Management's discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. The discussion and analysis should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this annual report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.

Overview

The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of individuals and small to medium sized businesses in its primary service area. The principal business of the Company is to attract deposits and to lend or invest those deposits on profitable terms. These deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts and certificates of deposit.

The Company actively extends both personal and commercial credit and is involved in the construction and real estate lending market. Loans consist of varying terms and can be secured or unsecured. Loans to individuals are for personal, household and family purposes. Loans to businesses are for such purposes as working capital, financing of facilities and equipment purchases.

Critical Accounting Policies

The preparation of our consolidated financial statements and accompanying notes are governed by accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to use judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. While we believe our judgments, estimates and assumptions are reasonable under the circumstances, actual results may differ materially under different conditions or using different assumptions.

We believe our critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.

The Financial Accounting Standards Board ("FASB") Accounting Standards Codification (the "Codification" or "ASC"). In June 2009, the FASB issued an accounting standard which established the Codification to become the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, with the exception of guidance issued by the U.S. Securities and Exchange Commission and its staff. All guidance contained in the Codification carries an equal level of authority. The Codification is not intended to change GAAP, but rather is expected to simplify accounting research by reorganizing current GAAP into approximately 90 accounting topics. We adopted this accounting standard in preparing our consolidated financial statements for the period ended December 31, 2009. The adoption of this accounting standard, which was subsequently codified into ASC Topic 105, "Generally Accepted Accounting Principles," had no impact on retained earnings and will have no impact on our statements of income and condition.

Allowance for Loan Losses; Impairment of Loans. The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb estimated credit losses on existing loans. If judgments and assumptions were to differ significantly from those used by management to estimate the allowance, the allowance for loan losses and the provision for loan losses on our income statement could be impacted materially. In addition, the allowance for loan losses is subject to review by various regulators who conduct examinations of the allowance for loan losses and may require adjustments to the allowance based upon the regulators' assessment regarding our adequacy and the methodology used. (For further discussion of the Company's allowance for loan losses, see "Lending Activities - Allowance for Loan Losses" located below in this Management's Discussion and Analysis of Financial Condition and Results of Operations.)

A loan is considered impaired when it is probable that we will be unable to collect all interest and principal payments due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or the fair value of the collateral if the loan is collateral dependent. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.

Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when fair value of the asset declines below cost and is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.

Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting policies relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan's yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, we utilize estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management's estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

Accounting for Income Taxes. The determination of the Company's effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, our tax returns are subject to audit by various tax authorities. Although we believe our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

Selected Financial Ratios

The information presented below is derived in part from our audited consolidated financial statements and notes thereto, which appear elsewhere in this annual report on Form 10-K (see Item 8, "Financial Statements and Supplementary Data," below). This information should be read in conjunction with our consolidated financial statements.

                                              2011              2010          2009
    Return on average assets (1)                 0.83 %            0.74 %       0.40 %
    Return on average equity (2)                 8.46 %            5.60 %       3.62 %
    Average equity to average assets (3)        12.63 %           13.29 %      10.99 %
    Dividend payout ratio (4)                   30.77 %           36.92 %      61.54 %

(1) Net income after tax, before preferred stock dividends and accretion of discount, divided by average total assets.

(2) Net income after tax, before preferred stock dividends and accretion of discount, divided by average common equity.

(3) Average equity divided by average total assets.

(4) Represents common dividends declared per share divided by basic net income per share.

Financial Condition of the Company

Total Assets. The Company's total assets increased by $27.5 million, or 10.3%, from $267.1 million at December 31, 2010 to $294.6 million at December 31, 2011. The increase in assets resulted primarily from a $23.3 million, or 64.8%, increase in our aggregate cash, securities available for sale, interest-bearing deposits in other banks and federal funds sold.

Investments. Investments in certain securities available for sale late in the third quarter increased our portfolio by $27.9 million, or 160.9%, to $45.3 million at December 31, 2011 compared to $17.4 million at December 31, 2010. Certificates of deposit, interest-bearing deposits in other banks, and federal funds sold decreased by a total of $6.9 million, from $15.6 million at December 31, 2010 to $8.7 million at December 31, 2011.

Loans. Loans held for investment, net, were $213.2 million at December 31, 2011, a slight decrease of $1.1 million, or 0.5%, from the loan balance of $214.3 million at December 31, 2010.

Bank-owned Life Insurance ("BOLI"). Late in the fourth quarter of 2011, the Bank purchased life insurance on various executives with a cash surrender value of $5.0 million. These policies, whose beneficiary is the Company, were obtained so that the annual BOLI income would help offset some of our employee benefit costs.

Asset Quality. Nonperforming assets were $1,719,000, or 0.58% of assets, at December 31, 2011, compared to $263,000 in nonperforming assets at December 31, 2010. In addition to a bank branch site that we no longer plan to utilize, we obtained an additional property during the third quarter of 2011 through foreclosure proceedings against one borrower.

Deposits. Total deposits at December 31, 2011 were $250.0 million compared to $224.1 million at December 31, 2010, an increase of $25.9 million, or 11.5%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $29.9 million, or 17.0%, from $175.7 million at December 31, 2010 to $205.6 million at December 31, 2011.

Average total deposits increased by $14.1 million, or 6.1%, from $230.2 million for the twelve month period ended December 31, 2010 to $244.3 million for the twelve month period ended December 31, 2011. Average core deposits increased by $14.6 million over the comparable twelve-month periods. In addition, the mix of average noninterest-bearing deposits to average total deposits increased from 34.4% in the twelve months of 2010 to 36.2% in the twelve months of 2011.

Borrowed Funds. Borrowed funds increased by $2.8 million, from $3.5 million at December 31, 2010 to $6.3 million at December 31, 2011.

Capital. Stockholders' equity decreased by $1.2 million, or 3.0%, from $37.6 million at December 31, 2010 to $36.4 million at December 31, 2011. In March 2011, consistent with our strategic plan and with the approval of the U.S. Treasury, the Company redeemed 2,606 shares of Series A Preferred Stock, resulting in a decrease of $2.6 million (or 25.0%) in the outstanding balance of our TARP preferred stock. During the third quarter of 2011, the Company sold to the U. S. Treasury $7.8 million of non-cumulative preferred stock in connection with our participation in the SBLF program. The Company used the proceeds from this transaction to redeem the remaining $7.8 million balance of our outstanding TARP preferred stock. The resulting $2.4 million reduction in stockholders' equity from the decrease in the balance of preferred stock was partially offset by an increase in retained earnings of $1.2 million between December 31, 2010 and December 31, 2011.

Net Interest Income

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, primarily from loan and investment securities portfolios, and interest expense, primarily on customer deposits and other Company borrowings. Changes in net interest income result from changes in volume, spread and margin. For purposes of determining such changes in net interest income, (a) volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, (b) spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and (c) margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-bearing liabilities. During the years ended December 31, 2011 and 2010, our average interest-earning assets were $269.1 million and $262.6 million, respectively. During these same years, our net interest margins, on a tax-equivalent basis, were 4.12% and 3.90%, respectively.

Average Balances and Average Rates Earned and Paid. The following table sets forth for the Company, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts on a tax-equivalent basis of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. In preparing the table, nonaccrual loans are included in the average loan balance.

                                                                         YEAR ENDED                                    YEAR ENDED                                    YEAR ENDED
                                                                     DECEMBER 31, 2011                             DECEMBER 31, 2010                             DECEMBER 31, 2009
                                                             Average                       Yield/          Average                       Yield/          Average                       Yield/
                                                           Balance (1)       Interest       Cost         Balance (1)       Interest       Cost         Balance (1)       Interest       Cost
                                                                                                                 (Dollars in Thousands)
Interest-earning assets (2)
Loans (2) (3)                                             $     214,962      $  11,423        5.31 %    $     193,394      $  10,218        5.28 %    $     177,897      $   9,022        5.07 %
Investment securities - taxable                                  26,561            799        3.01 %           41,996          1,404        3.34 %           54,790          2,141        3.91 %
FHLB and Federal Reserve Stock                                    1,972             48        2.44 %            2,232             40        1.79 %            1,718             27        1.59 %
Federal funds sold                                                  136             -         0.08 %              651              1        0.12 %            3,210              2        0.06 %
Other interest income                                            25,489             93        0.36 %           24,365            132        0.54 %            9,943             93        0.93 %


Total interest-earning assets                                   269,120         12,363        4.59 %          262,638         11,795        4.49 %          247,558         11,285        4.56 %

Noninterest-earning assets
Other real estate owned                                             522                                           102                                           181
Other assets                                                     17,263                                        17,656                                        17,049


Total assets                                              $     286,905                                 $     280,396                                 $     264,788


Interest-bearing liabilities
Money market, NOW accounts                                $     103,907      $     579        0.56 %    $      98,962      $     586        0.59 %    $     103,646      $     688        0.66 %
Savings deposits                                                  3,488              6        0.18 %            2,957              6        0.20 %            2,883             17        0.58 %
Certificates of deposit                                          48,517            634        1.31 %           49,072            806        1.64 %           52,026          1,371        2.64 %


Total interest-bearing deposits                                 155,912          1,219        0.78 %          150,991          1,398        0.93 %          158,555          2,076        1.31 %


Other borrowings                                                  4,304             44        1.02 %           10,982            144        1.30 %           10,104            140        1.36 %


Total interest-bearing liabilities                              160,216          1,263        0.79 %          161,973          1,542        0.96 %          168,659          2,216        1.31 %


Noninterest-bearing liabilities
Demand deposits                                                  88,371                                        79,237                                        65,009
Other liabilities                                                 2,092                                         1,930                                         2,030


Total liabilities                                               250,679                                       243,140                                       235,698


Stockholders' equity                                             36,226                                        37,256                                        29,090


Total liabilities and stockholders' equity                $     286,905                                 $     280,396                                 $     264,788


Net interest income and interest rate spread                                 $  11,100        3.80 %                       $  10,253        3.53 %                       $   9,069        3.25 %


Net interest margin                                                                           4.12 %                                        3.90 %                                        3.66 %


Ratio of average interest-earning assets to average
interest-bearing liabilities                                     167.97 %                                      162.15 %                                      146.78 %

(1) The calculations are based on daily average balances.

(2) Yields are stated on a taxable-equivalent basis assuming tax rates in effect for the periods presented.

(3) For the purposes of these computations, nonaccrual loans are included in average loan balances.

Rate/Volume Analysis

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period's rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period's volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

                                                        Year Ended                               Year Ended
                                                December 31, 2011 vs. 2010               December 31, 2010 vs. 2009
                                                Increase (Decrease) Due to               Increase (Decrease) Due to
                                             Volume          Rate        Total        Volume          Rate        Total
                                                                       (Dollars in Thousands)
Interest income
Loans                                       $   1,146       $   59      $ 1,205      $    808        $  388      $ 1,196
Investment securities taxable                    (477 )       (128 )       (605 )        (454 )        (283 )       (737 )
FHLB & FRB stock                                   (5 )         13            8             9             4           13
Federal funds sold                                 (1 )         -            (1 )          (2 )           1           (1 )
Other interest income                               6          (45 )        (39 )          91           (52 )         39


Total interest income                             669         (101 )        568           452            58          510


Interest expense
Deposits:
Money Market/NOW accounts                          26          (33 )         (7 )         (30 )         (72 )       (102 )
Savings deposits                                    1           (1 )         -             -            (11 )        (11 )
Certificates of deposit                            (9 )       (163 )       (172 )         (74 )        (491 )       (565 )
Borrowings                                        (74 )        (26 )       (100 )          11            (7 )          4


Total interest expense                            (56 )       (223 )       (279 )         (93 )        (581 )       (674 )


Net interest income Increase (decrease)     $     725       $  122      $   847      $    545        $  639      $ 1,184

Comparison of Operating Results for the Twelve Months Ended December 31, 2011 and 2010

Overview. The Company's pretax income was $3.5 million for the year 2011, compared to pretax income of $3.2 million for the year 2010, an increase of $323,000. This increase resulted from a $737,000 increase in net interest income, a $383,000 decrease in provision for loan losses, and a decrease in noninterest expense of $178,000, the total of which was partially offset by a $907,000 decrease in gains on sales of securities from $994,000 in 2010 to $87,000 in 2011.

Net Interest Income. The Company's net interest income before provision for loan losses increased by $737,000 to $10.9 million in the year 2011, compared to $10.2 million in the year 2010. Interest income in the year 2011 grew significantly, primarily due to a change in the mix of our average interest-earning assets from securities to loans. Our interest rate spread increased 27 basis points from 3.53% in the year 2010 to 3.80% in the year 2011, and our net interest margin increased 22 basis points from 3.90% in the year 2010 to 4.12% in the year 2011.

Provision for Loan Losses. A reduction to the provision for loan losses of $15,000 was recorded for the twelve months of 2011, compared to an increase in the provision of $368,000 for the twelve months of 2010. The reduction in 2011 related primarily to a decrease in the outstanding balance of our loan portfolio during 2011 combined with a net recovery in our allowance for loan losses.

Noninterest Income. Total noninterest income decreased by $975,000, from $1.8 million in the year 2010 to $868,000 in the year 2011. The primary factor in this decrease was $994,000 of gains on the sales of investment securities during 2010, compared to a gain of only $87,000 during 2011. In addition, service charges on deposit accounts were $334,000 in 2011, $111,000 less than in 2010.

Noninterest Expense. Total noninterest expense decreased by $178,000 from $8.5 million in the year 2010 to $8.3 million in the year 2011. Decreases in compensation expense, FDIC assessment, and loss on early extinguishment of debt of $49,000, $137,000 and $263,000, respectively, were partially offset by increases in occupancy and other expenses of $67,000 and $111,000, respectively.

Income Taxes. The Company's income tax expense for the year 2011 was $1,134,000, reflecting an effective tax rate of 32.4%, compared to income tax expense of $1,093,000 for the year 2010, reflecting an effective tax rate of 34.4%. This reduction in effective tax rate was primarily attributable to an increase in tax-exempt interest income from loans and reductions in nondeductible expenses.

Net Income Available to Common Stockholders. The Company repaid $2.6 million, or 25%, of its outstanding TARP preferred stock in March 2011, with a resulting decrease in net income available to common shareholders of $57,000 from the accelerated accretion of the corresponding discount on our outstanding TARP preferred stock. During the third quarter of 2011, we redeemed all of our remaining TARP preferred stock with the proceeds of $7.8 million in non-cumulative preferred stock issued in connection with our participation in the SBLF program, expensing the remaining net discount on the TARP preferred stock, which reduced income available to common shareholders by a total of $153,000 in the third quarter of 2011. During the fourth quarter of 2011, we lowered the dividend rate on our SBLF preferred stock to 1% based on qualified lending increases under the SBLF program. Even after the impact of preferred stock dividends and accelerated accretion of the entire discount on our TARP preferred stock, net income available to common stockholders was $1.8 million for the year 2011, compared to $1.5 million for the year 2010, an increase of $288,000.

The following tables set forth, for the periods indicated, components of noninterest income and noninterest expense:

                                                  $4,383,032       $4,383,032
                                                  Years Ended December 31,
                                                    2011             2010
        Noninterest income
        Service charges on deposit accounts     $    334,120     $    445,122
        Gain on sale of investment securities         87,345          993,590
        Income from bank-owned life insurance         18,805           18,151
        ATM transaction fees                         145,671          137,937
        Credit card interchange fees                  41,810           40,231
        Merchant discount fees                        34,089           39,043
        Late charges and other fees on loans         128,510           85,387
        Other                                         77,387           83,468

        Total noninterest income                $    867,737     $  1,842,929

                                                        $4,383,032       $4,383,032
                                                        Years Ended December 31,
                                                          2011             2010
   Noninterest expense
   Compensation                                       $  4,383,032     $  4,431,787
   Data processing                                         579,968          555,963
   Occupancy                                               838,159          771,639
   Furniture and equipment                                 583,289          585,833
   Taxes and licenses                                      338,223          342,066
. . .