,550
               
Total net loans
 
$
737,871
     
716,261
 
 
The Bank grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties, and also in Mecklenburg, Wake and Durham counties of North Carolina.  Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.  Risk characteristics of the major components of the Bank's loan portfolio are discussed below:
 
·
Construction and land development loans – The risk of loss is largely dependent on the initial estimate of whether the property's value at completion equals or exceeds the cost of property construction and the availability of take-out financing.  During the construction phase, a number of factors can result in delays or cost overruns.  If the estimate is inaccurate or if actual construction costs exceed estimates, the value of the property securing the loan may be insufficient to ensure full repayment when completed through a permanent loan, sale of the property, or by seizure of collateral.  As of June 30, 2017, construction and land development loans comprised approximately 10% of the Bank's total loan portfolio.
 
12

 
 
·
Single-family residential loans – Declining home sales volumes, decreased real estate values and higher than normal levels of unemployment could contribute to losses on these loans.  As of June 30, 2017, single-family residential loans comprised approximately 38% of the Bank's total loan portfolio, and include Banco's single-family residential stated income loans, which were approximately 5% of the Bank's total loan portfolio.

·
Commercial real estate loans – Repayment is dependent on income being generated in amounts sufficient to cover operating expenses and debt service.  These loans also involve greater risk because they are generally not fully amortizing over a loan period, but rather have a balloon payment due at maturity.  A borrower's ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property.  As of June 30, 2017, commercial real estate loans comprised approximately 33% of the Bank's total loan portfolio.

·
Commercial loans – Repayment is generally dependent upon the successful operation of the borrower's business.   In addition, the collateral securing the loans may depreciate over time, be difficult to appraise, be illiquid or fluctuate in value based on the success of the business.  As of June 30, 2017, commercial loans comprised approximately 13% of the Bank's total loan portfolio.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management's opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all of the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
The following tables present an age analysis of past due loans, by loan type, as of June 30, 2017 and December 31, 2016:

June 30, 2017     
                       
(Dollars in thousands)     
                       
   
Loans 30-89
Days Past
Due
   
Loans 90 or
More Days
Past Due
   
Total
Past Due
Loans
   
Total
Current
Loans
   
Total
Loans
   
Accruing
Loans 90 or
More Days
Past Due
Real estate loans:
                                 
Construction and land development
 
$
3,706
     
-
     
3,706
     
67,507
     
71,213
     
-
Single-family residential
   
949
     
174
     
1,123
     
239,870
     
240,993
     
55
Single-family residential -
                                             
Banco de la Gente stated income
   
1,365
     
273
     
1,638
     
37,237
     
38,875
     
-
Commercial
   
12
     
249
     
261
     
243,696
     
243,957
     
-
Multifamily and farmland
   
-
     
12
     
12
     
30,113
     
30,125
     
-
Total real estate loans
   
6,032
     
708
     
6,740
     
618,423
     
625,163
     
55
                                               
Loans not secured by real estate:
                                             
Commercial loans
   
1,070
     
-
     
1,070
     
93,497
     
94,567
     
-
Farm loans
   
-
     
-
     
-
     
1,591
     
1,591
     
-
Consumer loans
   
52
     
6
     
58
     
10,041
     
10,099
     
-
All other loans
   
-
     
-
     
-
     
13,618
     
13,618
     
-
Total loans
 
$
7,154
     
714
     
7,868
     
737,170
     
745,038
     
55
 
 
13

 
 
December 31, 2016
                                 
(Dollars in thousands)
                                 
   
Loans 30-89
Days Past
Due
   
Loans 90 or
More Days
Past Due
   
Total
Past Due
Loans
   
Total
Current
Loans
   
Total
 Loans
   
Accruing
Loans 90 or
More Days
Past Due
Real estate loans:
                                 
Construction and land development
 
$
-
     
10
     
10
     
61,739
     
61,749
     
-
Single-family residential
   
4,890
     
80
     
4,970
     
235,730
     
240,700
     
-
Single-family residential -
                                             
Banco de la Gente stated income
   
5,250
     
249
     
5,499
     
34,690
     
40,189
     
-
Commercial
   
342
     
126
     
468
     
247,053
     
247,521
     
-
Multifamily and farmland
   
471
     
-
     
471
     
20,576
     
21,047
     
-
Total real estate loans
   
10,953
     
465
     
11,418
     
599,788
     
611,206
     
-
                                               
Loans not secured by real estate:
                                             
Commercial loans
   
273
     
-
     
273
     
87,323
     
87,596
     
-
Farm loans
   
-
     
-
     
-
     
-
     
-
     
-
Consumer loans
   
68
     
6
     
74
     
9,758
     
9,832
     
-
All other loans
   
3
     
-
     
3
     
15,174
     
15,177
     
-
Total loans
 
$
11,297
     
471
     
11,768
     
712,043
     
723,811
     
-
 
The following table presents non-accrual loans as of June 30, 2017 and December 31, 2016:

(Dollars in thousands)
         
   
June 30, 2017
   
December 31, 2016
Real estate loans:
         
Construction and land development
 
$
18
     
22
Single-family residential
   
1,444
     
1,662
Single-family residential -
             
Banco de la Gente stated income
   
1,461
     
1,340
Commercial
   
1,440
     
669
Multifamily and farmland
   
12
     
78
Total real estate loans
   
4,375
     
3,771
               
Loans not secured by real estate:
             
Commercial loans
   
249
     
21
Consumer loans
   
21
     
33
Total
 
$
4,645
     
3,825
 
At each reporting period, the Bank determines which loans are impaired.  Accordingly, the Bank's impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank.  REAS is staffed by certified appraisers that also perform appraisals for other companies.  Factors, including the assumptions and techniques utilized by the appraiser, are considered by management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.  An allowance for each impaired loan that is not collateral dependent is calculated based on the present value of projected cash flows.  If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses.  Impaired loans under $250,000 are not individually evaluated for impairment with the exception of the Bank's troubled debt restructured ("TDR") loans in the residential mortgage loan portfolio, which are individually evaluated for impairment.  Accruing impaired loans were $22.4 million, $23.5 million and $23.7 million at June 30, 2017, December 31, 2016 and June 30, 2016, respectively.  Interest income recognized on accruing impaired loans was $740,000, $596,000 and $1.2 million for the six months ended June 30, 2017, the six months ended June 30, 2016 and the year ended December 31, 2016, respectively.  No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.
 
 
14

 
The following table presents impaired loans as of June 30, 2017:

June 30, 2017
                           
(Dollars in thousands)
                           
                             
   
Unpaid
Contractual
Principal
Balance
   
Recorded
Investment
With No
Allowance
   
Recorded
Investment
With
Allowance
   
Recorded
Investment
 in Impaired
Loans
   
Related
Allowance
Real estate loans:
                           
Construction and land development
 
$
253
     
-
     
257
     
257
     
9
Single-family residential
   
4,666
     
1,152
     
3,896
     
5,048
     
38
Single-family residential -
                                     
Banco de la Gente stated income
   
17,439
     
-
     
18,029
     
18,029
     
1,123
Commercial
   
4,190
     
1,699
     
2,769
     
4,468
     
68
Multifamily and farmland
   
12
     
-
     
78
     
78
     
-
Total impaired real estate loans
   
26,560
     
2,851
     
25,029
     
27,880
     
1,238
                                       
Loans not secured by real estate:
                                     
Commercial loans
   
253
     
-
     
288
     
288
     
27
Consumer loans
   
187
     
-
     
197
     
197
     
3
Total impaired loans
 
$
27,000
     
2,851
     
25,514
     
28,365
     
1,268
 
The following table presents the average impaired loan balance and the interest income recognized by loan class for the three and six months ended June 30, 2017 and 2016.
 
(Dollars in thousands)   
                                       
   
Three months ended      
   
Six months ended      
   
June 30, 2017
   
June 30, 2016
   
June 30, 2017
   
June 30, 2016
   
Average
Balance
   
Interest
Income Recognized
   
Average
Balance
   
Interest
Income Recognized
   
Average
Balance
   
Interest
Income Recognized
   
Average
Balance
   
Interest
Income Recognized
Real estate loans:
                                             
Construction and land development
 
$
304
     
2
     
455
     
4
     
265
     
6
     
405
     
7
Single-family residential
   
4,595
     
63
     
8,680
     
33
     
5,185
     
131
     
9,769
     
82
Single-family residential -
                                                             
Banco de la Gente stated income
   
17,539
     
232
     
17,888
     
219
     
17,271
     
469
     
17,875
     
449
Commercial
   
3,831
     
66
     
5,694
     
24
     
3,778
     
125
     
5,978
     
49
Multifamily and farmland
   
45
     
-
     
78
     
-
     
56
     
-
     
80
     
3
Total impaired real estate loans
   
26,314
     
363
     
32,795
     
280
     
26,555
     
731
     
34,107
     
590
                                                               
Loans not secured by real estate:
                                                             
Commercial loans
   
129
     
3
     
141
     
-
     
95
     
3
     
139
     
1
Consumer loans
   
221
     
3
     
233
     
2
     
215
     
6
     
240
     
5
Total impaired loans
 
$
26,664
     
369
     
33,169
     
282
     
26,865
     
740
     
34,486
     
596
 
 
15

 
 
The following table presents impaired loans as of December 31, 2016:

December 31, 2016  
                                   
(Dollars in thousands)   
                                 
                                         
   
Unpaid
Contractual
Principal
Balance
   
Recorded
Investment
With No
Allowance
   
Recorded
Investment
With
Allowance
   
Recorded
Investment
in Impaired
Loans
   
Related
Allowance
   
Average
Outstanding
Impaired
Loans
   
YTD
Interest
Income
Recognized
Real estate loans:
                                       
Construction and land development
 
$
282
     
-
     
278
     
278
     
11
     
330
     
13
Single-family residential
   
5,354
     
703
     
4,323
     
5,026
     
47
     
7,247
     
164
Single-family residential -
                                                     
Banco de la Gente stated income
   
18,611
     
-
     
18,074
     
18,074
     
1,182
     
17,673
     
861
Commercial
   
3,750
     
1,299
     
2,197
     
3,496
     
166
     
4,657
     
152
Multifamily and farmland
   
78
     
-
     
78
     
78
     
-
     
78
     
-
Total impaired real estate loans
   
28,075
     
2,002
     
24,950
     
26,952
     
1,406
     
29,985
     
1,190
                                                       
Loans not secured by real estate:
                                                     
Commercial loans
   
27
     
-
     
27
     
27
     
-
     
95
     
-
Consumer loans
   
211
     
-
     
202
     
202
     
3
     
222
     
8
Total impaired loans
 
$
28,313
     
2,002
     
25,179
     
27,181
     
1,409
     
30,302
     
1,198
 
Changes in the allowance for loan losses for the three and six months ended June 30, 2017 and 2016 were as follows:

(Dollars in thousands)  
                                   
 
Real Estate Loans         
                     
 
Construction
and Land Development
 
Single-
Family
Residential
 
Single-
Family
Residential - Banco de la
Gente
Stated
Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
and All
Other
 
Unallocated
 
Total
 
Six months ended June 30, 2017:
                                     
Allowance for loan losses:
                                     
Beginning balance
$
1,152
 
2,126
 
1,377
 
1,593
 
52
 
675
 
-
 
204
 
371
 
7,550
 
Charge-offs
 
-
 
(44
)
-
 
(66
)
-
 
(37
)
-
 
(182
)
-
 
(329
)
Recoveries
 
10
 
16
 
-
 
14
 
-
 
15
 
-
 
78
 
-
 
133
 
Provision
 
21
 
(279
)
(84
)
(78
)
23
 
51
 
-
 
58
 
101
 
(187
)
Ending balance
$
1,183
 
1,819
 
1,293
 
1,463
 
75
 
704
 
-
 
158
 
472
 
7,167
 
                                           
Three months ended June 30, 2017:
                                     
Allowance for loan losses:
                                     
Beginning balance
$
969
 
2,003
 
1,328
 
1,655
 
73
 
628
 
-
 
178
 
429
 
7,263
 
Charge-offs
 
-
 
(24
)
-
 
-
 
(66
)
(35
)
-
 
(73
)
-
 
(198
)
Recoveries
 
3
 
9
 
-
 
6
 
-
 
7
 
-
 
28
 
-
 
53
 
Provision
 
211
 
(169
)
(35
)
(198
)
68
 
104
 
-
 
25
 
43
 
49
 
Ending balance
$
1,183
 
1,819
 
1,293
 
1,463
 
75
 
704
 
-
 
158
 
472
 
7,167
 
                                           
Allowance for loan losses at June 30, 2017:
                                 
Ending balance: individually
                                     
evaluated for impairment
$
-
 
-
 
1,103
 
65
 
-
 
27
 
-
 
-
 
-
 
1,195
 
Ending balance: collectively
                                     
evaluated for impairment
 
1,183
 
1,819
 
190
 
1,398
 
75
 
677
 
-
 
158
 
472
 
5,972
 
Ending balance
$
1,183
 
1,819
 
1,293
 
1,463
 
75
 
704
 
-
 
158
 
472
 
7,167
 
                                           
Loans at June 30, 2017:
                                         
Ending balance
$
71,213
 
240,993
 
38,875
 
243,957
 
30,125
 
94,567
 
1,591
 
23,717
 
-
 
745,038
 
                                           
Ending balance: individually
                                     
evaluated for impairment
$
-
 
1,152
 
16,792
 
3,724
 
-
 
230
 
-
 
-
 
-
 
21,898
 
Ending balance: collectively
                                     
evaluated for impairment
$
71,213
 
239,841
 
22,083
 
240,233
 
30,125
 
94,337
 
1,591
 
23,717
 
-
 
723,140
 
 
 
16

 
 
(Dollars in thousands)   
                                   
 
Real Estate Loans         
                     
 
Construction
and Land Development
 
Single-
Family
Residential
 
Single-
Family
Residential - Banco de la
Gente
Stated
Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
and All
Other
 
Unallocated
 
Total
 
Six months ended June 30, 2016:
                                     
Allowance for loan losses:
                                       
Beginning balance
$
2,185
 
2,534
 
1,460
 
1,917
 
-
 
842
 
-
 
172
 
479
 
9,589
 
Charge-offs
 
-
 
(123
)
-
 
(106
)
-
 
(39
)
-
 
(240
)
-
 
(508
)
Recoveries
 
6
 
13
 
-
 
11
 
-
 
105
 
-
 
72
 
-
 
207
 
Provision
 
(609
)
(191
)
(106
)
(172
)
46
 
(105
)
-
 
230
 
159
 
(748
)
Ending balance
$
1,582
 
2,233
 
1,354
 
1,650
 
46
 
803
 
-
 
234
 
638
 
8,540
 
                                           
Three months ended June 30, 2016:
                                     
Allowance for loan losses:
                                         
Beginning balance
$
1,844
 
2,475
 
1,423
 
1,788
 
-
 
810
 
-
 
190
 
586
 
9,116
 
Charge-offs
 
-
 
(64
)
-
 
-
 
-
 
(10
)
-
 
(112
)
-
 
(186
)
Recoveries
 
3
 
5
 
-
 
6
 
-
 
99
 
-
 
28
 
-
 
141
 
Provision
 
(265
)
(183
)
(69
)
(144
)
46
 
(96
)
-
 
128
 
52
 
(531
)
Ending balance
$
1,582
 
2,233
 
1,354
 
1,650
 
46
 
803
 
-
 
234
 
638
 
8,540
 
                                           
Allowance for loan losses at June 30, 2016:
                                     
Ending balance: individually
                                         
evaluated for impairment
$
-
 
94
 
1,092
 
177
 
-
 
-
 
-
 
-
 
-
 
1,363
 
Ending balance: collectively
                                         
evaluated for impairment
 
1,582
 
2,139
 
262
 
1,473
 
46
 
803
 
-
 
234
 
638
 
7,177
 
Ending balance
$
1,582
 
2,233
 
1,354
 
1,650
 
46
 
803
 
-
 
234
 
638
 
8,540
 
                                           
Loans at June 30, 2016:
                                         
Ending balance
$
60,075
 
229,586
 
41,910
 
232,035
 
18,688
 
91,347
 
1
 
28,389
 
-
 
702,031
 
                                           
Ending balance: individually
                                         
evaluated for impairment
$
-
 
1,116
 
17,430
 
4,716
 
-
 
-
 
-
 
-
 
-
 
23,262
 
Ending balance: collectively
                                         
evaluated for impairment
$
60,075
 
228,470
 
24,480
 
227,319
 
18,688
 
91,347
 
1
 
28,389
 
-
 
678,769
 
 
The provision for loan losses for the three months ended June 30, 2017 was an expense of $49,000, as compared to a credit of $531,000 for the three months ended June 30, 2016.  The increase in the provision for loan losses is primarily attributable to a $43.0 million increase in loans from June 30, 2016 to June 30, 2017.
 
The provision for loan losses for the six months ended June 30, 2017 was a credit of $187,000, as compared to a credit of $748,000 for the six months ended June 30, 2016.  The decrease in the credit to the provision for loan losses is primarily attributable to a $43.0 million increase in loans from June 30, 2016 to June 30, 2017.

The Company utilizes an internal risk grading matrix to assign a risk grade to each of its loans.  Loans are graded on a scale of 1 to 8.  These risk grades are evaluated on an ongoing basis.  A description of the general characteristics of the eight risk grades is as follows:
 
·
Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists.  Certificates of deposit or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.
·
Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company's range of acceptability.  The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.
·
Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company's range of acceptability but higher than normal. This may be a new organization or an existing organization in a transitional phase (e.g. expansion, acquisition, market change).
·
Risk Grade 4 – Management Attention: These loans have higher risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends is observed.  These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.
·
Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there has been some recent past due history on repayment and there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company's position at some future date.
·
Risk Grade 6 – Substandard: A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any).  There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
 
17

 
 
·
Risk Grade 7 – Doubtful: Loans classified as Doubtful have all the weaknesses inherent in loans classified as Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.
·
Risk Grade 8 – Loss: Loans classified as Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.  This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future.  Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.
 
The following tables present the credit risk profile of each loan type based on internally assigned risk grades as of June 30, 2017 and December 31, 2016:
 
June 30, 2017     
                               
(Dollars in thousands)
                                     
 
Real Estate Loans         
                   
 
Construction
and Land Development
 
Single-
Family
Residential
 
Single-
Family
Residential -
Banco de
la Gente
Stated
Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
 
All Other
 
Total
                                       
1- Excellent Quality
$
-
 
12,094
 
-
 
-
 
-
 
519
 
-
 
902
 
-
 
13,515
2- High Quality
 
11,919
 
113,039
 
-
 
37,406
 
2,110
 
17,641
 
-
 
3,610
 
1,141
 
186,866
3- Good Quality
 
45,833
 
85,597
 
16,179
 
184,567
 
24,783
 
71,151
 
1,547
 
4,913
 
11,652
 
446,222
4- Management Attention
 
6,537
 
22,504
 
15,413
 
15,904
 
2,049
 
4,740
 
44
 
606
 
825
 
68,622
5- Watch
 
6,632
 
4,696
 
3,532
 
4,593
 
1,171
 
234
 
-
 
28
 
-
 
20,886
6- Substandard
 
292
 
3,063
 
3,751
 
1,487
 
12
 
282
 
-
 
40
 
-
 
8,927
7- Doubtful
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
8- Loss
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
Total
$
71,213
 
240,993
 
38,875
 
243,957
 
30,125
 
94,567
 
1,591
 
10,099
 
13,618
 
745,038
                                         
                                         
                                         
December 31, 2016   
                                   
(Dollars in thousands)
                                       
 
Real Estate Loans            
                   
 
Construction
and Land Development
 
Single-
Family
 Residential
 
Single-
Family
Residential -
Banco de
la Gente
Stated
Income
 
Commercial
 
Multifamily
and
Farmland
 
Commercial
 
Farm
 
Consumer
 
All Other
 
Total
                                         
1- Excellent Quality
$
-
 
14,996
 
-
 
-
 
-
 
541
 
-
 
959
 
-
 
16,496
2- High Quality
 
9,784
 
109,809
 
-
 
39,769
 
2,884
 
26,006
 
-
 
3,335
 
2,507
 
194,094
3- Good Quality
 
33,633
 
82,147
 
16,703
 
176,109
 
14,529
 
55,155
 
-
 
4,842
 
10,921
 
394,039
4- Management Attention
 
10,892
 
25,219
 
15,580
 
24,753
 
2,355
 
5,586
 
-
 
619
 
1,749
 
86,753
5- Watch
 
7,229
 
4,682
 
3,943
 
4,906
 
1,201
 
246
 
-
 
31
 
-
 
22,238
6- Substandard
 
211
 
3,847
 
3,963
 
1,984
 
78
 
62
 
-
 
42
 
-
 
10,187
7- Doubtful
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
-
8- Loss
 
-
 
-
 
-
 
-
 
-
 
-
 
-
 
4
 
-
 
4
Total
$
61,749
 
240,700
 
40,189
 
247,521
 
21,047
 
87,596
 
-
 
9,832
 
15,177
 
723,811
 
Current year TDR modifications, past due TDR loans and non-accrual TDR loans totaled $2.6 million and $5.9 million at June 30, 2017 and December 31, 2016, respectively.  The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  There were no performing loans classified as TDR loans at June 30, 2017.  There was $81,000 in performing loans classified as TDR loans at December 31, 2016.

There were no new TDR modifications during the six months ended June 30, 2017 and 2016.

There were no loans modified as TDR that defaulted during the three and six months ended June 30, 2017 and 2016, which were within 12 months of their modification date.  Generally, a TDR loan is considered to be in default once it becomes 90 days or more past due following a modification.
 
18


 
(4)
    Net Earnings Per Share
 
Net earnings per share is based on the weighted average number of shares outstanding during the period while the effects of potential shares outstanding during the period are included in diluted earnings per share.  The average market price during the year is used to compute equivalent shares.

The reconciliation of the amounts used in the computation of both "basic earnings per share" and "diluted earnings per share" for the three and six months ended June 30, 2017 and 2016 is as follows:
 
For the three months ended June 30, 2017
               
   
Net Earnings
 (Dollars in thousands)
   
Weighted
Average
Number of
Shares
   
Per Share
Amount
Basic earnings per share
 
$
2,811
     
5,444,922
   
$
0.52
Effect of dilutive securities:
                     
Restricted stock units
   
-
     
86,519
       
Diluted earnings per share
 
$
2,811
     
5,531,441
   
$
0.51
                       
                       
For the six months ended June 30, 2017
                     
   
Net Earnings
 (Dollars in thousands)
   
Weighted
Average
Number of
Shares
   
Per Share
Amount
Basic earnings per share
 
$
5,016
     
5,436,149
   
$
0.92
Effect of dilutive securities:
                     
Restricted stock units
   
-
     
85,149
       
Diluted earnings per share
 
$
5,016
     
5,521,298
   
$
0.91
                       
                       
For the three months ended June 30, 2016
                     
   
Net Earnings
(Dollars in thousands)
   
Weighted
Average
Number of
Shares
   
Per Share
Amount
Basic earnings per share
 
$
2,964
     
5,510,538
   
$
0.54
Effect of dilutive securities:
                     
Restricted stock units
   
-
     
67,660
       
Diluted earnings per share
 
$
2,964
     
5,578,198
   
$
0.53
                       
                       
For the six months ended June 30, 2016
                     
   
Net Earnings
(Dollars in thousands)
   
Weighted
Average
Number of
Shares
   
Per Share
Amount
Basic earnings per share
 
$
5,418
     
5,510,538
   
$
0.98
Effect of dilutive securities:
                     
Restricted stock units
   
-
     
65,129
       
Diluted earnings per share
 
$
5,418
     
5,575,667
   
$
0.97
 
(5)
    Stock-Based Compensation
 
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan that was approved by shareholders on May 7, 2009 (the "Plan") whereby certain stock-based rights, such as stock options, restricted stock, restricted stock units, performance units, stock appreciation rights or book value shares, may be granted to eligible directors and employees.  A total of 258,780 shares are currently reserved for possible issuance under the Plan.   All stock-based rights under the Plan must be granted or awarded by May 7, 2019 (or ten years from the Plan effective date).
 
19


The Company granted 29,514 restricted stock units under the Plan at a grant date fair value of $7.90 per share during the first quarter of 2012, of which 5,355 restricted stock units were forfeited by the executive officers of the Company as required by the agreement with the U.S. Department of the Treasury ("UST") in conjunction with the Company's participation in the Capital Purchase Program ("CPP") under the Troubled Asset Relief Program ("TARP").  In July 2012, the Company granted 5,355 restricted stock units at a grant date fair value of $8.25 per share. The Company granted 26,795 restricted stock units under the Plan at a grant date fair value of $11.90 per share during the second quarter of 2013.  The Company granted 21,056 restricted stock units under the Plan at a grant date fair value of $15.70 per share during the first quarter of 2014.  The Company granted 15,075 restricted stock units under the Plan at a grant date fair value of $17.97 per share during the first quarter of 2015.  The Company granted 5,040 restricted stock units under the Plan at a grant date fair value of $18.60 per share during the first quarter of 2016.  The Company granted 3,740 restricted stock units under the Plan at a grant date fair value of $27.50 per share during the first quarter of 2017.  The Company recognizes compensation expense on the restricted stock units over the period of time the restrictions are in place (five years from the grant date for the 2012 grants, four years from the grant date for the 2013, 2015, 2016 and 2017 grants and three years from the grant date for the 2014 grants).  The amount of expense recorded each period reflects the changes in the Company's stock price during such period.  As of June 30, 2017, the total unrecognized compensation expense related to the restricted stock unit grants under the Plan was $400,000.

The Company recognized compensation expense for restricted stock unit awards granted under the Plan of $471,000 and $252,000 for the six months ended June 30, 2017 and 2016, respectively.

(6)
Fair Value

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company's financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in the value of financial instruments held by the Company since purchase, origination or issuance.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.  These levels are:

·
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.
·
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
·
Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Cash and Cash Equivalents
For cash, due from banks and interest-bearing deposits, the carrying amount is a reasonable estimate of fair value.  Cash and cash equivalents are reported in the Level 1 fair value category.

Investment Securities Available for Sale
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available.  If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities.  Fair values for investment securities with quoted market prices are reported in the Level 1 fair value category.  Fair value measurements obtained from independent pricing services are reported in the Level 2 fair value category. All other fair value measurements are reported in the Level 3 fair value category.

Other Investments
For other investments, the carrying value is a reasonable estimate of fair value.  Other investments are reported in the Level 3 fair value category.
 
20

 
 
Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at the lower of aggregate cost or market value.  The cost of mortgage loans held for sale approximates the market value.  Mortgage loans held for sale are reported in the Level 3 fair value category.

Loans
The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.  Loans are reported in the Level 3 fair value category, as the pricing of loans is more subjective than the pricing of other financial instruments.

Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.  Cash surrender value of life insurance is reported in the Level 2 fair value category.

Other Real Estate
The fair value of other real estate is based upon independent market prices, appraised values of the collateral or management's estimation of the value of the collateral.  Other real estate is reported in the Level 3 fair value category.

Deposits
The fair value of demand deposits, interest-bearing demand deposits and savings is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.  Deposits are reported in the Level 2 fair value category.

Securities Sold Under Agreements to Repurchase
For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.  Securities sold under agreements to repurchase are reported in the Level 2 fair value category.

Federal Home Loan Bank ("FHLB") Borrowings
The fair value of FHLB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.  FHLB borrowings are reported in the Level 2 fair value category.

Junior Subordinated Debentures
Because the Company's junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.  Junior subordinated debentures are reported in the Level 2 fair value category.

Commitments to Extend Credit and Standby Letters of Credit
Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.

Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
 
21

 
 
The table below presents the balance of securities available for sale, which are measured at fair value on a recurring basis by level within the fair value hierarchy, as of June 30, 2017 and December 31, 2016.
 
(Dollars in thousands)
                     
   
June 30, 2017         
   
Fair Value Measurements
   
Level 1
Valuation
   
Level 2
Valuation
   
Level 3
Valuation
Mortgage-backed securities
 
$
60,377
     
-
     
60,377
     
-
U.S. Government
                             
sponsored enterprises
 
$
39,627
     
-
     
39,627
     
-
State and political subdivisions
 
$
139,530
     
-
     
139,530
     
-
Corporate bonds
 
$
1,536
     
-
     
1,536
     
-
Trust preferred securities
 
$
250
     
-
     
-
     
250
 
(Dollars in thousands)
                     
   
December 31, 2016         
   
Fair Value Measurements
   
Level 1
Valuation
   
Level 2
Valuation
   
Level 3
Valuation
Mortgage-backed securities
 
$
67,585
     
-
     
67,585
     
-
U.S. Government
                             
sponsored enterprises
 
$
38,222
     
-
     
38,222
     
-
State and political subdivisions
 
$
141,856
     
-
     
141,856
     
-
Corporate bonds
 
$
1,533
     
-
     
1,533
     
-
Trust preferred securities
 
$
750
     
-
     
-
     
750
 
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the six months ended June 30, 2017.
 
(Dollars in thousands)
     
   
Investment Securities Available for Sale
 
   
Level 3 Valuation
 
Balance, beginning of period
 
$
750
 
Change in book value
   
-
 
Change in gain/(loss) realized and unrealized
   
-
 
Purchases/(sales and calls)
   
(500
)
Transfers in and/or (out) of Level 3
   
-
 
Balance, end of period
 
$
250
 
         
Change in unrealized gain/(loss) for assets still held in Level 3
 
$
-
 
 
The fair value measurements for mortgage loans held for sale, impaired loans and other real estate on a non-recurring basis at June 30, 2017 and December 31, 2016 are presented below.  The fair value measurement process uses certified appraisals and other market-based information; however, in many cases, it also requires significant input based on management's knowledge of, and judgment about, current market conditions, specific issues relating to the collateral and other matters.  As a result, all fair value measurements for impaired loans and other real estate are considered Level 3.
 
(Dollars in thousands)
                       
   
Fair Value Measurements
June 30, 2017
   
Level 1
Valuation
   
Level 2
Valuation
   
Level 3
Valuation
 
Mortgage loans held for sale
 
$
3,513
     
-
     
-
     
3,513
 
Impaired loans
 
$
27,097
     
-
     
-
     
27,097
 
Other real estate
 
$
-
     
-
     
-
     
-
 
 
22

 
(Dollars in thousands)
                       
   
Fair Value
Measurements
December 31, 2016 
 
Level 1
Valuation
   
Level 2
Valuation
   
Level 3
Valuation
 
Mortgage loans held for sale
 
$
5,709
     
-
     
-
     
5,709
 
Impaired loans
 
$
25,772
     
-
     
-
     
25,772
 
Other real estate
 
$
283
     
-
     
-
     
283
 
 
(Dollars in thousands)
               
 
Fair Value
June 30, 2017
 
Fair Value
December 31, 2016
 
Valuation
Technique
 
Significant
Unobservable
Inputs
 
General Range
of Significant
Unobservable
Input Values
Mortgage loans
held for sale
$
3,513
 
5,709
 
Rate lock
commitment
 
N/A
 
N/A
Impaired loans
$
27,097
 
25,772
 
 Appraised value
and discounted
 cash flows
 
Discounts to
reflect current
market conditions
and ultimate
collectability
 
0 - 25%
Other real estate
$
-
 
283
 
 Appraised value
 
Discounts to
reflect current
market conditions
 and estimated
costs to sell
 
0 - 25%
 
The carrying amount and estimated fair value of financial instruments at June 30, 2017 and December 31, 2016 are as follows:

(Dollars in thousands)
                           
         
Fair Value Measurements at June 30, 2017
   
Carrying
Amount
   
Level 1
   
Level 2
   
Level 3
   
Total
Assets:
                           
Cash and cash equivalents
 
$
75,055
     
75,055
     
-
     
-
     
75,055
Investment securities available for sale
 
$
241,320
     
-
     
241,070
     
250
     
241,320
Other investments
 
$
2,680
     
-
     
-
     
2,680
     
2,680
Mortgage loans held for sale
 
$
3,513
     
-
     
-
     
3,513
     
3,513
Loans, net
 
$
737,871
     
-
     
-
     
742,471
     
742,471
Cash surrender value of life insurance
 
$
15,351
     
-
     
15,351
     
-
     
15,351
                                       
Liabilities:
                                     
Deposits
 
$
892,485
     
-
     
-
     
882,109
     
882,109
Securities sold under agreements
                                     
to repurchase
 
$
49,977
     
-
     
49,977
     
-
     
49,977
FHLB borrowings
 
$
20,000
     
-
     
19,934
     
-
     
19,934
Junior subordinated debentures
 
$
20,619
     
-
     
20,619
     
-
     
20,619
 
23

 
 
(Dollars in thousands)
                           
         
Fair Value Measurements at December 31, 2016
   
Carrying
Amount
   
Level 1
   
Level 2
   
Level 3
   
Total
Assets:
                           
Cash and cash equivalents
 
$
70,094
     
70,094
     
-
     
-
     
70,094
Investment securities available for sale
 
$
249,946
     
-
     
249,196
     
750
     
249,946
Other investments
 
$
2,635
     
-
     
-
     
2,635
     
2,635
Mortgage loans held for sale
 
$
5,709
     
-
     
-
     
5,709
     
5,709
Loans, net
 
$
716,261
     
-
     
-
     
720,675
     
720,675
Cash surrender value of life insurance
 
$
14,952
     
-
     
14,952
     
-
     
14,952
                                       
Liabilities:
                                     
Deposits
 
$
892,918
     
-
     
-
     
884,510
     
884,510
Securities sold under agreements
                                     
to repurchase
 
$
36,434
     
-
     
36,434
     
-
     
36,434
FHLB borrowings
 
$
20,000
     
-
     
18,864
     
-
     
18,864
Junior subordinated debentures
 
$
20,619
     
-
     
20,619
     
-
     
20,619
 
 (7)
Regulatory Matters

On August 31, 2015, the Federal Deposit Insurance Corporation ("FDIC") and the North Carolina Office of the Commissioner of Banks ("Commissioner") issued a Consent Order (the "Order") in connection with compliance by the Bank with the Bank Secrecy Act and its implementing regulations (collectively, the "BSA").  The Order was issued pursuant to the consent of the Bank.  In consenting to the issuance of the Order, the Bank did not admit or deny any unsafe or unsound banking practices or violations of law or regulation.

The Order requires the Bank to take certain affirmative actions to comply with its obligations under the BSA, including, without limitation, strengthening its Board of Directors' oversight of BSA activities; reviewing, enhancing, adopting and implementing a revised BSA compliance program; completing a BSA risk assessment; developing a revised system of internal controls designed to ensure full compliance with the BSA; reviewing and revising customer due diligence and risk assessment processes, policies and procedures; developing, adopting and implementing effective BSA training programs; assessing BSA staffing needs and resources and appointing a qualified BSA officer; establishing an independent BSA testing program; ensuring that all reports required by the BSA are accurately and properly filed and engaging an independent firm to review past account activity to determine whether suspicious activity was properly identified and reported.

Prior to implementation, certain of the actions described above are subject to review by, and approval or non-objection from, the FDIC and the Commissioner.  The Order will remain in effect and be enforceable until it is modified, terminated, suspended or set aside by the FDIC and the Commissioner.

The Bank continues to make progress in addressing the issues identified in the Order and expects that it will be able to undertake and implement all required actions within the time period specified in the Order.  The Bank has incurred and will continue to incur additional non-interest expenses associated with the implementation of corrective actions; however, these expenses are not expected to have a significant impact on the results of operations or financial position of the Company.  Operating under the Order will limit the Bank's and the Company's ability to participate in acquisitions, to open new branches, and to allocate funds to its stock repurchase plan until such time as the Order has been modified, terminated, suspended or set aside by the FDIC and the Commissioner.

(8)
Subsequent Events

The Company has reviewed and evaluated subsequent events and transactions for material subsequent events through the date the financial statements are issued.  Management has concluded that there were no material subsequent events.
 
24

 
 
Item 2.
Management's Discussion  and Analysis of Financial Condition and Results of Operations
 
The following is a discussion of our financial position and results of operations of the Company and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company's Consolidated Financial Statements and Notes thereto on pages A-24 through A-67 of the Company's 2016 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2017 Annual Meeting of Shareholders.

Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company. The Company is the parent company of the Bank and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Wake and Durham counties, operating under the banking laws of North Carolina and the rules and regulations of the FDIC.

Overview
Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating the allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Current economic conditions, while not as robust as those experienced in the pre-crisis period from 2004 to 2007, have stabilized such that businesses in our market area are growing and investing again.  The uncertainty expressed in the local, national and international markets through the primary economic indicators of activity, however, continues to limit the level of activity in our markets.

Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.

Our business emphasis has been and continues to be to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We expect growth to be achieved in our local markets and through expansion opportunities in contiguous or nearby markets.  While we would be willing to consider growth by acquisition in certain circumstances, we do not consider the acquisition of another company to be necessary for our continued ability to provide a reasonable return to our shareholders.  We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability and experience of our Bank officers and managers.
 
25


 
The Federal Reserve maintained the Federal Funds rate at 0.25% from December 2008 to December 2015 before increasing the Fed Funds rate to 0.50% on December 16, 2015, 0.75% on December 14, 2016, 1.00% on March 15, 2017 and 1.25% on June 14, 2017.  This continued period of historically low interest rates has presented a challenge to the Company to maintain its net interest margin as loan rates fell and remained low, primarily because of competition for credit worthy customers.  The cost of deposits has also fallen but has reached the point where there is little room left to reduce this cost.  While the 0.25% Fed Funds rate increases in December 2015, December 2016, March 2017 and June 2017 will be helpful, the negative impact of such low interest rates will remain until the Fed Funds rate increases to levels approaching the historical norms experienced prior to the crisis beginning in 2008.

Summary of Significant Accounting Policies
The Company's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition.  Many of the Company's accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  A more complete description of the Company's significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company's 2016 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2017 Annual Meeting of Shareholders.

Many of the Company's assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectibility of loans is reflected through the Company's estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectibility.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company's internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in this management's discussion and analysis and the Notes to the Consolidated Financial Statements.  Fair value of the Company's financial instruments is discussed in Note (6) of the Notes to Consolidated Financial Statements (Unaudited) included in this Quarterly Report.

Results of Operations
Summary.  Net earnings were $2.8 million or $0.52 basic net earnings per share and $0.51 diluted net earnings per share for the three months ended June 30, 2017, as compared to $3.0 million or $0.54 basic net earnings per share and $0.53 diluted net earnings per share for the same period one year ago.  The decrease in second quarter net earnings is primarily attributable to an increase in the provision for loan losses, a decrease in non-interest income and an increase in non-interest expense, which were partially offset by an increase in net interest income, as discussed below.

The annualized return on average assets was 1.02% for the three months ended June 30, 2017, compared to 1.13% for the same period one year ago, and annualized return on average shareholders' equity was 10.04% for the three months ended June 30, 2017, compared to 10.73% for the same period one year ago.

Year-to-date net earnings as of  June 30, 2017 were $5.0 million or $0.92 basic net earnings per share and $0.91 diluted net earnings per share, as compared to $5.4 million or $0.98 basic net earnings per share and $0.97 diluted net earnings per share for the same period one year ago.  The decrease in year-to-date net earnings is primarily attributable to a decrease in the credit to the provision for loan losses, a decrease in non-interest income and an increase in non-interest expense, which were partially offset by an increase in net interest income, as discussed below.

The annualized return on average assets was 0.92% for the six months ended June 30, 2017, compared to 1.03% for the same period one year ago, and annualized return on average shareholders' equity was 9.05% for the six months ended June 30, 2017, compared to 9.81% for the same period one year ago.

Net Interest Income.  Net interest income, the major component of the Company's net earnings, was $9.8 million for the three months ended June 30, 2017, compared to $9.0 million for the three months ended June 30, 2016.  The increase in net interest income was primarily due to a $646,000 increase in interest income, which was primarily attributable to an increase in the average outstanding balance of loans and a 0.75% increase in the prime rate since June 2016, combined with a $191,000 decrease in interest expense, which was primarily attributable to a decrease in the average outstanding balance of FHLB borrowings during the three months ended June 30, 2017, as compared to the same period one year ago.
 
26

 

Interest income was $10.5 million for the three months ended June 30, 2017, compared to $9.8 million for the three months ended June 30, 2016.  The increase in interest income was primarily due to an increase in interest income on loans, which was partially offset by a decrease in interest income on investment securities.  During the quarter ended June 30, 2017, average loans increased $50.1 million to $743.3 million from $693.2 million for the quarter ended June 30, 2016.  During the quarter ended June 30, 2017, average investment securities available for sale decreased $17.2 million to $236.0 million from $253.2 million for the quarter ended June 30, 2016.  The average yield on loans for the quarters ended June 30, 2017 and 2016 was 4.69% and 4.63%, respectively.  The average yield on investment securities available for sale was 3.80% and 3.72% for the quarters ended June 30, 2017 and 2016, respectively.  The average yield on earning assets was 4.41% and 4.32% for the quarters ended June 30, 2017 and 2016, respectively.

  Interest expense was $622,000 for the three months ended June 30, 2017, compared to $813,000 for the three months ended June 30, 2016.  The decrease in interest expense was the result of lower cost of funds and reductions in FHLB borrowings and certificates of deposit.  The average rate paid on interest-bearing checking and savings accounts was 0.12% and 0.11% for the three months ended June 30, 2017 and 2016, respectively.  The average rate paid on certificates of deposit was 0.36% for the three months ended June 30, 2017, as compared to 0.39% for the same period one year ago.  The average rate paid on interest-bearing liabilities was 0.35% for the three months ended June 30, 2017, as compared to 0.47% for the same period one year ago.  During the quarter ended June 30, 2017, average certificates of deposit decreased $16.4 million to $135.5 million from $151.9 million for the quarter ended June 30, 2016.  Average FHLB borrowings decreased $23.5 million to $20.0 million for the three months ended June 30, 2017 from $43.5 million for the three months ended June 30, 2016.

The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the three months ended June 30, 2017 and 2016. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders' equity.  Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 35.98% for securities that are both federal and state tax exempt and an effective tax rate of 32.98% for federal tax exempt securities.  Non-accrual loans and the interest income that was recorded on non-accrual loans, if any, are included in the yield calculations for loans in all periods reported.
 
27


 
 
Three months ended   
 
Three months ended   
 
June 30, 2017      
 
June 30, 2016      
(Dollars in thousands)
Average
Balance
 
Interest
 
Yield /
Rate
 
Average
Balance
   
Interest
 
Yield /
Rate
Interest-earning assets:
                       
                         
Loans receivable
$
743,275
   
8,688
 
4.69%
 
$
693,238
   
7,973
 
4.63%
Investments - taxable
 
66,063
   
425
 
2.58%
   
78,333
   
485
 
2.49%
Investments - nontaxable*
 
173,277
   
1,846
 
4.27%
   
179,145
   
1,910
 
4.29%
Other
 
19,037
   
48
 
1.01%
   
15,130
   
18
 
0.48%
                               
Total interest-earning assets
 
1,001,652
   
11,007
 
4.41%
   
965,846
   
10,386
 
4.32%
                               
Non-interest earning assets:
                             
Cash and due from banks
 
53,546
             
47,337
         
Allowance for loan losses
 
(7,256
)
           
(9,222
)
       
Other assets
 
53,342
             
55,589
         
                               
Total assets
$
1,101,284
           
$
1,059,550
         
                               
                               
Interest-bearing liabilities:
                             
                               
NOW, MMDA & savings deposits
$
481,374
   
143
 
0.12%
 
$
434,846
   
122
 
0.11%
Time deposits
 
135,511
   
120
 
0.36%
   
151,901
   
148
 
0.39%
FHLB borrowings
 
20,000
   
201
 
4.03%
   
43,500
   
415
 
3.84%
Trust preferred securities
 
20,619
   
145
 
2.82%
   
20,619
   
118
 
2.30%
Other
 
47,811
   
13
 
0.11%
   
39,389
   
10
 
0.10%
                               
Total interest-bearing liabilities
 
705,315
   
622
 
0.35%
   
690,255
   
813
 
0.47%
                               
Non-interest bearing liabilities and shareholders' equity:
                         
Demand deposits
 
280,156
             
257,622
         
Other liabilities
 
3,533
             
543
         
Shareholders' equity
 
112,280
             
111,130
         
                               
Total liabilities and shareholder's equity
$
1,101,284
           
$
1,059,550
         
                               
Net interest spread
     
$
10,385
 
4.06%
         
9,573
 
3.85%
                               
Net yield on interest-earning assets
           
4.16%
             
3.99%
                               
Taxable equivalent adjustment
                             
Investment securities
     
$
546
             
571
   
                               
Net interest income
     
$
9,839
             
9,002
   
                               
*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $39.6 million in 2017 and $39.1 million in 2016. Tax rates of 3.00% and 4.00% were used to calculate the tax equivalent yield on these securities in 2017 and 2016, respectively.
 
Year-to-date net interest income as of June 30, 2017 was $19.3 million compared to $18.1 million for the same period one year ago.  The increase in net interest income was primarily due to a $805,000 increase in interest income, which was primarily attributable to an increase in the average outstanding balance of loans and a 0.75% increase in the prime rate since June 2016, combined with a $402,000 decrease in interest expense, which was primarily attributable to a decrease in the average outstanding balance of FHLB borrowings during the six months ended June 30, 2017, as compared to the same period one year ago.

Interest income was $20.5 million for the six months ended June 30, 2017, compared to $19.7 million for the six months ended June 30, 2016.  The increase in interest income was primarily due to an increase in interest income on loans, which was partially offset by a decrease in interest income on investment securities.  During the six months ended June 30, 2017, average loans increased $43.9 million to $736.4 million from $692.5 million for the six months ended June 30, 2016.  During the six months ended June 30, 2017, average investment securities available for sale decreased $16.7 million to $238.4 million from $255.1 million for the six months ended June 30, 2016 primarily due to paydowns on mortgage-backed securities.  The average yield on loans for the six months ended June 30, 2017 and 2016 was 4.65% and 4.64%, respectively.  The average yield on investment securities available for sale was 3.78% and 3.73% for the six months ended June 30, 2017 and 2016, respectively.  The average yield on earning assets was 4.38% and 4.34% for the six months ended June 30, 2017 and 2016, respectively.
 
 
 
28

 

  Interest expense was $1.2 million for the six months ended June 30, 2017, compared to $1.6 million for the six months ended June 30, 2016.  The decrease in interest expense was the result of lower cost of funds and reductions in FHLB borrowings and certificates of deposit.  The average rate paid on interest-bearing checking and savings accounts was 0.12% and 0.11% for the six months ended June 30, 2017 and 2016, respectively.  The average rate paid on certificates of deposit was 0.36% for the six months ended June 30, 2017, as compared to 0.41% for the same period one year ago.  The average rate paid on interest-bearing liabilities was 0.35% for the six months ended June 30, 2017, as compared to 0.47% for the same period one year ago.  During the six months ended June 30, 2017, average certificates of deposit decreased $14.9 million to $138.2 million from $153.1 million for the six months ended June 30, 2016.  Average FHLB borrowings decreased $23.7 million to $20.0 million for the six months ended June 30, 2017 from $43.7 million for the six months ended June 30, 2016.

The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the six months ended June 30, 2017 and 2016. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders' equity.  Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 35.98% for securities that are both federal and state tax exempt and an effective tax rate of 32.98% for federal tax exempt securities.  Non-accrual loans and the interest income that was recorded on non-accrual loans, if any, are included in the yield calculations for loans in all periods reported.
 
29

 
 
 
Six months ended   
 
Six months ended  
 
June 30, 2017       
 
June 30, 2016       
(Dollars in thousands)
Average
Balance
 
Interest
   
Yield /
Rate
 
Average
Balance
 
Interest
 
Yield /
Rate
Interest-earning assets:
                       
                         
Loans receivable
$
736,413
   
16,969
   
4.65%
 
$
692,536
   
15,996
   
4.64%
Investments - taxable
 
67,855
   
863
   
2.56%
   
80,205
   
1,030
   
2.58%
Investments - nontaxable*
 
173,829
   
3,714
   
4.31%
   
179,134
   
3,802
   
4.27%
Other
 
17,196
   
78
   
0.91%
   
15,020
   
36
   
0.48%
                                   
Total interest-earning assets
 
995,293
   
21,624
   
4.38%
   
966,895
   
20,864
   
4.34%
                                   
Non-interest earning assets:
                                 
Cash and due from banks
 
53,841
               
40,920
           
Allowance for loan losses
 
(7,440
)
             
(9,416
)
         
Other assets
 
52,223
               
54,883
           
                                   
Total assets
$
1,093,917
             
$
1,053,282
           
                                   
                                   
Interest-bearing liabilities:
                                 
                                   
NOW, MMDA & savings deposits
$
481,170
   
275
   
0.12%
 
$
435,173
   
241
   
0.11%
Time deposits
 
138,204
   
248
   
0.36%
   
153,129
   
310
   
0.41%
FHLB borrowings
 
20,000
   
393
   
3.96%
   
43,720
   
822
   
3.78%
Trust preferred securities
 
20,619
   
280
   
2.74%
   
20,619
   
231
   
2.25%
Other
 
45,113
   
24
   
0.11%
   
36,263
   
18
   
0.10%
                                   
Total interest-bearing liabilities
 
705,106
   
1,220
   
0.35%
   
688,904
   
1,622
   
0.47
                                   
Non-interest bearing liabilities and shareholders' equity:
                             
Demand deposits
 
274,366
               
253,375
           
Other liabilities
 
2,704
               
(63
)
         
Shareholders' equity
 
111,741
               
111,066
           
                                   
Total liabilities and shareholder's equity
$
1,093,917
             
$
1,053,282
           
                                   
Net interest spread
     
$
20,404
   
4.04%
         
19,242
   
3.87%
                                   
Net yield on interest-earning assets
             
4.13%
               
4.00%
                                   
Taxable equivalent adjustment
                                 
Investment securities
     
$
1,099
               
1,144
     
                                   
Net interest income
     
$
19,305
               
18,098
     
                                   
*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $38.9 million in 2017 and $38.5 million in 2016. Tax rates of 3.00% and 4.00% were used to calculate the tax equivalent yield on these securities in 2017 and 2016, respectively.
 
Changes in interest income and interest expense can result from variances in both volume and rates.  The following table presents the impact on the Company's tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated.  The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.
 
30

 
   
Three months ended June 30, 2017
 compared to three months
ended June 30, 2016
   
Six months ended June 30, 2017
 compared to six months
ended June 30, 2016
 
(Dollars in thousands)
 
Changes in
average
volume
   
Changes in
average
 rates
   
Total
Increase
(Decrease)
   
Changes in
average
volume
   
Changes in
average
 rates
   
Total
Increase
(Decrease)
 
Interest income:
                                   
Loans: Net of unearned income
 
$
580
     
135
     
715
     
1,013
     
(40
)
   
973
 
Investments - taxable
   
(77
)
   
17
     
(60
)
   
(158
)
   
(9
)
   
(167
)
Investments - nontaxable
   
(62
)
   
(2
)
   
(64
)
   
(113
)
   
25
     
(88
)
Other
   
7
     
23
     
30
     
7
     
35
     
42
 
Total interest income
   
448
     
173
     
621
     
749
     
11
     
760
 
                                                 
Interest expense:
                                               
NOW, MMDA & savings deposits
   
13
     
8
     
21
     
26
     
8
     
34
 
Time deposits
   
(15
)
   
(13
)
   
(28
)
   
(28
)
   
(34
)
   
(62
)
FHLB borrowings
   
(230
)
   
16
     
(214
)
   
(456
)
   
27
     
(429
)
Trust preferred securities
   
-
     
27
     
27
     
-
     
49
     
49
 
Other
   
1
     
2
     
3
     
5
     
1
     
6
 
Total interest expense
   
(231
)
   
40
     
(191
)
   
(453
)
   
51
     
(402
)
Net interest income
 
$
679
     
133
     
812
     
1,202
     
(40
)
   
1,162
 
 
Provision for Loan Losses. The provision for loan losses for the three months ended June 30, 2017 was an expense of $49,000, as compared to a credit of $531,000 for the three months ended June 30, 2016.  The increase in the provision for loan losses is primarily attributable to a $43.0 million increase in loans from June 30, 2016 to June 30, 2017.

The provision for loan losses for the six months ended June 30, 2017 was a credit of $187,000, as compared to a credit of $748,000 for the six months ended June 30, 2016.  The decrease in the credit to the provision for loan losses is primarily attributable to a $43.0 million increase in loans from June 30, 2016 to June 30, 2017.

Non-Interest Income.  Total non-interest income was $3.3 million for the three months ended June 30, 2017, compared to $3.6 million for the three months ended June 30, 2016.  The decrease in non-interest income is primarily attributable to a $324,000 decrease in gains on the sale of securities during the three months ended June 30, 2017, compared to the same period one year ago.

Non-interest income was $6.2 million for the six months ended June 30, 2017, compared to $6.9 million for the six months ended June 30, 2016.  The decrease in non-interest income is primarily attributable to a $324,000 decrease in gains on the sale of securities, a $162,000 decrease in service charges and fees and a $363,000 increase in net losses on other real estate owned properties during the six months ended June 30, 2017, as compared to the six months ended June 30, 2016.

Non-Interest Expense.  Total non-interest expense was $9.3 million for the three months ended June 30, 2017, compared to $9.1 million for the three months ended June 30, 2016.  The increase in non-interest expense was primarily due to a $167,000 increase in salaries and benefits expense and a $218,000 increase in advertising expenses during the three months ended June 30, 2017, as compared to the three months ended June 30, 2016.  The increase in salaries and benefits expense is primarily due to an increase in the number of full-time equivalent employees and annual salary increases.  The increase in advertising expenses is primarily due to costs associated with the Bank's rebranding initiative, which was introduced in March 2017.

Non-interest expense was $19.1 million for the six months ended June 30, 2017, compared to $18.6 million for the six months ended June 30, 2016.  The increase in non-interest expense was primarily due to a $820,000 increase in salaries and benefits expense, a $459,000 increase in other non-interest expense and a $302,000 increase in advertising expenses, which were partially offset by a $689,000 decrease in professional fees, and a $176,000 decrease in occupancy expense during the six months ended June 30, 2017, as compared to the six months ended June 30, 2016.  The increase in salaries and benefits expense is primarily due to an increase in the number of full-time equivalent employees, annual salary increases and an increase in expenses associated with restricted stock units issued to officers resulting from an increase in the Company's stock price from $25.07 at December 31, 2016 to $31.60 at June 30, 2017.  The increase in other non-interest expense is primarily due to increases in telecommunications expense, expense associated with restricted stock units issued to directors, deposit program expense and fraud/forgery expense.  The increase in advertising expenses is primarily due to costs associated with the Bank's rebranding initiative, which was introduced in March 2017.  The decrease in professional fees is primarily due to a decrease in consulting fees associated with the Order issued in August 2015.  The decrease in occupancy expense is primarily due to a reduction in depreciation expense.
 
31


Income Taxes.  The Company reported income tax expense of $925,000 and $1.0 million for the three months ended June 30, 2017 and 2016, respectively.  This represented an effective tax rate of 25% and 26% for the respective periods.

The Company reported income tax expense of $1.5 million and $1.7 million for the six months ended June 30, 2017 and 2016, respectively.  This represented an effective tax rate of 23% and 24% for the respective periods.

Analysis of Financial Condition
Investment Securities.  Available for sale securities were $241.3 million at June 30, 2017, compared to $249.9 million at December 31, 2016.  Average investment securities available for sale for the six months ended June 30, 2017 were $238.4 million, compared to $252.7 million for the year ended December 31, 2016.

Loans.  At June 30, 2017, loans were $745.0 million, compared to $723.8 million at December 31, 2016.  Average loans represented 74% and 71% of average earning assets for the six months ended June 30, 2017 and the year ended December 31, 2016, respectively.  The Company had $3.5 million and $5.7 million in mortgage loans held for sale as of June 30, 2017 and December 31, 2016, respectively.

Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Real estate mortgage loans include both commercial and residential mortgage loans.  At June 30, 2017, the Company had $101.2 million in residential mortgage loans, $99.2 million in home equity loans and $349.5 million in commercial mortgage loans, which include $277.6 million secured by commercial property and $76.9 million secured by residential property.   Residential mortgage loans include $62.7 million made to customers in the Company's traditional banking offices and $38.8 million in mortgage loans originated in the Company's Latino banking offices.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.

At June 30, 2017, the Company had $71.2 million in construction and land development loans.  The following table presents a breakout of these loans.
 
(Dollars in thousands)
         
 
Number of
Loans
 
Balance
Outstanding
 
Non-accrual
Balance
Land acquisition and development - commercial purposes
48
 
$
7,990
 
$
-
Land acquisition and development - residential purposes
202
   
22,916
   
18
1 to 4 family residential construction
121
   
22,901
   
-
Commercial construction
24
   
17,406
   
-
Total construction and land development
395
 
$
71,213
 
$
18
 
Current year TDR modifications, past due TDR loans and non-accrual TDR loans totaled $2.6 million and $5.9 million at June 30, 2017 and December 31, 2016, respectively.  The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  There were no performing loans classified as TDR loans at June 30, 2017.  There was $81,000 in performing loans classified as TDR loans at December 31, 2016.

Allowance for Loan Losses.  The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·
the Bank's loan loss experience;
·
the amount of past due and non-performing loans;
·
specific known risks;
·
the status and amount of other past due and non-performing assets;
·
underlying estimated values of collateral securing loans;
·
current and anticipated economic conditions; and
·
other factors which management believes affect the allowance for potential credit losses.
 
 
32


 
Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank's originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan's performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank's Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank's Credit Administration. Any issues regarding the risk assessments are addressed by the Bank's senior credit administrators and factored into management's decision to originate or renew the loan. The Bank's Board of Directors reviews, on a monthly basis, an analysis of the Bank's reserves relative to the range of reserves estimated by the Bank's Credit Administration.

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than $1.0 million, excluding loans in default, and loans in process of litigation or liquidation.  The third party's evaluation and report is shared with management and the Bank's Board of Directors.

Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses.  The provision for loan losses charged or credited to earnings is based upon management's judgment of the amount necessary to maintain the allowance at a level appropriate to absorb probable incurred losses in the loan portfolio at the balance sheet date.  The amount each quarter is dependent upon many factors, including growth and changes in the composition of the loan portfolio, net charge-offs, delinquencies, management's assessment of loan portfolio quality, the value of collateral, and other macro-economic factors and trends.  The evaluation of these factors is performed quarterly by management through an analysis of the appropriateness of the allowance for loan losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment.  When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management's current evaluation of the Bank's loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.

The general allowance reflects reserves established under GAAP for collective loan impairment.  These reserves are based upon historical net charge-offs using the greater of the last two, three, four or five years' loss experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves.

The unallocated allowance is determined through management's assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management's acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the unallocated portion may fluctuate from period to period based on management's evaluation of the factors affecting the assumptions used in calculating the allowance.

Effective December 31, 2012, stated income mortgage loans from the former Banco division of the Bank were analyzed separately from other single family residential loans in the Bank's loan portfolio.  These loans are first mortgage loans made to the Latino market, primarily in Mecklenburg, North Carolina and surrounding counties.  These loans are non-traditional mortgages in that the customer normally did not have a credit history, so all credit information was accumulated by the loan officers.  These loans were made as stated income loans rather than full documentation loans because the customer may not have had complete documentation on the income supporting the loan.
 
33


Various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations.  Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment.  Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Bank's loan portfolio as of the date of the financial statements.  Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the six months ended June 30, 2017 as compared to the six months ended June 30, 2016.   Revisions, estimates and assumptions may be made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

The allowance for loan losses at June 30, 2017 was $7.2 million or 0.96% of total loans, compared to $7.6 million or 1.04% of total loans at December 31, 2016. 

The following table presents the percentage of loans assigned to each risk grade at June 30, 2017 and December 31, 2016.
 
 
Percentage of Loans
 
By Risk Grade
Risk Grade
6/30/2017
6/30/2016
Risk Grade 1 (Excellent Quality)
1.19%
1.49%
Risk Grade 2 (High Quality)
25.08%
25.22%
Risk Grade 3 (Good Quality)
60.22%
54.87%
Risk Grade 4 (Management Attention)
9.21%
13.26%
Risk Grade 5 (Watch)
2.80%
2.81%
Risk Grade 6 (Substandard)
1.20%
2.04%
Risk Grade 7 (Doubtful)
0.00%
0.00%
Risk Grade 8 (Loss)
0.00%
0.00%
 
At June 30, 2017, including non-accrual loans, there were four relationships exceeding $1.0 million in the Watch risk grade (which totaled $7.2 million) and one relationship exceeding $1.0 million in the Substandard risk grade (which totaled $1.0 million).

Non-performing Assets.  Non-performing assets totaled $4.7 million at June 30, 2017 or 0.42% of total assets, compared to $4.1 million or 0.38% of total assets at December 31, 2016.  Non-accrual loans were $4.6 million at June 30, 2017 and $3.8 million at December 31, 2016.  As a percentage of total loans outstanding, non-accrual loans were 0.62% at June 30, 2017, compared to 0.53% at December 31, 2016.  Non-accrual loans include $4.4 million in commercial and residential mortgage loans, $18,000 in construction and land development loans and $270,000 in other loans at June 30, 2017, compared to $3.7 million in commercial and residential mortgage loans, $22,000 in construction and land development loans and $54,000 in other loans at December 31, 2016.  The Bank had loans 90 days past due and still accruing totaling $55,000 at June 30, 2017.  The Bank had no loans 90 days past due and still accruing at December 31, 2016.  The Bank had no other real estate owned at June 30, 2017 and $283,000 at December 31, 2016.

 Deposits.  Total deposits at June 30, 2017 were $892.5 million compared to $892.9 million at December 31, 2016. Core deposits, which include non-interest bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposit of denominations less than $250,000, were $869.3 million at June 30, 2017 as compared to $865.4 million at December 31, 2016.  Certificates of deposit in amounts of $250,000 or more totaled $22.5 million at June 30, 2017, as compared to $26.8 million at December 31, 2016.  At June 30, 2017, brokered deposits were $5.5 million as compared to $7.2 million at December 31, 2016.  Brokered deposits outstanding as of June 30, 2017 had a weighted average rate of 0.07% with a weighted average original term of 28 months as compared to brokered deposits outstanding at December 31, 2016, which had a weighted average rate of 0.05% with a weighted average original term of 23 months.

Borrowed Funds. Borrowings from the FHLB totaled $20.0 million at June 30, 2017 and December 31, 2016.  The average balance of FHLB borrowings for the six months ended June 30, 2017 was $20.0 million, compared to $42.9 million for the year ended December 31, 2016.  The FHLB borrowings outstanding at June 30, 2017 had interest rates ranging from 2.98% to 4.40% and all mature in 2018.

Securities sold under agreements to repurchase were $50.0 million at June 30, 2017 compared to $36.4 million at December 31, 2016.
 
34


Junior Subordinated Debentures (related to Trust Preferred Securities).  In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II ("PEBK Trust II"), which issued $20.0 million of guaranteed preferred beneficial interests in the Company's junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued in December 2001 by PEBK Capital Trust, a wholly owned Delaware statutory trust of the Company, and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the Consolidated Financial Statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, which became effective on June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount plus any accrued but unpaid interest.

Asset Liability and Interest Rate Risk Management.  The objective of the Company's Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities.  This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income.

The Company manages its exposure to fluctuations in interest rates through policies established by our Asset/Liability Committee ("ALCO").  ALCO meets quarterly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company.  ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements.  The ability to control these fluctuations has a direct impact on the profitability of the Company.  Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company's rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year.  Rate sensitive assets therefore include both loans and available for sale securities.  Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds.  Average rate sensitive assets for the six months ended June 30, 2017 totaled $995.3 million, exceeding average rate sensitive liabilities of $705.1 million by $290.2 million.

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  The Company did not have any interest rate derivatives outstanding as of June 30, 2017.

Included in the rate sensitive assets are $283.6 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee ("FOMC").  The Company utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At June 30, 2017, the Company had $178.0 million in loans with interest rate floors.  The floors were in effect on $38.5 million of these loans pursuant to the terms of the promissory notes on these loans.   The weighted average rate on these loans is 0.67% higher than the indexed rate on the promissory notes without interest rate floors.

 Liquidity. The objectives of the Company's liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements.  Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities.  In addition, the Company's liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit.  As of June 30, 2017, such unfunded commitments to extend credit were $204.8 million, while commitments in the form of standby letters of credit totaled $3.8 million.
 
35

 

The Company uses several sources to meet its liquidity requirements.  The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposit of denominations less than $250,000. The Company considers these to be a stable portion of the Company's liability mix and the result of on-going consumer and commercial banking relationships.  As of June 30, 2017, the Company's core deposits totaled $869.3 million, or 97% of total deposits.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreements to repurchase and FHLB borrowings.  The Bank is also able to borrow from the Federal Reserve Bank ("FRB") on a short-term basis.  The Company's policies include the ability to access wholesale funding of up to 40% of total assets.  The Company's wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina.  The Company's ratio of wholesale funding to total assets was 2.30% as of June 30, 2017.

The Bank has a line of credit with the FHLB equal to 20% of the Bank's total assets, with an outstanding balance of $20.0 million at June 30, 2017 and December 31, 2016.  At June 30, 2017, the carrying value of loans pledged as collateral to the FHLB totaled $129.2 million compared to $128.3 million at December 31, 2016.  The remaining availability under the line of credit with the FHLB was $61.7 million at June 30, 2017 compared to $66.8 million at December 31, 2016.  The Bank had no borrowings from the FRB at June 30, 2017 or December 31, 2016.  FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At June 30, 2017, the carrying value of loans pledged as collateral to the FRB totaled $384.1 million compared to $374.5 million at December 31, 2016.

The Bank also had the ability to borrow up to $59.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of June 30, 2017.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 25.37% at June 30, 2017 and 24.78% at December 31, 2016.  The minimum required liquidity ratio as defined in the Bank's Asset/Liability and Interest Rate Risk Management Policy was 10% at June 30, 2017 and December 31, 2016.

Contractual Obligations and Off-Balance Sheet Arrangements.  The Company's contractual obligations and other commitments as of June 30, 2017 and December 31, 2016 are summarized in the table below.  The Company's contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements.  Other commitments include commitments to extend credit.  Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
 
(Dollars in thousands)
     
 
June 30, 2017
 
December 31, 2016
Contractual Cash Obligations
     
Long-term borrowings
$
20,000
 
20,000
Junior subordinated debentures
 
20,619
 
20,619
Corporate Center renovation
 
440
 
2,170
Operating lease obligations
 
4,466
 
4,648
Total
$
45,525
 
47,437
Other Commitments
       
Commitments to extend credit
$
204,831
 
195,528
Standby letters of credit and financial guarantees written
 
3,802
 
3,728
Income tax credits
 
2,534
 
2,864
Total
$
211,167
 
202,120
 
The Company enters into derivative contracts from time to time to manage various financial risks.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date.  Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk.  Further discussions of derivative instruments are included above in the section entitled "Asset Liability and Interest Rate Risk Management".
 
36


 
Capital Resources.  Shareholders' equity was $113.9 million, or 10.3% of total assets, as of June 30, 2017, compared to $107.4 million, or 9.9% of total assets, as of December 31, 2016.  The increase in shareholders' equity is primarily due to an increase in retained earnings due to net income and an increase in accumulated other comprehensive income resulting from an increase in unrealized gain on investment securities.

Annualized return on average equity for the six months ended June 30, 2017 was 9.05% compared to 9.81% for the six months ended June 30, 2016.  Total cash dividends paid on common stock were $1.3 million and $1.0 million for the six months ended June 30, 2017 and 2016, respectively.

The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.  The Board of Directors does not currently anticipate issuing any additional series of preferred stock.

In 2016, the Company's Board of Directors authorized a stock repurchase program, pursuant to which up to $2 million was allocated to repurchase the Company's common stock.  Any purchases under the Company's stock repurchase program were made periodically as permitted by securities laws and other legal requirements in the open market or in privately negotiated transactions.  The timing and amount of any repurchase of shares were determined by the Company's management, based on its evaluation of market conditions and other factors.  The Company has repurchased approximately $2.0 million, or 92,738 shares of its common stock, under this program as of June 30, 2017.

In 2013, the Federal Reserve Board approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations.  The Basel III capital standards, which became effective January 1, 2015, include new risk-based capital and leverage ratios, which are being phased in from 2015 to 2019. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are as follows: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total risk based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% (unchanged from previous rules).  An additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes beginning on January 1, 2016 at 0.625% and is being phased in through 2019 (increasing by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019).  This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount.  These limitations establish a maximum percentage of eligible retained earnings that could be utilized for such actions.

Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 6.0% or greater and a common equity Tier 1 capital ratio of 4.5% or greater, as required by the Basel III capital standards referenced above.  Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill.  Tier 1 capital at June 30, 2017 and December 31, 2016 includes $20.0 million in trust preferred securities.  The Company's Tier 1 capital ratio was 15.36% and 15.20% at June 30, 2017 and December 31, 2016, respectively.  Total risk-based capital is defined as Tier 1 capital plus supplementary capital.  Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets.  The Company's total risk-based capital ratio was 16.21% and 16.12% at June 30, 2017 and December 31, 2016, respectively.  The Company's common equity Tier 1 capital consists of common stock and retained earnings.   The Company's common equity Tier 1 capital ratio was 12.97% and 12.75% at June 30, 2017 and December 31, 2016, respectively.  Financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater.  The Company's Tier 1 leverage capital ratio was 11.69% and 11.19% at June 30, 2017 and December 31, 2016, respectively.

The Bank's Tier 1 risk-based capital ratio was 14.91% and 14.85% at June 30, 2017 and December 31, 2016, respectively.  The total risk-based capital ratio for the Bank was 15.77% and 15.78% at June 30, 2017 and December 31, 2016, respectively.   The Bank's common equity Tier 1 capital ratio was 14.91% and 14.85% at June 30, 2017 and December 31, 2016, respectively.  The Bank's Tier 1 leverage capital ratio was 11.28% and 10.88% at June 30, 2017 and December 31, 2016, respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater and a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be "well capitalized" at June 30, 2017.
 
 
37

 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
There have been no material changes in the Quantitative and Qualitative Disclosures About Market Risk from those previously disclosed in Part 7A. of Part II of the Company's Form 10-K, filed with the Securities and Exchange Commission on March 16, 2017.
 
 
38

 
Item 4.
Controls and Procedures
 
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report.  Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

There have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.



39

 
PART II.
OTHER INFORMATION
   
Item 1.
Legal Proceedings
   
 
The discussion of the Order issued by the FDIC and the Commissioner in connection with compliance by the Bank with the BSA and its implementing regulations on August 31, 2015 as set forth in Note (7) of the Consolidated Financial Statements included in Item 1 hereof is incorporated herein by reference.
   
Item 1A.
Risk Factors
   
 
There have been no material changes from the Risk Factors from those previously disclosed in the Company's Form 10-K in response to Item 1A. of Part I to Form 10-K, filed with the Securities and Exchange Commission on March 16, 2017.
   
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
ISSUER PURCHASES OF EQUITY SECURITIES
       
                   
              Total   Maximum
              Number of   Number (or
              Shares   Approximate
              Purchased as   Dollar Value) of
              Part of   Shares that
    Total         Publicly   May Yet Be
    Number of     Average   Announced   Purchased
    Shares     Price Paid   Plans or   Under the Plans
Period
   Purchased     per Share   Programs   or Programs (2)
 April 1 - 30, 2017
 
581
   
$
30.14
 
-
 
$
16,180
                       
 May 1 - 31, 2017
 
375
     
28.14
 
-
 
$
16,180
                       
 June 1 - 30, 2017
 
-
     
-
 
-
 
$
16,180
                       
 Total
 
956
(1)
 
$
29.67
 
-
     
                       
(1) The Company purchased 956 shares on the open market in the three months ended June 30, 2017 for its deferred compensation plan. All purchases were funded by participant contributions to the plan.
                       
(2) Reflects dollar value of shares that may yet be purchased under the Stock Repurchase Plan authorized by the Company's Board of Directors in 2016.
 
Item 3.
Defaults Upon Senior Securities
     
 
Not applicable
 
     
Item 5.
Other Information
     
 
Not applicable
 
     
Item 6.
Exhibits
 
     
 
Exhibit (3)(i)(a)
Articles of Incorporation of the Registrant, incorporated by reference to
   
Exhibit (3)(i) to the Form 8-A filed with the Securities and Exchange
   
Commission on September 2, 1999
     
 
Exhibit (3)(i)(b)
Articles of Amendment dated December 19, 2008, regarding the Series A
   
Preferred Stock, incorporated by reference to Exhibit (3)(1) to the Form 8-K filed
   
with the Securities and Exchange Commission on December 29, 2008
 
 
40

 
 
 
Exhibit (3)(i)(c)
Articles of Amendment dated February 26, 2010, incorporated by reference to
   
Exhibit (3)(2) to the Form 10-K filed with the Securities and Exchange
   
Commission on March 25, 2010
     
 
Exhibit (3)(ii)
Second Amended and Restated Bylaws of the Registrant, incorporated by
   
reference to Exhibit (3)(ii) to the Form 8-K filed with the Securities and
   
Exchange Commission on June 24, 2015
     
 
Exhibit (4)
Specimen Stock Certificate, incorporated by reference to Exhibit (4) to the Form
   
8-A filed with the Securities and Exchange Commission on September 2, 1999
     
 
Exhibit (10)(i)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Tony W. Wolfe dated December 18, 2008, incorporated by
   
reference to Exhibit (10)(a)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(ii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Joseph F. Beaman, Jr. dated December 18, 2008, incorporated
   
by reference to Exhibit (10)(b)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(iii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and William D. Cable, Sr. dated December 18, 2008, incorporated
   
by reference to Exhibit (10)(c)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(iv)
Employment Agreement dated January 22, 2015 between the Registrant and
   
William D. Cable, Sr., incorporated by reference to Exhibit (10)(c) to the Form 8-K
   
filed with the Securities and Exchange Commission on February 9, 2015
     
 
Exhibit (10)(v)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and Lance A. Sellers dated December 18, 2008, incorporated by
   
reference to Exhibit (10)(d)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(vi)
Employment Agreement dated January 22, 2015 between the Registrant and
   
Lance A. Sellers, incorporated by reference to Exhibit (10)(a) to the Form 8-K
   
filed with the Securities and Exchange Commission on February 9, 2015
     
 
Exhibit (10)(vii)
Amended and Restated Executive Salary Continuation Agreement between
   
Peoples Bank and A. Joseph Lampron, Jr. dated December 18, 2008, incorporated
   
by reference to Exhibit (10)(f)(iii) to the Form 8-K filed with the Securities and
   
Exchange Commission on December 29, 2008
     
 
Exhibit (10)(viii)
Employment Agreement dated January 22, 2015 between the Registrant and A.
   
Joseph Lampron, Jr., incorporated by reference to Exhibit (10)(b) to the Form 8-K
   
filed with the Securities and Exchange Commission on February 9, 2015
     
 
Exhibit (10)(ix)
Peoples Bank Directors' and Officers' Deferral Plan, incorporated by reference
   
to Exhibit (10)(h) to the Form 10-K filed with the Securities and Exchange
   
Commission on March 28, 2002
     
 
Exhibit (10)(x)
Rabbi Trust for the Peoples Bank Directors' and Officers' Deferral Plan,
   
incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 28, 2002
     
 
Exhibit (10)(xi)
Description of Service Recognition Program maintained by Peoples Bank,
   
incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 27, 2003
 
 
41

 
 
 
Exhibit (10)(xii)
Capital Securities Purchase Agreement dated as of June 26, 2006, by and among
   
the Registrant, PEBK Capital Trust II and Bear, Sterns Securities Corp.,
   
incorporated by reference to Exhibit (10)(j) to the Form 10-Q filed with the
   
Securities and Exchange Commission on November 13, 2006
     
 
Exhibit (10)(xiii)
Amended and Restated Trust Agreement of PEBK Capital Trust II, dated as of
   
June 28, 2006, incorporated by reference to Exhibit (10)(k) to the Form 10-Q filed
   
with the Securities and Exchange Commission on November 13, 2006
     
 
Exhibit (10)(xiv)
Guarantee Agreement of the Registrant dated as of June 28, 2006, incorporated
   
by reference to Exhibit (10)(l) to the Form 10-Q filed with the Securities and
   
Exchange Commission on November 13, 2006
     
 
Exhibit (10)(xv)
Indenture, dated as of June 28, 2006, by and between the Registrant and LaSalle
   
Bank National Association, as Trustee, relating to Junior Subordinated Debt
   
Securities Due September 15, 2036, incorporated by reference to Exhibit (10)(m)
   
to the Form 10-Q filed with the Securities and Exchange Commission on
   
November 13, 2006
     
 
Exhibit (10)(xvi)
Form of Amended and Restated Director Supplemental Retirement Agreement
   
between Peoples Bank and Directors Robert C. Abernethy, James S. Abernethy,
   
Douglas S. Howard, John W. Lineberger, Jr., Gary E. Matthews, Dr. Billy L.
   
Price, Jr., Larry E. Robinson, W. Gregory Terry, Dan Ray Timmerman, Sr. and
   
Benjamin I. Zachary, incorporated by reference to Exhibit (10)(n) to the Form
   
8-K filed with the Securities and Exchange Commission on December 29, 2008
     
 
Exhibit (10)(xvii)
2009 Omnibus Stock Ownership and Long Term Incentive Plan incorporated
   
by reference to Exhibit (10)(o) to the Form 10-K filed with the Securities and
   
Exchange Commission on March 20, 2009
     
 
Exhibit (14)
Code of Business Conduct and Ethics of Peoples Bancorp of North Carolina,
   
Inc., incorporated by reference to Exhibit (14) to the Form 10-K filed with the
   
Securities and Exchange Commission on March 25, 2005
     
 
Exhibit (31)(a)
Certification of principal executive officer pursuant to section 302 of the
   
Sarbanes-Oxley Act of 2002
     
 
Exhibit (31)(b)
Certification of principal financial officer pursuant to section 302 of the
   
Sarbanes-Oxley Act of 2002
     
 
Exhibit (32)
Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
   
906 of the Sarbanes-Oxley Act of 2002
     
 
Exhibit (101)
The following materials from the Company's 10-Q Report for the quarterly
   
period ended June 30, 2017, formatted in XBRL: (i) the Condensed Consolidated
   
Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the
   
Condensed Consolidated Statements of Changes in Shareholders' Equity, (iv) the
   
Condensed Consolidated Statements of Cash Flows, and (v) the Notes to the
   
Condensed Consolidated Financial Statements, tagged as blocks of text.*
     
   
*Furnished, not filed.
 
 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
   
Peoples Bancorp of North Carolina, Inc.
     
     
     
August 2, 2017
 
 /s/ Lance A. Sellers
Date
 
Lance A. Sellers
   
President and Chief Executive Officer
   
(Principal Executive Officer)
     
     
     
August 2, 2017
 
 /s/ A. Joseph Lampron, Jr.
Date
 
A. Joseph Lampron, Jr.
   
Executive Vice President and Chief Financial Officer
   
(Principal Financial and Principal Accounting Officer)

 
 
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