UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2012

¨	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: 000-49976

ALLIANCE BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

VIRGINIA

46-0488111

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

14200 Park Meadow Drive, Suite 200 South, Chantilly, Virginia 20151

(Address of principal executive offices) (Zip Code)

(703) 814-7200

(Registrant’s telephone number, including area code)

N/A

(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 x 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

As of May 11, 2012 the number of outstanding shares of registrant’s common stock, par value $4.00 per share was: 5,109,969.

ALLIANCE BANKSHARES CORPORATION

INDEX


		Page

PART I FINANCIAL INFORMATION

Item 1.	Financial Statements		2
	Consolidated Balance Sheets at March 31, 2012 (Unaudited) and December 31, 2011,		2
	Consolidated Statements of Operations for the three months ended March 31, 2012 and 2011 (Unaudited)		3
	Consolidated Statements of Comprehensive Income for the three months ended March 31, 2012 and 2011 (Unaudited)		4
	Consolidated Statements of Changes in Shareholders’ Equity for the three months ended March 31, 2012 and 2011 (Unaudited)		5
	Consolidated Statements of Cash Flows for the three months ended March 31, 2012 and 2011 (Unaudited)		6
	Notes to Consolidated Financial Statements (Unaudited)		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		29

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		57

Item 4.	Controls and Procedures		60

PART II OTHER INFORMATION

Item 1.	Legal Proceedings		61

Item 1A.	Risk Factors		61

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		62

Item 3.	Defaults Upon Senior Securities		62

Item 4.	Mine Safety Disclosures		62

Item 5.	Other Information		62

Item 6.	Exhibits		63

SIGNATURES			64

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Alliance Bankshares Corporation

Consolidated Balance Sheets

March 31, 2012 and December 31, 2011

(Dollars in thousands, except share and per share amounts)


	March 31, 2012			December 31, 2011
	(unaudited)			(audited)
ASSETS

Cash and due from banks	$	66,589		$	45,837
Federal funds sold		25,307			16,567
Trading security, at fair value		454			596
Investment securities available-for-sale, at fair value		105,744			123,463
Restricted stock, at cost		4,772			4,772
Loans, net of allowance for loan losses of $5,070 and $5,393		292,015			301,483
Premises and equipment, net		1,297			1,415
Other real estate owned, net		4,683			3,748
Deferred tax assets, net of allowance $5,291 and $5,291		1,378			1,553
Accrued interest and other assets		6,425			7,049

TOTAL ASSETS	$	508,664		$	506,483

LIABILITIES AND SHAREHOLDERS’ EQUITY

LIABILITIES:
Non-interest bearing deposits	$	118,067		$	112,450
Savings and NOW deposits		57,415			51,475
Money market deposits		15,885			23,370
Time deposits		189,106			193,148

Total deposits		380,473			380,443
Repurchase agreements		43,842			40,420
Federal Home Loan Bank advances ($28,887 and $29,350 at fair value)		43,887			44,350
Trust Preferred Capital Notes		10,310			10,310
Other liabilities		2,421			2,838
Commitments and contingent liabilities		—			—

Total liabilities		480,933			478,361


SHAREHOLDERS’ EQUITY:
Common stock, $4 par value; 15,000,000 shares authorized; 5,109,969 shares issued and outstanding at March 31, 2012 and December 31, 2011		20,440			20,440
Capital surplus		25,924			25,915
Retained (deficit)		(18,702	)		(18,269	)
Accumulated other comprehensive income, net		69			36

Total shareholders’ equity		27,731			28,122

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	508,664		$	506,483

See Notes to Consolidated Financial Statements (Unaudited).

Alliance Bankshares Corporation

Consolidated Statements of Operations

(Unaudited)

For the Three Months Ended March 31, 2012 and 2011

(Dollars in thousands, except share and per share amounts)


	2012			2011
INTEREST INCOME:
Loans	$	4,183		$	4,545
Investment securities		323			1,321
Trading security		10			33
Federal funds sold		15			10

Total interest income		4,531			5,909

INTEREST EXPENSE:
Savings and NOW deposits		29			32
Time deposits		747			997
Money market deposits		30			49
Repurchase agreements		57			88
FHLB advances		268			259
Trust preferred capital notes		103			92

Total interest expense		1,234			1,517

Net interest income		3,297			4,392
Provision for loan losses		450			306

Net interest income after provision for loan losses		2,847			4,086

OTHER INCOME:
Deposit account service charges		34			37
Net gain on sale of available-for-sale securities		3			79
Gain (loss) and fair value adjustments on trading securities		(71	)		(127	)
Fair value adjustments on FHLB advances		463			151
Other operating income		40			44

Total other income		469			184

OTHER EXPENSES:
Salaries and employee benefits		1,164			1,392
Occupancy expense		591			561
Equipment expense		134			168
Other real estate owned expense		41			35
FDIC assessments		222			350
Operating expenses		1,439			1,217

Total other expenses		3,591			3,723

Income (loss) before income taxes		(275	)		547
Income tax expense		158			182

NET INCOME (LOSS)	$	(433	)	$	365

Net income (loss) per common share, basic	$	(0.08	)	$	0.07

Net income (loss) per common share, diluted	$	(0.08	)	$	0.07

See Notes to Consolidated Financial Statements (Unaudited).

Alliance Bankshares Corporation

Consolidated Statements of Comprehensive Income

(Unaudited)

For the Three Months Ended March 31, 2012 and 2011

(Dollars in thousands)


	2012			2011
NET INCOME (LOSS)	$	(433	)	$	365
Other comprehensive income (loss):
Unrealized holding gains (losses) on securities net of taxes of $19 in 2012 and ($125) in 2011		35			(244	)
Reclassification adjustment, net of taxes of ($1) in 2012 and ($27) in 2011		(2	)		(52	)

Total other comprehensive income (loss)		33			(296	)

TOTAL COMPREHENSIVE INCOME (LOSS)	$	(400	)	$	69

See Notes to Consolidated Financial Statements (Unaudited).

Alliance Bankshares Corporation

Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

For the Three Months Ended March 31, 2012 and 2011

(Dollars in thousands)


	Common Stock		Capital Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Share- holders’ Equity
BALANCE, DECEMBER 31, 2010		20,427	$	25,857		$	(12,311	)	$	(288	)	$	33,685

Net income		—		—			365			—			365
Other comprehensive (loss), net of tax		—		—			—			(296	)		(296	)
Exercise of stock options		6		(2	)		—			—			4

BALANCE, March 31, 2011	$	20,433	$	25,855		$	(11,946	)	$	(584	)	$	33,758


BALANCE, DECEMBER 31, 2011	$	20,440	$	25,915		$	(18,269	)	$	36		$	28,122

Net (loss)		—		—			(433	)		—			(433	)
Other comprehensive income, net of tax		—		—			—			33			33
Stock-based compensation expense		—		9			—			—			9

BALANCE, March 31, 2012	$	20,440	$	25,924		$	(18,702	)	$	69		$	27,731

See Notes to Consolidated Financial Statements (Unaudited).

Alliance Bankshares Corporation

Consolidated Statements of Cash Flows

(Unaudited)

For the Three Months Ended March 31, 2012 and 2011

(Dollars in thousands)


	2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(433	)	$	365
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation, amortization and accretion		719			371
Loss on disposal of fixed assets		—			15
Provision for loan losses		450			306
Losses and valuation adjustments on other real estate owned		28			12
Stock-based compensation expense		9			—
Net (gain) on sale of securities available-for-sale		(3	)		(79	)
Fair value adjustments		(392	)		(24	)
Deferred tax expense		158			—
Changes in assets and liabilities affecting operations:
Accrued interest and other assets		622			833
Other liabilities		(417	)		(160	)

Net cash provided by operating activities		741			1,639

CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in federal funds sold		(8,740	)		9,598
Purchase of securities available-for-sale		(59,582	)		(9,756	)
Proceeds from sale of securities available-for-sale		71,020			15,264
Paydowns on securities available-for-sale		5,755			4,293
Net change in trading securities		71			1,867
Net change in restricted stock		—			(19	)
Net change in loan portfolio		8,055			12,517
Proceeds from sale of other real estate owned		—			292
Purchase of premises and equipment		(20	)		(168	)

Net cash provided by investing activities		16,559			33,888

CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in cash provided by (expended on):
Non-interest bearing deposits		5,617			(3,952	)
Savings and NOW deposits		5,940			(3,336	)
Money market deposits		(7,485	)		(853	)
Time deposits		(4,042	)		7,328
Repurchase agreements		3,422			(9,161	)
Proceeds from exercise of stock options		—			4

Net cash provided by (used in) financing activities		3,452			(9,970	)

NET INCREASE IN CASH AND CASH EQUIVALENTS		20,752			25,557
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR		45,837			24,078

CASH AND CASH EQUIVALENTS, END OF YEAR	$	66,589		$	49,635

See Notes to Consolidated Financial Statements (Unaudited).

Notes to Consolidated Financial Statements (Unaudited)

1. General

Alliance Bankshares Corporation (Bankshares or Company) is a bank holding company that conducts substantially all its operations through its subsidiaries. Alliance Bank Corporation (the Bank) is state-chartered and a member of the Federal Reserve System. The Bank places special emphasis on serving the needs of individuals, small and medium size businesses and professional concerns in the greater Washington D.C. Metropolitan region, primarily in the Northern Virginia submarket.

On June 26, 2003, Alliance Virginia Capital Trust I (Trust), a Delaware statutory trust and a subsidiary of Bankshares, was formed for the purpose of issuing Bankshares’ trust preferred debt.

On May 3, 2012, WashingtonFirst Bankshares, Inc. (WFBI), Bankshares and the Bank entered into an Agreement and Plan of Reorganization (Merger Agreement), pursuant to which Bankshares will merge with and into WFBI, with WFBI being the surviving corporation (Merger). Each share of Bankshares’ outstanding common stock will be converted into and become the right to receive, subject to proration in accordance with the terms of the Merger Agreement and at the election of each shareholder of Bankshares, either 0.4435 shares of common stock of WFBI or cash in the amount of $5.30, subject in either case to adjustment in certain circumstances, provided that no more than 20% of the common shares of Bankshares may elect to receive cash. Completion of the Merger is subject to (i) approval of the Merger by the shareholders of each of Bankshares and WFBI, (ii) applicable regulatory approvals, including the Federal Reserve Board and the Virginia State Corporation Commission, and (iii) other customary closing conditions.

Under the Merger Agreement, Bankshares agreed to conduct its business in the ordinary course while the Merger is pending, and, except as permitted under the Merger Agreement, to generally refrain from, among other things, redeeming, purchasing or otherwise acquiring any shares of its capital stock, amending its articles of incorporation or bylaws, soliciting any third party acquisition proposals and entering into any new line of business, without the consent of WFBI.

The accompanying unaudited consolidated financial statements reflect the financial condition and results of operations of Bankshares on a consolidated basis and have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial reporting. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications of a normal and recurring nature considered necessary to present fairly Bankshares’ financial position as of March 31, 2012, and December 31, 2011, results of operations and comprehensive income for the three month period ended March 31, 2012 and 2011, and cash flows and changes in shareholders’ equity for the three month period ended March 31, 2012 and 2011. The notes included herein should be read in conjunction with the financial statements and accompanying notes included in Bankshares’ Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (the SEC).

Operating results for the three month periods ended March 31, 2012 and 2011 are not necessarily indicative of full year financial results.

2. Stock Option Plan

Accounting Standards Codification (ASC) 718-10, “Stock Compensation”, requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and nonvested shares, based on the fair value of those awards at the date of grant. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.

As of March 31, 2012, there was $73 thousand of total unrecognized compensation expense related to stock options, which will be recognized over the remaining requisite service period which is estimated to be three years or less.

Stock option compensation expense is the estimated fair value of options granted amortized on a straight-line basis over the requisite service period for each separately vesting portion of the award. The fair value of each grant is estimated at the grant date using the Black-Scholes option-pricing model. There were no grants of stock options for the first three months of 2012.

Stock option activity for the three months ended March 31, 2012 is summarized below:


	Number of Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)		Aggregate Intrinsic Value⁽¹⁾ (in thousands)
Outstanding at January 1, 2012		257,846		$	8.88
Granted		—			—
Exercised		—			—
Forfeited		(15,700	)		11.29
Expired		(4,750	)		11.72

Outstanding at March 31, 2012		237,396		$	8.67		4.5	$	91

Exercisable at March 31, 2012		181,246		$	10.48		4.5	$	22

⁽¹⁾ Intrinsic value is the difference between the underlying stock’s price and the strike price. If the difference is negative, the intrinsic value is given as zero.

3. Fair Value Measurements

Bankshares uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic of Financial Accounting Standards Board (FASB), ASC 820-10, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for Bankshares’ various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, Bankshares groups its financial assets and liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

•

Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.

•

Level 2 – Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

•

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

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following describes the valuation techniques used by Bankshares to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Trading and Available-for-Sale Securities – Trading and available-for-sale securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). Financial assets and liabilities that are traded infrequently have values based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own view about the assumptions that market participants would use in pricing the asset or liability (Level 3).

FHLB Advances – Under the fair value accounting standards, certain liabilities can be carried at fair value. The designated instruments are recorded on a fair value basis at the time of issuance. As of March 31, 2012, Bankshares had one wholesale liability as a fair value instrument: a long-term Federal Home Loan Bank (FHLB) advance.

Wholesale instruments are designated as either Level 2 or Level 3 under the ASC 820-10 fair value hierarchy. Level 2 liabilities are based on quoted market prices using independent valuation techniques for similar instruments with like characteristics. This information is deemed to be observable market data. Level 3 liabilities are financial instruments that are difficult to value due to dysfunctional, distressed markets or lack of actual trading volume. Management gathers certain data to value the instrument, including swap curves, conversion swaptions and discounted cash flows. These data points are modeled to reflect the estimate of the fair value of the liability.

The following tables present the balances of financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011:


	Fair Value Measurements at March 31, 2012
	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Assets/ Liabilities at Fair Value
	(Dollars in thousands)
Assets:
Trading security – PCMO	$	454	$	—	$	454	$	—	$	454
Available-for-sale securities:
U.S. treasuries		—		—		—		—		—
U.S. corporations and agencies		18,692		—		18,692		—		18,692
U.S. government CMOs		55,964		—		55,964		—		55,964
U.S. government agency MBS		21,533		—		21,533		—		21,533
PCMOs		967		—		967		—		967
Municipal securities		8,588		—		8,588				8,588

Total assets	$	106,198	$	—	$	106,198	$	—	$	106,198

Liabilities:
FHLB advance	$	28,887	$	—	$	—	$	28,887	$	28,887

Total liabilities	$	28,887	$	—	$	—	$	28,887	$	28,887


	Fair Value Measurements at December 31, 2011
	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Assets/ Liabilities at Fair Value
	(Dollars in thousands)
Assets:
Trading security – PCMO	$	596	$	—	$	596	$	—	$	596
Available-for-sale securities:
U.S. treasuries		71,115		71,115		—		—		71,115
U.S. corporations and agencies		9,751		—		9,751		—		9,751
U.S. government CMOs		31,038		—		31,038		—		31,038
U.S. government agency MBS		7,698		—		7,698		—		7,698
PCMOs		950		—		950		—		950
Municipal securities		2,911		—		2,911				2,911

Total assets	$	124,059	$	71,115	$	52,944	$	—	$	124,059

Liabilities:
FHLB advance	$	29,350	$	—	$	—	$	29,350	$	29,350

Total liabilities	$	29,350	$	—	$	—	$	29,350	$	29,350

The following tables present the activity in Level 3 fair value measurements for the three months ended March 31, 2012 and the year ended December 31, 2011:


Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
( Dollars in thousands)
	Other Real Estate Owned			FHLB Advances
Beginning balance, January 1, 2012	$	1,473		$	29,350
Transfers into (out of) Level 3		(1,473	)		—
Realized (gains) losses on liabilities		—			(463	)

Ending balance, March 31, 2012	$	—		$	28,887


Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
( Dollars in thousands)
	Other Real Estate Owned		FHLB Advances		AFS Securities			Trading Securities
Beginning balance, January 1, 2011	$	—	$	26,208	$	43,611		$	2,075
Transfers into (out of) Level 3		1,473		—		(26,940	)		(596	)
Sales, maturities or calls		—		—		(16,286	)		(1,489	)
Realized gains (losses) on assets		—		—		170			10
Realized (gains) losses on liabilities		—		3,142
Unrealized gains (losses) on assets		—		—		(555	)

Ending balance, December 31, 2011	$	1,473	$	29,350	$	—		$	—

For the assets and liabilities selected for fair value accounting where available, management obtained pricing on each instrument from independent third parties who relied upon pricing models using widely available and industry standard yield curves. At December 31, 2011, the securities previously carried at level three were moved to level two due to the fact that the pricing was identical to the normal market price. Management will continue to monitor these instruments. Changes in fair values associated with fluctuations in market values reported above are reported as fair value adjustments on the Consolidated Statements of Operations.

The following table displays quantitative information about level 3 fair value measurements for March 31, 2012 (Dollars in thousands):

Fair
Value

Valuation
Technique

Unobservable
Input

Range
(Weighted Average)

FHLB advance

28,887

Pricing model

Yield curves

2.27% - 2.52% (2.50%)

Certain financial and nonfinancial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by Bankshares to measure certain financial and nonfinancial assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans. Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the underlying collateral, if any. 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 using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered to be Level 3. Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Operations.

Other Real Estate Owned (OREO). OREO is measured at fair value using an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2). However, if an appraisal of the real estate property is over two years old, then the fair value is considered to be Level 3. Any fair value adjustments are recorded in the period recognized as OREO expense in the Consolidated Statements of Operations.

The following tables summarize Bankshares’ assets that were measured at fair value on a nonrecurring basis as of the dates indicated:


	Carrying Value at March 31, 2012
Description	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)
	(Dollars in thousands)
Assets:
Impaired loans, net of valuation allowance	$	5,813	$	—	$	5,813	$	—
OREO	$	4,683	$	—	$	4,683	$	—


	Carrying Value at December 31, 2011
Description	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)
	(Dollars in thousands)
Assets:
Impaired loans, net of valuation allowance	$	6,760	$	—	$	6,760	$	—
OREO	$	3,748	$	—	$	2,275	$	1,473

The following describes the valuation techniques used by Bankshares to measure certain financial assets and liabilities not previously described in this note that are not recorded at fair value on a recurring basis in the financial statements:

Cash, Due from Banks, and Federal Funds Sold

For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Loans Receivable

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (e.g., one-to-four family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for other loans (e.g., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Restricted Stock

Restricted investments in correspondent banks are carried at cost based on the underlying redemption provisions of the instruments and therefore are not included in the fair value disclosures.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Deposit Liabilities

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, statement savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-Term Borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on Bankshares’ current incremental borrowing rates for similar types of borrowing arrangements.

Trust Preferred Capital Notes

The fair value of Bankshares’ Trust Preferred Capital Notes, which is discussed in Note 10, is estimated using discounted cash flow analyses based on Bankshares’ current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. Fair value of off-balance sheet financial commitments are considered immaterial and are therefore not included in the table below.

The following table reflects the fair value of financial instruments as of March 31, 2012 and December 31, 2011:


	Fair Value Measurements at March 31, 2012, Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Balance
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	66,589	$	66,589	$	—	$	—	$	66,589
Federal funds sold		25,307		25,307		—		—		25,307
Trading securities		454		—		454		—		454
Available-for-sale securities		105,744		—		105,744		—		105,744
Loans, net		292,015		—		288,217		—		288,217
Accrued interest receivable		1,613		—		1,613		—		1,613

Financial liabilities:
Non-interest-bearing deposits	$	118,067		—	$	118,067	$	—	$	118,067
Interest-bearing deposits		262,406		—		263,730		—		263,730
Short-term borrowings		43,842		—		43,842		—		43,842
FHLB advances		15,000		—		15,000		—		15,000
FHLB advances, at fair value		28,887		—		—		28,887		28,887
Trust Preferred Capital Notes		10,310		—		10,310		—		10,310
Accrued interest payable		1,243		—		1,243		—		1,243


	Fair Value Measurements at December 31, 2011, Using:
	Carrying Value		Quoted Prices in Active Markets for Identical Assets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Balance
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	45,837	$	45,837	$	—	$	—	$	45,837
Federal funds sold		16,567		16,567		—		—		16,567
Trading security		596		—		596		—		596
Available-for-sale securities		123,463		—		123,463		—		123,463
Loans, net		301,483		—		297,163		—		297,163
Accrued interest receivable		1,815		—		1,815		—		1,815
Financial liabilities:
Non-interest-bearing deposits	$	112,450		—	$	112,450	$	—	$	112,450
Interest-bearing deposits		267,993		—		268,691		—		268,691
Short-term borrowings		40,420		—		40,420		—		40,420
FHLB advances		15,000		—		15,000		—		15,000
FHLB advances, at fair value		29,350		—		—		29,350		29,350
Trust Preferred Capital Notes		10,310		—		10,310		—		10,310
Accrued interest payable		1,155		—		1,155		—		1,155

4. Trading Security

The following table reflects the single trading security accounted for on a fair value basis and the effective yield of the instruments as of the dates indicated:


	March 31, 2012					December 31, 2011
	Fair Value		Yield			Fair Value		Yield
	(Dollars in thousands)
Trading security:
PCMO⁽¹⁾	$	454		5.40	%	$	596		5.44	%

Total trading security	$	454		5.40	%	$	596		5.44	%

⁽¹⁾

As of March 31, 2012, trading assets consisted of one PCMO instrument. This PCMO was rated AAA by at least one ratings agency on the purchase date. Currently the security has a rating below investment grade.

This instrument is currently performing as expected

At March 31, 2012 and December 31, 2011, the trading security was not pledged.

5. Investment Securities

The amortized cost, unrealized holding gains and losses, and the fair value of investment securities at March 31, 2012 are summarized as follows:


	March 31, 2012
	Amortized		Unrealized					Fair
	Cost		Gains		Losses			Value
	(Dollars in thousands)
Available-for-sale securities:
U.S. government corporations and agencies	$	18,702	$	29	$	(39	)	$	18,692
U.S. government agency CMOs		55,774		315		(125	)		55,964
U.S. government agency MBS		21,458		79		(4	)		21,533
PCMOs		970		—		(3	)		967
Municipal securities		8,733		67		(212	)		8,588

Total available-for-sale securities	$	105,637	$	490	$	(383	)	$	105,744

The amortized cost, unrealized holding gains and losses, and the fair value of investment securities at December 31, 2011 are summarized as follows:


	December 31, 2011
	Amortized		Unrealized					Fair
	Cost		Gains		Losses			Value
	(Dollars in thousands)
Available-for-sale securities:
U.S. treasuries	$	71,119	$	—	$	(4	)	$	71,115
U.S. government corporations and agencies		9,737		35		(21	)		9,751
U.S. government agency CMOs		30,893		195		(50	)		31,038
U.S. government agency MBS		7,672		26		—			7,698
PCMOs		1,005		—		(55	)		950
Municipal securities		2,982		70		(141	)		2,911

Total available-for-sale securities	$	123,408	$	326	$	(271	)	$	123,463

There were no held-to-maturity investments at March 31, 2012 or December 31, 2011.

The following tables present the aggregate amount of unrealized loss in investment securities as of March 31, 2012 and December 31, 2011. The aggregate amount is determined by summation of all the related securities that have a continuous loss at period end, and the length of time that the loss has been unrealized is shown by terms of “less than 12 months” and “12 months or more.” The fair value is the approximate market value as of the period end.


	March 31, 2012
	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
	(Dollars in thousands)
U.S. government corporations and agencies	$	3,990	$	(39	)	$	—	$	—			3,990	$	(39	)
U.S. government agency CMOs		17,701		(125	)		—		—			17,701		(125	)
U.S. government agency MBS		5,298		(4	)		—		—			5,298		(4	)
PCMOs		967		(3	)		—		—			967		(3	)
Municipal securities		6,183		(91	)		548		(121	)		6,731		(212	)

Total temporarily impaired investment securities	$	34,139	$	(262	)	$	548	$	(121	)	$	34,687	$	(383	)


	December 31, 2011
	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
	(Dollars in thousands)
U.S. treasuries	$	71,115	$	(4	)	$	—	$	—		$	71,115	$	(4	)
U.S. government corporations and agencies		3,327		(21	)		—		—			3,327		(21	)
U.S. government agency CMOs		7,401		(50	)		—		—			7,401		(50	)
U.S. government agency MBS		—		—			—		—
PCMOs		—		—			950		(55	)		950		(55	)
Municipal securities		526		(4	)		525		(137	)		1,051		(141	)

Total temporarily impaired investment securities	$	82,369	$	(79	)	$	1,475	$	(192	)	$	83,844	$	(271	)

Bankshares’ investment security portfolio is primarily comprised of U.S. government and fixed rate bonds, whose prices move inversely with interest rates. At the end of any accounting period, the portfolio may have both unrealized gains and losses. Unrealized losses within Bankshares’ portfolio typically occur as market interest rates rise. Such unrealized losses are considered temporary in nature. Under ASC 320-10-35, Debt and Equity Securities Recognition and Presentation of Other-Than-Temporary Impairments, an impairment is considered “other than temporary” if any of the following conditions are met: Bankshares intends to sell the security, it is more likely than not that Bankshares will be required to sell the security before recovery of its amortized cost basis, or Bankshares does not expect to recover the security’s entire amortized cost basis (even if Bankshares does not intend to sell). In the event that a security would suffer impairment for a reason that was “other than temporary,” Bankshares would be expected to write down the security’s value to its new fair value, and the amount of the write-down would be included in earnings as a realized loss. As of March 31, 2012 and December 31, 2011, management does not consider any of the unrealized losses to be other-than-temporarily impaired and no impairment charges have been recorded.

There are a total of 22 investment securities totaling $34.7 million that have an unrealized loss and are considered temporarily impaired as of March 31, 2012. Management believes the unrealized losses noted in the table above are a result of current market conditions and interest rates, and do not reflect on the ability of the issuers to repay the obligations. Approximately $27.0 million or 77.8% of the investment securities with an unrealized loss are backed by U.S. Government Agencies or Corporations and other forms of underlying collateral.

Bankshares’ investment in Federal Home Loan Bank (FHLB) stock totaled $3.4 million at March 31, 2012. FHLB stock is generally viewed as a long term investment and as a restricted investment security which is carried at cost, because there is no market for the stock other than the FHLBs or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing temporary declines in value. Bankshares does not consider this investment to be other than temporarily impaired as of March 31, 2012 and no impairment has been recognized. FHLB stock is included in restricted stock on the Consolidated Balance Sheets.

6. Loans

The following table summarizes the composition of the loan portfolio by dollar amount and percentage as of the dates indicated:


	March 31, 2012						December 31, 2011
	Amount			Percentage			Amount			Percentage
	(Dollars in thousands)
Real estate:
Residential real estate	$	94,921			32.0	%	$	101,248			33.0	%
Commercial real estate		133,332			44.9	%		137,610			44.8	%
Construction/land		41,172			13.9	%		39,176			12.8	%

Total real estate		269,425			90.7	%		278,034			90.6	%
Commercial and industrial		26,018			8.8	%		26,820			8.7	%
Consumer		1,642			0.5	%		2,022			0.7	%

Gross loans		297,085			100.0	%		306,876			100.0	%

Less: allowance for loan losses		(5,070	)					(5,393	)

Net loans	$	292,015					$	301,483

As of March 31, 2012 and December 31, 2011, there were $9 thousand and $25 thousand, respectively, in checking account overdrafts that were reclassified on the Consolidated Balance Sheets as loans.

The following tables represent the credit quality of loans by class for March 31, 2012 and 2011:


	Credit Quality Loans By Class As of March 31, 2012 (Dollars in thousands)

INTERNAL RISK RATING GRADES	Pass		Watch		Special Mention		Substandard		Doubtful		Loss		Total Loans
Risk Rating Number		1 to 5		6		7		8		9		10

Commercial and industrial	$	22,849	$	914	$	477	$	1,778	$	—	$	—	$	26,018
Commercial real estate
Owner occupied		62,843		1,155		2,005		3,538		—		—		69,541
Non-owner occupied		52,335		5,033		4,607		1,816		—		—		63,791
Construction/land
Residential construction		15,456		800		—		—		544		—		16,800
Other construction & land		14,442		47		1,831		6,816		1,236		—		24,372
Residential real estate
Equity lines		28,155		59		100		—		—		—		28,314
Single family		52,679		3,417		2,132		2,922		—		—		61,150
Multifamily		5,457		—		—		—		—		—		5,457
Consumer – non real estate		1,458		—		184		—		—		—		1,642

Totals	$	255,674	$	11,425	$	11,336	$	16,870	$	1,780	$	—	$	297,085


	Credit Quality Loans By Class As of December 31, 2011 (Dollars in thousands)
INTERNAL RISK RATING GRADES	Pass		Watch		Special Mention		Substandard		Doubtful		Loss		Total Loans
Risk Rating Number¹		1 to 5		6		7		8		9		10

Commercial and industrial	$	23,901	$	927	$	224	$	1,768	$	—	$	—	$	26,820
Commercial real estate
Owner occupied		63,192		625		1,742		2,610		—		—		68,169
Non-owner occupied		60,069		1,231		8,141		—		—		—		69,441
Construction/land
Residential construction		9,356		175		599		3,753		876		—		14,759
Other construction & land		16,018		—		1,662		5,837		900		—		24,417
Residential real estate
Equity lines		27,311		430		718		95		552		—		29,106
Single family		56,134		4,876		—		5,347		—		—		66,357
Multifamily		5,785		—		—		—		—		—		5,785
Consumer – non real estate		1,836		—		186		—		—		—		2,022

Totals	$	263,602	$	8,264	$	13,272	$	19,410	$	2,328	$	—	$	306,876

¹ Internal risk ratings of pass (rating numbers 1 to 5) and watch (rating number 6) are deemed to be unclassified assets. Internal risk ratings of special mention (rating number 7), substandard (rating number 8), doubtful (rating number 9) and loss (rating number 10) are deemed to be classified assets.

The following tables set forth aging and non-accrual loans by class:


	Aging and Non-accrual Loans by Class As of March 31, 2012
	(Dollars in thousands)
	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		90-days Past Due and Still Accruing		Non-accrual Loans
Commercial & industrial	$	1,002	$	18	$	370	$	1,390	$	24,628	$	370	$	955
Commercial real estate
Owner occupied		109		—		2,560		2,669		66,872		—		2,560
Non-owner occupied		5,490		—		—		5,490		58,301		—		—
Construction/land
Residential construction		—		—		544		544		16,256		—		544
Other construction & land		1,071		1,029		5,933		8,033		16,339		—		6,961
Residential real estate
Equity lines		498		—		—		498		27,816		—		—
Single family		695		—		163		858		60,292		—		163
Multifamily		—		—		—		—		5,457		—		—
Consumer-non real estate		—		—		—		—		1,642		—		—

Total loans	$	8,865	$	1,047	$	9,570	$	19,482	$	277,603	$	370	$	11,183


	Aging and Non-accrual Loans By Class As of December 31, 2011
	(Dollars in thousands)
	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		90-days Past Due and Still Accruing		Non-accrual Loans
Commercial and industrial	$	1,228	$	367	$	—	$	1,595	$	25,225	$	—	$	977
Commercial real estate
Owner occupied		121		—		2,610		2,731		65,438		—		2,610
Non-owner occupied		—		992		—		992		68,449		—		—
Construction/land
Residential construction		—		—		540		540		14,219		—		540
Other construction & land		—		1,225		5,988		7,213		17,204		—		7,139
Residential real estate
Equity lines		304		33		184		521		28,585		—		236
Single family		74		29		1,733		1,836		64,521		—		1,762
Multifamily		—		—		—		—		5,785		—		—
Consumer -non real estate		186		—		—		186		1,836		—		—

Total loans	$	1,913	$	2,646	$	11,055	$	15,614	$	291,262	$	—	$	13,264

7. Allowance for Loan Losses

The following table summarizes the activity in the allowance for loan losses for the periods presented:


	Three Months Ended March 31, 2012			Year Ended December 31, 2011			Three Months Ended March 31, 2011
	(Dollars in thousands)
Balance, beginning of year	$	5,393		$	5,281		$	5,281
Provision for loan losses		450			1,549			306
Loans charged off		(782	)		(1,702	)		(206	)
Recoveries of loans charged off		9			265			230

Net charge-offs		(773	)		(1,437	)		24

Balance, end of year	$	5,070		$	5,393		$	5,611

The following tables represent the allocation of allowance for loan losses by segment:


	Allowance for Loan Losses As of March 31, 2012
	(Dollars in thousands)
	Commercial and Industrial			Commercial Real Estate			Construction Land		Residential Real Estate			Consumer			Total
Beginning Balance:	$	210		$	1,508		$	1,808	$	1,826		$	41		$	5,393
Charge-offs		—			—			—		(782	)		—			(782	)
Recoveries		—			—			—		9			—			9
Provision		(56	)		(53	)		515		57			(13	)		450

Ending Balance:	$	154		$	1,455		$	2,323	$	1,110		$	28		$	5,070

Individually evaluated for impairment	$	—		$	84		$	1,982	$	55		$	—		$	2,121

Collectively evaluated for impairment	$	210		$	1,424		$	276	$	998		$	41		$	2,949

Loans:
Ending Balance:	$	26,018		$	133,332		$	41,172	$	94,921		$	1,642		$	297,085

Individually evaluated for impairment	$	955		$	2,560		$	7,505	$	163		$	—		$	11,183

Collectively evaluated for impairment	$	25,063		$	130,772		$	33,667	$	94,758		$	1,642		$	285,902


	Allowance for Loan Losses As of December 31, 2011
	(Dollars in thousands)
	Commercial and Industrial			Commercial Real Estate			Construction Land			Residential Real Estate			Consumer			Total
Beginning Balance:	$	463		$	1,420		$	700		$	2,613		$	85		$	5,281
Charge-offs		(10	)		(173	)		(404	)		(1,044	)		(71	)		(1,702	)
Recoveries		116			9			—			134			6			265
Provision		(359	)		252			1,512			123			21			1,549

Ending Balance:	$	210		$	1,508		$	1,808		$	1,826		$	41		$	5,393

Individually evaluated for impairment	$	—		$	135		$	1,376		$	760		$	—		$	2,271

Collectively evaluated for impairment	$	210		$	1,373		$	432		$	1,066		$	41		$	3,122

Loans:
Ending Balance:	$	26,820		$	137,610		$	39,176		$	101,248		$	2,022		$	306,876

Individually evaluated for impairment	$	977		$	2,610		$	7,678		$	1,999		$	—		$	13,264

Collectively evaluated for impairment	$	25,843		$	135,000		$	31,498		$	99,249		$	2,022		$	293,612

Impaired loans and non-accrual loans are summarized as follows as of the dates indicated:


	March 31, 2012		December 31, 2011
	(Dollars in thousands)
Impaired loans without a valuation allowance	$	3,249	$	4,233
Impaired loans with a valuation allowance		7,934		9,031

Total impaired loans	$	11,183	$	13,264
Valuation allowance related to impaired loans	$	2,121	$	2,271

Total loans past due 90 days and still accruing	$	370	$	—

Average investment in impaired loans	$	11,587	$	13,538

Interest income recognized on impaired loans	$	—	$	234

Interest income recognized on a cash basis on impaired loans	$	—	$	234

The following tables represent specific allocation for impaired loans by class:


	Specific Allocation for Impaired Loans by Class As of March 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
With no related allowance:
Commercial & Industrial	$	955	$	1,025	$	—	$	1,027	$	—
Commercial Real Estate
Owner occupied		—		—		—		—		—
Non-owner occupied		—		—		—		—		—
Construction/Land
Residential		—		—		—		—		—
Other construction & land		2,294		2,294		—		2,294		—
Residential real estate
Single family		—		—		—		—		—
With an allowance recorded:
Commercial & Industrial		—		—		—		—		—
Commercial real estate
Owner occupied		2,560		2,656		84		2,658		—
Non-owner occupied		—		—		—		—		—
Construction/Land
Residential		544		550		259		550		—
Other construction & land		4,667		4,891		1,723		4,892		—
Residential Real Estate
Single family		163		166		55		166		—

Total:	$	11,183	$	11,582	$	2,121	$	11,587	$	—


	Specific Allocation for Impaired Loans by Class As of December 31, 2011
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
With no related allowance:
Commercial & Industrial	$	977	$	1,033	$	—	$	1,037	$	15
Commercial Real Estate
Owner occupied		—		—		—		—		—
Non-owner occupied		—		—		—		—		—
Construction/Land
Residential		—		—		—		—		—
Other construction & land		2,293		2,293		—		2,199		87
Residential real estate
Single family		963		963		—		968		37
With an allowance recorded:
Commercial & Industrial		—		—		—		—		—
Commercial real estate
Owner occupied		2,610		2,669		135		2,311		20
Non-owner occupied		—		—		—		—		—
Construction/Land
Residential		540		546		259		546		—
Other construction & land		4,845		5,049		1,118		5,436		53
Residential Real Estate
Single family		1,036		1,039		759		1,041		22

Total:	$	13,264	$	13,592	$	2,271	$	13,538	$	234

There were no non-accrual loans excluded from impaired loan disclosures as of March 31, 2012 and December 31, 2011. No additional funds are committed to be advanced in connection with impaired loans.

At March 31, 2012, there were $904 thousand in troubled debt restructured loans. At December 31, 2011, there were $956 thousand in troubled debt restructured loans. The following table reflects loan modifications classified as TDR’s during the period ended of March 31, 2012.

Modifications

For the Three Months Ended March 31, 2012

(Dollars in thousands)

Number
of
Contracts

Pre-Modification
Outstanding
Recorded
Investment

Post-
Modification
Outstanding
Recorded
Investment

Troubled debt restructurings

Residential Real Estate-Single family

—

There were no troubled debt restructurings modified within the previous 12 months that defaulted during the three months ended March 31, 2012.

For purposes of this disclosure, a TDR payment default occurs when, within 12 months of the original TDR modification, either the TDR is placed in non-accrual status or a charge-off has occurred.

8. Other Real Estate Owned (OREO)

The table below reflects changes in other real estate owned (OREO) for the periods indicated:


	Three Months Ended March 31, 2012			Twelve Months Ended December 31, 2011
	(Dollars in thousands)
Balance, beginning of period	$	3,748		$	4,627
Properties acquired at foreclosure		963			434
Sales of foreclosed properties		—			(959	)
Valuation adjustments		(28	)		(354	)

Balance, end of period	$	4,683		$	3,748

The table below reflects expenses applicable to OREO for the periods indicated:


	Three Months Ended March 31, 2012		Twelve Months Ended December 31, 2011
	(Dollars in thousands)
Net loss on sales of OREO	$	—	$	12
Valuation adjustments		28		354
Operating expenses		13		88

Total OREO related expense	$	41	$	454

9. Federal Home Loan Bank Advances

Bankshares has two advances from the FHLB: one fixed rate advance and one floating rate advance.

At March 31, 2012 and December 31, 2011, the FHLB advance accounted for on a fair value basis had a value of $28.9 million and $29.4 million, respectively, and matures in 2021. The weighted average interest rate on this long-term FHLB advance was 3.985% at March 31, 2012 and December 31, 2011. The par value of this FHLB advance was $25.0 million at March 31, 2012 and December 31, 2011.

At March 31, 2012 and December 31, 2011, there was one FHLB advance accounted for on a cost basis. Bankshares renewed this floating rate advance in the first quarter of 2012 for $15.0 million. The advance matures in 2013 and the interest rate at March 31, 2012 was 0.32% and 0.379% at December 31, 2011. The weighted average interest rate for both FHLB advances outstanding is 2.61%.

10. Trust Preferred Capital Notes of Subsidiary Trust

On June 30, 2003, Bankshares’ wholly-owned Delaware statutory business trust privately issued $10.0 million face amount of the Trust’s floating rate trust preferred capital securities (Trust Preferred Capital Notes) in a pooled trust preferred capital securities offering. The trust issued $310 thousand in common equity to Bankshares. Simultaneously, the trust used the proceeds of the sale to purchase $10.3 million principal amount of Bankshares’ floating rate junior subordinated debentures due 2033 (Subordinated Debentures). Both the Trust Preferred Capital Notes and the Subordinated Debentures are callable at any time. The Subordinated Debentures are an unsecured obligation of Bankshares and are junior in right of payment to all present and future senior indebtedness of Bankshares. The Trust Preferred Capital Notes are guaranteed by Bankshares on a subordinated basis. The Trust Preferred Capital Notes are presented in the Consolidated Balance Sheets of Bankshares under the caption “Trust Preferred Capital Notes.” Bankshares records distributions payable on the Trust Preferred Capital Notes as an interest expense in its Consolidated Statements of Operations. The interest rate associated with the Trust Preferred Capital Notes is three month LIBOR plus 3.15% subject to quarterly interest rate adjustments. Under the indenture governing the Trust Preferred Capital Notes, Bankshares has the right to defer payments of interest for up to twenty consecutive quarterly periods. Beginning with the quarter ended September 30, 2009 and through March 31, 2012, Bankshares elected to defer the interest payments as permitted under the indenture. The interest deferred under the indenture compounds quarterly at the interest rate then in effect. As of March 31, 2012 the total amount of deferred and compounded interest owed under the indenture is $1.1 million. The base interest rate as of March 31, 2012 was 3.62% and as of December 31, 2011 was 3.70%.

All or a portion of the Trust Preferred Capital Notes may be included in the regulatory computation of capital adequacy as Tier 1 capital. Under the current guidelines, Tier 1 capital may include up to 25% of shareholders’ equity excluding accumulated other comprehensive income (loss) in the form of Trust Preferred Capital Notes. At March 31, 2012 and December 31, 2011, $9.2 million and $9.4 million was considered Tier 1 capital.

11. Net Income (Loss) per Share

The following table shows the weighted average number of shares used in computing net income (loss) per common share and the effect on weighted average number of shares of potential dilutive common stock. Potential dilutive common stock had no effect on income (loss) available to common shareholders for the periods presented.


Three Months Ended March 31,	2012						2011
	Shares			Per Share Amount			Shares		Per Share Amount
	(Dollars in thousands)
Basic net income per share		5,109,969		$	(0.08	)		5,108,048	$	0.07

Effect of dilutive securities, stock options		—						14,981

Diluted net income per share		5,109,969		$	(0.08	)		5,123,029	$	0.07

Net income (loss) utilized in the earnings per share calculations above	$	(433	)				$	365

Average shares of 160,909 and 310,341 have been excluded from the calculation for the three months ended March 31, 2012 and March 31, 2011, respectively, because their effects were anti-dilutive.

12. Supplemental Cash Flow Information

Supplemental disclosures of cash flow information for the three months ended March 31, 2012 and 2011:


	March 31, 2012		March 31, 2011
	(Dollars in thousands)
Supplemental Disclosures of Cash Flow Information:
Interest paid during the three months	$	1,146	$	1,435
Income taxes paid during the three months	$	—	$	—
Supplemental Disclosures of Noncash Activities:
Fair value adjustment for securities	$	51	$	(448	)
Transfer of loans to foreclosed assets	$	963	$	210

13. Mergers and Acquisitions

On May 3, 2012, WFBI, Bankshares and the Bank entered into the Merger Agreement with respect to the Merger and a related bank merger agreement by and between the Bank and WashingtonFirst Bank (WF Bank), WFBI’s wholly owned subsidiary bank (Bank Merger). The consummation of the Merger and the Bank Merger are conditioned upon, among other things, approvals of applicable regulatory agencies and the shareholders of each of Bankshares and WFBI.

The consideration to be received by the shareholders of Bankshares in the Merger is a combination of stock and cash. Pursuant to the Merger Agreement, each share of Bankshares’ outstanding common stock will be converted into and become the right to receive, subject to proration in accordance with the terms of the Merger Agreement and at the election of each shareholder of Bankshares, either 0.4435 shares of common stock of WFBI or cash in the amount of $5.30, subject in either case to adjustment in certain circumstances, provided that no more than 20% of the common shares of Bankshares may elect to receive cash.

The Merger is expected to close in the fourth quarter of 2012, pending approval of the shareholders of each of Bankshares and WFBI and the receipt of all required regulatory approvals, as well as other customary conditions as described in the Current Report on Form 8-K previously filed on May 8, 2012.

14. Subsequent Events

Bankshares evaluated subsequent events that occurred after the balance sheet date, but before the financial statements are issued. There are two types of subsequent events: (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including estimates inherent in the process of preparing financial statements, and (2) nonrecognized, or those that provided evidence about conditions that did not exist at the date of the balance sheet but arose after that date. As of the report date there were no subsequent events that would cause adjustments to or disclosures in the financial statements other than the Merger as described in Note 13.

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

The following discussion is intended to assist readers in understanding and evaluating the financial condition and results of operations of Bankshares and the Bank on a consolidated basis. This discussion and analysis should be read in conjunction with Bankshares’ Annual Report on Form 10-K for the year ended December 31, 2011, and the unaudited consolidated financial statements and accompanying notes included elsewhere in this report.

Internet Access to Corporate Documents

Information about Bankshares can be found on the Bank’s website at www.alliancebankva.com. Under “Documents / SEC Filings” in the Investor Relations section of the website, Bankshares posts its annual reports, quarterly reports, current reports, definitive proxy materials and any amendments to those reports as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (SEC). All such filings are available free of charge.

The information available on the Bank’s website is not part of the Quarterly Report on Form 10-Q or any other report filed by Bankshares with the SEC.

Forward-Looking Statements

Some of the matters discussed below and elsewhere in this report include forward-looking statements. Forward-looking statements often use words such as “believe,” “expect,” “plan,” “may,” “will,” “should,” “project,” “contemplate,” “anticipate,” “forecast,” “intend” or other words of similar meaning. Forward-looking statements in this report may include, but are not limited to, statements regarding the proposed merger (the Merger) of Bankshares and WashingtonFirst Bankshares, Inc., profitability, liquidity, Bankshares’ loan portfolio, adequacy of the allowance for loan losses and provisions for loan losses, trends regarding net charge-offs, trends regarding levels of non-performing assets, interest rates and yields, interest rate sensitivity, market risk, regulatory developments, capital requirements, business strategy, the effects of Bankshares’ efforts to reposition its business and other goals or objectives.

You can also identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. The forward-looking statements Bankshares makes in this report are subject to significant risks, assumptions and uncertainties, including among other things, the following important factors that could affect the actual outcome of future events:

•

Changes in the strength of the national economy in general and the local economies in Bankshares’ market areas that adversely affect Bankshares’ customers and their ability to transact profitable business with us, including the ability of Bankshares’ borrowers to repay their loans according to their terms or a change in the value of the related collateral;

•

Retention of existing employees;

•

Maintaining and developing well established and valuable client relationships and referral source relationships;

•

Changing trends in customer profiles and behavior;

•

Direct and substantive competition from other financial services companies targeting certain key business lines;

•

Other competitive factors within the financial services industry;

•

Changes in the availability of funds resulting in increased costs or reduced liquidity;

•

Changes in accounting policies, rules and practices;

•

Changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, and soundness of other financial institutions Bankshares does business with;

•

The timing of and value realized upon the sale of Other Real Estate Owned (OREO) property;

•

Changes in the assumptions underlying the establishment of reserves for possible loan losses and other estimates;

•

Fiscal and governmental policies of the United States federal government;

•

Reactions in financial markets related to potential or actual downgrades in the sovereign credit rating of the United States and the budget deficit or national debt of the United States government;

•

The impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act, related regulatory rulemaking processes and other legislative and regulatory initiatives on the regulation and supervision of financial institutions, specifically depository institutions;

•

The impact of changes to capital requirements that apply to financial institutions and depository institutions, including changes related to the proposed Basel III capital standards;

•

Changes in the way the FDIC insurance premiums are assessed;

•

Changes in interest rates and market prices, which could reduce our net interest margins, asset valuations and expense expectations;

•

Timing and implementation of certain balance sheet strategies;

•

Impairment concerns and risks related to Bankshares’ investment portfolio, and the impact of fair value accounting, including income statement volatility;

•

Assumptions used within our Asset Liability Management (ALM) process and Net Interest Income (NII) and Economic Value of Equity (EVE) models;

•

Changes in tax laws and regulations;

•

Bankshares’ ability to recognize future tax benefits;

•

Impacts of implementing various accounting standards;

•

Deposit attrition, operating costs, customer losses and business disruption in connection with the Merger, including adverse effects on relationships with employees, may be greater than expected;

•

The ability to complete the Merger as expected and within the expected timeframe;

•

The possibility that required regulatory and shareholder approvals of the Merger may not be obtained, or one or more of the other conditions to the completion of the Merger may not be satisfied;

•

The expected growth opportunities or cost savings from the Merger may not be fully realized or may take longer to realize than expected; and

•

Other factors described from time to time in our SEC filings.

In addition, Bankshares’ 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 Bankshares’ counterparties and by changes in the regulatory and competitive landscape. Additionally, other risks that could cause actual results to differ from predicted results are set forth in Item 1A of Bankshares’ Annual Report on Form 10-K for the year ended December 31, 2011.

Because of these and other uncertainties, Bankshares’ actual results and performance may be materially different from results indicated by these forward-looking statements. In addition, Bankshares’ past results of operations are not necessarily indicative of future performance.

Bankshares cautions you that the above list of important factors is not exclusive. These forward-looking statements are made as of the date of this report, and Bankshares may not undertake steps to update these forward-looking statements to reflect the impact of any circumstances or events that arise after the date the forward-looking statements are made.

Critical Accounting Policies

Bankshares’ financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Bankshares uses historical loss factors as one factor in determining the inherent loss that may be present in its loan portfolio. Actual losses could differ significantly from the historical factors that Bankshares uses in estimating risk. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of Bankshares’ transactions would be the same, the timing of events that would impact its financial statements could change.

Allowance for Loan Losses. The allowance for loan losses is an estimate of the losses that may be sustained in Bankshares’ loan portfolio. The allowance is based on two basic principles of accounting: (1) ASC 450-10-05, Contingencies which requires that losses be accrued when they are probable of occurring and estimable, and (2) ASC 310-10-35, Receivables which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses has two basic components: the general allowance and the specific allowance.

The general allowance is developed following the accounting principles contained in ASC 450-10-05, Contingencies and represents the largest component of the total allowance. It is determined by aggregating unclassified loans and unimpaired loans by loan type based on common purpose, collateral, repayment source or other credit characteristics and then applying factors which in the judgment of management represent the expected losses inherent in the portfolio. In determining these factors, Bankshares considers the following: (1) delinquencies and overall risk ratings, (2) loss history, (3) trends in volume and terms of loans, (4) effects of changes in lending policy, (5) the experience and depth of the borrowers’ management, (6) national and local economic trends, (7) concentrations of credit by individual credit size and by class of loans, (8) quality of loan review system and (9) the effect of external factors (e.g., competition and regulatory requirements).

ASC 310-10-35, Receivables is the basis upon which Bankshares determines specific reserves on individual loans which comprise the specific allowance. Specific loans to be evaluated for impairment are identified based on the borrower’s loan size and the loan’s risk

rating, collateral position and payment history. If it is determined that it is likely that the Bank will not receive full payment in a timely manner, the loan is determined to be impaired. Each such identified loan is then evaluated to determine the amount of reserve that is appropriate based on ASC 310-10-35. This standard also requires that losses be accrued based on the differences between the value of collateral, present value of expected future cash flows or values that are observable in the secondary market and the loan balance.

Share-Based Compensation. ASC 718-10, Stock Compensation, requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and non-vested shares, based on the fair value of those awards at the date of grant. Compensation cost has been measured using the Black-Scholes model to estimate fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.

Deferred Tax Asset. Bankshares, using a third party consultant routinely evaluates the likelihood of the recognition of deferred tax assets. The analysis is used to determine if a valuation allowance for deferred tax assets is necessary. Bankshares reviews and analyzes various forms of positive and negative evidence in determining whether a valuation allowance is necessary and if so to what degree a valuation allowance is warranted.

At December 31, 2011, Bankshares performed an analysis to determine if a valuation allowance for deferred tax assets was necessary. Its analysis reviewed various forms of positive and negative evidence in determining whether a valuation allowance is necessary and if so to what degree a valuation allowance is warranted. The three year cumulative loss position of Bankshares is considered negative evidence when determining if a valuation allowance is necessary. Bankshares considered positive evidence such as previous earnings patterns, multiyear business projections and the potential realization of net operating loss, (NOL) carry forwards within the prescribed time periods. In addition, Bankshares considered tax planning strategies that would impact the timing and extent of taxable income. Based on the analysis and the guidance in the relevant accounting literature, it was not considered more likely than not, that Bankshares will not be able to realize all its deferred tax assets. A valuation allowance of $5.3 million related to the deferred tax asset was recorded at December 31, 2011and March 31, 2012.

Overview

Notwithstanding the Merger Agreement, Bankshares’ primary long-term goals continue to be maximizing earnings and deploying capital in profit driven initiatives that will enhance shareholder value in a sustainable fashion. In pursuit of these goals, Bankshares’ current emphasis is on optimizing profitability in the near term and strengthening the financial performance of the Company, while also transitioning its operations to focus more closely on traditional banking activities and to reposition Bankshares for the future. Bankshares’ transitional strategies include, among others, continuing the following initiatives:

•

Diversifying the loan portfolio by increasing Bankshares’ focus on commercial loans and loans secured by owner occupied commercial real estate, while continuing to be an active lender in attractive segments of the residential and commercial real estate markets.

•

Reducing the investment securities portfolio and eliminating the trading assets portfolio.

•

Continuing to attentively manage the level of non-performing assets by addressing problem loans on a timely basis.

•

Increasing low cost deposits by local commercial and retail customers, while working to reduce Bankshares’ brokered deposit portfolio.

•

Reducing Bankshares’ operating and funding costs.

Performance Highlights

•

Net loss for the quarter ended March 31, 2012 was $433 thousand compared to net income of $365 for the same period in 2011, a decrease of $798 thousand. Earnings per common share, basic and diluted, amounted to $(0.08) at March 31, 2012, compared to $0.07 at March 31, 2011.

•

Total assets were $508.7 million at March 31, 2012, an increase of $2.2 million from December 31, 2011 total assets of $506.5 million. The increase in total assets is directly related to the increase of $20.8 million in cash and due from banks, with such increase being offset by a $9.5 million decrease in net loans and a $17.7 million decrease in the investment portfolio.

•

Total loans were $297.1 million at March 31, 2012, a decrease of $9.8 million, or 3.19%, from the December 31, 2011 balance of $306.9 million. This decrease in total loans was primarily attributable to several payoffs in residential and commercial real estate loans, offset by an increase in construction loans.

•

Our ratio of non-performing assets to total assets was 3.37% as of March 31, 2012 compared to 3.55% as of December 31, 2011, or a decrease of 18 basis points. This decrease is due to management electing to foreclose on one loan of $963 thousand and charge off another loan in the amount of $347 thousand. Both loans were to the same borrower.

•

As of March 31, 2012, the composition of non-performing assets was $11.2 million of non-accrual loans, $4.7 million of OREO, $370 thousand of loans past due 90 days and still accruing, and $904 thousand of troubled debt restructured loans for a total of $17.1 million, compared to total non-performing assets as of December 31, 2011, of $18.0 million. The non-accrual balance decreased by $2.1 million at March 31, 2012, as compared to December 31, 2011. This decrease is primarily attributable to foreclosure on a $963 thousand loan and charge off of $347 thousand. Both loans were to the same borrower.

•

The investment securities portfolio totaled $105.7 million at March 31, 2012. This compares to $123.5 million of investments as of December 31, 2011, a decrease of $17.8 million. This decrease is attributable to the maturation of certain investments.

•

The net interest margin for the quarter ended March 31, 2012 was 3.10% compared to 3.78% for the same period in 2011, a decrease of 68 basis points. This decrease was due to an increase in average non-accrual loans during the quarter to $12.1 million from $5.4 million in the same quarter in 2011.

•

Deposits were $380.5 million at March 31, 2012, a minimal increase from the December 31, 2011 balance of $380.4 million.

•

Non-interest bearing deposits were $118.1 million at March 31, 2012, or 31.0% of total deposits. This compares to the December 31, 2011 level of $112.5 million or 29.6% of total deposits.

Financial Performance Measures. Bankshares’ net loss for the three month period ended March 31, 2012 was $433 thousand, a decrease of $798 thousand over the first quarter of 2011 net income of $365 thousand. The net loss of $433 thousand includes net interest income of $3.3 million compared to $4.4 million for the same period last year, a decrease of $1.1 million. The decrease is due primarily to a decrease in interest income in the amount of $1.4 million, which was primarily driven by the change in the investment portfolio mix in anticipation of the merger in 2011. This increase was partially offset by a decrease of $283 thousand in the cost of funds. For the three months ended March 31, 2012, total interest expense was $1.2 million compared to $1.5 million for the three months ended March 31, 2011. These results led to $(0.08) basic and diluted earnings per share for the quarter ended March 31, 2012, compared to $0.07 basic and diluted earnings per share for the quarter ended March 31, 2011. Weighted average basic shares outstanding were 5,109.969 for the three months ended March 31, 2012 and 5,108,048 for the three months ended March 31, 2011. Weighted average diluted shares outstanding were 5,270,878 for the three months ended March 31, 2012 and 5,123,029 for the three months ended March 31, 2011.

Net interest margin decreased to 3.10% for the three months ended March 31, 2012 compared to 3.78% for the three months ended March 31, 2011, a decrease of 68 basis points. A key contributing factor to the lower net interest margin was higher average non-accrual loans and lower yields on investment securities during 2012 was primarily driven by the change in the investment portfolio mix in anticipation of the planned merger in 2011. Total interest income reversed for the first quarter ended March 31, 2012 was $190 thousand compared to $193 thousand for the first quarter ended March 31, 2011.

Results of Operations

Net Interest Income. Net interest income (on a fully tax equivalent basis) for the three months ended March 31, 2012 was $3.3 million compared to $4.4 million for the same period in 2011. Interest income on earning assets was $1.4 million lower for the three months ended March 31, 2012, compared to the first quarter of 2011. Of the $1.4 million decrease in interest income, $297 thousand is attributable to the $300 thousand lower average balance in loans and $6.7 million higher average non-accrual loans. The reduction in the average balance in the investment securities portfolio was $22.2 million and contributed $185 thousand to the reduction in interest income. The decrease in yield from 3.89% to 1.14% in the investment securities portfolio also contributed to $810 thousand to the decrease in interest income. This decrease was primarily driven by the change in the investment portfolio mix in anticipation of the merger in 2011. The average balance of interest-bearing deposits decreased by $18.8 million and contributed $58 thousand to the decrease in interest expense. The average rate paid on deposits improved to 1.29% from 1.62%, which reduced interest expense by $272 thousand.

The following table illustrates average balances of total assets and total interest-bearing liabilities for the three month periods indicated, showing the average distribution of assets, liabilities, shareholders’ equity and related income, expense and corresponding weighted average yields and rates. The average balances used in these tables and other statistical data were calculated using daily average balances.


	Three Months Ended March 31,
	2012								2011
	Average Balance			Income/ Expense		Yield/ Rate¹			Average Balance			Income/ Expense		Yield/ Rate¹
	(Dollars in thousands)
Assets
Interest-earning assets:
Loans⁽²⁾	$	301,600		$	4,183		5.58	%	$	325,151		$	4,545		5.67	%
Trading securities		567			10		7.09	%		1,828			33		7.32	%
Investment securities		118,587			336		1.14	%		140,745			1,350		3.89	%
Federal funds sold		8,842			15		0.68	%		6,567			10		0.62	%

Total interest earning assets		429,596			4,544		4.25	%		474,291			5,938		5.08	%

Non-interest earning assets:
Cash and due from banks		25,532								19,296
Premises and equipment		1,373								1,603
Other real estate owned (OREO)		3,865								4,501
Other assets		8,254								18,578
Less: allowance for loan losses		(5,069	)							(5,479	)

Total non-interest earning assets		33,955								38,499

Total Assets	$	463,551							$	512,790

Liabilities and Shareholders’ Equity
Interest-bearing liabilities:
Interest-bearing demand deposits	$	41,084		$	28		0.27	%	$	41,879		$	25		0.24	%
Money market deposit accounts		15,747			30		0.77	%		25,533			49		0.78	%
Savings accounts		3,963			1		0.10	%		3,819			7		0.74	%
Time deposits		189,721			747		1.58	%		198,045			997		2.04	%

Total interest-bearing deposits		250,515			806		1.29	%		269,276			1,078		1.62	%
FHLB advances⁽³⁾		46,543			268		2.32	%		41,206			259		2.55	%
Other borrowings		48,627			160		1.32	%		78,448			180		0.93	%

Total interest-bearing liabilities		345,685			1,234		1.44	%		388,930			1,517		1.58	%

Non-interest bearing liabilities:
Demand deposits		87,197								87,960
Other liabilities		2,576								2,281

Total liabilities		435,458								479,171
Shareholders’ Equity		28,093								33,619

Total Liabilities and Shareholders’ Equity	$	463,551							$	512,790

Interest Spread⁽⁴⁾							2.81	%							3.51	%

Net Interest Margin⁽⁵⁾				$	3,310		3.10	%				$	4,421		3.78	%

⁽¹⁾

The rates and yields are on a fully tax equivalent basis assuming a 34% federal tax rate.

⁽²⁾

The Bank had average non-accrual loans of $12.1 million and $5.4 million in the first quarter of 2012 and 2011, respectively. The 2012 and 2011 interest income on non-accrual loans excluded from the loans above was $190 thousand and $193 thousand, respectively.

⁽³⁾

Average fair value of FHLB advances for the first quarter of 2012 and 2011 was $29.3 million and $26.1 million, respectively.

⁽⁴⁾

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

⁽⁵⁾

Net interest margin is net interest income expressed as a percentage of average earning assets.

Average loan balances were $301.6 million for the three months ended March 31, 2012 compared to $325.2 million for the same period in 2011. The decrease in average loans is primarily due to several large payoffs. Bankshares longer-term strategy is to grow small business commercial loans and owner occupied commercial real estate. The related interest income from loans was $4.2 million in the three months ended March 31, 2012 compared to $4.5 million in the same period in 2011. The average yield on loans of 5.58% during the three months ended March 31, 2012 was 9 basis points lower than the yield of 5.67% in the first quarter of 2011. Interest rates are established for classes of loans that include variable rates based on Wall Street Journal Prime or other identifiable bases while others carry fixed rates with terms out to 15 years. Most new variable rate originations include minimum start rates and/or floors.

At the three months ended March 31, 2012, we held one security in our trading portfolio with an average balance of $567 thousand, compared to $1.8 million for the three months ended March 31, 2011. The trading security interest income for the three months ended March 31, 2012 was $10 thousand compared to $33 thousand for the three months ended March 31, 2011. The reduction in average trading securities reflects management’s business strategy to eliminate the trading securities portfolio as we reposition the balance sheet and led to the reduction in associated interest income. At March 31, 2012, the carrying value of the security was $454 thousand.

Investment securities averaged $118.6 million for the quarter ended March 31, 2012 compared to $140.7 million for the same quarter in 2011. Investment securities income was $336 thousand for the three months ended March 31, 2012 compared to $1.4 million for the three months ended March 31, 2011. The average tax equivalent yields on investment securities for the three months ended March 31, 2012 and 2011 were 1.14% and 3.89% respectively. The reduction in average investment securities from the sale of securities reflects management’s business strategy to reduce the investment securities portfolio.

Short-term investments in federal funds sold contributed $15 thousand to interest income in the three month period ended March 31, 2012, compared to $10 thousand for the same period in 2011. The average balance for the three months ended March 31, 2012 was $8.8 million, a $2.2 million increase from the prior year average balance of $6.6 million.

The average balance of cash and due from banks was $25.5 million and $19.3 million for the three months ended March 31, 2012 and 2011, respectively.

Total average interest-earning assets yielded 4.25% for the three months ended March 31, 2012 compared to the yield of 5.08% for the same period in 2011. Total interest income on a fully tax equivalent basis was $4.5 million for the three months ended March 31, 2012 compared to $5.9 million for the three months ended March 31, 2011. As discussed above, interest income decreased from the first quarter of 2011 to the first quarter of 2012 due to smaller average loans and securities balances, which are a product of our strategy to reposition our balance sheet.

Total average interest-bearing deposits were $345.7 million in the first quarter of 2012, or $43.2 million lower than the first quarter of 2011 level of $388.9 million. A key driver of the decrease is the decline in average time deposits and money market accounts. The average balance for time deposits for the first quarter of 2012 was $189.7 million compared to $198.0 million for the same period in 2011, a decrease of $8.3 million. Interest expense for all interest-bearing liabilities amounted to $1.2 million for the three months ended March 31, 2012 compared to $1.5 million for the three months ended March 31, 2011, a savings of $283 thousand. The average cost of interest-bearing liabilities for the first quarter of 2012 was 1.44% or 14 basis points lower than the first quarter of 2011 level of 1.58%. The lower interest rate environment allowed for competitive repricing of interest-bearing demand accounts, money market accounts, savings accounts and client based time deposits. The benefits of the repricing are seen in the lower time deposit cost of 1.58% during the first quarter of 2012 compared to 2.04% during the same period of 2011.

As of March 31, 2012, the brokered certificate of deposit portfolio carried an average coupon rate of 1.27% compared to an average coupon rate of 1.72% at March 31, 2011.

Non-interest bearing demand deposits averaged $87.2 million for the first three months of 2012, or $763 thousand less than the first quarter of 2011 level of $88.0 million. These balances are subject to seasonal changes.

The following table describes the impact on our tax equivalent interest income and expense resulting from changes in average balances and average rates for the periods indicated. The change in interest income due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.


	Volume and Rate Analysis Three Months Ended March 31 2012 compared to 2011
	Change Due To:
	(Decrease)			Volume			Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans	$	(362	)	$	(297	)	$	(65	)
Trading securities		(23	)		(22	)		(1	)
Investment securities		(1,014	)		(188	)		(826	)
Federal funds sold		5			4			1

Total (decrease) in interest income		(1,394	)		(503	)		(891	)

Interest-Bearing Liabilities:
Interest-bearing deposits		(272	)		(58	)		(214	)
Borrowed funds		(11	)		224			(235	)

Total (decrease) in interest expense		(283	)		166			(449	)

(Decrease) in net interest income	$	(1,111	)	$	(669	)	$	(442	)

Non-Interest Income

Non-interest income amounted to $469 thousand during the three months ended March 31, 2012, an increase of $285 thousand from $184 thousand for the same period of 2011.

Bankshares recorded a net gain of $3 thousand on the sale of investment securities in the three months ended March 31, 2012, compared to a net gain of $79 thousand in the three months ended March 31, 2011.

Fair value adjustments on the FHLB advance and the PCMO security recorded for the three months ended March 31, 2012 resulted in a net gain of $392 thousand, compared to a net gain of $24 thousand for the same period in 2011, an increase of $368 thousand. The net gain of $392 thousand for the three months ended March 31, 2012 is primarily driven by a positive fair value adjustment of $463 thousand on the FHLB advance.

Non-Interest Expense

During the three months ended March 31, 2012, Bankshares made important progress toward its strategic goal of decreasing its non-interest expenses.

Non-interest expense for the three months ended March 31, 2012, amounted to $3.6 million compared to $3.7 million for the same period in 2011, a decrease of $132 thousand. A key component of non-interest expenses are salary and employee benefits expense. Salary and employee benefits expenses for the quarter ended March 31, 2012 were $1.2 million, compared to the first quarter of 2011 level of $1.4 million, a decrease of $228 thousand. Occupancy expenses and equipment expenses collectively totaled $725 thousand for the quarter ended March 31, 2012 compared to the 2011 level of $729 thousand, a decrease of $4 thousand.

OREO expense was $41 thousand for the first quarter ended March 31, 2012 compared to $35 thousand for the same period in 2011. A valuation adjustment on a property contributed to the increase in the OREO expenses for the quarter.

Income Taxes

Bankshares recorded income tax expense of $158 thousand in the first quarter of 2012, compared to $182 thousand for the same period in 2011.

At December 31, 2011, Bankshares performed an analysis to determine if a valuation allowance for deferred tax assets was necessary. Its analysis reviewed various forms of positive and negative evidence in determining whether a valuation allowance is necessary and if so to what degree a valuation allowance is warranted. The three year cumulative loss position of Bankshares is considered negative evidence when determining if a valuation allowance is necessary. Bankshares considered positive evidence such as previous earnings patterns, multiyear business projections and the potential realization of net operating loss (NOL) carry forwards within the prescribed time periods. In addition, Bankshares considered tax planning strategies that would impact the timing and extent of taxable income. Based on the analysis and the guidance in the relevant accounting literature, it was not considered more likely than not, that Bankshares will not be able to realize all its deferred tax assets. A valuation allowance of $5.3 million related to the deferred tax assets was recorded at December 31, 2011. and March 31, 2012.

The income tax provision at March 31, 2012, is directly related to the fair value gain on the Federal Home Loan Bank (FHLB) advance.

Analysis of Financial Condition

Trading Security. At March 31, 2012 and December 31, 2011, the trading portfolio consisted of one PCMO security with a fair value of $454 thousand and $596 thousand respectively. The current effective portfolio yield is 5.40%.

The following table reflects our trading asset and effective yield on the instrument as of the dates indicated:


	Trading Security
	March 31,					December 31,
	2012					2011
	Fair					Fair
	Value		Yield			Value		Yield
	(Dollars in thousands)
PCMO⁽¹⁾	$	454		5.40	%	$	596		5.44	%

Totals	$	454		5.40	%	$	596		5.44	%

Investment Securities – Available for Sale

We actively manage our portfolio duration and composition with changing market conditions and changes in balance sheet risk management needs. Additionally, the securities are pledged as collateral for certain borrowing transactions and repurchase agreements. The total amount of the investment securities accounted for under available-for-sale accounting was $105.7 million at March 31, 2012 compared to $123.5 million at December 31, 2011. Targeted efforts to strategically restructure our balance sheet in anticipation of the merger during 2011 led to shifts in our investment portfolio mix and reduced the investment securities portfolio’s balance at March 31, 2012.

On March 31, 2012, our investment portfolio contained callable and non-callable U.S. government corporation and agencies securities, U.S. government agency collateralized mortgage obligations (CMOs), U.S. government agency mortgage backed securities (MBS), PCMOs, and municipal securities.

On March 31, 2012, U.S. government agency securities were $18.7 million or 17.7% of the portfolio, PCMOs, CMOs and MBS were $78.5 million, or 74.3%, and municipal securities were $8.6, million or 8.1%, of the portfolio.

The yield on the investment securities portfolio as of March 31, 2012 was 2.54%. During the first quarter of 2012, the Bank earned $336 thousand on the investment securities portfolio or an effective tax equivalent yield of 1.14%. The investment securities portfolio contains mortgage oriented products (CMO, PCMO, and MBS) and SBA securities. When prepayments on these instruments occur at a faster rate than anticipated, premium amortization increases which adversely impacts the portfolio yield. During the first quarter of 2012, the Bank experienced greater than expected prepayments on a variety of investment securities. The U. S. treasuries matured during the first quarter and were re-invested in higher yielding securities.


	Investment Securities – Available-for-Sale
	March 31, 2012								December 31, 2011
	Fair Value		Yield			% of Total			Fair Value		Yield			% of Total
	(Dollars in thousands)
U.S. treasuries	$	—					0.00	%	$	71,115		0.01	%		57.6	%
U.S. government corporations and agencies		18,692		2.51	%		17.7	%		9,751		2.63	%		7.9	%
U.S. government agency CMOs		55,964		2.44	%		53.0	%		31,038		2.16	%		25.1	%
U.S. government agency MBS		21,533		2.16	%		20.4	%		7,698		2.01	%		6.2	%
PCMOs		967		2.82	%		0.9	%		950		2.82	%		0.8	%
Municipal securities		8,588		4.14	%		8.1	%		2,911		5.06	%		2.4	%

Total Investment Securities
Available-for-Sale	$	105,744		2.54	%		100.0	%	$	123,463		1.02	%		100.0	%

The following table summarizes the contractual maturity of the investment securities on an amortized cost basis and their weighted average yield as of March 31, 2012:


	Contractual Maturities of Investment Securities March 31, 2012
	(Dollars in thousands)
	Within One Year					After One Year but Within Five Years					After Five Years but Within Ten Years					After Ten Years
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Total^(4,5)		Yield
Available-For-Sale Securities
U.S. government corporations and agencies	$	—		0.00	%	$	—		0.00	%	$	—		0.00	%	$	18,702		2.51	%	$	18,702		2.51	%
U.S. government agency CMOs⁽¹⁾		—		0.00	%		—		0.00	%		2,905		2.25	%		52,869		2.45	%		55,774		2.44	%
U.S. government agency MBS⁽¹⁾		—		0.00	%		—		0.00	%		—		0.00	%		21,458		2.16	%		21,458		2.16	%
PCMOs⁽¹⁾		—		0.00	%		—		0.00	%		—		0.00	%		970		2.82	%		970		2.82	%
Municipal securities⁽²⁾		—		0.00	%		—		0.00	%		1,269		3.60	%		7,464		4.24	%		8,733		4.15	%

Total Available-For-Sale Securities⁽³⁾	$	—		0.00	%	$	—		0.00	%	$	4,174		2.66	%	$	101,463		2.53	%	$	105,637		2.54	%

⁽¹⁾

Contractual maturities of CMOs, PCMOs and MBS are not reliable indicators of their expected life because mortgage borrowers have the right to prepay mortgages at any time.

⁽²⁾

Municipal securities yield is on a fully tax equivalent basis assuming a 34% federal tax rate.

⁽³⁾

Bankshares did not have any held-to-maturity securities as of March 31, 2012.

⁽⁴⁾

Total above is amortized cost and does not include unrealized loss of $108 thousand.

⁽⁵⁾

Total available for sale securities amounted to $105.7 million. The fair value of the contractual maturities listed in the total above amounts to $105.7 million.

Restricted Securities

Bankshares’ securities portfolio contains restricted securities that are required to be held as part of the Company’s banking operations. These include stock of the Federal Reserve Bank, the FHLB and others. The following table summarizes the balances of restricted stock at the dates indicated:


	Restricted Stocks
	March 31,		December 31,
	2012		2011
	(Dollars in thousands)
Federal Reserve Bank Stock	$	1,201	$	1,201
FHLB stock		3,365		3,365
Bankers’ Bank stock		206		206

Total Restricted Stock	$	4,772	$	4,772

Loan Portfolio

In its lending activities, Bankshares seeks to develop substantial relationships with clients whose business and individual banking needs will grow with the Bank. Bankshares has made significant efforts to be responsive to the lending needs in the markets served, while maintaining sound asset quality and credit practices. Bankshares grants credit to commercial business, commercial real estate, real estate construction, and residential real estate and consumer borrowers in the normal course of business. The loan portfolio net of discounts and fees was $297.1 million as of March 31, 2012 or $9.8 million lower than the December 31, 2011 levels of $306.9 million.

The following table summarizes the composition of the loan portfolio by dollar amount and each segment as a percentage of the total loan portfolio as of the dates indicated:


	Loan Portfolio
	March 31, 2012					December 31, 2011
	Amount		Percent			Amount		Percent
	(Dollars in thousands)
Residential real estate	$	94,921		32	%	$	101,248		33	%
Commercial real estate		133,332		45	%		137,610		45	%
Construction/land		41,172		14	%		39,176		13	%
Commercial and industrial		26,018		9	%		26,820		9	%
Consumer – non real estate		1,642		1	%		2,022		0	%
Other		—		0	%		—		0	%

Total Loans	$	297,085		100	%	$	306,876		100	%

Substantially all loans are initially underwritten based on identifiable cash flows and supported by appropriate advance rates on collateral, which is independently valued. Commercial loans are generally secured by accounts receivable, equipment and business assets. Commercial real estate is secured by owner-occupied or non-owner occupied commercial properties of all types. Real estate construction loans are supported by projects which generally require an appropriate level of pre-sales or pre-leasing. Generally, all commercial and real estate loans have full recourse to the owners and/or sponsors. Residential real estate is secured by first or second trusts on both owner-occupied and investor-owned residential properties.

As noted in the table above, loans secured by various types of real estate constitute a significant portion of total loans. Commercial real estate loans represent the largest dollar exposure. Substantially all of these loans are secured by properties in the Metropolitan Washington, D.C. area with the heaviest concentration in Northern Virginia and Fairfax County in particular. Risk is managed through diversification by sub-market, property type, and loan size. Risk is further managed by seeking investment property loans with multiple tenants and by emphasizing owner-occupied loans. The average loan size in this portfolio is $620 thousand as of March 31, 2012.

The table also shows a modest increase in the construction / land portion of the portfolio, which represented 14% of the portfolio at March 31, 2012 compared to 13% at December 31, 2011. The current levels of construction/land loans are a product of management’s efforts to de-emphasize this type of lending in recent years. New originations in this segment are being underwritten in the context of current market conditions and are particularly focused in sub-markets which appear to be the strongest in the region. Legacy loans, particularly in the land portion of this portfolio, have been largely converted to amortizing loans with regular principal and interest payments. Bankshares expects to see further reductions in its land exposure offset by potential increases in certain residential construction activities, as market conditions improve.

Loans secured by residential real estate have remained relatively constant since December 31, 2011, as a percent of the portfolio, with growth in our 1-4 family first trust loans partially offset by the reductions in our 1-4 family subordinate trust loans (HELOCs and closed-end 2^nd mortgages). All loans in both categories represent loans underwritten by Bankshares (Bankshares does not purchase loans for this portfolio) to customers with whom Bankshares has direct contact in the local communities it serves. Bankshares believes that its underwriting criteria reflect current market conditions. The portfolio of first mortgage loans had an average size per housing unit of $287 thousand as of March 31, 2012. Bankshares’ subordinate trust loans averaged $115 thousand per property as of March 31, 2012. While Bankshares recognizes that the Metropolitan Washington, D.C. residential real estate market is in a nascent recovery, Bankshares believes its current underwriting standards, an emphasis on serving the sub-markets Bankshares knows, the granularity of its portfolio, and its continued reduction of the subordinate trust portfolio represent appropriate risk management strategies for this portfolio.

The following table presents the maturities or repricing periods of selected loans outstanding at March 31, 2012:


	Loan Maturity Distribution As of March 31, 2012
	One Year or Less		After One Year Through Five Years		After Five Years		Total
	(Dollars in thousands)
Commercial and industrial	$	14,308	$	10,430	$	1,280	$	26,018
Construction/land		32,074		6,011		3,087		41,172

Total	$	46,382	$	16,441	$	4,367	$	67,190

Loans with:
Fixed rates	$	60,304	$	76,370	$	64,553	$	201,227
Variable rates		42,759		48,936		4,163		95,858

Total	$	103,063	$	125,306	$	68,716	$	297,085

Asset Quality

Bankshares segregates loans meeting the criteria for special mention, substandard, doubtful and loss from non-classified, or pass rated, loans. Bankshares reviews the characteristics of each rating at least annually, generally during the first quarter of each year. The characteristics of these ratings are as follows:

Pass and watch rated loans (risk ratings 1 to 6) are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loans, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that the borrower will maintain this type of payment history. Routinely, acceptable personal guarantors support these loans.

Special mention loans (risk rating 7) have a specific defined weakness in the borrower’s operations and/or the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history is characterized by late payments. Bankshares’ risk exposure to special mention loans is mitigated by collateral supporting the loan. The collateral is considered to be well-managed, well maintained, accessible and readily marketable.

Substandard loans (risk rating 8) are considered to have specific and well-defined weaknesses that jeopardize the viability of Bankshares’ credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantors to pay the loan may not adequately protect Bankshares. There is a distinct possibility that Bankshares will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet Bankshares’ definition of an impaired loan unless the loan is significantly past due and the borrower’s performance and financial condition provide evidence that it is probable Bankshares will be unable to collect all amounts due.

Substandard non-accrual loans have the same characteristics as substandard loans. However these loans have a non-accrual classification generally because the borrower’s principal or interest payments are 90 days or more past due.

Doubtful rated loans (risk rating 9) have all the weakness inherent in a loan that is classified as substandard but with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss related to doubtful rated loans is extremely high.

Loss (risk rating 10) rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off.

The table below represents the Company’s loan portfolio by risk rating, classification, and loan portfolio segment as of March 31, 2012.


	Credit Quality Asset By Class As of March 31, 2012 (Dollars in thousands)
INTERNAL RISK RATING GRADES	Pass		Watch		Special Mention		Substandard		Doubtful		Loss		Total Loans
Risk Rating Number¹	1 to 5		6		7		8		9		10
Commercial and industrial	$	22,849	$	914	$	477	$	1,778	$	—	$	—	$	26,018
Commercial real estate
Owner occupied		62,843		1,155		2,005		3,538		—		—		69,541
Non-owner occupied		52,335		5,033		4,607		1,816		—		—		63,791
Construction/land
Residential construction		15,456		800		—		—		544		—		16,800
Other construction & land		14,442		47		1,831		6,816		1,236		—		24,372
Residential real estate
Equity lines		28,155		59		100		—		—		—		28,314
Single family		52,679		3,417		2,132		2,922		—		—		61,150
Multifamily		5,457		—		—		—		—		—		5,457
Consumer – non real estate		1,458		—		184		—		—		—		1,642

Totals	$	255,674	$	11,425	$	11,336	$	16,870	$	1,780	$	—	$	297,085

Internal risk ratings of pass (rating numbers 1 to 5) and watch (rating number 6) are deemed to be unclassified assets. Internal risk ratings of special mention (rating number 7), substandard (rating number 8), doubtful (rating number 9) and loss (rating number 10) are deemed to be classified assets.

As part of our normal credit risk management practices, we regularly monitor the payment performance of our borrowers. Substantially all loans require some form of payment on a monthly basis, with a high percentage requiring regular amortization of principal. However, certain HELOCs, commercial and industrial lines of credit, and construction loans generally require only monthly interest payments.

When payments are 90 days or more in arrears or when Bankshares determines that it is no longer prudent to recognize current interest income on a loan, Bankshares may classify the loan as non-accrual. Three lending relationships are major contributors to the increase in non-accrual levels during 2011. The first relationship, with an aggregate exposure of $4.6 million, continues to make note payments but payments are inconsistent and its ability to sustain payments remains in question. The second relationship, with an aggregate exposure of $2.3 million, was to be curtailed in the fall of 2011 from the sale of collateral property. The proposed sale did not occur as anticipated due to a utility easement issue with the collateral property. The third relationship has an exposure of $2.3 million. The collateral appears adequate at this time while Bankshares works with the client to sell underlying property. The decrease in the amount of loans on non-accrual from $13.3 million at December 31, 2011, to $11.2 million at March 31, 2012, was primarily due to the foreclosure and purchase into OREO of an improved residential property in Fairfax County, Virginia, that was a loan of $1.3 million as of December 31, 2011.

From time to time, a loan may be past due 90 days or more but is in the process of collection and thus warrants remaining on accrual status. Bankshares had one such loan in the amount of $370 thousand at March 31, 2012, that is past due and still accruing.

The following table sets forth the aging and non-accrual loans by class as of March 31, 2012:


	Aging and Non-accrual Loans By Class As of March 31, 2012
	(Dollars in thousands)
	30-59 Days Past Due		60-89 Days Past Due		90 Days or More Past Due		Total Past Due		Current¹		90-days Past Due and Still Accruing		Non-accrual Loans
Commerical and industrial	$	1,002	$	18	$	370	$	1,390	$	24,628	$	370	$	955
Commercial real estate
Owner occupied		109		—		2,560		2,669

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ALLIANCE BANKSHARES CORP 10-Q