First Community Bankshares Inc: Form 10-Q for the period ended Jun 30, 2011

Unless the context suggests otherwise, the terms “First Community,” “Company,” “we,” “our,” and “us” refer to First Community Bancshares, Inc. and its subsidiaries as a consolidated entity.

The following discussion and analysis is provided to address information about the Company’s financial condition and results of operations for the periods covered. This discussion and analysis should be read in conjunction with the Company’s 2010 Annual Report on Form 10-K (“2010 Form 10-K”) and the other financial information included in this report.

The Company is a multi-state financial holding company headquartered in Bluefield, Virginia, with total assets of $2.21 billion at June 30, 2011. Through its community bank subsidiary, First Community Bank (the “Bank”), the Company provides financial, trust and investment advisory services to individuals and commercial customers through 54 locations in Virginia, West Virginia, North Carolina, and Tennessee. The Company is also the parent of GreenPoint Insurance Group, Inc. (“GreenPoint”), a North Carolina based full-service insurance agency offering commercial and personal lines of insurance. The Bank is the parent of Investment Planning Consultants, Inc. (“IPC”), a registered investment advisory firm that offers wealth management and investment advice. The Company’s common stock is traded on the NASDAQ Global Select Market under the symbol, “FCBC”.

FORWARD-LOOKING STATEMENTS

The Company may from time to time make written or oral “forward-looking statements,” including statements contained in its filings with the Securities and Exchange Commission (“SEC”) (including this Quarterly Report on Form 10-Q and the Exhibits hereto and thereto), in its reports to stockholders and in other communications which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include, among others, statements with respect to the Company’s beliefs, plans, objectives, goals, guidelines, expectations, anticipations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors (many of which are beyond the Company’s control). The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” and similar expressions are intended to identify forward-looking statements. We caution that the forward-looking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Actual results, performance or achievements could differ materially from those contemplated, expressed, or implied by the forward-looking statements. The following factors, among others, could cause our financial performance to differ materially from that expressed in such forward-looking statements:

• The strength of the United States economy in general and the strength of the local economies in which we conduct operations;
• Geopolitical conditions, including acts or threats of terrorism, actions taken by the United States or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the United States and abroad;
• The effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”);
• Inflation, interest rate, market and monetary fluctuations;
• The timely development of competitive new products and services and the acceptance of these products and services by new and existing customers;
• The willingness of users to substitute competitors’ products and services for our products and services;
• The impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, securities and insurance, and the application thereof by regulatory bodies;
• Technological changes;
• The effect of acquisitions we may make, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions;
• The growth and profitability of noninterest or fee income being less than expected;
• Changes in the level of our non-performing assets and charge-offs;
• The effect of changes in accounting policies and practices, as may be adopted from time to time by bank regulatory agencies, the SEC, the Public Company Accounting Oversight Board, the Financial Accounting Standards Board or other accounting standards setters;
• Possible other-than-temporary impairments of securities held by us;
• The impact of current governmental efforts to restructure the U. S. financial regulatory system, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”);

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• Changes in consumer spending and savings habits; and
• Unanticipated regulatory or judicial proceedings.

If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Quarterly Report on Form 10-Q and other reports filed by us with the SEC. Therefore, we caution you not to place undue reliance on our forward-looking information and statements.

The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company. These factors and other risks and uncertainties are discussed in Item 1A., “Risk Factors,” in Part II of this Quarterly Report on Form 10-Q and the Company’s 2010 Form 10-K.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

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

Estimates, assumptions, and judgments are necessary principally when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded based upon the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third party sources, when available. When third party information is not available, valuation adjustments are estimated by management primarily through the use of financial modeling techniques and appraisal estimates.

The Company’s accounting policies are fundamental to understanding Management’s Discussion and Analysis of Financial Condition and Results of Operation. The disclosures presented in the Notes to the Consolidated Financial Statements and in Management’s Discussion and Analysis provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the accounting for and valuation of investment securities, the determination of the allowance for loan losses, accounting for acquisitions and intangible assets, and accounting for income taxes as the four accounting areas that require the most subjective or complex judgments. The identified critical accounting policies are described in detail in the Company’s 2010 Form 10-K.

COMPANY OVERVIEW

The Company is a financial holding company which operates within the four-state region of Virginia, West Virginia, North Carolina, and Tennessee. The Company operates through the Bank, IPC, and GreenPoint to offer a wide range of financial services. The Company reported total assets of $2.21 billion at June 30, 2011.

The Company funds its lending activities primarily through the retail deposit operations of its branch banking network. Retail and wholesale repurchase agreements and borrowings from the Federal Home Loan Bank (“FHLB”) provide additional funding as needed. The Company invests its funds primarily in loans to retail and commercial customers. In addition to loans, the Company invests a portion of its funds in various debt securities, including those of United States agencies, state and political subdivisions, and certain corporate notes and debt instruments. The Company also maintains overnight interest-bearing balances with the Federal Reserve and other correspondent banks. The difference between interest earned on assets and interest paid on liabilities is the Company’s primary source of earnings. The Company’s net interest income is supplemented by fees for services, commissions on sales, and various deposit service charges.

The Company also conducts asset management activities through the Bank’s Trust and Financial Services Division (“Trust Division”) and its registered investment advisory firm, IPC. The Bank’s Trust Division and IPC manage assets with an

- 34 - aggregate market value of $892 million as of June 30, 2011. These assets are not assets of the Company, but are managed under various fee-based arrangements as fiduciary or agent.

RECENT LEGISLATION

On July 21, 2010, sweeping financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” was signed into law by President Obama. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:

• Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws.
• Require financial holding companies, such as First Community, to be well-capitalized and well-managed as of July 21, 2011. Bank holding companies and banks must also be both well-capitalized and well-managed in order to engage in interstate bank acquisitions.
• Impose comprehensive regulation of the over-the-counter derivatives market, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institutions themselves.
• Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders.
• Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000 and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions.
• Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
• Amend the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.
• Increase the authority of the Federal Reserve to examine bank holding companies, such as First Community, and their non-bank subsidiaries.

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

RESULTS OF OPERATIONS

Overview

The following includes significant developments regarding the Company and its operations in the second quarter and first half of 2011:

• Net income increased $597 thousand, or 11.64%, to $5.73 million for the second quarter of 2011, as compared to the second quarter of 2010.
• Return on average assets for the second quarter of 2011 improved to 1.02%, as compared to 0.91% for the second quarter of 2010.
• The ratio of non-performing assets to total assets was 129 basis points for the second quarter of 2011, an improvement of 3 basis points from year-end 2010.

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Net Income

Net income available to common shareholders for the three months ended June 30, 2011, was $5.60 million, or $0.31 per diluted common share, compared with net income available to common shareholders of $5.13 million, or $0.29 per diluted common share, for the three months ended June 30, 2010, an increase of $466 thousand. The increase in net income was primarily due to net gains on the sale of securities, a decrease in the provision for loan losses, and the reduction of interest on deposits and borrowings, which were partially offset by the increase in other operating expenses and reduction of interest on earning assets.

Net income available to common shareholders for the six months ended June 30, 2011, was $11.35 million, or $0.63 per diluted common share, compared with net income available to common shareholders of $10.41 million, or $0.59 per diluted common share, for the six months ended June 30, 2010, an increase of $939 thousand. The increase in net income was primarily due to net gains on the sale of securities, a decrease in the provision for loan losses, and the reduction of interest on deposits and borrowings, which were partially offset by the increase in other operating expenses, reduction of interest on earning assets, and increase in salaries and employee benefits.

Net Interest Income — Quarterly Comparison (See Table I)

Net interest income, the largest contributor to earnings, was $17.75 million for the three months ended June 30, 2011, compared with $18.54 million for the corresponding period in 2010, a decrease of $788 thousand, or 4.25%. Tax-equivalent net interest income totaled $18.49 million for the three months ended June 30, 2011, a decrease of $843 thousand, or 4.36%, from $19.33 million for the corresponding period in 2010. The decrease in tax-equivalent net interest income was largely due to decreases in average earning assets and the interest earned on those assets as a result of a sustained low rate environment.

Average earning assets decreased $40.65 million while average interest-bearing liabilities decreased $88.89 million during the second quarter of 2011 compared with the same period of 2010. The yield on average earning assets decreased 48 basis points to 4.99% from 5.47% between the three-month periods ended June 30, 2011 and 2010, respectively. Total cost of interest-bearing liabilities decreased 39 basis points between the second quarters of 2011 and 2010, which resulted in a net interest rate spread that was 9 basis points lower, at 3.66%, for the second quarter of 2011 compared with 3.75% for the same period last year. The Company’s tax-equivalent net interest margin of 3.83% for the three months ended June 30, 2011, decreased 9 basis points from 3.92% for the same period of 2010.

The yield on loans decreased 16 basis points to 5.88% from 6.04% for the three months ended June 30, 2011 and 2010, respectively. Tax-equivalent loan interest income for the second quarter of 2011 decreased $905 thousand, or 4.30%, compared with the second quarter of 2010 due to the effect of the extended low interest rate environment in the United States and reduction in loans stemming from significant prepayments and scheduled amortization of loans.

The tax-equivalent yield on available-for-sale securities decreased 68 basis points to 3.93% during the three months ended June 30, 2011, while the average balance decreased by $116.50 million, or 23.35%, compared with the same period in 2010. The average balance of the held-to-maturity securities portfolio continued to decline as securities matured or were called and were not replaced.

Average interest-bearing balances with banks were $174.78 million during the second quarter of 2011, and the yield was 0.23%. Interest-bearing balances with banks are comprised largely of excess liquidity kept at the Federal Reserve and bear overnight market rates.

The average balances of interest-bearing demand deposits increased $31.40 million, or 12.64%, while the average rate paid during the second quarter of 2011 decreased 24 basis points when compared with the same period in 2010. During the three months ended June 30, 2011, the average balances of savings deposits decreased $7.23 million, or 1.71%, while the average rate paid decreased 51 basis points compared to the same period in 2010. Average time deposits decreased $70.92 million, or 9.30%, while the average rate paid on time deposits decreased 45 basis points from 2.14% in the second quarter of 2010 to 1.69% in the second quarter of 2011. The level of average noninterest-bearing demand deposits increased $12.01 million, or 5.79%, to $219.40 million during the quarter ended June 30, 2011, compared with the corresponding period of the prior year. During the quarter ended June 30, 2011, the Company reduced the level of time deposit only customer relationships during the same period.

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The average balance of retail repurchase agreements, which consist of collateralized retail deposits and commercial treasury accounts, decreased $12.46 million, or 13.23%, to $81.74 million for the second quarter of 2011 compared with the same period in 2010. During this same period, the interest rate paid on the retail repurchase agreements decreased 38 basis points to 0.69%. The decrease in the average balance of retail repurchase agreements is largely attributed to customers converting retail repurchase agreements to time deposit and lower balances in commercial treasury accounts in the slow economy. There were no federal funds purchased on average during the second quarters of 2011 and 2010. Wholesale repurchase agreements remained unchanged at $50.00 million and the rate remained at 3.75% for the second quarters of 2011 and 2010. The average balance of FHLB borrowings and other long-term debt decreased by $29.68 million, or 15.16%, in the second quarter of 2011 to $166.12 million, compared with the same period in 2010, while the rate paid on those borrowings increased 44 basis points between the periods.

Net Interest Income — Year-to-Date Comparison (See Table II)

Net interest income was $36.03 million for the six months ended June 30, 2011, compared with $37.16 million for the corresponding period in 2010, a decrease of $1.13 million, or 3.05%. Tax-equivalent net interest income totaled $37.63 million for the six months ended June 30, 2011, a decrease of $1.13 million, or 2.92%, from $38.76 million for the corresponding period in 2010. The decrease in tax-equivalent net interest income was largely due to decreases in average earning assets and decreases in the interest earned on those assets as a result of a sustained low rate environment.

Average earning assets decreased $19.94 million while interest-bearing liabilities decreased $67.77 million during the first half of 2011 compared with the same period of 2010. The yield on average earning assets decreased 44 basis points to 5.13% from 5.57% between the six months ended June 30, 2011 and 2010, respectively. Total cost of interest-bearing liabilities decreased 37 basis points between the first six months of 2011 and 2010, which resulted in a net interest rate spread that was 7 basis points lower, at 3.73%, for the first half of 2011 compared with 3.80% for the same period last year. The Company’s tax-equivalent net interest margin of 3.89% for the six months ended June 30, 2011, decreased 8 basis points from 3.97% for the same period of 2010.

The yield on loans decreased 19 basis points to 5.94% from 6.13% for the six months ended June 30, 2011 and 2010, respectively. Tax-equivalent loan interest income for the first half of 2011 decreased $1.81 million, or 4.26%, compared with the first half of 2010 due to the effect of the extended low interest rate environment in the United States and reduction in loan volume.

The tax-equivalent yield on available-for-sale securities decreased 70 basis points to 4.06% during the six months ended June 30, 2011, while the average balance decreased by $65.96 million, or 13.46%, compared with the same period in 2010. The average balance of the held-to-maturity securities portfolio continued to decline as securities matured or were called and were not replaced.

Average interest-bearing balances with banks were $141.66 million during the first half of 2011, and the yield was 0.24%. Interest-bearing balances with banks are comprised largely of excess liquidity kept at the Federal Reserve and bear overnight market rates.

The average balances of interest-bearing demand deposits increased $33.25 million, or 13.71%, while the average rate paid during the first half of 2011 decreased 13 basis points when compared with the same period in 2010. During the six months ended June 30, 2011, the average balances of savings deposits increased $3.67 million, or 0.88%, while the average rate paid decreased 49 basis points compared to the same period in 2010. Average time deposits decreased $71.64 million, or 9.22%, while the average rate paid on time deposits decreased 44 basis points from 2.22% in the first half of 2010 to 1.78% in the first half of 2011. The level of average noninterest-bearing demand deposits increased $12.42 million, or 6.11%, to $215.67 million for the six months ended June 30, 2011, compared with the corresponding period of the prior year.

The average balance of retail repurchase agreements, which consist of collateralized retail deposits and commercial treasury accounts, decreased $7.90 million, or 8.49%, to $85.19 million for the first half of 2011 compared with the same period in 2010. During this same period, the interest rate paid on the retail repurchase agreements decreased 40 basis points to 0.74%. The decrease in the average balance of retail repurchase agreements is largely attributed to customers converting retail repurchase agreements to time deposit and lower balances in commercial treasury accounts in the slow economy. There were no federal funds purchased on average during the first half of 2011 and 2010. Wholesale repurchase agreements remained unchanged at $50.00 million for the six months ended June 30, 2011 and 2010, while the rate increased 2 basis points between the two periods due to changes in the structure within those borrowings. The average balance of FHLB borrowings and other long-term debt decreased by $25.15 million, or 12.75%, in the first half of 2011 to $172.12 million compared to the same period in 2010, while the rate paid on those borrowings increased 47 basis points between the periods. The Company prepaid a $25.00 million FHLB advance that carried a 4.00% interest rate during the first quarter of 2011.

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Table I

AVERAGE BALANCE SHEETS AND NET INTEREST INCOME ANALYSIS

(Dollars in Thousands)

(1) Fully taxable equivalent at the rate of 35% (“FTE”). The FTE basis adjusts for the tax benefits of income on certain tax-exempt loans and investments using the federal statutory rate of 35% for each period presented. The Company believes this measure to be the preferred industry measurement of net interest income and provides relevant comparison between taxable and non-taxable amounts.

(2) Non-accrual loans are included in average balances outstanding but with no related interest income during the period of non-accrual.

(3) Represents the difference between the yield on earning assets and cost of funds.

(4) Represents tax-equivalent net interest income divided by average earning assets.

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Table II

AVERAGE BALANCE SHEETS AND NET INTEREST INCOME ANALYSIS

(Dollars in Thousands)

(1) Fully taxable equivalent at the rate of 35% (“FTE”). The FTE basis adjusts for the tax benefits of income on certain tax-exempt loans and investments using the federal statutory rate of 35% for each period presented. The Company believes this measure to be the preferred industry measurement of net interest income and provides relevant comparison between taxable and non-taxable amounts.

(2) Non-accrual loans are included in average balances outstanding but with no related interest income during the period of non-accrual.

(3) Represents the difference between the yield on earning assets and cost of funds.

(4) Represents tax-equivalent net interest income divided by average earning assets.

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The following table summarizes the changes in tax-equivalent interest earned and paid detailing the amounts attributable to (i) changes in volume (change in the average volume times the prior year’s average rate), (ii) changes in rate (changes in the average rate times the prior year’s average volume), and (iii) changes in rate/volume (change in the average volume column times the change in average rate).

(In Thousands)

Provision and Allowance for Loan Losses

During the last four years, there has been significant stress in both commercial and residential real estate markets, resulting in significant declines in real estate valuations. Decreases in real estate values adversely affect the value of property used as collateral for loans, including loans originated by the Company. In addition, adverse changes in the economy, particularly continued high rates of unemployment may have a negative effect on the ability of the Company’s borrowers to make timely loan payments. A further increase in loan delinquencies could adversely impact loan loss experience, causing potential increases in the provision and allowance for loan losses.

The Company’s allowance for loan losses was $26.48 million at June 30, 2011, $26.48 million at December 31, 2010, and $25.01 million at June 30, 2010. The Company’s allowance for loan loss activity for the three- and six-month periods ended June 30, 2011 and 2010 is as follows:

(In Thousands)

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The total allowance for loan losses to loans held for investment ratio was 1.93% at June 30, 2011, compared with 1.91% at December 31, 2010, and 1.89% at June 30, 2010. Management considers the allowance to be adequate based upon its analysis of the portfolio as of June 30, 2011. Although management utilizes its best judgment and information available, the adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. In addition, the determination of the allowance for loan losses necessarily requires management to make various assumptions. Therefore, actual loan losses could differ materially from management’s determination if actual conditions differ significantly from the assumptions utilized. While management believes the allowance for loan losses is adequate as of June 30, 2011, actual results may prove different and these differences could be significant. The allowance methodology was recently enhanced to further segment the commercial loan portfolio by risk grade. Historical loss rates for each risk grade are adjusted by environmental factors to estimate the amount of reserve needed by segment. The Company believes this enhancement results in increased granularity within the allowance for loan losses and will be more reflective of trends within the commercial loan portfolio.

During the second quarter and first half of 2011, the Company incurred net charge-offs of $3.08 million and $4.69 million, respectively, compared with $3.09 million and $6.53 million in the respective periods of 2010. Annualized net charge-offs for the second quarter of 2011 were 0.90% of the average loan balance, compared to 0.69% of the average loan balance for the same period of 2010. The Company made provisions for loan losses of $3.08 million and $4.69 million, respectively, for the three- and six-month periods ended June 30, 2011, compared to $3.60 million and $7.26 million, respectively, in the same period of 2010. Provisions for loan losses covered 100.00% of net charge-offs for the three- and six-month periods ended June 30, 2011.

Total delinquent loans as of June 30, 2011, measured 2.12% of total loans, of which 0.52% were comprised of loans 30-89 days delinquent and 1.60% were comprised of loans in non-accrual status. Total delinquent loans have decreased approximately $7.29 million, or 20.02%, since December 31, 2010. Non-performing loans, comprised of non-accrual loans and unseasoned loan restructurings (as the Company does not have any loans that are 90 days past due and still accruing), as a percentage of total loans were 1.67% at June 30, 2011, 1.78% at December 31, 2010, and 1.35% at June 30, 2010.

At June 30, 2011, non-accrual loans, including acquired, impaired non-accrual loans, were primarily composed of the following categories of loans: 27.97% were single family residential mortgage; 24.07% were non-farm, non-residential commercial loans; and 20.51% were commercial and industrial loans. Approximately $3.50 million, or 15.88%, of non-accrual loans is attributed to the TriStone loan portfolio that was acquired during the third quarter of 2009.

During the second quarter of 2011, the company downgraded a $4.60 million loan within the hospitality industry to substandard, which accounted for a majority of the increase in sub-standard loans within the non-farm, non-residential loan segment.

Noninterest Income

Noninterest income consists of all revenues that are not included in interest and fee income related to earning assets. Total noninterest income for the second quarter of 2011 was $11.36 million compared with noninterest income of $8.90 million in the same period of 2010, an increase of $2.46 million. Exclusive of the impact of other-than-temporary impairment (“OTTI”) charges and gains on the sale of securities, noninterest income for the quarter ended June 30, 2011, increased $251 thousand, or 3.18%, compared to the same period in 2010. Wealth management revenues decreased $82 thousand, or 8.10%, to $930 thousand for the three months ended June 30, 2011, compared with the same period in 2010. Service charges on deposit accounts increased $6 thousand, or 0.18%, to $3.35 million for the three months ended June 30, 2011, compared with the same period in 2010. Other service charges and fees increased $211 thousand, or 16.88%, to $1.46 million for the three months ended June 30, 2011, compared with the same period in 2010. Insurance commissions for the second quarter of 2011 were $1.56 million, an increase of $172 thousand, or 12.38%, from the comparable period in 2010. Other operating income totaled $834 thousand for the three months ended June 30, 2011, a decrease of $56 thousand, or 6.29%, compared with the same period in 2010. For the quarter ended June 30, 2011, the Company recognized no OTTI charges, compared to $185 thousand of OTTI charges related to two pooled trust preferred securities and several small equity holdings during the same period of 2010. During the second quarter of 2011, net securities gains of $3.22 million were realized compared with net gains of $1.20 million in the comparable period in 2010.

Noninterest income for the first half of 2011 was $20.86 million compared with noninterest income of $17.48 million in the same period of 2010, an increase of $3.38 million. Exclusive of the impact of OTTI charges and gains on the sale of securities, noninterest income for the six months ended June 30, 2011, increased $113 thousand, or 0.70%, compared to the same period in 2010. Wealth management revenues decreased $73 thousand, or 3.85%, to $1.82 million for the first half of 2011, compared with the same period in 2010. Service charges on deposit accounts increased $45 thousand, or 0.71%, to $6.38 million for the six months ended June 30, 2011, compared with the same period in 2010. Other service charges and fees increased $336 thousand, or 13.28%, to $2.87 million for the six months ended June 30, 2011, compared with the same period in 2010. Insurance commissions for the first half of 2011 were $3.50 million, a decrease of $86 thousand, or 2.40%, from the comparable period in 2010. The decrease in insurance commissions reflects the effects of the recent recession, as well as the soft insurance market. Other operating income totaled $1.75 million for the six months ended June 30, 2011, a decrease of $109 thousand, or 5.86%, compared with the same period in 2010. For the six months ended June 30, 2011, the Company recognized $527 thousand of OTTI charges related to a non-agency mortgage-backed security, compared to $185 thousand of OTTI charges related to two pooled trust preferred securities and several small equity holdings during the same period of 2010.

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During the first half of 2011, net securities gains of $5.06 million were realized compared with net gains of $1.45 million in the comparable period in 2010.

Over the course of the first half of 2011, the Company strategically harvested gains in the investment portfolio as changes in the interest rate environment presented opportunities. Additionally, approximately $967 thousand of the gains realized during the period were recoveries of investment security impairments that occurred during 2009.

For a more detailed discussion of activities regarding investment securities and impairment charges, please see Note 3 to the Consolidated Financial Statements included in Part I.

Noninterest Expense

Noninterest expense totaled $17.74 million for the quarter ended June 30, 2011, an increase of $1.14 million, or 6.87%, from the same period in 2010. Salaries and employee benefits for the second quarter of 2011 increased $198 thousand, or 2.33%, compared to the same period in 2010. Occupancy and furniture and equipment expenses decreased $11 thousand, or 0.44%, between the comparable periods. Deposit insurance premiums and assessments were $414 thousand for the three-month period ended June 30, 2011, a decrease of $296 thousand, or 41.69%, compared to the same period in 2010, which was primarily due to the FDIC’s change in assessment methodology for deposit insurance to one based on tangible assets. Other operating expense totaled $5.90 million for the second quarter of 2011, an increase of $1.24 million, or 26.63%, from $4.66 million for the second quarter of 2010. The increase in other operating expense was primarily due to a $1.27 million increase in expenses and losses associated with other real estate owned between the comparable quarters.

Noninterest expense totaled $35.80 million for the six months ended June 30, 2011, an increase of $3.13 million, or 9.58%, from the same period in 2010. Salaries and employee benefits for the first half of 2011 increased $1.36 million, or 8.25%, compared to the same period in 2010. The Company has increased staffing levels in credit administration, marketing, and compliance due to increasing regulatory burdens. The Company has also experienced a significant increase in health insurance costs in recent quarters. Occupancy and furniture and equipment expenses decreased $13 thousand, or 0.56%, between the comparable periods. Deposit insurance premiums and assessments were $1.29 million for the six-month period ended June 30, 2011, a decrease of $119 thousand, or 8.43%, compared to the same period in 2010. Other operating expense totaled $10.67 million for the first half of 2011, an increase of $1.47 million, or 16.01%, from $9.19 million for the first half of 2010. The increase in other operating expenses includes an increase of $772 thousand in expenses and losses associated with other real estate owned.

During the first quarter of 2011, the Company prepaid a $25.00 million FHLB advance, and the expense associated with that prepayment was $471 thousand.

Income Tax Expense

Income tax expense is comprised of federal and state current and deferred income taxes on pre-tax earnings of the Company. Income taxes as a percentage of pre-tax income may vary significantly from statutory rates due to items of income and expense which are excluded, by law, from the calculation of taxable income. These items are commonly referred to as permanent differences. The most significant permanent differences for the Company include income on municipal securities which are exempt from federal income tax and the increases in the cash surrender values of life insurance policies.

For the second quarter of 2011, income taxes were $2.57 million compared with income taxes of $2.12 million for the second quarter of 2010. For the quarters ended June 30, 2011 and 2010, the effective tax expense rates were 30.99% and 29.25%, respectively. For the six months ended June 30, 2011, income taxes were $4.92 million compared with $4.30 million for the same period of 2010. For the six months ended June 30, 2011 and 2010, the effective tax expense rates were 30.00% and 29.25%, respectively.

FINANCIAL CONDITION

Total assets at June 30, 2011, decreased $37.84 million, or 1.69%, to $2.21 billion from December 31, 2010. At June 30, 2011, cash and cash equivalents increased $118.43 million since year-end 2010. At June 30, 2011, total liabilities were $1.90 billion, a decrease of $70.16 million, or 3.55%, from December 31, 2010. Deposits decreased $41.28 million, securities sold under agreements to repurchase decreased $3.12 million, and borrowings decreased $25.01 million during the six-month period ended June 30, 2011.

Securities

Available-for-sale securities were $349.98 million at June 30, 2011, compared with $480.06 million at December 31, 2010, a decrease of $130.09 million, or 27.10%. The market value of securities available-for-sale as a percentage of amortized cost improved from 96.40% at December 31, 2010, to 97.23% at June 30, 2011, reflecting improved pricing on certain issues. Held-to-maturity securities declined to $4.11 million at June 30, 2011, compared with $4.64 million at December 31, 2010.

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During the second quarter of 2011, the Company recognized no OTTI charges. For the first half of 2011, the Company recognized OTTI charges in earnings related to a non-agency mortgage-backed security of $527 thousand. During the three- and six-month periods ended June 30, 2011, the Company recognized no OTTI charges on equity securities.

For a more detailed discussion of investment securities, please see Note 3 to the Consolidated Financial Statements included in Part I.

Loan Portfolio

Loans Held for Sale

The $920 thousand balance of loans held for sale at June 30, 2011, represents mortgage loans that are sold to investors on a best efforts basis. Accordingly, the Company does not retain the interest rate risk involved in the commitment. The gross notional amount of outstanding commitments to originate mortgage loans for customers at June 30, 2011, was $3.50 million on 22 loans.

Loans Held for Investment

Total loans held for investment were $1.37 billion at June 30, 2011, representing a decrease of $12.26 million from December 31, 2010, and a decrease of $25.94 million from June 30, 2010. The average loan to deposit ratio was 85.57% for the second quarter of 2011, compared with 85.54% for the fourth quarter of 2010, and 85.19% for the second quarter of 2010. Year-to-date average loans of $1.38 billion decreased $18.37 million when compared to year-to-date average loans of $1.40 billion in 2010.

The held for investment loan portfolio continues to be diversified among loan types and industry segments. The following table presents the various loan categories and changes in composition as of June 30, 2011, December 31, 2010, and June 30, 2010.

(Dollars in Thousands)

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Non-Performing Assets

Non-performing assets include loans on non-accrual status, unseasoned loan restructurings, loans contractually past due 90 days or more and still accruing interest, and other real estate owned (“OREO”). Non-performing assets were $28.50 million at June 30, 2011, $29.65 million at December 31, 2010, and $25.98 million at June 30, 2010. The percentage of non-performing assets to total assets was 1.29% at June 30, 2011, 1.32% at December 31, 2010, and 1.16% at June 30, 2010.

The following table details non-performing assets by category at the close of each of the quarters ended June 30, 2011, December 31, 2010, and June 30, 2010.

(Dollars in Thousands)

Ongoing activity within the classification and categories of non-performing loans include collections on delinquencies, foreclosures, loan restructurings, and movements into or out of the non-performing classification as a result of changing economic conditions, borrower financial capacity, and resolution efforts on the part of the Company. There were no loans 90 days past due and still accruing at June 30, 2011, December 31, 2010, or June 30, 2010. OREO was $5.59 million at June 30, 2011, an increase of $675 thousand from December 31, 2010, and is carried at the lesser of estimated net realizable value or cost. OREO increased from December 31, 2010, as a result of escalation in asset resolution and foreclosure activity. At June 30, 2011, OREO consisted of 49 properties with an average book value of $193 thousand and an average holding period of 7 months. During the three- and six-month periods ended June 30, 2011, net losses on the sale of OREO totaled $1.55 million and $1.70 million, respectively.

The Company’s Special Assets staff assumes the management and monitoring of all loans determined to be seriously delinquent or impaired. When resolution of delinquent loans through secondary repayment sources becomes evident, updated appraisals are ordered and the Company generally begins to complete the tasks necessary to gain control of the collateral and prepare for liquidation including, but not limited to, engagement of counsel, inspection of collateral, and continued communication with the borrower, if appropriate. Special Assets staff also regularly reviews the relationship to identify any potential adverse developments during this time and continues to seek alternative resolution processes, where possible.

At June 30, 2011, the allowance for loan losses related to loan restructurings totaled $1.32 million. Total interest income recognized on loan restructurings for the three- and six- month periods ended June 30, 2011, totaled $132 thousand and $254 thousand, respectively. When restructuring loans for troubled borrowers, the Company generally makes concessions in interest rates and amortization terms.

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Deposits and Other Borrowings

Total deposits decreased by $41.28 million, or 2.55%, during the first six months of 2011. Noninterest-bearing demand deposits increased $14.34 million to $219.49 million at June 30, 2011, compared with $205.15 million at December 31, 2010. Interest-bearing demand deposits increased $9.20 million to $271.62 million at June 30, 2011, from December 31, 2010. Savings decreased $21.14 million, or 4.96%, and time deposits decreased $43.68 million, or 6.01%, during the first half of 2011.

Securities sold under repurchase agreements decreased $3.12 million, or 2.21%, in the first six months of 2011 to $137.78 million. There were no federal funds purchased outstanding at June 30, 2011, as the Company maintained a very strong liquidity position throughout the first half of 2011.

Stockholders’ Equity

Total stockholders’ equity increased $32.33 million, or 11.98%, from $269.88 million at December 31, 2010, to $302.20 million at June 30, 2011. Changes in stockholders’ equity during the period were primarily the result of net income of $11.48 million, an increase in accumulated other comprehensive income of $4.99 million, the completion of an $18.92 million capital raise through the private placement of convertible preferred stock, and the payment of common dividends of $3.58 million. The convertible preferred stock was issued for general corporate purposes, including the possible capitalization of the Company’s future growth plans.

Risk-Based Capital

Risk-based capital guidelines promulgated by federal banking agencies weight balance sheet assets and off-balance sheet commitments based on inherent risks associated with the respective asset types. At June 30, 2011, the Company’s total risk-based capital ratio was 17.59% compared with 15.33% at December 31, 2010. The Company’s Tier 1 risk-based capital ratio was 16.33% at June 30, 2011, compared with 14.07% at December 31, 2010. The Company’s Tier 1 leverage ratio at June 30, 2011, was 11.00% compared with 9.44% at December 31, 2010. At June 30, 2011, the Bank was deemed “well-capitalized” under regulatory capital adequancy standards.

Liquidity and Capital Resources

At June 30, 2011, the Company maintained liquidity in the form of cash and cash equivalent balances of $194.85 million, unpledged securities available-for-sale of $103.12 million, and total FHLB credit availability of approximately $160.71 million. Cash and cash equivalents as well as advances from the FHLB are immediately available for satisfaction of deposit withdrawals, customer credit needs and operations of the Company. Investment securities available-for-sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company also maintains approved lines of credit with correspondent banks as backup liquidity sources.

The Company is a holding company, which is a separate legal entity from the Bank, and at June 30, 2011, maintained cash balances of $23.36 million. The principal source of the Company’s income is dividends from the Bank, which are subject to regulatory restrictions and limitations. As a result of investment securities impairments in 2009, the Bank is limited as to the dividends it can pay to the Company. Accordingly, the Bank would need permission from the Virginia Bureau of Financial Institutions prior to paying dividends to the Company. The cash reserves and investments held by the Company, as well as management fee arrangements provide adequate working capital to meet its obligations and projected dividends to shareholders for the next twelve months and through the projected period of dividend restrictions.

The Company maintains a liquidity policy as a means to manage liquidity and the associated risk. The policy includes a Liquidity Contingency Plan (the “Liquidity Plan”) that is designed as a tool for the Company to detect liquidity issues promptly in order to protect depositors, creditors and shareholders. The Liquidity Plan includes monitoring various internal and external indicators such as changes in core deposits and changes in market conditions. It provides for timely responses to a wide variety of funding scenarios ranging from changes in loan demand to a decline in the Company’s quarterly earnings to a decline in the market price of the Company’s stock. The Liquidity Plan calls for specific responses designed to meet a wide range of liquidity needs based upon assessments on a recurring basis by the Company and its Board of Directors.

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Interest Rate Risk and Asset/Liability Management

The Company’s profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk to the degree that interest-earning assets reprice differently than interest-bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment.

The Company’s primary component of operational revenue, net interest income, is subject to variation as a result of changes in interest rate environments in conjunction with unbalanced repricing opportunities on earning assets and interest-bearing liabilities. Interest rate risk has four primary components: repricing risk, basis risk, yield curve risk and option risk. Repricing risk occurs when earning assets and paying liabilities reprice at differing times as interest rates change. Basis risk occurs when the underlying rates on the assets and liabilities the institution holds change at different levels or in varying degrees. Yield curve risk is the risk of adverse consequences as a result of unequal changes in the spread between two or more rates for different maturities for the same instrument. Lastly, option risk is due to embedded options, often put or call options, given or sold to holders of financial instruments.

In order to mitigate the effect of changes in the general level of interest rates, the Company manages repricing opportunities and thus, its interest rate sensitivity. The Company seeks to control its interest rate risk exposure to insulate net interest income and net earnings from fluctuations in the general level of interest rates. To measure its exposure to interest rate risk, quarterly simulations of net interest income are performed using financial models that project net interest income through a range of possible interest rate environments including rising, declining, most likely and flat rate scenarios. The simulation model used by the Company captures all earning assets, interest-bearing liabilities and off-balance sheet financial instruments and combines the various factors affecting rate sensitivity into an earnings outlook and estimates of the economic value of equity in a range for a range of assumed interest rate scenarios. The results of these simulations indicate the existence and severity of interest rate risk in each of those rate environments based upon the current balance sheet position, assumptions as to changes in the volume and mix of interest-earning assets and interest-paying liabilities and the Company’s estimate of yields to be attained in those future rate environments and rates that will be paid on various deposit instruments and borrowings. These assumptions are inherently uncertain and, as a result, the model cannot precisely predict the impact of fluctuations in interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and the Company’s strategies. However, the earnings simulation model is currently the best tool available to the Company and the industry for managing interest rate risk.

Specific strategies for management of interest rate risk have included shortening the amortized maturity of new fixed-rate loans, increasing the volume of adjustable-rate loans to reduce the average maturity of the Company’s interest-earning assets, and monitoring the term and structure of liabilities to maintain a balanced mix of maturity and repricing structures to mitigate potential exposure. At June 30, 2011, modeling indicates that the Company is in a relatively neutral position with respect to sensitivity to interest rate changes.

The Company has established policy limits for tolerance of interest rate risk in various interest rate scenarios. In addition, the policy addresses exposure limits to changes in the economic value of equity according to predefined policy guidelines. The most recent simulation indicates that current exposure to interest rate risk is within the Company’s defined policy limits.

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The following table summarizes the projected impact on the next twelve months’ net interest income and the economic value of equity as of June 30, 2011, and December 31, 2010, of immediate and sustained rate shocks in the interest rate environments of plus 300 to minus 100 basis points from the base case rate simulation, assuming no remedial measures are effected. At June 30, 2011, the Federal Open Market Committee maintained a target range for federal funds of 0 to 25 basis points, rendering complete downward shocks greater than 100 basis points unrealistic and not meaningful. In the downward rate shocks presented, benchmark interest rates are dropped with floors near 0%.

Rate Sensitivity Analysis

(Dollars in Thousands)

(Dollars in Thousands)

The economic value of equity is a measure which reflects the impact of changing rates on the underlying values of the Company’s assets and liabilities in various rate scenarios. The scenarios illustrate the potential estimated impact of instantaneous rate shocks on the underlying value of equity. The economic value of equity is based on the present value of all the future cash flows under the different rate scenarios.

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Disclosure Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer (“CEO”) along with the Company’s Chief Financial Officer (“CFO”), of the effectiveness of the Company’s disclosure controls and procedures pursuant to the Securities Exchange Act of 1934 (“Exchange Act”) Rule 13a-15(b). Based on that evaluation, the Company’s CEO along with the Company’s CFO concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2011, in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings.

The Company’s management, including the CEO and CFO, does not expect that the Company’s disclosure controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls.

Changes in Internal Control over Financial Reporting

The Company assesses the adequacy of its internal control over financial reporting quarterly and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2011, that have materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

There were no material changes to the risk factors as previously disclosed under Item 1A. of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.