(3)

Loans

Major classifications of loans at September 30, 2012 and December 31, 2011 are summarized as follows:

(Dollars in thousands)
	September 30, 2012		December 31, 2011
Real estate loans
Construction and land development	$	80,733	93,812
Single-family residential		249,167	267,051
Commercial		203,603	214,415
Multifamily and farmland		4,964	4,793
Total real estate loans		538,467	580,071

Commercial loans (not secured by real estate)		60,358	60,646
Farm loans (not secured by real estate)		12	-
Consumer loans (not secured by real estate)		10,303	10,490
All other loans (not secured by real estate)		16,642	19,290
Total loans		625,782	670,497

Less allowance for loan losses		16,551	16,604

Total net loans	$	609,231	653,893

The Bank grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties of North Carolina. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management's opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

The following tables present an age analysis of past due loans, by loan type, as of September 30, 2012 and December 31, 2011:

September 30, 2012
(Dollars in thousands)
	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due	Total Past Due Loans	Total Current Loans	Total Loans	Accruing Loans 90 or More Days Past Due
Real estate loans
Construction and land development	$	1,513	1,846	3,359	77,374	80,733	-
Single-family residential		8,145	4,758	12,903	236,264	249,167	2,396
Commercial		743	2,492	3,235	200,368	203,603	-
Multifamily and farmland		209	-	209	4,755	4,964	-
Total real estate loans		10,610	9,096	19,706	518,761	538,467	2,396

Commercial loans (not secured by real estate)		854	18	872	59,486	60,358	-
Farm loans (not secured by real estate)		-	-	-	12	12	-
Consumer loans (not secured by real estate)		119	5	124	10,179	10,303	2
All other loans (not secured by real estate)		-	-	-	16,642	16,642	-
Total loans	$	11,583	9,119	20,702	605,080	625,782	2,398

December 31, 2011
(Dollars in thousands)
	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due	Total Past Due Loans	Total Current Loans	Total Loans	Accruing Loans 90 or More Days Past Due
Real estate loans
Construction and land development	$	10,033	3,338	13,371	80,441	93,812	-
Single-family residential		16,536	6,189	22,725	244,326	267,051	2,709
Commercial		1,002	958	1,960	212,455	214,415	-
Multifamily and farmland		13	-	13	4,780	4,793	-
Total real estate loans		27,584	10,485	38,069	542,002	580,071	2,709

Commercial loans (not secured by real estate)		576	9	585	60,061	60,646	-
Consumer loans (not secured by real estate)		116	36	152	10,338	10,490	-
All other loans (not secured by real estate)		-	-	-	19,290	19,290	-
Total loans	$	28,276	10,530	38,806	631,691	670,497	2,709

The following table presents the Company's non-accrual loans as of September 30, 2012 and December 31, 2011:

(Dollars in thousands)
	September 30, 2012		December 31, 2011
Real estate loans
Construction and land development	$	10,866	13,257
Single-family residential		4,255	5,522
Commercial		3,239	2,451
Total real estate loans		18,360	21,230

Commercial loans (not secured by real estate)		457	403
Consumer loans (not secured by real estate)		22	152
Total	$	18,839	21,785

At each reporting period, the Bank determines which loans are impaired. Accordingly, the Bank's impaired loans are reported at their estimated fair value on a non-recurring basis. An allowance for each impaired loan, which is generally collateral-dependent, is calculated based on the fair value of its collateral. The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank. REAS is staffed by certified appraisers that also perform appraisals for other companies. Factors including the assumptions and techniques utilized by the appraiser are considered by management. If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses. Impaired loans under $250,000 are not individually evaluated for impairment, with the exception of the Bank's troubled debt restructured ("TDR") loans in the residential mortgage loan portfolio, which are individually evaluated for impairment. Accruing impaired loans were $38.7 million, $21.1 million and $30.6 million at September 30, 2012, September 30, 2011 and December 31, 2011, respectively. Interest income recognized on accruing impaired loans was $1.4 million, $897,000 and $1.7 million for the nine months ended September 30, 2012, the nine months ended September 30, 2011 and the year ended December 31, 2011, respectively. No interest income is recognized on non-accrual impaired loans subsequent to their classification as impaired.

The following tables present the Company's impaired loans as of September 30, 2012 and December 31, 2011:

September 30, 2012
(Dollars in thousands)
	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance	Recorded Investment With Allowance	Recorded Investment in Impaired Loans	Related Allowance	Average Outstanding Impaired Loans
Real estate loans
Construction and land development	$	28,090	12,832	7,437	20,269	1,821	13,806
Single-family residential		29,652	5,193	23,416	28,609	1,343	28,620
Commercial		7,903	6,953	317	7,270	114	5,565
Multifamily and farmland		200	200	-	200	-	201
Total impaired real estate loans		65,845	25,178	31,170	56,348	3,278	48,192

Commercial loans (not secured by real estate)		1,155	1,117	-	1,117	-	1,187
Consumer loans (not secured by real estate)		-	30	-	30	-	38
Total impaired loans	$	67,000	26,325	31,170	57,495	3,278	49,417

December 31, 2011
(Dollars in thousands)
	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance	Recorded Investment With Allowance	Recorded Investment in Impaired Loans	Related Allowance	Average Outstanding Impaired Loans
Real estate loans
Construction and land development	$	28,721	14,484	6,098	20,582	3,264	17,848
Single-family residential		26,382	969	24,719	25,688	1,427	25,102
Commercial		7,717	3,845	3,139	6,984	77	4,518
Multifamily and farmland		209	-	209	209	1	214
Total impaired real estate loans		63,029	19,298	34,165	53,463	4,769	47,682

Commercial loans (not secured by real estate)		1,111	-	1,083	1,083	26	1,485
Consumer loans (not secured by real estate)		157	-	152	152	2	140
Total impaired loans	$	64,297	19,298	35,400	54,698	4,797	49,307

Changes in the allowance for loan losses for the nine months ended September 30, 2012 and the year ended December 31, 2011 were as follows:

Nine months ended September 30, 2012
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development			Single- Family Residential		Commercial		Multifamily and Farmland	Commercial		Farm	Consumer and All Other		Unallocated	Total
Allowance for loan losses:
Beginning balance	$	7,182		5,357		1,731		13	1,029		-	255		1,037	16,604
Charge-offs		(3,045	)	(1,149	)	(547	)	-	(498	)	-	(403	)	-	(5,642	)
Recoveries		522		71		374		-	95		-	115		-	1,177
Provision		1,733		817		(21	)	-	(18	)	-	222		1,679	4,412
Ending balance	$	6,392		5,096		1,537		13	608		-	189		2,716	16,551

Ending balance: individually
evaluated for impairment	$	1,527		1,637		114		-	-		-	-		-	3,278
Ending balance: collectively
evaluated for impairment		4,865		3,459		1,423		13	608		-	189		2,716	13,273
Ending balance	$	6,392		5,096		1,537		13	608		-	189		2,716	16,551

Loans:
Ending balance	$	80,733		249,167		203,603		4,964	60,358		12	26,945		-	625,782

Ending balance: individually
evaluated for impairment	$	19,734		23,770		6,798		-	346		-	-		-	50,648
Ending balance: collectively
evaluated for impairment	$	60,999		225,397		196,805		4,964	60,012		12	26,945		-	575,134

Year ended December 31, 2011
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development			Single- Family Residential		Commercial		Multifamily and Farmland		Commercial		Consumer and All Other		Unallocated	Total
Allowance for loan losses:
Beginning balance	$	5,774		6,097		1,409		17		1,174		430		592	15,493
Charge-offs		(7,164	)	(2,925	)	(1,271	)	-		(314	)	(586	)	-	(12,260	)
Recoveries		241		201		24		-		121		152		-	739
Provision		8,331		1,984		1,569		(4	)	48		259		445	12,632
Ending balance	$	7,182		5,357		1,731		13		1,029		255		1,037	16,604

Ending balance: individually
evaluated for impairment	$	1,250		1,289		-		-		-		-		-	2,539
Ending balance: collectively
evaluated for impairment		5,932		4,068		1,731		13		1,029		255		1,037	14,065
Ending balance	$	7,182		5,357		1,731		13		1,029		255		1,037	16,604

Loans:
Ending balance	$	93,812		267,051		214,415		4,793		60,646		29,780		-	670,497

Ending balance: individually
evaluated for impairment	$	20,280		20,661		3,845		-		-		-		-	44,786
Ending balance: collectively
evaluated for impairment	$	73,532		246,390		210,570		4,793		60,646		29,780		-	625,711

The Company utilizes an internal risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 9. These risk grades are evaluated on an ongoing basis. A description of the general characteristics of the nine risk grades is as follows:

·	Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists. CD or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.

·	Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company's range of acceptability. The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.

·	Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company's range of acceptability but higher than normal. This may be a new organization or an existing organization in a transitional phase (e.g. expansion, acquisition, market change).

Risk Grade 4 – Management Attention: These loans have higher risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends is observed. These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.

·	Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there has been some recent past due history on repayment and there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company's position at some future date.

Risk Grade 6 – Substandard: A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any). There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Risk Grade 7 – Low Substandard: These loans have the general characteristics of a Grade 6 Substandard loan, with heightened potential concerns. The exact amount of loss is not yet known because neither the liquidation value of the collateral nor the borrower's predicted repayment ability is known with confidence.

Risk Grade 8 – Doubtful: Loans classified as Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.

Risk Grade 9 – Loss: Loans classified as Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future. Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.

The following tables present the credit risk profile of each loan type based on internally assigned risk grades as of September 30, 2012 and December 31, 2011.

September 30, 2012
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development		Single- Family Residential	Commercial	Multifamily and Farmland	Commercial	Farm	Consumer	All Other	Total

1- Excellent Quality	$	192	23,029	-	-	954	-	1,350	-	25,525
2- High Quality		5,132	58,651	24,297	36	9,737	-	4,213	2,376	104,442
3- Good Quality		23,443	88,980	116,735	2,647	36,287	12	4,226	14,261	286,591
4- Management Attention		24,565	48,969	49,292	1,364	12,103	-	388	5	136,686
5- Watch		8,177	11,249	8,609	717	351	-	89	-	29,192
6- Substandard		19,224	18,289	4,670	200	926	-	37	-	43,346
7- Low Substandard		-	-	-	-	-	-	-	-	-
8- Doubtful		-	-	-	-	-	-	-	-	-
9- Loss		-	-	-	-	-	-	-	-	-
Total	$	80,733	249,167	203,603	4,964	60,358	12	10,303	16,642	625,782

December 31, 2011
(Dollars in thousands)
	Real Estate Loans
	Construction and Land Development		Single- Family Residential	Commercial	Multifamily and Farmland	Commercial	Consumer	All Other	Total

1- Excellent Quality	$	197	25,474	-	-	715	1,344	-	27,730
2- High Quality		5,183	64,817	25,506	50	8,801	4,070	2,774	111,201
3- Good Quality		27,675	100,388	136,137	3,448	36,585	4,259	16,509	325,001
4- Management Attention		28,138	50,253	40,312	358	12,882	429	7	132,379
5- Watch		15,923	11,767	2,795	728	622	89	-	31,924
6- Substandard		16,696	14,352	9,665	209	1,041	154	-	42,117
7- Low Substandard		-	-	-	-	-	-	-	-
8- Doubtful		-	-	-	-	-	-	-	-
9- Loss		-	-	-	-	-	145	-	145
Total	$	93,812	267,051	214,415	4,793	60,646	10,490	19,290	670,497

At September 30, 2012, TDR loans were $21.8 million, including $1.8 million in performing TDR loans. Effective March 31, 2012, performing TDR balances reflect current year TDR loans only, in accordance with GAAP. Previously reported TDR amounts reflect cumulative TDR loans from prior periods in addition to current year TDR loans. At December 31, 2011, TDR loans were $44.1 million, including $15.1 million in performing TDR loans. The terms of these loans have been renegotiated to provide a reduction in principal or interest as a result of the deteriorating financial position of the borrower.

The following table presents an analysis of TDR loans by loan type as of September 30, 2012 and December 31, 2011.

September 30, 2012
(Dollars in thousands)
	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Real estate loans
Construction and land development	20	$	16,735	9,824
Single-family residential	97		10,965	10,118
Commercial	5		3,136	981
Multifamily and Farmland	1		322	200
Total real estate TDR loans	123		31,158	21,123

Commercial loans (not secured by real estate)	14		1,271	706
Consumer loans (not secured by real estate)	1		2	6
Total TDR loans	138	$	32,431	21,835

December 31, 2011
(Dollars in thousands)
	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Real estate loans
Construction and land development	29	$	19,762	12,840
Single-family residential	241		25,541	24,846
Commercial	15		7,200	5,013
Multifamily and Farmland	1		322	209
Total real estate TDR loans	286		52,825	42,908

Commercial loans (not secured by real estate)	21		1,711	1,083
Consumer loans (not secured by real estate)	8		124	142
Total TDR loans	315	$	54,660	44,133