2011 Annual Report Outside Cover - Final.pdf 3/8/2012 3:06:35 PM 230558_BNY_Cvr_r1.indd 1 3/13/12 2:02 PM FORWARD LOOKING INFORMATION This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the current beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and statements preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions. Any forward-looking statements in this document are subject to risks relating to, among other things, the factors described under the heading “Risk Factors”in Part I, Item 1.A to our Annual Report of Form 10-K for the fiscal year ended December 31, 2011 (the “Form 10-K”), as well as the following: 1. changing laws, regulations, standards, and government programs, that may limit our revenue sources, eliminate insurance currently available on some deposit products, significantly increase our costs, including compliance and insurance costs, and place additional burdens on our limited management resources; 2. poor economic or business conditions, nationally and in the regions in which we do business, that have resulted in, and may continue to result in, among other things, a deterioration in credit quality and/or reduced demand for credit and other banking services, and additional workout and other real estate owned (“OREO”) expenses; 3. decreases in real estate and other asset prices, whether or not due to changes in economic conditions, that may reduce the value of the assets that serve as collateral for many of our loans; 4. competitive pressures among depository and other financial institutions that may impede our ability to attract and retain depositors, borrowers and other customers, retain our key employees, and/or maintain and improve our net interest margin and income and non-interest income, such as fee income; and 5. a lack of liquidity in the market for our common stock that may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock. Our management believes our forward-looking statements are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results, financial condition, and share value are beyond our ability to predict or control. We undertake no obligation to update forward- looking statements. LETTER TO THE SHAREHOLDERS My Fellow Shareholders: to report I am pleased that Pacific Financial Corporation continued to make very good financial progress toward normalized operating results during 2011. Earnings increased from $1.6 million in 2010 to $2.8 million for 2011, representing 8 consecutive quarters of earnings. For shareholders, that represents an improvement of 12-cents per share over 2010. While banks have generally returned to year-over-year profitability, many have been unable to string together 4 or more consecutive quarters of profitability. During last year’s annual meeting with shareholders, I indicated our top 4 objectives for 2011 would be: 1. Loan/asset quality improvement 2. Net interest margin improvement 3. Core deposit & loan growth 4. Hold the line on net overhead Dennis A. Long President & CEO Improving the overall quality of our loan portfolio has not been an easy task in view of the ongoing sluggish local economic growth. Regardless, credit quality substantially improved during 2011. By example, net loan charge-offs for 2010 were $4.1 million, while in 2011 net loan charge-offs totaled $2.0 million. In addition, the provision for credit losses declined from $3.6 million in 2010 to $2.5 million in 2011, which further evidences the continuing improvement in the overall quality of the loan portfolio. While other real estate owned (OREO) increased from year-end 2010 by $1.1 million to $7.7 million as of the close of 2011, gaining full control of loan collateral brings us much closer to resolution on problem assets. Our OREO properties are appraised every 6 months with corresponding adjustments to book value, if necessary, which helps to ensure that balance sheet carrying values closely represent market prices. While the total dollar value of OREO increased from 2010, we were successful in selling 11 properties totaling $2.3 million during 2011. In addition, we have already experienced good sales activity during the first two months of 2012. Even though asset quality is not back to historic norms, the trend lines suggest the potential for ongoing improvement during 2012. The forecast for improvement could, of course, be derailed if the present economic recovery were to falter. The economic outlook appears to be improving for now. Net interest margin (NIM) improvement was another of the primary objectives set forth for 2011. You may recall that in 2009 NIM declined to 3.62% and, as forecast, we saw improvement in 2010 to 3.96%. During 2011 NIM improved again to 4.08%, and reached 4.28% for the fourth quarter of 2011. The reasons for the continuing improvement stem from a substantial change in the mix of deposits, along with the favorable re-pricing of both our Junior Subordinated Debentures, and Federal Home Loan Bank borrowings. As an overall financial result, net interest income improved by $806,000 during 2011 over 2010. Our third primary objective was to change the mix of our deposit liabilities and re-establish loan growth. We were successful with our deposit products by shifting higher priced certificates of deposit to non-interest bearing demand and lower cost interest bearing deposits. Certificates of deposit declined by $44 million while other, less expensive, interest bearing deposits increased by $47 million. Meanwhile we enjoyed some modest overall good loan growth of roughly $13.5 million during the 12 months ending December 31, 2011. Rounding out the primary objectives was to hold the line on net overhead (non-interest expense minus non-interest income). While the number did increase from $17.9 million to $18.0 million, it represented an increase of less than ½ of 1%. We are beginning to see declines in our FDIC insurance costs and, with fewer loan problems, there will be fewer collection costs. We recently announced the opening of a loan production office in Burlington, Washington that will add some overhead burden in 2012; however, we believe the increased loan activity and accompanying net interest income will cover the costs. As we look to the future, we are well-positioned to profitably grow our balance sheet. The growth remains possible because of our continued three solid regulatory capital ratios. Comparative year-end capital ratios were as follows: Capital Ratio Tier 1 Leverage Tier 1 Risk-based Total Risk-based Actual 2011 10.2% 13.6% 14.8% Actual 2010 9.7% 13.2% 14.5% Regulatory Well-Capitalized 5.0% 6.0% 10.0% It remains important for our Company to continue to hold above average capital since global economic uncertainty could unravel the present recovery. As the sustainability of the economic recovery becomes more certain, the Company’s Board of Directors will consider the prospects of returning to a cash dividend for our shareholders. Presently, our capital is a substantial resource and protective cushion while the economy rights itself. While the progress our company has made over the past 3 years has been significant, we remain hard at work completing the process. The Bank’s employees have done some very fine work resolving problem loans, while building new and stronger relationships with our customers. Although many of the challenges for 2012 remain similar to 2011, there is a renewed energy among our staff to add significantly more business during 2012. Calling efforts have increased and, though it is early, we have begun to see positive results. As shareholders, if you have friends or family interested in banking services, let us help them achieve their financial dreams. Our reputation for providing excellent customer service will delight those who give us a try. Meanwhile, thank you for your ongoing support and investment in Pacific Financial Corporation. Sincerely, Dennis A. Long President and Chief Executive Officer IN MEMORY VERNON LINDSKOG August 24, 1931 – May 23, 2011 Founding Director The Bank of Grays Harbor 1979 – 2000 SELECTED FINANCIAL DATA The following selected consolidated five year financial data should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes presented in this report. Dollars are in thousands, except per share data. Operations Data Net interest income Provision for credit losses Non-interest income Non-interest expense Provision (benefit) for income taxes Net income (loss) Net income (loss) per share: Basic (1) Diluted (1) Dividends declared Dividends declared per share (1) Dividend payout ratio Performance Ratios Interest rate spread Net interest margin (2) Efficiency ratio (3) Return on average assets Return on average equity Balance Sheet Data Total assets Loans, net Total deposits Total borrowings Shareholders’ equity Book value per share (1) (4) Tangible book value per share (1) Equity to assets ratio As of and For the Year Ended December 31, 2009 2008 2010 2007 2011 $23,685 2,500 7,614 25,648 333 $2,818 $0.28 0.28 - - - - - - $22,879 3,600 8,451 26,400 (304) $1,634 $0.16 0.16 - - - - - - $21,753 9,944 7,025 29,691 (4,519) $(6,338) $(0.74) (0.74) - - - - - - 4.22% 4.08% 81.95% 0.44% 4.55% 4.10% 3.96% 84.26% 0.25% 2.77% 3.76% 3.62% 103.17% (0.96)% (11.63)% $21,715 4,791 5,057 21,591 (561) $951 $0.13 0.13 333 0.05 35% 4.23% 4.12% 80.65% 0.16% 1.83% $24,503 482 4,475 20,379 2,086 $6,031 $0.83 0.82 4,955 0.75 82% 4.92% 4.82% 70.33% 1.08% 11.46% $641,254 463,766 548,050 24,644 63,270 6.25 5.01 9.87% $644,403 455,064 544,954 35,328 59,769 5.90 4.66 9.28% $668,626 471,154 567,695 39,880 57,649 5.70 4.44 8.62% $625,835 478,695 511,307 60,757 50,074 6.84 5.08 8.00% $565,587 433,904 467,336 37,446 50,699 6.98 5.19 8.96% Asset Quality Ratios Nonperforming loans to total loans Allowance for credit losses to total loans Allowance for credit losses to nonperforming loans Nonperforming assets to total assets 2.96% 2.34% 2.15% 2.28% 3.36% 2.30% 79.28% 3.39% 106.18% 2.57% 68.49% 3.42% 3.49% 1.57% 44.97% 3.80% 1.46% 1.14% 78.10% 1.13% (1) Retroactively adjusted for a 1.1 to 1 stock split effective January 13, 2009. (2) Net interest income divided by average earning assets. (3) Non-interest expense divided by the sum of net interest income and non-interest income. (4) Shareholder equity divided by shares outstanding. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Pacific Financial Corporation Aberdeen, Washington We have audited the accompanying consolidated balance sheets of Pacific Financial Corporation and subsidiary (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pacific Financial Corporation and subsidiary as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 22, 2012 expressed an unqualified opinion on the Company’s internal control over financial reporting. Portland, Oregon March 22, 2012 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 Consolidated Balance Sheets (Dollars in Thousands, Except Per Share Amounts) Assets Cash and due from banks (See note 2) Interest bearing deposits in banks Securities available for sale, at fair value (amortized cost of $47,015 and $42,402) Securities held to maturity (fair value of $7,118 and $6,584) Federal Home Loan Bank stock, at cost Loans held for sale Loans Allowance for credit losses Loans - net Premises and equipment Other real estate owned Accrued interest receivable Cash surrender value of life insurance Goodwill Other intangible assets Other assets Total assets Liabilities and Shareholders’ Equity Liabilities Deposits: Demand, non-interest bearing Savings and interest-bearing demand Time, interest-bearing Total deposits Accrued interest payable Secured borrowings Short-term borrowings Long-term borrowings Junior subordinated debentures Other liabilities Total liabilities Commitments and Contingencies (See note 13) Shareholders’ Equity Common stock (par value $1); authorized: 25,000,000 shares; issued and outstanding: 2011 and 2010 – 10,121,853 shares Additional paid-in capital Retained earnings Accumulated other comprehensive loss Total shareholders’ equity Total liabilities and shareholders’ equity See notes to consolidated financial statements. 1 2011 2010 $12,607 28,525 47,652 7,025 3,182 14,541 474,893 11,127 463,766 14,884 7,725 2,156 17,275 11,282 1,268 9,366 $7,428 54,330 41,893 6,454 3,182 10,144 465,681 10,617 455,064 15,181 6,580 2,334 16,748 11,282 1,303 12,480 $641,254 $644,403 $108,899 286,642 152,509 548,050 1,490 741 - - 10,500 13,403 3,800 577,984 $95,115 253,347 196,492 544,954 1,380 925 10,500 10,500 13,403 2,972 584,634 - - - - 10,122 41,342 12,051 (245) 63,270 10,122 41,316 9,233 (902) 59,769 $641,254 $644,403 Pacific Financial Corporation and Subsidiary Years Ended December 31, 2011, 2010 and 2009 Consolidated Statements of Income (Dollars in Thousands, Except Per Share Amounts) Interest and Dividend Income Loans Federal funds sold and deposits in banks Securities available for sale: Securities held to maturity: Taxable Tax-exempt Taxable Tax-exempt Total interest and dividend income Interest Expense Deposits Short-term borrowings Long-term borrowings Secured borrowings Junior subordinated debentures Total interest expense Net interest income Provision for Credit Losses Net interest income after provision for credit losses Non-Interest Income Service charges on deposit accounts Net gains (loss) on sale of other real estate owned Net gains from sales of loans Net gains on sales of securities available for sale Net other-than-temporary impairment (net of $256, $0 and $0 recognized in other comprehensive income before taxes) Earnings on bank owned life insurance Other operating income Total non-interest income Non-Interest Expense Salaries and employee benefits Occupancy Equipment State taxes Data processing Professional services Other real estate owned write-downs Other real estate owned operating costs FDIC assessments Other Total non-interest expense Income (loss) before income taxes Income Taxes (Benefit) Net income (loss) Earnings (Loss) Per Share Weighted Average Shares Outstanding: Basic Diluted Basic Diluted See notes to consolidated financial statements. 2 2011 2010 2009 $27,186 92 $28,520 116 $29,800 109 1,024 707 18 291 29,318 4,643 - - 597 41 352 5,633 23,685 2,500 21,185 1,799 (83) 3,593 698 (330) 527 1,410 7,614 13,723 1,523 1,011 473 1,415 739 1,049 450 938 4,327 25,648 3,151 333 1,214 716 21 273 30,860 6,574 - - 849 61 497 7,981 22,879 3,600 19,279 1,783 260 4,168 422 - - 541 1,277 8,451 13,530 1,544 1,222 480 1,247 767 1,272 614 1,361 4,363 26,400 1,330 (304) 1,841 745 27 298 32,820 9,264 26 1,164 75 538 11,067 21,753 9,944 11,809 1,649 (1,418) 4,638 484 - - 489 1,183 7,025 13,558 1,560 1,219 436 1,246 866 3,689 507 1,802 4,808 29,691 (10,857) (4,519) $2,818 $1,634 $(6,338) $0.28 $0.28 $0.16 $0.16 $(0.74) $(0.74) 10,121,853 10,121,870 10,121,853 10,121,853 8,539,237 8,539,237 Pacific Financial Corporation and Subsidiary Years Ended December 31, 2011, 2010 and 2009 Consolidated Statements of Shareholders’ Equity (Dollars in Thousands, Except Per Share Amounts) Balance at January 1, 2009 7,317,430 $7,318 $31,626 $13,937 $(2,807) $50,074 Shares of Common Stock Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Loss Total - - - - - - (6,338) - - (6,338) Comprehensive loss: Net loss Unrealized holding loss on securities of $1,727 (net of tax of $890) less reclassification adjustment for net gains included in net income of $319 (net of tax of $165) Amortization of unrecognized prior service costs and net gains/losses Comprehensive loss - - - - - - - - - - - - - - - - - - - - 1,408 1,408 57 - - - - 57 (4,873) 12,394 54 Issuance of common stock Stock compensation expense 2,804,423 - - 2,804 - - 9,590 54 Balance at December 31, 2009 10,121,853 $10,122 $41,270 $7,599 $(1,342) $57,649 Comprehensive income: Net income Unrealized holding gain on securities of $802 (net of tax of $273) less reclassification adjustment for net gains included in net income of $279 (net of tax of $143) Amortization of unrecognized prior service costs and net gains/losses Comprehensive loss Stock compensation expense - - - - - - 1,634 - - 1,634 - - - - - - - - - - - - - - - - 46 - - - - - - 523 (83) - - 523 (83) 2,074 46 Balance at December 31, 2010 10,121,853 $10,122 $41,316 $9,233 $(902) $59,769 Comprehensive income: Net income Unrealized holding gain on securities of $1,001 (net of tax of $516) less reclassification adjustment for net gains included in net income of $243 (net of tax of $125) Amortization of unrecognized prior service costs and net gains/losses Comprehensive income Stock compensation expense - - - - - - 2,818 - - 2,818 - - - - - - - - - - - - - - - - 26 - - - - - - 758 (101) - - 758 (101) 3,475 26 Balance at December 31, 2011 10,121,853 $10,122 $41,342 $12,051 $(245) $63,270 See notes to consolidated financial statements. 3 Pacific Financial Corporation and Subsidiary Years Ended December 31, 2011, 2010 and 2009 Consolidated Statements of Cash Flows (Dollars in Thousands) Cash Flows from Operating Activities Net income (loss) Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization Provision for credit losses Deferred income taxes Originations of loans held for sale Proceeds from sales of loans held for sale Net gains on sales of loans Net gain on sales of securities available for sale Net OTTI recognized in earnings (Gain) loss on sales of other real estate owned Loss on sale of premises and equipment Earnings on bank owned life insurance Decrease in accrued interest receivable Increase in accrued interest payable Other real estate owned write-downs Additions to other real estate owned Proceeds from Internal Revenue Service tax refund (Increase) decrease in prepaid expenses Other - net Net cash provided by (used in) operating activities Cash Flows from Investing Activities Net (increase) decrease in interest bearing deposits in banks Net (increase) decrease in federal funds sold Activity in securities available for sale: Sales Maturities, prepayments and calls Purchases Activity in securities held to maturity: Maturities Purchases Proceeds from sales of government loan pools (Increase) decrease in loans made to customers, net of principal collections Purchases of premises and equipment Proceeds from sales of other real estate owned Net cash provided by (used in) investing activities (continued) See notes to consolidated financial statements. 4 2011 2010 2009 $2,818 $1,634 $(6,338) 1,428 2,500 (815) (172,274) 170,797 (3,593) (698) 330 83 23 (527) 178 110 1,049 (260) 1,876 801 1,869 5,695 25,805 - - 17,407 7,564 (29,553) 255 (828) 9,845 (23,505) (1,019) 1,101 7,072 1,585 3,600 (886) (209,301) 215,548 (4,168) (422) - - (260) 14 (541) 203 255 1,272 - - - - 1,289 1,054 10,876 (19,262) 5,000 17,179 8,069 (12,325) 1,048 (56) 5,272 114 (470) 6,440 11,009 1,611 9,944 (2,696) (274,264) 276,668 (4,638) (484) - - 1,418 - - (489) 235 123 3,689 - - - - (4,590) (2,231) (2,042) (34,486) (4,225) 11,072 9,780 (23,366) 384 (1,450) - - (11,867) (552) 5,834 (48,876) Pacific Financial Corporation and Subsidiary Years Ended December 31, 2011, 2010 and 2009 Consolidated Statements of Cash Flows (concluded) (Dollars in Thousands) Cash Flows from Financing Activities Net increase (decrease) in deposits Net decrease in short-term borrowings Decrease in secured borrowings Proceeds from issuance of long-term borrowings Prepayments of long-term borrowings Common stock issued Cash dividends paid Net cash provided by (used in) financing activities 2011 2010 2009 $3,096 (10,500) (184) 7,500 (7,500) - - - - (7,588) $(22,741) (4,500) (52) - - - - - - - - (27,293) $56,388 (23,500) (377) 3,000 - - 12,394 (333) 47,572 Net change in cash and due from banks 5,179 (5,408) (3,346) Cash and Due from Banks Beginning of year End of year Supplemental Disclosures of Cash Flow Information Interest paid Income taxes paid Supplemental Disclosures of Non-Cash Investing Activities Fair value adjustment of securities available for sale, net of tax Transfer of loans held for sale to loans held for investment Other real estate owned acquired in settlement of loans Financed sale of other real estate owned Reclass of current portion of long-term borrowings to 7,428 12,836 16,182 $12,607 $7,428 $12,836 $5,523 332 $7,726 725 $10,944 183 $758 300 (4,278) 1,160 $523 - - (8,093) 726 $1,408 1,408 (11,252) 456 short-term borrowings - - 10,500 4,500 See notes to consolidated financial statements. 5 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Pacific Financial Corporation (the Company), and its wholly owned subsidiary, Bank of the Pacific (the Bank), after elimination of intercompany transactions and balances. The Company has two wholly owned subsidiaries, PFC Statutory Trust I and II (the Trusts), which do not meet the criteria for consolidation, and therefore, are not consolidated in the Company’s financial statements. The Company was incorporated in the State of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank. Nature of Operations The Company is a holding company which operates primarily through its subsidiary bank. The Bank operates 16 branches located in Grays Harbor, Pacific, Skagit, Whatcom and Wahkiakum Counties in western Washington and one in Clatsop County, Oregon. The Bank provides loan and deposit services to customers, who are predominately small- and middle-market businesses and middle-income individuals in western Washington and the north coast of Oregon. In 2006, the Bank completed a deposit transfer and assumption transaction with an Oregon-based bank for a $1,268 premium. In connection with completion of the transaction, the Oregon Department of Consumer and Business Services issued a Certificate of Authority to the Bank authorizing it to conduct a banking business in the State of Oregon. The premium, and the resultant right to conduct business in Oregon, is recorded as an indefinite-lived intangible asset. Consolidated Financial Statement Presentation The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and practices within the banking industry. The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, as of the date of the balance sheet, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for credit losses, the valuation of deferred tax assets, the valuation of investments, the valuation of other real estate owned and the evaluation of goodwill and investments for impairment. Securities Available for Sale Securities available for sale consist of debt securities that the Company intends to hold for an indefinite period, but not necessarily to maturity. Securities available for sale are reported at fair value. Unrealized gains and losses, net of the related deferred tax effect, are reported net as a separate component of shareholders’ equity entitled “accumulated other comprehensive loss.” Realized gains and losses on securities available for sale, determined using the specific identification method, are included in earnings. Amortization of premiums and accretion of discounts are recognized in interest income over the period to maturity. For mortgage-backed securities, actual maturity may differ from contractual maturity due to principal payments and amortization of premiums and accretion of discounts may vary due to prepayment speed assumptions. 6 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) Securities Held to Maturity Debt securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts, which are recognized in interest income over the period to maturity. Declines in the fair value of individual securities held to maturity and available for sale that are deemed to be other than temporary are reflected in earnings when identified. Management evaluates individual securities for other than temporary impairment (“OTTI”) on a quarterly basis. OTTI is separated into a credit and noncredit component. Noncredit component losses are recorded in other comprehensive (loss) when the Company a) does not intend to sell the security or b) is not more likely than not it will be required to sell the security prior to the security’s anticipated recovery. Credit component losses are reported in non-interest income. Federal Home Loan Bank Stock The Company’s investment in Federal Home Loan Bank (“FHLB”) stock is carried at par value. The Company is required to maintain a minimum level of investment in FHLB stock based on specific percentages of its outstanding mortgages, total assets or FHLB advances. The Company views its investment in the FHLB stock as a long-term investment. As of December 31, 2011, the FHLB of Seattle reported that it had not met all of its regulatory capital requirements, and remained classified as “undercapitalized” by its regulator, the Federal Housing Finance Agency. The FHLB will not pay a dividend or repurchase capital stock while it is deemed undercapitalized. While the FHLB was classified as undercapitalized as of December 31, 2011, the Company does not believe that its investment in the FHLB is impaired. However, this estimate could change in the near term if: 1) significant other-than-temporary losses are incurred on the FHLB’s mortgage-backed securities causing a significant decline in its regulatory capital status; 2) the economic losses resulting from credit deterioration on the FHLB’s mortgage-backed securities increases significantly; or 3) capital preservation strategies being utilized by the FHLB become ineffective. Loans Held for Sale Mortgage loans originated for sale in the foreseeable future in the secondary market are carried at the lower of aggregate cost or estimated fair value. Gains and losses on sales of loans are recognized at settlement date and are determined by the difference between the sales proceeds and the carrying value of the loans. Net unrealized losses are recognized through a valuation allowance established by charges to income. Loans held for sale that are unable to be sold in the secondary market are transferred to loans receivable when identified. Loans Receivable Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances adjusted for any charge-offs, the allowance for credit losses, any deferred fees or costs on originated loans, and unamortized premiums or discounts on 7 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) purchased loans. Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment of yield over the contractual life of the related loans using the effective interest method. Interest income on loans is accrued over the term of the loans based upon the principal outstanding. The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they come due. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. Interest income is subsequently recognized only to the extent that cash payments are received until, in management’s judgment, the borrower has the ability to make contractual interest and principal payments, in which case the loan is returned to accrual status. Allowance for Credit Losses The allowance for credit losses is established through a provision that is charged to earnings as probable losses are incurred. Losses are charged against the allowance when management believes the collectability of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance for credit losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which includes a general formulaic allowance and a specific allowance on impaired loans. The formulaic portion of the general credit loss allowance is established by applying a loss percentage factor to the different loan types based on historical loss experience adjusted for qualitative factors. A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls are generally not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, construction and real estate loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral less estimated selling costs if the loan is collateral dependent. When the net realizable value of an impaired loan is less than the book value of the loan, impairment is recognized by adjusting the allowance for credit losses. Uncollected accrued interest is reversed against interest income. If ultimate collection of principal is in doubt, all subsequent cash receipts including interest payments on impaired loans are applied to reduce the principal balance. 8 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation, which is computed on the straight- line method over the estimated useful lives of the assets. Asset lives range from 3 to 39 years. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is less. Gains or losses on dispositions are reflected in earnings. Other Real Estate Owned Real estate properties acquired through, or in lieu of, foreclosure are to be sold and are initially recorded at the lower of cost or fair value of the properties less estimated costs of disposal. Any write-down to fair value at the time of transfer to other real estate owned (“OREO”) is charged to the allowance for credit losses. Properties are evaluated regularly to ensure that the recorded amounts are supported by their current fair values, and that write-downs to reduce the carrying amounts to fair value less estimated costs to dispose are recorded as necessary. Any subsequent reductions in carrying values, and revenue and expense from the operations of properties, are charged to operations. Goodwill and other intangible assets At December 31, 2011 the Company had $12,550 in goodwill and other intangible assets. Goodwill is initially recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Goodwill is not amortized but is reviewed for potential impairment during the second quarter on an annual basis or, more frequently, if events or circumstances indicate a potential impairment, at the reporting unit level. The Company has one reporting unit, the Bank, for purposes of computing goodwill. The analysis of potential impairment of goodwill requires a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company would be required to progress to the second step. In the second step the Company calculates the implied fair value of its reporting unit. The Company compares the implied fair value of goodwill to the carrying amount of goodwill on the Company’s balance sheet. If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss must be recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination. The estimated fair value of the Company is allocated to all of the Company’s individual assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the Company is the price paid to acquire it. The allocation process is performed only for purposes of determining the amount of goodwill impairment, as no assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process. The results of the Company’s annual second quarter step two test determined the implied fair value of goodwill was greater than the carrying value on the Company’s balance sheet and no goodwill impairment existed. As of December 31, 2011 management determined there were no events or circumstances which would more likely than not reduce the fair value of its reporting unit below its carrying value. No assurance can be given that the Company will not record an impairment loss on goodwill in the future. 9 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) Core deposit intangibles are amortized to non-interest expense using a straight line method over seven years. Net unamortized core deposit intangible totaled $0 and $35 at December 31, 2011 and 2010, respectively. Amortization expense related to core deposit intangible totaled $35, $142, and $142 during each of the years ended December 31, 2011, 2010, and 2009. Impairment of long-lived assets Management periodically reviews the carrying value of its long-lived assets to determine if an impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life, of which there have been none. In making such determination, management evaluates the performance, on an undiscounted basis, of the underlying operations or assets which give rise to such amount. Transfers of Financial Assets Transfers of financial assets, including cash, investment securities, loans and loans held for sale, are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through either an agreement to repurchase them before their maturity, or the ability to cause the buyer to return specific assets. Income Taxes Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax bases of assets and liabilities, and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The Company files a consolidated federal income tax return. The Bank provides for income taxes separately and remits to the Company amounts currently due in accordance with a tax allocation agreement between the Company and the Bank. As of December 31, 2011, the Company had no unrecognized tax benefits. The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in “Income Taxes (Benefit)” in the consolidated statements of income. There were no amounts related to interest and penalties recognized for the year ended December 31, 2011. The tax years that remain subject to examination by federal and state taxing authorities are the years ended December 31, 2010, 2009 and 2008. 10 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) Stock-Based Compensation The Company accounts for stock based compensation in accordance with GAAP. Accounting guidance requires measurement of compensation cost for all stock based awards based on the grant date fair value and recognition of compensation cost over the service period of stock based awards. The fair value of stock options is determined using the Black-Scholes valuation model. The Company’s stock compensation plans are described more fully in Note 15. Cash Equivalents and Cash Flows The Company considers all amounts included in the balance sheet caption “Cash and due from banks” to be cash equivalents. Cash flows from loans, interest bearing deposits in banks, federal funds sold, short- term borrowings, secured borrowings and deposits are reported net. The Company maintains balances in depository institution accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. Earnings Per Share Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share reflect the potential dilution that could occur if common shares were issued pursuant to the exercise of options under the Company’s stock option plans. Stock options excluded from the calculation of diluted earnings per share because they are antidilutive, were 581,448, 818,612, and 820,837 in 2011, 2010 and 2009, respectively. Outstanding warrants also excluded were 699,642 for each of the years in 2011 through 2009, respectively. Comprehensive Income Recognized revenue, expenses, gains and losses are included in net income. Certain changes in assets and liabilities, such as prior service costs and amortization of prior service costs related to defined benefit plans and unrealized gains and losses on securities available for sale, are reported within equity in other accumulated comprehensive loss in the consolidated balance sheets. Such items, along with net income, are components of comprehensive income. Gains and losses on securities available for sale are reclassified to net income as the gains or losses are realized upon sale of the securities. Other-than-temporary impairment charges are reclassified to net income at the time of the charge. Business Segment The Company operates a single business segment. The financial information that is used by the chief operating decision maker in allocating resources and assessing performance is only provided for one reportable segment as of December 31, 2011, 2010 and 2009. 11 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (continued) Recent Accounting Pronouncements In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The provisions of ASU No. 2011-02 provide additional guidance related to determining whether a creditor has granted a concession, include factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibit creditors from using the borrower’s effective rate test to evaluate whether a concession has been granted to the borrower, and add factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision in ASU No. 2011-02 also ends the FASB’s deferral of the additional disclosures about troubled debt restructurings as required by ASU No. 2010-20. The Company adopted provisions of ASU No. 2011- 02 during the current period. The Company adopted the provisions of ASU No. 2010-20 retrospectively to all modifications and restructuring activities that have occurred from January 1, 2011 and it did not have a material impact on the Company’s consolidated financial statements. See Note 4 to the Consolidated Financial Statements for the disclosures required by ASU No. 2010-20. In May 2011, FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards. The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The Company is currently assessing the impact of ASU 2011-04 on its consolidated financial statements. In June 2011, FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. This ASU will require companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements. It eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The standard does not change the items which must be reported in other comprehensive income, how such items are measured or when they must be reclassified to net income. This standard is effective for interim and annual periods beginning after December 15, 2011. The FASB subsequently deferred the effective date of certain provisions of this standard pertaining to the reclassification of items out of accumulated other comprehensive income, pending the issuance of further guidance on that matter. Because this ASU impacts presentation only, it will have no effect on the Company’s financial condition, results of operations or cash flows. In September 2011, FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment.” The provisions of ASU No. 2011-08 permit an entity an option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity 12 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 1 - Summary of Significant Accounting Policies (concluded) believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further impairment testing is required. ASU No. 2011-08 includes examples of events and circumstances that may indicate that a reporting unit’s fair value is less than its carrying amount. The provisions of ASU No. 2011- 08 are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted provided that the entity has not yet performed its annual impairment test for goodwill. The Company performs its annual impairment test for goodwill in the second quarter of each year. The adoption of ASU No. 2011-08 is not expected to have a material impact on the Company’s consolidated financial statements. Note 2 - Restricted Assets Federal Reserve Board regulations require that the Bank maintain certain minimum reserve balances in cash on hand and on deposit with the Federal Reserve Bank, based on a percentage of deposits. The average amount of such balances for the years ended December 31, 2011 and 2010 was approximately $611 and $790, respectively. Note 3 - Securities Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local governments, other corporations, and mortgaged backed securities (“MBS”). Investment securities have been classified according to management’s intent. The amortized cost of securities and their approximate fair value are as follows: Securities Available for Sale December 31, 2011 U.S. Government agency securities Obligations of states and political subdivisions Agency MBS Non-agency MBS Corporate bonds Total December 31, 2010 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value $73 21,398 16,709 6,825 2,010 $11 1,462 255 25 - - $- - 1 49 968 98 $84 22,859 16,915 5,882 1,912 $47,015 $1,753 $1,116 $47,652 U.S. Government agency securities Obligations of states and political subdivisions Agency MBS Non-agency MBS Corporate bonds $1,103 20,588 7,555 10,145 3,011 $11 623 187 4 37 $5 59 12 1,265 30 $1,109 21,152 7,730 8,884 3,018 Total $42,402 $862 $1,371 $41,893 13 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 3 - Securities (continued) Securities Held to Maturity December 31, 2011 State and municipal securities Agency MBS Total December 31, 2010 State and municipal securities Agency MBS Total Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value $6,732 293 $7,025 $6,084 370 $6,454 $68 25 $93 $104 26 $130 $- - - - $- - $- - - - $- - $6,800 318 $7,118 $6,188 396 $6,584 Unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, as of December 31, 2011 and 2010 are summarized as follows: December 31, 2011 Available for Sale Obligations of states and political subdivisions Agency MBS Non-agency MBS Corporate bonds Less than 12 Months Unrealized Fair Loss Value More than 12 Months Fair Value Unrealized Loss Total Fair Value Unrealized Loss $77 4,985 590 1,912 $1 49 90 98 $- - - - 4,223 - - $- - - - 878 - - $77 4,985 4,813 1,912 $1 49 968 98 Total $7,564 $238 $4,223 $878 $11,787 $1,116 December 31, 2010 Available for Sale U.S. Government agency securities Obligations of states and political subdivisions Agency MBS Non-agency MBS Corporate bonds Less than 12 Months Unrealized Fair Loss Value More than 12 Months Fair Value Unrealized Loss Total Fair Value Unrealized Loss $995 4,825 903 2,071 1,949 $5 59 12 154 30 $- - - - - - 6,503 - - $- - $995 - - - - 1,111 - - 4,825 903 8,574 1,949 $5 59 12 1,265 30 Total $10,743 $260 $6,503 $1,111 $17,246 $1,371 14 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 3 - Securities (concluded) At December 31, 2011, there were 16 investment securities in an unrealized loss position, of which 6 were in a continuous loss position for 12 months or more. The unrealized losses on these securities were caused by changes in interest rates, widening pricing spreads and market illiquidity, causing a decline in the fair value subsequent to their purchase. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market environment. Based on management’s evaluation and because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2011, except as described below with respect to one non-agency MBS. For non-agency MBS the Company estimates expected future cash flows of the underlying collateral, together with any credit enhancements. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies, future expected default rates and collateral value by vintage) and prepayments. The expected cash flows of the security are then discounted to arrive at a present value amount. For the year ended December 31, 2011, one non-agency MBS was determined to be other-than-temporarily impaired resulting in the Company recording $256 in impairments not related to credit losses through other comprehensive income and $330 in impairments related to credit losses through earnings. The Company did not engage in originating subprime mortgage loans and it does not believe that it has material exposure to subprime mortgage loans or subprime mortgage backed securities. Additionally, the Company does not have any investment in, or exposure to, collateralized debt obligations, structured investment vehicles or Euro zone sovereign debt. The contractual maturities of investment securities held to maturity and available for sale at December 31, 2011 are shown below. Investments in mortgage-backed securities are shown separately as maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations, with or without call or prepayment penalties. Due in one year or less Due from one year to five years Due from five to ten years Due after ten years Mortgage-backed securities Held to Maturity Available for Sale Amortized Cost Fair Value Amortized Cost Fair Value $- - 1,009 949 4,774 293 $- - 1,049 977 4,774 318 $2,717 5,361 2,625 10,768 25,544 $2,763 5,383 2,785 12,012 24,709 Total $7,025 $7,118 $47,015 $47,652 Gross gains realized on sales of securities were $720, $533 and $484 and gross losses realized were $22, $111 and $0 in 2011, 2010 and 2009, respectively. Securities carried at approximately $44,906 at December 31, 2011 and $36,290 at December 31, 2010 were pledged to secure public deposits and for other purposes required or permitted by law. 15 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans Loans and Leases Loans (including loans held for sale) at December 31 consist of the following: Commercial and agricultural Real estate: Construction, land development and other land loans Residential 1-4 family Multi-family Commercial real estate – owner occupied Commercial real estate – non owner occupied Farmland Consumer Less unearned income Total 2011 2010 $90,731 $84,575 47,156 90,552 7,682 118,469 103,005 23,752 8,928 490,275 (841) 46,256 89,212 9,113 109,936 106,079 22,354 9,128 476,653 (828) $489,434 $475,825 16 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) Allowance for Credit Losses Changes in the allowance for credit losses and recorded investment in loans for the year ended December 31, 2011 is as follows: Commercial Real Estate (“CRE”) Commercial Residential Real Estate Consumer Unallocated 2011 Total Allowance for Credit Losses: Beginning balance Charge-offs Recoveries Provision for credit losses $816 (161) 69 288 $5,385 (2,005) 750 2,673 $1,754 (665) 107 (150) $690 (93) 8 37 $1,972 - - - - (348) $10,617 (2,924) 934 2,500 Ending balance $1,012 $6,803 $1,046 $642 $1,624 $11,127 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans held for sale Ending Balance Less unearned income Ending balance total loans - - 1,987 45 - - - - 2,032 1,012 4,816 1,001 642 1,624 9,095 $529 $13,076 $827 $- - $- - $14,432 90,202 279,306 82,866 8,928 - - - - 14,541 - - $90,731 $292,382 $98,234 $8,928 - - - - $- - 461,302 14,541 $490,275 (841) $489,434 17 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) Changes in the allowance for credit losses and recorded investment in loans for the years ended December 31, 2010 is as follows: Commercial Real Estate (“CRE”) Commercial Residential Real Estate Consumer Unallocated 2010 Total Allowance for Credit Losses: Beginning balance Charge-offs Recoveries Provision for credit losses $1,307 (469) 13 (35) $5,864 (2,055) 19 1,557 $2,477 (1,518) 48 747 $261 (119) 6 542 $1,183 - - - - 789 $11,092 (4,161) 86 3,600 Ending balance $816 $5,385 $1,754 $690 $1,972 $10,617 142 674 - - - - - - - - 142 5,385 1,754 690 1,972 10,475 1,267 10,201 3,205 - - 83,308 274,424 84,976 9,128 Loans held for sale - - - - 10,144 - - Ending balance Less unearned income Ending balance total loans Credit Quality Indicators $84,575 $284,625 $98,325 $9,128 - - - - - - 14,673 451,836 10,144 $- - $476,653 (828) $475,825 Federal regulations require that the Bank periodically evaluates the risks inherent in its loan portfolios. In addition, the Washington Division of Banks and the FDIC have authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. These terms are used as follows: • • “Substandard” loans have one or more defined weaknesses and are characterized by the distinct possibility some loss will be sustained if the deficiencies are not corrected. “Doubtful” loans have the weaknesses of loans classified as “Substandard”, with additional characteristics that suggest the weaknesses make collection or recovery in full after liquidation of collateral questionable on the basis of currently existing facts, conditions and values. There is a high possibility of loss in loans classified as “Doubtful”. 18 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) • “Loss” loans are considered uncollectible and of such little value that continued classification of the credit as a loan is not warranted. If a loan or a portion thereof is classified as “Loss”, it must be charged-off, meaning the amount of the loss is charged against the allowance for credit losses, thereby reducing the reserve. The Bank also classifies some loans as “Pass” or Other Loans Especially Mentioned (“OLEM”). Within the Pass classification certain loans are “Watch” rated because they have elements of risk that require more monitoring that other performing loans. Pass grade loans include a range of loans from very high credit quality to acceptable credit quality. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with higher grades within the Pass category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Overall, loans with a Pass grade show no immediate loss exposure. Loans classified as OLEM continue to perform but have shown deterioration in credit quality and require close monitoring. Loans by credit quality risk rating at December 31, 2011 are as follows: Other Loans Especially Mentioned Pass Substandard Doubtful Total $83,920 $2,232 $4,579 $- - $90,731 Commercial Real estate: Construction and development Residential 1-4 family Multi-family CRE – owner occupied CRE – non owner occupied Farmland Total real estate 37,804 86,239 7,682 111,028 77,414 22,543 342,710 1,394 741 - - 1,856 13,877 110 17,978 Consumer 8,804 53 7,958 3,572 - - 5,585 11,714 1,099 29,928 63 Subtotal Less unearned income Total loans $435,434 $20,263 $34,570 - - - - - - - - - - - - - - 8 $8 47,156 90,552 7,682 118,469 103,005 23,752 390,616 8,928 $490,275 (841) $489,434 19 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) Loans by credit quality risk rating at December 31, 2010 are as follows: Other Loans Especially Mentioned Pass Substandard Doubtful Total $80,400 $1,967 $1,716 $492 $84,575 Commercial Real estate: Construction and development Residential 1-4 family Multi-family CRE – owner occupied CRE – non owner occupied Farmland Total real estate 29,293 81,932 9,113 105,021 75,002 21,846 322,207 5,199 1,669 - - 705 14,983 115 22,671 Consumer 8,987 50 11,764 5,611 - - 4,210 16,094 393 38,072 67 - - - - - - - - - - - - - - 24 Subtotal Less unearned income Total loans Insider Loans $411,594 $24,688 $39,855 $516 46,256 89,212 9,113 109,936 106,079 22,354 382,950 9,128 $476,653 (828) $475,825 Certain related parties of the Company, principally directors and their affiliates, were loan customers of the Bank in the ordinary course of business during 2011 and 2010. Total related party loans outstanding at December 31, 2011 and 2010 to executive officers and directors were $982 and $1,419, respectively. During 2011 and 2010, new loans of $3 and $15, respectively, were made, and repayments totaled $440 and $175, respectively. In management’s opinion, these loans and transactions were on the same terms as those for comparable loans and transactions with non-related parties. No loans to related parties were on non-accrual, past due or restructured at December 31, 2011. 20 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) Impaired Loans Following is a summary of information pertaining to impaired loans at December 31, 2011: Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized With no related allowance recorded: Commercial Residential real estate Commercial real estate: CRE – owner occupied CRE – non-owner occupied Construction and development With an allowance recorded: Commercial Residential real estate Commercial real estate: CRE – non-owner occupied Construction and development Total: Commercial Residential real estate Commercial real estate: CRE – owner occupied CRE – non-owner occupied Construction and development $530 528 629 2,912 5,335 - - 298 3,627 573 530 826 629 6,539 5,908 $556 620 719 2,912 7,501 - - 298 3,997 573 556 918 719 6,909 8,074 $- - - - - - - - - - - - 45 1,782 205 - - 45 - - 1,782 205 $355 1,314 971 3,181 5,868 202 74 725 716 557 1,388 971 3,906 6,584 $15 16 7 21 188 5 - - - - 3 20 16 7 21 191 21 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) Following is a summary of information pertaining to impaired loans at December 31, 2010: With no related allowance recorded: Commercial Residential real estate Commercial real estate: CRE – owner occupied CRE – non-owner occupied Construction and development With an allowance recorded: Commercial Total: Commercial Residential real estate Commercial real estate: CRE – owner occupied CRE – non-owner occupied Construction and development Aging Analysis Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized $759 3,205 726 2,741 6,734 $822 3,766 768 2,739 10,055 508 492 1,267 3,205 726 2,741 6,734 1,314 3,766 768 2,739 10,055 $- - - - - - - - - - 142 142 - - - - - - - - $794 3,674 752 2,734 11,695 506 1,300 3,674 752 2,734 11,695 $5 12 7 65 467 37 42 12 7 65 467 The following table illustrates an age analysis of past due loans as of December 31, 2011. 30-59 Days Past Due 60-89 Days Past Due Current Greater Than 90 Days Past Due and Still Accruing Total Past Due Non- accrual Loans Total Loans $89,981 $220 $- - $- - $220 $530 $90,731 41,570 88,661 7,682 116,979 96,332 23,752 374,976 8,869 (841) 76 880 - - 508 134 - - 1,598 59 - - - - 184 - - 353 - - - - 537 - - - - - - 299 - - - - - - - - 299 - - - - 76 1,363 - - 861 134 - - 2,434 59 - - 5,510 528 - - 629 6,539 - - 13,206 47,156 90,552 7,682 118,469 103,005 23,752 390,616 - - - - 8,928 (841) Commercial Real estate: Construction & development Residential 1-4 family Multi-family CRE - owner occupied CRE - non-owner occupied Farmland Total real estate Consumer Less unearned income Total $472,985 $1,877 $537 $299 $2,713 $13,736 $489,434 22 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) The following table illustrates an age analysis of past due loans as of December 31, 2010. 30-59 Days Past Due 60-89 Days Past Due Current Greater Than 90 Days Past Due and Still Accruing Total Past Due Non- accrual Loans Total Loans $83,044 $280 $- - $- - $280 $1,251 $84,575 40,636 86,329 9,113 108,154 105,746 22,184 372,162 9,100 (828) 91 637 - - 256 - - - - 984 28 - - - - - - - - 1,056 - - - - 1,056 - - - - - - - - - - - - - - - - - - - - - - 91 637 - - 1,312 - - - - 2,040 28 - - 5,529 2,246 - - 470 333 170 8,748 - - - - 46,256 89,212 9,113 109,936 106,079 22,354 382,950 9,128 (828) Commercial Real estate: Construction & development Residential 1-4 family Multi-family CRE - owner occupied CRE - non-owner occupied Farmland Total real estate Consumer Less unearned income Total $463,478 $1,292 $1,056 $- - $2,348 $9,999 $475,825 Interest income on non-accrual loans that would have been recorded had those loans performed in accordance with their initial terms was $752,000, $2,568,000, and $1,659,000 for 2011, 2010, and 2009, respectively. Modifications A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. There are various types of concessions when modifying a loan, however, forgiveness of principal is rarely granted by the Company. Commercial and industrial loans modified in a TDR may involve term extensions, below market interest rates and/or interest-only payments wherein the delay in the repayment of principal is determined to be significant when all elements of the loan and circumstances are considered. Additional collateral, a co-borrower, or a guarantor is often required. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. Residential mortgage loans modified in a TDR are primarily comprised of loans where monthly payments are lowered to accommodate the borrowers’ financial needs. Land loans are typically structured as interest-only 23 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (continued) monthly payments with a balloon payment due at maturity. Land loans modified in a TDR typically involve extending the balloon payment by one to three years, and providing an interest rate concession. Home equity modifications are made infrequently and are uniquely designed to meet the specific needs of each borrower. Loans modified in a TDR are typically already on non-accrual status and partial charge-offs have in some cases already been taken against the outstanding loan balance. As a result, loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. The Company’s practice is to re-appraise collateral dependent loans semi-annually. During the three and nine months ended September 30, 2011, there was no impact on the allowance from TDRs during the periods, as the loans classified as TDRs during the periods did not have a specific reserve and were already considered impaired loans at the time of modification. The Company closely monitors the performance of modified loans for delinquency, as delinquency is considered an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan. The following tables present TDRs as of December 31, 2011 all of which were modified due to financial stress of the borrower. Current TDRs Subsequently Defaulted TDRs Number of Contracts Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Number of Contracts Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Commercial and agriculture Construction & development (1) Residential real estate CRE - owner occupied CRE - non-owner occupied 1 7 2 1 1 $335 5,931 264 59 2,180 $335 5,296 263 58 2,180 Ending balance (2) 12 $8,769 $8,132 - - 2 - - - - - - 2 $- - 2,561 - - - - - - $- - 2,465 - - - - - - $2,561 $2,465 (1) Includes two loans totaling $398 on accrual status which were accruing loans at the time of modification and are performing in accordance with the terms of the TDR. The remaining TDRs are all on non-accrual status as of December 31, 2011. (2) The period end balances are inclusive of all partial paydowns and charge-offs since the modification date. Loans modified in a TDR that were fully paid down, fully charged-off, or foreclosed upon by period end are not reported. 24 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 4 - Loans (concluded) The construction and development loan TDRs that subsequently defaulted were modified by extending the maturity date. Both loans were on non-accrual status prior to and after the TDR. The subsequent default reported above occurred during the three months ended September 30, 2011. There were no other loans modified as a TDR within the previous 12 months that subsequently defaulted during the year ended December 31, 2011. Troubled debt restructuring loans are considered impaired loans. The Company had no commitments to lend additional funds for loans classified as troubled debt restructured at December 31, 2011. TDRs as of December 31, 2010 are as follows: Current TDRs Subsequently Defaulted TDRs Number of Contracts Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Number of Contracts Pre-TDR Outstanding Recorded Investment Post-TDR Outstanding Recorded Investment Residential real estate Construction & development Ending balance 1 1 2 $417 561 $978 $324 608 $932 - - - - - - - - - - - - - - - - - - Note 5 - Premises and Equipment The components of premises and equipment at December 31 are as follows: Land and premises Equipment, furniture and fixtures Construction in progress Less accumulated depreciation and amortization Total premises and equipment 2011 2010 $17,882 7,421 60 25,363 10,479 $17,609 7,275 113 24,997 9,816 $14,884 $15,181 Depreciation expense was $1,022, $1,134, and $1,188 for 2011, 2010 and 2009, respectively. The Bank leases premises under operating leases. Rental expense of leased premises was $375, $356 and $370 for 2011, 2010 and 2009, respectively, which is included in occupancy expense. 25 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 5 - Premises and Equipment (concluded) Minimum net rental commitments under non-cancelable operating leases having an original or remaining term of more than one year for future years ending December 31 are as follows: 2012 2013 2014 2015 2016 Total minimum payments required $355 317 226 171 97 $1,166 Certain leases contain renewal options from five to ten years and escalation clauses based on increases in property taxes and other costs. Note 6 – Other Real Estate Owned The following table presents the activity related to OREO for the years ended December 31: Balance at beginning of year Additions Dispositions Fair value write-downs Balance at end of year 2011 2010 $6,580 4,539 (2,345) (1,049) $6,665 8,093 (6,906) (1,272) $7,725 $6,580 At December 31, 2011, OREO consisted of 27 properties as follows: twelve land acquisition and development properties totaling $3,239; three residential construction properties totaling $911; seven commercial real estate properties totaling $2,148; and five residential real estate properties totaling $1,427. Net gains and (losses) on sales of OREO totaled $(83), $260 and $(1,418) for the years ended December 31, 2011, 2010 and 2009, respectively. 26 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 7 - Deposits The composition of deposits at December 31 is as follows: Demand deposits, non-interest bearing NOW and money market accounts Savings deposits Time certificates, $100,000 or more Other time certificates Total 2011 2010 $108,899 221,191 65,451 95,028 57,481 $95,115 197,354 55,993 126,303 70,189 $548,050 $544,954 Scheduled maturities of time certificates of deposit are as follows for future years ending December 31: 2012 2013 2014 2015 2016 Total Note 8 - Borrowings $87,581 27,322 11,833 11,311 14,462 $152,509 Long-term borrowings at December 31, 2011 and 2010 represent advances from the Federal Home Loan Bank of Seattle (“FHLB”). Advances at December 31, 2011 bear interest at 2.67% to 2.94% and mature in various years as follows: 2013 - $3,000, 2014 - $2,500 and 2015 - $5,000. The Bank has pledged $162,656 of loans as collateral for these borrowings at December 31, 2011. Secured borrowings at December 31, 2011 and 2010 represent borrowings collateralized by participation interests in loans originated by the Bank. These borrowings are repaid as payments (normally monthly) are made on the underlying loans, bearing interest ranging from 4.50% to 6.66%. Original maturities range from March 2012 to May 2012. Short-term borrowings represent FHLB term borrowings with scheduled maturity dates within one year. Short-term borrowings may also include federal funds purchased that generally mature within one to four days from the transaction date; however there were no federal funds purchased at December 31, 2011, and 2010. The following is a summary of short-term borrowings for the years ended: Amount outstanding at end of year Weighted average interest rate at December 31 Maximum month-end balance during the year Average balance during the year Average interest rate during the year 27 2011 2010 $- - - -% 10,500 6,885 3.84% $10,500 3.85% 10,500 7,502 2.72% Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 9 - Junior Subordinated Debentures At December 31, 2011, two wholly-owned subsidiary grantor trusts established by the Company had outstanding $13,000 of Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering of trust preferred securities to purchase a like amount of Junior Subordinated Debentures (the “Debentures”) of the Company. The Debentures are the sole assets of the trusts. The Company’s obligations under the Debentures and the related documents, taken together, constitute a full and unconditional guarantee by the Company of the obligations of the trusts. The trust preferred securities are mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. The Company has the right to redeem the Debentures in whole or in part on or after specified dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date. The following table is a summary of the trust preferred securities and debentures at December 31, 2011: Issuance Trust Issuance Date Preferred Security Rate Type PFC Statutory Trust I PFC Statutory Trust II 12/2005 6/2006 $5,000 $8,000 Variable (1) Variable (1) Initial Rate 6.39% 7.02% Rate at 12/31/11 Maturity Date 2.00% 2.00% 3/2036 7/2036 (1) The variable rate preferred securities reprice quarterly based on the three month LIBOR rate. The Company has the right to redeem the debentures issued in the December 2005 offering beginning March 2011, and the June 2006 offering beginning July 2011, subject to regulatory approval. The Debentures issued by the Company to the grantor trusts totaling $13,000 are reflected in the consolidated balance sheet in the liabilities section under the caption “junior subordinated debentures.” The Company records interest expense on the corresponding junior subordinated debentures in the consolidated statements of income. The Company recorded $403 in the consolidated balance sheet at December 31, 2011 and 2010, respectively, for the common capital securities issued by the issuer trusts. During the second quarter of 2009, the Company elected to exercise the right to defer interest payments on its junior subordinated debentures associated with its trust preferred securities. Under the terms of the indentures, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going into default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. As of December 31, 2011 and 2010, deferred interest totaled $1,252 and $900, respectively, and is included as a component of accrued interest payable on the balance sheet. 28 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 10 - Income Taxes Income taxes for the years ended December 31 is as follows: Current Deferred Total income tax benefit 2011 2010 2009 $1,148 (815) $582 (886) $(1,823) (2,696) $333 $(304) $(4,519) The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31 are: Deferred Tax Assets Allowance for credit losses Deferred compensation Supplemental executive retirement plan Unrealized loss on securities available for sale Loan fees/costs OREO write-downs OREO operating expenses Tax credit carry-forwards Other Total deferred tax assets Deferred Tax Liabilities Depreciation Loan fees/costs Unrealized gain on securities available for sale Core deposit intangible Prepaid expenses FHLB dividends Other Total deferred tax liabilities Net deferred tax assets 29 2011 $3,850 132 799 - - 290 600 161 447 237 6,516 $214 1,402 217 - - 108 143 81 2,165 2010 $3,673 124 621 171 245 703 87 665 107 6,396 $132 1,823 - - 12 124 143 237 2,471 $4,351 $3,925 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 10 - Income Taxes (concluded) Net deferred tax assets are recorded in other assets in the consolidated financial statements. The following is a reconciliation between the statutory and effective federal income tax rate for the years ended December 31: Income (loss) tax at statutory rate Adjustments resulting from: Tax-exempt income Net earnings on life insurance policies Low income housing tax credit Other 2011 Amount Percent of Pre-tax Income 2010 Amount Percent of Pre-tax Income 2009 Amount Percent Pre-tax Income $1,103 35.0% $466 35.0% $(3,800) (35.0)% (519) (16.5) (530) (39.8) (505) (4.7) (171) (108) 28 (5.4) (3.4) 0.9 (176) (108) 44 (13.3) (8.1) 3.3 (184) (108) 78 (1.7) (0.9) 0.7 Total income tax (benefit) expense $333 10.6% $(304) (22.9)% $(4,519) (41.6)% Note 11 - Employee Benefits Incentive Compensation Plan The Bank has a plan that provides incentive compensation to key employees if the Bank meets certain performance criteria established by the Board of Directors. The cost of this plan was $80, $210, and $73 in 2011, 2010 and 2009, respectively. 401(k) Plans The Bank has established a 401(k) profit sharing plan for those employees who meet the eligibility requirements set forth in the plan. Eligible employees may contribute up to 15% of their compensation. Matching contributions by the Bank are at the discretion of the Board of Directors. Contributions totaled $58, $60 and $36 for 2011, 2010 and 2009, respectively. Director and Employee Deferred Compensation Plans The Company has director and employee deferred compensation plans. Under the terms of the plans, a director or employee may participate upon approval by the Board. The participant may then elect to defer a portion of his or her earnings (directors’ fees or salary) as designated at the beginning of each plan year. Payments begin upon retirement, termination, death or permanent disability, sale of the Company, the ten-year anniversary of the participant’s participation date, or at the discretion of the Company. There are currently no participants in the director deferred compensation plan. There is currently one participant in the employee deferred compensation plan. Total deferrals plus earnings in the employee deferred compensation plan were $35, $35 and $35 at December 31, 2011, 2010 and 2009, respectively. There is no ongoing expense to the Company for these plans. 30 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 11 - Employee Benefits (continued) The directors of a bank acquired by the Company in 1999 adopted two deferred compensation plans for directors - one plan providing retirement income benefits for all directors and the other, a deferred compensation plan, covering only those directors who have chosen to participate in the plan. At the time of adopting these plans, the Bank purchased life insurance policies on directors participating in both plans which may be used to fund payments to them under these plans. Cash surrender values on these policies were $3,694 and $3,581 at December 31, 2011 and 2010, respectively. In 2011, 2010 and 2009, the net benefit recorded from these plans, including the cost of the related life insurance, was $402, $377 and $362, respectively. Both of these plans were fully funded and frozen as of September 30, 2001. Plan participants were given the option to either remain in the plan until reaching the age of 70 or to receive a lump-sum distribution. Participants electing to remain in the plan will receive annual payments over a ten-year period upon reaching 70 years of age. The liability associated with these plans totaled $347 and $323 at December 31, 2011 and 2010, respectively. Executive Long-Term Compensation Agreements The Company has executive long-term compensation agreements to selected employees that provide incentive for those covered employees to remain employed with the Company for a defined period of time. The cost of this plan was $79, $39 and $55 in 2011, 2010 and 2009, respectively. Supplemental Executive Retirement Plan Effective January 1, 2007, the Company adopted a non-qualified Supplemental Executive Retirement Plan (SERP) that provides retirement benefits to its executive officers. The SERP is unsecured and unfunded and there are no plan assets. The post-retirement benefit provided by the SERP is designed to supplement a participating officer’s retirement benefits from social security, in order to provide the officer with a certain percentage of final average income at retirement age. The benefit is generally based on average earnings, years of service and age at retirement. At the inception of the SERP, the Company recorded a prior service cost to accumulated other comprehensive income of $704. The Company has purchased bank owned life insurance covering all participants in the SERP. The cash surrender value of these policies totaled $5,622 and $5,497 at December 31, 2011 and 2010, respectively. The following table sets forth the net periodic pension cost and obligation assumptions used in the measurement of the benefit obligation for the years ended December 31: Net periodic pension cost: Service Cost Interest Cost Amortization of prior service cost Amortization of net (gain)/loss Net periodic pension cost Weighted average assumptions: Discount rate Rate of compensation increases 31 2011 $143 97 90 3 $333 2010 $122 86 90 (15) $283 2009 $173 98 130 (10) $391 5.12% n/a 5.90% n/a 6.67% n/a Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 11 - Employee Benefits (concluded) The following table sets forth the change in benefit obligation at December 31: Change in Benefit Obligation: Benefit obligation at beginning of year Service cost Interest cost Actuarial loss Benefit obligation at end of year 2011 2010 $1,648 143 97 194 $1,282 122 86 158 $2,082 $1,648 Amounts recognized in accumulated other comprehensive loss at December 31 are as follows: (Gain) loss Prior service cost 2011 $213 452 2010 $22 542 Total recognized in accumulative other comprehensive loss $665 $564 The following table summarizes the projected and accumulated benefit obligations at December 31: Projected benefit obligation Accumulated benefit obligation Estimated future benefit payments as of December 31, 2011 are as follows: 2012 – 2016 2017 – 2021 Note 12 - Dividend Reinvestment Plan 2011 2010 $2,082 2,082 $1,648 1,648 $8 1,423 In November 2005, the Company instituted a dividend reinvestment plan which allows for all or part of cash dividends to be reinvested in shares of Company common stock based upon participant elections. Under the plan, 1,100,000 shares are authorized for dividend reinvestment, of which 89,771 shares have been issued through December 31, 2011. Note 13 - Commitments and Contingencies The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets. 32 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 13 - Commitments and Contingencies (concluded) The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s commitments at December 31 is as follows: Commitments to extend credit Standby letters of credit 2011 2010 $91,596 1,310 $90,888 1,123 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Many of the commitments expire without being drawn upon; therefore total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances where the Bank deems necessary. Certain executive officers have entered into employment contracts with the Bank which provide for contingent payments subject to future events. In connection with certain loans held for sale, the Bank typically makes representations and warranties that the underlying loans conform to specified guidelines. If the underlying loans do not conform to the specifications, the Bank may have an obligation to repurchase the loans or indemnify the purchaser against loss. The Bank believes that the potential for loss under these arrangements is remote. Accordingly, no contingent liability is recorded in the consolidated financial statements. The Bank has agreements with commercial banks for lines of credit totaling $16,000, of which none was used at December 31, 2011. In addition, the Bank has a credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets, $10,500 of which was used at December 31, 2011. These borrowings are collateralized under blanket pledge and custody agreements. The Bank also has a borrowing arrangement with the Federal Reserve Bank under the Borrower-in-Custody program. Under this program, the Bank has an available credit facility of $47,064, subject to pledged collateral. As of December 31, 2011, loans carried at $73,535 were pledged as collateral to the Federal Reserve Bank. The Company is currently not party to any material pending litigation. However, because of the nature of its activities, the Company may be subject to or threatened with legal actions in the ordinary course of business. In the opinion of management, liabilities arising from these claims, if any, will not have a material effect on the financial condition, results of operations or cash flows of the Company. 33 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 14 - Significant Concentrations of Credit Risk Most of the Bank’s business activity is with customers and governmental entities located in the state of Washington, including investments in state and municipal securities. Loans to any single borrower or group of borrowers are generally limited by state banking regulations to 20% of the Bank’s shareholder’s equity, excluding accumulated other comprehensive income (loss). Standby letters of credit were granted primarily to commercial borrowers. The Bank, as a matter of practice, generally does not extend credit to any single borrower or group of borrowers in excess of $7,500. Note 15 - Stock Options The Company’s 2000 Stock Incentive Plan provided for incentive and non-qualified stock options and other types of stock based awards, as defined under current tax laws, to key personnel. Under the plan, the Company was authorized to issue up to 1,100,000 shares; however the plan expired January 1, 2011. On April 27, 2011, the shareholders of the Company approved the 2011 Equity Incentive Plan, pursuant to which the Company is authorized to issue up to 900,000 shares of common stock in connection with awards under the plan (895,000 shares are available for grant at December 31, 2011). Under the plan, options either become exercisable ratably over five years or vest fully five years from the date of grant. Under the plan, the Company may grant up to 300,000 options for its common stock to a single individual in a calendar year. The Company uses the Black-Scholes option pricing model to calculate the fair value of stock-based awards based on assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s common shares. The expected term of stock options granted is based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant. Grant period ended December 31, 2011 December 31, 2010 December 31, 2009 Expected Life Risk Free Interest Rate Expected Volatility Dividend Yield Average Fair Value 6.5 years 6.5 years 6.5 years 1.50% 3.20% 2.90% 22.51% 18.95% 18.69% - - % - - % 1.20% $1.05 $0.34 $0.24 34 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 15 - Stock Options (continued) A summary of the status of the Company’s stock option plans as of December 31, 2011, 2010 and 2009, and changes during the years ending on those dates, is presented below: 2011 2010 2009 Weighted Average Exercise Price Shares Weighted Average Exercise Price Shares Weighted Average Exercise Price Shares Outstanding at beginning of year 818,612 $11.07 820,837 $11.08 684,527 $12.58 Granted Exercised Expired Forfeited 5,000 - - (178,439) (58,725) 3.95 - - 10.10 10.98 1,000 - - - - (3,225) 7.00 - - - - 11.27 213,750 - - (35,310) (42,130) 7.00 - - 12.27 13.76 Outstanding at end of year 586,448 $11.32 818,612 $11.07 820,837 $11.08 Exercisable at end of year 411,708 $12.93 599,727 $12.06 529,922 $12.35 A summary of the status of the Company’s nonvested options as of December 31, 2011 and 2010 and changes during the period then ended are presented below: Non-vested beginning of period Granted Vested Forfeited 2011 Weighted Average Fair Value $0.51 1.05 1.79 0.49 Shares 218,885 5,000 (20,185) (28,960) Shares 290,915 1,000 (70,850) (2,180) Non-vested end of period 174,740 $0.37 218,885 2010 Weighted Average Fair Value $0.60 0.34 0.89 0.67 $0.51 35 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 15 - Stock Options (concluded) The following information summarizes information about stock options outstanding and exercisable at December 31, 2011: Range of exercise prices 0.00 – 11.10 11.11 – 12.49 12.50 – 14.74 14.75 – 16.00 Options Outstanding Weighted average remaining contractual life (years) Weighted average exercise price Number Options Exercisable Weighted average remaining contractual life (years) Weighted average exercise price Number 275,478 44,550 145,475 120,945 586,448 5.6 4.0 3.6 3.0 4.5 $8.01 11.80 14.27 15.14 116,578 38,390 136,675 120,065 $11.32 411,708 2.6 3.7 3.5 3.0 3.1 $9.51 11.77 14.25 15.13 $12.93 The aggregate intrinsic value of all options outstanding at December 31, 2011 and 2010 was $0 and $0, respectively. The aggregate intrinsic value of all options that were exercisable at December 31, 2011 and 2010 was $0 and $0, respectively. There were no options exercised during 2010 or 2011. Stock based compensation recognized in 2011 and 2010 was $26 ($17 net of tax) and $46 ($30 net of tax), respectively. Future compensation expense for unvested awards outstanding as of December 31, 2011 is estimated to be $59 recognized over a weighted average period of 1.8 years. Note 16 - Regulatory Matters The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material adverse effect on the Company’s consolidated financial statements. Under capital adequacy guidelines on the regulatory framework for prompt corrective action, the Bank must meet specific capital adequacy guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Tier 1 capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of Tier 1 and total capital (as defined) to risk-weighted assets (as defined). 36 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 16 - Regulatory Matters (concluded) As of December 31, 2011, the most recent notification from the Bank’s regulator categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category. The Company and the Bank’s actual capital amounts and ratios are presented in the table below. Management believes, as of December 31, 2011, the Company and the Bank meet all capital requirements to which they are subject. To be Well Capitalized Under Prompt December 31, 2011 Tier 1 capital (to average assets): Actual Amount Ratio Capital Adequacy Corrective Action Purposes Amount Provisions Amount Ratio Ratio Company Bank $63,965 65,022 10.35 10.18% $25,137 4.00% 25,128 4.00 NA NA $31,410 5.00% Tier 1 capital (to risk-weighted assets): Company Bank Total capital (to risk-weighted assets): Company Bank 63,965 13.56 13.79 65,022 69,926 14.82 70,980 15.05 18,870 4.00 18,860 4.00 37,740 8.00 37,720 8.00 NA NA 6.00 28,290 NA NA 47,150 10.00 December 31, 2010 Tier 1 capital (to average assets): Company Bank $61,086 61,577 9.72% 9.80 $25,139 4.00% 25,130 4.00 NA NA $31,412 5.00% Tier 1 capital (to risk-weighted assets): Company Bank Total capital (to risk-weighted assets): Company Bank 61,086 13.21 61,577 13.35 66,925 14.48 67,401 14.62 18,493 4.00 18,446 4.00 36,985 8.00 36,892 8.00 NA NA 6.00 27,669 NA NA 46,114 10.00 The Company and the Bank are subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. 37 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 17 - Fair Value of Financial Instruments The following methods and assumptions were used by the Company in estimating the fair values of financial instruments disclosed in these consolidated financial statements: Cash, Interest Bearing Deposits at Other Financial Institutions, and Federal Funds Sold The carrying amounts of cash, interest bearing deposits at other financial institutions, and federal funds sold approximate their fair value. Securities Available for Sale and Held to Maturity Fair values for securities are based on quoted market prices. Loans, net and Loans Held for Sale The fair value of loans is estimated based on comparable market statistics for loans with similar credit ratings. An additional liquidity discount is also incorporated to more closely align the fair value with observed market prices. Fair value of loans held for sale is based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined based on an aggregate loan basis. Deposits The fair value of deposits with no stated maturity date is included at the amount payable on demand. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation based on interest rates currently offered on similar certificates. Secured borrowings For variable rate secured borrowings that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Short-Term Borrowings The fair value of the Company’s short-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements. Long-Term Borrowings The fair value of the Company’s long-term borrowings is estimated using discounted cash flow analysis based on the Company’s incremental borrowing rates for similar types of borrowing arrangements. Junior Subordinated Debentures The fair value of the junior subordinated debentures and trust preferred securities is estimated using discounted cash flow analysis based on interest rates currently available for junior subordinated debentures. Off-Balance-Sheet Instruments The fair value of commitments to extend credit and standby letters of credit was estimated using the rates currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the customers. Since the majority of the Company’s off- balance-sheet instruments consist of non-fee producing, variable-rate commitments, the Company has determined they do not have a material fair value. 38 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 17 - Fair Value of Financial Instruments (continued) The estimated fair value of the Company’s financial instruments at December 31 are as follows: Financial Assets Cash and due from banks, interest-bearing deposits in banks, and federal funds sold Securities available for sale Securities held to maturity Loans held for sale Loans, net Financial Liabilities Deposits Secured borrowings Short-term borrowings Long-term borrowings Junior subordinated debentures 2011 Carrying Amount $41,132 47,652 7,025 14,541 463,766 $548,050 741 - - 10,500 13,403 Fair Value $41,132 47,652 7,118 14,808 419,059 $549,472 741 - - 10,867 6,691 2010 Carrying Amount $61,758 41,893 6,454 10,144 455,064 $544,954 925 10,500 10,500 13,403 Fair Value $61,758 41,893 6,584 10,144 408,261 $546,753 925 10,775 10,858 6,916 The Company uses an established hierarchy for measuring fair value that is intended to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows: Level 1 – Valuations based on quoted prices in active exchange markets for identical assets or liabilities; also includes certain corporate debt securities actively traded in over-the-counter markets. Level 2 – Valuations of assets and liabilities traded in less active dealer or broker markets. Valuations include quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model–derived valuations whose inputs are observable or whose significant value drivers are observable. Valuations may be obtained from, or corroborated by, third- party pricing services. This category generally includes certain U.S. Government, agency and non-agency securities, state and municipal securities, mortgage-backed securities, corporate securities, and residential mortgage loans held for sale. Level 3 – Valuations based on unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, yield curves and similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities, but in all cases are corroborated by external data, which may include third-party pricing services. 39 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 17 - Fair Value of Financial Instruments (continued) The following table presents the balances of assets and liabilities measured at fair value on a recurring basis at December 31, 2011 and December 31, 2010: December 31, 2011 Securities available-for-sale U.S. Government agency securities Obligations of state and political subdivisions Agency MBS Non-agency MBS Corporate bonds Readily Available Market Inputs Level 1 Observable Market Inputs Level 2 Significant Unobservable Inputs Level 3 $- - - - - - - - 918 $84 21,719 16,915 5,882 994 $- - 1,140 - - - - - - Total $84 22,859 16,915 5,882 1,912 Total $918 $45,594 $1,140 $47,652 December 31, 2010 Securities available-for-sale U.S. Government agency securities Obligations of state and political subdivisions Agency MBS Non-agency MBS Corporate bonds $- - - - - - - - 1,069 $1,109 19,995 7,730 8,884 1,949 $- - 1,157 - - - - - - $1,109 21,152 7,730 8,884 3,018 Total $1,069 $39,667 $1,157 $41,893 The Company uses a third party pricing service to assist the Company in determining the fair value of the investment portfolio. The following table presents a reconciliation of assets that are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the years ended December 31, 2011 and 2010, respectively. There were no transfers of assets in to or out of Level 3 during 2011 and 2010. Balance beginning of year Included in other comprehensive income Matured Balance end of year 2011 2010 $1,157 - - (17) $1,593 (40) (396) $1,140 $1,157 40 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 17 - Fair Value of Financial Instruments (concluded) Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and OREO. The following methods were used to estimate the fair value of each such class of financial instrument: Loans held for sale – Loans held for sale are carried at the lower of cost or market. Loans held for sale are measured at fair value based on a discounted cash flow calculation using interest rates currently available on similar loans. The fair value was determined based on an aggregated loan basis. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs. Impaired loans – A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principle) according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows or by the net realizable value of the collateral if the loan is collateral dependent. Other real estate owned – OREO is initially recorded at the lower of the carrying amount of the loan or fair value of the property less estimated costs to sell. This amount becomes the property’s new basis. Management considers third party appraisals in determining the fair value of particular properties. Any write-downs based on the property fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses. Management periodically reviews OREO in an effort to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any additional write-downs based on re- evaluation of the property fair value are charged to non-interest expense. The following table presents the Company’s assets that were accounted for at fair value on a nonrecurring basis at December 31, 2011 and 2010: Readily Available Market Inputs Level 1 Observable Market Inputs Level 2 Significant Unobservable Inputs Level 3 $- - $- - $- - $- - $- - $- - $- - $10,144 $- - $- - $7,183 $6,455 $- - $2,755 $5,245 Total $7,183 $6,455 $10,144 $2,755 $5,245 December 31, 2011 Impaired loans OREO December 31, 2010 Loans held for sale Impaired loans OREO Other real estate owned with a pre-foreclosure loan balance of $4,872 was acquired during the year ended December 31, 2011. Upon foreclosure, these assets were written down $594 to their fair value, less estimated costs to sell, which was charged to the allowance for credit losses during the period. 41 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 18 - Earnings (Loss) Per Share Disclosures Following is information regarding the calculation of basic and diluted earnings (loss) per share for the years indicated. Net Income (Loss) (Numerator) Shares (Denominator) Year Ended December 31, 2011 Basic earnings per share: Effect of dilutive securities: Diluted earnings per share: Year Ended December 31, 2010 Basic earnings per share: Effect of dilutive securities: Diluted earnings per share: Year Ended December 31, 2009 Basic earnings (loss) per share: Effect of dilutive securities: Diluted earnings (loss) per share: $2,818 - - $2,818 $1,634 - - $1,634 $(6,338) - - $(6,338) 10,121,853 17 10,121,870 10,121,853 - - 10,121,853 8,539,237 - - 8,539,237 Per Share Amount $0.28 - - $0.28 $0.16 - - $0.16 $(0.74) - - $(0.74) The number of shares shown for “options” is the number of incremental shares that would result from the exercise of options and use of the proceeds to repurchase shares at the average market price during the year. 42 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 19 - Condensed Financial Information - Parent Company Only Condensed Balance Sheets - December 31, Assets Cash Investment in the Bank Other assets Total assets Liabilities and Shareholders’ Equity Junior subordinated debentures Due to the Bank Other liabilities Shareholders’ equity 2011 $356 77,327 438 2010 $578 73,260 430 $78,121 $74,268 $13,403 196 1,252 63,270 $13,403 196 900 59,769 Total liabilities and shareholders’ equity $78,121 $74,268 Condensed Statements of Income - Years Ended December 31, Dividend Income from the Bank Other Income Total Income Expenses Income (loss) before income tax benefit Income Tax Benefit Income (loss) before equity in undistributed income of the Bank Equity in Undistributed Income of the Bank 2011 2010 2009 $- - 8 8 (600) (592) - - (592) 3,410 $- - 15 15 (759) (744) - - (744) 2,378 $- - 17 17 (835) (818) - - (818) (5,520) Net income (loss) $2,818 $1,634 $(6,338) 43 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Note 19 - Condensed Financial Information - Parent Company Only (concluded) Condensed Statements of Cash Flows - Years Ended December 31, Operating Activities Net income (loss) Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in undistributed income of subsidiary Net change in other assets Net change in other liabilities Other - net Net cash provided by (used in) operating activities Financing Activities Common stock issued Dividends paid Net cash used in financing activities 2011 2010 2009 $2,818 $1,634 $(6,338) (3,410) (8) 352 26 (222) - - - - - - (2,378) (15) 586 46 (127) 5,520 777 370 54 383 - - - - - - 12,394 (12,585) (191) Net increase (decrease) in cash (222) (127) 192 Cash Beginning of year End of year 578 705 $356 $578 513 $705 44 Pacific Financial Corporation and Subsidiary December 31, 2011 and 2010 and for the three years ended December 31, 2011 Notes to Consolidated Financial Statements, Dollars in Thousands Except Per Share Amounts Quarterly Data (Unaudited) Year Ended December 31, 2011 Interest income Interest expense Net interest income Provision for credit losses Non-interest income Non-interest expenses Income before income taxes Income taxes (benefit) First Quarter Second Quarter Third Quarter Fourth Quarter $7,365 1,680 5,685 500 1,333 6,142 376 (56) $7,313 1,548 5,765 - - 1,374 6,594 545 (58) $7,406 1,336 6,070 1,050 2,455 6,060 1,415 211 Net income $432 $603 $1,204 Earnings per common share: Basic Diluted Year Ended December 31, 2010 Interest income Interest expense Net interest income Provision for credit losses Non-interest income Non-interest expenses Income before income taxes Income taxes (benefit) $.04 .04 $7,930 2,228 5,702 800 1,730 6,082 550 (84) $.06 .06 $7,756 2,076 5,680 1,200 2,456 6,507 429 (74) Net Income $634 $503 Earnings per common share: Basic Diluted $.05 .05 $.06 .06 45 $.12 .12 $7,631 1,888 5,743 850 2,015 6,331 577 98 $479 $.05 .05 $7,234 1,069 6,165 950 2,452 6,852 815 236 $579 $.06 .06 $7,543 1,789 5,754 750 2,250 7,480 (226) (244) $18 $.00 .00 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with Pacific’s audited consolidated financial statements and related notes appearing elsewhere in this report. In addition, please refer to Pacific’s forward- looking statement disclosure included elsewhere in this report. EXECUTIVE OVERVIEW The following are important factors in understanding the Company financial condition and liquidity: • • Total assets at December 31, 2011, decreased by $3,149,000, or 0.5%, to $641,254,000 compared to $644,403,000 at the end of 2010. Decreases in interest bearing deposits in banks and other assets were the primary contributors to overall asset decline, which were partially offset by growth in investments available-for-sale and loans. The Bank remains well capitalized with a total risk-based capital ratio of 15.05% at December 31, 2011, compared to 14.62% at December 31, 2010. Tier one leverage ratio was 10.35% at December 31, 2011, compared to 9.80% at December 31, 2010. • Non-performing assets (“NPAs”) totaled $21,760,000 at December 31, 2011, which represents 3.39% of total assets, an increase from $16,579,000 at December 31, 2010. The increase is largely due to the addition of one large commercial real estate loan totaling $3,627,000 to non-performing loans and an increase in other real estate owned (“OREO”). Non-performing assets continue to be concentrated in construction and land development loans and related OREO, which represents $9,660,000, or 44.4%, of non-performing assets. • Demand deposits, savings, money market and certificates of deposits less than $100,000, increased during 2011 by $34,371,000, or 8.2%, to $453,022,000 and comprise 82.7% of total deposits at year- end. The increase in core deposits was almost entirely offset by planned decreases during 2011 in retail certificates of deposits and brokered certificates of deposits of $29,763,000 and $14,220,000, respectively, resulting in a net increase overall in total deposits of $3,096,000, or 0.6%, during 2011. • As a result of core deposit growth, lower borrowings and increased interest bearing deposits with banks, the Company's liquidity ratio of approximately 41% at December 31, 2011, translates into over $260 million in available funding for general operations and to meet loan and deposit needs. The Company’s net income for 2011 was $2,818,000, or $0.28 per diluted share, compared to net income of $1,634,000, or $0.16 per diluted share, in 2010. The following are significant components of the Company’s results of operations for 2011 as compared to 2010. • Net interest income increased to $23,685,000 compared to $22,879,000 in 2010 due to decreases in rates paid on deposits and an increase in non-interest bearing demand deposits. Net interest margin for 2011 increased 12 basis points to 4.08% compared to 3.96% in 2010. • The provision for credit losses decreased by $1,100,000, or 30.6%, to $2,500,000 for 2011. The decrease is the result of overall improvement in credit quality as evidenced by decreases in net charge-offs, loans classified as substandard or worse, and impaired loans. Net charge-offs totaled $1,990,000 during 2011 compared to $4,075,000 in 2010. Loans classified as Substandard or worse totaled $34,578,000 at December 31, 2011 compared to $40,371,000 one year ago. Impaired loans totaled $14,432,000 at December 31, 2011 compared to $14,673,000 one year ago. While credit quality has 46 improved during the year, non-performing loans remain elevated compared to long-term historical levels and remain concentrated primarily in the residential construction and land development loan portfolios and commercial real estate loans. • Non-interest income decreased $837,000, or 9.9%, to $7,614,000 for 2011 due to decreased gain on sales of loans and OREO, as well as other-than-temporary-impairment (“OTTI”) losses. • Non-interest expense decreased $752,000, or 2.8%, to $25,648,000 for 2011. The decrease is primarily attributable to decreases in FDIC assessments, OREO write-downs, and equipment expenses, which were only partially offset by increases in salaries and employee benefits, and data processing expenses. • In 2011, return on average assets and return on average equity increased to 0.44% and 4.55%, respectively, compared to 0.25% and 2.77%, respectively, in 2010. BUSINESS OVERVIEW Weak economic conditions and ongoing strains in the financial and housing markets which began in 2008 generally continued in 2010 and 2011 and presented an unusually challenging environment for banks. The banking industry and the securities markets were materially and adversely affected by significant declines in the value of nearly all asset classes and by a lack of liquidity, especially in late 2008. The Company’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent on the economy in our markets. The continued economic downturn, and more specifically the slowdown in residential real estate sales, has resulted in further uncertainty. The result has been an increase in loan delinquencies and foreclosures, primarily in our residential construction and land development portfolios as compared to prior periods. In addition, the Company has experienced elevated charge-offs, significantly higher levels of provision for credit losses and higher nonperforming loan levels compared to the Company’s longer term historical record. Although economic conditions in general appear to be stabilizing, the Company’s future operating results and financial performance may be significantly affected by the prolonged weak economy in the Company’s market area and the course of the recovery. According to the U.S. Bureau of Labor Statistics, the unemployment rate in Washington was 8.5% at December 31, 2011 compared to 9.3% in 2010, 9.2% in 2009 and 6.5% in 2008, and in Oregon the unemployment rate was 8.9% for 2011, compared to 10.6% in 2010 and 2009 and 8.3% in 2008. The unemployment rate in Oregon is higher than the national unemployment rate of 8.5% at December 31, 2011. According to the Washington State Employment Security Department unemployment rates in Grays Harbor, Pacific, Skagit, Wahkiakum and Whatcom counties at December 31, 2011 were 13.5%, 11.9%, 10.2%, 11.9% and 8.1%, respectively, compared to 13.1%, 11.8%, 10.3%, 13.8%, and 8.1% in 2010, respectively, and 13.43%, 12.1%, 10.8%, 14.2%, and 8.3%, respectively, in 2009. Excluding Whatcom County, all Washington counties in which the Company operates have unemployment rates greater than the state and national rates. According to the Oregon Employment Department, the unemployment rate for Clatsop County increased from 9.0% in 2009 to 9.2% in 2010 before falling to 7.8% at December 31, 2011. Closed sales activity for single-family homes and condominiums had been on a declining trend in recent years; however, it began to rebound in 2010 and 2011 in selective counties within our geographic footprint. Year over year changes in closed sales activity in Grays Harbor, Skagit and Whatcom counties were 4.5%, 5.3%, and 0.5%, 47 respectively, during 2011. Sales prices of single-family homes and condominiums have decreased, however, in 2011 in the same counties by 20.5%, 18.7%, and 18.6%, respectively. Limited data is available on sales activity and sales prices for Pacific, Wahkiakum and Clatsop counties. Commercial real estate has performed better than residential real estate, but is generally affected by a slow economy as well. As a result, sales of commercial real estate properties have experienced a significant decline, which in Whatcom County totaled $194.5 million in 2008 compared to $114.0 million in 2009 and $135 million in 2010. Sales rebounded slightly in 2010 to $139.6 million and were relatively flat in 2011 at $140.3 million; however, results are still indicative of the high level of illiquidity that exists in the market. Limited data is available on commercial real estate in the smaller, more rural counties in which we operate. OPERATING STRATEGY The Company’s vision is to achieve and maintain a balanced growth in loans and deposits while maintaining top peer group financial performance; to consistently exceed all internal and external customer expectations by listening, understanding and identifying their needs; provide timely products and services through a cost effective delivery system while maintaining customer value expectations; and positively impacting our community through our passion and commitment to be the responsible corporate citizens that others model themselves after. In order to achieve long-term growth and accomplish our long-term financial objectives, the Company determined it needs to successfully execute its long-term strategies. These strategies for 2011 and corresponding results in 2011 are as follows: • • • Improve asset quality by proactively managing problem assets, selectively reducing loan concentrations, selling OREO and managing credit exposures. While non-performing assets increased slightly in 2011 to $22,158,000, or 3.46% of total assets, loans classified as Substandard or worse decreased by $5,793,000, or 14.3%, to $34,578,000 at December 31, 2011 compared to $40,371,000 one year ago. Additionally, net charge-offs, provision for credit losses, and OREO write- downs all showed significant improvement as stated above under “EXECUTIVE OVERVIEW” during 2011. Improve net interest margin by reinvesting short-term cash and cash equivalents into higher yielding assets, growing lost cost deposits, and decreasing rates paid on junior subordinated debentures. Net interest margin increased from 3.96% in 2010 to 4.08% for the year ended December 31, 2011. Expand our market share in existing markets by growing core areas of the balance sheet including commercial real estate and commercial loans and retail deposits through the quality and breadth of our branch network, superior sales practices, and an emphasis on customer and employee satisfaction. Non-maturity deposits (total deposits less time deposits) grew by $47,079,000, or 13.5%, during 2011. Commercial real estate loan balances increased $5,459,000, or 2.5%, during 2011, while commercial and agricultural loan balances increased $6,156,000, or 7.3%, during the same period. Operating strategies for 2012 are as follows: • Continue to improve asset quality through proactive management of problem loans, monitoring existing performing loans, and selling OREO properties. 48 • Increase net interest margin through reinvestment of short-term cash and cash equivalents into higher yielding loans and continued decreases in rates paid on deposits based on recent announcements by the Federal Reserve that interest rates are expected to remain low until the end of 2014. • Reduce controllable operating expenses through fiscal restraint and increased emphasis on non- interest income and improved efficiencies. The Company has formed a committee whose goal is to find additional cost savings or revenue enhancement opportunities. • • Increase core deposits and other retail deposits. Continue to focus on total customer banking relationships and superior customer service. In addition to our retail branch network, we maintain an excellent suite of cash management services including business remote check deposits, positive pay, payroll services and automated clearing house services that give us a competitive advantage over smaller institutions and enables us to compete with larger banks operating in our market areas. Expand our presence within our existing market areas with strategic emphasis on northern Clatsop County, Oregon and Skagit County, Washington. In addition to these areas, we believe the consolidation of financial institutions in Western Washington will provide opportunities to grow our franchise through organic growth for locally owned community institutions with local decision making authority, such as Bank of the Pacific. The Company will continue to be disciplined in its approach as it pertains to future expansion focusing on Pacific Northwest markets it knows and understands. As part of our expansion strategy, the Company recently hired a commercial lending team and announced plans to open a loan production office in Burlington, Washington. The degree to which we will be able to execute on these strategies will depend to a large degree on the local and national economy, improvement in the local markets for residential real estate, and limited deterioration in the credit quality of our commercial real estate loans. RESULTS OF OPERATIONS Years ended December 31, 2011, 2010, and 2009 General. The following table presents condensed consolidated statements of income for the Company for each of the years in the three-year period ended December 31, 2011. (dollars in thousands) Interest and dividend income Interest expense Net interest income Provision for credit losses Net interest income after provision for credit losses Other operating income Other operating expense Income (loss) before income taxes Income taxes (benefit) 2011 $29,318 5,633 23,685 2,500 21,185 7,614 25,648 3,151 333 Increase (Decrease) Amount % 2010 Increase (Decrease) Amount % 2009 $(1,542) (2,348) 806 (1,100) 1,906 (837) (752) 1,821 637 (5.0) (29.4) 3.5 (30.6) 9.9 9.9 (2.9) 136.9 209.5 $30,860 7,981 22,879 3,600 19,279 8,451 26,400 1,330 (304) $(1,960) (3,086) 1,126 (6,344) 7,470 1,426 (3,291) 12,187 4,215 (6.0) (27.9) 5.2 (63.8) 63.3 20.3 (11.1) 112.3 93.3 $32,820 11,067 21,753 9,944 11,809 7,025 29,691 (10,857) (4,519) Net income (loss) $2,818 $1,184 72.5 $1,634 $7,972 125.8 $(6,338) 49 Net income. For the year ended December 31, 2011, net income was $2,818,000 compared to $1,634,000 in 2010. Our net income (loss) in 2009 was $(6,338,000) for the same period. The increase in net income for 2011 was primarily due to increased net interest income and decreased provisions for credit losses, OREO write- downs and FDIC assessments. Net Interest Income. The Company derives the majority of its earnings from net interest income, which is the difference between interest income earned on interest earning assets and interest expense incurred on interest bearing liabilities. The Company’s net interest income is affected by the change in the level and mix of interest- earning assets and interest-bearing liabilities, referred to as volume changes. The Company’s net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond the Company’s control, such as federal economic policies, legislative tax policies and actions by the Federal Open Market Committee of the Federal Reserve (FOMC). Interest rates on deposits are affected primarily by rates charged by competitors and actions by the FOMC. The FOMC heavily influences market interest rates, including deposit and loan rates offered by many financial institutions. Also, as rates near zero, it becomes more difficult to match decreases in rates on interest earning assets with decreases in rates paid on interest bearing liabilities. Approximately 78% of the Company’s loan portfolio is tied to short-term rates, and therefore, re-price immediately when interest rate changes occur. The Company’s funding sources also re-price when rates change; however, there is a meaningful lag in the timing of the re-pricing of deposits as compared to loans and decreases in interest rates become less easily matched by decreases in deposit rates as rates approach zero. Because of its focus on commercial lending, the Company will continue to have a high percentage of floating rate loans. The Company anticipates that the low rate environment will continue to put pressure on yields on loans; however, management expects that decreases in rates paid on deposits will result in some increase in net interest margin in 2012. 50 The following table sets forth information with regard to average balances of interest earning assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin. Year Ended December 31, 2011 Interest Income (Expense) Average Balance Avg Rate Average Balance 2010 Interest Income (Expense) Avg Rate Average Balance 2009 Interest Income (Expense) Avg Rate $483,974 $27,481 5.68% $485,872 $28,835 5.93% $500,796 $30,065 6.00% 29,844 24,613 54,457 3,183 38,535 $580,149 10,280 15,065 7,579 41,845 (11,028) $643,890 1,042 1,512 2,554 - - 92 $30,127 26,451 3.49 24,421 6.14 50,872 4.69 3,183 - - 0.24 37,885 5.19% $577,812 1,235 1,498 2,733 - - 116 $31,684 35,085 4.67 25,033 6.13 60,118 5.37 3,135 - - 0.31 36,610 5.48% $600,659 1,868 1,580 3,448 - - 109 $33,622 5.32 6.31 5.74 - - 0.30 5.60% 10,399 15,580 8,071 43,782 (11,413) $644,231 10,470 16,402 9,327 34,886 (9,621) $662,123 (dollars in thousands) Assets Earning assets: Loans (1) Investment securities: Taxable Tax-Exempt (1) Total investment securities Federal Home Loan Bank Stock Federal funds sold and deposits in banks Total earnings assets / interest income Cash and due from banks Premises and equipment (net) Other real estate owned Other assets Allowance for credit losses Total assets Liabilities and Shareholders’ Equity Interest bearing liabilities: Deposits: Savings and interest-bearing demand Time certificates Total deposits $275,630 176,631 452,261 $(1,612) (3,031) (4,643) 0.58% $238,123 220,618 1.72 458,741 1.03 $(1,729) (4,845) (6,574) 0.73% $210,004 266,929 2.20 476,933 1.43 $(1,803) (7,461) (9,264) 0.86% 2.80 1.94 Short-term borrowings Long-term borrowings Secured borrowings Junior subordinated debentures Total borrowings Total interest-bearing liabilities/ 6,885 10,500 777 13,403 31,565 (264) (333) (41) (352) (990) 3.84 3.17 5.28 2.63 3.14 7,502 15,674 951 13,403 37,530 (204) (645) (61) (497) (1,407) 2.72 4.12 6.41 3.71 3.75 3,107 31,660 1,326 13,403 49,496 (26) (1,164) (75) (538) (1,803) 0.84 3.68 5.66 4.01 3.64 Interest expense $483,826 $(5,633) 1.16% $496,271 $(7,981) 1.61% $526,429 $(11,067) 2.10% Demand deposits Other liabilities Shareholders’ equity Total liabilities and shareholders’ equity 93,413 4,709 61,942 $643,890 84,556 4,361 59,043 $644,231 77,282 3,900 54,512 $662,123 Net interest income (1) Net interest income as a percentage of average earning assets Interest income Interest expense Net interest income Net interest margin (2) $24,494 $23,703 $22,555 5.19% 0.97% 4.22% 4.08% 5.48% 1.38% 4.10% 3.96% 5.60% 1.84% 3.76% 3.62% Tax equivalent adjustment (1) $809 $824 $802 (1) Interest earned on tax-exempt loans and securities has been computed on a 34% tax equivalent basis. (2) Net interest income divided by average interest earning assets. 51 For purposes of computing the average rate, the Company used historical cost balances which do not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Nonaccrual loans and loans held for sale are included in “loans.” Interest income on loans includes loan fees of $480,000, $575,000, and $888,000 in 2011, 2010, and 2009, respectively. Net interest income on a tax equivalent basis totaled $24,494,000 for the year ended December 31, 2011, an increase of $791,000, or 3.3%, compared to 2010. Net interest income on a tax equivalent basis increased 5.1% to $23,703,000 in 2010 compared to 2009. The Company’s tax equivalent interest income decreased 4.9% to $30,127,000 in 2011, from $31,684,000 in 2010 and $33,622,000 in 2009. The decrease in interest income in 2011 and 2010 was primarily due to the decline in yield earned on our loan and investment portfolios; however, this decline was more than offset by decreases in interest expense during the year. Average interest earning balances with banks at December 31, 2011, were relatively flat at $38.5 million with an average yield of 0.24% compared to $37.9 million with an average yield of 0.31% for the same period in 2010. Net interest margin continued to be negatively affected in 2011 and 2010 by increased levels of interest bearing cash invested at relatively low yields. The Company’s average loan portfolio decreased $1,898,000, or 0.4%, from year end 2010 to year end 2011, and decreased $14,924,000, or 3.0%, from 2009 to 2010. The decrease in 2011 is due to decreases in multi-family and non-owner occupied commercial real estate loans. These were partially offset by growth in commercial and owner-occupied commercial real estate loans in the second half of the year. The decrease in 2010 is due to decreases in construction and land development loans and commercial loans, which were partially offset by an increase in commercial real estate loan balances outstanding. Overall, loan demand remains soft in the current economic environment and competition for new loans is fierce. The Company’s average investment portfolio increased $3,585,000, or 7.0%, from 2010 to 2011, and decreased $9,246,000, or 15.4%, from 2009 to 2010. Interest and dividend income on investment securities for the year ended December 31, 2011 decreased $179,000, or 6.5%, compared to the same period in 2010. The average tax equivalent yield on investment securities decreased to 4.69% at December 31, 2011, from 5.37% at December 31, 2010 and 5.74% at year-end 2009. The decrease in 2011 is attributable to the reduction in rates earned on adjustable rate mortgage-backed securities and the maturity and sale of higher yielding securities that cannot be replaced in the current low rate environment. The Company’s average interest-bearing deposits decreased $6,480,000, or 1.4%, from 2010 to 2011, and decreased $18,192,000, or 3.8%, in 2010 from 2009. The Company attributes the decrease in 2011 and 2010 to the planned runoff of brokered certificates of deposits which was partially offset by growth in all other deposit categories. Even though the Company offers a wide variety of retail deposit products to both consumer and commercial customers, future deposit growth will be challenging as the Company anticipates increased deposit regulations stemming from the Dodd-Frank Act. Average borrowings decreased during 2011 by $5,965,000, or 15.9%, and decreased by $11,966,000, or 24.2%, during 2010. The decrease in average borrowing balances outstanding is primarily due to the maturity of $10,500,000 in FHLB advances in 2011. The pay down in borrowings was funded by growth in lower cost demand, money market and savings deposits. Average short-term borrowings in 2011 and 2010 represent FHLB term borrowings which had been reclassified as short-term borrowings due to scheduled maturity dates within one year. 52 Interest expense for the year ended December 31, 2011 decreased $2,348,000, or 29.4%, compared to the same period in 2010. The 2011 average rate paid on deposits declined to 1.03% from 2010 primarily due to a decrease in rates paid on time certificates of deposits and money market accounts. Additionally, during 2011, junior subordinated debentures totaling $5,155,000 converted from a fixed rate to a variable rate, resulting in a decrease in the rate paid on the balance outstanding from 6.39% to approximately 2.00%, which further improved net interest margin during the current year. The decrease in interest expense for borrowings in 2010 is attributable to maturities of long-term advances and continued rate reductions on variable rate junior subordinated debentures which are tied to the three month London Interbank Offer Rate, which has decreased considerably since 2008. The Company’s overall cost of interest-bearing liabilities decreased to 1.16% in 2011 from 1.61% and 2.10% in 2010 and 2009, respectively. The net interest margin increased to 4.08% for the year ended December 31, 2011, up from 3.96% in the prior year. This was mainly due to an improvement in the average cost of funds to 1.16% at December 31, 2011 from 1.61% one year ago, that was only partially offset by a decline in the Company’s average yield earned on assets from 5.48% for year ended December 31, 2010 to 5.19% for the current period. In 2010, decreasing levels of nonperforming loans placed on nonaccrual status positively affected our net interest margin which improved to 3.96% from 3.62% in 2009. During 2009, the net interest margin decreased 50 basis points to 3.62% as a result of declining loan yields caused by materially lower market interest rates which we were unable to fully offset by reducing rates paid on deposits and borrowings. The reversal of interest income on loans placed on non-accrual status also contributed to the margin compression and reduced net interest income in 2009. The following table presents changes in net interest income attributable to changes in volume or rate. Changes not solely due to volume or rate are allocated to volume and rate based on the absolute values of each. (dollars in thousands) Interest earned on: Loans Securities: Taxable Tax-exempt Total securities Fed funds sold and interest bearing deposits in other banks Total interest earning assets Interest paid on: Savings and interest bearing demand deposits Time deposits Total borrowings Total interest bearing liabilities 2011 compared to 2010 Increase (decrease) due to Net Rate Volume 2010 compared to 2009 Increase (decrease) due to Net Rate Volume $(112) $(1,242) $(1,354) $(889) $(341) $(1,230) 145 12 157 2 47 (338) 2 (336) (193) 14 (179) (422) (38) (460) (26) (1,604) (24) (1,557) 4 (1,345) (211) (44) (255) 3 (593) (633) (82) (715) 7 (1,938) (249) 865 206 822 366 949 211 1,526 117 1,814 417 2,348 (224) 1,170 447 (1,393) 298 1,446 (51) 1,693 74 2,616 396 3,086 Change in net interest income $869 $(78) $791 $48 $1,100 $1,148 53 Non-Interest Income. Non-interest income was $7,614,000 for 2011, a decrease of $837,000, or 9.9%, from 2010 when it totaled $8,451,000. The 2010 amount increased $1,426,000, or 20.3%, compared to the 2009 total of $7,025,000. The decrease in 2011 is mostly attributable to a decrease in gain on sales of loans and OREO, as well as OTTI losses totaling $330,000. The increase in 2010 was primarily a result of increased gains on sale of OREO, increased service charges on deposits and increased earnings related to bank owned life insurance (BOLI). The following table represents the principal categories of non-interest income for each of the years in the three- year period ended December 31, 2011. (dollars in thousands) 2011 Increase (Decrease) Amount Increase (Decrease) Amount % 2010 % 2009 Service charges on deposit accounts Net gain (loss) on sale of other real estate owned Net gains on sales of loans Net gain (loss) on sales of securities Net OTTI losses Earnings on bank owned life insurance Other operating income $1,799 $16 0.9 $1,783 $134 8.1 $1,649 (83) 3,593 698 (330) 527 1,410 (343) (575) 276 330 (14) 133 (131.9) (13.8) 65.4 n/a 260 4,168 422 - - 1,678 (470) (62) - - 118.3 (10.1) (12.8) - - (1,418) 4,638 484 - - (2.6) 10.4 541 1,277 52 94 10.6 7.9 489 1,183 Total non-interest income $7,614 $(837) (9.9) $8,451 $1,426 20.3 $7,025 Service charges on deposits increased 0.9% and 8.1% during 2011 and 2010, respectively. The Company continues to emphasize the importance of exceptional customer service and believes this emphasis, together with the implementation of an automated overdraft privilege program in April 2010, contributed to the increase in service charge revenue in 2010. However, due to overdraft regulations requiring opt-in provisions effective August 2010 and FDIC legislation regarding overdraft rules, overdraft revenue was relatively unchanged in 2011 as expected. The Company continues to sell long-term fixed and adjustable rate residential real estate loans into the secondary market to generate non-interest income. The $575,000 decrease in income from gains on sales of loans in the current year is due to a decline in mortgage refinancing activity compared to the prior two years when decreasing mortgage rates resulted in unprecedented new mortgage and refinance activity. The $470,000 decrease in income from gains on sales of loans in 2010 was mostly related to a decrease in secondary market volume due to the expiration of government incentive programs including tax credits. The sale of one-to-four family mortgage loans totaled $170.8 million for the year ended December 31, 2011, as compared to $215.5 million for the year ended December 31, 2010, and $276.7 million for the year ended December 31, 2009. Management expects gains on sale of loans to continue to decrease in 2012 from their peak in 2009. Net loss on sale of OREO totaled $83,000 on eleven properties sold during the year ended December 31, 2011 compared to a net gain on sale of OREO of $260,000 for the year ended December 31, 2010. The gain on sale of OREO in 2010 was largely due to a gain recognized on the sale of one commercial land lot. During 2009, the Company completed a bulk sale of 36 improved residential OREO properties for a net loss on sale of $1,418,000. Management felt this was prudent in view of the one-time net operating loss five year carry-back rule that 54 was applicable in 2009 for tax purposes, the improved credit quality of the balance sheet that resulted, and the cost savings resulting from the elimination of burdensome operating and maintenance costs of the properties, including taxes, insurance, and home-owner dues. The Company recorded net gains on sale of securities available-for-sale of $698,000, $422,000 and $484,000, for the years ended December 31, 2011, 2010 and 2009, respectively. During 2011, one non-agency mortgage-backed security was determined to be other-than-temporarily-impaired resulting in the Company recording $330,000 in impairment charges related to credit losses through earnings. As of December 31, 2011, an additional $256,000 in impairments not related to credit losses has been recorded through other comprehensive income. There were no additional OTTI securities at December 31, 2011 or December 31, 2010. Income from other sources totaled $1,937,000 in 2011, an increase of $119,000 from 2010, or 6.5%, due primarily to increases in visa debit card interchange revenue and automated teller machine fees, which were partially offset by a decrease in earnings from BOLI due to lower earnings credit rates. Income from other sources in 2010 increased $146,000, or 8.7%, to $1,818,000 as the result of increases in visa debit card interchange revenue and earnings on BOLI. Non-Interest Expense. Total non-interest expense in 2011 was $25,648,000, a decrease of $752,000, or 2.8%, compared to $26,400,000 in 2010. In 2010, non-interest expense decreased $3,291,000, or 11.1%, compared to $29,691,000 in 2009. The decrease in 2011 was mostly related to reductions in FDIC assessments, OREO write-downs and operating costs, and occupancy and equipment expenses. These were partially offset by increases in expenses for data processing, marketing and salaries and employee benefits. The decrease in 2010 was primarily attributable to decreases in FDIC insurance assessments, OREO write-downs, and salaries and employee benefits (including commissions). The following table shows the principal categories of non-interest expense for each of the years in the three-year period ended December 31, 2011. (dollars in thousands) Salaries and employee benefits Occupancy and equipment State taxes Data processing Professional services FDIC and state assessments OREO write-downs OREO operating expenses Marketing and advertising Other expense Increase (Decrease) Amount $193 (232) (7) 168 (28) (423) (223) (164) 114 (150) 2011 $13,723 2,534 473 1,415 739 938 1,049 450 523 3,804 % 2010 (1.4) (8.4) (1.5) 13.5 (3.7) (31.1) (17.5) (26.7) 27.9 (3.8) $13,530 2,766 480 1,247 767 1,361 1,272 614 409 3,954 Increase (Decrease) Amount $(28) (13) 44 1 (99) (441) (2,417) 107 14 (459) % 2009 (0.2) (0.5) 10.1 0.1 (11.4) (24.5) (65.5) 21.1 3.5 (10.4) $13,558 2,779 436 1,246 866 1,802 3,689 507 395 4,413 Total non-interest expense $25,648 $(752) (2.8) $26,400 $(3,291) (11.1) $29,691 Salary and employee benefits, the largest component of non-interest expense, increased by $193,000, or 1.4%, in 2011 to $13,723,000 and decreased by $28,000, or 0.2%, in 2010 compared to 2009. The increase in 2011 is attributable to annual performance and merit increases, as well as temporary additions to staff to assist with a core system conversion that occurred in April 2011. The decrease in 2010 is attributable to a decline in commissions 55 paid on mortgage loans sold due to a decrease in the volume of loans sold, which was partially offset by pay increases as a result of routine performance evaluations. Full time equivalent employees at December 31, 2011, were 213 compared to 222 at December 31, 2010. Also included in salaries and benefits for 2010 and 2009 was stock compensation expense of $26,000 and $46,000, respectively. For more information regarding stock options, see Note 15 - “Stock Options” to the Company’s audited consolidated financial statements included elsewhere in this report. Occupancy and equipment expenses decreased $232,000 and $13,000 to $2,534,000 and $2,766,000, respectively, in 2011 and 2010 compared with $2,779,000 for 2009, due primarily to reductions in depreciation expense, building repair and maintenance, and annual equipment hardware maintenance. The decrease in 2010 was mostly related to the consolidation of two branches, one in October 2008 (Everson) and the other in April 2009 (Birch Bay). Data processing expense increased $168,000, or 13.5%, in 2011 compared to 2010. In order to improve technology capabilities, processing time and efficiency, Management converted its core operating system in April 2011. Additionally, in late 2010 the Company rolled out mobile banking and e-delivery services. The Company will continue to invest in new technology when necessary in order to support future growth. Data processing expense in 2010 was flat at $1,247,000 compared to $1,246,000 in 2009. FDIC assessment expense totaled $938,000 in 2011 compared with $1,361,000 in 2010 and $1,802,000 in 2009. The decrease in 2011 is mostly attributable to a decrease in assessment rates effective April 2011 due to changes issued by the FDIC to assess premiums based on average assets rather than on domestic deposits. This change had a favorable impact on community banks. The decrease in 2010 is due to the elimination of a one-time special assessment imposed by the FDIC on all insured depository institutions in 2009, which for us totaled $306,000, as well as increases in assessment rates effective April 1, 2009. OREO write-downs decreased $223,000 and $2,417,000, in 2011 and 2010, respectively. The decrease in 2011 is due to less severe declines in real estate market values in 2011 compared to the previous two years. The decrease in 2010 is mostly due to the bulk sale of 36 OREO properties completed in 2009 which resulted in a sizeable write-down of OREO in 2009 and a decrease in foreclosure activity compared to 2009. Marketing and advertising expense increased by 27.9% to $523,000 in 2011 compared with $409,000 in 2010 due to campaigns associated with e-delivery services, annuity sales and communication related to the core system conversion. Marketing and advertising expense increased by 3.5% to $409,000 in 2010 compared with $395,000 for 2009 due to advertising expenses related to the implementation of an automated overdraft privilege program and increased brand awareness in our market areas. Other operating expense decreased 3.8% to $3,804,000 in 2011 compared with $3,954,000 in 2011, primarily due to decreases in directors and office insurance and core deposit intangible amortization, which declined $125,000 and $106,000, respectively. Other operating expense decreased 10.4% to $3,954,000 in 2010 compared with $4,413,000 for 2009, primarily due to small decreases in a broad range of categories with the most notable in credit reports and loan origination expense, each of which declined $31,000 and $67,000, respectively. The Company continues to focus ongoing efforts on reducing controllable expenses. Income Taxes (Benefit). For the years ended December 31, 2011, 2010, and 2009, income taxes (benefit) totaled $333,000, ($304,000) and ($4,519,000), respectively, representing effective tax rates of 10.6%, (22.9%) and 41.6%, respectively. The effective tax rate differs from the statutory rate of 34.6% due to tax exempt income representing an increasing share of income as investments in municipal securities and loans, income earned on BOLI, and tax credits received on investments in low income housing partnerships remained at historical levels, while other earnings declined sharply. 56 Deferred income tax assets or liabilities reflect the estimated future tax effects attributable to differences as to when certain items of income or expense are reported in the financial statements versus when they are reported in the tax returns. At December 31, 2011 and 2010, the Company had a net deferred tax asset of $4,351,000 and $3,925,000, respectively. See “Critical Accounting Policies” in this section below. FINANCIAL CONDITION At December 31, 2011 and 2010 Cash and Cash Equivalents Total cash and cash equivalents, including federal funds sold, decreased to $41,132,000 at December 31, 2011, from $61,758,000 at December 31, 2010, due to deployment of excess cash balances into higher performing investments and an increase in loans. Investment Portfolio The investment portfolio provides the Company with an income alternative to loans. The majority of securities are classified as available-for-sale and carried at fair value with a small amount classified as held-to-maturity and carried at amortized cost. The Company regularly reviews its portfolio in conjunction with overall balance sheet management strategies. From time to time securities may be sold to reposition the portfolio in response to strategies developed by the Company’s asset liability committee or to realize gains within the portfolio. The Company’s investment securities portfolio increased $6,330,000, or 13.1%, during 2011 to $54,677,000 due to the investment in municipals and agency mortgage-backed securities as an alternative to cash. The Company’s investment securities portfolio decreased $12,779,000, or 20.9%, during 2010 to $48,347,000 from $61,126,000 at year end 2009 due to investment security sales of $17,179,000 to recognize gains in the portfolio of $422,000. The Company regularly reviews its investment portfolio to determine whether any of its securities are other than temporarily impaired. In addition to accounting and regulatory guidance, in determining whether a security is other than temporarily impaired, the Company considers whether it intends to sell the security and if it does not intend to sell the security, whether it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. The Company also considers cash flow analysis for mortgage-backed securities under various prepayment, default, and loss severity scenarios in determining whether a mortgage- backed security is other than temporarily impaired. At December 31, 2011, the Company owned 6 securities in a continuous unrealized loss position for twelve months or longer, with an amortized cost of $5,101,000 and fair value of $4,223,000. These securities that have been in a continuous unrealized loss position for twelve months or longer at December 31, 2011, had investment grade ratings upon purchase. Following its evaluation of factors deemed relevant, management determined, in part because the Company does not have the intent to sell these securities and it is not more likely than not that it will have to sell the securities before recovery of cost basis, which may be at maturity, the Company does not have any other than temporarily impaired securities at December 31, 2011, with the exception of one non-agency mortgage-backed security. For more information regarding our investment securities and analysis of the value of securities in our investment portfolio, see Note 3 - “Securities” and Note 17 – “Fair Value of Financial Instruments” to the Company’s audited consolidated financial statements included elsewhere in this report. 57 The carrying values of investment securities at December 31 in each of the last three years are as follows: Held To Maturity (dollars in thousands) Obligations of states and political subdivisions Mortgage-backed securities Total Available For Sale (dollars in thousands) U.S. Government agency securities Obligations of states and political subdivisions Mortgage-backed securities Corporate bonds Mutual funds 2011 $6,732 293 $7,025 2011 $84 22,859 22,797 1,912 - - 2010 $6,084 370 $6,454 2010 $1,109 21,152 16,614 3,018 - - 2009 $6,958 491 $7,449 2009 $973 22,080 25,624 - - 5,000 Total $47,652 $41,893 $53,677 The following table presents the maturities of investment securities at December 31, 2011. Taxable equivalent values are used in calculating yields assuming a tax rate of 34%. Held To Maturity (dollars in thousands) Obligations of states and political subdivisions Weighted average yield Mortgage-backed securities Weighted average yield Total Available For Sale (dollars in thousands) U.S. Agency securities Weighted average yield Obligations of states and political subdivisions Weighted average yield Mortgage-backed securities Weighted average yield Corporate bonds Weighted average yield Due in one year or less Due after one through five years Due after five through ten years Due after ten years Total - - - - - - - - - - $1,009 5.64% - - - - $949 6.05% - - - - $4,774 $6,732 6.78% 293 5.57% 293 ____ $1,009 $949 $5,067 $7,025 Due in one year or less Due after one through five years Due after five through ten years Due after ten years Total $- - - - 2,763 3.81% - - - - - - - - $- - - - 3,471 3.93% 13 3.09% 1,912 2.82 % $- - - - 2,785 4.43% 866 1.22% - - - - $84 7.05% 13,840 5.20% 21,918 2.90% - - - - $84 22,859 22,797 1,912 ____ Total $2,763 $5,396 $3,651 $35,842 $47,652 58 Loan Portfolio General. Total loans were $489,434,000 at December, 2011, an increase of $13,609,000, or 2.9%, compared to December 31, 2010. The increase in total loans was driven primarily by increases in commercial loans and commercial real estate loans. Competition for commercial loans in the markets we serve is fierce and loan demand has been soft. The increases in commercial loans have been centered in agricultural loans and tax- exempt municipal financing. The following table sets forth the composition of the Company’s loan portfolio (including loans held for sale) at December 31 in each of the past five years. (dollars in thousands) 2011 2010 2009 2008 2007 Commercial and agricultural Construction, land development and other land loans Residential real estate 1-4 family Multi-family Farmland Commercial real estate Installment Credit cards and overdrafts Less unearned income $90,731 $84,575 $93,125 $91,888 $128,145 47,156 90,552 7,682 23,752 221,474 6,772 2,156 (841) 46,256 89,212 9,113 22,354 216,015 7,029 2,099 (828) 64,812 91,821 8,605 22,824 205,184 7,216 1,929 (881) 100,725 82,468 7,860 18,092 188,444 7,293 1,959 (925) 93,249 60,616 6,353 20,125 137,620 7,283 3,363 (681) Total $489,434 $475,825 $494,635 $497,804 $456,073 The Company’s strategy is to originate loans primarily in its local markets. Depending on the purpose of a loan, loans may be secured by a variety of collateral, including real estate, business assets, and personal assets. Loans, including loans held for sale, represent 76% and 74% of total assets as of December 31, 2011 and 2010, respectively. The majority of the Company’s loan portfolio is comprised of commercial and agricultural loans (commercial loans) and real estate loans. The commercial and agricultural loans are a diverse group of loans to small, medium, and large businesses for purposes ranging from working capital needs to term financing of equipment. The majority of recent growth in our overall loan portfolio has arisen out of the commercial real estate loan category, which constitutes 45% of our loan portfolio. Our commercial real estate portfolio generally consists of a wide cross-section of retail, small office, warehouse, and industrial type properties. Loan to value ratios for the Company’s commercial real estate loans generally did not exceed 75% at origination and debt service ratios were generally 125% or better. While we have significant balances within this lending category, we believe that our lending policies and underwriting standards are sufficient to reduce risk even in a downturn in the commercial real estate market. Additionally, this is a sector in which we have significant and long-term management experience. It is our strategic plan to seek growth in commercial and small business loans where available and owner occupied commercial real estate loans. We remain aggressive in managing our construction loan portfolio and continue to be successful at limiting our overall exposure in the residential construction and land development segments. While these segments have historically played a significant role in our loan portfolio, balances are now under 10% of total loans outstanding. We believe this segment will remain challenged into 2012, although to a lesser extent than the previous three years. 59 The Bank is not engaging in new land acquisition and development financing. Limited residential speculative construction financing is being provided for a select and small group of borrowers, which is designed to facilitate exit from the related loans. It was the Company’s strategic objective to reduce concentrations in land and residential construction and total commercial real estate below the regulatory guidelines of 100% and 300% of risk based capital, respectively, which was completed in the first quarter of 2010. As of December 31, 2011, concentration in commercial real estate as a percentage of risk-based capital stood at 225% and concentration in land and residential construction as a percentage of risk based capital was 55%. Loan Maturities and Sensitivity in Interest Rates. The following table presents information related to maturity distribution and interest rate sensitivity of loans outstanding, based on scheduled repayments at December 31, 2011. (dollars in thousands) Commercial Construction, land development and other land loans Residential real estate 1-4 family Multi-family Farmland Commercial real estate Installment Credit cards and overdrafts Total Less unearned income Total loans Due in one year or less Due after one through five years Due after five years Total $43,069 $35,756 $11,906 $90,371 39,323 47,018 874 8,118 66,887 1,106 2,156 $208,551 6,890 19,654 6,146 13,679 149,720 3,524 - - $235,369 943 23,880 662 1,955 4,867 2,142 - - $46,355 47,156 90,552 7,682 23,752 221,474 6,772 2,156 $490,275 (841) $489,434 Total loans maturing after one year with Predetermined interest rates (fixed) Floating or adjustable rates (variable) Total $37,734 197,635 $235,369 $45,719 636 $46,355 $83,453 198,271 $281,724 At December 31, 2011, 42.6% of the total loan portfolio presented above was due in one year or less. Nonperforming Assets. Nonperforming assets are defined as loans on non-accrual status, loans past due ninety days or more and still accruing interest, troubled debt restructurings still accruing interest, and OREO. The Company’s policy for placing loans on non-accrual status is based upon management’s evaluation of the ability of the borrower to meet both principal and interest payments as they become due. Generally, loans with interest or principal payments which are ninety or more days past due are placed on non-accrual (unless they are well- secured and in the process of collection) and previously accrued interest is reversed against income. Non-performing assets totaled $21,760,000 at December 31, 2011. This represents 3.39% of total assets, compared to $16,579,000, or 2.57%, at December 31, 2010, and $22,859,000, or 3.42%, at December 31, 2009. Construction, land development, and other land loans and associated OREO balances, continue to be the primary component of non-performing assets, representing $9,660,000, or 44.4%, of non-performing assets; as well as commercial real estate loans. 60 The following table presents information related to the Company’s non-accrual loans and other non-performing assets at December 31 in each of the last five years. (dollars in thousands) 2011 2010 2009 2008 2007 Accruing loans past due 90 days or more $299 $- - $547 $2,274 $2,932 Non-accrual loans: Construction, land development and other land loans Residential real estate 1-4 family Multi-family real estate Commercial real estate Farmland Commercial Installment Total non-accrual loans (1) 5,510 528 - - 7,168 - - 530 - - 13,736 5,529 2,246 - - 803 170 1,251 - - 9,999 9,886 1,323 353 2,949 87 1,049 - - 15,647 11,787 615 - - 1,477 - - 797 - - 14,676 2,326 1,044 - - - - - - 109 - - 3,479 Total non-performing loans 14,035 9,999 16,194 16,950 6,411 OREO: Construction, land development and other land loans Residential real estate 1-4 family Commercial real estate Total OREO 4,150 1,427 2,148 7,725 4,043 540 1,997 6,580 4,850 220 1,595 6,665 5,443 1,367 - - 6,810 - - - - - - - - Total non-performing assets (2) $21,760 $16,579 $22,859 $23,760 $6,411 Troubled debt restructured loans on accrual status Allowance for credit losses (Allowance) Allowance to non-performing loans Allowance to non-performing assets Non-performing loans to total loans (3) Non-performing assets to total assets $398 $11,127 79.28% 51.14% 2.96% 3.39% $- - $10,617 106.18% 64.04% 2.15% 2.57% $- - $11,092 68.49% 48.52% 3.36% 3.42% $- - $7,623 44.97% 32.08% 3.49% 3.80% $- - $5,007 78.10% 78.10% 1.46% 1.13% (1) Includes $7,734,000 and $932,000 in non-accrual troubled debt restructured loans (“TDRs”) as of December 31, 2011 and 2010, respectively, which are also considered impaired loans. There were no TDRs as of December 31, 2007 through 2009. (2) Does not include TDRs on accrual status. (3) Excludes loans held for sale Non-performing loans increased $4,036,000, or 40.4%, from the balance at December 31, 2011 due to an increase in non-accrual commercial real estate loans. The increase is made up primarily of one loan totaling $3,627,000. The level of non-performing loans is still considered elevated by historical standards and reflects the continued weakness in the real estate market and economy. Additionally, the transfer of loans to OREO contributed to the overall increase in non-performing assets in 2011. 61 Non-performing loans decreased $6,195,000, or 38.3%, in 2010 from the balance at December 31, 2009 due primarily to transfers to OREO upon foreclosure. The decrease in non-performing loans in 2010 was mostly in the construction and land development and commercial real estate categories, which was partially offset by an increase in 1-4 family residential real estate loans. The Company continues to aggressively monitor and identify non-performing assets and take action based upon available information. The balance of non-performing loans at year end 2011 is equal to 2.96% of total loans, excluding loans held for sale, compared to 2.15% at December 31, 2010. The totals are net of charge-offs based on the difference between carrying value on our books and management’s estimate of fair market value after taking into account the result of appraisals and other factors. The Company had troubled debt restructures totaling $7,734,000 and $932,000 at December 31, 2011 and 2010, respectively, which were on non-accrual status. There were no TDRs as of December 31, 2007 through 2009. A TDR is a loan for which the terms have been modified in order to grant a concession to a borrower that is experiencing financial difficulty. Troubled debt restructurings are considered impaired loans and reported as such. For more information regarding TDRs, see Note 4 - “Loans” to the Company’s audited financial statements included elsewhere in this report. Interest income on non-accrual loans that would have been recorded had those loans performed in accordance with their initial terms was $752,000, $2,568,000, and $1,659,000 for 2011, 2010, and 2009, respectively. Interest income recognized on impaired loans was $255,000, $593,000, and $444,000 for 2011, 2010, and 2009, respectively. Currently, it is our practice to obtain new appraisals on non-performing collateral dependent loans and/or OREO semi-annually. Based upon the appraisal review for non-performing loans, the Company will record the loan at the lower of carrying value or fair value of collateral (less costs to sell) by recording a charge-off to the allowance for credit losses or by designating a specific reserve per accounting principles generally accepted in the United States. Generally, the Company will record the charge-off rather than designate a specific reserve. As a result, the carrying amount of non-performing loans will not exceed the estimated value of the underlying collateral. During 2011 and 2010, as a result of these appraisals and other factors, the Company recorded OREO write- downs of $1,049,000 and $1,272,000, respectively. The Company will continue to reevaluate non-performing assets over the coming months as market conditions change. OREO at December 31, 2011 totaled $7,725,000 and includes: twelve land or land development properties totaling $3,239,000, three residential construction properties totaling $911,000, seven commercial real estate properties totaling $2,148,000; and five single family residences collectively valued at $1,427,000. The balances are recorded at the estimated net realizable value less selling costs. Loan Concentrations. The Company has credit risk exposure related to real estate loans. The Company makes loans for acquisition, construction and other purposes that are secured by real estate. At December 31, 2011, loans secured by real estate totaled $390,616,000, which represents 79.8% of the total loan portfolio. Real estate construction loans comprised $47,156,000 of that amount, while real estate loans secured by residential properties totaled $90,552,000. As a result of these concentrations of loans, the loan portfolio is susceptible to deteriorating economic and market conditions in the Company’s market areas. The Company generally requires collateral on all real estate exposures and typically originates loans at loan-to-value ratios at loan origination of no greater than 80%. See “Risk Factors” appearing in the Form 10-K. 62 Allowance and Provision for Credit Losses. The allowance for credit losses reflects management’s current estimate of the amount required to absorb probable losses on loans in its loan portfolio based on factors present as of the end of the period. Loans deemed uncollectible are charged against and reduce the allowance. Periodic provisions for credit losses are charged to current expense to replenish the allowance for credit losses in order to maintain the allowance at a level that management considers adequate. The amount of provision is based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. Estimated loss factors used in the allowance for credit loss analysis are established based in part on historic charge-off data by loan category, portfolio migration analysis, economic conditions and other qualitative factors. See “Critical Accounting Policies” in this section below, as well as “Risk Factors” in the Form 10-K. There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off. The determination that a loan may become uncollectible, in whole or in part, is a matter of significant management judgment. Similarly, the adequacy of the allowance for credit losses is a matter of judgment that requires consideration of many factors, including (a) economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers’ financial data, together with industry data, the competitive situation, the borrowers’ management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth review, at a minimum of quarterly or more frequently as considered necessary, of all loans judged to present a possibility of loss (if, as a result of such quarterly review, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. An analysis of the adequacy of the allowance is conducted by management quarterly and is reviewed by the Board of Directors. Based on this analysis and applicable accounting standards, management considers the allowance for credit losses of $11,127,000 to be adequate at December 31, 2011. 63 Transactions in the allowance for credit losses for the years ended December 31 are as follows: (dollars in thousands) 2011 2010 2009 2008 2007 Balance at beginning of year Charge-offs: Construction and land development Residential real estate 1-4 family Commercial real estate Commercial Credit card Installment Total charge-offs Recoveries: Construction and land development Residential real estate 1-4 family Commercial real estate Commercial Credit card Installment Total recoveries Net charge-offs (recoveries) Provision for credit losses Balance at end of year Ratio of net charge-offs (recoveries) to average loans outstanding $10,617 $11,092 $7,623 $5,007 $4,033 790 665 1,215 161 38 55 2,924 630 107 120 69 3 5 934 1,891 1,518 164 469 38 81 4,161 2 48 17 13 3 3 86 4,687 940 505 238 80 74 6,524 - - 2 17 17 4 9 49 2,039 14 - - 18 66 89 2,226 - - 3 37 - - 2 9 51 - - - - 40 - - 18 93 151 - - - - 21 619 2 1 643 1,990 2,500 $11,127 4,075 3,600 $10,617 6,475 9,944 $11,092 2,175 4,791 $7,623 (492) 482 $5,007 0.41% 0.84% 1.29% .46% (.11)% During the year ended December 31, 2011, provision for credit losses totaled $2,500,000 compared to $3,600,000 and $9,944,000 for the same periods in 2010 and 2009, respectively. The decrease in provision for credit losses in the current year is due to improving credit quality as evidenced by decreases in net charge-offs, substandard loans, and impaired loans. Loans classified as substandard decreased $5,285,000 to $34,570,000 at December 31, 2011. Impaired loans decreased $241,000 to $14,432,000 at December 31, 2011. The decrease in provision for credit losses in 2010 is the result of decreases in non-performing loans outstanding from $16,194,000 at December 31, 2009 compared to $9,999,000 at December 31, 2010 and a decrease in charged off loans. The provision reflects management’s continuing evaluation of the loan portfolio’s credit quality, which is affected by a broad range of economic metrics. During 2009, provision for credit losses increased as the result of increases in net charge-offs as demonstrated in the table above, which therefore increased the Company’s historical loss experience and loan loss rates. The increase in provision for credit losses in 2009 was also impacted by an increase in classified loans, primarily within our land acquisition and development and residential construction loan portfolios. During the year ended December 31, 2011, the Company increased loss rates on commercial real estate loans, which were offset by decreases in loss rates on residential real estate, spec construction, credit cards and land development based on decreased charge-offs in these categories. During the year ended December 31, 2010, the Company increased loss rates on residential real estate, home equity lines of credit and overdrafts, which were offset by decreases in loss rates on spec construction, credit cards and land development based on decreased charge-offs in these categories. During the year ended December 31, 2010, the Company increased loss rates on land acquisition and development and speculative residential construction after experiencing increased charge-offs in these categories. 64 For the year ended December 31, 2011, net charge-offs were $1,990,000 compared to $4,075,000 for the same period in 2010. Net-charge-offs are centered in the real estate and construction and land development portfolios, which accounted for $1,813,000 of total net charge-offs for the year and reflects a continued weak real estate market. The allowance for credit losses was $11,127,000 at December 31, 2011, compared with $10,617,000 at December 31, 2010, an increase of $510,000, or 4.8%. The increase in 2011 is due to provision expense of $2,500,000 which exceeded net charge-offs of $1,990,000, and is reflective of management’s review of qualitative factors including the continued uncertainty in the economy and financial industry, pervasive high unemployment rates in our geographic markets, and continued deterioration in real estate values, albeit at a slower pace than in the last two years. The allowance for credit losses decreased to $10,617,000 at year-end 2010 compared to $11,092,000 at year- end 2009. The decrease in 2010 is due to net charge-offs of $4,075,000 which exceeded provision for credit losses of $3,600,000. The increase in 2009 was attributable to additional provision for credit losses arising out of increases in loan loss rates, adversely classified loans and an increase in the unallocated portion of the allowance due to the volatility in the real estate market, and was reflective of the depressed and deteriorating economic conditions in our markets. The ratio of the allowance for credit losses to total loans outstanding (excluding loans held for sale) was 2.34%, 2.28% and 2.30% at December 31, 2011, 2010 and 2009, respectively. The Company’s loan portfolio contains a significant portion of government guaranteed loans which are fully guaranteed by the United States Government. Government guaranteed loans were $52,928,000 and $51,310,000 at December 31, 2011 and 2010, respectively. The ratio of allowance for credit losses to total loans outstanding excluding the government guaranteed loans was 2.64% and 2.50%, respectively. The Financial Accounting Standards Board (FASB) has issued accounting guidance relating to 1) accounting by creditors for impairment of a loan and 2) accounting by creditors for impairment of a loan for income recognition disclosures. The Company measures impaired loans based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair market value of the collateral if the loan is collateral dependent. The Company excludes loans that are currently measured at fair value or at the lower of cost or fair value, and certain large groups of smaller balance homogeneous loans that are collectively measured for impairment. The following table summarizes the Bank’s impaired loans at December 31: (dollars in thousands) 2011 2010 2009 2008 2007 Total impaired loans Total impaired loans with valuation allowance Valuation allowance related to impaired loans $14,432 $14,673 $25,738 $22,117 $6,431 4,498 2,032 508 142 2,962 638 462 118 3,052 72 No valuation allowance was considered necessary for the remaining impaired loans. The balance of the allowance for credit losses in excess of these specific reserves is available to absorb losses from all non-impaired loans. It is the Company’s policy to charge-off any loan or portion of a loan that is deemed uncollectible in the ordinary course of business. The entire allowance for credit losses is available to absorb such charge-offs. 65 The Company allocates its allowance for credit losses among major loan categories primarily on the basis of historical data. Based on certain characteristics of the portfolio and management’s analysis, losses can be estimated for major loan categories. The following table presents the allocation of the allowance for credit losses among the major loan categories based primarily on historical net charge-off experience and other business considerations at December 31 in each of the last five years. (dollars in thousands) 2011 Reserve % of Total Loans* 2010 Reserve % of Total Loans* 2009 Reserve % of Total Loans* 2008 Reserve % of Total Loans* 2007 Reserve % of Total Loans* Commercial loans Real estate loans Consumer loans Unallocated Total allowance $1,012 7,849 642 1,624 $11,127 18% 80% 2% - - $816 7,139 690 1,972 100% $10,617 18% 80% 2% - - $1,308 8,341 260 1,183 100% $11,092 19% $1,392 5,975 79% 256 2% - - - - 100% $7,623 18% $1,780 3,016 80% 211 2% - - - - 100% $5,007 28% 70% 2% - - 100% Ratio of allowance for credit losses to loans outstanding at end of year 2.34% 2.28% 2.30% 1.57% 1.14% * Represents the total of all outstanding loans in each category as a percent of total loans outstanding. The table indicates an increase of $906,000 in the allowance due to increases in the portion of the allowance related to commercial and real estate loans which was partially offset by decreases in the consumer and unallocated portion. The changes in 2011 and 2010 are attributable to changes in the loan loss rates. The increase in 2009 is due to an increase of $2,366,000 in the allowance related to real estate loans from December 31, 2008 to December 31, 2009 and the addition of an unallocated reserve of $1,183,000 which were the result of increases and changes in percentage allocations caused by deterioration in the housing market in our market areas, as well as an increase in the loan loss rates relative to real estate loans. Deposits The Company’s primary source of funds has historically been customer deposits. A variety of deposit products are offered to attract customer deposits. These products include non-interest bearing demand accounts, NOW accounts, savings accounts, and time deposits. Interest-bearing accounts earn interest at rates established by management, based on competitive market factors and the need to increase or decrease certain types or maturities of deposits. The Company has succeeded in growing its deposit base over the last three years despite increasing competition for deposits in our markets. The Company believes that it has benefited from its local identity and superior customer service. Attracting deposits remains integral to the Company’s business as it is the primary source of funds for loans and a major decline in deposits or failure to attract deposits in the future could have an adverse effect on operations and financial condition. The Company relies primarily on its branch staff and current customer relationships to attract and retain deposits. The Company’s strategic plan contemplates and focuses on continued growth in non-interest bearing accounts, which contribute to higher levels of non-interest income and net interest margin, through increased sales efforts and continued focus on customer service and emphasis on our expanded electronic services. We expect significant competition for deposits of this nature to continue for the foreseeable future and our ability to attract and retain non-interest bearing demand deposits may be influenced by the expiration of government programs providing expanded insurance coverage to such accounts in 2012. 66 Deposit detail by category as of December 31, 2011, 2010 and 2009, respectively, follows: (dollars in thousands) Non-interest bearing demand Interest bearing demand Money market deposits Savings deposits Time deposits Total 2011 2010 2009 $108,899 122,160 99,031 65,451 152,509 $95,115 103,358 93,996 55,993 196,492 $86,046 91,968 86,260 51,053 252,368 $548,050 $544,954 $567,695 Total deposits increased 0.6% to $548 million at December 31, 2011 compared to $545 million at December 31, 2010. However, all categories except time deposits experienced year over year increases due to continued sales efforts coupled with customers seeking FDIC insured products rather than equity markets. Non- interest bearing demand deposits increased $13,784,000, or 14.5% as business customers continued to build cash reserves. Interest bearing demand deposits increased $18,802,000, or 18.2%, due to increased public funds and the continued success of Dream Checking. The Dream Checking account pays a higher rate of interest upon meeting certain electronic requirements such as debit card and automated clearing house transactions. The balances in Dream Checking accounts totaled $47.1 million and $43.4 million at December 31, 2011 and 2010, respectively. Money market and savings accounts increased $5,035,000 and $9,458,000, respectively, primarily due to continued growth in the Whatcom County market. Time deposits decreased $43,983,000, or 22.4%, due to a combination of decreases in retail deposits of $29,763,000 and decreases in brokered deposits of $14,220,000. The decrease in retail deposits is due to our commitment to maintain a disciplined pricing strategy, focusing on enhancing long-term customer relationships rather than rate sensitive customers. Brokered deposits, excluding CDARS, totaled $13,000,000, $27,220,000 and $60,220,000 at December 31, 2011, 2010 and 2009, respectively. The decrease in 2011 and 2010 was due to management’s strategy to roll off brokered deposits as they came due during the year, of which $14.2 and $33.0 million matured in 2011 and 2010, respectively. This was achievable due to excess cash balances and growth in core deposits. The increase in brokered deposits in 2009 was primarily to replace maturing public deposits totaling $21,978,000 that became less attractive due to regulatory pledging requirements. Changes in the market or new regulatory restrictions could limit our ability to maintain or acquire brokered deposits in the future. The ratio of non-interest bearing deposits to total deposits was 19.9%, 17.5% and 15.2% at December 31, 2011, 2010 and 2009, respectively. The following table sets forth the average balances for each major category of deposits and the weighted average interest rate paid for deposits for the periods indicated. (dollars in thousands) Non-interest bearing demand Deposits Interest bearing demand deposits Savings and money market deposits Time deposits 2011 2010 2009 Average Deposits Rate Average Deposits Rate Average Deposits Rate $93,413 113,399 162,231 176,631 0.00% 0.72% 0.49% 1.72% $84,556 97,820 140,303 220,618 0.00% 0.93% 0.58% 2.20% $77,282 77,030 132,974 266,929 0.00% 0.98% 0.79% 2.80% Total $545,674 0.85% $543,297 1.21% $554,215 2.07% 67 Maturities of time certificates of deposit as of December 31, 2011 are summarized as follows: (dollars in thousands) 3 months or less Over 3 through 6 months Over 6 through 12 months Over 12 months Total Short-Term Borrowings Under $100,000 Over $100,000 $10,647 7,684 17,936 21,214 $57,481 $14,147 9,206 27,960 43,715 Total $24,794 16,890 45,896 64,929 $95,028 $152,509 The following is information regarding the Company’s short-term borrowings for the years ended December 31, 2011, 2010 and 2009. (dollars in thousands) 2011 2010 2009 Amount outstanding at end of period Weighted average interest rate thereon Maximum month-end balance during the year Average balance during the year Average interest rate during the year CONTRACTUAL OBLIGATIONS $- - - - % 10,500 6,885 3.84% $10,500 3.85 % 10,500 7,502 2.72% $4,500 3.77% 24,000 3,107 0.84% The Company is party to many contractual financial obligations at December 31, 2011, including without limitation, borrowings from the FHLB, junior subordinated debentures associated with trust preferred securities and operating leases for branch locations. The following is information regarding the dates payments of such obligations are due. Contractual obligations Operating leases Total deposits Federal Home Loan Bank borrowings Secured borrowings Junior subordinated debentures Less than 1 year Payments due by Period 3 – 5 years More than 5 years 1 – 3 years $355 483,122 - - 741 - - $543 39,155 5,500 - - - - $268 25,773 5,000 - - - - $- - - - - - - - 13,403 Total $1,166 548,050 10,500 741 13,403 Total long-term obligations $484,218 $45,198 $31,041 $13,403 $573,860 68 COMMITMENTS AND CONTINGENCIES AND OFF-BALANCE SHEET ARRANGEMENTS The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit, and involve, to varying degrees, elements of credit risk in excess of the amount recognized on the consolidated balance sheets. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. A summary of the Bank’s commitments at December 31 is as follows: Commitments to extend credit Standby letters of credit KEY FINANCIAL RATIOS 2011 2010 $91,596 1,310 $90,888 1,123 Year ended December 31, 2011 2010 2009 2008 2007 Return on average assets Return on average equity Average equity to average assets ratio Dividend payout ratio .44% 4.45% 9.62% - -% .25% 2.77% 9.16% - -% (.96)% (11.63)% 8.23% - -% .16% 1.83% 8.89% 35% 1.08% 11.46% 9.41% 82% LIQUIDITY AND CAPITAL RESOURCES Liquidity. The primary concern of depositors, creditors and regulators is the Company’s ability to have sufficient funds readily available to repay liabilities as they mature. In order to evaluate whether adequate funds are and will be available at all times, the Company monitors and projects the amount of funds required on a daily basis. The Bank’s primary source of liquidity is deposits from its customer base, which has historically provided a stable source of “core” demand and consumer deposits. Other sources of liquidity are available, including borrowings from the Federal Reserve Bank, the FHLB and from correspondent banks. Liquidity requirements can also be met through disposition of short-term assets. In management’s opinion, the Company maintains an adequate level of liquid assets for its known and reasonably foreseeable liquidity requirements, consisting of cash and amounts due from banks, interest bearing deposits and federal funds sold to support the daily cash flow requirements. Management expects to continue to rely on customer deposits as the primary source of liquidity, but may also obtain liquidity from maturity of its investment securities, sale of securities currently available for sale, loan sales, brokered deposits, government sponsored programs, loan repayments, net income, and other borrowings. Although deposit balances have shown historical growth, deposit habits of customers may be influenced by changes in the financial services industry, interest rates available on other investments, general economic conditions, consumer confidence, changes to government insurance programs, and competition. Competition for deposits is presently quite intense, even in our traditional markets of operations in Western Washington, making deposit retention challenging and new deposit growth quite difficult. Reductions in deposits could adversely affect the Company’s financial condition, results of operations, and liquidity. See “Risk Factors” appearing in the Form 10-K. 69 Borrowings may be used on a short-term basis to compensate for reductions in deposits, but are generally not considered a long term solution to liquidity issues. Long-term borrowings at December 31, 2011 and 2010 represent advances from the FHLB of Seattle. Advances at December 31, 2011 bear interest at 2.67% to 2.94% and mature in various years as follows: 2013 - $3,000,000, 2014 - $2,500,000 and 2015 - $5,000,000. The Bank has pledged $119,336,000 of loans as collateral for these borrowings at December 31, 2011. Based on pledged collateral, at December 31, 2011, the Bank had $108,836,000 of available borrowing capacity on its line at the FHLB, although each advance is subject to prior consent. The Bank also has a borrowing facility of $47,064,000 at the Federal Reserve Bank, of which none was used at December 31, 2011. The Bank has pledged $73,535,000 of loans as collateral to the Federal Reserve Bank. The holding company specifically relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of trust preferred securities for its funds, which are used for various corporate purposes. Dividends from the Bank are the holding company’s most important source of funds, and are subject to regulatory restrictions and the capital needs of the Bank, which are always primary. Sales of trust preferred securities (“TRUPs”) have historically also been a source of liquidity for the holding company and capital for both the holding company and the Bank; however, we have not issued TRUPs since 2006 and do not anticipate TRUPs will be a source of liquidity in 2012 or beyond. The Company and the Bank are subject to certain restrictions on the payment of dividends without prior regulatory approval. At December 31, 2011, two wholly-owned subsidiary grantor trusts established by the Company had issued and outstanding $13,403,000 of trust preferred securities. During 2009, the Company elected to exercise the right to defer interest payments on trust preferred debentures. Under the terms of the indenture, the Company has the right to defer interest payments for up to twenty consecutive quarterly periods without going in to default. During the period of deferral, the principal balance and unpaid interest will continue to bear interest as set forth in the indenture. In addition, the Company will not be permitted to pay any dividends or distributions on, or redeem or make a liquidation payment with respect to, any of the Company’s common stock during the deferral period. As of December 31, 2011 and 2010, deferred interest totaled $1,252,000 and $900,000, respectively, and is included in accrued interest payable on the balance sheet. On July 2, 2003, the Federal Reserve issued Supervisory Letter SR 03-13 clarifying that Bank Holding Companies should continue to report trust preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities to be counted in Tier 1 capital subject to certain limitations. The Federal Reserve has indicated it will review the implications of any accounting treatment changes and, if necessary or warranted, will provide appropriate guidance. For additional information regarding trust preferred securities, see our audited consolidated financial statements and related notes included elsewhere in this report, including Note 9 – “Junior Subordinated Debentures”. Capital. The Company conducts its business through the Bank. Thus, the Company needs to be able to provide capital and financing to the Bank should the need arise. The primary sources for obtaining capital are additional stock sales and retained earnings. Total shareholders’ equity was $63,220,000 at December 31, 2011, an increase of $3,501,000, or 5.9%, compared to December 31, 2010. The increase is largely attributable to earnings retention. Total shareholders’ equity averaged $61,942,000 in 2011, which includes $11,282,000 of goodwill. Shareholders’ equity averaged $59,043,000 in 2010, compared to $54,512,000 in 2009. The Company’s Board of Directors considers financial results, growth plans, and anticipated capital needs in formulating its dividend policy. The payment of dividends is subject to adequate financial resources at the Bank, which depend in part on operating results and limitations imposed by law and governmental regulations or actions of regulators. 70 The Federal Reserve has established guidelines for risk-based capital requirements for bank holding companies. Under the guidelines, one of four risk weights is applied to balance sheet assets, each with different capital requirements based on the credit risk of the asset. The Company’s capital ratios include the assets of the Bank on a consolidated basis in accordance with the requirements of the Federal Reserve. The Company’s capital ratios have exceeded the minimum required to be classified “well capitalized” during each of the past three years. The following table sets forth the minimum required capital ratios and actual ratios for December 31, 2011 and 2010. (dollars in thousands) December 31, 2011 Tier 1 capital (to average assets) Consolidated Bank Tier 1 capital (to risk-weighted assets) Consolidated Bank Total capital (to risk-weighted assets) Consolidated Bank December 31, 2010 Tier 1 capital (to average assets) Consolidated Bank Tier 1 capital (to risk-weighted assets) Consolidated Bank Total capital (to risk-weighted assets) Consolidated Bank Actual Amount Requirements for Adequately Capitalized Ratio Amount Ratio $63,965 65,022 10.18% 10.35% $25,137 25,128 63,965 65,022 13.56% 13.79% 69,926 70,980 14.82% 15.05% 18,870 18,860 37,740 37,720 $61,086 61,577 9.72% 9.80% $25,139 25,130 61,086 61,577 13.21% 13.35% 66,925 67,401 14.48% 14.62% 18,493 18,446 36,985 36,892 4.00% 4.00% 4.00% 4.00% 8.00% 8.00% 4.00% 4.00% 4.00% 4.00% 8.00% 8.00% Goodwill Valuation. Goodwill is assigned to reporting units for purposes of impairment testing. The Company has one reporting unit, the Bank, for purposes of computing goodwill. The Company performs an annual review in the second quarter of each fiscal year, or more frequently if indications of potential impairment exist, to determine if the recorded goodwill is impaired. As of December 31, 2011, management determined there were no events or circumstances which would more likely than not reduce the fair value of its reporting unit below its carrying value. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include, among others: a significant decline in expected future cash flows; a sustained, significant decline in our stock price and market capitalization; a significant adverse change in legal factors or in the business climate; adverse assessment or action by a regulator; and unanticipated competition. Any adverse change in these factors could have a significant impact on the recoverability of such assets and could have a material impact on the Company’s Consolidated Financial Statements. 71 The goodwill impairment test involves a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value. The Company estimates fair value using the best information available, including market information and a discounted cash flow analysis, which is also referred to as the income approach. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a rate that reflects current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in loans and deposits, estimates of future expected changes in net interest margins and cash expenditures. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics to the reporting unit. We validate our estimated fair value by comparing the fair value estimates using the income approach to the fair value estimates using the market approach. As part of our process for performing the step one impairment test of goodwill, the Company estimated the fair value of the reporting unit utilizing the income approach and the market approach in order to derive an enterprise value of the Company. In determining the discount rate for the discounted cash flow model, the Company used a modified capital asset pricing model that develops a rate of return utilizing a risk-free rate and equity risk premium resulting in a discount rate of 14.5%. This approach also includes adjustments for the industry the Company operates in and size of the Company. In addition, assumptions used by the Company in its discounted cash flow model (income approach) included an average annual revenue growth rate that approximated 2%; an asset growth of 1% in year one, 2% in year two, 3% annually in years three through five and 4% in year six; net interest margin of 4.21%; and a return on assets that ranged from 0.2% to 1.1%. In applying the market approach method, the Company considered all acquired banks between January 1, 2010 and June 30, 2011 with total assets between $100 million and $5 billion and non-performing assets to total assets between 2% and 6%. This resulted in selecting 23 comparable institutions which were analyzed based on a variety of financial metrics (tangible equity, return on assets, return on equity, net interest margin, efficiency ratio, nonperforming assets, and reserves for loan losses). After selecting comparable institutions, the Company derived the fair value of the reporting unit by completing a comparative analysis of the relationship between their financial metrics listed above and their market values utilizing various market multiples. Focus was placed on the price to tangible book value of equity multiple as this multiple generally reflects returns on the capital employed within the industry and is generally correlated with the profitability of each individual company. The Company concluded a fair value of its reporting unit of $69.0 million, by giving similar consideration to the values derived from 1) the income approach of $67.6 million, and 2) the market approach of $69.1 million; compared to a carrying value of its reporting unit of $75.2 million. Based on the results of the step one goodwill impairment analysis, the Company determined the second step must be performed. In the second step the Company calculates the implied fair value of its reporting unit. Under the step two goodwill impairment analysis, the Company calculated the fair value for its unrecognized core deposit intangible, as well as the remaining assets and liabilities of the reporting unit. Significant adjustments were made to the fair value of the Company’s loans receivable compared to its recorded value. The fair value of loans was estimated by calculating the present value of the expected cash flows of the loans over their lives discounted by the applicable risk-adjusted market rate for each loan category. The discount rates used to calculate the present value of each of the loan categories were developed from the option-adjusted spreads over comparable maturity Treasury securities with adjustments for credit risk grades. Because credit risk grades for some loan categories fall between primary credit risk grades, a risk grade differential was calculated to allow for interpolation of the option-adjusted spreads. The Company segregated its loan portfolio into fourteen categories based on collateral type. The weighted average discount rates for these individual categories ranged from 5.0% to 11.4%. The 72 calculated implied fair value of the Company’s goodwill totaled $14.7 million and exceeded the carrying value by $3.4 million, or 30.1%. Based on results of the second step of the impairment test, the Company determined no impairment charge of goodwill was required. Even though the Company determined that there was no goodwill impairment, continued declines in our stock price as well as values of others in the financial industry, declines in revenue for the Bank or significant adverse changes in the operating environment for the financial industry may result in a future impairment charge. It is possible that changes in circumstances existing at the measurement date or at other times in the future, or in the numerous estimates associated with management’s judgments, assumptions and estimates made in assessing the fair value of our goodwill, could result in an impairment charge of a portion or all of our goodwill. If the Company recorded an impairment charge, its financial position and results of operations would be adversely affected, however, such an impairment charge would have no impact on our liquidity, cash flows or regulatory capital. New Accounting Pronouncements. For a discussion of new accounting pronouncements and their impact on the Company, see Note 1 of the Notes to the audited consolidated financial statements included elsewhere in this report. CRITICAL ACCOUNTING POLICIES The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its evaluation of accounting policies that involve the most complex and subjective decisions and assessments, management has identified the following as its most critical accounting policies. Allowance for Credit Losses The Company’s allowance for credit losses methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for credit losses that management believes is appropriate at each reporting date. Quantitative factors include the Company’s historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company’s markets, including economic conditions and, in particular, the state of certain industries. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it intends to enhance its methodology accordingly. A materially different amount could be reported for the provision for credit losses in the statement of operations to change the allowance for credit losses if management’s assessment of the above factors were different. This discussion and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management’s Discussion and Analysis section entitled “Allowance and Provision for Credit Losses.” See “Risk Factors” appearing in the Form 10-K for a discussion of certain risks faced by the Company. 73 Goodwill Goodwill is initially recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Goodwill is presumed to have an indefinite useful life and is tested for impairment no less than annually. The Company has one reporting unit, the Bank, for purposes of computing goodwill. The Company performs an annual review each year, or more frequently if indicators of potential impairment exist, to determine if the recorded goodwill is impaired. The analysis of potential impairment of goodwill requires a two-step process. The first step is the estimation of fair value. If step one indicates that impairment potentially exists, the second step is performed to measure the amount of impairment, if any. Goodwill impairment exists when the estimated fair value of goodwill is less than its carrying value. The results of the Company’s annual second quarter step two test determined the implied fair value of goodwill was greater than the carrying value on the Company’s balance sheet and no goodwill impairment existed. As of December 31, 2011 management determined there were no events or circumstances which would more likely than not reduce the fair value of its reporting unit below its carrying value. No assurance can be given that the Company will not record an impairment loss on goodwill in the future. Investment Valuation and Other-Than-Temporary-Impairment (“OTTI”) The Company records investments in securities available-for-sale at fair value and securities held-to-maturity at amortized cost. Fair value is determined based on quoted prices for similar assets and liabilities traded in the same market; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. Declines in fair value below amortized cost are reviewed to determine if they are other than temporary. If the decline in fair value is judged to be other than temporary, the impairment loss is separated into a credit and noncredit component. Noncredit losses are recorded in other comprehensive income (loss) when the Company a) does not intend to sell the security or b) is not more likely than not it will be required to sell the security prior to the security’s anticipated recovery. Credit component losses are reported in non-interest income. The Company regularly reviews its investment portfolio to determine whether any of its securities are other-than-temporarily impaired. Valuation of OREO Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure (OREO) are recorded at the lower of cost or fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. Any differences between management’s assessment of fair value, less estimated costs to sell, and the carrying value of the loan at the date a particular property is transferred into OREO are charged to the allowance for credit losses. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and trigger a corresponding charge to non-interest expense in the Consolidated Statements of Income. Expenses from the maintenance and operations of OREO are included in other non-interest expense. Income Taxes Deferred tax assets and liabilities result from differences between the financial statement carrying amounts and the tax basis of assets and liabilities, and are reflected at currently enacted income taxes rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. 74 The Company had net deferred tax assets (“DTAs”) of $4,351,000 at December 31, 2011, compared to $3,925,000 at December 31, 2010. The most significant portions of the deductible temporary differences relate to the allowance for credit losses and fair value adjustments or impairment write-downs related to OREO. As of December 31, 2011, the Company believes that it is more likely than not that it will be able to fully realize its DTA and therefore has not recorded a valuation allowance. Assessing the need for, and the amount of, a valuation allowance requires significant judgment and analysis of both positive and negative evidence regarding realization of the DTA. The realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If future taxable income should prove non-existent or less than the amount of temporary differences giving rise to the net DTAs within the tax years to which they may be applied, the assets will not be realized and net income will be reduced. An extended period of losses could result in the Company establishing a valuation allowance against its DTA. The establishment of a valuation allowance would be accounted for as a charge against income and could have a material effect on our results of operations in a particular period. ASSET AND LIABILITY MANAGEMENT The largest component of the Company’s earnings is net interest income. Interest income and interest expense are affected by general economic conditions, competition in the market place, market interest rates and repricing and maturity characteristics of the Company’s assets and liabilities. Exposure to interest rate risk is primarily a function of differences between the maturity and repricing schedules of assets (principally loans and investment securities) and liabilities (principally deposits). Assets and liabilities are described as interest rate sensitive for a given period of time when they mature or can reprice within that period. The difference between the amount of interest sensitive assets and interest sensitive liabilities is referred to as the interest sensitivity “GAP” for any given period. The “GAP” may be either positive or negative. If positive, more assets reprice than liabilities. If negative, the reverse is true. Certain shortcomings are inherent in the interest sensitivity “GAP” method of analysis. Complexities such as prepayment risk and customer responses to interest rate changes are not taken into account in the “GAP” analysis. Accordingly, management also utilizes a net interest income simulation model to measure interest rate sensitivity. Simulation modeling gives a broader view of net interest income variability, by providing various rate shock exposure estimates. Management regularly reviews the interest rate risk position and provides measurement reports to the Board of Directors. 75 The following table shows the dollar amount of interest sensitive assets and interest sensitive liabilities at December 31, 2011 and differences between them for the maturity or repricing periods indicated. (dollars in thousands) Interest earning assets Loans, including loans held for sale Investment securities Fed Funds sold and interest bearing balances with banks Federal Home Loan Bank stock Total interest earning assets Interest bearing liabilities Interest bearing demand deposits Savings and money market deposits Time deposits Short term borrowings Long term borrowings Secured borrowings Junior subordinated debentures Total interest bearing liabilities Net interest rate sensitivity GAP Cumulative interest rate sensitivity GAP Cumulative interest rate sensitivity GAP as a % of earning assets Due in one year or less Due after one through five years Due after five years Total $207,710 3,789 28,525 - - $240,024 $122,160 164,482 87,581 - - - - 741 13,403 $388,367 $(148,343) $235,369 15,835 $46,355 35,053 $489,434 54,677 - - - - $251,204 - - 3,182 $84,590 28,525 3,182 $575,818 $- - - - 64,928 - - 10,500 - - - - $75,428 $- - - - - - - - - - - - - - $- - $122,160 164,482 152,509 - - 10,500 741 13,403 $463,795 $175,776 27,433 $84,590 112,023 $112,023 112,023 4.8% 19.5% 19.5% Effects of Changing Prices. The results of operations and financial condition presented in this report are based on historical cost information, and are unadjusted for the effects of inflation. Since the assets and liabilities of financial institutions are primarily monetary in nature, the performance of the Company is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. The effects of inflation on financial institutions are normally not as significant as its influence on businesses which have investments in plants and inventories. During periods of high inflation there are normally corresponding increases in the money supply, and financial institutions will normally experience above-average growth in assets, loans and deposits. Inflation does increase the price of goods and services, and therefore operating expenses increase during inflationary periods. 76 GENERAL CORPORATE AND SHAREHOLDER INFORMATION Administrative Headquarters 1101 S. Boone Street Aberdeen, WA 98520 (360) 533-8870 Independent Accountants Deloitte & Touche LLP Portland, Oregon Transfer Agent and Registrar Computershare 480 Washington Blvd. Jersey City, NJ 07310-1900 Telephone: 1-877-870-2422 Shareholder Services BNY Mellon Shareholder Services, our transfer agent, maintains the records for our registered shareholders and can help you with a variety of shareholder related services at no charge including: Change of name or address Consolidation of accounts Duplicate mailings Lost stock certificates Transfer of stock to another person Additional administrative services As a Pacific Financial Corporation shareholder, you are invited to take advantage of our convenient shareholder services or request more information about Pacific Financial Corporation. Access your investor statements online 24 hours a day, 7 days a week with MLink. For more information, go to www.bnymellon.com/shareowner/equityaccess. Annual Meeting The annual meeting of shareholders will be held on April 25, 2012 at 7 p.m. at 1101 S. Boone Street, Aberdeen, WA 98520. Form 10-K Our report on Form 10-K, including the financial statements and financial statement schedules, is available without charge to shareholders or beneficial owners of our common stock upon written request to Sandra Clark, Executive Secretary, Pacific Financial Corporation, P.O. Box 1826, Aberdeen, Washington 98520. Stock Information Pacific Financial Corporation is a reporting company with the Securities and Exchange Commission (SEC). The company stock is traded on the OTC Bulletin Board exchange under the symbol PFLC.OB. Historically, trading in our stock has been very limited and the trades that have occurred cannot be characterized as amounting to an established public trading market. At December 31, 2011, there were approximately 1,121 shareholders of record. Quarter Ended March 31 June 30 September 30 December 31 2011 Stock Prices 2010 Stock Prices High $7.00 4.55 4.25 4.25 Low High $4.50 4.06 3.75 3.60 $4.20 4.95 4.45 5.00 Low $3.65 3.65 3.85 4.01 The Company did not declare a dividend in 2011 or 2010. Under federal banking law, the payment of dividends by the Company and the Bank is subject to capital adequacy requirements established by the Federal Reserve and the FDIC. In addition, payment of dividends by either entity is subject to regulatory limitations. Payment of dividends on the Common Stock is also affected by statutory limitations, which restrict the ability of the Bank to pay upstream dividends to the Company. See also Note 9 to our audited financial statements included in this report. 77 Susan C. Freese Pharmacist Dwayne M. Carter President Brooks Manufacturing Co. Edwin W. Ketel Owner Oceanside Animal Clinic Dennis A. Long President & CEO Pacific Financial Corporation SUBSIDIARIES Bank of the Pacific 300 E. Market Street Aberdeen, WA 98520 360-533-8870 www.bankofthepacific.com BOARD OF DIRECTORS Gary C. Forcum, Chairman Private Investor Douglas M. Schermer Owner Schermer Construction Inc. G. Dennis Archer, Vice Chairman Founder and Director of Tax Services Archer Group Randy W. Rognlin Co-Owner Rognlins, Inc. Randy J. Rust Private Investor OFFICERS Dennis A. Long President & CEO CEO, Bank of the Pacific John Van Dijk Corporate Secretary President & COO, Bank of the Pacific Bruce MacNaughton Vice President Executive Vice President & CCO, Bank of the Pacific Denise J. Portmann Treasurer Executive Vice President & CFO, Bank of the Pacific This annual report is furnished upon request to customers of Bank of the Pacific pursuant to the requirements of the Federal Deposit Insurance Corporation (FDIC) to provide an annual disclosure statement. This statement has not been reviewed or confirmed for accuracy or relevance by the FDIC. 78 2011 Annual Report Outside Cover - Final.pdf 3/8/2012 3:06:35 PM 230558_BNY_Cvr_r1.indd 1 3/13/12 2:02 PM