PALMETTO BANCSHARES INC - FORM 10-K/A

File	Filename
Attached files
EX-31.1 - SECTION 302 CEO CERTIFICATION - PALMETTO BANCSHARES INC	dex311.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - PALMETTO BANCSHARES INC	dex312.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K/A

Amendment No. 1

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2010

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 0-26016

PALMETTO BANCSHARES, INC.

(Exact name of registrant as specified in its charter)


South Carolina		74-2235055
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

306 East North Street, Greenville, South Carolina		29601
(Address of principal executive offices)		(Zip Code)

(800) 725-2265

(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Act.


Large accelerated filer ¨		Accelerated filer ¨
Non accelerated filer ¨		Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act). Yes ¨ No x

The aggregate market value of the voting and nonvoting common equity held by nonaffiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $14,105,595 as of the last business day of the registrant’s most recently completed second fiscal quarter. See Part II, Item 5.

50,513,722 shares of the registrant’s common stock were outstanding as of February 22, 2011.

DOCUMENTS INCORPORATED BY REFERENCE

None

Explanatory Note

This Amendment No. 1 (this “Amendment”) amends our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission (the “Commission”) on February 28, 2011 (the “Original Form 10-K”). On February 28, 2011 we also filed a Registration Statement on Form S-3 (the “Registration Statement”). For the Registration Statement to be declared effective, it must include the information required by Part III, Items 10 through 14 of Form 10-K which was not included in the Original Form 10-K. Accordingly, we are filing this amendment to Form 10-K to include the information required by Part III, Items 10 through 14 of Form 10-K. The information included herein as required by Part III, Items 10 through 14of Form 10-K is more limited that what is required to be included in the definitive proxy statement to be filed in connection with our annual meeting of shareholders. Accordingly, the definitive proxy statement to be filed at a later date will include additional information related to the topics herein and additional information not required by Part III, Items 10 through 14 of Form 10-K.

The reference on the cover page of the Original Form 10-K to the incorporation by reference of our definitive proxy statement into Part III of the Original Form 10-K is hereby deleted.

This Amendment also amends the Original Form 10-K to correct an inadvertent typographical error in the “Lending Activities—Allowance for Loan Losses” subsection of Part II—Item 7 of the Original 10-K Filing. The amount originally disclosed as charge-offs on loans individually evaluated for impairment of $9.9 million was the fourth quarter 2010 amount. The context and intent of the statement was to disclose the amount of charge-offs on loans individually evaluated for impairment for the year ended December 31, 2010, which was $33.7 million. This change had no impact on our financial position, results of operations, or cash flows.

For purposes of this Amendment, and in accordance with Rule 12b-15 under the Securities Exchange Act of 1934 (the “Exchange Act”), Items 7, 10 through 14, and 15(a)(3) of the Original Report have been amended and restated in their entirety. In addition, as required by Rule 12b-15 under the Exchange Act, new certifications by our principal executive officer and principal financial officer are filed as exhibits to this Amendment under Item 15 of Part IV hereof. Except as stated herein, this Amendment does not reflect events occurring after the filing of the Original Report with the SEC on February 28, 2011 and no attempt has been made in this Amendment to modify or update other disclosures as presented in the Original 10-K Filing. Accordingly, this Amendment should be read in conjunction with our filings with the SEC subsequent to the filing of the Original 10-K Filing.

PART II

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis presents the more significant factors impacting our financial condition as of December 31, 2010 and 2009 and results of operations and cash flows for the years ended December 31, 2010, 2009, and 2008. This discussion should be read in conjunction with, and is intended to supplement, all of the other Items presented in this Annual Report on Form 10-K. Percentage calculations contained herein have been calculated based on actual not rounded results.

Critical Accounting Policies and Estimates

General

The Company’s accounting and financial reporting policies are in conformity, in all material respects, to accounting principles generally accepted in the U.S. and to general practices within the financial services industry. The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of income and expense during the reporting period. While we base estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates. Management, in conjunction with the Company’s independent registered public accounting firm, has discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of our Board of Directors.

We consider accounting policies and estimates to be critical to our financial condition, results of operations, or cash flows if the accounting policy or estimate requires management to make assumptions about matters that are highly uncertain and for which different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial condition, results of operations, or cash flows.

Our significant accounting policies are discussed in Item 8. Financial Statements and Supplementary Data, Note 1. Of those significant accounting policies, we have determined that accounting for our allowance for loan losses and the related reserve for unfunded commitments, valuation of loans held for sale, mortgage-servicing rights, goodwill, foreclosed real estate, the realization of our deferred tax asset, defined benefit pension plan, the valuation of our common stock, and the determination of fair value of financial instruments are deemed critical because of the valuation techniques used and the sensitivity of the amounts recorded in our Consolidated Financial Statements to the methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires subjective and complex judgments and could be subject to revision as new information becomes available.

Allowance for Loan Losses

We consider our accounting policies related to the allowance for loan losses to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense. The allowance for loan losses represents our best estimate of probable inherent losses that have been incurred within the existing portfolio of loans. The allowance for loan losses is necessary to reserve for estimated probable loan losses inherent in the loan portfolio. Our allowance for loan losses methodology is based on historical loss experience by loan type, specific homogeneous risk pools, and specific loss allocations. Our process for determining the appropriate level of the allowance for loan losses is designed to account for asset deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, potential problem loans, criticized loans, and loans charged-off or recovered, among other factors.

The level of the allowance for loan losses reflects our continuing evaluation of specific lending risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio. Portions of the allowance for loan losses may be allocated for specific loans. However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off. While we utilize our best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications and collateral valuation.

We record allowances for loan losses on specific loans when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan. Specific allowances for loans considered individually significant and that exhibit probable or observed weaknesses are determined by analyzing, among other things, the borrower’s ability to repay amounts owed, guarantor support, collateral deficiencies, the relative risk rating of the loan, and economic conditions impacting the borrower’s industry.

The starting point for the general component of the allowance is the historical loss experience of specific types of loans. We calculate historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual loan net charge-offs to the total population of loans in the pool. We use a five-year look-back period when computing historical loss rates. However, given the increase in loan charge-offs beginning in 2009, we also utilized a three-year look-back period during 2010 for computing historical loss rates as an additional reference point in determining the allowance for loan losses.

We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors we considered in the determination of the December 31, 2010 allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include, without limitation, changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, peer comparisons, and other external factors. The general reserve portion of the allowance for loan losses calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.

Loans identified as losses by management, internal loan review, and / or bank examiners are charged-off. We review each impaired loan on a loan-by-loan basis to determine whether the impairment should be recorded as a charge-off or a reserve based on our assessment of the status of the borrower and the underlying collateral. In general, for collateral dependent loans, the impairment is recorded as a charge-off unless the fair value was based on an internal valuation pending receipt of a third party appraisal or other extenuating circumstances. Consumer loan accounts are charged-off generally based on pre-defined past due time periods.

In addition to our portfolio review process as discussed elsewhere in this item, various regulatory agencies, as part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions to the allowance for loan losses based on their judgments and information available to them at the time of their examination. While we use available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes on the Bank’s borrowers.

We believe that the allowance for loan losses at December 31, 2010 is adequate to cover probable inherent losses in the loan portfolio. However, underlying assumptions may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which was not known to management at the time of the issuance of the Company’s Consolidated Financial Statements. Therefore, our assumptions may or may not prove valid. Thus, there can be no assurance that loan losses in future periods, including potential incremental losses resulting from the sale of the commercial loans held for sale, will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required. Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting the Company’s business, financial condition, results of operations, and cash flows.

See Item 1A. Risk Factors contained herein for discussion regarding the material risks and uncertainties that we believe impact our allowance for loan losses.

Commercial Loans Held for Sale

Commercial loans held for sale are carried at the lower of cost or fair value less estimated selling costs. A valuation allowance is recorded to reflect the excess of the recorded investment in the loan and the fair value less estimated selling costs. Commercial loans held for sale for which binding sales contracts have been entered into as of the balance sheet date are accounted for at the contract amount. Collateral dependent commercial loans held for sale are valued based on independent collateral appraisals less estimated selling costs. If quoted market prices, binding sales contracts or appraised collateral values are not available, we consider discounted cash flow analyses with market assumptions.

There can be no assurances that the loans will be sold, or that any bids offered will be at the currently recorded balances. Accordingly, to the extent that we accept bids for these loans, we may receive significantly less than the current net carrying amount of the loans and incur a corresponding incremental loss on any such loan sales.

Mortgage-Servicing Rights

The value of our mortgage-servicing rights is an accounting estimate that depends heavily on current economic conditions specifically the interest rate environment and management’s judgments. We utilize the expertise of a third party consultant on a quarterly basis to assess the portfolio’s value including, but not limited to, capitalization, impairment, and amortization rates. Estimates of the amount and timing of prepayment rates, loan loss experience, costs to service loans, and discount rates are used to estimate the fair value of our mortgage-servicing rights portfolio. Amortization of the mortgage-servicing rights portfolio is based on the ratio of net servicing income received in the current period to total net servicing income projected to be realized from the mortgage-servicing rights portfolio. Projected net servicing income is determined based on the estimated future balance of the underlying mortgage loan portfolio that declines over time from prepayments and scheduled loan amortization. Future prepayment rates are estimated based on current interest rate levels, other economic conditions, market forecasts, and relevant characteristics of the mortgage-servicing rights portfolio such as loan types, interest rate stratification, and recent prepayment experience. We believe that the modeling techniques and assumptions used are reasonable; however, such assumptions may or may not prove valid. Thus, there can be no assurance that mortgage-servicing rights portfolio capitalization, amortization, and impairment in future periods will not exceed the current capitalization, amortization, and impairment amounts. Moreover, no assurance can be given that changing economic conditions and other relevant factors impacting our mortgage-servicing rights portfolio will not cause actual occurrences to differ from underlying assumptions thus adversely impacting our business, financial condition, results of operations, and cash flows.

Goodwill

In the third quarter 2010, the Company recorded a goodwill impairment charge of $3.7 million. Goodwill resulted from past business combinations from 1988 through 1999. We perform our annual impairment testing as of June 30 each year. However, due to the overall adverse economic environment and the negative impact on the banking industry as a whole, including the impact to the Company resulting in net losses and a decline in market capitalization based on our common stock price, we also performed impairment tests of our goodwill quarterly in 2010.

Our common stock is not listed on any national securities exchange or quoted on the OTC Bulletin Board. Our common stock is, however, quoted on the Pink Sheets under the symbol “PLMT.PK”. Although our common stock is quoted on the Pink Sheets, there is currently only a limited public trading market for our common stock. Private trading of our common stock also has been limited and has typically been conducted through the Private Trading System on our website. The Private Trading System is a passive mechanism created to assist buyers and sellers in facilitating trades in our common stock. In addition, buyers and sellers may privately negotiate transactions in our common stock. Because there is not an established market for our common stock, management may not be aware of all prices at which our common stock has been traded. Accordingly, we normally determine the value of our common stock based on the last five trades of the stock facilitated by the Company through the Private Trading System.

While there were trades in our common stock in the first and second quarters of 2010 through the Private Trading System, there were not any trades through the Private Trading System during the three month period ended September 30, 2010. The Private Placement was consummated on October 7, 2010 pursuant to which the Company issued 39,975,980 million shares of common stock at $2.60 per share. This per share issue price was negotiated by the Company at arm’s length with the investors and was supported by a fairness opinion from the investment banking firm engaged by the Company’s Board of Directors, including a comparison to common stock prices as a percentage of book value for publicly traded banks with similar asset quality and financial condition of the Company, and in comparison to recent merger and acquisition transactions. Accordingly, we believe it was appropriate to utilize the $2.60 issue price in our goodwill impairment evaluation.

The first step of the goodwill impairment evaluation was performed by comparing the fair value of our reporting unit with its carrying amount, including goodwill. Since the carrying amount of the reporting unit exceeded its fair value, the second step of the goodwill impairment test was performed to measure the amount of impairment loss. The second step of the goodwill impairment test compared the implied fair value of our reporting unit goodwill with the carrying amount of that goodwill. Since the carrying amount of reporting unit goodwill exceeded the implied fair value of that goodwill, an impairment loss was recognized in an amount equal to that excess. The evaluation at September 30, 2010 indicated that the carrying value of the Company’s goodwill exceeded the fair value and resulted in a third quarter noncash charge of $3.7 million, eliminating the goodwill as an asset on the Company’s Consolidated Balance Sheets. This charge had no effect on the liquidity, regulatory capital, or daily operations of the Company and was recorded as a component of noninterest expense on the Consolidated Statement of Income (Loss).

Foreclosed Real Estate

The value of our foreclosed real estate portfolio represents another accounting estimate that depends heavily on current economic conditions. Foreclosed real estate is carried at fair value less estimated selling costs, establishing a new cost basis. Fair value of such real estate is reviewed regularly and writedowns are recorded when it is determined that the carrying value of the real estate exceeds the fair value less estimated costs to sell. Writedowns resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.

The fair value of properties in the foreclosed real estate portfolio is generally determined from appraisals obtained from independent appraisers. We review the appraisal assumptions for reasonableness and may make

adjustments when necessary to reflect current market conditions. Such assumptions may not prove to be valid. Moreover, no assurance can be given that changing economic conditions and other relevant factors impacting our foreclosed real estate portfolio will not cause actual occurrences to differ from underlying assumptions thus adversely impacting our business, financial condition, results of operations, and cash flows.

Realization of Net Deferred Tax Asset

We use certain assumptions and estimates in determining income taxes payable or refundable, deferred income tax liabilities and assets for events recognized differently in our financial statements and income tax returns, and income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. We exercise considerable judgment in evaluating the amount and timing of recognition of the resulting income tax liabilities and assets. These judgments and estimates are reevaluated on a periodic basis as regulatory and business factors change.

We include the current and deferred tax impact of our tax positions in the financial statements only when it is more likely than not (likelihood of greater than 50%) that such positions will be sustained by taxing authorities, with full knowledge of relevant information, based on the technical merits of the tax position. While we support our tax positions by unambiguous tax law, prior experience with the taxing authority, and analysis that considers all relevant facts, circumstances and regulations, we must still rely on assumptions and estimates to determine the overall likelihood of success and proper quantification of a given tax position.

As of December 31, 2010, prior to the valuation allowance, net deferred tax assets totaling $20.5 million were recorded in the Company’s Consolidated Balance Sheets. Based on our projections of future operating results over the next several years, cumulative tax losses over the previous three years, tax loss deductibility limitations as discussed below and available tax planning strategies, we recorded a valuation allowance against the net deferred tax asset at December 31, 2010. The Private Placement that was consummated on October 7, 2010 is considered to be a change in control under the Internal Revenue Service rules. Accordingly, with the assistance of third party specialists, we were required to determine the fair value of the Company and our assets for the purpose of evaluating any potential limitation or deferral of our ability to carry forward pre-acquisition net operating losses and to determine the amount of net unrealized built-in losses as of October 7, 2010, which also limits the amount of net operating losses that may be used in the future. As a result of the valuations and tax analysis, we currently estimate that future utilization of net operating loss carry forwards and built-in losses of $46 million generated prior to October 7, 2010 will be limited to $1.1 million per year.

Analysis of our ability to realize deferred tax assets requires us to apply significant judgment and is inherently subjective because it requires the future occurrence of circumstances that cannot be predicted with certainty. While we recorded a valuation allowance against our net deferred tax asset for financial reporting purposes at December 31, 2010, the net operating losses are able to be carried forward for income tax purposes for up to twenty years. Thus, to the extent we return to profitability and generate sufficient taxable income in the future, we will be able to utilize a portion of the net operating losses for income tax purposes and reverse a portion of the valuation allowance for financial reporting purposes. The determination of how much of the net operating losses we will be able to utilize and, therefore, how much of the valuation allowance that may be reversed and the timing is based on our future results of operations and the amount and timing of actual loan charge-offs and asset writedowns.

Additionally, for regulatory capital purposes, deferred tax assets are limited to the assets which can be realized through (i) carryback to prior years or (ii) taxable income in the next twelve months. At December 31, 2010, all of our net deferred tax asset was excluded from Tier 1 and total capital based on these criteria. We will continue to evaluate the realizability of our deferred tax asset on a quarterly basis for both financial reporting purposes and regulatory capital purposes. The evaluation may result in the inclusion of a portion of the deferred tax asset in our regulatory capital calculation in future periods.

Defined Benefit Pension Plan

We account for our defined benefit pension plans on an actuarial basis. Pension assumptions are significant inputs to the actuarial models that measure pension benefit obligations and related impacts on income. In particular, the assumed discount rate and expected return on assets are important elements of defined benefit pension plan expense and asset / liability measurement with regard to the plan. We evaluate these critical assumptions annually. Lower discount rates increase present values and subsequent year pension expense, while higher discount rates decrease present values and subsequent year pension expense. To determine the expected long-term rate of return on defined benefit pension plan assets, we consider asset allocations and historical returns on various categories of plan assets. Both of these key assumptions are sensitive to changes. In addition, the pension plan includes common stock of the Company, which is not traded on an exchange and the value of which is subject to change based on our financial results. At December 31, 2010, the fair value of Company’s common stock included in the plan was 0.3% of total fair value of assets of the plan. Additionally, we periodically evaluate other assumptions involving demographic factors, such as retirement age, mortality, and turnover and update such factors to reflect experience and expectations for the future.

Effective 2008, we ceased accruing pension benefits for employees under our noncontributory, defined benefit pension plan. Although no previously accrued benefits were lost, employees no longer accrue benefits for service subsequent to 2007. Amounts recognized within our Consolidated Financial Statements with regard to this change to our defined benefit pension plan were also computed on an actuarial basis. Because of the considerable judgment necessary in the determination of all such assumptions, actual results in any given year may differ from actuarial assumptions. In addition, we may decide to terminate the pension plan which, based on the valuation of the plan assets and actuarial valuation of the accrued benefits to the participants at that time, would require a cash contribution to the plan for any resulting unfunded liability. While not computed on such basis, the current unfunded liability was $5.2 million at December 31, 2010.

Valuation of Common Stock

On a periodic basis, we utilize the market price of our common stock within various valuations and calculations relating to our defined benefit pension plan assets, our trust department assets under management, our employee retirement accounts, our impairment analysis of goodwill, our granting of awards under our 2008 Restricted Stock Plan, our calculation of earnings per share on a diluted basis, and our valuation of such stock serving as loan collateral.

Our common stock is not listed on any national securities exchange or quoted on the OTC Bulletin Board. Our common stock is, however, quoted on the Pink Sheets under the symbol “PLMT.PK”. Although our common stock is quoted on the Pink Sheets, there is currently only a limited public trading market for our common stock. Private trading of our common stock also has been limited and has typically been conducted through the Private Trading System on our website. In addition, buyers and sellers may privately negotiate transactions in our common stock. Because there is not an established market for our common stock, we may not be aware of all prices at which our common stock has been traded. Additionally, we have not determined whether the trades of which we are aware were the result of arm’s-length negotiations between the parties. We normally determine the value of our common stock based on the last five trades of the stock facilitated by the Company through the Private Trading System. The liquidity of our common stock depends upon the presence in the marketplace of willing buyers and sellers.

One of the requirements of the Private Placement is that the Company will use its reasonable best efforts to list the shares of our common stock on NASDAQ or another national securities exchange within nine months of the closing date of the Private Placement on October 7, 2010. While it is our intent to seek to list our common stock on NASDAQ, no assurances can be provided at this time that we will meet such listing requirements.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. Additionally, we may be required to record other assets at fair value on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or writedowns of individual assets. Further, we include in the Notes to the Consolidated Financial Statements information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used, and the related impact to income. Additionally, for financial instruments not recorded at fair value, we disclose the estimate of their fair value.

Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date. Accounting standards establish a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The three levels of inputs that are used to classify fair value measurements are as follows:

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Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments generally include securities traded on active exchange markets, such as the New York Stock Exchange, as well as securities that are traded by dealers or brokers in active over-the-counter markets. Instruments we classify as Level 1 are instruments that have been priced directly from dealer trading desks and represent actual prices at which such securities have traded within active markets. Level 1 instruments also include commercial loans held for sale for which binding sales contracts have been entered into as of the balance sheet date.

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Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques, such as matrix pricing, for which all significant assumptions are observable in the market. Instruments we classify as Level 2 include securities that are valued based on pricing models that use relevant observable information generated by transactions that have occurred in the market place that involve similar securities. Level 2 instruments also include mortgage loans held for sale that are valued based on prices for other mortgage whole loans with similar characteristics and commercial loans held for sale that are based on independent collateral appraisals.

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Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques.

We attempt to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, we use quoted market prices to measure fair value. If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently-sourced market parameters. Most of our financial instruments use either of the foregoing methodologies, collectively Level 1 and Level 2 measurements, to determine fair value adjustments recorded to our financial statements. However, in certain cases, when market observable inputs for model-based valuation techniques may not be readily available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.

The degree of management judgment involved in determining the fair value of an instrument is dependent upon the availability of quoted market prices or observable market parameters. For instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not fully available, management

judgment is necessary to estimate fair value. In addition, changes in the market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. When significant adjustments are required to available observable inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.

Significant judgment may be required to determine whether certain assets measured at fair value are included in Level 2 or Level 3. If fair value measurement is based upon recent observable market activity of such assets or comparable assets (other than forced or distressed transactions) that occur in sufficient volume and do not require significant adjustment using unobservable inputs, those assets are classified as Level 2. If not, they are classified as Level 3. Making this assessment requires significant judgment.

Executive Summary of 2010 Financial Results

Context for 2010 and the Company

The Palmetto Bank has been operating since 1906 and the Bank’s holding company, Palmetto Bancshares, Inc., was incorporated in 1982. Given the Company’s 104 year history, the Company has developed long-standing relationships with customers in the communities in which we operate and a recognizable name, which has resulted in a well-established branch network and loyal deposit base. As a result, the Company has historically had a lower cost of deposits than its peers due to a higher core deposit mix.

The Company operated under the same executive management team for more than 30 years until 2009. During that time, the Company grew to become the fifth largest banking institution headquartered in South Carolina and one of the most profitable banking franchises in the Carolinas. From 1999 to 2008, the Company averaged a return on average assets and return on average equity of 1.25% and 15.2%, respectively, and the Company’s net interest margin averaged 4.78%. In addition, over the same time period, noninterest income to average assets averaged 1.60%.

As a result of the challenges that developed in 2008, the Company accelerated its management succession plan and in early 2009 the board of directors hired a new Chief Executive Officer and Chief Operating Officer. As the impact of the recession worsened, the Company’s new management team quickly developed and implemented a comprehensive Strategic Project Plan to address all areas of the Company with an immediate emphasis on aggressively resolving the Company’s asset quality issues, including through the hiring in July 2009 of a new Chief Credit Officer who brought over 25 years of credit experience to the Company.

Both 2009 and 2010 were very challenging years for the Company, the banking industry, and the U.S. economy in general. In relation to the Company, the overall economic context for our financial condition and results of operations include the following:

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Ongoing financial stress in the overall U.S. economy during 2010 that generally started with an economic crisis in August 2008 and continued into 2009, for which the banking industry and the Company continue to be adversely affected.

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Volatile equity markets that declined significantly during the first half of 2009 and have since begun to improve although daily volatility continues.

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Significant stress on the banking industry resulting in significant governmental financial assistance to many financial institutions, extensive regulatory and congressional scrutiny, and new comprehensive reform legislation, including unknown regulations to be adopted as a result.

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General anxiety on the part of our customers and the general public.

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Uncertainty about the future and when the economy will return to “normal” and questions about what will be the “new normal.”

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Low and uncertain interest rate environment particularly given government intervention in the financial markets, with current expectations of rising interest rates although the timing is uncertain.

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High levels of unemployment nationally and in our local markets, and uncertainty about when the trend will begin to improve.

Additional context specific to the Company includes the following:

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Fast growth from 2004 through the first quarter of 2009, growing total assets 57% during that period which resulted in the Company reaching a natural “maturity/life cycle hump” that is typical for banks that reach that asset size. Typical challenges associated with this stage of our life cycle include:

•

Stress on our infrastructure requiring investment in the number and expertise of employees and refinement of policies and procedures.

•

Required investments in technology to invest in the future, and rationalization of the technology investments versus our historical investment in facilities.

•

Adapting products and services and related pricing and fees to remain relevant to our current and evolving customer base and competitiveness in the market place, and developing broader distribution channels for delivery of our products and services.

•

Application of a more sophisticated risk management approach, including a comprehensive view of risk, processes and procedures, internal and vendor expertise, and the “way we do business.”

•

Executive management succession plan implemented effective July 1, 2009 and resulting organizational changes.

•

In planning for the retirement of the former Chief Executive Officer of the Company and the Chief Executive Officer of the Bank (who also served as the President, Chief Operating Officer, and Chief Accounting Officer of the Company), effective July 1, 2009 the Company named Samuel L. Erwin as Chief Executive Officer and President of the Bank and Lee S. Dixon as Chief Operating Officer of the Company and the Bank. Subsequently, Mr. Erwin also assumed the title of Chief Executive Officer of the Company on January 1, 2010, and Mr. Dixon assumed additional responsibilities as Chief Risk Officer of the Company and the Bank in October 2009 and as the Chief Financial Officer of the Company and the Bank as of July 1, 2010. Messrs. Erwin and Dixon have proven bank turn around and operational capabilities and rapidly developed and implemented the Company’s Strategic Project Plan in June 2009 as summarized below.

•

During 2009 and 2010, we realigned our organizational structure and began the process of more specifically delineating our businesses. Additional organizational and senior management changes included designating an internal executive to be responsible for our Commercial Bank in August 2009 and another internal executive to be responsible for our Wealth Management business in October 2010. In addition, the Company hired a new Chief Credit Officer in July 2009, new Retail Banking Executive in October 2010, and a new Chief Financial Officer in November 2010.

•

Significant deterioration in asset quality during 2009 resulting in a net loss for 2009 which was the first annual net loss in the history of the Company since the Great Depression in the 1930s. Asset quality challenges continued in 2010, and we also incurred a net loss in 2010 driven primarily by credit losses.

•

Increased regulatory scrutiny given declining asset quality, financial results and capital position, which resulted in the Bank agreeing to the issuance of a Consent Order with its primary bank regulatory agencies in June 2010.

•

Strategic repositioning and reduction of the balance sheet to reduce commercial real estate loan concentrations and individually larger and more complex loans originated during 2004 through 2008, as well as intentional reduction in the amount of federal funds purchased, FHLB advances, and higher

priced certificates of deposit used to fund loan growth during that period. Gross loans decreased $362.9 million from March 31, 2009 (peak quarter end loans) to December 31, 2010. Borrowings and certificates of deposits also decreased $145.9 million from June 30, 2009 (peak quarter end borrowings).

In light of the above, in 2009, management and the Board of Directors reacted quickly and defined three strategic initiatives, which are currently summarized as follows:


Component	Primary Emphasis	Time Horizon

Strategic Project Plan	• Manage through the extended recession and volatile economic environment • Execute the Strategic Project Plan related to credit quality, earnings, liquidity, and capital (the Strategic Project Plan is described in more detail below), including preparation for a potential formal agreement with the bank regulatory agencies and raising additional capital	June 2009 – October 2010

2010 Annual Strategic Plan	• Strategic planning at the corporate and department level for calendar year 2010 in the context of the uncertain economic environment • Acceleration of overcoming the growth hump/life cycle stage of maturity resulting from fast growth reaching a high of $1.5 billion in assets • Positioning the Bank to return to profitability in the post-capital raise and post-recession environment These efforts will continue as part of the execution of our annual strategic plan in 2011.	Calendar year 2010

Bank of the Future	• Reinventing the Bank to be “the bank of the future” • Determining the “customer of tomorrow” and refining our products, services, and distributions channels to meet their expectations • Adapting to the rapidly changing financial services landscape, including lower earnings due to the low interest rate environment, potential regulatory restrictions on historical sources of income, and higher compliance costs • Intended listing of common stock on the NASDAQ stock exchange • Preparing for growth through organic growth given banking market disruption in our geographic markets and the potential for growth through mergers and acquisitions	Two to five years

We believe it is critical to focus on all three strategic initiatives simultaneously to optimize long-term shareholder value. As a result, management and the Board of Directors focused a tremendous amount of time and effort on addressing all three initiatives in 2009 and 2010 with the overall objectives being: 1) to aggressively deal with our credit quality, earnings and capital issues as quickly as possible and 2) to accelerate into a much shorter time frame the “reinvention of The Palmetto Bank” that might otherwise normally take several years to accomplish. While the National Bureau of Economic Research concluded that the recession officially ended in June 2009, the impact of

the recession is continuing to be felt by the banking industry and the Company. Accordingly, our focus has been and continues to be centered on managing through the effects of the recession to position the Company to return to profitability once the economy begins to recover.

The consummation of the Private Placement on October 7, 2010 in which the Company received $103.9 million of gross proceeds is a significant step forward in the implementation of these strategic initiatives. The Private Placement resulted in the Company’s and the Bank’s capital adequacy ratios exceeding the well-capitalized minimums. In addition, while financial challenges remain, the completion of the Private Placement repositioned the Company from a defensive posture to a more offensive oriented posture in terms of balance sheet management, market presence, customer retention, and new customer acquisition.

As summarized in more detail below, we are continuing our keen focus on improving credit quality and earnings. Overall, with the completion of the Private Placement in October 2010, we are in the process of repositioning the balance sheet as part of our balance sheet management efforts to utilize our excess cash more effectively to improve our net interest margin. This includes investing in higher yielding investment securities until loan growth resumes, as well as paying down higher priced funding such as FHLB advances and maturing CDs. We are also continuing to adapt our organizational structure to fit the current and future size and scope of our business activities and operations. Such efforts include hiring management personnel with specialized industry experience, more specifically delineating our businesses, and preparing “go to market” strategies with relevant products and services and marketing plans by business.

Summary Financial Results and Company Response

The national and local economy and the banking industry continue to deal with the effects of the most pronounced recession in decades. In South Carolina, unemployment rose significantly throughout 2009 and into 2010 and is higher than the national average, and residential and commercial real estate projects are depressed with significant deterioration in values. As a result, the impact in our geographic area and to individual borrowers was severe. As a result of the extended recession, our financial results in the years ended December 31, 2009 and 2010 were significantly impacted by the following in comparison to our historical financial results in the year ended December 31, 2008:

•

Provision for loan losses totaling $47.1 million and $73.4 million in 2010 and 2009, respectively, compared to $5.6 million for 2008.

•

Loss on commercial loans held for sale totaling $7.6 million in 2010 compared to none in 2009 and 2008.

•

Net loss from writedowns, expenses, operations, and sales of foreclosed real estate totaling $11.7 million and $3.2 million in 2010 and 2009, respectively, compared to $516 thousand in 2008.

•

Foregone interest of $4.7 million and $3.7 million in 2010 and 2009, respectively, compared to none in 2008 on cash invested at the Federal Reserve at 25 basis points to maintain liquidity versus the average yield on our investment securities of 2.75% and 4.75%, respectively.

•

Higher FDIC deposit insurance assessments totaling $4.5 million and $3.3 million in 2010 and 2009, respectively, compared to $786 thousand in 2008 due to industry wide increases in general assessment rates, our voluntary participation in the FDIC’s Transaction Account Guarantee Program, our capital classification being below well-capitalized throughout most of 2010, and an industry-wide special assessment in 2009.

•

Goodwill impairment totaling $3.7 million in 2010.

•

Higher credit-related expenses for problem asset workout and other expenses to execute the Strategic Project Plan, which were not incurred prior to the third quarter of 2009.

•

Valuation allowance of $20.5 million recorded against deferred tax assets in 2010 resulting in the elimination or deferral of tax benefits that would have otherwise been available to reduce our net loss in 2010.

In total, the above events reduced our earnings by approximately $91.9 million and $76.7 million for the years ended December 31, 2010 and 2009, respectively, compared to the year ended December 31, 2008. Accordingly, we believe consummation of the Private Placement and successful completion of the Strategic Project Plan will result in significant improvement to our earnings going forward.

The credit-related costs for banks associated with the recession are significant. Beginning in the fourth quarter of 2008 and continuing throughout 2010, construction, acquisition and development real estate projects have slowed down, guarantors are financially stressed, and increasing credit losses have surfaced. During 2009 and 2010, delinquencies over 90 days increased resulting in an increase in nonaccrual loans indicating significant credit quality deterioration and probable losses. In particular, loans secured by real estate including acquisition, construction and development projects demonstrated stress given reduced cash flows of individual borrowers, limited bank financing and credit availability, and slow property sales. This deterioration has manifested itself in our borrowers in several ways: decreases in cash flows from underlying properties supporting the loans (e.g., slower property sales for development type projects or lower occupancy rates or rental rates for operating properties), decreases in cash flows from the borrowers themselves, increased pressure on guarantors due to illiquid and diminished personal balance sheets resulting from investing additional personal capital in the projects, and declines in fair values of real estate related assets, resulting in lower cash proceeds from sales or fair values declining to the point that borrowers are no longer willing to sell the assets at such deep discounts.

This resulted in a significant increase in the level of nonperforming assets through March 31, 2010, with a continued elevated level of such assets through December 31, 2010. While nonperforming assets are still high, we have now experienced three consecutive quarters of a reduction with an overall reduction of 21.6% since the peak at March 31, 2010.

In addition, many of these loans are collateral dependent real estate loans for which we are required to write down the loans to fair value less estimated selling costs with the fair values determined primarily based on third party appraisals. During 2009 and 2010, appraised values decreased significantly, even in comparison to appraisals received when the loans were originated in 2006 to 2009, and upon reappraisal since origination. As a result, our evaluation of our loan portfolio and foreclosed assets in 2010 and 2009 resulted in significant credit losses.

Recent Regulatory Developments

As a result of these circumstances and the examination of the Supervisory Authorities in November 2009, the Bank agreed to the issuance of the Consent Order with the Supervisory Authorities effective on June 10, 2010. A summary of the requirements of the Consent Order and the Bank’s status on complying with the Consent Order is as follows:


Requirements of the Consent Order		Bank’s Compliance Status

Achieve and maintain, within 120 days from the effective date of the Consent Order, Total Risk Based capital at least equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% of total assets.		On October 7, 2010, the Company consummated the Private Placement pursuant to which the Company received gross proceeds of $103.9 million from the issuance of shares of the Company’s common stock. Substantially all of the net proceeds of the Private Placement were contributed to the Bank as a capital contribution, resulting in the Company’s and the Bank’s capital levels being above the amounts specified in the Consent Order and to be categorized as well-capitalized.


Requirements of the Consent Order		Bank’s Compliance Status

Determine, within 30 days of the last day of the calendar quarter, its capital ratios. If any capital measure falls below the established minimum, within 30 days provide a written plan to the supervisory authorities describing the means and timing by which the Bank shall increase such ratios to or in excess of the established minimums.		At December 31, 2010, as a result of the Private Placement consummated on October 7, 2010, as noted above, the Company received gross proceeds of $103.9 million from the issuance of shares of the Company’s common stock. Substantially all of the net proceeds of the Private Placement were contributed to the Bank as a capital contribution, resulting in the Bank’s capital levels being above the amounts specified in the Consent Order.

Establish, within 30 days from the effective date of the Consent Order, a plan to monitor compliance with the Consent Order, which shall be monitored by the Bank’s Board of Directors.		We have implemented a plan to monitor compliance with the Consent Order.

Develop, within 60 days from the effective date of the Consent Order, a written analysis and assessment of the Bank’s management and staffing needs.		We prepared a written analysis and assessment of the Bank’s management and staffing needs and submitted the plan to the Supervisory Authorities in August 2010.

Notify the supervisory authorities in writing of the resignation or termination of any of the Bank’s directors or senior executive officers.		We believe we have complied with this provision of the Consent Order.

Eliminate, within 10 days from the effective date of the Consent Order, by charge-off or collection, all assets or portions of assets classified “Loss” and 50% of those assets classified “Doubtful.”		We believe we have complied with this provision of the Consent Order.

Review and update, within 60 days from the effective date of the Consent Order, its policy to ensure the adequacy of the Bank’s allowance for loan and lease losses, which must provide for a review of the Bank’s allowance for loan and lease losses at least once each calendar quarter.		We believe we have complied with this provision of the Consent Order. We submitted our revised policy to the Supervisory Authorities in July 2010.

Submit, within 60 days from the effective date of the Consent Order, a written plan to reduce classified assets, which shall include, among other things, a reduction of the Bank’s risk exposure in relationships with assets in excess of $1,000,000 which are criticized as “Substandard,” “Doubtful,” or “Special Mention”.		As part of our Strategic Project Plan summarized below, we have developed written loan workout plans to reduce classified assets, and we submitted our plans to the Supervisory Authorities in July 2010. The Supervisory Authorities may also amend the requirements of the Consent Order based on the results of their ongoing examinations.

Revise, within 60 days from the effective date of the Consent Order, its policies and procedures for managing the Bank’s Adversely Classified Other Real Estate Owned.		As part of our Strategic Project Plan summarized below, we have revised our policies and procedures for managing our real estate acquired in foreclosure, and we submitted our policies and procedures to the Supervisory Authorities in July 2010.


Requirements of the Consent Order		Bank’s Compliance Status

Not extend any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified, in whole or in part, “Loss” or “Doubtful” and is uncollected. In addition, the Bank may not extend any additional credit to any borrower who has a loan or other extension of credit from the Bank that has been criticized, in whole or in part, “Substandard” or “Special Mention” and is uncollected, unless the Bank’s board of directors determines that failure to extend further credit to a particular borrower would be detrimental to the best interests of the Bank.		We believe we have complied with this provision of the Consent Order.

Perform, within 90 days from the effective date of the Consent Order, a risk segmentation analysis with respect to the Bank’s Concentrations of Credit and develop a written plan to systematically reduce any segment of the portfolio that is an undue concentration of credit.		As part of our Strategic Project Plan summarized below, we have performed a risk segmentation analysis of our concentrations of credit and developed a plan to reduce our concentration in commercial real estate. We continue to monitor our concentrations and, in particular, are working aggressively to reduce our concentrations in commercial real estate. We submitted our plan to the Supervisory Authorities in August 2010.

Review, within 60 days from the effective date of the Consent Order and annually thereafter, the Bank’s loan policies and procedures for adequacy and, based upon this review, make all appropriate revisions to the policies and procedures necessary to enhance the Bank’s lending functions and ensure their implementation.		As part of our Strategic Project Plan summarized below, in 2009 and 2010 we reviewed our loan policies and procedures for adequacy and made appropriate revisions to enhance our lending and credit administration functions. We have continued to refine our policies and procedures in 2010. We submitted the revised policy to the Supervisory Authorities in July 2010.

Adopt, within 60 days from the effective date of the Consent Order, an effective internal loan review and grading system to provide for the periodic review of the Bank’s loan portfolio in order to identify and categorize the Bank’s loans, and other extensions of credit which are carried on the Bank’s books as loans, on the basis of credit quality.		As part of our Strategic Project Plan summarized below, in 2009 and 2010 we reviewed our loan review and grading system to provide for the periodic review of our loan portfolio to review and categorize our loans. As described in more detail elsewhere in this report, we have conducted internal and external loan reviews in 2009 and 2010. We submitted the revised policy to the Supervisory Authorities in July 2010.


Requirements of the Consent Order		Bank’s Compliance Status

Review and update, within 60 days from the effective date of the Consent Order, its written profit plan to ensure the Bank has a realistic, comprehensive budget for all categories of income and expense, which must address, at minimum, goals and strategies for improving and sustaining the earnings of the Bank, the major areas in and means by which the Bank will seek to improve the Bank’s operating performance, realistic and comprehensive budgets, a budget review process to monitor income and expenses of the Bank to compare actual figure with budgetary projections, the operating assumptions that form the basis for and adequately support major projected income and expense components of the plan, and coordination of the Bank’s loan, investment, and operating policies and budget and profit planning with the funds management policy.		We have prepared annual budgets for 2010 and 2011 that were approved by the Bank’s Board of Directors. We submitted the budgets to the Supervisory Authorities in August 2010.

Review and update, within 60 days from the effective date of the Consent Order, its written plan addressing liquidity, contingent funding, and asset liability management.		As part of our Strategic Project Plan summarized below, in 2009 and 2010 we reviewed and updated our written Asset Liability and Investments Plan, and we submitted the plan to the Supervisory Authorities in July 2010.

Eliminate, within 30 days from the effective date of the Consent Order, all violations of law and regulation or contraventions of policy set forth in the FDIC’s safety and soundness examination of the Bank in November 2009.		At June 30, 2010, we had eliminated all matters set forth in the FDIC’s safety and soundness examination of the Bank in November 2009.

Not accept, renew, or rollover any brokered deposits unless it is in compliance with the requirements of 12 C.F.R. § 337.6(b).		Prior to and at December 31, 2010, the Bank did not have any brokered deposits.

Limit asset growth to 10% per annum.		We believe we have complied with this provision of the Consent Order.

Not declare or pay any dividends or bonuses or make any distributions of interest, principal, or other sums on subordinated debentures without the prior approval of the Supervisory Authorities.		We believe we have complied with this provision of the Consent Order.

Not offer an effective yield on deposits of more than 75 basis points over the national rates published by the FDIC weekly on its website unless otherwise specifically permitted by the FDIC.		We believe we have complied with this provision of the Consent Order. On April 1, 2010, we were notified by the FDIC that it had determined that the geographic areas in which we operate were considered high-rate areas. Accordingly, the Bank is able to offer interest rates on deposits up to 75 basis points over the prevailing interest rates in our geographic areas. The FDIC has informed us that this high-rate determination is also effective for calendar year 2011.


Requirements of the Consent Order		Bank’s Compliance Status

Furnish, by within 30 days from the effective date of the Consent Order and within 30 days of the end of each quarter thereafter, written progress reports to the supervisory authorities detailing the form and manner of any actions taken to secure compliance with the Consent Order.		We believe we have complied with this provision of the Consent Order, and we have submitted the required progress reports to the Supervisory Authorities.

We intend to take all actions necessary to enable the Bank to comply with the requirements of the Consent Order, and as of the date hereof we have submitted all documentation required thus far to the Supervisory Authorities. There can be no assurance that the Bank will be able to comply fully with the provisions of the Consent Order, and the determination of our compliance will be made by the Supervisory Authorities. However, we believe we are currently in compliance with all provisions of the Consent Order except for the requirement to reduce the total amount of our criticized assets at September 30, 2009 by a total of 75% by May 30, 2012. The Consent Order requires a reduction in criticized assets by specified percentages by certain dates, with the first date being December 7, 2010 when a 25% ($56.7 million) reduction in criticized assets was required. We reduced our criticized assets by more than the amount necessary to meet the December 6, 2010 deadline. Our next incremental deadline, June 7, 2011, stipulates a 45% ($102.0 million) reduction in criticized assets from the September 30, 2009 balances. As of February 22, 2011, we have reduced our criticized assets by 53.2% ($114.9 million). Failure to meet the requirements of the Consent Order could result in additional regulatory requirements, which could ultimately lead to the Bank being taken into receivership by the FDIC. In addition, the Supervisory Authorities may amend the Consent Order based on the results of their ongoing examinations.

Strategic Project Plan

In response to the challenging economic environment and our negative financial results and in preparation for a potential formal agreement from the banking regulatory agencies, in June 2009 the Board of Directors and management adopted and began executing a proactive and aggressive Strategic Project Plan (the “Plan”) to address the issues related to credit quality, liquidity, earnings, and capital. Execution of the Plan is being overseen by the special Regulatory Oversight Committee of the Board of Directors, and we have engaged external expertise to assist with its implementation. The Plan contemplated substantially all of the requirements of the Consent Order and therefore we believe we have already made substantial progress towards complying with the requirements of the Consent Order. However, certain provision of the Consent Order required us to submit written plans to the Supervisory Authorities for their review and / or approval, and all provisions of the Consent Order are subject to examination by the Supervisory Authorities in subsequent examinations.

Since June 2009, we have been, and continue to be, keenly focused on executing the Plan which now also reflects the requirements of the Consent Order. No one can predict the ongoing impact of the recession given its length and severity. However, it is our expectation that our hard work, the eventual improvement in the economy and the real estate markets, and raising additional capital, will help our borrowers and us weather this storm and continue our road to recovery and return to profitability.

Credit Quality. Given the negative asset quality trends within our loan portfolio, which began in 2008, accelerated during 2009, and continued throughout 2010, we have worked aggressively to identify and quantify potential losses and execute plans to reduce problem assets. The credit quality plan includes, among other things:

•

Performing detailed loan reviews of our loan portfolio in 2009 and 2010. The loan reviews were performed by management as well as by an independent loan review firm that reported their results directly to the Board of Directors. These internal and independent loan reviews will continue in 2011.

•

For problem loans identified, we prepared written workout plans that are borrower specific to determine how best to resolve the loans which could include restructuring the loans, requesting additional collateral, demanding payment from guarantors, sale of the loans, or foreclosure and sale of the collateral.

•

We also increased our monitoring of borrower and industry sector concentrations and are limiting additional credit exposure to these concentrations.

•

In July 2009, we hired a new Chief Credit Officer and reevaluated our lending policies and procedures and credit administration function and implemented significant enhancements. Among other changes, we reorganized our credit administration function, hired additional internal resources and external consulting assistance, and reorganized our line of business lending roles and responsibilities including separate designation of a commercial lending business with more direct oversight and clearer accountability.

•

In 2010, we hired additional personnel with expertise in problem asset workout and disposition, and in June 2010 we hired a seasoned department manager for our Special Assets Department which is now comprised of five individuals.

•

We are actively marketing problem assets for sale. Nonperforming assets declined $13.5 million (10.8%) during 2010, and by 21.6% since the peak at March 31, 2010. The decline during the fourth quarter 2010 was the third consecutive quarterly decline in nonperforming assets.

•

In September 2010, we decided to market for sale commercial loans totaling $90.9 million at September 30, 2010. During the fourth quarter of 2010, we sold five loans, representing two relationships, with a gross book value of $10.4 million, and we are continuing our efforts to sell the remaining loans held for sale. At December 31, 2010, we had commercial loans held for sale aggregating $66.2 million, of which $2.0 million were under contract for sale and expected to close in the first quarter 2011.

Liquidity. In June 2009, we implemented a forward-looking liquidity plan and increased our liquidity monitoring. The liquidity plan includes, among other things:

•

Implementing proactive customer deposit retention initiatives specific to large deposit customers and our deposit customers in general.

•

Executing targeted deposit growth and retention campaigns which resulted in retained and new certificates of deposit through June 30, 2010. Since June 30, 2010, our deposits have remained stable through our normal growth and retention efforts, and therefore we have not utilized any special campaigns. In addition, given our cash position, in the fourth quarter 2010 continuing into the first quarter 2011, we are not pursuing special CD campaigns and have reduced our deposit pricing to allow our higher priced CDs to roll off as they mature.

•

Evaluating our sources of available financing and identifying additional collateral for pledging for FHLB and Federal Reserve borrowings.

•

Accelerating the filing of our 2009 income tax refund claims resulting in refunds received totaling $20.9 million, all of which were received during the three month period ended March 31, 2010, reduced by $661 thousand as a result of the filing of an amended 2009 federal income tax return in June 2010.

•

Anticipated filing of our 2008 income tax refund claims for the carryback of net operating losses generated in 2010. The carryback of these losses is expected to result in the refund of $7.4 million of income taxes previously paid for the 2008 tax year. The refund is expected to be received in 2011.

•

During 2009 and most of 2010, maintaining cash received primarily from loan and security repayments invested in cash rather than being reinvested in other earning assets. Maintaining this cash balance has reduced our interest income by $4.7 million for the year ended December 31, 2010 when compared with investing these funds at the average yield of 2.75% on our investment securities. Following the consummation of our Private Placement on October 7, 2010, we have redeployed, through February 22, 2011, $96.0 million of this cash into investment securities and prepaid $91 million of FHLB advances which were scheduled to mature in January through April 2011.

At February 22, 2011, funding sources included cash invested at the Federal Reserve totaling $156.4 million, approximately $4.1 million in available repurchase agreement capacity, $82.8 million from the FHLB, and our correspondent bank line of credit totaling $5 million.

Capital. At December 31, 2010, as a result of the consummation of the Private Placement on October 7, 2010, all of our capital ratios exceeded the well-capitalized regulatory minimum thresholds and the requirements of the Consent Order. In addition, to preserve our capital, we have:

•

Not paid a dividend on our common stock since the first quarter of 2009.

•

Reduced our loan portfolio by $362.9 million and total assets by $48.3 million since March 31, 2009.

•

Evaluated other capital saving alternatives such as asset sales and reducing outstanding credit commitments.

•

Issued unsecured convertible debt from the Company in March 2010 of $380 thousand, the proceeds of which were contributed to the Bank as a capital contribution. On October 7, 2010, as a result of the Private Placement, these notes were converted into common stock of the Company.

•

As a condition of the Private Placement, conducted a $10 million follow-on common stock offering to our legacy shareholders as of October 6, 2010 and institutional investors in the Private Placement. The follow-on offering was fully subscribed resulting in the issuance of common stock for gross proceeds of $10.0 million in December 2010 and the first quarter 2011. The net proceeds of the offering were invested in the Bank.

Earnings. We have been implementing an earnings plan that is focused on improvement through a combination of revenue increases and expense reductions, including assistance from external consulting firms to review our current and potential new products and services and related rates and fees, and to identify process and efficiency improvements.

•

With respect to net interest income, we implemented risk-based loan pricing and interest rate floors on renewed and new loans meeting certain criteria. At December 31, 2010, loans aggregating $214.6 million had interest rate floors, of which $196.1 million had floors greater than or equal to 5%. In June and July 2010, we began loan specials intended to generate additional loan volume for residential mortgage, auto, credit card, consumer, and commercial loans. In light of the current low interest rate environment, we have also reduced the interest rates paid on our deposit accounts. Given expectations for rising interest rates, during 2010 we also borrowed longer-term advances from the FHLB, and extended maturities on certain CD specials to lock in the low interest rates at the time of the specials. In December 2010 and January 2011, we used excess cash earning 0.25 basis points to prepay $91.0 million of FHLB advances bearing interest at an average rate of 1.58%.

•

We are evaluating additional sources of noninterest income. For example, in March 2010, we introduced a new checking account, MyPal checking, and a new savings account, Smart Savings, both of which provide noninterest income resulting from service charges or debit card transactions. We also evaluated the profitability of all of our pre-existing checking accounts and in October 2010 upgraded a large number of unprofitable checking accounts to the MyPal account. In addition, we revised our existing fees and implemented new fees, with various implementation dates generally between October 1, 2010 and March 31, 2011.

•

We identified specific opportunities for noninterest expense reductions, which were realized in 2009 and 2010, and are continuing to review other expense areas for additional reductions. These expense reductions have been and will continue to be partially offset by the higher level of credit-related costs incurred due to legal, consulting, and carrying costs related to our higher level of nonperforming assets.

•

We continue to critically evaluate each of our businesses to determine their contribution to our financial performance and their relative risk / return relationship. Based on the evaluation to date, we sold two product lines during 2010. In March 2010, we sold our merchant services business and entered into a

referral and services agreement with Global Direct Payments, Inc. (“Global Direct”) related to our merchant services business which resulted in a net gain of $587 thousand. Similarly, in December 2010, we sold our credit card portfolio and entered into a joint marketing agreement with Elan Financial Services, Inc., which resulted in a net gain of $1.2 million.

Summary

In summary, during the year ended December 31, 2010, we continued to be impacted by the negative financial conditions of our borrowers and the economy in general, but we have also made substantial progress on the execution of the Strategic Project Plan adopted in June 2009. We completed a significant component of the Plan by consummation of the Private Placement on October 7, 2010. We believe that raising capital, combined with an improving economy and our continued focus on credit quality and earnings improvements, will accelerate our road to recovery and return to profitability in the post-recession environment. We believe that we may return to profitability, on a quarterly basis, at some point during 2012. However, as discussed in this report, our performance is subject to numerous risks and uncertainties, many of which are beyond our control, and we can provide no assurances regarding when or if we will return to profitability.

Financial Condition

During 2009 and 2010, we realigned our organizational structure and began the process of more specifically delineating our businesses. However, at this time we do not yet have in place a reporting structure to separately report and evaluate our various lines of businesses. Our organization structure delineation and more granular line of business management reporting efforts will continue in 2011. Accordingly, the discussion and analysis of our financial condition and results of operations herein is provided on a consolidated basis, with commentary on business specific implications if more granular information is available.

Overview

PALMETTO BANCSHARES, INC. AND SUBSIDIARY

Consolidated Balance Sheets

(dollars in thousands)


	December 31,						Dollar variance			Percent variance
	2010			2009			Dollar variance			Percent variance
Assets
Cash and cash equivalents
Cash and due from banks	$	223,017		$	188,084		$	34,933			18.6	%

Total cash and cash equivalents		223,017			188,084			34,933			18.6
FHLB stock, at cost		6,785			7,010			(225	)		(3.2	)
Investment securities available for sale, at fair value		218,775			119,986			98,789			82.3
Mortgage loans held for sale		4,793			3,884			909			23.4
Commercial loans held for sale		66,157			—			66,157			100.0
Loans, gross		793,426			1,040,312			(246,886	)		(23.7	)
Less: allowance for loan losses		(26,934	)		(24,079	)		(2,855	)		11.9

Loans, net		766,492			1,016,233			(249,741	)		(24.6	)
Premises and equipment, net		28,109			29,605			(1,496	)		(5.1	)
Goodwill		—			3,691			(3,691	)		(100.0	)
Accrued interest receivable		4,702			4,322			380			8.8
Foreclosed real estate		19,983			27,826			(7,843	)		(28.2	)
Income tax refund receivable		7,436			20,869			(13,433	)		(64.4	)
Deferred tax asset		—			5,799			(5,799	)		(100.0	)
Other		8,998			8,454			544			6.4

Total assets	$	1,355,247		$	1,435,763		$	(80,516	)		(5.6	)%

Liabilities and shareholders’ equity
Liabilities
Deposits
Noninterest-bearing	$	141,281		$	142,609		$	(1,328	)		(0.9	)%
Interest-bearing		1,032,081			1,072,305			(40,224	)		(3.8	)

Total deposits		1,173,362			1,214,914			(41,552	)		(3.4	)
Retail repurchase agreements		20,720			15,545			5,175			33.3
Commercial paper (Master notes)		—			19,061			(19,061	)		(100.0	)
FHLB borrowings		35,000			101,000			(66,000	)		(65.3	)
Accrued interest payable		1,187			2,020			(833	)		(41.2	)
Other		11,079			8,208			2,871			35.0

Total liabilities		1,241,348			1,360,748			(119,400	)		(8.8	)

Shareholders’ equity
Preferred stock		—			—			—			—
Common stock		474			32,282			(31,808	)		(98.5	)
Capital surplus		133,112			2,599			130,513			5,021.7
Retained earnings (deficit)		(13,108	)		47,094			(60,202	)		(127.8	)
Accumulated other comprehensive loss, net of tax		(6,579	)		(6,960	)		381			(5.5	)

Total shareholders’ equity		113,899			75,015			38,884			51.8

Total liabilities and shareholders’ equity	$	1,355,247		$	1,435,763		$	(80,516	)		(5.6	)%

Cash and Cash Equivalents

Cash and cash equivalents increased $34.9 million at December 31, 2010 over December 31, 2009 due primarily as a result of maintaining our excess cash with the Federal Reserve to provide liquidity, notwithstanding the negative impact to our interest income since we only earn 25 basis points on our deposits with the Federal Reserve versus investing this cash in higher earning assets. For the year ended December 31, 2010, the difference between the interest earned on the cash at the Federal Reserve at 25 basis points and the interest that could have been earned by investing this cash in the securities portfolio at the average yield on the portfolio of 2.75% was $4.7 million. Upon consummation of the Private Placement in October 2010, we began redeploying this cash balance by investing $100 million in investment securities in the fourth quarter 2010 and prepaying $91.0 million of FHLB advances in December 2010 and January 2011. We also plan to redeploy an additional $55 million into investment securities in the first quarter 2011. We believe that redeploying our excess cash will improve our net interest margin going forward.

Concentrations and Restrictions. In an effort to manage counterparty risk, we generally do not sell federal funds to other financial institutions because they are essentially uncollateralized loans. We regularly evaluate the risk associated with the counterparties to these potential transactions to ensure that we would not be exposed to any significant risks with regard to our cash and cash equivalent balances.

The following table summarizes cash and cash equivalents pledged as collateral and therefore restricted at the dates indicated (in thousands).


	December 31, 2010		December 31, 2009
Secure a letter of credit	$	—	$	512
Merchant credit card agreements		451		836

Total	$	451	$	1,348

FHLB Stock

We are a member of the FHLB of Atlanta, which is one of twelve regional FHLBs that administer home financing credit for depository institutions. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans or advances to members in accordance with policies and procedures, established by the Board of Directors of the FHLB, which are subject to the oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. At December 31, 2010, we had $35.0 million of outstanding advances from the FHLB under an available credit facility of 10% of assets, which is limited to available collateral. We have the capacity to borrow an additional $53.3 million from the FHLB based on available collateral as of December 31, 2010.

As an FHLB member, the Company is required to purchase and maintain stock in the FHLB. At December 31, 2010, we had $6.8 million in FHLB stock, which was in compliance with this requirement. No ready market exists for this stock, and it has no quoted market value. Purchases and redemptions are normally transacted each quarter to adjust our investment to the required amount based on the FHLB requirements, and requests for redemptions are met at the discretion of the FHLB. We have experienced no interruption in such redemptions. Historically, redemption of this stock has been at par value. Dividends are paid on this stock also at the discretion of the FHLB. We have received dividends on our FHLB stock and the average dividend yield for 2010 was 0.33%; however, there can be no guarantee of future dividends. The carrying value of FHLB stock approximates fair value. The carrying value of this stock was $7.0 million at December 31, 2009.

Investment Activities

General. Our primary objective in managing the investment portfolio is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns. We are required under federal regulations to maintain adequate liquidity to ensure safe and sound operations. We maintain investment balances based on a continuing assessment of cash flows, the level of loan production, current interest rate risk strategies, and the assessment of the potential future direction of market interest rate changes. Investment securities differ in terms of default, interest rate, liquidity, and expected rate of return risk.

Composition. The following table summarizes the composition of our investment securities available for sale portfolio at the dates indicated (dollars in thousands).


	December 31, 2010					December 31, 2009					December 31, 2008
	Total		% of total			Total		% of total			Total		% of total
U.S. Treasury and federal agencies	$	37,426		17.1	%	$	16,297		13.6	%	$	—		—	%
State and municipal		52,462		24.0			46,785		39.0			50,830		40.5
Collateralized mortgage obligations		108,171		49.4			40,318		33.6			54,639		43.5
Other mortgage-backed (federal agencies)		20,716		9.5			16,586		13.8			20,127		16.0

Total investment securities available for sale	$	218,775		100.0	%	$	119,986		100.0	%	$	125,596		100.0	%

Average balances of investment securities available for sale increased to $135.4 million during the year ended December 31, 2010 from $119.2 million during the same period of 2009. This increase was the result of purchases in July 2010 of U.S. Treasury and federal agencies purchased to acquire additional securities to pledge as collateral for FHLB borrowings, as well as reinvestment of our excess cash into securities in the fourth quarter 2010.

The fair value of the investment securities available for sale portfolio represented 16.1% of total assets at December 31, 2010 and 8.4% of total assets at December 31, 2009.

Through February 22, 2011, we purchased additional state and municipal, collateralized mortgage obligations, and other mortgage-backed investment securities aggregating approximately $53.3 million.

Unrealized Position. The following table summarizes the amortized cost and fair value composition of our investment securities available for sale portfolio at the dates indicated (dollars in thousands).


	December 31, 2010				December 31, 2009				December 31, 2008
	Amortized cost		Fair value		Amortized cost		Fair value		Amortized cost		Fair value
U.S. Treasury and federal agencies	$	37,430	$	37,426	$	16,294	$	16,297	$	—	$	—
State and municipal		51,243		52,462		44,908		46,785		50,297		50,830
Collateralized mortgage obligations		107,876		108,171		42,508		40,318		58,033		54,639
Other mortgage-backed (federal agencies)		20,189		20,716		15,783		16,586		19,876		20,127

Total investment securities available for sale	$	216,738	$	218,775	$	119,493	$	119,986	$	128,206	$	125,596

U.S. Treasury and federal agency securities are government debts issued by the U.S. Treasury through the Bureau of the Public Debt. U.S. Treasury and federal agency securities are the debt financing instruments of the U.S. federal government. Our U.S. Treasury and federal agency securities are very liquid and are heavily traded.

State and municipal investment securities are debt investment securities issued by a state, municipality, or county in order to finance its capital expenditures. The most substantial risk associated with buying state and

municipal investment securities is the financial risk associated with the municipality from which the securities are purchased. Although municipal bonds in smaller municipalities can sometimes be difficult to sell quickly, we do not currently anticipate that we will liquidate this portfolio in the near term.

Collateralized mortgage obligations are a mortgage-backed security sub-type in which the mortgages are ordered into tranches by some quality (such as repayment time) with each tranche sold as a separate security. These mortgage-backed securities separate the mortgage pools into short, medium, and long-term tranches. Our collateralized mortgage obligations are all fixed rate and are paid a fixed rate of interest at regular intervals. Monthly fluctuations in income occur only as there are changes in amortization or accretions due to changes in prepayment speeds.

Other mortgage-backed investment securities include investment instruments that represent ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the mortgage-backed investment security. Monthly income from other mortgage-backed investment securities may fluctuate as interest rates change due to the volume of mortgage prepayments.

We use prices from third party pricing services and, to a lesser extent, indicative (non-binding) quotes from third party brokers, to measure fair value of our investment securities. We utilize multiple third party pricing services and brokers to obtain fair values; however, we generally obtain one price / quote for each individual security. For securities priced by third party pricing services, we determine the most appropriate and relevant pricing service for each security class and have that vendor provide the price for each security in the class. We record the unadjusted value provided by the third party pricing service / broker in our Consolidated Financial Statements, subject to our internal price verification procedures.

Pledged. Public depositors from state and local municipalities typically require that the Bank pledge investment grade securities to the accounts to ensure repayment. Although the funds are usually a low cost, relatively stable source of funding for the Bank, availability depends on the particular government’s fiscal policies and cash flow needs.

Investments securities were pledged as collateral for the following at the dates indicated (in thousands).


	December 31, 2010		December 31, 2009
Public funds deposits	$	67,260	$	73,185
Federal funds from correspondent banks		—		6,300
FHLB advances and line of credit		48,344		29,767

Total	$	115,604	$	109,252

Other-Than-Temporary Impairment. The following tables summarize the number of securities in each category of investment securities available for sale, the fair value, and the gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at the dates indicated (dollars in thousands).


	December 31, 2010
	Less than 12 months						12 months or longer						Total
	#		Fair value		Gross unrealized losses		#		Fair value		Gross unrealized losses		#		Fair value		Gross unrealized losses
U.S. Treasury and federal agencies		2	$	21,428	$	6		—	$	—	$	—		2	$	21,428	$	6
State and municipal		12		7,211		468		—		—		—		12		7,211		468
Collateralized mortgage obligations		10		38,295		376		—		—		—		10		38,295		376
Other mortgage-backed (federal agencies)		3		6,861		120		—		—		—		3		6,861		120

Total investment securities available for sale		27	$	73,795	$	970		—	$	—	$	—		27	$	73,795	$	970


	December 31, 2009
	Less than 12 months						12 months or longer						Total
	#		Fair value		Gross unrealized losses		#		Fair value		Gross unrealized losses		#		Fair value		Gross unrealized losses
U.S. Treasury and federal agencies		1	$	300	$	—		—	$	—	$	—		1	$	300	$	—
State and municipal		2		662		3		—		—		—		2		662		3
Collateralized mortgage obligations		3		10,323		412		6		16,624		1,946		9		26,947		2,358
Other mortgage-backed (federal agencies)		2		1,444		35		—		—		—		2		1,444		35

Total investment securities available for sale		8	$	12,729	$	450		6	$	16,624	$	1,946		14	$	29,353	$	2,396

Gross unrealized losses decreased $1.4 million from December 31, 2009 to December 31, 2010, primarily within the collateralized mortgage obligation sector of the investment securities portfolio. Eleven collateralized mortgage obligations were sold during the year ended December 31, 2010. The gross unrealized losses on the sold collateralized mortgage obligations totaled $2.0 million at December 31, 2009.

Based on our other-than-temporary impairment analysis at December 31, 2010, we concluded that gross unrealized losses detailed in the preceding table were not other-than-temporarily impaired as of that date.

Based on our other-than-temporary impairment analysis at December 31, 2009, one collateralized mortgage obligation with a fair value of $2.3 million and amortized cost of $3.3 million was other-than-temporarily impaired. We reached this conclusion based on the fair value of the security being below the amortized cost and our analysis of broker-provided fair values as verified by other external sources. Due to the fact that at the time of the analysis we did not intend to sell this security nor was it more likely than not that we would have to sell the security prior to the recovery of its amortized cost basis less any current period credit loss, the amount of impairment related to credit loss was recognized in earnings and the amount of impairment related to other matters was recognized in other comprehensive income. For the year ended December 31, 2009, a $49 thousand other-than-temporary credit impairment was recognized in Other noninterest expense in the Consolidated Statements of Income (Loss).

Fair values of the investment securities portfolio could decline in the future if the underlying performance of the collateral for collateralized mortgage obligations or other securities deteriorates and the levels do not provide sufficient protection for contractual principal and interest. As a result, there is risk that additional other-than-temporary impairments may occur in the future particularly in light of the current economic environment.

Ratings. The following table summarizes Moody’s Investors Service’s (“Moody’s”) ratings, by segment, of the investment securities available for sale based on fair value, at December 31, 2010. An Aaa rating is based not only on the credit of the issuer, but may also include consideration of the structure of the securities and the credit quality of the collateral.


	U.S. Treasury and federal agencies			State and municipal			Collateralized mortgage obligations			Other mortgage-backed (federal agencies)
Aaa		100	%		8	%		100	%		100	%
Aa1-A1		—			64			—			—
Baa1		—			10			—			—
Not rated or withdrawn rating		—			18			—			—

Total		100	%		100	%		100	%		100	%

Of the state and municipal investment securities not rated or with withdrawn ratings by Moody’s at December 31, 2010, 24% were rated AAA by Standard and Poor’s, 47% were rated AA+, 22% were rated AA, 5% were rated AA-, and 2%, or $204 thousand, were not rated by Standard and Poor’s.

Maturities. The following table summarizes the maturity distribution schedule with corresponding weighted-average yields of amortized cost of investment securities available for sale at and for the period ended December 31, 2010 (dollars in thousands). Weighted-average yields have not been computed on a fully taxable-equivalent basis. Collateralized mortgage obligations and other mortgage-backed securities are included in maturity categories based on their stated maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.


	Amortized cost		Book yield
U.S. Treasury and federal agencies
In one year or less	$	37,430		0.2	%
After 1 through 5 years		—		—
After 5 through 10 years		—		—
After 10 years		—		—

Total U.S. Treasury and federal agencies		37,430		0.2
State and municipal
In one year or less		3,389		3.3
After 1 through 5 years		24,924		3.5
After 5 through 10 years		13,220		3.5
After 10 years		9,710		3.1

Total state and municipal		51,243		3.4
Collateralized mortgage obligations
In one year or less		—		—
After 1 through 5 years		—		—
After 5 through 10 years		12,564		1.5	%
After 10 years		95,312		1.7	%

Total collateralized mortgage obligations		107,876		1.6	%
Other mortgage-backed (federal agencies)
In one year or less		—		—
After 1 through 5 years		49		4.0
After 5 through 10 years		2,639		5.2
After 10 years		17,501		4.1

Total other mortgage-backed (federal agencies)		20,189		4.2

Total investment securities available for sale	$	216,738		1.2	%

The weighted average life of investment securities available for sale was 3.0 years, based on expected prepayment activity, at December 31, 2010. Since 59% of the portfolio, based on amortized cost, is collateralized mortgage obligations or other mortgage-backed securities, the expected remaining maturity may differ from contractual maturity because borrowers generally have the right to prepay obligations before the underlying mortgages mature. Given the general expectation of a rising interest rate environment, we are intentionally investing in shorter-term duration securities to minimize our interest rate risk if interest rates begin to rise.

Concentrations. The following table summarizes issuer concentrations of collateralized mortgage obligations whose aggregate book values exceed 10% of shareholders’ equity at December 31, 2010 (dollars in thousands).


Issuer	Aggregate fair value		Aggregate amortized cost		Amortized cost as a % of shareholders’ equity
Freddie Mac	$	30,226	$	30,112		26.4	%
Fannie Mae		24,930		24,934		21.9	%
Ginnie Mae		50,387		50,394		44.2	%

The following table summarizes issuer concentrations of other mortgage-backed investment securities whose book values exceed 10% of shareholders’ equity at December 31, 2010 (dollars in thousands).


Issuer	Aggregate fair value		Aggregate amortized cost		Amortized cost as a % of shareholders’ equity
Fannie Mae	$	15,523	$	15,014		13.2	%

Realized Gains and Losses. The following table summarizes the gross realized gains and losses on investment securities available for sale for the periods indicated (in thousands).


	For the years ended December 31,
	2010			2009		2008
Realized gains	$	1,149		$	2	$	1
Realized losses		(1,139	)		—		—

Net realized gains	$	10		$	2	$	1

Lending Activities

General. Loans continue to be the largest component of our assets. During the year ended December 31, 2010, gross loans declined approximately $246.9 million (23.7%), including the net transfer of $84.9 million commercial real estate loans to the held for sale portfolio in 2010, as we actively seek to reduce our commercial real estate loan portfolio to improve our credit quality and preserve capital. Based on our risk assessment of borrowers, we also implemented risk-based loan pricing and interest rate floors, or minimum interest rates, both at origination and renewal. In addition, we are proactively addressing the reduction of our nonperforming assets through restructurings, charge-offs, and sales.

Commercial Loans Held for Sale. In September 2010, we decided to market for sale commercial loans totaling $90.9 million at September 30, 2010, and we are evaluating the bids received on a loan by loan basis. In general, we believe potential buyers are making bids at heavily discounted prices given the need for the banking industry in general and our Company in particular to deleverage commercial real estate assets. We believe this was particularly true in the fourth quarter of 2010 as banks sought to rid themselves of problem assets prior to year end. In many cases, we have not accepted such discounted bids. In certain cases, however, we are making the strategic decision to sell certain assets at amounts less than their recorded book values to continue to reduce our criticized assets and concentration in commercial real estate as required by the Consent Order.

During the fourth quarter of 2010, we entered into contracts to sell loans with a gross book value of $13.9 million, of which $10.4 million closed in the fourth quarter. During the fourth quarter of 2010, we transferred $6.0 million of commercial loans held for sale back to loans held for investment, as our intentions with respect to these loans had changed. We are continuing our efforts to sell the remaining loans held for sale. At December 31, 2010, we had commercial loans held for sale aggregating $66.2 million, of which $2.0 million were under contract for sale and expected to close in the first quarter 2011. Writedowns of $1.1 million were recorded in the fourth quarter 2010 to reduce the value of these assets to fair value, some of which were based on the contract values, less estimated costs to sell.

The loans held for sale were marketed for sale by loan sale advisory firms and through our own efforts, and we made the strategic decision in the fourth quarter to accept bids on certain loans that were lower than their appraised values which were the basis for their initial carrying amounts in loans held for sale. In making this decision, we attempted to balance the negative capital impact of selling loans at a loss with the positive impact of reducing our nonperforming assets, with the reduction in nonperforming assets also a requirement of the Consent Order.

At December 31, 2010, commercial loans held for sale are carried at the lower of cost or fair value, and a valuation allowance of $2.3 million is recorded against the loans held for sale resulting in a net carrying amount in the Consolidated Balance Sheets of $66.2 million. Of the aggregate balance of commercial loans held for sale, 98.6% are commercial real estate loans based on FDIC code.

Loans Composition. Disclosure guidance related to a company’s allowance for loan losses and the credit quality of its financing receivables require the loans and allowance for loan losses disclosures to be provided on a disaggregated basis. This disaggregated basis has been defined as portfolio segments, the level at which we develop and document our methodology to determine our allowance for loan losses, and classes, a level of information below the portfolio segment that provides an understanding as to the nature and extent of exposure in our loan portfolio. For reporting purposes, loan classes are based on FDIC code, and portfolio segments are an aggregation of those classes based on the way we develop and document our allowance for loan losses. FDIC codes are based on the underlying loan collateral.

The following table summarizes gross loans, categorized by portfolio segment, at the dates indicated (dollars in thousands).


	December 31, 2010						December 31, 2009					December 31, 2008					December 31, 2007					December 31, 2006
	Total			% of total			Total		% of total			Total		% of total			Total		% of total			Total		% of total
Commercial real estate	$	573,822			66.8	%	$	695,263		66.8	%	$	781,745		67.5	%	$	659,615		63.2	%	$	559,748		59.2	%
Single-family residential		178,980			20.8			203,330		19.6			217,734		18.8			209,274		20.0			156,238		16.5
Commercial and industrial		47,812			5.6			61,788		5.9			73,609		6.4			77,555		7.4			126,742		13.4
Consumer		52,652			6.1			76,296		7.3			79,295		6.8			93,983		9.0			101,098		10.7
Other		6,317			0.7			3,635		0.4			6,097		0.5			4,343		0.4			2,087		0.2

Total loans	$	859,583			100.0	%	$	1,040,312		100.0	%	$	1,158,480		100.0	%	$	1,044,770		100.0	%	$	945,913		100.0	%

Less: Commercial loans held for sale		(66,157	)					—					—					—					—

Loans, gross	$	793,426					$	1,040,312				$	1,158,480				$	1,044,770				$	945,913

Loans included in the preceding loan composition table are net of participations sold. Participations sold totaled $12.5 million (2 loans) at both December 31, 2010 and 2009, respectively. With regard to participations sold, we serve as the lead bank and are therefore responsible for certain administration and other management functions as agent to the participating banks. We are in active discussions with the participating banks to keep them informed of the status of these loans and determine loan workout plans.

Mortgage loans serviced for the benefit of others amounted to $423.6 million and $426.6 million at December 31, 2010 and December 31, 2009, respectively, and are not included in our Consolidated Balance Sheets.

Underwriting. General. There are inherent risks associated with our lending activities. Prudent risk taking requires sound policies intended to manage the risk within the portfolio and control processes intended to ensure compliance with those policies. We continue to review our lending policies and procedures and credit administration function. During 2009 and 2010, we implemented several enhancements, including centralized controls over construction draws, reduction of lending limit approval authorities, prohibition of out-of-market loans to borrowers for which we do not have a previously existing relationship, hiring and reassignment of personnel with expertise in credit administration and special assets management, and internal and external training in areas of negotiation and financial statement analysis.

We do not generally originate loan in excess of 100% of collateral value, offer loan payment arrangements resulting in negative amortization, engage in lending practices subjecting borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.), nor do we offer loan payment arrangements with minimum payments that are less than accrued interest.

Loan Scoring and Approval. We have established and follow guidelines with regard to the scoring and approval of loans. Our loan approval process is multi-layered and incorporates a computer-based scoring analysis for all consumer loans and all commercial loans whereby the total corporate exposure is less than $500 thousand. All commercial loans with total corporate exposure greater than or equal to $500 thousand are reviewed and approved by individuals with the process and our officer’s credit committee if greater than $5.0 million, and, if over certain higher limits, by the Board of Directors.

Monitoring and Validation. Compliance with our underwriting policies and procedures is monitored through a loan approval and documentation review process and the resulting exception reports.

We perform, internally and through the use of an independent third party, independent loan reviews to validate our loan risk program on a periodic basis. Although all of the loans within our loan portfolio are included in the population from which to select loans subject to review, commercial real estate loans are given more weight in the loan review selection process as a result of their risk characteristics and their concentration within our loan portfolio. Loan review reports are submitted to the management Credit Committee and the Board of Directors, and the third party loan review firm meets independently with the Credit Committee of the Board of Directors. The loan review process complements and reinforces our risk identification and assessment decisions.

Given our significant credit losses in 2009 and 2010, we implemented several enhancements including detailed loan reviews, written workout plans for problem loans, increased monitoring of borrower and industry sectors, hiring and reassignment of personnel with expertise in credit administration and special assets management, and active marketing and reduction of problem assets from our portfolio. During 2009 and 2010, we also significantly enhanced our internal loan reporting and reporting to the Board of Directors.

Commercial Real Estate. Commercial real estate loans are subject to underwriting standards and processes similar to commercial business loans with additional standards with regard to real estate collateral. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. We monitor and evaluate commercial real estate loans based on collateral type. In addition, we analyze the loans based on owner occupied commercial real estate loans versus nonowner occupied loans.

We make commercial real estate loans to businesses within varying industry sectors. Interest rates charged on these real estate loans are determined by market conditions existing at the time of the loan commitment. Generally, loans have adjustable rates, although the rate may be fixed, generally for three to five years, for the term of the loan depending on market conditions, collateral, and our relationship with the borrower. Amortization of commercial and installment real estate loans varies but typically does not exceed 20 years. Normally, we have collateral securing real estate loans appraised by independent third party appraisers prior to originating the loan.

We originate loans to developers and builders that are secured by nonowner occupied properties. Such loans are typically approved based on predetermined loan-to-collateral values. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates, and / or financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and values associated with the complete projects and often involve the disbursement of funds with repayment dependent on the success of the ultimate project. Sources of repayment for these types of loans may be precommitted permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from us until permanent financing is obtained. We monitor these loans by conducting onsite inspections. During 2009 and 2010, we centralized the oversight and disbursement of construction draws to contractors working for borrowers, and we hired a construction draw manager to review advance requests before funds are advanced to borrowers. We believe that these loans have higher risks than other real estate loans because their repayment is sensitive to interest rate changes, governmental regulation of real property, general economic and market conditions, and the availability of long-term financing particularly in the current economic environment. During 2009 and 2010, the higher risk nature of these loans was evidenced by the higher concentration of charge-offs of these types of loans.

Commercial and Industrial. Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably while prudently expanding the borrower’s business. Underwriting standards are designed to promote relationship banking rather than transactional banking. If we believe that the borrower’s management possesses sound ethics and solid business acumen, we examine current and projected cash flows to determine the likelihood that the borrower will repay its obligations as agreed. Commercial and industrial loans are primarily made based on the projected cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The actual cash flows of borrowers, however, may not be as expected, and the collateral securing loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and generally incorporate a personal guarantee. However, we make some short-term loans on an unsecured basis. In the case of loans secured by accounts receivable or inventory, the availability of funds for the repayment of these loans may depend substantially on the ability of the borrower to collect amounts due from its customers or to liquidate inventory at sufficient prices. During 2009 and 2010, we increased our procedures for monitoring loans secured by commercial and industrial collateral by centralizing the monitoring of all accounts receivable and inventory lines under Credit Underwriting, which monitors and tests the collateral. Also, as each loan matures and is considered for renewal, we place a defined monitoring schedule in the approval package and track it centrally for adherence to our policy. Results are reported to the management Credit Committee on a quarterly basis.

Our commercial and industrial loans are generally made with terms that do not exceed five years. Such loans may have fixed or variable interest rates with variable rates that change at periods ranging from one day to one year based on the prime lending rate as the interest rate index.

Single-family Residential. Underwriting standards for single-family real estate purpose loans are heavily regulated by statutory requirements, which include, but are not limited to, maximum loan-to-value percentages.

Our mortgage lenders make both fixed-rate and adjustable-rate single-family mortgage loans with terms generally ranging from 10 to 30 years. We may offer loans that have interest rates that adjust annually or adjust annually after being fixed for a period of several years in accordance with a designated index.

Adjustable-rate mortgage loans may be originated with a limit on any increase or decrease in the interest rate per year further limited by the amount by which the interest rate can increase or decrease over the life of the loan. In order to encourage the origination of adjustable-rate mortgage loans with interest rates that adjust annually, we generally offer a more attractive rate of interest on such loans than on fixed-rate mortgage loans.

Effective January 1, 2010, to better manage our regulatory compliance and provide more consistent underwriting and loan pricing, we began originating all new single-family first mortgage and closed-end second mortgage loans through our Mortgage department rather than through our branch network.

A large percentage of our originated single-family mortgage loans are underwritten pursuant to guidelines that permit the sale of these loans in the secondary market to government or private agencies. We participate in secondary market activities by selling whole loans and participations in loans primarily to the FHLB under its Mortgage Partnership Program and Freddie Mac. This practice enables us to satisfy demand for these loans in our local communities, to meet our asset and liability objectives and to develop a source of fee income through the servicing of these loans. We may sell fixed-rate, adjustable-rate, and balloon-term loans. Based on current interest rates as well as other factors, we normally sell most of our originations of conforming residential mortgage loans to Freddie Mac and retain the servicing of the underlying loans. Recently, there has been extensive media reporting related to potential recourse relating to residential mortgage loan sales. In certain loan sales, we provide recourse whereby we are required to repurchase loans on the occurrence of certain specific events. In 2009 and 2010, we repurchased three loans associated with our mortgage loan sales, and at December 31, 2010 we do not believe we have any outstanding obligations to repurchase mortgage loans previously sold.

To protect against declines in collateral value, when we originate and underwrite single-family mortgage loans to be retained in our residential mortgage portfolio, if the loan exceeds 80% of the collateral value, we generally require private mortgage insurance that protects us against losses of at least 20% of the mortgage loan amount.

Consumer. Our loan scoring and approval policies and procedures, as outlined previously, coupled with relatively small loan amounts that are spread across many individual borrowers, minimize risk within the consumer sectors of our loan portfolio.

Pledged. To borrow from the FHLB, members must pledge collateral. Acceptable collateral includes, among other types of collateral, a variety of residential, multifamily, home equity lines and second mortgages, and commercial loans. At December 31, 2010 and 2009, $346.3 million and $407.0 million of gross loans were pledged to collateralize FHLB advances and letters of credit, respectively, of which $92.5 million and $162.0 million, respectively, was available as lendable collateral.

At December 31, 2010 and December 31, 2009, $10.9 million and $ 108.8 million, respectively, of loans were pledged as collateral to cover the various Federal Reserve System services that we utilize.

Concentrations. General. During 2009 and continuing into 2010, we increased our monitoring of borrower and industry sector concentrations and are limiting additional credit exposure to these concentrations, in particular the segments of our loan portfolio secured by commercial real estate. In addition, we are proactively executing loan workout plans with a particular focus on reducing our concentrations in these segments. In addition, we are evaluating the potential sale, individually or in bulk, of performing and nonperforming commercial loans. In September 2010, we decided to market for sale commercial loans to reduce our nonperforming assets and concentration in commercial real estate. During the fourth quarter of 2010, we sold five loans, representing two relationships, with a gross book value of $10.4 million and we are continuing our efforts to sell the remaining commercial loans held for sale. At December 31, 2010, commercial loans held for sale aggregated $66.2 million, of which $2.0 million were under contract for sale and expected to close in the first quarter 2011. Sale of these loans is reducing our commercial real estate concentration.

Loan Type/Industry Concentration. The following table summarizes loans secured by commercial real estate, categorized by FDIC code, at December 31, 2010 (dollars in thousands).


	Commercial real estate included in gross loans		Commercial real estate included in commercial loans held for sale		Total commercial real estate loans		% of gross loans and commercial loans held for sale			% of Bank’s total regulatory capital
Secured by commercial real estate
Construction, land development, and other land loans	$	125,331	$	11,122	$	136,453		15.9	%		104.5	%
Multifamily residential		18,327		7,943		26,270		3.1			20.1
Nonfarm nonresidential		364,939		46,160		411,099		47.8			314.7

Total loans secured by commercial real estate	$	508,597	$	65,225	$	573,822		66.8	%		439.3	%

The following table further categorizes loans secured by commercial real estate at December 31, 2010 (dollars in thousands).


	Commercial real estate included in gross loans		Commercial real estate included in commercial loans held for sale		Total commercial real estate loans		% of gross loans and commercial loans held for sale			% of Bank’s total regulatory capital
Development commercial real estate loans
Secured by:
Land—unimproved (commercial or residential)	$	46,286	$	2,174	$	48,460		5.7	%		37.1	%
Land development—commercial		12,676		463		13,139		1.5			10.1
Land development—residential		45,858		7,939		53,797		6.3			41.2
Commercial construction:
Retail		4,425		—		4,425		0.5			3.4
Office		241		—		241		—			0.2
Multifamily		1,693		—		1,693		0.2			1.3
Industrial and warehouse		947		—		947		0.1			0.7
Miscellaneous commercial		3,275		—		3,275		0.4			2.4

Total development commercial real estate loans		115,401		10,576		125,977		14.7			96.4
Existing and other commercial real estate loans
Secured by:
Hotel / motel		62,036		33,533		95,569		11.1			73.2
Retail		17,650		6,375		24,025		2.8			18.4
Office		23,469		1,656		25,125		2.9			19.2
Multifamily		18,327		7,943		26,270		3.1			20.1
Industrial and warehouse		11,538		1,488		13,026		1.5			10.0
Healthcare		13,008		—		13,008		1.5			10.0
Miscellaneous commercial		119,191		2,637		121,828		14.2			93.3
Residential construction—speculative		820		546		1,366		0.2			1.0

Total existing and other commercial real estate loans		266,039		54,178		320,217		37.3			245.2
Commercial real estate owner occupied and residential loans
Secured by:
Commercial—owner occupied		118,046		471		118,517		13.8			90.7
Commercial construction—owner occupied		3,525		—		3,525		0.4			2.7
Residential construction—contract		5,586		—		5,586		0.6			4.3

Total commercial real estate owner occupied and residential loans		127,157		471		127,628		14.8			97.7

Total loans secured by commercial real estate	$	508,597	$	65,225	$	573,822		66.8	%		439.3	%

Geographic Concentration. Unlike larger national or regional banks that are more geographically diversified, we primarily provide our services to customers within our market area. Deterioration in local economic conditions could result in declines in asset quality, loan collateral values, or the demand for our products and services, among other things. In addition, during 2006 to 2008, we originated out-of-market loans, purchased participation loans from other banks, and / or obtained brokered loans brought to us by loan brokers, which were generally to non-customers for whom we had no pre-existing banking relationship. In connection with our 2009 and 2010 loan portfolio and lending practices reviews, we determined that out-of-market loans were a significant contributing factor to our increased credit losses and, as such, no longer originate such loans.

Although our geographic concentration limits us to the economic risks within our market area, our lack of geographic diversification may make it particularly sensitive to adverse impacts of negative economic conditions that impact our market area.

Maturities and Sensitivities of Loans to Changes in Interest Rates. The following table summarizes our total loan portfolio, including mortgage and commercial loans held for sale, by portfolio segment, at December 31, 2010 that, based on contractual terms, were due during the periods noted. Loans having no stated maturity and no stated schedule of repayment, except for equity lines of credit, are reported as due in one year or less. Equity lines of credit are mortgage loans intended to be long-term real estate consumer products and are reported as due after five years. The table also summarizes our loan portfolio at December 31, 2010 with regard to fixed-rate and variable-rate maturity or repricing terms due in periods after one year (in thousands).


	Maturity or Repricing Term								Rate structure for loans with maturities or repricing terms over one year
	Due in one year or less		Due after one year through five years		Due after five years		Total		Fixed-rate		Variable- rate
Commercial real estate	$	239,384		294,632		39,806		573,822		334,438		—
Single-family residential		55,380		41,721		86,672		183,773		104,611		23,782
Commercial and industrial		24,624		21,488		1,700		47,812		23,188		—
Consumer		5,008		41,652		5,992		52,652		47,644		—
Other		3,063		2,088		1,166		6,317		3,254		—

Total loans, including mortgage and commercial loans held for sale	$	327,459		401,581		135,336		864,376		513,135		23,782

Asset Quality. Given the negative credit quality trends which began in 2008, accelerated during 2009, and continued into 2010, we have performed extensive analysis of our nonconsumer loan portfolio, with particular focus on commercial real estate loans. The analyses included internal and external loan reviews that required detailed, written analyses for the loans reviewed and vetting of the risk rating, accrual status, and collateral valuation of the loans by the loan officers, our senior management team, external consultants, and an external loan review firm. Of particular significance is that these reviews have currently identified 30 specifically identified borrower relationships (43 individual loans) that have resulted in $70.7 million (63%) of the $112.9 million of net loan charge-offs, writedowns on loans held for sale, and writedowns on foreclosed assets recorded in the past eight quarters. In general, these loans, have one or more of the following common characteristics:

•

Individually larger commercial real estate loans originated in 2004 through 2008 that were larger and more complex loans than we historically originated.

•

Out-of-market loans, participated loans purchased from other banks, or brokered loans brought to us by loan brokers, which were generally to non-customers for whom we generally had no pre-existing banking relationship.

•

Concentrated originations in commercial real estate, including acquisition development and construction loans, by loan officers who did not have the level of specialized expertise necessary to more effectively underwrite and manage these types of loans.

In general, our entire commercial real estate loan portfolio has been impacted by the challenging economic environment in 2008, 2009, and 2010. However, this pool of loans is the primary contributor to our deteriorated asset quality, charge-offs, and resulting net loss over the past eight quarters. In addition, this pool of loans has exhibited a loss given default much higher than the remainder of the loan portfolio that is comprised of in-market loans to our ongoing customers that were underwritten by loan officers using our normal credit underwriting standards. Accordingly, as we evaluate the credit quality of the remaining loan portfolio, we do not currently believe that the higher loss rate incurred on this particular pool of loans is indicative of the loss rate to be incurred on the remainder of the loan portfolio.

As part of the credit quality plan, to continue to address the impact of the economic environment on our loan portfolio, we are continuing our detailed review of the loan portfolio and are focused on executing detailed loan workout plans for all of our problem loans led by a team of seasoned commercial lenders and using external loan workout consulting expertise. It is clear that many of our borrowers are continuing to face financial stress manifesting itself in the following ways:

•

Cash flows from the underlying properties supporting the loans decreased,

•

Personal cash flows from the borrowers themselves and guarantors under pressure due to illiquid and diminished personal balance sheets resulting from investing additional personal capital in the projects, and

•

Fair values of real estate related assets declining, resulting in lower cash proceeds from sales or fair values declining to the point that borrowers are no longer willing to sell the assets at such deep discounts.

We also continue to review our lending policies and procedures and credit administration function. To this end, during 2009 and 2010 we implemented several enhancements as follows:

•

Construction draws: In 2009, we centralized the oversight and disbursement of construction draws to contractors working for borrowers, and hired a construction draw manager to review advance requests before funds are advanced to borrowers.

•

Loan Policy: In 2009 and 2010, we amended our loan policy to, among other changes, reduce lending limit approval authorities, prohibit out-of-market loans to borrowers for which we do not have a previously existing relationship, and prohibit brokered loans.

•

Credit Administration: In 2009, we hired a new Chief Credit Officer who brings over 25 years of credit administration, loan review, and credit policy experience to the Company; we reassigned two commercial lenders to credit analysts in the Credit Administration department; and we hired an additional Credit Administration executive.

•

Special Assets: In 2009 and 2010, we engaged two external workout consultants (who have since completed their engagements); reassigned a commercial lender; hired two experienced special assets professionals, and we hired a seasoned department leader to manage our Special Assets Department. This department is currently comprised of five people and these internal personnel and external consultants have been focused exclusively on accelerated resolution of our problem assets.

•

Training: During 2010, we conducted additional training including external specialists in the areas of problem loan workout and negotiating skills, analysis of personal financial statements and business tax returns, cash flow analysis, perfecting security interests in collateral, and appraisals.

Delinquent Loans. We determine past due and delinquent status based on contractual terms. When a borrower fails to make a scheduled loan payment, we attempt to cure the default through several methods including, but not limited to, collection contact and assessment of late fees. If these methods do not result in the borrower remitting the past due payment, further action may be taken. Interest on loans deemed past due continues to accrue until the loan is placed in nonaccrual status.

Nonperforming Assets. Nonaccrual loans are those loans that we have determined offer a more than normal risk of future uncollectibility. In most cases, loans are automatically placed in nonaccrual status by the loan system when the loan payment becomes 90 days delinquent and no acceptable arrangement has been made between us and the borrower. Loans may be manually placed in nonaccrual status if we determine that some factor other than delinquency (such as imminent foreclosure or bankruptcy proceedings) causes us to believe that more than a normal amount of risk exists with regard to collectability. When the loan is placed in nonaccrual status, accrued interest income is reversed based on the effective date of nonaccrual status. Thereafter, any cash payments received on the nonaccrual loan are applied as a principal reduction until the entire amortized cost has been recovered. Any additional amounts received are reflected in interest income.

When the probability of future collectability on a nonaccrual loan declines, we may take additional collection measures, including commencing foreclosure. Specific steps must be taken when commencing foreclosure action on loans secured by real estate, which takes time based on state-specific legal requirements.

At December 31, 2010, nonperforming assets decreased $13.5 million (10.8%) from December 31, 2009, which is a total decline of 21.6% from the peak at March 31, 2010 and the third consecutive quarterly decline. However, we continue to have a high risk loan portfolio given the concentration in commercial real estate and the number of individually large criticized loans.

The following table summarizes nonperforming assets, by class, at the dates indicated (dollars in thousands).


	December 31,
	2010			2009			2008			2007			2006
Construction, land development and other land loans	$	52,528		$	47,901		$	15,409		$	182		$	—
Multifamily residential		7,943			9,844			231			—			—
Nonfarm nonresidential		18,781			23,330			23,761			3,164			4,873
Single-family real estate, revolving, open end loans		998			127			305			143			54
Single-family real estate, closed end, first lien		7,607			7,079			2,264			638			1,229
Single-family real estate, closed end, junior lien		866			446			57			—			115
Commercial and industrial		2,197			7,475			763			567			549
Credit cards		26			372			—			—			—
All other consumer		459			312			178			116			179
Farmland		—			50			—			—			—

Total nonaccrual loans		91,405			96,936			42,968			4,810			6,999
Real estate acquired in settlement of loans		19,983			27,826			6,719			7,743			600
Repossessed automobiles acquired in settlement of loans		104			188			564			403			319

Total foreclosed assets		20,087			28,014			7,283			8,146			919

Total nonperforming assets	$	111,492		$	124,950		$	50,251		$	12,956		$	7,918

Less: Nonaccrual commercial loans held for sale		(27,940	)		—			—			—			—

Adjusted nonperforming assets	$	83,552		$	124,950		$	50,251		$	12,956		$	7,918

Loans*	$	859,583		$	1,040,312		$	1,158,480		$	1,044,770		$	945,913
Total assets		1,355,247			1,435,763			1,368,328			1,246,680			1,152,701
Total nonaccrual loans as a percentage of:
loans* and foreclosed assets		10.39	%		9.07	%		3.69	%		0.46	%		0.74	%
total assets		6.74			6.75			3.14			0.39			0.61
Total nonperforming assets as a percentage of:
loans* and foreclosed assets		12.67	%		11.70	%		4.31	%		1.23	%		0.84	%
total assets		8.23			8.70			3.67			1.04			0.69

includes gross loans and commercial loans held for sale

Loans placed in nonaccrual status during 2010 resulted from loans becoming delinquent on contractual payments due to deterioration in the financial condition of the borrowers or guarantors such that payment in full of principal or interest was not expected due to personal cash flows from the borrowers and guarantors inadequate to service the loans, interest reserves on the loans being depleted, a decrease in operating cash flows from the underlying properties supporting the loans, or a decline in fair values of the collateral resulting in lower cash proceeds from property sales.

Twenty-three loans with a balance at December 31, 2010 greater than $1 million comprised approximately 62% of our nonaccrual loans at December 31, 2010. The following table summarizes the composition of these loans by collateral type (dollars in thousands).


	Total nonaccrual loans > $1 million		% of total nonaccrual loans
Residential/residential lots/golf course development	$	39,470		43	%
Multifamily residential		7,400		8
Real estate for commercial use		8,700		10
Marina		1,228		1

Total nonaccrual loans > $1 million secured by commercial real estate	$	56,798		62	%

Additionally, four of these loans (18% based on the principal balance at December 31, 2010) were purchased participations and six of these loans (23% based on the principal balance at December 31, 2010) are out-of-market loans. In 2009, we amended our loan policy to preclude originating any new loans of these kinds.

While a loan is in nonaccrual status, cash received is applied to the principal balance. Additional interest income of $4.3 million would have been reported during the year ended December 31, 2010 had loans classified as nonaccrual during the period performed in accordance with their original terms. As a result, our earnings did not include this interest income.

The following table summarizes the changes in the Foreclosed real estate portfolio at the dates and for the periods indicated (in thousands). Foreclosed real estate is net of participations sold of $4.6 million (three properties) at December 31, 2010.


	At and for the years ended December 31,
	2010			2009			2008
Foreclosed real estate, beginning of period	$	27,826		$	6,719		$	7,743
Plus: New foreclosed real estate		20,423			24,628			2,778
Less: Proceeds from sale of foreclosed real estate		(17,616	)		(689	)		(3,511	)
Less: Gain / (loss) on sale of foreclosed real estate		587			(72	)		(123	)
Less: Provision charged to expense		(11,237	)		(2,760	)		(168	)

Foreclosed real estate, end of period	$	19,983		$	27,826		$	6,719

The following table summarizes the Foreclosed real estate portfolio, by FDIC code, at December 31, 2010 (in thousands).


Construction, land development, and other land loans	$	6,727
Single-family residential		1,807
Multifamily residential		1,956
Nonfarm, nonresidential		9,493

Total real estate acquired in settlement of loans	$	19,983

Four individual properties greater than $1 million comprised approximately 48% of our foreclosed real estate portfolio at December 31, 2010. Of these properties, 37% were retirement center properties, 32% were retail offices, 20% were hotel properties, and 11% were commercial lots. Additionally, 57% of these properties were participations. Two of the four were the result of out-of-market loans.

These properties are being actively marketed with the primary objective of liquidating the collateral at a level which most accurately approximates fair value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time. As a result, loan charge-offs were recorded prior to or upon foreclosure to writedown the loans to fair value less estimated costs to sell. For some assets, additional writedowns have been taken based on receipt of updated third party appraisals for which appraised values continue to decline. Based on currently available valuation information, the carrying value of these assets is believed to be representative of their fair value less estimated costs to sell although there can be no assurance that the ultimate proceeds from the sale of these assets will be equal to or greater than the carrying values particularly in the current real estate environment and the continued downward trend in third party appraised values.

During the year ended December 31, 2010, we sold 99 properties with an aggregate net carrying amount of $17.0 million in total foreclosed real estate sales at a net gain of $587 thousand.

Subsequent to December 31, 2010, four properties with an aggregate net carrying amount of $2.2 million were sold at a loss of $62 thousand. At February 22, 2011, 11 additional properties with an aggregate net carrying amount of $5.4 million were under contract for sale to close in the first and/or second quarter of 2011.

We are actively addressing the elevated level of nonperforming assets and will continue to be aggressive in working to resolve these issues as quickly as possible. For problem assets identified, we prepared written workout plans that are borrower specific to determine how best to resolve the loans which could include restructuring the loans, requesting additional collateral, demanding payment from guarantors, sale of the loans, or foreclosure and sale of the collateral. We are also actively marketing for sale commercial loans held for sale. However, given the nature of the projects related to such loans and the distressed values within the real estate market, immediate resolution in all cases is not expected. Therefore, it is reasonable to expect that current negative asset quality trends may continue for coming periods when compared to historical periods. The carrying values of these assets may require additional adjustment for further declines in estimated fair values.

Troubled Debt Restructurings. Troubled debt restructurings are loans which have undergone concessionary adjustments and were restructured from their original contractual terms due to financial difficulty of the borrower, for example, reduction in the contractual interest rate below that at which the borrower could obtain new credit from another lender. As part of our proactive actions to resolve problem loans and the resulting determination of our individual loan workout plans, we may restructure loans to assist borrowers facing cash flow challenges in the current economic environment to facilitate ultimate repayment of the loan. At December 31, 2010, the principal balance of troubled debt restructurings, in gross loans and commercial loans held for sale, totaled $44.9 million, of which loans totaling $17.2 million are classified as commercial loans held for sale.

Historically, we have not split loans into two legally separate loans. However, at December 31, 2010, we had four loans that had been legally split into separate loans (commonly referred to as an A/B loan structure), with both the A and B loans accounted for as troubled debt restructures. Restructuring these loans into legally separate loans resulted in charge-offs of $1.5 million of the B loans during 2010. All of the A loans are currently performing in accordance with their terms. The aggregate balances of the A and B loans at December 31, 2010 were $8.2 million and $11.4 million, respectively.

Twelve individual loans greater than $1 million comprised $35.8 million (80%) of our troubled debt restructurings, including commercial loans held for sale, at December 31, 2010. One of the loans experienced rate concessions, two experienced term concessions, five experienced rate and term concessions, and three experienced a reduction in required principal paydowns. At December 31, 2010, 11 of the loans totaling $34.3 million are performing as expected under the new terms.

A troubled debt restructuring can be removed from this classification in years after the restructuring if both of the following conditions exist: the restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of the restructuring for a new loan with comparable risk, and the loan is not impaired based on the terms specified by the restructuring agreement. For the year ended December 31, 2010, no loans were removed from this classification. In the first quarter of 2011, we anticipate that $8.2 million of these loans will be removed from troubled debt restructuring status as they are performing in accordance with their restructured terms.

Potential Problem Loans. Potential problem loans consist of commercial loans not already classified as nonaccrual for which questions exist as to the current sound worth and paying capacity of the borrower or of the collateral pledged, if any, have a well-defined weakness or weaknesses that jeopardize the liquidation of the loan, and are characterized by the distinct possibility that we will sustain some loss of the deficiencies are not corrected. We monitor these loans closely and review performance on a regular basis. As of December 31, 2010, total potential problem loans (loans classified as substandard and doubtful) totaled $117.1 million, of which $34.9 million were in commercial loans held for sale. Total potential problem loans decreased 20.6% from their peak of $147.5 million at June 30, 2010.

Allowance for Loan Losses. The allowance for loan losses represents an amount that we believe will be adequate to absorb probable losses inherent in our loan portfolio as of the balance sheet date. Assessing the adequacy of the allowance for loan losses is a process that requires considerable judgment. Our judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may impact the overall loan portfolio or an individual borrower’s ability to repay, the amount and quality of collateral securing the loans, our historical loan loss experience, and borrower and collateral specific considerations for loans individually evaluated for impairment.

The allowance for loan losses increased from $24.1 million, or 2.31% of gross loans, at December 31, 2009 to $26.9 million, or 3.39% of gross loans, at December 31, 2010. The increased allowance and coverage ratio resulted from the overall trends in our asset quality, loan portfolio, and economic factors, some of which offset one another. We believed it was appropriate for the provision for loan losses to cover net charge-offs in 2010 and incremental specific reserves on new loans individually analyzed for impairment that were added to the list during the year.

The allowance for loan losses at December 31, 2010 decreased $2.4 million from September 30, 2010. The decrease in the allowance for loan losses resulted primarily from the declining trend in nonaccrual loans, criticized and classified loans, and acquisition, development and construction loans.

The December 31, 2010 allowance for loan losses, and, therefore indirectly the provision for loan losses for the year ended December 31, 2010, was determined based on the following specific factors, though not intended to be an all inclusive list:

•

The impact of the ongoing depressed overall economic environment, including within our geographic market,

•

The cumulative impact of the extended duration of this economic deterioration on our borrowers, in particular commercial real estate loans for which we have a heavy concentration,

•

The level of real estate development loans, in which the majority of our losses have occurred, although such loans have decreased to 15.9% of the loan portfolio, including commercial loans held for sale, at December 31, 2010 from 19.8% at December 31, 2009,

•

The asset quality trends in our loan portfolio, including a high level of nonperforming assets at December 31, 2010, which while still at an elevated level, decreased for the past three consecutive quarters,

•

The trend in our criticized and classified loans, which while still at an elevated level, decreased 11.6% and 8.8% from the previous quarter,

•

The trend and elevated level of the historical loan loss rates within our loan portfolio,

•

The results of our internal and external loan reviews during 2010, and

•

Our individual impaired loan analysis which identified:

•

Continued stress on borrowers given increasing lack of liquidity and limited bank financing and credit availability, and

•

Continued downward trends in appraised values and market assumptions used to value real estate dependent loans.

The following table summarizes activity within our allowance for loan losses, by portfolio segment, at the dates and for the periods indicated (dollars in thousands). Loans charged-off and recovered are charged or credited to the allowance for loan losses at the time realized.


	At and for the years ended December 31,
	2010			2009			2008			2007			2006
Allowance for loan losses, beginning of period	$	24,079		$	11,000		$	7,418		$	8,527		$	8,431
Provision for loan losses		47,100			73,400			5,619			988			1,625
Less: Allowance reclassified as commercial loans held for sale valuation allowance		2,358			—			—			—			—
Less: Allowance reclassified in credit card portfolio sale		452			—			—			—			—
Loan charged-off
Commercial real estate		33,481			49,753			198			496			191
Single-family residential		4,214			4,060			367			371			247
Commercial and industrial		3,135			4,945			430			505			453
Consumer		1,483			2,033			1,174			991			791
Other		647			—			—			—			—

Total loans charged-off		42,960			60,791			2,169			2,363			1,682
Recoveries
Commercial real estate		544			111			9			13			6
Single-family residential		98			5			11			39			15
Commercial and industrial		154			88			18			54			37
Consumer		729			266			94			160			95
Other		—			—			—			—			—

Total loans recovered		1,525			470			132			266			153

Net loans charged-off		41,435			60,321			2,037			2,097			1,529

Allowance for loan losses, end of period	$	26,934		$	24,079		$	11,000		$	7,418		$	8,527

Average gross loans	$	943,101		$	1,124,599		$	1,107,007		$	986,518		$	895,062
Ending gross loans		793,426			1,040,312			1,158,480			1,044,770			945,913
Nonaccrual loans		91,405			96,936			42,968			4,810			6,999
Net loans charged-offs as a percentage of average gross loans		4.39	%		5.36	%		0.18	%		0.21	%		0.17	%
Allowance for loan losses as a percentage of ending gross loans		3.39			2.31			0.95			0.71			0.90
Allowance for loan losses as a percentage of nonaccrual loans		29.47			24.84			25.60			154.22			121.83

In addition to loans charged-off in their entirety in the ordinary course of business, included within loans charged-off for the year ended December 31, 2010 were $33.7 million in gross loan charge-offs relating to loans individually evaluated for impairment. The determination was made to take partial charge-offs on certain collateral dependent loans based on the status of the underlying real estate projects or our expectation that these loans would be foreclosed on and we would take possession of the collateral. The loan charge-offs were recorded to writedown the loans to the fair value of the collateral less estimated costs to sell generally based on fair values from third party appraisals.

We analyze individual loans within the portfolio and make allocations to the allowance for loan losses based on each individual loan’s specific factors and other circumstances that impact the collectability of the loan. The population of loans evaluated to be potential impaired loans includes all troubled debt restructures and all loans with interest reserves, as well as significant individual loans classified as doubtful or on nonaccrual status. At December 31, 2010, we had two loans totaling $3.3 million with Bank funded interest reserves. Based on their performance, these loans were not considered impaired.

In situations where a loan is determined to be impaired (primarily because it is probable that all principal and interest due according to the terms of the loan agreement will not be collected as scheduled), the loan is excluded from the general reserve calculation described below and is evaluated individually for impairment. The impairment analysis is based on the determination of the most probable source of repayment which is typically liquidation of the underlying collateral but may also include discounted future cash flows or, in rare cases, the market value of the loan itself. At December 31, 2010, $79.1 million of our loans evaluated individually for impairment, including commercial loans held for sale, were valued based on collateral value, $23.9 million were valued based on discounted future cash flows, $3.4 million were valued based on a loan’s observable market price, and $1.3 million were based on bid prices for contracted loan sales expected to close in the first quarter of 2011.

Generally, for larger impaired loans valued based on the value of the collateral, current appraisals performed by approved third party appraisers are the basis for estimating the current fair value of the collateral. However, in situations where a current appraisal is not available, we use the best available information (including recent appraisals for similar properties, communications with qualified real estate professionals, information contained in reputable trade publications, and other observable market data) to estimate the current fair value. The estimated costs to sell the property, if not already included in the appraisal, are then deducted from the appraised value to arrive at the net realizable value of the loan used to calculate the loan’s specific reserve.

The following table summarizes the composition of and information relative to impaired loans, by class, at December 31, 2010 (in thousands).


	Gross Loans						Commercial Loans Held for Sale				Total Loans
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:
Construction, land development and other land loans	$	29,183	$	39,953			$	11,123	$	25,303	$	40,306	$	65,256
Multifamily residential		—		—				7,943		14,010		7,943		14,010
Nonfarm nonresidential		11,504		17,099				19,674		30,367		31,178		47,466

Total commercial real estate		40,687		57,052				38,740		69,680		79,427		126,732

Single-family real estate, revolving, open end loans		—		—				—		—		—		—
Single-family real estate, closed end, first lien		2,567		6,233				595		1,374		3,162		7,607
Single-family real estate, closed end, junior lien		—		—				—		—		—		—

Total single-family residential		2,567		6,233				595		1,374		3,162		7,607

Commercial and industrial		117		117				—		—		117		117

Total impaired loans with no related allowance recorded	$	43,371	$	63,402			$	39,335	$	71,054	$	82,706	$	134,456

With an allowance recorded:
Construction, land development and other land loans	$	11,164	$	17,527	$	3,103					$	11,164	$	17,527	$	3,103
Multifamily residential		—		—		—						—		—		—
Nonfarm nonresidential		10,936		10,936		2,273						10,936		10,936		2,273

Total commercial real estate		22,100		28,463		5,376						22,100		28,463		5,376

Single-family real estate, revolving, open end loans		—		—		—						—		—		—
Single-family real estate, closed end, first lien		1,300		1,300		94						1,300		1,300		94
Single-family real estate, closed end, junior lien		165		165		57						165		165		57

Total single-family residential		1,465		1,465		151						1,465		1,465		151

Commercial and industrial		1,381		1,450		819						1,381		1,450		819

Total impaired loans with an allowance recorded	$	24,946	$	31,378	$	6,346					$	24,946	$	31,378	$	6,346

Total:
Construction, land development and other land loans	$	40,347	$	57,480	$	3,103	$	11,123	$	25,303	$	51,470	$	82,783	$	3,103
Multifamily residential		—		—		—		7,943		14,010		7,943		14,010		—
Nonfarm nonresidential		22,440		28,035		2,273		19,674		30,367		42,114		58,402		2,273

Total commercial real estate		62,787		85,515		5,376		38,740		69,680		101,527		155,195		5,376

Single-family real estate, revolving, open end loans		—		—		—		—		—		—		—		—
Single-family real estate, closed end, first lien		3,867		7,533		94		595		1,374		4,462		8,907		94
Single-family real estate, closed end, junior lien		165		165		57		—		—		165		165		57

Total single-family residential		4,032		7,698		151		595		1,374		4,627		9,072		151

Commercial and industrial		1,498		1,567		819		—		—		1,498		1,567		819

Total impaired loans	$	68,317	$	94,780	$	6,346	$	39,335	$	71,054	$	107,652	$	165,834	$	6,346

Interest income recognized on impaired loans during the year ended December 31, 2010 was $1.5 million. The average balance of total impaired loans was $105.7 million for the same period.

At December 31, 2009, the balance of impaired loans was $96.8 million. Of that balance, $11.3 million of the impaired loans had a related allowance for loan losses of $5.3 million. The average balance of impaired loans was $82.5 million and $22.6 million for the years ended December 31, 2009 and 2008, respectively.

We calculate our general allowance by applying our historical loss factors to each sector of the loan portfolio. For consistency of comparison on a quarterly basis, we utilize a five-year look-back period when computing historical loss rates. However, given the increase in charge-offs beginning in 2009, we also utilized a three-year look-back period in 2010 for computing historical loss rates as another reference point in determining the allowance for loan losses.

We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors we considered in the determination of the December 31, 2010 allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, peer comparisons, and other external factors. The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.

The following table summarizes the allocation of the allowance for loan losses, by portfolio segment, at December 31, 2010 (in thousands).


	Commercial Real Estate		Single-family Residential		Commercial and Industrial		Consumer		Other		Total
Allowance for loan losses:
Allowance for loan losses, beginning of period	$	13,369	$	3,683	$	4,853	$	2,173	$	1	$	24,079
Provision for loan losses		40,899		4,500		620		408		673		47,100
Less: Allowance reclassified to loans held for sale valuation allowance		2,352		6		—		—		—		2,358
Less: Allowance associated with credit card portfolio sale		—		—		—		452		—		452
Loan charge-offs		33,481		4,214		3,135		1,483		647		42,960
Loan recoveries		544		98		154		729		—		1,525

Net loans charged-off		32,937		4,116		2,981		754		647		41,435

Allowance for loan losses, end of period	$	18,979	$	4,061	$	2,492	$	1,375	$	27	$	26,934

Individually evaluated for impairment	$	5,376	$	151	$	819	$	—	$	—	$	6,346
Collectively evaluated for impairment		13,603		3,910		1,673		1,375		27		20,588

Allowance for loan losses, end of period	$	18,979	$	4,061	$	2,492	$	1,375	$	27	$	26,934


Gross loans, end of period:
Individually evaluated for impairment	$	62,787	$	4,032	$	1,498	$	—	$	—	$	68,317
Collectively evaluated for impairment		445,810		174,016		46,314		52,652		6,317		725,109

Total gross loans	$	508,597	$	178,048	$	47,812	$	52,652	$	6,317	$	793,426

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off. While we utilize the best judgment and information available to it, the ultimate adequacy of the allowance for loan losses depends on a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications.

In addition to our portfolio review process, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to recognize additions to the allowance for loan losses based on their judgments and information available to them at the time of their examinations. While we use available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes and other factors on our borrowers.

We believe that the allowance for loan losses at December 31, 2010 is appropriate and adequate to cover probable inherent losses in the loan portfolio. However, underlying assumptions may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which was not known to us at the time of the issuance of our Consolidated Financial Statements. Therefore, our assumptions may or may not prove valid. Thus, there can be no assurance that loan losses in future periods, including potential incremental losses resulting from the sale of the commercial loans held for sale, will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required. Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting our business, financial condition, results of operations, and cash flows.

Commercial Loans Held for Sale Valuation Allowance. At December 31, 2010, commercial loans held for sale are carried at the lower of cost or fair value, and reflect a valuation allowance of $2.3 million recorded against the loans held for sale resulting in a net carrying amount in the Consolidated Balance Sheets of $66.2 million. A valuation allowance is recorded against the loans held for sale for the excess of the recorded investment in the loan and the fair value less estimated selling costs.

In September 2010, we decided to market for sale commercial loans totaling $90.9 million at September 30, 2010, and we are evaluating the bids received on a loan by loan basis. In general, we believe potential buyers are making bids at heavily discounted prices given the need for the banking industry in general and our Company in particular to deleverage commercial real estate assets. We believe this was particularly true in the fourth quarter of 2010 as banks sought to rid themselves of problem assets prior to year end. In many cases, we have not accepted such discounted bids. In certain cases, however, we are making the strategic decision to sell certain assets at amounts less than their recorded book values to continue to reduce our criticized assets and concentration in commercial real estate as required by the Consent Order.

The following table summarizes activity within commercial loans held for sale and the related valuation allowance, at the dates and for the periods indicated (in thousands).


	Commercial loans held for sale, prior to valuation allowance		Valuation allowance on commercial loans held for sale
Beginning balance at December 31, 2009	$	—	$	—
Additions:
Loans held for investment transferred to loans held for sale		90,922		2,358
Additional valuation requirements for ending loans held for sale		—		1,198

Total additions		90,922		3,556

Reductions:
Loans held for sale sold		10,402		1,186
Net transfers out		5,665		36
Direct writedowns on loans held for sale		6,364		—

Total reductions		22,431		1,222

Ending balance at December 31, 2010	$	68,491	$	2,334

Premises and equipment, net

Premises and equipment, net decreased by $1.5 million (5.1%) during year ended December 31, 2010. As part of our earnings plan to improve our overall financial performance, we eliminated in 2010 all bank-owned automobiles provided to officers. Bank automobiles with a net book value of $270 thousand were sold at a loss of $21 thousand during 2010.

In June 2010, we sold one vacant bank-owned branch with a net book value of $46 thousand at a gain of $14 thousand. At December 31, 2010, another vacant branch facility with a net book value of $235 thousand is under contract for sale and included in Other assets in the Consolidated Balance Sheets.

Goodwill

In the third quarter 2010, we recorded a goodwill impairment charge of $3.7 million. Goodwill resulted from past business combinations from 1988 through 1999. We perform our annual impairment testing as of June 30 each year. However, due to the overall adverse economic environment and the negative impact on the banking industry as a whole, including the impact to the Company resulting in net losses and a decline in market capitalization based on our common stock price, we also performed impairment tests of our goodwill quarterly in 2010.

Our common stock is not listed on any national securities exchange or quoted on the OTC Bulletin Board. Our common stock is, however, quoted on the Pink Sheets under the symbol “PLMT.PK”. Although our common stock is quoted on the Pink Sheets, there is currently only a limited public trading market of our common stock. Private trading of our common stock also has been limited and has typically been conducted through the Private Trading System on our website. In addition, buyers and sellers may privately negotiate transactions in our common stock. Because there is not an established market for our common stock, we may not be aware of all prices at which our common stock has been traded. Accordingly, we normally determine the value of our common stock based on the last five trades of the stock facilitated by the Company through the Private Trading System on our website.

Company issued 39,975,980 million shares of common stock at $2.60 per share. This per share issue price was negotiated by the Company at arm’s length with the investors and was supported by a fairness opinion from the investment banking firm engaged by the Company’s Board of Directors, including a comparison to common stock prices as a percentage of book value for publicly traded banks with similar asset quality and financial condition of the Company, and in comparison to recent merger and acquisition transactions. Accordingly, we believe it was appropriate to utilize the $2.60 issue price in our goodwill impairment evaluation at September 30, 2010.

No impairment loss was recognized during 2009.

Deferred Tax Asset

As of December 31, 2010, prior to any valuation allowance, gross deferred tax assets totaling $25.9 million and gross deferred tax liabilities totaling $5.4 million were recorded in the Company’s Consolidated Balance Sheets. Based on our projections of future taxable income over the next three years, cumulative tax losses over the previous three years, limitations on future utilization of various deferred tax assets under the Internal Revenue Code, and available tax planning strategies, we recorded a valuation allowance against the net deferred tax asset in the amount of $20.5 million through a charge against income tax expense (benefit) at December 31, 2010. At December 31, 2009, net deferred tax assets totaled $5.8 million and were supported by an available net operating loss carryback against federal income taxes previously paid. No valuation allowance was recorded at December 31, 2009.

The Private Placement that was consummated on October 7, 2010 is considered to be a change in control under the Internal Revenue Code. Accordingly, with the assistance of third party specialists we were required to determine the fair value of the Company and our assets for the purpose of evaluating any potential limitation or deferral of our ability to carry forward pre-acquisition net operating losses and to determine the amount of net unrealized built-in losses as of October 7, 2010, which also limits the amount of net operating losses that may be used in the future. As a result of the valuations and tax analysis, we currently estimate that future utilization of net operating loss carry forwards and built-in losses of $46 million generated prior to October 7, 2010 will be limited to $1.1 million per year.

Analysis of our ability to realize deferred tax assets requires us to apply significant judgment and is inherently subjective because it requires the future occurrence of circumstances that cannot be predicted with certainty. While we recorded a valuation allowance against our net deferred tax asset for financial reporting purposes at December 31, 2010, the net operating losses are able to be carried forward for income tax purposes up to twenty years. Thus, to the extent we return to profitability and generate sufficient taxable income in the future, we will be able to utilize some of the net operating losses for income tax purposes and reverse a portion of the valuation allowance for financial reporting purposes. The determination of how much of the net operating losses we will be able to utilize and therefore how much of the valuation allowance that may be reversed and the timing is based on our future results of operations and the amount and timing of actual loan charge-offs and asset writedowns.

Deposit Activities

Traditional deposit accounts have historically been the primary source of funds for the Company and a competitive strength of our Company. Traditional deposit accounts also provide a customer base for the sale of additional financial products and services and fee income through service charges. We set targets for growth in deposit accounts annually in an effort to increase the number of products per banking relationship. Deposits are attractive sources of funding because of their stability and generally low cost as compared with other funding sources.

The following table summarizes our composition of deposits at the dates indicated (dollars in thousands).


	December 31,
	2010					2009					2008					2007					2006
	Total		% of total			Total		% of total			Total		% of total			Total		% of total			Total		% of total
Noninterest-bearing transaction deposit accounts	$	141,281		12.0	%	$	142,609		11.7	%	$	134,465		12.6	%	$	135,920		12.8	%	$	134,229		13.5	%
Interest-bearing transaction deposit accounts		292,827		25.0			307,258		25.3			364,315		34.0			387,248		36.6			313,613		31.5

Transaction deposit accounts		434,108		37.0			449,867		37.0			498,780		46.6			523,168		49.4			447,842		45.0
Money market deposit accounts		143,143		12.2			119,082		9.8			93,746		8.7			118,681		11.2			124,874		12.6
Savings deposit accounts		49,472		4.2			40,335		3.3			36,623		3.4			34,895		3.3			41,887		4.2
Time deposit accounts		546,639		46.6			605,630		49.9			442,347		41.3			382,859		36.1			379,584		38.2

Total deposits	$	1,173,362		100.0	%	$	1,214,914		100.0	%	$	1,071,496		100.0	%	$	1,059,603		100.0	%	$	994,187		100.0	%

In March 2010, we introduced a new checking account, MyPal checking, and a new savings account, Smart Savings. These accounts combine traditional banking features and nonbanking features and are expected to be a source of both additional deposits and noninterest income resulting primarily from service charges or debit card transactions.

The MyPal checking account includes a monthly fee of $5, which is reduced by $0.50 each time an account holder uses their debit card. Thus, ten debit card transactions per month results in no monthly fee to the account holder. However, the Company earns a per transaction fee from the merchant each time the debit cards are used. In addition, the MyPal checking account includes a competitive interest rate, free checks, free identity theft protection and safety deposit rental for a period of time, and comes with a membership rewards program that provides purchase discounts to the account holders for items such as airfare, car rental and hotel, and every day savings at a wide variety of national and local retailers and entertainment companies.

The Smart Savings account can be linked to any of our checking accounts and results in $1 being transferred from the account holder’s checking account to the Smart Saving account each time the account holder uses their debit card. The Company initially matched each $1 transfer with $1 for the first six months. Effective October 1, 2010, the match was reduced to $0.10 per each $1 transfer. The maximum match is $250 per year. The Smart Savings account is also interest-bearing.

We also evaluated the profitability of all of our pre-existing checking accounts and in October 2010 upgraded a large number of unprofitable checking accounts to the MyPal account. We are also revising our existing fees (some increases and some decreases) and eliminating existing fees or implementing new fees based on our analysis of our fee structure in relation to our costs and competitor fees, with various implementation dates generally between October 1, 2010 and March 31, 2011.

The Dodd-Frank Act, which was signed into law on July 21, 2010, calls for new limits on interchange transaction fees that banks receive from merchants via card networks like Visa, Inc. and MasterCard, Inc. when a customer uses a debit card. In December 2010, the Federal Reserve issued a proposal to implement a provision in the Dodd-Frank Act that requires the Federal Reserve to set debit-card interchange fees. The proposed rule, if implemented in its current form, would result in a significant reduction in debit-card interchange revenue. Though the rule technically does not apply to institutions with less than $10 billion in assets, such as the Bank, there is concern that the price controls may harm community banks, which could be pressured by the marketplace to lower their own interchange rates. The results of this proposed legislation may impact our interchange income from debit card transactions in the future.

During the first and second quarters of 2010, we conducted targeted deposit growth and retention campaigns related to maturing certificates of deposit and to attract new deposits. The CD campaigns included CDs with various maturities ranging from 6 months to 60 months, as well as 15, 20, and 36 month step-up add-on CDs that allow holders to reset their interest rate up to one, two and three times, respectively, over the life of the CD and to add to the CDs over their lives. These CD campaigns ended on June 30, 2010. From January 1, 2010 through June 30, 2010, these campaigns resulted in the retention of existing CDs and generation of new CDs totaling $258.1 million. However, in the second half of 2010, we did not aggressively pursue retention of maturing CDs given our excess cash and to reduce our net deposit funding cost. At December 31, 2010, CDs decreased $59.0 million from December 31, 2009. In general, this CD runoff was expected as part of our balance sheet management efforts to attract and retain lower priced transaction deposit accounts and shrink our higher priced deposit base given the decline in the loan portfolio and is expected to continue in the first quarter 2011.

At December 31, 2010, traditional deposit accounts as a percentage of liabilities were 94.5% compared with 89.3% at December 31, 2009. Interest-bearing deposits decreased $40.2 million during the year ended December 31, 2010, primarily due to higher priced time deposit accounts not being retained at maturity as part of our balance sheet management efforts. Noninterest-bearing deposits decreased $1.3 million during the same period. Traditional deposit accounts continue to be our primary source of funding, and, as part of our liquidity plan, we are proactively pursuing deposit retention initiatives with our deposit customers. We are also pursuing strategies to increase our transaction deposit accounts as a proportion of our total deposits.

The Dodd-Frank Act also permanently raises the current standard maximum deposit insurance amount to $250,000. The standard maximum insurance amount of $100,000 had been temporarily raised to $250,000 until December 31, 2013. The FDIC insurance coverage limit applies per depositor, per insured depository institution for each account ownership category. In addition, the FDIC provides unlimited deposit insurance coverage for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. We elected to voluntarily participate in the program through December 31, 2010. Throughout 2010, participating institutions paid fees of 15 to 25 basis points (annualized), depending on the Risk Category assigned to the institution, on the balance of each covered account in excess of $250 thousand. Coverage under the program was in addition to and separate from the basic coverage available under the FDIC’s general deposit insurance rules. We believe participation in the program enhanced our ability to retain customer deposits. As a result of the Dodd-Frank Act, the voluntary TAGP program will end on December 31, 2010, and all institutions will be required to provide full deposit insurance on noninterest-bearing transaction accounts until December 31, 2012. There will not be a separate assessment for this as there was for institutions participating in the TAGP program.

The table set forth below summarizes the average balances of interest-bearing deposits by type and the weighted average rates paid thereon for the periods indicated (dollars in thousands).


	For the years ended December 31,
	2010							2009							2008
	Average balance		Interest expense		Weighted average rate paid			Average balance		Interest expense		Weighted average rate paid			Average balance		Interest expense		Weighted average rate paid
Transaction deposit accounts	$	292,696	$	248		0.08	%	$	323,613	$	526		0.16	%	$	374,382	$	4,966		1.33	%
Money market deposit accounts		137,955		622		0.45			108,566		602		0.55			105,834		1,922		1.82
Savings deposit accounts		46,112		124		0.27			40,871		132		0.32			37,692		129		0.34
Time deposit accounts		552,854		12,566		2.27			578,026		18,251		3.16			400,516		16,677		4.16

Total interest-bearing deposits	$	1,029,617	$	13,560		1.32	%	$	1,051,076	$	19,511		1.86	%	$	918,424	$	23,694		2.58	%

Jumbo Time Deposit Accounts. Jumbo time deposit accounts are accounts with balances totaling $100,000 or greater at the date indicated. Jumbo time deposit accounts totaled 22.7% of total interest-bearing liabilities at December 31, 2010. The following table summarizes our jumbo time deposit accounts by maturity at December 31, 2010 (in thousands).


Three months or less	$	44,092
Over three months through six months		17,994
Over six months through twelve months		90,171

Twelve months or less		152,257
Over twelve months		94,912

Total jumbo time deposit accounts	$	247,169

Jumbo time deposit accounts totaled $263.7 million at December 31, 2009. We believe our balance sheet management efforts to attract and retain lower priced transaction deposit accounts and shrink our higher priced deposit base contributed to the decrease in jumbo time deposit accounts.

Borrowing Activities

Borrowings as a percentage of total liabilities decreased from 10.0% at December 31, 2009 to 4.5% at December 31, 2010. The decrease was due to less reliance on such borrowed funding sources as liquidity was provided through deposit growth and cash retention of proceeds from loan payments and maturing securities. We also utilized excess cash balances in December 2010 to prepay $61.0 million of FHLB advances.

The following table summarizes our borrowings composition at the dates indicated (dollars in thousands).


	December 31, 2010					December 31, 2009
	Total		% of total			Total		% of total
Retail repurchase agreements	$	20,720		37.2	%	$	15,545		11.5	%
Commercial paper		—		—			19,061		14.0
FHLB advances		35,000		62.8			101,000		74.5

Total borrowed funds	$	55,720		100.0	%	$	135,606		100.0	%

The following table provides further detail with respect to our borrowings composition at the dates and for the periods indicated (dollars in thousands).


	At and for the years ended December 31,
	2010			2009			2008
Retail repurchase agreements
Amount outstanding at year-end	$	20,720		$	15,545		$	16,357
Average amount outstanding during year		22,809			23,227			18,063
Maximum amount outstanding at any month-end		26,106			29,461			21,817
Rate paid at year-end*		0.25	%		0.25	%		0.25	%
Weighted average rate paid during the year		0.25			0.25			1.37

Commercial paper
Amount outstanding at year-end	$	—		$	19,061		$	27,955
Average amount outstanding during year		8,435			24,085			32,415
Maximum amount outstanding at any month-end		18,948			27,041			37,487
Rate paid at year-end*		—	%		0.25	%		0.25	%
Weighted average rate paid during the year		0.25			0.25			1.11

Other short-term borrowings—lines of credit from correspondent banks
Amount outstanding at year-end	$	—		$	—		$	35,785
Average amount outstanding during year		1			5,335			13,240
Maximum amount outstanding at any month-end		—			17,295			38,171
Rate paid at year-end		—	%		—	%		0.68	%
Weighted average rate paid during the year		—			0.62			2.27

FHLB borrowings
Amount outstanding at year-end	$	35,000		$	101,000		$	96,000
Average amount outstanding during year		95,231

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