UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

x	Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011

¨	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: 000-17377

COMMONWEALTH BANKSHARES, INC.

(Exact name of registrant as specified in its charter)


VIRGINIA		54-1460991
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

403 Boush Street Norfolk, Virginia		23510
(Address of principal executive offices)		(Zip Code)

(757) 446-6900

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $2.066 Par Value – 6,897,081 shares as of August 11, 2011

Commonwealth Bankshares, Inc.

Form 10-Q for the Quarter Ended June 30, 2011

Table of Contents


		Page
PART I - FINANCIAL INFORMATION

ITEM 1 –	FINANCIAL STATEMENTS

	Consolidated Balance Sheets	3
	June 30, 2011
	December 31, 2010

	Consolidated Statements of Operations	4
	Three months ended June 30, 2011
	Three months ended June 30, 2010
	Six months ended June 30, 2011
	Six months ended June 30, 2010

	Consolidated Statements of Comprehensive Loss	5
	Six months ended June 30, 2011
	Six months ended June 30, 2010

	Consolidated Statements of Equity (Deficit)	6
	Six months ended June 30, 2011
	Year ended December 31, 2010
	Year ended December 31, 2009

	Consolidated Statements of Cash Flows	7
	Six months ended June 30, 2011
	Six months ended June 30, 2010

	Notes to Consolidated Financial Statements	8 - 38

ITEM 2 –	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	39 - 63

ITEM 3 –	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	63

ITEM 4 –	CONTROLS AND PROCEDURES	63 - 65

PART II - OTHER INFORMATION

ITEM 1 –	LEGAL PROCEEDINGS	66

ITEM 1A –	RISK FACTORS	66

ITEM 2 –	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	67

ITEM 3 –	DEFAULTS UPON SENIOR SECURITIES	67

ITEM 4 –	(REMOVED AND RESERVED)	67

ITEM 5 –	OTHER INFORMATION	67

ITEM 6 –	EXHIBITS	68

SIGNATURES		69

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Commonwealth Bankshares, Inc.

Consolidated Balance Sheets


	June 30, 2011 (Unaudited)			December 31, 2010 (Audited)
Assets

Cash and cash equivalents:
Cash and due from banks	$	3,072,838		$	2,673,337
Interest bearing deposits in banks		82,015,561			117,213,705
Federal funds sold		285,650			7,689

Total cash and cash equivalents		85,374,049			119,894,731


Investment securities:
Available for sale, at fair market value		12,544,963			9,213,650
Held to maturity, at amortized cost (fair market value was $94,020 and $123,920, respectively)		93,183			123,350

Total investment securities		12,638,146			9,337,000

Equity securities, restricted, at cost		6,986,800			8,756,550
Loans held for sale		—			1,750,280

Loans		840,493,764			947,499,773
Allowance for loan losses		(59,632,841	)		(79,038,370	)

Loans, net		780,860,923			868,461,403


Premises and equipment, net		33,202,600			34,327,776
Other real estate owned, net of valuation allowance		46,901,819			32,227,981
Accrued interest receivable		4,810,749			5,490,347
Other assets		15,099,100			14,307,616

Total assets	$	985,874,186		$	1,094,553,684


Liabilities and Equity (Deficit)

Liabilities:
Deposits:
Noninterest-bearing demand deposits	$	37,824,892		$	41,287,081
Interest-bearing		863,272,755			918,946,865

Total deposits		901,097,647			960,233,946

Short-term borrowings		12,500,000			29,000,000
Long-term debt		50,000,000			50,000,000
Trust preferred capital notes		20,619,000			20,619,000
Accrued interest payable		3,483,561			3,685,174
Other liabilities		2,474,048			2,704,398

Total liabilities		990,174,256			1,066,242,518

Equity (deficit):
Common stock, par value $2.066, 100,000,000 shares authorized; 6,897,082 and 6,897,084 shares issued and outstanding as of June 30, 2011 and December 31, 2010, respectively		14,249,370			14,249,376
Additional paid-in capital		63,838,140			63,838,137
Retained deficit		(82,866,710	)		(49,891,697	)
Accumulated other comprehensive income (loss)		219,737			(133,095	)

Total stockholders’ equity (deficit)		(4,559,463	)		28,062,721
Noncontrolling interests		259,393			248,445

Total equity (deficit)		(4,300,070	)		28,311,166

Total liabilities and equity (deficit)	$	985,874,186		$	1,094,553,684

See notes to unaudited consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Operations (Unaudited)


	Three months ended						Six months ended
	June 30, 2011			June 30, 2010			June 30, 2011			June 30, 2010
Interest and dividend income:
Loans, including fees	$	11,358,129		$	14,790,220		$	23,317,221		$	29,532,956
Investment securities:
Taxable		88,133			48,733			157,035			87,304
Tax exempt		—			6,976			990			14,411
Dividend income, equity securities, restricted		42,338			41,211			97,906			80,235
Other interest income		58,893			105,638			120,476			216,108

Total interest and dividend income		11,547,493			14,992,778			23,693,628			29,931,014


Interest expense:
Deposits		4,792,764			6,503,210			10,061,052			13,317,527
Short-term borrowings		14,137			49,339			40,855			84,455
Long-term debt		482,623			477,785			959,941			955,104
Trust preferred capital notes		97,729			337,013			192,695			665,073

Total interest expense		5,387,253			7,367,347			11,254,543			15,022,159

Net interest income		6,160,240			7,625,431			12,439,085			14,908,855

Provision for loan losses		22,505,601			5,009,144			27,504,801			10,007,195

Net interest income (loss) after provision for loan losses		(16,345,361	)		2,616,287			(15,065,716	)		4,901,660


Noninterest income:
Service charges on deposit accounts		212,789			268,634			430,498			549,809
Other service charges and fees		253,605			239,115			469,780			449,704
Mortgage brokerage income		22,185			108,746			70,549			202,201
Title insurance income		11,998			39,982			24,318			72,671
Investment service income		18,842			54,657			25,322			228,676
Losses on other real estate owned, net		(1,375,530	)		(658,924	)		(2,222,301	)		(1,014,794	)
Other		104,961			121,284			183,274			296,927

Total noninterest income		(751,150	)		173,494			(1,018,560	)		785,194


Noninterest expense:
Salaries and employee benefits		2,500,852			2,506,723			5,041,607			3,048,940
Net occupancy expense		980,129			961,353			1,979,762			1,976,406
Furniture and equipment expense		461,195			514,532			922,903			1,018,597
Legal and other professional fees		1,725,982			295,594			2,568,744			529,226
FDIC insurance		1,013,427			725,490			2,053,751			1,413,834
Other real estate owned expense		758,363			356,773			1,219,847			614,925
Other operating expense		1,945,472			1,302,354			3,357,889			2,372,248

Total noninterest expense		9,385,420			6,662,819			17,144,503			10,974,176


Loss before income taxes		(26,481,931	)		(3,873,038	)		(33,228,779	)		(5,287,322	)
Income tax benefit		(264,124	)		(1,357,920	)		(261,418	)		(1,854,863	)

Net Loss		(26,217,807	)		(2,515,118	)		(32,967,361	)		(3,432,459	)
Less: Net income attributable to noncontrolling interests		2,407			28,396			7,652			33,847

Net loss attributable to the Company	$	(26,220,214	)	$	(2,543,514	)	$	(32,975,013	)	$	(3,466,306	)


Loss per share attributable to the Company’s common stockholders:
Basic	$	(3.80	)	$	(0.37	)	$	(4.78	)	$	(0.50	)

Diluted	$	(3.80	)	$	(0.37	)	$	(4.78	)	$	(0.50	)

Basic weighted average shares outstanding		6,897,082			6,889,729			6,897,082			6,889,267
Diluted weighted average shares outstanding		6,897,082			6,889,729			6,987,082			6,889,267

See notes to unaudited consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Comprehensive Loss (Unaudited)


	Six months ended
	June 30, 2011			June 30, 2010
Net loss	$	(32,967,361	)	$	(3,432,459	)
Other comprehensive income, net of income tax:
Net change in unrealized gain on securities available for sale		352,832			10,505

Comprehensive loss		(32,614,529	)		(3,421,954	)
Less: Comprehensive income attributable to noncontrolling interests		7,652			33,847

Comprehensive loss attributable to the Company	$	(32,622,181	)	$	(3,455,801	)

See notes to unaudited consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Equity (Deficit) (Unaudited)

Six Months Ended June 30, 2011, and Years Ended December 31, 2010 and 2009


	Common Shares			Common Amount			Additional Paid-in Capital			Retained Earnings (Deficit)			Accumulated Other Comprehensive Income (loss)			Noncontrolling Interests			Total Equity (Deficit)
Balance, January 1, 2009		6,851,417		$	14,155,028		$	63,757,066		$	28,421,313		$	38,839		$	405,570		$	106,777,816
Comprehensive loss:
Net income (loss)		—			—			—			(25,781,103	)		—			37,065			(25,744,038	)
Change in unrealized loss on securities available for sale, net of tax effect		—			—			—			—			(26,761	)		—			(26,761	)

Total comprehensive loss																				(25,770,799	)

Issuance of common stock		37,034			76,512			82,477			—			—			—			158,989
Cash dividends - $0.10 per share		—			—			—			(685,710	)		—			—			(685,710	)

Balance, December 31, 2009		6,888,451			14,231,540			63,839,543			1,954,500			12,078			442,635			80,480,296
Comprehensive loss:
Net income (loss)		—			—			—			(51,846,197	)		—			10,912			(51,835,285	)
Change in unrealized loss on securities available for sale, net of tax effect		—			—			—			—			(145,173	)		—			(145,173	)

Total comprehensive loss																				(51,980,458	)

Purchase of subsidiary shares from noncontrolling interest holder		—			—			—			—			—			(188,604	)		(188,604	)
Cash distribution to noncontrolling interest holder		—			—			—			—			—			(16,498	)		(16,498	)
Issuance of common stock		8,633			17,836			(1,406	)		—			—			—			16,430

Balance, December 31, 2010		6,897,084			14,249,376			63,838,137			(49,891,697	)		(133,095	)		248,445			28,311,166
Comprehensive loss:
Net income (loss)		—			—			—			(32,975,013	)		—			7,652			(32,967,361	)
Change in unrealized gain on securities available for sale, net of tax effect		—			—			—			—			352,832			—			352,832

Total comprehensive loss																				(32,614,529	)

Cash contribution from noncontrolling interest holder		—			—			—			—			—			3,296			3,296

Redemption of fractional shares of common stock		(2	)		(6	)		3			—			—			—			(3	)

Balance, June 30, 2011		6,897,082		$	14,249,370		$	63,838,140		$	(82,866,710	)	$	219,737		$	259,393		$	(4,300,070	)

See notes to unaudited consolidated financial statements.

Commonwealth Bankshares, Inc.

Consolidated Statements of Cash Flows


	Six Months Ended
	June 30, 2011			June 30, 2010
Operating Activities:
Net loss	$	(32,967,361	)	$	(3,432,459	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Provision for loan losses		27,504,801			10,007,195
Depreciation and amortization		1,163,601			1,384,598
Gain on the sale of premises and equipment		(7,473	)		—
Proceeds from loans held for sale		1,750,280			—
Loss on other real estate owned		2,222,301			1,014,794
Net amortization of premiums and accretion of discounts on investment securities		35,682			314
Increase in deferred tax assets		(8,788,728	)		(1,533,951	)
Increase in deferred tax asset valuation allowance		8,788,728			—
Net change in:
Accrued interest receivable		679,598			1,171,984
Other assets		(791,484	)		(1,580,889	)
Accrued interest payable		(201,613	)		486,974
Other liabilities		(230,350	)		(2,311,438	)

Net cash provided by (used in) operating activities		(842,018	)		5,207,122


Investing Activities:
Purchase of investment securities available for sale		(4,084,433	)		(3,247,500	)
Net purchase of premises and equipment		(59,202	)		(895,818	)
Improvements to other real estate owned		(298,777	)		(70,695	)
Net decrease in loans		37,202,930			29,730,551
Purchase of subsidiary shares from noncontrolling interests		—			(188,604	)
Proceeds from:
Sale of loans		—			28,590,113
Calls and maturities of investment securities held to maturity		29,935			22,607
Sales, calls and maturities of investment securities available for sale		1,070,502			2,016,798
Sale of equity securities, restricted		1,769,750			—
Sale of premises and equipment		28,250			—
Sale of other real estate owned		6,295,387			3,781,563

Net cash provided by investing activities		41,954,342			59,739,015


Financing Activities:
Net increase (decrease):
Demand, interest-bearing demand and savings deposits		(16,690,370	)		4,515,112
Time deposits		21,425,070			17,245,700
Brokered time deposits		(63,870,999	)		(70,676,000	)
Short-term borrowings		(16,500,000	)		—
Dividends reinvested and (redemption of) fractional shares of stock		(3	)		4,557
Distributions to noncontrolling interests		—			(12,260	)
Contributions from noncontrolling interests		3,296			—

Net cash used in financing activities		(75,633,006	)		(48,922,891	)

Net increase (decrease) in cash and cash equivalents		(34,520,682	)		16,023,246
Cash and cash equivalents, January 1		119,894,731			185,520,349

Cash and cash equivalents, June 30	$	85,374,049		$	201,543,595


Supplemental cash flow disclosure:
Interest paid during the period	$	11,456,156		$	14,535,185

Income taxes paid during the period	$	5,906		$	—


Supplemental noncash disclosure:
Transfer between loans and other real estate owned	$	22,986,567		$	8,894,018

Sale of other real estate owned financed by bank loans	$	93,818		$	1,615,250

See notes to unaudited consolidated financial statements.

Commonwealth Bankshares, Inc.

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 1 – Basis of Presentation

The accounting and reporting policies of Commonwealth Bankshares, Inc. (the “Parent”) and its subsidiaries, Commonwealth Bankshares Capital Trust II (the “Trust”), and Bank of the Commonwealth (the “Bank”) and its subsidiaries, BOC Title of Hampton Roads, Inc. T/A Executive Title Center, BOC Insurance Agencies of Hampton Roads, Inc., Community Home Mortgage of Virginia Inc. T/A Bank of the Commonwealth Mortgage, Commonwealth Financial Advisors, LLC, Commonwealth Property Associates, LLC, WOV Properties, LLC, Moyock One, LLC, Ten Rivers Lots, LLC and Tivest Community Development Corp. are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to accepted practices within the banking industry. The accompanying consolidated financial statements include the accounts of the Parent, the Bank and the Bank’s subsidiaries, collectively referred to as the “Company.” All significant intercompany balances and transactions have been eliminated in consolidation. In addition, the Parent owns the Trust which is an unconsolidated subsidiary. The subordinated debt owed to this Trust is reported as a liability of the Parent.

The accompanying unaudited consolidated financial statements have been prepared in accordance with GAAP for interim financial reporting and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. For further information, refer to the financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010. The results of operations for the six months ended June 30, 2011 are not necessarily indicative of the results to be expected for the full year.

Certain prior period amounts have been reclassified to conform to the presentation for the current period. These reclassifications have no effect on the previously reported net loss.

Adoption of New Accounting Standards

In January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures About Fair Value Measurements.” ASU 2010-06 requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and, (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and non-recurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy were required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010 and did not have a significant impact on the Company’s financial statements.

In July 2010, the FASB issued ASU No. 2010-20, “Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (Topic 310).” The guidance significantly expanded the disclosures that the Company must make about the credit quality of financing receivables and the allowance for credit losses. The objectives of the enhanced disclosures are to provide financial statement users with additional information about the nature of credit risks inherent in the Company’s financing receivables, how credit risk is analyzed and assessed when determining the allowance for credit losses, and the reasons for the change in the allowance for credit losses. The disclosures as of the end of the reporting period were effective for the Company’s interim and annual periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period were effective for the Company’s interim and annual periods beginning on or after December 15, 2010 and were effective in the interim reporting period ending June 30, 2011. The adoption of this ASU enhanced the disclosures related to the credit quality of our loan portfolio as described in Note 5. In January 2011, the FASB issued ASU 2011-01, “Deferral of the Effective date of Disclosures about Troubled Debt Restructurings in ASU 2010-10.” The update defers the effective date of reporting TDR credit quality disclosures until after the FASB had clarified its guidelines for determining what constitutes a TDR (see below).

In December 2010, the FASB issued ASU 2010-28, “When to Perform Step 2 of the Goodwill Impairment test for Reporting Units with Zero or Negative Carrying Amounts.” The update requires companies to perform a step 2 analysis if the carrying value of a reporting unit is zero or negative and if it is more likely than not that goodwill is impaired. The update is effective for goodwill impairment testing performed during 2011 with any resulting impairment charge recorded through a cumulative effect adjustment to beginning retained earnings. The Company has adopted the standard as of January 1, 2011 and will apply the new guidance to future goodwill impairment testing. The Company does not expect the standard to have a substantive impact on its goodwill impairment evaluation.

In April 2011, the FASB issued ASU No. 2011-02, Receivables (Topic 310) “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The amendments in this update provide guidance and clarification in evaluating whether a restructuring constitutes a troubled debt restructuring. In making this determination, a creditor must separately conclude that both of the following exist: (1) the restructuring constitutes a concession; and (2) the debtor is experiencing financial difficulties. In addition, the amendments to Topic 310 clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a troubled debt restructuring, and should disclose the information required by paragraphs 310-10-50-33 through 50-34, which was deferred by Accounting Standards Update No. 2011-01, “Receivables (Topic 310): Deferral of the Effective date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20,” for interim and annual periods beginning on or after June 15, 2011. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The Company has adopted this standard as of July 1, 2011 and will apply the new guidance in its determination of trouble debt restructuring and related disclosure requirements but does not expect the standard to have a significant impact on the Company’s financial statements.

New Accounting Standards Not Yet Adopted

In April 2011, the FASB issued ASU No. 2011-03, “Transfers and Servicing (Topic 860): Reconsiderations of Effective Control for Repurchase Agreements.” The update addresses effective control in repurchase agreements and eliminates the requirement for entities to consider whether the transferor (i.e., seller) has the ability to repurchase the financial assets in a repurchase agreement. This new accounting guidance will be effective, on a prospective basis to new transactions or modifications to existing transactions, on January 1, 2012. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

In May 2011, the FASB issued ASU No. 2011-04 “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” The amendments clarify the application of the highest and best use and valuation premise concepts, preclude the application of blockage factors in the valuation of all financial instruments and include criteria for applying the fair value measurement principles to portfolios of financial instruments. The amendments additionally prescribe enhanced financial statement disclosures for Level 3 fair value measurements. The new amendments will be effective on January 1, 2012. The Company is currently assessing the impact of this guidance on the consolidated financial position and results of operations.

In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” The new guidance removes current presentation options and requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. The new accounting guidance will be effective for the Company for the three months ended March 31, 2012. The adoption of this guidance, which involves disclosures only, will not impact the Company’s consolidated financial position or results of operations.

Note 2 – Regulatory Matters and Going Concern Considerations

Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Prompt Corrective Action Directive

Effective July 1, 2011, the Bank entered into a Prompt Corrective Action Directive (the “Directive”) with the Board of Governors of the Federal Reserve System (the “Board of Governors”). Please see Exhibit 10.1 to the Company’s Form 8-K filed July 7, 2011 for a copy of the Directive.

The Directive requires that within 30 days of the effective date of the Directive or such additional time as the Board of Governors may permit, the Bank, in conjunction with the Parent must: (a) increase the Bank’s equity through the sale of shares or contributions to surplus in an amount sufficient to make the Bank adequately capitalized as defined in section 208.43(b)(2) of Regulation H of the Board of Governors; (b) enter into and close a contract to be acquired by a depository institution holding company or combine with another insured depository institution; or (c) take other necessary measures to make the Bank adequately capitalized.

The Bank was not able to meet the 30-day timeline prescribed by the Directive for reaching the required capital levels. The Board of Governors, as outlined in the Directive, may permit additional time as they see fit. The Parent and the Bank’s management and Board of Directors have implemented a capital plan with various alternatives to reach and maintain the required capital levels. This plan was originally accepted by the Federal Reserve Bank of Richmond (the “Federal Reserve” or “FRB”) in 2010 in response to the Written Agreement (as defined and discussed below). An updated capital restoration plan was submitted to the Federal Reserve in June 2011, due to our immediate capital needs. This plan was not accepted by the Federal Reserve since the Company had not received any firm commitments for new capital. If the Company does not raise sufficient amounts of new equity capital, or alternatively, execute another strategic initiative, the Company may become subject to a voluntary or involuntary bankruptcy filing and the Company believes it is possible that the Bank could be placed into FDIC receivership by bank regulators or acquired by a third party in a transaction in which the Parent receives no value for its interest in the Bank. Such a transaction would not likely have an impact on the operations of the Bank or its customers, and customer deposits would continue to be subject to FDIC insurance. The Company engaged two investment banking firms to explore all alternatives to increase the Bank’s equity position and restore the Bank’s capital levels back to a well capitalized status. Management and the Board are actively engaged and continue to diligently work with the Company’s investment bankers and work closely with the Bank’s regulators in an effort to comply with the terms of the Directive. The Board and Management’s goal remains to return the Bank to well capitalized status. Achievement of the required capital levels could be impacted, positively or negatively, as a result of certain uncertainties, including, but not limited to, asset quality, changing economic conditions, earnings levels, property values and the receptiveness of the capital markets.

The Directive also (a) restricts the Bank from making any capital distribution, including, but not limited to, the payment of dividends; (b) requires prior written approval from the FRB and the fulfillment of one of the requirements to make the Bank adequately capitalized described above, for the Bank to solicit and accept new deposit accounts or renew any time deposit bearing an interest rate that exceeds the prevailing effective rates on deposits of comparable amounts and maturities in the Bank’s market area; (c) restricts the payment of bonuses to senior executive officers and increases in compensation of such officers; (d) restricts asset growth, acquisitions, branching, and new lines of business; and (e) restricts certain activities, including, but not limited to, making any material change in accounting methods and engaging in any covered transaction as defined in Section 23A(b) of the Federal Reserve Act, without the prior written approval of the Federal Deposit Insurance Corporation.

2010, the Company received notification from the FDIC that its market area is considered a high rate area, and as a result, the interest rates paid for deposits by the Bank are the average rate for similar products within its market area. The Company has not paid bonuses or increased compensation to senior executive officers. The Company does not intend to make acquisitions, extend or enter into any new branching or new lines of business; and has complied with the restrictions on certain activities, including making any material change in accounting methods and engaging in any covered transaction.

Thirty days after the date of the Directive and monthly thereafter, the Bank is required to submit to the FRB written progress reports detailing the steps taken to comply with the Directive. The FRB, in its sole discretion, may grant extensions of time to the Bank to comply with any provision of the Directive.

To date, all progress reports required by the Directive have been submitted within the required timeframes outlined in the Directive.

Written Agreement

Effective July 2, 2010, the Company and the Bank entered into a written agreement with the FRB and the Virginia State Corporation Commission – Bureau of Financial Institutions (the “Bureau” or “SCC”) (the final written agreement, as executed by the parties, is herein called the “Written Agreement”). Please see Exhibit 10.1 to the Company’s Form 8-K filed July 9, 2010 for a copy of the Written Agreement.

Under the terms of the Written Agreement, the Bank has agreed to develop and submit for approval within the time periods specified therein written plans to: (a) strengthen board oversight of management and the Bank’s operation; (b) strengthen credit risk management policies; (c) enhance lending and credit administration; (d) enhance the Bank’s management of commercial real estate concentrations; (e) improve the Bank’s position with respect to loans, relationships, or other assets in excess of $1 million which are now or in the future become past due more than 90 days, which are on the Bank’s problem loan list, or which are adversely classified in any report of examination of the Bank; (f) review and revise, as appropriate, current policy and maintain sound processes for determining, documenting and recording an adequate allowance for loan and lease losses (“ALLL”); (g) enhance management of the Bank’s liquidity position and funds management practices; and (h) reduce the Bank’s reliance on brokered deposits.

In addition, the Bank has agreed that it will: (a) not extend, renew, or restructure any credit that has been criticized by the Federal Reserve or the Bureau absent prior board of directors approval in accordance with the restrictions in the Written Agreement; (b) eliminate all assets or portions of assets classified as “loss” and thereafter charge off all assets classified as “loss” in a federal or state report of examination, unless otherwise approved by the Federal Reserve and the Bureau; (c) not accept any new brokered deposits (contractual renewals or rollovers of existing brokered deposits are permitted); and (d) appoint a committee to monitor compliance with the terms of the Written Agreement.

Under the terms of the Written Agreement, both the Company and the Bank agreed to a capital restoration plan to maintain sufficient capital at the Company, on a consolidated basis, and the Bank, on a stand-alone basis, and to refrain from declaring or paying dividends without prior regulatory approval. The Company has agreed that it will not take any other form of payment representing a reduction in the Bank’s capital or make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without prior regulatory approval. The Company may not incur, increase or guarantee any debt without prior regulatory approval and has agreed not to purchase or redeem any shares of its stock without prior regulatory approval.

The Company is also required to obtain prior approval for the appointment of new directors, the hiring or promotion of senior executive officers, and to comply with restrictions on “golden parachute” payments.

To date, the Company has met all of the deadlines for taking actions required by the Federal Reserve and the Bureau under the terms of the Written Agreement and continues to enhance its oversight of management and the operations of the Bank as it embraces the need for strong and effective corporate governance to ensure the safe and sound operation of the Bank. The Board is actively engaged and determined to make the Bank a strong and well managed institution. A Committee has been appointed to oversee the Company’s compliance with the terms of the Written Agreement and has met each month beginning January, 2010 to review compliance. The Board and senior management of the Company and the Bank agree with the goal of financial soundness represented by the Written Agreement and have taken appropriate action to comply with each requirement (including timelines) specified in the Written Agreement, as the requirements and related actions follow:

Board Oversight and Source of Strength. Within 60 days of the Written Agreement, the board of directors of the Bank shall submit to the Federal Reserve and the Bureau a written plan to strengthen the board’s oversight of management and the operations of the Bank.

The Board Oversight Action Plan was submitted to the Federal Reserve and the Bureau within the 60 day period and addressed, among other things, the establishment of measures to ensure the Bank staff’s adherence to approved policies and procedures, an assessment of the structure of senior management and the Board, including committees, and specific staffing needs. The Action Plan addressed all the findings and recommendations of the independent board and management assessment that was performed by a third party consulting firm in 2010.

The Board and management of the Company and the Bank remain firmly committed and continue to fully utilize their financial and managerial resources to serve as a source of strength to the Bank, including taking steps to ensure that the Bank complies with the Written Agreement.

Credit Risk Management. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written plan to strengthen credit risk management practices.

The Credit Risk Management Plan was submitted to the Federal Reserve and the Bureau within the 60 day period and addressed, among other things, upgrades to board and management governance, credit policies, portfolio management activities, problem loan management, ALLL methodology, credit analysis, closing department controls, organization structure, staffing and credit training.

Lending and Credit Administration. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau enhanced lending policies and procedures, and credit administration procedures.

The Company completely revised the Bank’s lending policies and procedures. The new enhanced policies and procedures were submitted to the Federal Reserve and the Bureau within the 60 day period and addressed, among other things, strengthening underwriting standards, cash flow analyses, guarantor analysis and collateral analysis, procedures on ensuring all current financial information on borrowers is obtained, and enhanced appraisal ordering and review procedures.

Concentrations of Credit. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written plan to strengthen the Bank’s management of commercial real estate concentrations.

The Concentration of Credit Plan was submitted to the Federal Reserve and the Bureau within the 60 day period and addressed, among other things, procedures to identify, limit and manage concentrations of credit, setting acceptable concentration levels along with timetables and means to reduce the concentrations, and enhanced monitoring and reporting of commercial real estate concentrations. The Board and Management continue to monitor and manage concentrations closely and review detailed reports on concentrations at least quarterly.

Asset Improvement. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written plan designed to improve the Bank’s position through repayment, amortization, liquidation or other means on each loan in excess of $1 million, including other real estate owned that is past due more than 90 days, on the Bank’s problem loan list or adversely classified. Also, for any such loan, the Bank is required to submit a plan to improve the position on such loan and must submit a progress report updating each improvement plan within 30 days after the end of each quarter.

The Asset Improvement Plan and the specific action plans (Problem Loan Reports) for each loan required were submitted to the Federal Reserve and the Bureau within the required time periods.

The Bank has not extended, renewed, or restructured any credit that has been criticized by the Federal Reserve or the Bureau absent prior Board approval in accordance with the restrictions in the Written Agreement.

Allowance for Loan and Lease Losses. Within 90 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written program for the maintenance of an adequate ALLL and within 60 days the Bank shall send a revised ALLL methodology.

The Bank’s revised ALLL methodology and program was submitted to the Federal Reserve and the Bureau within the required time periods.

The Bank has eliminated all assets or portions of assets classified as “loss” and charged off all assets classified as “loss” in a federal or state report of examination.

Capital Plan. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written plan to maintain sufficient capital.

The Capital Plan was submitted to the Federal Reserve and the Bureau within the 60 day period and outlined several initiatives to improve the Bank’s capital position. This plan was originally accepted by the Federal Reserve in 2010. An updated capital restoration plan was submitted to the Federal Reserve in June 2011, due to our immediate capital needs. This plan was not accepted by the Federal Reserve since the Company had not received any firm commitments for new capital. During 2010, the Company formed a Capital Committee of the Board whose sole focus is to improve the capital position of the Bank. The Committee has been actively involved in several strategies to improve the Bank’s equity position including shrinking the balance sheet through loan sales, revenue enhancements and cost cutting measures. In addition, the Company has engaged two investment banking firms to explore all alternatives to increase the Bank’s equity position and restore the Bank’s capital levels back to a well capitalized status (Please also see the above capital discussion under “Prompt Corrective Action Directive”).

Liquidity and Funds Management. Within 60 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable enhanced written plan to improve management of the Bank’s liquidity position and funds management practices.

The Liquidity Contingency Funding Plan and Liquidity Risk Management Policy was submitted to the Federal Reserve and the Bureau within the 60 day period. Management reviews liquidity daily and takes necessary actions to insure adequate funding resources exist. Liquidity stress tests are performed and reviewed with the Board quarterly.

Brokered Deposits. Within 30 days of the Written Agreement, the Bank shall submit to the Federal Reserve and the Bureau an acceptable written plan for reducing its reliance on brokered deposits and the Bank shall not accept any new brokered deposits during the term of the Written Agreement.

The Brokered Deposit Plan was submitted to the Federal Reserve and the Bureau within the 30 day period. Since entering into the Written Agreement, the Bank has not accepted any new brokered deposits.

Dividends and Distributions.

The Written Agreement requires that the Bank not declare or pay any dividends without the prior written approval of the Federal Reserve, the Director of the Division of Banking Supervision and Regulation of the Board of Governors (the “Director”), and the Bureau. The Company shall not declare or pay any dividends without the prior written approval of the Federal Reserve, the Director, and the Bureau, and shall not take any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve and the Bureau. The Company and its non-bank subsidiary shall not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve, the Director, and the Bureau.

The Company has not declared or paid any dividends. The Company has not directly or indirectly taken any other form of payment representing a reduction in capital from the Bank, and will not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without prior written approval of the Federal Reserve.

Debt and Stock Redemption.

The Written Agreement requires the Company and its non-bank subsidiary to not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Federal Reserve and the Bureau, and to not directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Federal Reserve and the Bureau.

The Company and its non-bank subsidiary have not directly or indirectly, incurred, increased, or guaranteed any debt nor directly or indirectly, purchased or redeemed any shares of stock. The Company and its non-bank subsidiary have not and will not, directly or indirectly, incur, increase, or guarantee any debt nor, directly or indirectly, purchase or redeem any shares of stock.

Compliance with Laws, Regulations and the Agreement.

The Written Agreement requires the Bank to immediately take all necessary steps to correct all violations of law and regulation cited in the October 2009 report of examination, and required the Bank’s board of directors to take the necessary steps to ensure the Bank’s future compliance with all applicable laws and regulations. Within 60 days of the Written Agreement, the Bank shall submit acceptable policies and procedures to ensure compliance with certain provisions of the Bank Holding Company Act including, but not limited to, policies and procedures that prevent the Bank from requiring that loan customers of the Bank utilize real estate title insurance services provided by affiliates of the Bank. The Written Agreement also requires that, in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, the Company and the Bank shall comply with the notice provisions of Section 32 of the FDI Act and Subpart H of Regulation Y of the Board of Governors and also provide notice to the Bureau. The Company and the Bank shall not appoint any individual to the Company’s or the Bank’s board of directors or employ or change the responsibilities of any individual as a senior executive officer if the Federal Reserve or the Bureau notifies the Company or the Bank of disapproval within the time limits prescribed by Subpart H of Regulation Y. In addition, the Company and the Bank shall comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act and Part 359 of the FDIC’s regulations.

To the best of the Board and Bank’s knowledge, the Bank is in compliance with all laws and regulations and will continue to do so. The Bank has and will continue to submit to the Federal Reserve and the Bureau a written progress report detailing the form and manner of all actions taken to secure compliance with the Agreement and their results within 30 days after the end of each calendar quarter.

Troubled Condition

In a letter dated December 11, 2009, the FRB notified the Company that the FRB deemed the Bank to be in “troubled condition” within the meaning of federal statutes and regulations. As a result, the Parent and the Bank are subject to additional limitations and regulatory restrictions, including restrictions on future changes in senior executive management and directors, making “golden parachute” payments and incurring debt. Also as a result of the Bank’s troubled condition, each of the Parent and the Bank may not pay dividends to its shareholders (including payments by the Parent on its trust preferred securities), and may not purchase or redeem shares of its stock without prior approval of the FRB and the Bureau.

Capital Ratios

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). For the Company, Tier 1 Capital consists of shareholders’ equity and qualifying trust preferred securities, excluding any net unrealized gain (loss) on securities available for sale, goodwill and intangible assets. For the Bank, Tier 1 Capital consists of shareholders’ equity excluding any net unrealized gain (loss) on securities available for sale, goodwill and intangible assets. For both the Company and the Bank, total capital consists of Tier 1 Capital and the allowable portion of the allowance for loan losses. Risk-weighted assets for the Company and the Bank were $817,934 thousand and $817,156 thousand, respectively at June 30, 2011 and $886,225 thousand $885,471 thousand, respectively at December 31, 2010.

As of June 30, 2011, the Bank’s regulatory capital requirements resulted in the Bank being categorized as critically undercapitalized under the regulatory framework for prompt corrective action as a result of the Bank’s Tier 1 capital to average assets ratio dropping below 2%. To be categorized as adequately capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following tables. At June 30, 2011 and December 31, 2010, the Company and the Bank were below these levels. Although there can be no assurance of success, the Board and management are pursuing strategies designed to restore the Bank to well-capitalized status at all levels, and are continuing to explore options for raising additional capital. The Company’s and the Bank’s actual capital amounts and ratios as of June 30, 2011 and December 31, 2010 are also presented in the table.


	Actual						Minimum Capital Requirement					Mininum To Be Well Capitalized Under Prompt Corrective Action Provisions
(dollars in thousands)	Amount			Ratio			Amount		Ratio			Amount		Ratio
As of June 30, 2011
Total capital (deficit) to risk weighted assets:
Consolidated	$	(4,779	)		-0.58	%	$	65,435		8.00	%		N/A		N/A
Bank		27,323			3.34	%		65,372		8.00	%	$	81,716		10.00	%
Tier 1 capital (deficit) to risk weighed assets:
Consolidated		(4,779	)		-0.58	%		32,717		4.00	%		N/A		N/A
Bank		16,498			2.02	%		32,686		4.00	%		49,029		6.00	%
Tier 1 capital (deficit) to average assets:
Consolidated		(4,779	)		-0.46	%		41,159		4.00	%		N/A		N/A
Bank		16,498			1.61	%		41,097		4.00	%		51,371		5.00	%

As of December 31, 2010
Total capital to risk weighted assets:
Consolidated	$	60,112			6.78	%	$	70,898		8.00	%		N/A		N/A
Bank		60,899			6.88	%		70,838		8.00	%	$	88,547		10.00	%
Tier 1 capital to risk weighed assets:
Consolidated		37,346			4.21	%		35,449		4.00	%		N/A		N/A
Bank		48,991			5.53	%		35,419		4.00	%		53,128		6.00	%
Tier 1 capital to average assets:
Consolidated		37,346			3.20	%		46,617		4.00	%		N/A		N/A
Bank		48,991			4.21	%		46,599		4.00	%		58,249		5.00	%

Going Concern Considerations

The consolidated financial statements of Commonwealth Bankshares, Inc. as of and for the year ended December 31, 2010, included in the Company’s annual report on Form 10-K for the year ended December 31, 2010, and as of and for the six months ended June 30, 2011, included in this quarterly report on Form 10-Q, have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets. Substantial doubt exists regarding the Company’s ability to continue as a going concern due to the Company’s financial results for 2010 and the first six months of 2011, the substantial uncertainty throughout the U.S. banking industry, the Written Agreement and the Directive described above under “Regulatory Matters,” the Bank’s critically undercapitalized status, continued operating losses and ongoing deterioration in asset quality, potential liquidity constraints and other factors.

The Company incurred a net loss of $51.8 million for the year ended December 31, 2010 and a net loss of $33.0 million for the first six months of 2011. These losses were largely the result of dramatic increases in non-performing assets, significant provisions for loan losses in 2010 and the first six months of 2011, establishing a deferred tax valuation allowance on its net deferred tax position of $23.6 million in 2010 and losses and expenses related to its other real estate owned. Primarily as a result of these losses, as of June 30, 2011 and December 31, 2010, the Company was considered critically undercapitalized and undercapitalized, respectively, under regulatory guidelines and must improve its capital in accordance with the Written Agreement and the Directive.

As a result of the continuing downturn in the financial markets, the access of financial services companies to many sources of capital has become significantly restricted or has become increasingly costly as compared to the prevailing market rates prior to the downturn. Management cannot predict when or if the capital markets will return to more favorable conditions. Management is actively evaluating a number of capital sources, asset reductions and other balance sheet management strategies to improve the Bank’s projected level of regulatory capital to support its balance sheet. There can be no assurances that the Company will be successful in its efforts to raise additional capital during 2011. An equity financing transaction could result in substantial dilution to the Company’s current shareholders and could adversely affect the market price of the Company’s common stock. It is difficult to predict if these efforts will be successful, either on a short-term or long-term basis. For a discussion of the Company’s capital restoration plan, please see the discussion above under “– Prompt Corrective Action Directive” and “–Written Agreement – Capital Plan.”

As a critically undercapitalized bank, federal banking regulations prohibit the Bank from originating or renewing brokered deposits and also restrict the interest rates that the Bank can offer on deposits. The Bank’s brokered deposits maturing over the next six and twelve months total $13.4 million and $92.6 million, respectively. Based on available asset liquidity of approximately $85.4 million (which excludes available for sale securities, the majority of which were pledged for public deposits) at June 30, 2011, in conjunction with the Bank’s ability to generate funding through the internet deposit market, management believes adequate liquidity exists to fund brokered deposits maturing through the end of this year and over the next twelve months. However, gathering internet deposits utilizing a deposit listing service has been a primary source of liquidity over the last 6 months, increasing $100.2 million since December 31, 2010. If our ability to continue to gather deposits utilizing this source was severely limited or restricted, it would adversely affect our ability to maintain adequate liquidity over the next 12 months. Additionally, because of our troubled condition our ability to borrow funds from the Federal Reserve Discount Window as a source of short-term liquidity could be restricted by the Federal Reserve Bank of Richmond, which has broad discretion in regulating such borrowing. Our ability to access our available borrowing capacity from the Federal Home Loan Bank of Atlanta (“FHLB”) in the future is subject to our credit risk rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter. Because borrowings from the FHLB and FRB have historically represented our primary source of debt financing, restrictions on our borrowing capacity from the FHLB or FRB could adversely affect our access to debt financing. As a result of the potential issues discussed above, the Company’s management has maintained a high level of liquid assets, and expects to have the ability to generate adequate liquidity through deposit funding, including the internet deposits. Management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet customers’ credit needs.

The Parent relies on dividends from the Bank as its primary source of liquidity. The Parent is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Parent to meet its obligations, including paying dividends as more fully described above under “Regulatory Matters.” In addition, the terms of the Written Agreement and the Directive described above limit the Bank’s ability to pay dividends to the Parent to satisfy its funding needs, and the Parent may not make payments on its outstanding Junior Subordinated Debentures related to the trust preferred securities without prior regulatory approval.

Note 3 – Stock Compensation Plans

As of June 30, 2011, the Company has two stock based compensation plans, which are described more fully in Item 11 of the Company’s annual report on Form 10-K for the year ended December 31, 2010. The 1999 Stock Incentive Plan, which was approved by shareholders on April 27, 1999, expired in February 2009. The plan will continue to govern all unexercised and unexpired awards. The current plan in place, the 2005 Stock Incentive Plan, was approved by the shareholders at the 2005 Annual Meeting of Shareholders and provides for the issuance of restricted stock awards, stock options in the form of incentive stock options and non-statutory stock options, stock appreciation rights and other stock–based awards to employees and directors of the Company.

During the six months ended June 30, 2011 and 2010, respectively, the Company granted no options under the 2005 Stock Incentive Plan to directors and officers of the Company, and options granted in previous years were immediately vested at the time of grant.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the following assumptions: expected life, expected volatility, risk-free interest rate, dividend growth rate and annual dividend paid.

The Company determined the expected life of the stock options using historical data. The risk-free interest rate is based on the 10 year U.S. Treasury in effect at the date of grant. Expected volatility is based on the historical volatility of the Company’s stock.

Option valuation models require the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a representative single measure of the fair value at which transactions may occur.

A summary of the Company’s stock option activity and related information is as follows:


	Stock Options Outstanding		Weighted Average Exercise Price		Remaining Contractual Life ( in months)		Aggregate Intrinsic Value
Balance at December 31, 2010		345,312	$	17.82
Granted		—		—
Forfeited		—		—
Exercised		—		—
Expired		104,679		17.75

Balance at June 30, 2011		240,633	$	17.84		46.21	$	(4,196,640	)

Balance exercisable at June 30, 2011		240,633	$	17.84		46.21	$	(4,196,640	)

Exercise prices for options outstanding and exercisable as of June 30, 2011 were as follows:


Range of Exercise Prices	Number of Options	Remaining Contractual Life (in months)	Weighted Average Exercise Price
$ 5.89	7,563	3.00	$5.89
$ 15.51 - $ 16.98	90,070	40.54	15.83
$ 19.01 - $ 24.87	143,000	52.07	19.74

$ 5.89 - $ 24.87	240,633	46.21	$17.84

Note 4 – Earnings Per Share

Basic loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding. Diluted loss per share is computed by dividing net loss by the weighted average common and potential dilutive common equivalent shares outstanding, determined as follows:


	Three months ended						Six months ended
	June 30, 2011			June 30, 2010			June 30, 2011			June 30, 2010
Net loss attributable to the Company	$	(26,220,214	)	$	(2,543,514	)	$	(32,975,013	)	$	(3,466,306	)
Weighted average shares outstanding		6,897,082			6,889,729			6,897,082			6,889,267

Basic loss per common share attributable to the Company’s common stockholders	$	(3.80	)	$	(0.37	)	$	(4.78	)	$	(0.50	)

Effect of dilutive securities on EPS:
Weighted average shares outstanding		6,897,082			6,889,729			6,897,082			6,889,267
Effect of stock options		—			—			—			—

Diluted average shares outstanding		6,897,082			6,889,729			6,897,082			6,889,267

Diluted loss per common share attributable to the Company’s common stockholders	$	(3.80	)	$	(0.37	)	$	(4.78	)	$	(0.50	)

Options to acquire 240,633 shares of common stock for both the three and six months ended June 30, 2011 and options to acquire 399,802 shares of common stock for both the three and six months ended June 30, 2010, were not included in computing diluted loss per common share because their effects were anti-dilutive.

Note 5 – Investment Securities

The amortized costs and fair values of investment securities are as follows:


	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
June 30, 2011
Available for sale:
Mortgage-backed securities	$	12,325,226	$	219,801	$	(64	)	$	12,544,963

	$	12,325,226	$	219,801	$	(64	)	$	12,544,963

Held to maturity:
Mortgage-backed securities	$	93,183	$	911	$	(74	)	$	94,020

	$	93,183	$	911	$	(74	)	$	94,020


December 31, 2010
Available for sale:
U.S. Government and agency securities	$	499,781	$	2,356	$	—		$	502,137
Mortgage-backed securities		8,672,320		11,300		(148,196	)		8,535,424
State and municipal securities		174,645		1,444		—			176,089

	$	9,346,746	$	15,100	$	(148,196	)	$	9,213,650

Held to maturity:
Mortgage-backed securities	$	123,350	$	658	$	(88	)	$	123,920

	$	123,350	$	658	$	(88	)	$	123,920

Information pertaining to securities with gross unrealized losses at June 30, 2011 and December 31, 2010, aggregated by investment category and length of time that the individual securities have been in a continuous loss position, follows:


	Less Than 12 Months				12 Months or More				Total
June 30, 2011	Estimated Fair Value		Unrealized Loss		Estimated Fair Value		Unrealized Loss		Estimated Fair Value		Unrealized Loss
Mortgage-backed securities	$	—	$	—	$	17,865	$	64	$	17,865	$	64

Total temporarily impaired securities	$	—	$	—	$	17,865	$	64	$	17,865	$	64


	Less Than 12 Months				12 Months or More				Total
December 31, 2010	Estimated Fair Value		Unrealized Loss		Estimated Fair Value		Unrealized Loss		Estimated Fair Value		Unrealized Loss
Mortgage-backed securities	$	7,167,226	$	148,062	$	21,246	$	134	$	7,188,472	$	148,196

Total temporarily impaired securities	$	7,167,226	$	148,062	$	21,246	$	134	$	7,188,472	$	148,196

At June 30, 2011, approximately 96.0% of the mortgage backed securities held by the Company were issued by the Government National Mortgage Association (GNMA), which is backed by the full faith and credit of the federal government and the remaining mortgage backed securities were issued by Fannie Mae (FNMA) and Freddie Mac (FHLMC) institutions which the federal government has affirmed its commitment to support.

The unrealized loss positions at June 30, 2011 were directly related to interest rate movements as there is minimal credit risk exposure in these investments. All securities are investment grade or better. There were no bonds with unrealized loss positions of less than 12 months duration at June 30, 2011. Securities with losses of one year or greater duration included 1 federal agency mortgage-backed security.

No impairment has been recognized on any securities in a loss position because of management’s intent and demonstrated ability to hold securities to scheduled maturity or call dates.

A maturity schedule of investment securities as of June 30, 2011 is as follows:


	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due:
In one year or less	$	8,664	$	9,442	$	—	$	—
After one year through five years		7,325,967		7,426,078		93,183		94,020
After five years through ten years		4,990,595		5,109,443		—		—

	$	12,325,226	$	12,544,963	$	93,183	$	94,020

At June 30, 2011 and December 31, 2010, the Company had investment securities with carrying values of $12,402,715 and $8,430,922, respectively, pledged to secure public deposits and $14,360 and $24,820, respectively, pledged to secure treasury, tax and loan deposits.

Note 6 – Loans and Allowance for Loan Losses

Major classifications of loans by portfolio segment at June 30, 2011 and December 31, 2010 were:


	June 30, 2011			December 31, 2010
Construction and development	$	86,399,303		$	109,504,581
Commercial		58,237,917			63,717,189
Commercial mortgage		474,336,338			526,154,023
Residential mortgage		219,665,081			246,060,473
Installment loans to individuals		7,101,944			8,298,460
Other		100,141			375,566

Gross loans		845,840,724			954,110,292
Unearned income		(1,661,046	)		(1,723,031	)
Unaccreted discount on acquired loans		(1,808,371	)		(1,954,995	)
Credit enhancement on acquired loans		(1,877,543	)		(2,932,493	)
Allowance for loan losses		(59,632,841	)		(79,038,370	)

Loans, net	$	780,860,923		$	868,461,403

As of June 30, 2011 and December 31, 2010, loans with a carrying value of $239.5 million and $253.6 million, respectively, were pledged to the Federal Home Loan Bank of Atlanta as collateral for borrowings and $31.8 million and $61.8 million, respectively, of loans were pledged to the Federal Reserve.

During the third quarter of 2010, the Company completed an asset purchase and sale agreement with an independent third party accounted for as a transfer of financial assets whereby the Company sold $13.6 million of certain non-performing commercial and construction and development loans (plus accrued interest, late charges, and fees related to the loans of $4.6 million) without recourse at book value, and paid cash of $52.0 million; in exchange for the purchase of a pool of existing performing residential mortgage home equity loans, with an estimated fair value of $71.3 million. The Company does not have any continuing interest related to the non-performing commercial and construction and development loans that were sold.

Since the current market for residential mortgage home equity loans is illiquid, the Company determined the fair value of the loan portfolio based on a level 3 valuation approach. The Company engaged an independent third party to assist management of the Company in estimating the value of the portfolio of performing residential mortgage home equity loans utilizing observable market rates and credit characteristics for similar instruments. The loans were segmented by loan type and credit risk ratings further delineated based on FICO score and LTV ratio. The Company utilized the discounted cash flow model to estimate the fair value of the loans using assumptions for the weighted average rate, weighted average maturity, prepayment speed, projected default rates, loss given the default and estimates of prevailing discount rates net of credit risks. The expected cash flow approach includes the credit losses directly in the projected cash flows. The net estimated discount rate utilized in the discounted cash flow was 4.5% in conjunction with a constant prepayment rate (CPR) of between 10% and 2.5%, depending on the combined loan to value ratio of the individual loans included in the portfolio. The fair value estimate also took into consideration that as part of the loan purchase the Bank also received a $2.9 million credit enhancement, representing 4% of the loan pool, as a non-refundable reserve against future losses on the pool of loans. The non-recurring fair value of the portfolio was determined to be 97.2% of par as of August 25, 2010. These loans are geographically dispersed throughout the United States and had a book value of $73.3 million. The loans were recorded at fair value. The difference between the fair value and the outstanding balance of the loans received (book value) is accreted to interest income over the average life of the loans as an adjustment to yield.

The Company’s allowance for loan losses is the amount considered adequate to absorb probable losses within its loan portfolio based on management’s evaluation of the size and current risk characteristics of each of the segments of its loan portfolio. Such evaluation considers numerous factors and credit quality indicators, including, but not limited to net charge-off trends, internal risk ratings and changes in such risk ratings, historical losses incurred, collateral values, borrower FICO scores (primarily for consumer loans and home mortgage equity lines of credit), delinquency rates, non-performing and restructured loans, underwriting practices, industry conditions and economic trends. The housing downturn and broader economic slowdown that accelerated in 2009 and has continued into 2011 has negatively affected both our consumer and commercial loan portfolios and was a significant factor management considered in the evaluation of all of the loan portfolio segments. During 2010, the Company updated its Allowance

for Loan and Lease Policy and enhanced its methodology for calculating the estimate for its general allocation (ASC Topic 450) portion of the allowance analysis by modifying the historical loss experience to a rolling three year quarterly time period, putting more weight on the most recent quarter’s loss experience and current conditions. This change resulted in an increase to the allowance for loan losses at June 30, 2011 as more recent charge-off history was weighted more heavily than prior history when losses were extremely low, and focusing environmental qualitative considerations on credit rating trends within the construction and development and commercial mortgage portfolio segments. These portfolio segments contain the highest risk of loss. Additionally, the Company further clarified the methodology for identifying loans that should be assessed for impairment under ASC Topic 310 (see below). The Company believes these changes to its methodology more accurately reflect the risk inherent in its portfolio by weighting recent loss and loan segment experiences more heavily. A variety of initiatives were undertaken to bolster the loan grading function further clarifying the identification of loans that should be assessed for impairment. These initiatives and procedures which augmented the loan function included the development of extensive loan reviews, relationship reviews, cash flow analysis, and the use of an independent third party loan review team to augment the identification of impaired loans.

The adequacy of the allowance for loan losses is periodically evaluated by the Company, in order to maintain the allowance at a level that is sufficient to absorb probable credit losses. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance representing estimations made pursuant to either FASB ASC Topic 450 “Accounting for Contingencies,” or FASB ASC Topic 310 “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as loss, doubtful or substandard. For these loans or other such loans that are also considered as impaired, an allowance is established based on a thorough analysis of the most probable form of repayment, including the present value of the loan’s expected future cash flows, the loan’s estimated observable market price, or the estimated fair value of the underlying collateral value depending on the most likely source of repayment. A reserve is established when the fair value of the impaired loan is lower than the carrying value of the loan. A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. For the majority of the real estate loans included in the construction and development, commercial mortgage and residential mortgage loan segments, the Company uses numerous sources of information in order make an evaluation of the property’s value that collateralizes these loans. Estimated collateral valuations are based on appraisals, broker price opinions, recent sales of similar properties, and other property-specific and relevant market information. The value estimate is based on an orderly disposition and marketing period of the property. In some instances, the Company adjusts externally provided appraisals for justifiable and well-documented reasons, such as age of the appraisal, the appraiser not being aware of certain property specific factors, or recent sales information. For commercial and industrial loans the Company relies more heavily on the borrower’s cash flow to support the fair value of the loan, however, also utilizes various sources of information to support the value of collateral such as equipment, accounts receivable or inventory; in addition to any real estate that may collateralize such loans.

The general component covers non-classified loans that are grouped into pools or segments based on similar characteristics and is based on historical loss experience and other credit quality indicators for each loan portfolio segment adjusted for qualitative factors. Such qualitative factors management considers are the known and inherent risks in each segment of the loan portfolio, including adverse circumstances that may affect the ability of the borrower to repay interest and/or principal, the estimated value of collateral, an analysis of the levels and trends of delinquencies, charge-offs and levels of concentrations within each loan segment of the portfolio, and the credit risk ratings of the various loan segments (in particular construction and development and commercial real estate loan portfolios). Such factors as the level and trend of interest rates, internal process factors and the condition of the national and local economies are also considered. The housing downturn and broader economic slowdown that accelerated in 2009 and has continued into 2011 has negatively affected both our consumer and commercial loan portfolios and has been a significant factor that management has considered in evaluating the general component of all loan segments. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.

The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. Increases and decreases in the allowance due to changes in the measurement of impaired loans, if applicable, are included in the provision for loan losses. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable.

When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance. Subsequent recoveries, if any, are credited to the allowance. The Bank’s policy regarding charge-offs requires all loans that are deemed uncollectible be charged off in the period that the loan is deemed uncollectible but in no case later than 90 days after a loan is placed in non-accrual status. Also, all loans classified as “loss” by regulators must be charged off in the period identified. All loans recommended for charge off will be approved by the President and ratified by the Executive Committee. In addition, for real estate loans that are collateral dependent for collection, the uncollectible portion of the loan is charged off at the time of foreclosure, repossession, or liquidation or at such time any portion of the loan is deemed to be uncollectible and in no case later than 90 days after a loan is placed in non-accrual status.

A summary of the activity in the allowance for loan losses by portfolio segment and recorded investment in loans for the six months ended June 30, 2011 and a summary of the activity in the allowance for loan losses for the six months ended June 30, 2010 were as follows:


	Six months ended June 30, 2011																					Six months ended June 30, 2010
(in thousands)	Construction and Development			Commercial			Commercial Mortgage			Residential Mortgage			Installment loans to Individuals			Other and Unallocated			Total			Total
Allowance for credit losses:
Beginning balance	$	13,893		$	7,950		$	45,314		$	8,563		$	815		$	2,503		$	79,038		$	45,771
Charge-offs		(11,302	)		(2,949	)		(28,909	)		(3,679	)		(469	)		(43	)		(47,351	)		(4,193	)
Recoveries		3			24			85			316			8			5			441			177
Provision		10,018			875			15,660			2,141			251			(1,440	)		27,505			10,007

Ending balance	$	12,612		$	5,900		$	32,150		$	7,341		$	605		$	1,025		$	59,633		$	51,762

Ending balance individually evaluated for impairment	$	7,041		$	3,122		$	18,455		$	4,421		$	225		$	—		$	33,264

Ending balance collectively evaluated for impairment	$	5,571		$	2,778		$	13,695		$	2,920		$	380		$	1,025		$	26,369

Gross Loans:
Ending balance	$	86,399		$	58,238		$	474,336		$	219,665		$	7,102		$	100		$	845,840

Ending balance individually evaluated for impairment	$	50,744		$	13,287		$	225,405		$	42,678		$	1,016		$	—		$	333,130

Ending balance collectively evaluated for impairment	$	35,655		$	44,951		$	248,931		$	176,987		$	6,086		$	100		$	512,710

A summary of the recorded investment in loans by portfolio segment and the total allowance for loan losses as of December 31, 2010 were as follows:


(in thousands)	Construction and Development		Commercial		Commercial Mortgage		Residential Mortgage		Installment loans to Individuals		Other and Unallocated		Total
Allowance for credit losses:
Ending balance	$	13,893	$	7,950	$	45,314	$	8,563	$	815	$	2,503	$	79,038

Ending balance individually evaluated for impairment	$	10,480	$	5,715	$	35,361	$	6,245	$	531	$	35	$	58,367

Ending balance collectively evaluated for impairment	$	3,413	$	2,235	$	9,953	$	2,318	$	284	$	2,468	$	20,671

Gross Loans:
Ending balance	$	109,505	$	63,717	$	526,154	$	246,060	$	8,298	$	376	$	954,110

Ending balance individually evaluated for impairment	$	68,659	$	13,715	$	230,249	$	41,812	$	938	$	35	$	355,408

Ending balance collectively evaluated for impairment	$	40,846	$	50,002	$	295,905	$	204,248	$	7,360	$	341	$	598,702

At June 30, 2011, management believed the allowance for loan losses is commensurate with the risk existing in its loan portfolio and is directionally consistent with the change in the quality of the loan portfolio. However, the allowance may be increased or decreased in the future based on loan balances outstanding, changes in internally generated credit quality ratings of the loan portfolio, changes in general economic conditions, or other risk factors. Additionally, the allowance is subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgments about information available at the time of the examinations.

In addition to the allowance for loan losses, the Company received a credit enhancement of $2.9 million related to the purchase of residential mortgage home equity loans as discussed above. This enhancement was based on loan to value ratios and distributed FICO scores at the time of purchase, and is included as an offset against loans on the consolidated balance sheet. Subsequent to the purchase of the loans, management reviewed the FICO scores and payment histories as the primary credit quality indicators to evaluate the credit quality of this portfolio. At the time of purchase there were no significant delinquencies in the portfolio. Past due loans within the acquired residential mortgage home equity loans as of June 30, 2011 are included in the Analysis of Past Due Loan table below; and make up the majority of the past due home equity lines of credit as of June 30, 2011 and December 31, 2010. Management intends on updating the FICO scores at least annually, and reviews both the delinquency trends and FICO scores within the portfolio quarterly to determine the adequacy of the allowance for loan losses related to the acquired loans. During the period ended June 30, 2011, the Company charged off approximately $1.0 million of the purchased home equity loans against the original $2.9 million credit enhancement (This charge-off is not included in the above summary of activity in the allowance for loan losses table). At June 30, 2011, management determined that the remaining $1.9 million of credit enhancement received in connection with the acquired loans and the unaccreted discount was adequate to cover future losses inherent in the pool of loans and no further allowance was required at June 30, 2011.

Accounting standards require certain disclosures concerning impaired loans. A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest due according to the contractual terms of the loan agreement. Impaired loans amounted to $333.1 million and $355.4 million, with specific reserves allocated from the allowance for loan losses of $33.3 million and $58.4 million as of June 30, 2011 and December 31, 2010, respectively. Impaired loans for which no specific reserves have been allocated from the allowance for loan losses amounted to $171.8 million and $136.1 million as of June 30, 2011 and December 31, 2010, respectively. Included in the above impaired loan amounts were non-accrual loans of $142.4 million and $125.0 million as of June 30, 2011 and December 31, 2010, respectively. Loans that were 90 days past due and still collecting interest at June 30, 2011 and December 31, 2010 were $8.6 million and $5.4 million, respectively.

Following is more detailed information about impaired loans as of June 30, 2011 and December 31, 2010 by loan class:


			Unpaid				Average		Interest
June 30, 2011	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans with no related allowance recorded:

Construction and development:
1-4 family residential construction	$	100,000	$	100,000	$	—	$	1,553,744	$	3,017
Other construction, land and land development		16,653,836		19,508,979		—		20,052,364		83,587
Commercial		3,544,098		3,655,098		—		2,942,542		9,486
Commercial mortgage:
Multifamily residential properties		3,760,052		3,760,052		—		3,225,719		67,301
Owner occupied non-residential		12,694,766		12,694,766		—		14,672,928		369,525
Other non-residential		110,312,826		135,958,447		—		97,108,665		2,261,526
Residential mortgage:
1-4 family		22,247,141		23,590,132		—		16,337,878		480,175
Home equity line of credit		1,723,594		2,778,545		—		1,807,921		26,907
Installment loans to individuals		755,861		755,861		—		564,134		(4,547	)
Other		—		—		—		—		—

	$	171,792,174	$	202,801,880			$	158,265,895	$	3,296,977

Impaired loans with an allowance recorded:

Construction and development:
1-4 family residential construction	$	170,850	$	170,850	$	9,438	$	457,182	$	—
Other construction, land and land development		33,818,961		40,228,817		7,032,001		39,202,543		563,722
Commercial		9,742,829		10,117,829		3,121,572		10,620,164		202,490
Commercial mortgage:
Multifamily residential properties		4,222,056		4,344,475		679,056		4,812,416		89,344
Owner occupied non-residential		6,856,657		6,856,657		790,804		6,271,839		141,090
Other non-residential		87,558,742		91,387,067		16,984,703		98,130,967		2,262,634
Residential mortgage:
1-4 family		18,116,518		18,367,889		4,278,819		22,970,210		495,660
Home equity line of credit		591,164		591,164		142,371		753,680		11,082
Installment loans to individuals		259,815		262,807		225,301		512,092		48,095
Other		—		—		—		11,642		—

	$	161,337,592	$	172,327,555	$	33,264,065	$	183,742,735	$	3,814,117


Total
Construction and development	$	50,743,647	$	60,008,646	$	7,041,439	$	61,265,833	$	650,326
Commercial		13,286,927		13,772,927		3,121,572		13,562,706		211,976
Commercial mortgage		225,405,099		255,001,464		18,454,563		224,222,534		5,191,420
Residential mortgage		42,678,417		45,327,730		4,421,190		41,869,689		1,013,824
Installment loans to individuals		1,015,676		1,018,668		225,301		1,076,226		43,548
Other		—		—		—		11,642		—

	$	333,129,766	$	375,129,435	$	33,264,065	$	342,008,630	$	7,111,094


			Unpaid
December 31, 2010	Recorded		Principal		Related
	Investment		Balance		Allowance
Impaired loans with no related allowance recorded:

Construction and development:
1-4 family residential construction	$	3,688,605	$	3,980,241	$	—
Other construction, land and land development		21,165,605		21,578,730		—
Commercial		2,607,768		3,272,559		—
Commercial mortgage:
Multifamily residential properties		1,628,566		1,628,566		—
Owner occupied non-residential		14,956,926		14,956,926		—
Other non-residential		77,423,188		80,429,324		—
Residential mortgage:
1-4 family		13,652,238		13,831,987		—
Home equity line of credit		636,843		636,843		—
Installment loans to individuals		344,627		344,627		—
Other		—		—		—

	$	136,104,366	$	140,659,803


Impaired loans with an allowance recorded:

Construction and development:
1-4 family residential construction	$	1,200,696	$	1,200,696	$	178,988
Other construction, land and land development		42,603,698		46,746,791		10,301,622
Commercial		11,106,948		11,106,948		5,715,089
Commercial mortgage:
Multifamily residential properties		6,178,531		6,178,531		1,218,460
Owner occupied non-residential		7,236,169		7,236,169		1,328,950
Other non-residential		122,825,285		131,114,836		32,813,898
Residential mortgage:
1-4 family		26,494,105		26,494,105		5,871,192
Home equity line of credit		1,028,847		1,028,847		373,548
Installment loans to individuals		594,337		594,337		530,774
Other		34,927		34,927		34,927

	$	219,303,543	$	231,736,187	$	58,367,448


Total
Construction and development	$	68,658,604	$	73,506,458	$	10,480,610
Commercial		13,714,716		14,379,507		5,715,089
Commercial mortgage		230,248,665		241,544,352		35,361,308
Residential mortgage		41,812,033		41,991,782		6,244,740
Installment loans to individuals		938,964		938,964		530,774
Other		34,927		34,927		34,927

	$	355,407,909	$	372,395,990	$	58,367,448

The Company is required to account for certain loan modifications or restructurings as troubled debt restructurings (“TDR”). In general, the modification or restructuring of a loan constitutes a TDR when we grant a concession to a borrower experiencing financial difficulty. TDRs typically result from the Company’s loss mitigation activities. The primary factor the Company uses to consider a loan for modification is delinquency and payment defaults. Other identifying factors utilized include the review and analysis of the borrower’s financial statements along with changes in value of underlying collateral. If there is significant doubt as to whether the debtor will be in a position to continue to make future payments, a loan will be considered for modification. Modifications typically include rate reductions, payment extensions, modifications to the payment amount and term of the loan or other actions intended to minimize the economic loss and to avoid foreclosure or repossession of collateral. Typically, the term of the loan is shortened to between 6 to 36 months, with a 12-month term being the most common. This avoids the Company committing to “Long Term” concessions and allows the Company the opportunity to review and revisit the loan terms within a shorter period of time.

At the time of a TDR, the borrower’s payment history, past due status and ability to make payments based on the revised terms of the loan are considered. If a loan was accruing prior to being modified as a TDR and the borrower is able to make such payments and there are no other factors or circumstances to the contrary, the loan will continue on an accruing status, provided the TDR is supported by a current well documented credit evaluation and positive prospects of repayment under the revised terms. This analysis is conducted by the loan officer having responsibility for the credit and very often with the support and further review by the credit analysis department. In most cases the analysis is reviewed and approved by the Company’s Senior Loan Committee and in cases where the customer relationship exceeds $1 million is further reviewed and discussed with the Company’s Executive Loan Committee. If a loan was on non-accrual status at the time of the TDR, the loan remains on non-accrual status following the modification. A TDR may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.

All TDRs are considered to be impaired and are evaluated as such in the quarterly loan loss allowance calculation and included in the credit quality indicator below by loan segment. As of June 30, 2011, loans classified as troubled debt restructurings were approximately $185.7 million, all of which are considered impaired and included in the tables above. Of this amount, $98.1 million was accruing and $87.6 million was non-accruing at June 30, 2011. None of the non-accrual troubled debt restructurings were returned to accrual status during the six months ended June 30, 2011 and are evaluated as such in the quarterly allowance calculation. As of December 31, 2010, approximately $172.0 million of loans were classified as troubled debt restructurings. Of this amount, $98.4 million was accruing and $73.6 million was non-accruing at December 31, 2010.

The following table presents information regarding TDR loans by classification at June 30, 2011 and December 31, 2010.

Troubled Debt Restructured Loans


(in thousands)	June 30, 2011		December 31, 2010
Construction and development	$	21,582	$	32,874
Commercial		8,538		9,305
Commercial mortgage		135,602		115,752
Residential mortgage		19,660		13,578
Installment and other loans		335		446

Total	$	185,717	$	171,955

It is the Company’s policy to not report as TDRs restructured loans that have continued to be in compliance with the modified terms and conditions for six months and yield a market rate of interest at the time of restructuring in years subsequent to the year in which the loan was first reported as a TDR.

The Company has modified loans that were not accounted for as TDRs. These modifications are typically granted for seasonality issues where cash flow is decreased. The time period involved is generally quite short in relation to the loan term; for example, such a non-TDR modification may be interest only payments for 90 days. We consider this treatment of interest only payments for a short time as an insignificant delay in payment; consequently, we do not consider these modifications as troubled debt restructurings. In addition, we do not consider interest rate modifications to reflect a decrease in market interest rates or maintain a relationship with the debtor, where the debtor is not experiencing financial difficulty and can obtain funding from other sources, to be a troubled debt restructuring under current guidance.

Loans, including impaired loans, are generally classified as non-accrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as non-accrual, if repayment in full of principal and/or interest is in doubt.

Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal.

While a loan is classified as non-accrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a non-accrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

Loans on a non-accrual status as of June 30, 2011 and December 31, 2010 were as follows:


	June 30, 2011		December 31, 2010
Construction and development:
1-4 family residential construction	$	170,850	$	2,045,522
Other construction, land and land development		31,258,338		39,335,220
Commercial		4,810,244		3,814,332
Commercial mortgage:
Multifamily residential properties		6,990,334		1,418,484
Owner occupied non-residential		6,350,849		5,703,011
Other non-residential		70,130,205		53,358,127
Residential mortgage:
1-4 family		20,405,640		18,109,931
Home equity line of credit		1,538,281		704,057
Installment loans to individuals		731,066		481,298
Other		—		34,928

Total	$	142,385,807	$	125,004,910

Management utilizes many factors in its ongoing monitoring and evaluation of the credit quality of its loan portfolio. Such evaluation considers numerous factors and credit quality indicators including net charge-off and historical incurred loss trends as reported in the above summary of loan loss activity; impaired, non-performing and restructured loans as reported above and associated collateral values; and the following delinquency rates and trends as reported in the aged analysis of past due loans. Past due loan reports, non-performing loans, charge-off loans, delinquency rates and trends are updated and reviewed by senior management at least monthly or more frequently as warranted.

The following table shows the past due loans by loan class as of June 30, 2011. The credit quality indicator information has been updated through June 30, 2011.


June 30, 2011	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		Investment > 90 Days and Accruing
Construction and development:
1-4 family residential construction	$	—	$	—	$	170,850	$	170,850	$	3,492,296	$	3,663,146	$	—
Other construction, land and land development		2,636,358		2,004,817		32,977,519		37,618,694		45,117,463		82,736,157		1,719,181
Commercial		2,362,401		990,734		5,772,004		9,125,139		49,112,778		58,237,917		961,760
Commercial mortgage:
Multifamily residential properties		—		—		6,990,334		6,990,334		23,906,714		30,897,048		—
Owner occupied non-residential		4,634,900		1,278,140		6,540,042		12,453,082		75,328,273		87,781,355		189,193
Other non-residential		18,271,200		7,027,403		72,952,010		98,250,613		257,407,322		355,657,935		2,821,805
Residential mortgage:
1-4 family		7,024,598		3,269,694		23,140,825		33,435,117		114,835,171		148,270,288		2,735,185
Home equity line of credit		2,396,999		378,579		1,672,181		4,447,759		66,947,034		71,394,793		133,900
Installment loans to individuals		74,350		7,078		761,931		843,359		6,258,585		7,101,944		30,865
Other		—		—		—		—		100,141		100,141		—

Total	$	37,400,806	$	14,956,445	$	150,977,696	$	203,334,947	$	642,505,777	$	845,840,724	$	8,591,889

The following table shows the past due loans by loan class as of December 31, 2010. The credit quality indicator information has been updated through December 31, 2010.


December 31, 2010	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		Investment > 90 Days and Accruing
Construction and development:
1-4 family residential construction	$	—	$	—	$	2,045,522	$	2,045,522	$	11,927,263	$	13,972,785	$	—
Other construction, land and land development		4,746,073		13,744,294		23,833,059		42,323,426		53,208,370		95,531,796		557,896
Commercial		1,736,126		1,630,466		3,164,449		6,531,041		57,186,148		63,717,189		—
Commercial mortgage:
Multifamily residential properties		—		318,659		2,234,410		2,553,069		30,254,579		32,807,648		815,926
Owner occupied non-residential		6,069,839		1,791,197		5,703,011		13,564,047		67,600,107		81,164,154		—
Other non-residential		14,394,387		4,758,354		54,955,037		74,107,778		338,074,443		412,182,221		2,484,970
Residential mortgage:
1-4 family		4,238,810		2,662,405		18,746,536		25,647,751		140,891,042		166,538,793		1,136,422
Home equity line of credit		5,473,753		912,107		1,060,727		7,446,587		72,075,093		79,521,680		356,670
Installment loans to individuals		335,712		298,175		257,436		891,323		7,407,137		8,298,460		—
Other		—		—		34,928		34,928		340,638		375,566		—

Total	$	36,994,700	$	26,115,657	$	112,035,115	$	175,145,472	$	778,964,820	$	954,110,292	$	5,351,884

Additionally, management utilizes other credit quality indicators in determining the allowance for loan losses and evaluating the credit quality of its loan portfolio including internal risk ratings and changes in such risk ratings by loan class, payment activity by loan class and loan to collateral values. Management uses the classification system defined in bank regulations to evaluate the level of credit risk in the loan portfolio in establishing its internal risk ratings. Using the risk-based approach, the loan portfolio is reviewed and assigned a quality risk rating based on management’s best judgment of the likelihood of repayment or, if a loan is troubled, the likelihood of timely and orderly liquidation without loss of either principal or interest. Management is constantly reviewing and updating the internal risk ratings. Risk ratings on all loans up for renewal are reviewed at the time of renewal. Classified or loans past due are reviewed at least monthly and pass loans are reviewed at least annually or more frequently as warranted. These internal ratings are divided into three groups as defined below:

•

Pass (not classified): Pass assets are well protected by the current net worth and paying capacity of the borrower, or guarantors, if any, or by the fair value, less cost to sell, of any underlying collateral.

•

Special Mention (a watch rating): A special mention asset has potential weaknesses that deserve management’s close attention due to Company specific or systematic conditions. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future point. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification.

•

Classified (an adverse rating): The three adverse classifications are Substandard, Doubtful, and Loss, as defined below.

•

Substandard: A “substandard” asset is inadequately protected by the current sound worth and paying capacity of the borrower or by the collateral pledged, if any. Assets so classified have a well-defined weakness, or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

•

Doubtful: An asset classified as “doubtful” has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently known facts, conditions, and values. The likelihood of a loss on an asset or portion of an asset classified as “doubtful” is high.

•

Loss: An asset or portion thereof, classified “loss” is considered uncollectible and of such little value that its continuance on the Bank’s books as an asset, without establishment of a specific valuation allowance or charge-off, is not warranted. This classification does not necessarily mean that an asset has no recovery, but rather, there is much doubt about, how much will be recovered, or whether recovery will occur.

The tables below present certain credit quality indicators related to the loan portfolio by class as of June 30, 2011 and December 31, 2010.

Credit Exposure – all loan portfolio segments, excluding acquired residential mortgage home equity loans Credit Profile by Internally Assigned Risk. The credit quality indicator information was updated through June 30, 2011.


June 30, 2011 Grade	Pass		Special Mention		Substandard		Doubtful		Loss
Construction and development:
1-4 family residential construction	$	3,392,296	$	—	$	270,850	$	—	$	—
Other construction, land and land development		29,735,497		2,527,863		45,443,766		4,604,058		424,973
Commercial		42,029,049		2,921,941		11,504,723		1,782,204		—
Commercial mortgage:
Multifamily residential properties		20,030,439		2,884,501		7,366,832		615,276		—
Owner occupied non-residential		64,910,188		3,319,744		19,551,423		—		—
Other non-residential		133,359,103		24,427,264		195,115,968		2,755,600		—
Residential mortgage:
1-4 family		94,045,278		13,861,351		38,966,540		1,071,137		325,982
Home equity line of credit, excluding loans acquired		6,873,868		723,080		1,767,193		—		—
Installment loans to individuals		5,492,861		593,407		941,226		74,450		—
Other		100,141		—		—		—		—

	$	399,968,720	$	51,259,151	$	320,928,521	$	10,902,725	$	750,955


December 31, 2010 Grade	Pass		Special Mention		Substandard		Doubtful
Construction and development:
1-4 family residential construction	$	7,971,634	$	1,111,850	$	4,889,301	$	—
Other construction, land and land development		30,060,155		1,702,338		56,249,107		7,520,196
Commercial		46,766,207		3,236,266		12,048,280		1,666,436
Commercial mortgage:
Multifamily residential properties		17,362,038		7,638,513		7,807,097		—
Owner occupied non-residential		54,891,415		4,079,644		22,193,095		—
Other non-residential		172,769,936		39,163,812		194,169,544		6,078,929
Residential mortgage:
1-4 family		110,608,023		15,784,427		39,015,250		1,131,093
Home equity line of credit, excluding loans acquired		8,460,338		1,235,951		1,208,472		—
Installment loans to individuals		7,292,786		66,710		886,309		52,655
Other		340,639		—		34,927		—

	$	456,523,171	$	74,019,511	$	338,501,382	$	16,449,309

All loans classified with a loss risk rating as of December 31, 2010 were charged off.

Credit Exposure - all loan portfolio segments

Credit Risk Profile Based on Payment Activity


	Performing Loans				Non-performing Loans
	June 30, 2011		December 31, 2010		June 30, 2011		December 31, 2010
Construction and development:
1-4 family residential construction	$	3,492,296	$	11,927,263	$	170,850	$	2,045,522
Other construction, land and land development		49,758,638		55,638,680		32,977,519		39,893,116
Commercial		52,465,913		59,902,857		5,772,004		3,814,332
Commercial mortgage:
Multifamily residential properties		23,906,714		30,573,238		6,990,334		2,234,410
Owner occupied non-residential		81,241,313		75,461,143		6,540,042		5,703,011
Other non-residential		282,705,925		356,339,124		72,952,010		55,843,097
Residential mortgage:
1-4 family		125,129,463		147,292,440		23,140,825		19,246,353
Home equity line of credit		69,722,612		78,460,953		1,672,181		1,060,727
Installment loans to individuals		6,340,013		7,817,162		761,931		481,298
Other		100,141		340,638		—		34,928

	$	694,863,028	$	823,753,498	$	150,977,696	$	130,356,794

The credit quality indicator information above was updated through June 30, 2011 and December 31, 2010, the respective periods identified in the table. Non-performing loans include non-accrual loans and loans contractually past due 90 days or more and still accruing interest.

Note 7 – Premises and Equipment

Premises and equipment are summarized as follows:


	June 30, 2011			December 31, 2010
Land	$	2,614,324		$	2,614,324
Building and improvements		9,095,014			9,095,014
Leasehold improvements		21,456,441			21,436,630
Furniture and equipment		17,399,492			17,560,679
Construction in progress		—			3,156

		50,565,271			50,709,803
Less accumulated depreciation		(17,362,671	)		(16,382,027	)

	$	33,202,600		$	34,327,776

Note 8 – Other Real Estate Owned

Other real estate owned is presented net of a valuation allowance for losses. An analysis of the valuation for losses on other real estate owned is as follows:


	June 30, 2011			June 30, 2010
Balance at beginning of year	$	1,985,125		$	1,144,328
Provision for losses		1,398,354			602,227
Charge-offs		(1,458,627	)		(562,833	)

Balance at end of period	$	1,924,852		$	1,183,722

Expenses applicable to other real estate owned include the following:


	June 30, 2011		June 30, 2010
Net loss on sale of real estate	$	823,947	$	412,567
Provision for losses		1,398,354		602,227
Operating expenses, net of rental income		1,219,847		614,925

Total	$	3,442,148	$	1,629,719

Note 9 - Deferred Income Taxes

The realization of deferred income tax assets (“DTA”) is assessed by management quarterly and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Management’s assessment is primarily dependent on historical taxable income and projections of future taxable income, which are directly related to the Company’s core earnings capacity and its prospects to generate core earnings in the future. A valuation allowance of $32.4 million and $23.6 million at June 30, 2011 and December 31, 2010, respectively, was established related to all components of the net deferred tax assets based on the determination after the above considerations that it was more likely than not that the deferred tax assets would not be fully realized, primarily as a result of the trend of significant losses experienced by the Company over the past two years and the first six months of 2011.

Due to the net operating loss incurred for the year ended December 31, 2010 and the ability to carry back that loss to prior years in which income taxes were paid, the Company has recorded income taxes receivable of approximately $6.2 million as of June 30, 2011 and $6.0 million as of December 31, 2010, which are included in other assets on the accompanying consolidated balance sheets.

The Company has no uncertain tax positions at June 30, 2011.

Note 10 – Fair Value Measurements

FASB ASC Topic 820 “Fair Value Measurements and Disclosures” defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. FASB ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

FASB ASC Topic 820 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses

valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, FASB ASC Topic 820 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

•

Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

•

Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

•

Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial and non-financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.

Financial assets measured at fair value on a recurring basis include the following:

Available for Sale Securities. Available for sale securities are recorded at fair value on a recurring basis. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within level 3 of the valuation hierarchy.

The following table summarizes financial assets measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:


Assets Measured at Fair Value on a Recurring Basis at June 30, 2011
(in thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at June 30, 2011
Assets
Available for sale:
Mortgage-backed securities	$	—	$	12,545	$	—	$	12,545

Assets Measured at Fair Value on a Recurring Basis at December 31, 2010
(in thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at December 31, 2010
Assets
Available for sale:
U.S. Government and agency securities	$	—	$	502	$	—	$	502
Mortgage-backed securities	$	—	$	8,536	$	—	$	8,536
State and municipal securities	$	—	$	176	$	—	$	176

Certain financial and non-financial assets are measured at fair value on a non-recurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).

Assets measured at fair value on a non-recurring basis include the following:

Impaired Loans. A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is based on the present value of expected future cash flows discounted at the historical effective interest rate, the observable market price of the loan or the fair value of the collateral. All collateral-dependent loans are measured for impairment based on the fair value of the collateral securing the loan. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent licensed appraiser outside of the Company using observable market data. Depending on the age of the appraisal and current economic conditions, management may appropriately discount the appraisals based on facts known to the Company, such as list prices or property condition. For example, an appraisal may assume the collateral is in good condition, but the Company’s credit administration area subsequently learns that repairs are necessary to bring the

property into saleable condition. Another example would be when the Company maintains an appraisal of a lot in a subdivision, and credit administration learns of a subsequent sale of similarly situated lots in the same area at lower prices. In both cases, downward adjustments in value are appropriately made to reflect our understanding of current conditions. This valuation would be considered Level 3. An allowance is allocated to an impaired loan if the carrying value exceeds the estimated fair value. Impaired loans had a carrying amount of $333.1 million and $355.4 million, with a valuation allowance of $33.3 million and $58.4 million at June 30, 2011 and December 31, 2010, respectively.

Other Real Estate Owned. Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at the lower of cost or estimated fair market value of the property, less estimated disposal costs, if any. The Company estimates fair value at the asset’s liquidation value less disposal costs using management’s assumptions which are based on current market trends and historical loss severities for similar assets. Any excess of cost over the estimated fair market value at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings in the Company’s consolidated statements of operations. Other real estate owned had a carrying amount of $46.9 million and $32.2 million at June 30, 2011 and December 31, 2010, respectively. For the six months ended June 30, 2011 and 2010, the Company recorded losses of $1.4 million and $602 thousand, respectively, due to valuation adjustments on other real estate owned property in its consolidated statements of operations.

Goodwill. Goodwill requires an impairment review at least annually and more frequently if certain impairment indicators are evident. As a result of the significant deterioration in the operations of the mortgage subsidiary (for which the goodwill was related), it was determined during the second quarter of 2011, that the entire amount of goodwill of $249.5 thousand was impaired and charged-off as a non-interest expense during the second quarter of 2011. Therefore, there was no goodwill outstanding as of June 30, 2011. Goodwill had a carrying amount of $249.5 thousand at December 31, 2010.

The following table summarizes assets measured at fair value on a non-recurring basis as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:


Assets Measured at Fair Value on a Non-Recurring Basis at June 30, 2011
(in thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at June 30, 2011
Assets
Impaired loans	$	—	$	—	$	299,866	$	299,866
Other real estate owned	$	—	$	—	$	46,902	$	46,902

Assets Measured at Fair Value on a Non-Recurring Basis at December 31, 2010
(in thousands)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at December 31, 2010
Assets
Impaired loans	$	—	$	—	$	297,040	$	297,040
Other real estate owned	$	—	$	—	$	32,228	$	32,228

FASB ASC Topic 825 “Financial Instruments” requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on

a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The methodologies for other financial assets and financial liabilities are discussed below:

Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values.

Investment Securities

Fair values are based on published market prices or dealer quotes. Available-for-sale securities are carried at their aggregate fair value.

Equity Securities, Restricted

The carrying amount approximates fair value.

Loans Held for Sale

The carrying value of loans held for sale is a reasonable estimate of fair value since the loans are expected to be sold within a short period.

Loans, Net

For loans receivable with short-term and/or variable characteristics, the total receivables outstanding approximate fair value. The fair value of other loans is estimated by discounting the future cash flows using the build up approach to a discount rate. Components of the discount rate include a risk free rate, credit quality component and a service charge component.

Accrued Interest Receivable and Accrued Interest Payable

The carrying amount approximates fair value.

Deposits

The fair value of non-interest bearing deposits and deposits with no defined maturity, by FASB ASC Topic 825 definition, is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using the build up approach to a discount rate. Components of the discount rate include a risk free rate, credit quality component and a service charge component.

Short-Term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values.

Long-Term Debt

The fair values of the Company’s long-term debt are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Trust Preferred Capital Notes

The fair value is estimated by discounting the future cash flows using a discounted rate of 3 month Libor plus the Company’s credit spread (1.40%).

Loan Commitments, Standby and Commercial Letters of Credit

Fair values for off-balance sheet lending commitments approximate the contract or notional value taking into account the remaining terms of the agreement and the counterparties’ credit standings. The fair values of these items are not significant and are not included in the following table.

The estimated fair value and the carrying value of the Company’s recorded financial instruments are as follows:


	June 30, 2011				December 31, 2010
(in thousands)	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Cash and cash equivalents	$	85,374	$	85,374	$	119,895	$	119,895
Investment securities		12,638		12,639		9,337		9,338
Equity securities, restricted		6,987		6,987		8,757		8,757
Loans held for sale		—		—		1,750		1,750
Loans, net		780,861		789,016		868,461		896,728
Accrued interest receivable		4,811		4,811		5,490		5,490
Deposits		901,098		920,105		960,234		981,150
Short-term borrowings		12,500		12,499		29,000		28,999
Long-term debt		50,000		55,491		50,000		54,470
Trust preferred capital notes		20,619		20,618		20,619		20,618
Accrued interest payable		3,484		3,484		3,685		3,685

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

General

The sole business of Commonwealth Bankshares, Inc. is to serve as a holding company for Bank of the Commonwealth. The Company was incorporated as a Virginia corporation on June 6, 1988, and on November 7, 1988 it acquired the Bank.

Bank of the Commonwealth was formed on August 28, 1970 under the laws of Virginia. Since the Bank opened for business on April 14, 1971, its main banking and administrative offices have been located in Norfolk, Virginia. The Bank currently operates four branches in Norfolk, six branches in Virginia Beach, four branches in Chesapeake, two branches in Portsmouth, one branch in Suffolk, and four branches in North Carolina, located in Powells Point, Waves, Moyock and Kitty Hawk. Bank of the Commonwealth Mortgage currently operates one mortgage branch office in Gloucester, Virginia. Executive Title Center currently operates one title insurance branch office in Suffolk, Virginia. Commonwealth Financial Advisors currently has one location in Norfolk, Virginia.

The Company concentrates its marketing efforts in the cities of Norfolk, Virginia Beach, Portsmouth, Chesapeake and Suffolk, Virginia and Northeastern North Carolina. The Company intends to continue concentrating its banking activities in its current markets, which the Company believes are attractive areas in which to operate.

The following discussion provides information about the important factors affecting the consolidated results of operations, financial condition, capital resources and liquidity of the Company. This report identifies trends and material changes that occurred during the reporting period and should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2010.

Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Quarterly Report on Form 10-Q that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of adequacy of the allowance for loan losses, future provisions for loan losses, charge-offs, non-performing assets, revenues, expenses, income or loss, earnings or loss per share, the payment or non-payment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to the Written Agreement, the Directive, regulatory and/or legal matters, the current federal grand jury and SEC investigations, products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates,” “expects,” “intends,” “targeted,” “continue,” “remain,” “will,” “should,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. For a discussion of the risks, uncertainties and assumptions that could affect our future events, developments or results, you should carefully review the risk factors summarized below and the more detailed discussions in the “Risk Factors” section in the 2010 Form 10-K and in this Form 10-Q. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

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The ability or inability of the Company and the Bank to implement a satisfactory capital plan and to otherwise comply with the terms of the Written Agreement and Directive.

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The ability or inability of the Company and the Bank to meet the standards necessary to return to a “well-capitalized” status.

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The effect of restrictions on the use of brokered loans and interest rates paid on deposits on the attraction and retention of deposits at cost-effective pricing.

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Inaccuracies in management’s estimate of the adequacy of the allowance for loan losses.

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Non-realization of current valuations of other real estate owned.

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Local, regional, national and international economic conditions and the impact they may have on the Company and its customers and the Company’s assessment of that impact.

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The costs and effects of legal and regulatory developments including the results of regulatory examinations or reviews, and the resolution of legal proceedings or regulatory or other governmental inquires, including but not limited to the current federal grand jury and SEC investigations.

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Volatility and disruption in national and international financial markets.

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The effect of ongoing publicity regarding the financial position of the Company and the Bank.

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Government intervention in the U.S. financial system.

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Changes in the level of non-performing assets and charge-offs.

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Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

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The ability or inability of the Company to remediate the current material weaknesses in its internal control over financial reporting, and maintain effective internal control over financial reporting and disclosure controls and procedures.

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The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve.

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Inflation, interest rate, securities market and monetary fluctuations.

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The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

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Changes in consumer spending, borrowing, repayment and savings habits.

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Changes in the financial performance and/or condition of the Company’s borrowers.

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Technological changes.

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The ability to maintain market share and control expenses.

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Changes in the competitive environment among bank holding companies and other financial service providers.

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The effect of the Dodd-Frank Act and other changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Company and the Bank must comply.

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The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.

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Changes in the Company’s organization or compensation and benefit plans.

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Greater than expected costs or difficulties related to the integration of new products and lines of business.

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The Company’s success at managing the risks involved in the foregoing items.

For a further discussion of certain risks, uncertainties and assumptions that could affect our future events, developments or results, you should carefully review the risk factors summarized below and the more detailed discussions in the “Risk Factors” sections in the 2010 Form 10-K and in this Form 10-Q.

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There is substantial doubt about our ability to continue as a going concern, which may affect our business relationships.

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The Bank may be subject to a federal conservatorship or receivership if it cannot comply with the Written Agreement or Directive, or if its condition continues to deteriorate.

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We may incur significant credit losses, particularly in light of current market conditions.

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We incurred significant losses in 2010 and the first six months of 2011 and may continue do so in the future and we can make no assurances as to when we will be profitable.

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We have entered into a Written Agreement with the Federal Reserve and the Bureau and a Directive with the Board of Governors that places significant restrictions on our operations and requires us to dedicate significant resources to complying with these agreements. The cost of compliance, as well as any failure to comply, with the Written Agreement or Directive may have a material adverse effect on us.

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The Bank was critically undercapitalized under regulatory guidelines at June 30, 2011, and continued losses and deterioration in credit quality are likely to cause the Bank’s capital levels to further decline in the near term.

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A continuation or further deterioration of the current economic environment could adversely impact our financial condition and results of operations.

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We may incur losses if we are unable to successfully manage interest rate risk.

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We may face substantial potential liability and significant regulatory action, including in connection with investigations being conducted by a federal grand jury and the SEC, which could have material adverse financial consequences or cause significant reputational harm to us.

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Our ability to attract and retain customers and employees could be adversely affected to the extent our reputation is harmed or there is speculation as to whether we will be able to continue as a going concern.

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We need to raise additional capital that may not be available to us.

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The Federal Reserve has required us to commit capital resources to support our bank subsidiary, which may adversely impact our financial condition.

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We may become subject to additional regulatory restrictions in the event that our regulatory capital levels continue to decline, including being placed into FDIC receivership by bank regulators.

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Our management has identified material weaknesses in our internal control over financial reporting, which if not properly remediated could result in material misstatements in our future interim and annual financial statements and have a material adverse effect on our business, financial condition, results of operations and prospects or the price of our common stock.

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The Company’s controls and procedures may fail or be circumvented.

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Our ability to access sufficient liquidity could have a negative impact on our financial condition.

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Current and future restrictions on brokered deposits and the conduct of our business could adversely impact our ability to attract deposits or otherwise impact our liquidity and profitability.

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Our ability to borrow from the Federal Reserve Discount Window and the Federal Home Loan Bank could be restricted.

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General business and economic conditions may significantly affect our earnings.

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We may be adversely affected by economic conditions in our market area.

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Our small to medium-sized business target market may have fewer financial resources to weather a downturn in the economy.

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Our concentration of real estate loans subjects us to increased risks in the event real estate values continue to decline due to the economic recession, a further deterioration in the real estate markets or other causes.

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We have a concentration of credit exposure in commercial real estate.

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If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.

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Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

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The Dodd-Frank Wall Street Reform and Consumer Protection Act could increase our regulatory compliance burden and associated costs, place restrictions on certain products and services, and limit our future capital raising strategies.

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Our profitability may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

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We may not be able to manage risks inherent in our business, particularly given the recent turbulent and dynamic market conditions.

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A failure of the technology we use could harm our business and our information systems may experience a breach in security.

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An extended disruption of vital infrastructure and other business interruptions could negatively impact our business.

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The Parent’s stock price can be volatile.

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The trading volume in the Parent’s common stock is less than that of other financial services companies.

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An investment in the Parent’s common stock is not an insured deposit.

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Consumers may decide not to use banks to complete their financial transactions.

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We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.

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If we fail to regain compliance with the continued listing requirements of the NASDAQ Global Select Market, our Common Stock could be delisted.

Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. In addition, as evidenced by a major increase in our loan losses, a continuation of the recent distress in significant portions of the national and local economy and global financial markets, particularly if it worsens, could continue to negatively impact our performance, both directly by affecting our revenues and the value of our assets and liabilities, and indirectly by affecting our counterparties and the economy generally. Dramatic declines in the housing market in the past three years have resulted in significant write-downs of asset values by financial institutions in the United States, including by us. Concerns about the stability of the U.S. financial markets generally have reduced the availability of funding to certain financial institutions, leading to a tightening of credit and a reduction of business activity. In addition, our business and financial performance could be impacted as the financial industry restructures in the current environment, both by changes in the creditworthiness and performance of our counterparties and by changes in the competitive landscape.

Critical Accounting Policies

Certain critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. The Company’s most critical accounting policy relates to the Company’s allowance for loan losses, which reflects the estimated losses resulting from the inability of the Company’s borrowers to make required loan payments. If the financial condition of the Company’s borrowers were to deteriorate, resulting in an impairment of their ability to make payments, the Company’s estimates would be updated, and additional provisions for loan losses may be required. See Note 1 – Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2010 and Note 6 – Loans and Allowance for Loan Losses, of the Notes to Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q for the six months ended June 30, 2011 for further information related to the allowance for loan losses.

Results of Operations and Financial Condition of Commonwealth Bankshares, Inc. and Subsidiaries

Overview

The challenging economic conditions experienced over the past three years continued to negatively impact the businesses and consumers in our market area during the first six months of 2011. Ongoing deterioration in our loan portfolio resulted in further declines in the commercial real estate sector and additional credit quality issues for the Bank. During the first six months of 2011, we charged-off $47.4 million in loans primarily as a result of declining collateral values associated with uncollected collateral dependent loans that were determined by updated appraisals received during the period. Consequently, management and the Board provided $27.5 million to the Bank’s allowance for loan losses during the six months ended June 30, 2011, which was in addition to the $52.5 million and $53.9 million provided in years ended December 31, 2010 and 2009, respectively. Addressing these troubled credits aggressively and conservatively has always been, and will continue to be, a top priority of the Company. At the same time, we have not lost sight of our fundamental belief in standing by our clients and our communities. Today’s environment requires stringent measures. We are committed to taking the actions necessary to withstand this difficult economic phase.

During the three and six months ended June 30, 2011, the Company reported a loss of $26.2 million and $33.0 million, respectively, as compared to losses of $2.5 million and $3.5 million for the corresponding periods in 2010. Provisions for loan losses of $27.5 million and $10.0 million during the 2011 and 2010 six month periods negatively impacted the corresponding earnings, and accounted for a significant portion of the increase in net loss during the three and six month periods of 2011 as compared with the same periods in 2010. Additionally, a decline in net interest income, increased losses on other real estate owned and related expenses and costs associated with current regulatory and legal matters continued to pressure earnings during the three and six month periods of 2011 as compared with the same periods of 2010. On a per share basis, diluted loss per share increased to $4.78 per share for the six months ended June 30, 2011 and $3.80 for the three months ended June 30, 2011 as compared with a loss of $0.50 and $0.37 per share for the six months and three months ended June 30, 2010. Book value per share at June 30, 2011 was negative $0.66 compared to $4.07 at December 31, 2010. There were no dividends paid to shareholders during the six months ended June 30, 2011 and 2010.

The Company’s return on average assets (“ROAA”) was negative 6.35% and negative 0.56% for the six months ended June 30, 2011 and 2010, respectively, while its return on average equity (“ROAE”) was negative 282.21% and negative 8.79% for the comparable 2011 and 2010 six month periods, respectively. For the quarters ended June 30, 2011 and 2010, ROAA was negative 10.22% and 0.82%, respectively. ROAE was negative 446.34% and 12.92% for the same three month period of 2011 and 2010, respectively. Ongoing net losses created by significant loan loss provisions, losses and expenses related to other real estate owned and expenses associated with regulatory and legal matters continue to be the primary factors negatively impacting these profitability measurements.

Total assets declined by $108.7 million to $985.9 million during the six months ended June 30, 2011. This decrease was primarily the result of decreases in cash and cash equivalents and loans outstanding. Total cash and cash equivalents declined $34.5 million to $85.4 million during the period, primarily resulting from paying off broker certificates of deposit as they matured and short-term borrowings. Management’s policy of aggressively resolving problem loan credits through charge-offs and foreclosure contributed to its net loan balances declining $107.0 million to $840.5 million at June 30, 2011.

As a result of our net losses in 2010 and for the first six months of 2011, our total risk-based capital ratio for the Bank fell below the adequately capitalized regulatory minimum threshold of 8% to 3.34% at June 30, 2011, and our leverage

ratio dropped to 1.61% at June 30, 2011, which is considered critically undercapitalized under the prompt corrective action guidelines. See Regulatory Matters below and in Note 2 to the Consolidated Financial Statements of this Form 10-Q. Our goals for repositioning the Bank include addressing our capital needs in order to return to a well capitalized capital status, as well as improving our liquidity position, maintaining an adequate allowance for loan losses and reducing expenses.

Material Trends

Partially as a result of the economy and partially due to our prior credit practices and administration, we experienced a significant deterioration in credit quality over the past three years. Increases in problem loans and non-performing assets resulted in significant amounts being added to our allowance for loan losses which, coupled with other credit related costs associated with carrying other real estate owned and losses from sales and valuation adjustments of other real estate owned, contributed to the net losses available to common shareholders of $33.0 million for the six months ended June 30, 2011, and net losses of $51.8 million in 2010 and $25.8 million in 2009. In light of continued economic weakness, uncertain real estate values going forward and the lingering impact of our prior credit practices and administration, problem credits may continue to rise, significant additional provisions for loan losses may be necessary to supplement the allowance for loan losses, and we may continue to incur significant losses related to other real estate owned and loan charge-offs. As a result, we may continue to incur significant credit costs throughout the remainder of 2011, which would adversely impact our financial condition, our results from operations, and value of our common stock.

Basis of Presentation

Management’s discussion and analysis of financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements which have been prepared assuming that we will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, there is substantial doubt regarding our ability to continue as a going concern due to the Company’s financial results for 2010 and the first six months of 2011, the substantial uncertainty throughout the U.S. banking industry, the Written Agreement and the Directive the Company and the Bank have entered into, the Bank’s critically undercapitalized status, continued operating losses and ongoing deterioration in asset quality, potential liquidity constraints and other factors. The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and do not include any adjustments that might result from the outcome of this uncertainty.

Regulatory Matters

Prompt Corrective Action Directive

Effective July 1, 2011, the Bank entered into a Prompt Corrective Action Directive with the Board of Governors. Please see Exhibit 10.1 to the Company’s Form 8-K filed July 7, 2011 for a copy of the Directive.

The Directive requires that within 30 days of the effective date of the Directive or such additional time as the Board of Governors may permit, the Bank, in conjunction with the Company must: (a) increase the Bank’s equity through the sale of shares or contributions to surplus in an amount sufficient to make the Bank adequately capitalized as defined in section 208.43(b)(2) of Regulation H of the Board of Governors; (b) enter into and close a contract to be acquired by a depository institution holding company or combine with another insured depository institution; or (c) take other necessary measures to make the Bank adequately capitalized.

engaged two investment banking firms to explore all alternatives to increase the Bank’s equity position and restore the Bank’s capital levels back to a well capitalized status. Management and the Board are actively engaged and continue to diligently work with the Company’s investment bankers as well as working closely with the Bank’s regulators in an effort to comply with the terms of the Directive. The Board and management’s goal remains to return the Bank to well capitalized status. Achievement of the required capital levels could be impacted, positively or negatively, as a result of certain uncertainties, including, but not limited to, asset quality, changing economic conditions, earnings levels, property values and the receptiveness of the capital markets.

To date, the Company is in compliance with the above directives. The Company has not made any capital distributions or paid any dividends. The Company has complied with the rate restrictions on deposit accounts. During the first quarter of 2010, the Company received notification from the FDIC that our market area is considered a high rate area, and as a result, the interest rates paid for deposits by the Bank are the average rate for similar products within our market area. The Company has not paid bonuses or increased compensation to senior executive officers. The Company does not intend to make acquisitions, extend or enter into any new branching or new lines of business; and has complied with the restrictions on certain activities, including making any material change in accounting methods and engaging in any covered transaction.

To date, all progress reports required by the Directive have been submitted within the required timeframes outlined in the Directive. See Note 2 – Regulatory Matters, of the Consolidated Financial Statements included in this Form 10-Q for additional information.

Written Agreement

Effective July 2, 2010, the Company and the Bank entered into a written agreement with the FRB and the Bureau (the final written agreement, as executed by the parties, is herein called the “Written Agreement”). Please see Exhibit 10.1 to the Company’s Form 8-K filed July 9, 2010 for a copy of the Written Agreement.

Under the terms of the Written Agreement, the Bank has agreed to develop and submit for approval within the time periods specified therein written plans to: (a) strengthen board oversight of management and the Bank’s operation; (b) strengthen credit risk management policies; (c) enhance lending and credit administration; (d) enhance the Bank’s management of commercial real estate concentrations; (e) improve the Bank’s position with respect to loans, relationships, or other assets in excess of $1 million which are now or in the future become past due more than 90 days, which are on the Bank’s problem loan list, or which are adversely classified in any report of examination of the Bank; (f) review and revise, as appropriate, current policy and maintain sound processes for determining, documenting and recording an adequate allowance for loan and lease losses; (g) enhance management of the Bank’s liquidity position and funds management practices; and (h) reduce the Bank’s reliance on brokered deposits.

refrain from declaring or paying dividends without prior regulatory approval. The Company has agreed that it will not take any other form of payment representing a reduction in the Bank’s capital or make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without prior regulatory approval. The Company may not incur, increase or guarantee any debt without prior regulatory approval and has agreed not to purchase or redeem any shares of its stock without prior regulatory approval. For a discussion of the Company’s capital restoration plan as updated by the requirements of the Directive, please see the discussion above under “ – Prompt Corrective Action Directive” and the discussion in Note 2 – Regulatory Matters – Prompt Corrective Action Directive, of the Consolidated Financial Statements included in this Form 10-Q.

To date, the Company has met all of the deadlines for taking actions required by the Federal Reserve and the Bureau under the terms of the Written Agreement and continues to enhance its oversight of management and the operations of the bank as it embraces the need for strong and effective corporate governance to ensure the safe and sound operation of the Bank. The Board is very actively engaged and determined to make the Bank a strong and well managed institution. A Committee has been appointed to oversee the Company’s compliance with the terms of the agreement and has met each month to review compliance. The Board and senior management of the Company agree with the goal of financial soundness represented by the Written Agreement and have taken appropriate action to comply with all requirements (including timelines) specified in the Written Agreement. See Note 2 – Regulatory Matters, of the Consolidated Financial Statements included in this Form 10-Q for additional information on the Written Agreement and the Company’s and the Bank’s efforts to comply with the Written Agreement.

Analysis of Results of Operations

Net Interest Income and Net Interest Margin

Net interest income, the fundamental source of the Company’s earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans, investment securities and overnight interest bearing deposits, while deposits, short-term borrowings, and long-term debt represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations.

Net interest income was $6.2 million and $12.4 million for the three and six month periods ended June 30, 2011, respectively, which represented a decrease of $1.5 million and $2.5 million or 19.2% and 16.6% from the three and six months ended June 30, 2010, respectively. Average loan balances and yields declined $99.3 million and 74 basis points, respectively, and non-accrual loans increased $55.7 million since June 2010, contributing to a $6.2 million decline in interest income and the 74 basis point drop in yield on loans for the six months ended June 30, 2011 as compared with the six months ended June 30, 2010. However, a $149.4 million decrease in average interest bearing liabilities, coupled with a 36 basis points improvement in the corresponding average cost, resulted in a $3.8 million or 25.1% decrease in interest expense over the same time period which partially offset the interest income decline. Additionally, a $89.0 million decrease in average FRB reserve balances used primarily to pay down brokered deposits and short-term borrowings over the past 12 months, which only earn 25 basis points; and the declines in deposit balances and rates, helped mitigate the impact of a shrinking and deteriorating loan portfolio, resulting in the Company’s net interest margin to remain relatively flat at 2.48% and 2.45% for the three and six months ended June 30, 2011 as compared to 2.57% and 2.49% for the same periods in the prior year.

Average interest earning assets decreased $183.3 million for the six months ended June 30, 2011 as compared to the six months ended June 30, 2010, while the corresponding yield on earnings assets declined 33 basis points for the same comparable period. The decline in average loan balances and FRB reserve balances discussed above represented the primary reasons for the decrease in average interest earning assets. Management’s policy of aggressively resolving problem loan credits through charge-offs and foreclosures, normal principal curtailments and management’s efforts to shrink the balance sheet to preserve capital levels contributed to the loan decrease while liquidity demands to fund maturing brokered CDs and ongoing operations represented the primary factor impacting the decrease in the FRB reserve balances. The $149.4 million decrease in average interest bearing liabilities over the past twelve months was primarily resulted from a $111.7 million decline in average time deposit balances and a $23.5 million drop in average interest bearing demand deposit balances. Repayment of brokered CDs as they matured impacted average time deposit balances while lower deposit rates being offered, market competition for demand deposits and continued economic instability contributed to lower balances in interest bearing demand deposit accounts.

The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets and represents the Company’s net yield on its earning assets. Net interest margin is an indicator of the Company’s effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competition and the economy. The spread that can be earned between interest earning assets and interest bearing liabilities depends to a large extent on the slope of the yield curve. For the three and six months ended June 30, 2011, the net interest margin was 2.48% and 2.45% respectively, compared to 2.57% and 2.49% reported for the first three and six months of 2010. While small, the decrease in net interest margin for the first six months of 2011 was primarily the result of a drop in the average yield on our average interest earning assets of 33 basis points. Ongoing credit quality, primarily related to the increase in non-accrual loans, resulted in a 74 basis points decline in average yield on loans to 5.17% for the first six months of 2011 as compared with 5.91% for the first six months of 2010. The drop in yield of our earning assets was offset with a decrease in the cost of our interest bearing liabilities of 36 basis points over the past twelve months. The decrease in our interest bearing liability costs primarily related to maturing time deposits re-pricing at a lower cost during the past year, resulting in our average cost of time deposits decreasing from 2.80% for the first six months of 2010 to 2.45% for the first six months of 2011. Additionally, the cost of the trust preferred capital notes dropped from 6.50% for the six months ended June 30, 2010 to 1.88% for the six months ended June 30, 2011 as a result of the notes adjusting from a fixed rate to a LIBOR based variable rate in 2011.

The following tables presents the average interest earning assets and average interest bearing liabilities, the average annualized yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the indicated periods. The variance in interest income and expense caused by differences in average balances and rate is shown in the subsequent table.

Average Balance Sheet and Net Interest Margin Analysis


	Three Months Ended June 30,
	2011								2010
(dollars in thousands)	Average Balance(1)			Annualized Interest		Average Yield/Rate(2)			Average Balance(1)			Annualized Interest		Average Yield/Rate(2)
Assets
Interest earning assets:
Loans (3)(4)(7)	$	883,323		$	45,557		5.16	%	$	995,545		$	59,328		5.96	%
Investment securities (3)		12,660			335		2.65	%		6,523			192		2.94	%
Equity securities		7,971			170		2.13	%		9,508			165		1.74	%
FRB reserve balance		90,127			236		0.26	%		177,276			423		0.24	%
Federal funds sold		643			1		0.16	%		453			1		0.22	%
Interest bearing deposits in banks		291			1		0.34	%		48			—		—
Statutory trust		619			12		1.94	%		619			40		6.46	%
Other investments		280			6		2.14	%		274			6		2.19	%

Total interest earning assets		995,914			46,318		4.65	%		1,190,246			60,155		5.05	%

Noninterest earning assets:
Cash and due from banks		2,860								3,157
Premises and equipment, net		33,524								35,017
Other assets		58,016								57,409
Less: allowance for loan losses		(61,350	)							(48,861	)

Total assets	$	1,028,964							$	1,236,968


Liabilities and Equity
Interest bearing liabilities:
Interest bearing demand deposits	$	56,735		$	242		0.43	%	$	83,497		$	869		1.04	%
Savings deposits		8,112			44		0.54	%		7,800			47		0.60	%
Time deposits		808,313			18,937		2.34	%		910,661			25,168		2.76	%
FHLB short-term borrowings		15,452			57		0.37	%		35,024			168		0.48	%
Long-term debt		50,000			1,936		3.87	%		50,000			1,916		3.83	%
Trust preferred capital notes		20,619			392		1.90	%		20,619			1,352		6.56	%

Total interest bearing liabilities		959,231			21,608		2.25	%		1,107,601			29,520		2.67	%

Noninterest bearing liabilities:
Demand deposits		42,091								43,226
Other		7,582								6,977

Total liabilities		1,008,904								1,157,804

Equity:
Stockholders’ equity		19,802								78,920
Noncontrolling interests		258								244

Total equity		20,060								79,164

Total liabilities and equity	$	1,028,964							$	1,236,968


Net interest income (tax equivalent basis)				$	24,710							$	30,635

Net interest margin (5) (tax equivalent basis)							2.48	%							2.57	%
Average interest spread (6) (tax equivalent basis)							2.40	%							2.38	%

(1)	Average balances are computed on daily balances and management believes such balances are representative of the operations of the Company.

(2)	Yield and rate percentages are all computed through the annualization of interest income and expenses versus the average balance of their respective accounts.

(3)

Tax equivalent basis. The tax equivalent adjustment to loans was less than $1 thousand and $5 thousand for the three months ended June 30, 2011 and 2010, respectively. The tax equivalent adjustment to investment securities was $15 thousand for the three months ended June 30, 2010. There was no tax equivalent adjustment to investment securities for the three months ended June 30, 2011.

(4)	Non-accrual loans are included in the average loan balances, and cash received on such loans is recorded as a reduction to loan principal. Loans are net of unearned income, and discount and credit enhancement related to acquired loans.

(5)	Net interest margin is net interest income, expressed as a percentage of average interest earning assets.

(6)	Interest spread is the average yield earned on interest earning assets, less the average rate incurred on interest bearing liabilities.

(7)	Loan fees included in interest income were $133.6 thousand and $108.1 thousand for the three months ended June 30, 2011 and 2010, respectively.

Average Balance Sheet and Net Interest Margin Analysis


	Six Months Ended June 30,
	2011								2010
(dollars in thousands)	Average Balance(1)			Annualized Interest		Average Yield/Rate(2)			Average Balance(1)			Annualized Interest		Average Yield/Rate(2)
Assets
Interest earning assets:
Loans (3)(4)(7)	$	909,308		$	47,021		5.17	%	$	1,008,612		$	59,561		5.91	%
Investment securities (3)		11,640			301		2.59	%		5,679			172		3.03	%
Equity securities		8,362			197		2.36	%		9,508			162		1.70	%
FRB reserve balance		94,777			242		0.26	%		183,765			435		0.24	%
Federal funds sold		653			1		0.15	%		641			1		0.16	%
Interest bearing deposits in banks		251			1		0.40	%		64			—		—
Statutory trust		619			12		1.94	%		619			40		6.46	%
Other investments		279			6		2.15	%		273			8		2.93	%

Total interest earning assets		1,025,889			47,781		4.66	%		1,209,161			60,379		4.99	%

Noninterest earning assets:
Cash and due from banks		2,743								2,997
Premises and equipment, net		33,826								35,323
Other assets		54,303								54,917
Less: allowance for loan losses		(69,892	)							(47,461	)

Total assets	$	1,046,869							$	1,254,937


Liabilities and Equity
Interest bearing liabilities:
Interest bearing demand deposits	$	59,836		$	263		0.44	%	$	83,368		$	855		1.03	%
Savings deposits		8,599			46		0.53	%		7,604			44		0.58	%
Time deposits		815,794			19,981		2.45	%		927,484			25,957		2.80	%
FHLB short-term borrowings		19,800			82		0.41	%		35,014			155		0.44	%
Long-term debt		50,000			1,936		3.87	%		50,000			1,926		3.85	%
Trust preferred capital notes		20,619			388		1.88	%		20,619			1,341		6.50	%

Total interest bearing liabilities		974,648			22,696		2.33	%		1,124,089			30,278		2.69	%

Noninterest bearing liabilities:
Demand deposits		41,342								43,124
Other		7,063								7,857

Total liabilities		1,023,053								1,175,070

Equity:
Stockholders’ equity		23,562								79,524
Noncontrolling interests		254								343

Total equity		23,816								79,867

Total liabilities and equity	$	1,046,869							$	1,254,937


Net interest income (tax equivalent basis)				$	25,085							$	30,101

Net interest margin (5) (tax equivalent basis)							2.45	%							2.49	%
Average interest spread (6) (tax equivalent basis)							2.33	%							2.30	%

(1)	Average balances are computed on daily balances and management believes such balances are representative of the operations of the Company.

(2)	Yield and rate percentages are all computed through the annualization of interest income and expenses versus the average balance of their respective accounts.

(3)

Tax equivalent basis. The tax equivalent adjustment to loans was less than $1 thousand and $5 thousand for the six months ended June 30, 2011 and 2010, respectively. The tax equivalent adjustment to investment securities was $1 thousand and $15 thousand for the six months ended June 30, 2011 and 2010, respectively.

(4)	Non-accrual loans are included in the average loan balances, and cash received on such loans is recorded as a reduction to loan principal. Loans are net of unearned income, and discount and credit enhancement related to acquired loans.

(5)	Net interest margin is net interest income, expressed as a percentage of average interest earning assets.

(6)	Interest spread is the average yield earned on interest earning assets, less the average rate incurred on interest bearing liabilities.

(7)	Loan fees included in interest income were $228.6 thousand and $213.2 thousand for the six months ended June 30, 2011 and 2010, respectively.

Effect of Changes in Rate and Volume on Net Interest Income

As the largest component of income, net interest income represents the amount that interest and fees earned on loans and investments exceeds the interest costs of funds used to support these earning assets. Net interest income is determined by the relative levels, rates and mix of earning assets and interest bearing liabilities. The following table attributes changes in net interest income either to changes in average volume or to rate changes in proportion to the relationship of the absolute dollar amount of the change in each.

Three Months Ended June 30, 2011
compared to
Three Months Ended June 30, 2010

Six Months Ended June 30, 2011
compared to
Six Months Ended June 30, 2010

Increase (Decrease)
Due to:

Interest
Income/Expense

Increase (Decrease)
Due to:

Interest
Income/Expense

(in thousands)

Volume

Rate

Variance

Volume

Rate

Variance

Interest Income:

Loans

(6,277

)

(7,494

)

Large Accelerated Filer

Accelerated Filer

Non-Accelerated Filer

Smaller Reporting Company

COMMONWEALTH BANKSHARES INC 10-Q