Caution about forward-looking statements

In addition to historical information, this report may contain forward-looking statements. For this purpose, any statement, that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to:

· the inability of the Bank to comply with the requirements of agreements with its regulators;

· the inability to reduce nonperforming assets consisting of nonaccrual loans and foreclosed real estate;

· our inability to improve our regulatory capital position;

· the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;

· changes in assumptions underlying the establishment of allowances for loan losses, and other estimates;

· changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;

· risks inherent in making loans such as repayment risks and fluctuating collateral values;

· changes in operations of Village Bank Mortgage Corporation as a result of the activity in the residential real estate market;

· legislative and regulatory changes, including the Dodd-Frank Act Wall Street Reform and Consumer Protection Act and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;

· exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;

· the effects of future economic, business and market conditions;

· governmental monetary and fiscal policies;

· changes in accounting policies, rules and practices;

· maintaining capital levels adequate to remain well capitalized;

· reliance on our management team, including our ability to attract and retain key personnel;

· competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

· demand, development and acceptance of new products and services;

· problems with technology utilized by us;

· changing trends in customer profiles and behavior; and

· other factors described from time to time in our reports filed with the SEC.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements. Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made. In addition, past results of operations are not necessarily indicative of future results.

General

The Company's primary source of earnings is net interest income, and its principal market risk exposure is interest rate risk. The Company is not able to predict market interest rate fluctuations and its asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on the Company's results of operations and financial condition.

Although we endeavor to minimize the credit risk inherent in the Company's loan portfolio, we must necessarily make various assumptions and judgments about the collectability of the loan portfolio based on our experience and evaluation of economic conditions. If such assumptions or judgments prove to be incorrect, the current allowance for loan losses may not be sufficient to cover loan losses and additions to the allowance may be necessary, which would have a negative impact on net income. Over the last three years, the Company has recorded record provisions for loan losses due primarily to deteriorating quality of loans collateralized by real estate located in its principal market area.

There is intense competition in all areas in which the Company conducts its business. The Company competes with banks and other financial institutions, including savings and loan associations, savings banks, finance companies, and credit unions. Many of these competitors have substantially greater resources and lending limits and provide a wider array of banking services. To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies. Competition is based on a number of factors, including prices, interest rates, services, availability of products and geographic location.

Given current economic uncertainty as well as stress on our capital ratios resulting from operating losses, the Company has adopted a balance sheet reduction plan that focuses on the reduction of nonperforming assets and higher risk-weighted assets that will help increase capital ratios in three ways. First, the lower overall asset size affords the Company's capital reserves to support a smaller balance sheet. Second, the reduced risk profile of the Company's ensuing loan portfolio requires less capital support during times of economic stress. Third, a reduced infrastructure reduces general and administrative expenses, which in turn reduces the need for additional capital.

Given the asset growth restriction in the Consent Order, as well as the Company's current weakened financial position, the Company does not anticipate undertaking growth via acquisition or de novo branching during the foreseeable future.

The Company's objective is to continue decreasing assets by loan and deposit attrition.

Results of operations

The following represents management's discussion and analysis of the financial condition of the Company at June 30, 2012 and December 31, 2011 and the results of operations for the Company for the three and six months ended June 30, 2012 and 2011. This discussion should be read in conjunction with the Company's condensed consolidated financial statements and the notes thereto appearing elsewhere in this Quarterly report.

Income Statement Analysis

Summary

For the three months ended June 30, 2012, the Company had a net loss of $(9,736,000) and net loss available to common shareholders of $(9,922,000), or $(2.33) per fully diluted share, compared to net income of $257,000 and net income available to common shareholders of $37,000, or $0.01 per fully diluted share, for the same period in 2011. For the six months ended June 30, 2012, the Company had a net loss totaling $(11,137,000) and a net loss available to common shareholders of $(11,543,000), or $(2.72) per fully diluted share, compared to net income totaling $340,000 and a net loss available to common shareholders of $(99,000), or $(0.02) per share on a fully diluted share, for the same period in 2011. This represents decreases in net income before payment of dividends of $(9,993,000) and $(11,476,000), for the three and six month periods, respectively.

The components of these decreases in net income before payment of dividends are presented following:

                                               Three Months        Six Months
                                                  Ended              Ended
                                              June 30, 2012      June 30, 2012

      Decrease in net interest income         $     (586,000 )   $   (1,204,000 )
      Increase in provision for loan losses       (5,760,000 )       (6,492,000 )
      Increase in noninterest income                 729,000          1,415,000
      Increase in noninterest expense               (626,000 )       (1,555,000 )
      Increase in tax expense                     (3,750,000 )       (3,640,000 )

                                              $   (9,993,000 )   $  (11,476,000 )

Our profitability continues to be negatively affected by the continued stress on our borrowers and real estate values from the recessionary economy. As a result, asset quality continues to be a concern and management is devoting substantial resources to problem asset resolution. The increase in the provision for loan losses is discussed further under Asset quality and provision for loan losses.

Our cost of deposits declined from 1.74% for the second quarter of 2011 to 1.31% for the second quarter of 2012. This decline in cost of deposits is a result of the repricing of higher cost certificates of deposit during low interest rate environment that has existed for the last three years as well as an effort to change our deposit mix so that we are not so dependent on higher cost deposits. Our mortgage company's profit increased in the first six months of 2012 compared to the same period of 2011 by $805,000 due to the mortgage company closing $140,359,000 in mortgage loans for the first two quarters of 2012 compared to $104,077,000 for the same period in 2011.

Net interest income

Net interest income, which represents the difference between interest earned on interest-earning assets and interest incurred on interest-bearing liabilities, is the Company's primary source of earnings. Net interest income can be affected by changes in market interest rates as well as the level and composition of assets, liabilities and shareholder's equity. Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. The net yield on interest-earning assets ("net interest margin") is calculated by dividing tax equivalent net interest income by average interest-earning assets. Generally, the net interest margin will exceed the net interest spread because a portion of interest earning assets are funded by various noninterest-bearing sources, principally noninterest-bearing deposits and shareholders' equity.

Net interest income for the second quarter of $4,351,000 represents a decrease of $(586,000), or 12%, compared to the second quarter of 2011, and a decrease of $70,000, or 2%, compared to the first quarter of 2012.

Compared to the second quarter of 2011, average interest-earning assets for the second quarter of 2012 decreased by $54,559,000 or 10%. The decrease in interest-earning assets was due primarily to decreases in portfolio loans of $34,106,000, investment securities of $19,655,000 and federal funds sold of $6,144,000, offset by increases in loans held for sale of $5,347,000. The primary reason for the decline in our portfolio loans that are interest-earning was loan charge-offs as well as loans placed on nonaccrual status. In addition to the decline in interest-earning assets, the average yield on interest-earning assets decreased to 4.89% for the second quarter of 2012 compared to 5.37% for the second quarter of 2011. These declines resulted in a decline in interest income from the second quarter of 2011 to the second quarter of 2012 of $3,588,000, or 18%.

Average interest-bearing liabilities for the second quarter of 2012 decreased by $58,175,000 or 12%, compared to the second quarter of 2011. The decrease in interest-bearing liabilities was due primarily to declines in average deposits of $57,207,000. The average cost of interest-bearing liabilities decreased to 1.41% for the six months ended 2012 from 1.80% for the six months ended 2011. The principal reason for the decrease in liability costs was the maintenance of short-term interest rates by the Federal Reserve. The continuing low interest rates have allowed us to reduce our cost of funds as certificates of deposit and borrowings mature. See our discussion of interest rate sensitivity below for more information.

The Company's net interest margin is not a measurement under accounting principles generally accepted in the United States, but it is a common measure used by the financial services industry to determine how profitably earning assets are funded. Our net interest margin over the last several quarters is provided in the following table:

                                                 Net
                                               Interest
                           Quarter Ended        Margin

                         June 30, 2011              3.65 %
                         September 30, 2011         3.63 %
                         December 31, 2011          3.38 %
                         March 31, 2012             3.53 %
                         June 30, 2012              3.65 %

The net interest margin declined during 2011, primarily as a result of increasing nonaccrual loans. Additionally our margin was compressed as our deposits generally do not reprice as quickly as our loans. The improvement in net interest margin for the second quarter of 2012 compared to the first quarter of 2012 is a result of utilizing lower interest-earning assets, primarily federal funds sold, to fund a decrease in interest-bearing liabilities of $22,234,000. As a result higher yielding loans represented 85% of total interest-bearing assets as compared to 83% for the first quarter of 2012. However, given the continued depressed economy and the potential impact on interest income from new nonaccrual loans, no assurance can be provided that increases in the net interest margin will continue to occur.

The following table illustrates average balances of total interest-earning assets and total interest-bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, shareholders' equity and related income, expense and corresponding weighted-average yields and rates. The average balances used in these tables and other statistical data were calculated using daily average balances. We had no tax exempt assets for the periods presented.

                                                 Average Balance Sheets
                                                     (in thousands)

                               Three Months Ended June 30, 2012                   Three Months Ended June 30, 2011
                                             Interest      Annualized                           Interest      Annualized
                           Average           Income/          Yield           Average           Income/          Yield
                           Balance           Expense          Rate            Balance           Expense          Rate


Loans net of deferred
fees                    $     405,173       $    5,448            5.39 %   $     443,722       $    6,648            6.01 %
Loans held for sale            16,122              166            4.13 %           9,728              119            4.91 %
Investment securities          36,243              215            2.38 %          51,464              353            2.75 %
Federal funds and
other                          20,060               12            0.24 %          37,527               20            0.21 %
Total interest
earning assets                477,598            5,841            4.91 %         542,441            7,140            5.28 %

Allowance for loan
losses and deferred
fees                          (14,161 )                                           (7,709 )
Cash and due from
banks                          13,796                                             13,577
Premises and
equipment, net                 26,428                                             27,386
Other assets                   37,444                                             32,547

Total assets            $     541,105                                      $     608,242

Interest bearing
deposits
Interest checking       $      42,711       $       36            0.34 %   $      37,513       $       69            0.74 %
Money market                   68,860               70            0.41 %          89,978              167            0.74 %
Savings                        17,752               22            0.50 %          12,073               22            0.73 %
Certificates                  262,106            1,118            1.71 %         317,615            1,647            2.08 %
Total                         391,429            1,246            1.28 %         457,179            1,905            1.67 %
Borrowings                     44,941              244            2.18 %          52,499              297            2.27 %
Total interest
bearing liabilities           436,370            1,490            1.37 %         509,678            2,202            1.73 %
Noninterest bearing
deposits                       64,405                                             46,130
Other liabilities               5,295                                              3,501
Total liabilities             506,070                                            559,309
Equity capital                 35,034                                             48,933
Total liabilities and
capital                 $     541,104                                      $     608,242

Net interest income before provision
for loan losses                             $    4,351                                         $    4,938

Interest spread -
average yield on
interest
earning assets, less
average rate on
interest bearing
liabilities                                                       3.54 %                                             3.55 %

Annualized net
interest margin (net
interest income
expressed as
percentage of average
earning assets)                                                   3.65 %                                             3.65 %

                                                 Average Balance Sheets
                                                     (in thousands)

                                Six Months Ended June 30, 2012                    Six Months Ended June 30, 2011
                                             Interest      Annualized                          Interest      Annualized
                            Average          Income/          Yield          Average           Income/          Yield
                            Balance          Expense          Rate           Balance           Expense          Rate


Loans net of deferred
fees                    $       412,503     $   11,217            5.47 %   $    446,609       $   13,567            6.13 %
Loans held for sale           14,616.52            297            4.08 %          9,270              241            5.24 %
Investment securities            33,775            366            2.18 %         53,430              653            2.47 %
Federal funds and
other                            29,358             32            0.22 %         35,502               39            0.22 %
Total interest
earning assets                  490,253         11,912            4.89 %        544,811           14,500            5.37 %

Allowance for loan
losses and deferred
fees                         (13,020.42 )                                        (7,510 )
Cash and due from
banks                            14,553                                           6,826
Premises and
equipment, net                   26,569                                          27,420
Other assets                     35,348                                          32,516

Total assets            $       553,703                                    $    604,063

Interest bearing
deposits
Interest checking       $        42,439     $       76            0.36 %   $     35,469       $      133            0.75 %
Money market                     71,141            146            0.41 %         91,479              371            0.82 %
Savings                          16,969             43            0.51 %         11,658               41            0.71 %
Certificates                    269,564          2,339            1.74 %        318,714            3,400            2.15 %
Total                           400,114          2,604            1.31 %        457,321            3,944            1.74 %
Borrowings                       47,180            535            2.28 %         48,148              580            2.43 %
Total interest
bearing liabilities             447,294          3,139            1.41 %        505,469            4,524            1.80 %
Noninterest bearing
deposits                         63,808                                          45,187
Other liabilities                 4,423                                           5,174
Total liabilities               515,525                                         555,830
Equity capital                   38,177                                          48,234
Total liabilities and
capital                 $       553,703                                    $    604,064

Net interest income before provision
for loan losses                             $    8,773                                        $    9,976

Interest spread -
average yield on
interest
earning assets, less
average rate on
interest bearing
liabilities                                                       3.48 %                                            3.57 %

Provision for loan losses

The provision for loan losses for the three months ended June 30, 2012 amounted to $6,660,000 compared to $900,000 for the three months ended June 30, 2011. The provision for loan losses for the six months ended June 30, 2012 was $8,395,000 compared to $1,903,000 for the six months ended June 30, 2011. These increases reflect the continued stress on our borrowers from the recessionary economy as well as recognition of declines in real estate values evidenced by current appraisals. Asset quality continues to be a concern as there continues to be uncertainty in the economy.

Additionally, a significant portion of the provision for loan losses is based upon loan charge-off history over the last two years. As charge-offs increased significantly during this period, the provision for loan losses based upon this history has significantly increased.

Noninterest income

Noninterest income increased from $2,406,000 for the three months ended June 30, 2011 to $3,135,000 for the three months ended June 30, 2012, an increase of $729,000, or 30%. The increase in noninterest income is primarily a result of increases in gain on sale of loans of $555,000 and a gain on sale of securities of $99,000. Noninterest income also increased from $4,443,000 for the first six months of 2011 to $5,858,000 for the first six months of 2012, an increase of $1,415,000, or 32%. The increase in noninterest income is primarily a result of higher gains on sale of loans of $933,000 and gain on sale of securities of $201,000.

Noninterest expense

Noninterest expense for the three months ended June 30, 2012 was $6,681,000 compared to $6,055,000 for the three months ended June 30, 2011, an increase of $626,000, or 10%. The more significant increases in noninterest expense occurred in expenses related to foreclosed real estate of $316,000 and salaries and benefits of $111,000.

Noninterest expense for the six months ended June 30, 2012 totaled $13,491,000, an increase of $1,555,000, or 13%, from $11,935,000 for the six months ended June 30, 2011. Expenses related to foreclosed real estate increased by $972,000, salaries and benefits increased by $159,000, occupancy expense increased by $166,000 and loan underwriting expense increased by $170,000.

Income taxes

Certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.

The net deferred tax asset is included in other assets on the balance sheet. Accounting Standards Codification Topic 740, Income Taxes, requires that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. Management considers both positive and negative evidence and analyzes changes in near-term market conditions as well as other factors which may impact future operating results. In making such judgments, significant weight is given to evidence that can be objectively verified. The deferred tax assets are analyzed quarterly for

changes affecting realization. Management determined that as of December 31, 2011, the objective negative evidence represented by the Company's recent losses outweighed the more subjective positive evidence and, as a result, recognized a valuation allowance on its net deferred tax asset of approximately $3,900,000. At June 30, 2012, management continues to believe that the objective negative evidence represented by the Company's continued losses in the second quarter outweighed the more subjective positive evidence and, as a result, recognized an addition to the valuation allowance on its net deferred tax asset of approximately $5,871,000. The net operating losses available to offset future taxable income amounted to $11,600,000 at June 30, 2012 and expire through 2030.

Commercial banking organizations conducting business in Virginia are not subject to Virginia income taxes. Instead, they are subject to a franchise tax based on bank capital. The Company recorded a franchise tax expense of $82,000 and $169,000 for the six months ended June 30, 2012 and 2011, respectively.

Balance Sheet Analysis

Our total assets decreased to $524,462,000 at June 30, 2012 from $581,704,000 at December 31, 2011, a decrease of $57,242,000, or 10%. During the second quarter of 2012, liquid assets (cash and due from banks, federal funds sold and investment securities available for sale) decreased by $29,147,000, loans held for sale increased by $3,561,000, net portfolio loans decreased by $33,646,000, and other real estate owned increased by $8,500,000.

Loans

. . .