f10q033111.htm

 


 

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10 – Q

[X]         QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934                                                              

For the quarterly period ended March 31, 2011.
or
[  ]         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934  For the transition period from ___________ to __________.

Commission File Number 0-16587

Summit Financial Group, Inc.
(Exact name of registrant as specified in its charter)

West Virginia
 
55-0672148
(State or other jurisdiction of
 
(IRS Employer
incorporation or organization)
 
Identification No.)

 
300 North Main Street
   
 
Moorefield, West Virginia
26836
 
 
(Address of principal executive offices)
(Zip Code)
 

(304) 530-1000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities and 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 þ
No o
 
     
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 o
No o
 

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 definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
                          Large accelerated filer o Accelerated filero
                    Non-accelerated filer o Smaller reporting companyþ

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date.
Common Stock, $2.50 par value
7,425,472 shares outstanding as of April 29, 2011

 
1

 
Summit Financial Group, Inc. and Subsidiaries
Table of Contents



     
Page
PART  I.
FINANCIAL INFORMATION
 
       
 
Item 1.
Financial Statements
 
       
   
Consolidated balance sheets
March 31, 2011 (unaudited), December 31, 2010, and March 31, 2010 (unaudited)
4
       
   
Consolidated statements of income
for the three months ended
March 31, 2011 and 2010 (unaudited)
5
       
   
Consolidated statements of shareholders’ equity
for the three months ended
March 31, 2011 and 2010 (unaudited)
6
       
   
Consolidated statements of cash flows
for the three months ended
March 31, 2011 and 2010 (unaudited)
7-8
       
   
Notes to consolidated financial statements (unaudited)
9-37
       
 
Item 2.
Management's Discussion and Analysis of Financial Condition
and Results of Operations
38-54
       
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
53
       
 
Item 4.
Controls and Procedures
54

 
2

 
Summit Financial Group, Inc. and Subsidiaries
Table of Contents



       
PART II.
OTHER INFORMATION
 
 
 
Item 1.
Legal Proceedings
55
       
 
Item 1A.
Risk Factors
55
       
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
None
       
 
Item 3.
Defaults upon Senior Securities
None
       
 
Item 4.
Removed and Reserved
 
       
 
Item 5.
Other Information
None
       
 
Item 6.
Exhibits
 
       
   
Exhibits
 
Exhibit 10.1       Second Amended and Restated Employment Agreement
 
 
   
Exhibit 11
Statement re:  Computation of Earnings per Share – Information contained in Note 4 to the Consolidated Financial Statements on page 15 of this Quarterly Report is incorporated herein by reference.
 
         
   
Exhibit 31.1
Sarbanes-Oxley Act Section 302 Certification of Chief Executive Officer
 
         
   
Exhibit 31.2
Sarbanes-Oxley Act Section 302 Certification of Chief Financial Officer
 
         
   
Exhibit 32.1
Sarbanes-Oxley Act Section 906 Certification of Chief Executive Officer
 
         
   
Exhibit 32.2
Sarbanes-Oxley Act Section 906 Certification of Chief Financial Officer
 
         
SIGNATURES
 
56


 
3

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Balance Sheets (unaudited)


   
March 31,
   
December 31,
   
March 31,
 
   
2011
   
2010
   
2010
 
 Dollars in thousands
 
(unaudited)
      (*)    
(unaudited)
 
 ASSETS
                   
 Cash and due from banks
  $ 4,263     $ 4,652     $ 5,163  
 Interest bearing deposits with other banks
    46,448       45,696       9,032  
 Securities available for sale
    293,240       271,730       262,565  
 Other investments
    21,956       22,941       24,008  
 Loans held for sale, net
    402       343       429  
 Loans, net
    979,387       995,319       1,112,526  
 Property held for sale
    66,961       70,235       50,562  
 Premises and equipment, net
    22,784       23,092       24,001  
 Accrued interest receivable
    5,797       5,879       6,519  
 Intangible assets
    8,914       9,002       9,265  
 Other assets
    32,043       29,581       32,426  
 Total assets
  $ 1,482,195     $ 1,478,470     $ 1,536,496  
                         
 LIABILITIES AND SHAREHOLDERS' EQUITY
                       
 Liabilities
                       
     Deposits
                       
         Non interest bearing
  $ 86,735     $ 74,604     $ 71,100  
         Interest bearing
    975,384       962,335       939,936  
 Total deposits
    1,062,119       1,036,939       1,011,036  
     Short-term borrowings
    1,879       1,582       27,456  
     Long-term borrowings
    283,516       304,109       361,335  
     Subordinated debentures
    16,800       16,800       16,800  
     Subordinated debentures owed to unconsolidated subsidiary trusts
    19,589       19,589       19,589  
     Other liabilities
    8,964       9,630       9,746  
 Total liabilities
    1,392,867       1,388,649       1,445,962  
                         
 Commitments and Contingencies
                       
                         
 Shareholders' Equity
                       
     Preferred stock and related surplus - authorized 250,000 shares;
                       
        Series 2009, 8% Non-cumulative convertible preferred stock,
                       
             par value $1.00; issued 3,710 shares
    3,519       3,519       3,519  
     Common stock and related surplus - authorized 20,000,000 shares;
                       
        $2.50 par value; issued and outstanding 2011 and
                       
         2010 -  7,425,472 shares
    24,515       24,508       24,508  
     Retained earnings
    60,879       61,201       63,519  
     Accumulated other comprehensive income (loss)
    415       593       (1,012 )
 Total shareholders' equity
    89,328       89,821       90,534  
                         
 Total liabilities and shareholders' equity
  $ 1,482,195     $ 1,478,470     $ 1,536,496  
                         
                         
(*) - December 31, 2010 financial information has been extracted from audited consolidated financial statements
         
 See Notes to Consolidated Financial Statements
                       
 
 
 
4

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Income (unaudited)


   
Three Months Ended
 
   
March 31,
   
March 31,
 
 Dollars in thousands, except per share amounts
 
2011
   
2010
 
 Interest income
           
     Interest and fees on loans
           
         Taxable
  $ 15,075     $ 16,958  
         Tax-exempt
    65       83  
     Interest and dividends on securities
               
         Taxable
    2,609       3,138  
         Tax-exempt
    434       455  
     Interest on interest bearing deposits with other banks
    17       11  
 Total interest income
    18,200       20,645  
 Interest expense
               
     Interest on deposits
    4,743       5,498  
     Interest on short-term borrowings
    1       57  
     Interest on long-term borrowings and subordinated debentures
    3,354       4,858  
 Total interest expense
    8,098       10,413  
 Net interest income
    10,102       10,232  
 Provision for loan losses
    3,000       5,350  
 Net interest income after provision for loan losses
    7,102       4,882  
 Other income
               
     Insurance commissions
    1,242       1,209  
     Service fees
    621       707  
     Realized securities gains (losses)
    1,628       264  
     Gain (loss) on sale of assets
    71       12  
     Writedown of OREO
    (3,443 )     -  
     Other
    497       353  
     Total other-than-temporary impairment loss on securities
    (1,828 )     (454 )
     Portion of loss recognized in other comprehensive income
    600       425  
     Net impairment loss recognized in earnings
    (1,228 )     (29 )
 Total other income
    (612 )     2,516  
 Other expense
               
     Salaries, commissions, and employee benefits
    3,842       3,724  
     Net occupancy expense
    509       521  
     Equipment expense
    580       629  
     Supplies
    78       109  
     Professional fees
    196       274  
     Amortization of intangibles
    88       88  
     FDIC premiums
    693       825  
     OREO expense
    434       232  
     Other
    556       1,208  
 Total other expense
    6,976       7,610  
 Income (loss) before income taxes
    (486 )     (212 )
 Income tax expense (benefit)
    (238 )     (332 )
 Net Income (loss)
    (248 )     120  
 Dividends on preferred shares
    74       74  
 Net Income (loss) applicable to common shares
  $ (322 )   $ 46  
                 
                 
  Basic earnings per common share
  $ (0.04 )   $ 0.01  
  Diluted earnings per common share
  $ (0.04 )   $ 0.01  
                 
                 
 See Notes to Consolidated Financial Statements
               

 
5

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Shareholders’ Equity (unaudited)



                     
Accumulated
       
   
Common
   
Preferred
         
Other
   
Total
 
   
Stock and
   
Stock and
         
Compre-
   
Share-
 
   
Related
   
Related
   
Retained
   
hensive
   
holders'
 
 Dollars in thousands, except per share amounts
 
Surplus
   
Surplus
   
Earnings
   
Income (Loss)
   
Equity
 
                               
 Balance, December 31, 2010
  $ 24,508     $ 3,519     $ 61,201     $ 593     $ 89,821  
 Three Months Ended March 31, 2011
                                       
     Comprehensive income:
                                       
       Net income (loss)
    -       -       (248 )     -       (248 )
       Other comprehensive income:
                                       
 Non-credit related other-than-temporary
                                       
    impairment on available for sale debt  securities
                                       
    of $594, net of deferred taxes of $226
    -       -       -       (372 )     (372 )
 Net unrealized gain on available for sale debt
                                       
    securities of $312 net of deferred taxes of
                                       
    $118 and reclassification adjustment for net
                                       
    realized gains included in net income of $1,628
    -       -       -       194       194  
     Total comprehensive income
                                    (426 )
     Exercise of stock options
    -       -       -       -       -  
     Stock compensation expense
    7       -       -       -       7  
     Preferred stock cash dividends declared ($20.00 per share)
    -       -       (74 )     -       (74 )
                                         
 Balance, March 31, 2011
  $ 24,515     $ 3,519     $ 60,879     $ 415     $ 89,328  
                                         
                                         
 Balance, December 31, 2009
  $ 24,508     $ 3,519     $ 63,474     $ (841 )   $ 90,660  
 Three Months Ended March 31, 2010
                                       
     Comprehensive income:
                                       
       Net income (loss)
    -       -       120       -       120  
       Other comprehensive income:
                                       
 Non-credit related other-than-temporary
                                       
    impairment on available for sale debt securities
                                       
       of $425, net of deferred taxes of $161
    -       -       -       (264 )     (264 )
 Net unrealized gain on available for sale debt
                                       
    securities of $150 net of deferred taxes of
                                       
    $57 and reclassification adjustment for net
                                       
    realized gains included in net income of $264
    -       -       -       93       93  
     Total comprehensive income
                                    (51 )
     Exercise of stock options
    -       -       -       -       -  
     Stock compensation expense
    -       -       -       -       -  
     Preferred stock cash dividends declared ($20.00 per share)
    -       -       (75 )     -       (75 )
                                         
 Balance, March 31, 2010
  $ 24,508     $ 3,519     $ 63,519     $ (1,012 )   $ 90,534  
                                         
                                         
                                         
                                         
                                         
 See Notes to Consolidated Financial Statements
                                       



 
6

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)



   
Three Months Ended
 
   
March 31,
   
March 31,
 
 Dollars in thousands
 
2011
   
2010
 
 Cash Flows from Operating Activities
           
     Net income (loss)
  $ (248 )   $ 120  
     Adjustments to reconcile net earnings to net cash
               
         provided by operating activities:
               
         Depreciation
    362       407  
         Provision for loan losses
    3,000       5,350  
         Stock compensation expense
    7       -  
         Deferred income tax (benefit)
    (1,630 )     (437 )
         Loans originated for sale
    (2,715 )     (1,781 )
         Proceeds from loans sold
    2,656       1,354  
         Securities (gains)
    (1,628 )     (264 )
         Other-than-temporary impairment of debt securities
    1,228       29  
         (Gain) on disposal of other repossessed assets & property held for sale
    (71 )     (12 )
         Write down of other repossessed assets & property held for sale
    3,443       -  
         Amortization of securities premiums (accretion of discounts), net
    373       (302 )
         Amortization of goodwill and purchase accounting
               
             adjustments, net
    91       91  
         Increase (decrease) in accrued interest receivable
    82       (196 )
         (Increase) in other assets
    (973 )     (1,574 )
         Increase (decrease) in other liabilities
    (665 )     739  
 Net cash provided by operating activities
    3,312       3,524  
 Cash Flows from Investing Activities
               
     Proceeds from (purchase of) interest bearing deposits
               
        with other banks
    (752 )     25,215  
     Proceeds from maturities and calls of securities available for sale
    2,889       6,034  
     Proceeds from sales of securities available for sale
    13,256       4,078  
     Principal payments received on securities available for sale
    17,311       13,144  
     Purchases of securities available for sale
    (55,226 )     (13,907 )
     Redemption of Federal Home Loan Bank Stock
    986       -  
     Net principal payments received on loans
    11,225       8,792  
     Purchases of premises and equipment
    (54 )     (175 )
     Proceeds from sales of other repossessed assets & property held for sale
    1,855       462  
 Net cash provided by (used in) investing activities
    (8,510 )     43,643  
 Cash Flows from Financing Activities
               
     Net increase in demand deposit, NOW and
               
         savings accounts
    50,571       6,935  
     Net (decrease) in time deposits
    (25,391 )     (13,236 )
     Net increase (decrease) in short-term borrowings
    296       (22,284 )
     Repayment of long-term borrowings
    (20,593 )     (20,158 )
     Dividends paid on preferred stock
    (74 )     (74 )
 Net cash provided by (used in) financing activities
    4,809       (48,817 )
 (Decrease) in cash and due from banks
    (389 )     (1,650 )
 Cash and due from banks:
               
         Beginning
    4,652       6,813  
         Ending
  $ 4,263     $ 5,163  
(Continued)
 
 See Notes to Consolidated Financial Statements
               


 
7

 
Summit Financial Group, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (unaudited)




             
   
Three Months Ended
 
   
March 31,
   
March 31,
 
 Dollars in thousands
 
2011
   
2010
 
             
 Supplemental Disclosures of Cash Flow Information
           
     Cash payments for:
           
         Interest
  $ 8,311     $ 10,636  
         Income taxes
  $ -     $ -  
                 
Supplemental Schedule of Noncash Investing and Financing Activities
         
     Other assets acquired in settlement of loans
  $ 1,707     $ 10,668  
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
                 
 See Notes to Consolidated Financial Statements
               

 
8

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

NOTE 1.  BASIS OF PRESENTATION

We, Summit Financial Group, Inc. and subsidiaries, prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for annual year end financial statements.  In our opinion, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature.

The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from these estimates.

The results of operations for the quarter ended March 31, 2011 are not necessarily indicative of the results to be expected for the full year.  The consolidated financial statements and notes included herein should be read in conjunction with our 2010 audited financial statements and Annual Report on Form 10-K.  Certain accounts in the consolidated financial statements for December 31, 2010 and March 31, 2010, as previously presented, have been reclassified to conform to current year classifications.

NOTE 2.  SIGNIFICANT NEW AUTHORITATIVE ACCOUNTING GUIDANCE
 
ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820) - Improving Disclosures About Fair Value Measurements, requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) company’s should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy is required for us beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for us on January 1, 2010. See Note 3 – Fair Value Measurements.
 
ASU No. 2010-20, Receivables (Topic 310) - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses requires entities to provide disclosures designed to facilitate financial statement users’ evaluation of (i) the nature of credit risk inherent in the entity’s portfolio of financing receivables, (ii) how that risk is analyzed and assessed in arriving at the allowance for credit losses and (iii) the changes and reasons for those changes in the allowance for credit losses. Disclosures must be disaggregated by portfolio segment, the level at which an entity develops and documents a systematic method for determining its allowance for credit losses, and class of financing receivable.  The required disclosures include, among other things, a rollforward of the allowance for credit losses as well as information about modified, impaired, non-accrual and past due loans and credit quality indicators. ASU 2010-20 will be effective for our financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period. Disclosures that relate to activity during a reporting period were effective January 1, 2011 and had no impact on our financial statements.
 
ASU No. 2011-01, Receivables (Topic 310) – Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 temporarily delayed the effective date of the disclosures regarding troubled debt restructurings in ASU No. 2010-20 for public entities.  The effective date is for interim and annual reporting periods ending after June 15, 2011.
 
 
9

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring provides additional guidance to clarify when a loan modification or restructuring is considered a troubled debt restructuring (TDR) in order to address current diversity in practice and lead to more consistent application of U.S. GAAP for debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist:  (1) the restructuring constitutes a concession, and (2) the debtor is experiencing financial difficulties. The amendments to Topic 310 clarify the guidance regarding the evaluation of both considerations above. Additionally, the amendments clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a TDR. This amendment is effective for us July 1, 2011.  Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, we may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011.
 
 
ASU No. 2010-28, Intangibles – Goodwill and Other (Topic 350) – When to Perform Step 2 of the goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance and examples in paragraph 350-20-35-30, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  This amendment was effective for us January 1, 2011 and had no impact on our financial statements.
 

NOTE 3.  FAIR VALUE MEASUREMENTS

ASC Topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value.

 
Level 1:  Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the   ability to access as of the measurement date.

 
Level 2:  Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be
                corroborated by observable market data.

 
Level 3:  Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
        
Accordingly, securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record other assets at fair value on a nonrecurring basis, such as loans held for sale, and impaired loans held for investment.  These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Available-for-Sale Securities:  Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.
 
 
10

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


Loans Held for Sale:  Loans held for sale are carried at the lower of cost or market value.  The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.  As such, we classify loans subject to nonrecurring fair value adjustments as Level 2.

Loans:  We do not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, Accounting by Creditors for Impairment of a Loan.  The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At March 31, 2011, substantially all of the total impaired loans were evaluated based on the fair value of the collateral.  In accordance with ASC Topic 310, impaired loans where an allowance is established based on the fair value of collateral requires classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan as nonrecurring Level 2.  When a current appraised value is not available and there is no observable market price, we record the impaired loan as nonrecurring Level 3.

When a collateral-dependent loan is identified as impaired, management immediately begins the process of evaluating the estimated fair value of the underlying collateral to determine if a related specific allowance for loan losses or charge-off is necessary.  Current appraisals are ordered once a loan is deemed impaired if the existing appraisal is more than twelve months old, or more frequently if there is known deterioration in value. For recently identified impaired loans, a current appraisal may not be available at the financial statement date. Until the current appraisal is obtained, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the loan’s underlying collateral since the date of the original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar collateral within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends.  When a new appraisal is received (which generally are received within 3 months of a loan being identified as impaired), management then re-evaluates the fair value of the collateral and adjusts any specific allocated allowance for loan losses, as appropriate.  In addition, management also assigns a discount of 7–10% for the estimated costs to sell the collateral. As of March 31, 2011, the appraised values of the underlying collateral for our collateral-dependent impaired loans which had a related specific allowance or prior charge-off was in excess of the total fair value by $12,107,000.

Other Real Estate Owned (“OREO”):  OREO consists of real estate acquired in foreclosure or other settlement of loans. Such assets are carried on the balance sheet at the lower of the investment in the real estate or its fair value less estimated selling costs.  The fair value of OREO is determined on a nonrecurring basis generally utilizing current appraisals performed by an independent, licensed appraiser applying an income or market value approach using observable market data (Level 2).  Updated appraisals of OREO are generally obtained if the existing appraisal is more than 18 months old or more frequently if there is a known deterioration in value.  However, if a current appraisal is not available, the original appraised value is discounted, as appropriate, to compensate for the estimated depreciation in the value of the real estate since the date of its original appraisal.  Such discounts are generally estimated based upon management’s knowledge of sales of similar property within the applicable market area and its knowledge of other real estate market-related data as well as general economic trends (Level 3).  Upon foreclosure, any fair value adjustment is charged against the allowance for loan losses.  Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest income in the consolidated statements of income.
 

 
11

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis
 
The table below presents the recorded amount of assets measured at fair value on a recurring basis.


   
Balance at
   
Fair Value Measurements Using:
 
Dollars in thousands
 
March 31, 2011
   
Level 1
   
Level 2
   
Level 3
 
Available for sale securities
                       
   U.S. Government sponsored agencies
  $ 31,389     $ -     $ 31,389     $ -  
   Mortgage backed securities:
                               
      Government sponsored agencies
    146,226       -       146,226       -  
      Nongovernment sponsored agencies
    52,540       -       52,540       -  
   State and political subdivisions
    22,168       -       22,168       -  
   Corporate debt securities
    965       -       965       -  
   Other equity securities
    77       -       77       -  
   Tax-exempt state and political subdivisions
    39,875       -       39,875       -  
Total available for sale securities
  $ 293,240     $ -     $ 293,240     $ -  



   
Balance at
   
Fair Value Measurements Using:
 
Dollars in thousands
 
December 31, 2010
   
Level 1
   
Level 2
   
Level 3
 
Available for sale securities
                       
   U.S. Government sponsored agencies
  $ 30,665     $ -     $ 30,665     $ -  
   Mortgage backed securities:
                               
      Government sponsored agencies
    123,037       -       123,037       -  
      Nongovernment sponsored agencies
    59,267       -       59,267       -  
   State and political subdivisions
    22,388       -       22,388       -  
   Corporate debt securities
    949       -       949       -  
   Other equity securities
    77       -       77       -  
   Tax-exempt state and political subdivisions
    35,347       -       35,347       -  
Total available for sale securities
  $ 271,730     $ -     $ 271,730     $ -  

There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended March 31, 2011.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles.  These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  Assets measured at fair value on a nonrecurring basis are included in the table below.
 
 
12

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

   
Total at
   
Fair Value Measurements Using:
 
Dollars in thousands
 
March 31, 2011
   
Level 1
   
Level 2
   
Level 3
 
Residential mortgage loans held for sale
  $ 402     $ -     $ 402     $ -  
                                 
Impaired loans
                               
    Commercial
  $ 1,423     $ -     $ -     $ 1,423  
    Commercial real estate
    16,512       -       14,137       2,375  
    Construction and development
    19,790       -       10,023       9,767  
    Residential real estate
    20,755       -       16,608       4,147  
Total impaired loans
  $ 58,480     $ -     $ 40,768     $ 17,712  
                                 
OREO
  $ 66,961     $ -     $ 66,961     $ -  




   
Total at
   
Fair Value Measurements Using:
 
Dollars in thousands
 
December 31, 2010
   
Level 1
   
Level 2
   
Level 3
 
Residential mortgage loans held for sale
  $ 343     $ -     $ 343     $ -  
                                 
Impaired loans
                               
    Commercial
  $ 630     $ -     $ -     $ 630  
    Commercial real estate
    16,408       -       13,569       2,839  
    Construction and development
    13,940       -       11,251       2,689  
    Residential real estate
    21,028       -       14,836       6,192  
Total impaired loans
  $ 52,006     $ -     $ 39,656     $ 12,350  
                                 
OREO
  $ 70,235     $ -     $ 69,855     $ 380  


Impaired loans, which are measured for impairment primarily using the fair value of the collateral for collateral-dependent loans, had a carrying amount at March 31, 2011 of $61,748,000, with a valuation allowance of $3,268,000, resulting in no additional provision for loan losses for the three months ended March 31, 2011.

ASC Topic 825, Financial Instruments, requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.  The following summarizes the methods and significant assumptions we used in estimating our fair value disclosures for financial instruments.

Cash and due from banks:  The carrying values of cash and due from banks approximate their estimated fair value.

Interest bearing deposits with other banks:  The carrying values of interest bearing deposits with other banks approximate their estimated fair values.

Federal funds sold:  The carrying values of Federal funds sold approximate their estimated fair values.

Securities:  Estimated fair values of securities are based on quoted market prices, where available.  If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable securities.

Loans held for sale:  The carrying values of loans held for sale approximate their estimated fair values.
 
 
13

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Loans:  The estimated fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms to borrowers of similar credit quality.  No prepayments of principal are assumed.

Accrued interest receivable and payable:  The carrying values of accrued interest receivable and payable approximate their estimated fair values.

Deposits:  The estimated fair values of demand deposits (i.e. non-interest bearing checking, NOW, money market and savings accounts) and other variable rate deposits approximate their carrying values.  Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities.  Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.

Short-term borrowings:  The carrying values of short-term borrowings approximate their estimated fair values.

Long-term borrowings:  The fair values of long-term borrowings are estimated by discounting scheduled future payments of principal and interest at current rates available on borrowings with similar terms.

Subordinated debentures:  The carrying values of subordinated debentures approximate their estimated fair values.

Subordinated debentures owed to unconsolidated subsidiary trusts:  The carrying values of subordinated debentures owed to unconsolidated subsidiary trusts approximate their estimated fair values.

Off-balance sheet instruments:  The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit standing of the counter parties.  The amounts of fees currently charged on commitments and standby letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values are not shown below.

The carrying values and estimated fair values of our financial instruments are summarized below:


   
March 31, 2011
   
December 31, 2010
 
         
Estimated
         
Estimated
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
 Dollars in thousands
 
Value
   
Value
   
Value
   
Value
 
 Financial assets
                       
     Cash and due from banks
  $ 4,263     $ 4,263     $ 4,652     $ 4,652  
     Interest bearing deposits with
                               
         other banks
    46,448       46,448       45,696       45,696  
     Securities available for sale
    293,240       293,240       271,730       271,730  
     Other investments
    21,956       21,956       22,941       22,941  
     Loans held for sale, net
    402       402       343       343  
     Loans, net
    979,387       987,922       995,319       1,002,889  
     Accrued interest receivable
    5,797       5,797       5,879       5,879  
    $ 1,351,493     $ 1,360,028     $ 1,346,560     $ 1,354,130  
 Financial liabilities
                               
     Deposits
  $ 1,062,119     $ 1,121,890     $ 1,036,939     $ 1,102,131  
     Short-term borrowings
    1,879       1,879       1,582       1,582  
     Long-term borrowings
    283,516       300,538       304,109       323,803  
     Subordinated debentures
    16,800       16,800       16,800       16,800  
     Subordinated debentures owed to
                               
         unconsolidated subsidiary trusts
    19,589       19,589       19,589       19,589  
     Accrued interest payable
    2,916       2,916       3,130       3,130  
    $ 1,386,819     $ 1,463,612     $ 1,382,149     $ 1,467,035  
 
 
14

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

NOTE 4.  EARNINGS PER SHARE

The computations of basic and diluted earnings per share follow:


   
For the Three Months Ended March 31,
 
   
2011
   
2010
 
         
Common
               
Common
       
Dollars in thousands,
 
Income
   
Shares
   
Per
   
Income
   
Shares
   
Per
 
except per share amounts
 
(Numerator)
   
(Denominator)
   
Share
   
(Numerator)
   
(Denominator)
   
Share
 
Net income
  $ (248 )               $ 120              
 Less preferred stock dividends
    (74 )                 (74 )            
                                         
 Basic EPS
  $ (322 )     7,425,472     $ (0.04 )   $ 46       7,425,472     $ 0.01  
                                                 
     Effect of dilutive securities:
                                               
         Stock options
    -       -               -       -          
         Convertible preferred stock
    -       -               -       -          
                                                 
Diluted EPS
  $ (322 )     7,425,472     $ (0.04 )   $ 46       7,425,472     $ 0.01  



Stock option grants and the conversion of preferred stock are disregarded in this computation if they are determined to be anti-dilutive.  Our anti-dilutive stock options at March 31, 2011 and 2010 totaled 312,180 shares and 309,180 shares, respectively.  Our anti-dilutive convertible preferred shares totaled 674,545 shares at March 31, 2011 and 2010.

NOTE 5.  SECURITIES

The amortized cost, unrealized gains, unrealized losses and estimated fair values of securities at March 31, 2011, December 31, 2010, and March 31, 2010 are summarized as follows:


   
March 31, 2011
 
   
Amortized
   
Unrealized
   
Estimated
 
 Dollars in thousands
 
Cost
   
Gains
   
Losses
   
Fair Value
 
 Available for Sale
                       
     Taxable debt securities:
                       
         U. S. Government agencies
                       
             and corporations
  $ 31,530     $ 217     $ 358     $ 31,389  
         Residential mortgage-backed securities:
                               
              Government-sponsored agencies
    143,883       2,751       408       146,226  
              Nongovernment-sponsored agencies
    52,516       1,890       1,866       52,540  
         State and political subdivisions
    23,324       21       1,177       22,168  
         Corporate debt securities
    999       -       34       965  
          Total taxable debt securities
    252,252       4,879       3,843       253,288  
     Tax-exempt debt securities:
                               
         State and political subdivisions
    40,238       273       636       39,875  
      Total tax-exempt debt securities
    40,238       273       636       39,875  
     Equity securities
    77       -       -       77  
      Total available for sale securities
  $ 292,567     $ 5,152     $ 4,479     $ 293,240  


 
15

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


   
December 31, 2010
 
   
Amortized
   
Unrealized
   
Estimated
 
 Dollars in thousands
 
Cost
   
Gains
   
Losses
   
Fair Value
 
 Available for Sale
                       
     Taxable debt securities
                       
         U. S. Government agencies
                       
             and corporations
  $ 30,645     $ 319     $ 299     $ 30,665  
         Residential mortgage-backed securities:
                               
             Government-sponsored agencies
    119,608       3,642       213       123,037  
             Nongovernment-sponsored entities
    60,257       2,528       3,518       59,267  
         State and political subdivisions
    23,342       6       960       22,388  
         Corporate debt securities
    999       -       50       949  
 Total taxable debt securities
    234,851       6,495       5,040       236,306  
     Tax-exempt debt securities
                               
         State and political subdivisions
    35,843       211       707       35,347  
 Total tax-exempt debt securities
    35,843       211       707       35,347  
     Equity securities
    77       -       -       77  
 Total available for sale securities
  $ 270,771     $ 6,706     $ 5,747     $ 271,730  



   
March 31, 2010
 
   
Amortized
   
Unrealized
   
Estimated
 
 Dollars in thousands
 
Cost
   
Gains
   
Losses
   
Fair Value
 
 Available for Sale
                       
     Taxable debt securities:
                       
         U. S. Government agencies
                       
             and corporations
  $ 53,229     $ 679     $ 108     $ 53,800  
         Residential mortgage-backed securities:
                               
              Government-sponsored agencies
    94,777       4,365       74       99,068  
              Nongovernment-sponsored agencies
    69,869       713       7,292       63,290  
         State and political subdivisions
    4,280       38       17       4,301  
         Corporate debt securities
    350       2       -       352  
          Total taxable debt securities
    222,505       5,797       7,491       220,811  
     Tax-exempt debt securities:
                               
         State and political subdivisions
    41,613       480       416       41,677  
      Total tax-exempt debt securities
    41,613       480       416       41,677  
     Equity securities
    77       -       -       77  
      Total available for sale securities
  $ 264,195     $ 6,277     $ 7,907     $ 262,565  


The maturities, amortized cost and estimated fair values of securities at March 31, 2011, are summarized as follows:


 
 
   
Available for Sale
 
   
Amortized
   
Estimated
 
 Dollars in thousands
 
Cost
   
Fair Value
 
 Due in one year or less
  $ 75,551     $ 77,327  
 Due from one to five years
    107,837       109,597  
 Due from five to ten years
    34,156       33,641  
 Due after ten years
    74,946       72,598  
 Equity securities
    77       77  
    $ 292,567     $ 293,240  
 
 
16

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

The proceeds from sales, calls and maturities of available for sale securities, including principal payments received on mortgage-backed obligations, and the related gross gains and losses realized, for the three months ended March 31, 2011 are as follows:


   
Proceeds from
   
Gross realized
 
         
Calls and
   
Principal
             
Dollars in thousands
 
Sales
   
Maturities
   
Payments
   
Gains
   
Losses
 
                               
Securities available for sale
  $ 13,256     $ 2,889     $ 17,311     $ 1,633     $ 5  



During the three months ended March 31, 2011, we recorded other-than-temporary impairment losses on securities as follows:


   
Three Months Ended
 
   
Residential MBS
             
   
Nongovernment
             
   
- Sponsored
   
Equity
       
 Dollars in thousands
 
Entities
   
Securities
   
Total
 
 March 31, 2011
                 
 Total other-than-temporary impairment losses
  $ (1,828 )   $ -     $ (1,828 )
 Portion of loss recognized in
                       
   other comprehensive income
    600       -       600  
 Net impairment losses recognized in earnings
  $ (1,228 )   $ -     $ (1,228 )
                         
 March 31, 2010
                       
 Total other-than-temporary impairment losses
  $ (454 )   $ -     $ (454 )
 Portion of loss recognized in
                       
   other comprehensive income
    425       -       425  
 Net impairment losses recognized in earnings
  $ (29 )   $ -     $ (29 )

Activity related to the credit component recognized on debt securities available for sale for which a portion of other-than-temporary impairment was recognized in other comprehensive income for the three months ended March 31, 2011 is as follows:

   
Three Months Ended
   
March 31, 2011
       
 Dollars in thousands
 
Total
 Beginning Balance
  $ (3,910 )
 Additions for the credit component on debt securities in which
       
     other-than-temporary impairment was not previously recognized
    (1,228 )
  Securities sold during the period
    -  
 Ending Balance
  $ (5,138 )


At March 31, 2011, our debt securities with other-than-temporary impairment in which only the amount of loss related to credit was recognized in earnings consisted solely of residential mortgage-backed securities issued by nongovernment-sponsored entities.  We utilize third party vendors to estimate the portion of loss attributable to credit using a discounted cash flow models.  The vendors estimate cash flows of the underlying collateral of each mortgage-backed security using models that incorporate their best estimates of current key assumptions, such as default rates, loss severity and prepayment rates.  Assumptions utilized vary widely from security to security, and are influenced by such factors as underlying loan interest rates, geographical location of underlying borrowers, collateral type and other borrower characteristics.  Specific such assumptions utilized by our vendors in their valuation of our other-than-temporarily impaired residential mortgage-backed securities issued by nongovernment-sponsored entities were as follows at March 31, 2011:
 
 
17

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


 
 Weighted
 Range
 
 Average
 Minimum
 Maximum
 Constant voluntary prepayment rates
12.0%
5.4%
17.6%
 Constant default rates
6.7%
3.5%
10.2%
 Loss severities
49.0%
40.0%
56.0%

Our vendors performing these valuations also analyze the structure of each mortgage-backed instrument in order to determine how the estimated cash flows of the underlying collateral will be distributed to each security issued from the structure.  Expected principal and interest cash flows on the impaired debt securities are discounted predominantly using unobservable discount rates which the vendors assume that market participants would utilize in pricing the specific security.  Based on the discounted expected cash flows derived from our vendor’s models, we expect to recover the remaining unrealized losses on residential mortgage-backed securities issued by nongovernment sponsored entities.

Provided below is a summary of securities available for sale which were in an unrealized loss position at March
31, 2011 and December 31, 2010, including debt securities for which a portion of other-than-temporary impairment has been recognized in other comprehensive income.

   
March 31, 2011
 
   
Less than 12 months
   
12 months or more
   
Total
 
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
 
Dollars in thousands
 
Fair Value
   
Loss
   
Fair Value
   
Loss
   
Fair Value
   
Loss
 
Temporarily impaired securities
                                   
   Taxable debt securities
                                   
     U. S. Government agencies
                                   
       and corporations
  $ 16,953     $ (344 )   $ 1,259     $ (14 )   $ 18,212     $ (358 )
     Residential mortgage-backed securities:
                                               
        Government-sponsored agencies
    41,034       (408 )     -       -       41,034       (408 )
        Nongovernment-sponsored entities
    1,304       (13 )     9,829       (795 )     11,133       (808 )
     State and political subdivisions
    17,107       (1,172 )     385       (5 )     17,492       (1,177 )
     Corporate debt securities
    965       (34 )     -       -       965       (34 )
   Tax-exempt debt securities
                                               
     State and political subdivisions
    20,170       (476 )     1,161       (160 )     21,331       (636 )
     Total temporarily impaired securities
    97,533       (2,447 )     12,634       (974 )     110,167       (3,421 )
Other-than-temporarily impaired securities
                                               
   Taxable debt securities
                                               
     Residential mortgage-backed securities:
                                               
        Nongovernment-sponsored entities
    474       (624 )     3,460       (434 )     3,934       (1,058 )
     Total other-than-temporarily
                                               
 impaired securities
    474       (624 )     3,460       (434 )     3,934       (1,058 )
 Total
  $ 98,007     $ (3,071 )   $ 16,094     $ (1,408 )   $ 114,101     $ (4,479 )

 
18

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)



   
December 31, 2010
 
   
Less than 12 months
   
12 months or more
   
Total
 
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
   
Estimated
   
Unrealized
 
Dollars in thousands
 
Fair Value
   
Loss
   
Fair Value
   
Loss
   
Fair Value
   
Loss
 
Temporarily impaired securities
                                   
   Taxable debt securities
                                   
     U. S. Government agencies
                                   
       and corporations
  $ 9,658     $ (284 )   $ 1,272     $ (15 )   $ 10,930     $ (299 )
     Residential mortgage-backed securities:
                                               
        Government-sponsored agencies
    24,869       (213 )     -       -       24,869       (213 )
        Nongovernment-sponsored entities
    7,506       (459 )     12,695       (2,716 )     20,201       (3,175 )
     State and political subdivisions
    18,215       (955 )     385       (5 )     18,600       (960 )
     Corporate debt securities
    949       (50 )     -       -       949       (50 )
   Tax-exempt debt securities
                                               
     State and political subdivisions
    17,523       (555 )     1,169       (152 )     18,692       (707 )
     Total temporarily impaired securities
    78,720       (2,516 )     15,521       (2,888 )     94,241       (5,404 )
Other-than-temporarily impaired securities
                                               
   Taxable debt securities
                                               
     Residential mortgage-backed securities:
                                               
        Nongovernment-sponsored entities
    71       (43 )     4,624       (300 )     4,695       (343 )
     Total other-than-temporarily
                                               
 impaired securities
    71       (43 )     4,624       (300 )     4,695       (343 )
 Total
  $ 78,791     $ (2,559 )   $ 20,145     $ (3,188 )   $ 98,936     $ (5,747 )


We held 102 available for sale securities, including debt securities with other-than-temporary impairment in which a portion of the impairment remains in other comprehensive income, having an unrealized loss at March 31, 2011.  We do not intend to sell these securities, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost bases.  We believe that this decline in value is primarily attributable to the lack of market liquidity and to changes in market interest rates and not due to credit quality.  Accordingly, no additional other-than-temporary impairment charge to earnings is warranted at this time.

At March 31, 2011, we had $1.9 million in total unrealized losses related to residential mortgage-backed securities issued by nongovernment sponsored entities.  We monitor the performance of the mortgages underlying these bonds.  Although there has been some deterioration in their collateral performance, we primarily hold the senior tranches of each issue which provides protection against defaults.  We attribute the unrealized loss on these mortgage-backed securities held largely to the current absence of liquidity in the markets for such securities.  The mortgages in these asset pools have been made to borrowers with strong credit history and significant equity invested in their homes.  Nonetheless, further weakening of economic fundamentals coupled with significant increases in unemployment and substantial deterioration in the value of high end residential properties could extend distress to this borrower population.  This could increase default rates and put additional pressure on property values. Should these conditions occur, the value of these securities could decline further and result in the recognition of additional other-than-temporary impairment charges recognized in earnings.

NOTE 6.  LOANS

Loans are generally stated at the amount of unpaid principal, reduced by unearned discount and allowance for loan losses. Interest on loans is accrued daily on the outstanding balances.  Loan origination fees and certain direct loan origination costs are deferred and amortized as adjustments of the related loan yield over its contractual life.

Generally, loans are placed on nonaccrual status when principal or interest is greater than 90 days past due based upon the loan's contractual terms.  Interest is accrued daily on impaired loans unless the loan is placed on nonaccrual status.  Impaired loans are placed on nonaccrual status when the payments of principal and interest are in default for a period of 90 days, unless the loan is both well-secured and in the process of collection.  Interest on nonaccrual loans is recognized primarily using the cost-recovery method.  Loans may be returned to accrual status when repayment is reasonably assured and there has been demonstrated performance under the terms of the loan or, if applicable, the terms of the restructured loans.
 
19

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


Commercial-related loans or portions thereof (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed.  This determination is made on a case by case basis considering many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.  We deem a loss confirmed when a loan or a portion of a loan is classified “loss” in accordance with bank regulatory classification guidelines, which state, “Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assts is not warranted”.

Consumer-related loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), which ever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Loans are summarized as follows:

   
March 31,
   
December 31,
   
March 31,
 
 Dollars in thousands
 
2011
   
2010
   
2010
 
 Commercial
  $ 92,227     $ 97,059     $ 121,258  
 Commercial real estate
                       
      Owner-occupied
    182,956       187,098       198,974  
      Non-owner occupied
    240,604       235,337       256,420  
 Construction and development
                       
      Land and land development
    93,675       99,085       109,381  
      Construction
    13,879       13,691       41,808  
 Residential real estate
                       
      Non-jumbo
    233,308       239,290       252,413  
      Jumbo
    61,878       61,340       66,862  
      Home equity
    50,499       50,987       50,654  
 Consumer
    22,968       24,145       27,303  
 Other
    4,326       4,511       5,296  
      Total loans, net of unearned fees
    996,320       1,012,543       1,130,369  
 Less allowance for loan losses
    16,933       17,224       17,843  
       Loans, net
  $ 979,387     $ 995,319     $ 1,112,526  




The following table presents the contractual aging of the recorded investment in past due loans by class as of March 31, 2011 and 2010 and December 31, 2010.

 
20

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)



   
At March 31, 2011
 
                                 
Recorded
 
                                 
Investment
 
   
Past Due
         
> 90 days
 
Dollars in thousands
 
30-59 days
   
60-89 days
   
> 90 days
   
Total
   
Current
   
and Accruing
 
Commercial
  $ 906     $ 4     $ 2,142     $ 3,052     $ 89,175     $ -  
Commercial real estate
                                               
     Owner-occupied
    72       473       2,765       3,310       179,646       -  
     Non-owner occupied
    1,916       53       1,421       3,390       237,214       -  
Construction and development
                                               
     Land and land development
    1,773       124       8,358       10,255       83,420       -  
     Construction
    -       51       150       201       13,678       -  
Residential mortgage
                                               
     Non-jumbo
    5,229       1,184       3,889       10,302       223,006       -  
     Jumbo
    -       -       927       927       60,951       -  
     Home equity
    148       -       74       222       50,277       -  
Consumer
    406       77       143       626       22,342       -  
Other
    8       3       9       19       4,307       9  
     Total
  $ 10,458     $ 1,969     $ 19,878     $ 32,304     $ 964,016     $ 9  





   
At December 31, 2010
 
                                 
Recorded
 
                                 
Investment
 
   
Past Due
         
> 90 days
 
Dollars in thousands
 
30-59 days
   
60-89 days
   
> 90 days
   
Total
   
Current
   
and Accruing
 
Commercial
  $ 388     $ 307     $ 1,286     $ 1,981     $ 95,078     $ -  
Commercial real estate
                                               
     Owner-occupied
    364       -       1,348       1,712       185,386       -  
     Non-owner occupied
    3,697       590       310       4,597       230,740       -  
Construction and development
                                               
     Land and land development
    3,023       131       9,732       12,886       86,199       -  
     Construction
    -       2       317       319       13,372       -  
Residential mortgage
                                               
     Non-jumbo
    3,557       2,412       3,953       9,922       229,368       -  
     Jumbo
    2,997       10,383       2,549       15,929       45,411       1,442  
     Home equity
    501       270       51       822       50,165       -  
Consumer
    420       147       107       674       23,471       -  
Other
    9       10       -       19       4,492       -  
                                                 
     Total
  $ 14,956     $ 14,252     $ 19,653     $ 48,861     $ 963,682     $ 1,442  



21

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
 


   
At March 31, 2010
 
                                 
Recorded
 
                                 
Investment
 
   
Past Due
         
> 90 days
 
Dollars in thousands
 
30-59 days
   
60-89 days
   
> 90 days
   
Total
   
Current
   
and Accruing
 
Commercial
  $ 155     $ 1,084     $ 469     $ 1,708     $ 119,550     $ -  
Commercial real estate
                                               
     Owner-occupied
    -       1,099       309       1,408       197,567       -  
     Non-owner occupied
    2,203       6,701       33,000       41,904       214,516       -  
Construction and development
                                               
     Land and land development
    10,039       1,568       10,277       21,884       87,496       -  
     Construction
    -       45       6,393       6,438       35,370       -  
Residential mortgage
                                               
     Non-jumbo
    5,214       1,072       2,765       9,051       243,243       -  
     Jumbo
    927       655       627       2,209       64,772       -  
     Home equity
    961       -       432       1,393       49,262       167  
Consumer
    293       132       190       615       26,687       3  
Other
    10       3       -       13       5,283       -  
                                                 
     Total
  $ 19,802     $ 12,359     $ 54,462     $ 86,623     $ 1,043,746     $ 170  


Nonaccrual loans:  The following table presents the nonaccrual loans included in the net balance of loans at March 31, 2011, December 31, 2010 and March 31, 2010.


Dollars in thousands
 
3/31/2011
   
12/31/2010
   
3/31/2010
 
Commercial
  $ 2,186     $ 1,318     $ 511  
Commercial real estate
                       
   Owner-occupied
    3,785       2,372       312  
   Non-owner occupied
    1,499       314       33,595  
Construction and development
                       
   Land & land development
    8,358       9,732       10,279  
   Construction
    201       317       6,407  
Residential mortgage
                       
   Non-jumbo
    4,908       4,918       3,083  
   Jumbo
    927       1,106       631  
   Home equity
    508       51       339  
Consumer
    197       141       206  
Other
    -       -       -  
     Total
  $ 22,569     $ 20,269     $ 55,363  

 
22

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Impaired loans:  Impaired loans include the following:

§  
Loans which we risk-rate (consisting of loan relationships having aggregate balances in excess of $2,000,000, or loans exceeding $500,000 and exhibiting credit weakness) through our normal loan review procedures and which, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement.   Risk-rated loans with insignificant delays or insignificant short falls in the amount of payments expected to be collected are not considered to be impaired.

§  
Loans that have been modified in a troubled debt restructuring.

Both commercial and consumer loans are deemed impaired upon being contractually modified in a troubled debt restructuring. Troubled debt restructurings typically result from our loss mitigation activities and occur when we grant a concession to a borrower who is experiencing financial difficulty in order to minimize our economic loss and to avoid foreclosure or repossession of collateral.  Once restructured in a troubled debt restructuring, a loan is generally considered impaired until its maturity, regardless of whether the borrower performs under the modified terms.  Although such a loan may be returned to accrual status if the criteria set forth in our accounting policy are met, the loan would continue to be evaluated for an asset-specific allowance for loan losses and we would continue to report the loan in the impaired loan table below.

The tables below set forth information about our impaired loans.



Method Used to Measure Impairment of Impaired Loans
         
Dollars in thousands
                   
Loan Category
 
03/31/2011
   
12/31/2010
   
03/31/2010
 
Method used to measure impairment
Commerical
  $ 1,436     $ 630     $ 517  
Fair value of collateral
Commerical real estate
                         
   Owner-occupied
    8,393       8,866       7,311  
Fair value of collateral
      2,618       2,623       2,398  
Discounted cash flow
   Non-owner occupied
    4,455       4,922       39,581  
Fair value of collateral
      530       530       1,951  
Discounted cash flow
Construction and development
                         
   Land & land development
    22,130       16,515       20,567  
Fair value of collateral
   Construction
    92       -       5,974  
Fair value of collateral
Residential mortgage
                         
   Non-jumbo
    5,906       4,533       2,257  
Fair value of collateral
      577       753       29  
Discounted cash flow
   Jumbo
    15,401       17,296       2,593  
Fair value of collateral
   Home equity
    210       213       -  
Fair value of collateral
Total
  $ 61,748     $ 56,881     $ 83,178    



The following tables present loans individually evaluated for impairment at March 31, 2011, December 31, 2010 and March 31, 2010.
 
 
23

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


   
March 31, 2011
 
                     
Average
   
Interest Income
 
   
Recorded
   
Unpaid
   
Related
   
Impaired
   
Recognized
 
Dollars in thousands
 
Investment
   
Principal Balance
   
Allowance
   
Balance
   
while impaired
 
                               
Without a related allowance
                             
  Commercial
  $ 1,422     $ 1,423     $ -     $ 215     $ 1  
  Commercial real estate
                                       
     Owner-occupied
    7,049       7,068       -       1,761       12  
     Non-owner occupied
    1,637       1,638       -       728       8  
  Construction and development
                                       
     Land & land development
    19,217       19,217       -       5,417       16  
     Construction
    -       -       -       -       -  
  Residential real estate
                                       
     Non-jumbo
    4,055       4,077       -       2,439       19  
     Jumbo
    13,128       13,129       -       4,376       75  
     Home equity
    -       -       -       -       -  
Total without a related allowance
  $ 46,508     $ 46,552     $ -     $ 14,936     $ 131  
                                         
With a related allowance
                                       
  Commercial
  $ 14     $ 14     $ 14     $ -     $ -  
  Commercial real estate
                                       
     Owner-occupied
    3,943       3,943       280       2,198       12  
     Non-owner occupied
    3,341       3,347       470       721       7  
  Construction and development
                                       
     Land & land development
    2,912       2,912       1,160       2,352       3  
     Construction
    92       92       5       1       -  
  Residential real estate
                                       
     Non-jumbo
    2,404       2,406       681       718       6  
     Jumbo
    2,272       2,272       448       757       -  
     Home equity
    210       210       210       178       -  
Total with a related allowance
  $ 15,188     $ 15,196     $ 3,268     $ 6,925     $ 28  
                                         
Total
                                       
   Commercial
  $ 39,627     $ 39,654     $ 1,929     $ 13,393     $ 59  
   Residential real estate
    22,069       22,094       1,339       8,468       100  
Total
  $ 61,696     $ 61,748     $ 3,268     $ 21,861     $ 159  
 
 
24

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


   
December 31, 2010
 
                     
Average
   
Interest Income
 
   
Recorded
   
Unpaid
   
Related
   
Impaired
   
Recognized
 
Dollars in thousands
 
Investment
   
Principal Balance
   
Allowance
   
Balance
   
while impaired
 
                               
Without a related allowance
                             
  Commercial
  $ 629     $ 630     $ -     $ 232     $ 9  
  Commercial real estate
                                       
     Owner-occupied
    7,538       7,556       -       9,052       440  
     Non-owner occupied
    3,314       3,321       -       12,852       734  
  Construction and development
                                       
     Land & land development
    9,213       9,214       -       12,852       468  
     Construction
    -       -       -       -       -  
  Residential real estate
                                       
     Non-jumbo
    2,161       2,696       -       2,074       76  
     Jumbo
    14,822       14,822       -       7,887       547  
     Home equity
    165       165       -       -       -  
Total without a related allowance
  $ 37,842     $ 38,404     $ -     $ 44,949     $ 2,274  
                                         
With a related allowance
                                       
  Commercial
  $ -     $ -     $ -     $ -     $ -  
  Commercial real estate
                                       
     Owner-occupied
    3,933       3,933       265       670       -  
     Non-owner occupied
    2,130       2,130       267       1,953       88  
  Construction and development
                                       
     Land & land development
    7,301       7,301       2,575       3,183       7  
     Construction
    -       -       -       -       -  
  Residential real estate
                                       
     Non-jumbo
    2,589       2,591       843       1,242       22  
     Jumbo
    2,474       2,474       877       1,343       31  
     Home equity
    48       48       48       12       1  
Total with a related allowance
  $ 18,475     $ 18,477     $ 4,875     $ 8,403     $ 149  
                                         
Total
                                       
   Commercial
  $ 34,058     $ 34,085     $ 3,107     $ 40,794     $ 1,746  
   Residential real estate
    22,259       22,796       1,768       12,558       677  
Total
  $ 56,317     $ 56,881     $ 4,875     $ 53,352     $ 2,423  

 
25

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


   
March 31, 2010
 
                     
Average
   
Interest Income
 
   
Recorded
   
Unpaid
   
Related
   
Impaired
   
Recognized
 
Dollars in thousands
 
Investment
   
Principal Balance
   
Allowance
   
Balance
   
while impaired
 
                               
Without a related allowance
                             
  Commercial
  $ 348     $ 348     $ -     $ 34     $ -  
  Commercial real estate
                    -                  
     Owner-occupied
    9,666       9,710       -       8,622       140  
     Non-owner occupied
    5,776       5,796       -       5,277       52  
  Construction and development
                                       
     Land & land development
    11,192       11,193       -       4,840       1  
     Construction
    -       -       -       -       -  
  Residential real estate
                                       
     Non-jumbo
    2,266       2,281       -       965       4  
     Jumbo
    1,583       1,582       -       18       -  
     Home equity
    -       -       -       -       -  
  Consumer
    -       -       -       -       -  
Total without a related allowance
  $ 30,831     $ 30,910     $ -     $ 19,756     $ 197  
                                         
With a related allowance
                                       
  Commercial
  $ 170     $ 169     $ 122     $ 169     $ -  
  Commercial real estate
                                       
     Owner-occupied
    -       -       -       -       -  
     Non-owner occupied
    35,678       35,736       6,122       35,240       50  
  Construction and development
                                       
     Land & land development
    9,374       9,374       2,578       9,374       65  
     Construction
    5,961       5,974       913       5,974       -  
  Residential real estate
                                       
     Non-jumbo
    383       384       384       384       6  
     Jumbo
    627       631       325       631       -  
     Home equity
    -       -       -       -       -  
Total with a related allowance
  $ 52,193     $ 52,268     $ 10,444     $ 51,772     $ 121  
                                         
Total
                                       
   Commercial
  $ 78,165     $ 78,300     $ 9,735     $ 69,530     $ 308  
   Consumer
    -       -       -       -       -  
   Residential
    4,859       4,878       709       1,998       10  
Total
  $ 83,024     $ 83,178     $ 10,444     $ 71,528     $ 318  


Included in impaired loans are troubled debt restructurings of $31,427,000 and $31,712,000 at March 31, 2011 and December 31, 2010, respectively, with no commitments to lend additional funds under these restructurings at either balance sheet date.

We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk.  We internally grade all commercial loans at the time of loan origination. In addition, we perform an annual loan review on all non-homogenous commercial loan relationships with an aggregate exposure of $2 million, at which time these loans are re-graded. We use the following definitions for our risk grades:
 
 
26

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Pass: Loans graded as Pass are loans to borrowers of acceptable credit quality and risk. They are higher quality loans that do not fit any of the other categories described below.

OLEM (Special Mention):  Commercial loans categorized as OLEM are potentially weak. The credit risk may be relatively minor yet represent a risk given certain specific circumstances. If the potential weaknesses are not monitored or mitigated, the asset may weaken or inadequately protect our position in the future.

Substandard:   Commercial loans categorized as Substandard are inadequately protected by the borrower’s ability to repay, equity, and/or the collateral pledged to secure the loan. These loans have identified weaknesses that could hinder normal repayment or collection of the debt. These loans are characterized by the distinct possibility that we will sustain some loss if the identified weaknesses are not mitigated.

Doubtful:  Commercial loans categorized as Doubtful have all the weaknesses inherent in those loans classified as Substandard, with the added elements that the full collection of the loan is improbable and the possibility of loss is high.

Loss:  Loans classified as loss are considered to be non-collectible and of such little value that their continuance as a bankable asset is not warranted. This does not mean that the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future.


Loan Risk Profile by Internal Risk Rating
                                                 
                                                             
   
Construction and Development
               
Commercial Real Estate
 
   
Land and land development
   
Construction
   
Commercial
   
Owner Occupied
   
Non-Owner Occupied
 
Dollars in thousands
 
3/31/2011
   
12/31/2010
   
3/31/2011
   
12/31/2010
   
3/31/2011
   
12/31/2010
   
3/31/2011
   
12/31/2010
   
3/31/2011
   
12/31/2010
 
Pass
  $ 60,697     $ 63,061     $ 13,579     $ 13,321     $ 84,524     $ 89,129     $ 162,168     $ 167,048     $ 218,857     $ 218,555  
OLEM (Special Mention)
    19,326       19,509       249       249       5,765       6,481       9,059       4,417       18,219       14,154  
Substandard
    13,652       15,796       51       121       1,938       1,449       11,729       15,633       3,528       2,628  
Doubtful
    -       719       -       -       -       -       -       -       -       -  
Loss
    -       -       -       -       -       -       -       -       -       -  
     Total
  $ 93,675     $ 99,085     $ 13,879     $ 13,691     $ 92,227     $ 97,059     $ 182,956     $ 187,098     $ 240,604     $ 235,337  

The following table presents the recorded investment in consumer, residential real estate, and home equity loans, which are generally evaluated based on the aging status of the loans, which was previously presented, and payment activity.


   
Performing
   
Nonperforming
 
Dollars in thousands
 
3/31/2011
   
12/31/2010
   
3/31/2010
   
3/31/2011
   
12/31/2010
   
3/31/2010
 
Residential real estate
                                   
   Non-jumbo
  $ 228,400     $ 233,857     $ 249,211     $ 4,908     $ 5,433     $ 3,083  
   Jumbo
    60,951       59,307       66,350       927       2,033       631  
   Home Equity
    49,991       50,936       50,149       508       51       506  
Consumer
    22,771       24,003       27,093       197       142       209  
Other
    4,326       4,511       5,296       -       -       -  
Total
  $ 366,439     $ 372,614     $ 398,099     $ 6,540     $ 7,659     $ 4,429  


Loan commitments:  ASC Topic 815, Derivatives and Hedging, requires that commitments to make mortgage loans should be accounted for as derivatives if the loans are to be held for sale, because the commitment represents a written option and accordingly is recorded at the fair value of the option liability.

 
27

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
NOTE 7.  ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses for the three month periods ended March 30, 2011 and 2010, and for the year ended December 31, 2010 is as follows:

   
Three Months Ended
   
Year Ended
 
   
March 31,
   
December 31,
 
Dollars in thousands
 
2011
   
2010
   
2010
 
 Balance, beginning of period
  $ 17,224     $ 17,000     $ 17,000  
 Losses:
                       
     Commercial
    1,827       23       601  
     Commercial real estate
    -       393       9,239  
     Construction and development
    -       2,790       7,937  
     Residential real estate
    1,503       1,267       3,836  
     Consumer
    55       84       279  
     Other
    10       49       233  
 Total
    3,395       4,606       22,125  
 Recoveries:
                       
     Commercial
    28       3       38  
     Commercial real estate
    9       4       273  
     Construction and development
    2       5       331  
     Residential real estate
    13       31       164  
     Consumer
    50       16       87  
     Other
    2       40       106  
 Total
    104       99       999  
    Net losses
    3,291       4,507       21,126  
Provision for loan losses
    3,000       5,350       21,350  
 Balance, end of period
  $ 16,933     $ 17,843     $ 17,224  



Activity in the allowance for loan losses by loan class during the first three months of 2011 is as follows:
 
 
28

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)


                                                                   
   
Construction & Land Development
                                                       
   
Land &
               
Commercial Real Estate
   
Residential Real Estate
                   
   
Land
                     
Non-
                                     
   
Devlop-
   
Construc-
   
Commer-
   
Owner
   
Owner
   
Non-
         
Home
   
Con-
             
Dollars in thousands
 
ment
   
tion
   
cial
   
Occupied
   
Occupied
   
jumbo
   
Jumbo
   
Equity
   
sumer
   
Other
   
Total
 
                                                                   
Allowance for loan losses
                                                             
Beginning balance
  $ 7,901     $ 322     $ 323     $ 1,107     $ 2,941     $ 2,420     $ 1,315     $ 600     $ 263     $ 32     $ 17,224  
   Charge-offs
    1,827       -       -       -       -       860       643       -       55       10       3,395  
   Recoveries
    2       -       28       -       9       11       1       1       51       2       104  
   Provision
    (173 )     126       40       199       250       1,625       794       185       (57 )     11       3,000  
Ending balance
  $ 5,903     $ 448     $ 391     $ 1,306     $ 3,200     $ 3,196     $ 1,467     $ 786     $ 201     $ 35     $ 16,933  
                                                                                         
Allowance related to:
                                                                                 
Loans individually
                                                                                       
   evaluated for impairment
  $ 1,161     $ 5     $ 13     $ 280     $ 470     $ 682     $ 447     $ 210     $ -     $ -     $ 3,268  
Loans collectively
                                                                                       
   evaluated for impairment
    4,742       443       378       1,026       2,730       2,514       1,020       576       201       35       13,665  
Loans acquired with
                                                                                       
   deteriorated credit quality
    -       -       -       -       -       -       -       -       -       -       -  
Total
  $ 5,903     $ 448     $ 391     $ 1,306     $ 3,200     $ 3,196     $ 1,467     $ 786     $ 201     $ 35     $ 16,933  
                                                                                         
Loans
                                                                                       
Loans individually
                                                                                       
   evaluated for impairment
  $ 22,130     $ 92     $ 1,436     $ 11,011     $ 4,985     $ 6,484     $ 15,401     $ 210     $ -     $ -     $ 61,749  
Loans collectively
                                                                                       
   evaluated for impairment
    71,545       13,787       90,791       171,945       235,619       226,824       46,477       50,289       22,968       4,326     $ 934,571  
Loans acquired with
                                                                                       
   deteriorated credit quality
    -       -       -       -       -       -       -       -       -       -       -  
Total
  $ 93,675     $ 13,879     $ 92,227     $ 182,956     $ 240,604     $ 233,308     $ 61,878     $ 50,499     $ 22,968     $ 4,326     $ 996,320  

 
29

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

NOTE 8.  GOODWILL AND OTHER INTANGIBLE ASSETS

The following tables present our goodwill by reporting unit at March 31, 2011 and other intangible assets by reporting unit at March 31, 2011 and December 31, 2010.
 
 


   
Goodwill Activity
 
   
Community
   
Insurance
       
Dollars in thousands
 
Banking
   
Services
   
Total
 
Balance, January 1, 2011
  $ 1,488     $ 4,710     $ 6,198  
   Acquired goodwill, net
    -       -       -  
                         
Balance, March 31, 2011
  $ 1,488     $ 4,710     $ 6,198  




   
Other Intangible Assets
 
   
March 31, 2011
   
December 31, 2010
 
   
Community
   
Insurance
         
Community
   
Insurance
       
 Dollars in thousands
 
Banking
   
Services
   
Total
   
Banking
   
Services
   
Total
 
 Unidentifiable intangible assets
                                   
    Gross carrying amount
  $ 2,267     $ -     $ 2,267     $ 2,267     $ -     $ 2,267  
    Less:  accumulated amortization
    1,801       -       1,801       1,763       -       1,763  
        Net carrying amount
  $ 466     $ -     $ 466     $ 504     $ -     $ 504  
                                                 
 Identifiable intangible assets
                                               
    Gross carrying amount
  $ -     $ 3,000     $ 3,000     $ -     $ 3,000     $ 3,000  
    Less:  accumulated amortization
    -       750       750       -       700       700  
        Net carrying amount
  $ -     $ 2,250     $ 2,250     $ -     $ 2,300     $ 2,300  


We recorded amortization expense of approximately $88,000 for the three months ended March 31, 2011 relative to our other intangible assets.  Annual amortization is expected to be approximately $351,000 for each of the years ending 2011 through 2013.

NOTE 9.  DEPOSITS

The following is a summary of interest bearing deposits by type as of March 31, 2011 and 2010 and December 31, 2010:


   
March 31,
   
December 31,
   
March 31,
 
 Dollars in thousands
 
2011
   
2010
   
2010
 
 Demand deposits, interest bearing
  $ 153,283     $ 150,291     $ 148,657  
 Savings deposits
    212,502       177,053       198,303  
 Retail time deposits
    392,394       404,704       358,190  
 Wholesale deposits
    217,205       230,287       234,786  
 Total
  $ 975,384     $ 962,335     $ 939,936  


 
30

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Brokered deposits represent certificates of deposit acquired through a third party.  The following is a summary of the maturity distribution of all certificates of deposit in denominations of $100,000 or more as of March 31, 2011:


Dollars in thousands
 
Amount
   
Percent
 
 Three months or less
  $ 47,360       12.1 %
 Three through six months
    32,605       8.4 %
 Six through twelve months
    82,107       21.1 %
 Over twelve months
    227,762       58.4 %
 Total
  $ 389,834       100.0 %


A summary of the scheduled maturities for all time deposits as of March 31, 2011 is as follows:


Dollars in thousands
   
Amount
 
 Nine month period ending December 31, 2011
  $ 242,966  
 Year ending December 31, 2012
    138,046  
 Year ending December 31, 2013
    86,300  
 Year ending December 31, 2014
    46,667  
 Year ending December 31, 2015
    41,565  
 Thereafter
    54,055  
    $ 609,599  


NOTE 10.  BORROWED FUNDS

Short-term borrowings:    A summary of short-term borrowings is presented below:



   
Three Months Ended March 31, 2011
 
               
Federal Funds
 
   
Short-term
         
Purchased
 
   
FHLB
   
Repurchase
   
and Lines
 
 Dollars in thousands
 
Advances
   
Agreements
   
of Credit
 
 Balance at March 31
  $ -     $ 925     $ 954  
 Average balance outstanding for the period
    -       781       953  
 Maximum balance outstanding at
                       
     any month end during period
    -       925       953  
 Weighted average interest rate for the period
    0.00 %     0.15 %     0.25 %
 Weighted average interest rate for balances
                       
     outstanding at March 31
    0.00 %     0.15 %     0.25 %

 
 
 
31

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)



   
Year Ended December 31, 2010
 
               
Federal Funds
 
   
Short-term
   
Short-Term
   
Purchased
 
   
FHLB
   
Repurchase
   
and Lines
 
 Dollars in thousands
 
Advances
   
Agreements
   
of Credit
 
 Balance at December 31
  $ -     $ 629     $ 953  
 Average balance outstanding for the period
    13,724       1,084       1,364  
 Maximum balance outstanding at
                       
     any month end during period
    45,000       1,787       3,617  
 Weighted average interest rate for the period
    0.42 %     0.34 %     1.39 %
 Weighted average interest rate for balances
                       
     outstanding at December 31
    0.00 %     0.15 %     0.25 %



   
Three Months Ended March 31, 2010
 
               
Federal Funds
 
   
Short-term
         
Purchased
 
   
FHLB
   
Repurchase
   
and Lines
 
 Dollars in thousands
 
Advances
   
Agreements
   
of Credit
 
 Balance at March 31
  $ 25,000     $ 1,505     $ 951  
 Average balance outstanding for the period
    41,187       1,158       2,621  
 Maximum balance outstanding at
                       
     any month end during period
    45,000       1,504       3,617  
 Weighted average interest rate for the period
    0.37 %     0.41 %     2.62 %
 Weighted average interest rate for balances
                       
     outstanding at March 31
    0.36 %     0.45 %     0.25 %

Long-term borrowings:  Our long-term borrowings of $283,516,000, $304,109,000 and $361,335,000 at March 31, 2011, December 31, 2010, and March 31, 2010 respectively, consisted primarily of advances from the Federal Home Loan Bank (“FHLB”) and structured reverse repurchase agreements with two unaffiliated institutions. All FHLB advances are collateralized primarily by similar amounts of residential mortgage loans, certain commercial loans, mortgage backed securities and securities of U. S. Government agencies and corporations.


               
Balance at
 
   
Balance at March 31,
   
December 31,
 
Dollars in thousands
 
2011
   
2010
   
2010
 
Long-term FHLB advances
  $ 162,233     $ 238,698     $ 182,375  
Long-term reverse repurchase agreements
    110,000       110,000       110,000  
Term loan
    11,283       12,637       11,734  
Total
  $ 283,516     $ 361,335     $ 304,109  


The term loan represents a long-term borrowing with an unaffiliated banking institution which is secured by the common stock of our subsidiary bank, bears a variable interest rate of prime minus 50 basis points, and matures in 2017.

Our long term borrowings bear both fixed and variable rates and mature in varying amounts through the year 2019.

The average interest rate paid on long-term borrowings for the three month period ended March 31, 2011 was 4.15% compared to 4.91% for the first three months of 2010.

Subordinated debentures:  We have subordinated debt totaling $16.8 million at March 31, 2011, December 31, 2010, and March 31, 2010.  The subordinated debt qualifies as Tier 2 capital under Federal Reserve Board guidelines until the debt is within 5 years of its maturity; thereafter the amount qualifying as Tier 2 capital is reduced by 20 percent each year until maturity.  During 2009, we issued $6.8 million in subordinated debt, of which $5 million was issued to an affiliate of a director of Summit.  We also issued $1.0 million and $0.8 million to two unrelated parties.  These three issuances bear an interest rate of 10 percent per annum, a term of 10 years, and are not prepayable by us within the first five years.  During 2008, we issued $10 million of subordinated debt to an unrelated institution, which bears a variable interest rate of 1 month LIBOR plus 275 basis points, a term of 7.5 years, and is not prepayable by us within the first two and one half years.
 

 
32

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Subordinated debentures owed to unconsolidated subsidiary trusts:  We have three statutory business trusts that were formed for the purpose of issuing mandatorily redeemable securities (the “capital securities”) for which we are obligated to third party investors and investing the proceeds from the sale of the capital securities in our junior subordinated debentures (the “debentures”).  The debentures held by the trusts are their sole assets.  Our subordinated debentures totaled $19,589,000 at March 31, 2011, December 31, 2010, and March 31, 2010.

In October 2002, we sponsored SFG Capital Trust I, in March 2004, we sponsored SFG Capital Trust II, and in December 2005, we sponsored SFG Capital Trust III, of which 100% of the common equity of each trust is owned by us.  SFG Capital Trust I issued $3,500,000 in capital securities and $109,000 in common securities and invested the proceeds in $3,609,000 of debentures. SFG Capital Trust II issued $7,500,000 in capital securities and $232,000 in common securities and invested the proceeds in $7,732,000 of debentures. SFG Capital Trust III issued $8,000,000 in capital securities and $248,000 in common securities and invested the proceeds in $8,248,000 of debentures.  Distributions on the capital securities issued by the trusts are payable quarterly at a variable interest rate equal to 3 month LIBOR plus 345 basis points for SFG Capital Trust I, 3 month LIBOR plus 280 basis points for SFG Capital Trust II, and 3 month LIBOR plus 145 basis points for SFG Capital Trust III, and equals the interest rate earned on the debentures held by the trusts, and is recorded as interest expense by us.  The capital securities are subject to mandatory redemption in whole or in part, upon repayment of the debentures.  We have entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of the guarantee.  The debentures of each Capital Trust are redeemable by us quarterly.

The capital securities held by SFG Capital Trust I, SFG Capital Trust II, and SFG Capital Trust III qualify as Tier 1 capital under Federal Reserve Board guidelines.  In accordance with these Guidelines, trust preferred securities generally are limited to 25% of Tier 1 capital elements, net of goodwill.  The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital.

A summary of the maturities of all long-term borrowings and subordinated debentures for the next five years and thereafter is as follows:


                 
Subordinated
 
                 
debentures owed
 
     
Long-term
   
Subordinated
   
to unconsolidated
 
Dollars in thousands
   
borrowings
   
debentures
   
subsidiary trusts
 
Year Ending December 31,
2011
  $ 14,801     $ -     $ -  
 
2012
    66,721       -       -  
 
2013
    41,885       -       -  
 
2014
    83,416       -       -  
 
2015
    1,894       10,000       -  
 
Thereafter
    74,799       6,800       19,589  
      $ 283,516     $ 16,800     $ 19,589  


NOTE 11.  STOCK OPTION PLAN

The 2009 Officer Stock Option Plan was adopted by our shareholders in May 2009 and provides for the granting of stock options for up to 350,000 shares of common stock to our key officers.    Each option granted under the Plan vests according to a schedule designated at the grant date and has a term of no more than 10 years following the vesting date.  Also, the option price per share was not to be less than the fair market value of our common stock on the date of grant.  The 2009 Officer Stock Option Plan, which expires in May 2019, replaces the 1998 Officer Stock Option Plan (collectively the “Plans”) that expired in May 2008.
 

 
33

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

The fair value of our employee stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise have a significant effect on the value of employee stock options granted but are not considered by the model. Because our employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options at the time of grant.  There were no options granted during the first three months of 2011 or 2010.

We recognize compensation expense based on the estimated number of stock awards expected to actually vest, exclusive of the awards expected to be forfeited.  During the first three months of 2011 and 2010, our stock compensation expense and related deferred taxes were insignificant.

A summary of activity in our Plans during the first three months of 2011 and 2010 is as follows:



   
For the Three Months Ended March 31,
 
   
2011
   
2010
 
         
Weighted-
         
Weighted-
 
         
Average
         
Average
 
         
Exercise
         
Exercise
 
   
Options
   
Price
   
Options
   
Price
 
 Outstanding, January 1
    317,180     $ 18.17       309,180     $ 18.54  
     Granted
    -       -       -       -  
     Exercised
    -       -       -       -  
     Forfeited
    -       -       -       -  
 Outstanding, March 31
    317,180     $ 18.17       309,180     $ 18.54  
                                 
                                 



Other information regarding options outstanding and exercisable at March 31, 2011 is as follows:

                                             
     
Options Outstanding
   
Options Exercisable
 
                 
Wted. Avg.
   
Aggregate
               
Aggregate
 
                 
Remaining
   
Intrinsic
               
Intrinsic
 
Range of
   
# of
         
Contractual
   
Value
   
# of
         
Value
 
exercise price
   
shares
   
WAEP
   
Life (yrs)
   
(in thousands)
   
shares
   
WAEP
   
(in thousands)
 
$ 2.54 - $6.00       64,150     $ 5.15       2.85     $ 7       59,150     $ 5.37     $ -  
  6.01 - 10.00       33,680       9.20       5.34       -       31,280       9.43       -  
  10.01 - 17.50       2,300       17.43       2.92       -       2,300       17.43       -  
  17.51 - 20.00       51,300       17.79       5.75       -       51,100       17.79       -  
  20.01 - 25.93       165,750       25.15       4.53       -       165,750       25.15       -  
                                                             
          317,180       18.17             $ 7       309,580       18.51     $ -  


NOTE 12.  COMMITMENTS AND CONTINGENCIES

Off-Balance Sheet Arrangements

We are a party to certain financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.  The contract amounts of these instruments reflect the extent of involvement that we have in this class of financial instruments.
 

 
34

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

Many of our lending relationships contain both funded and unfunded elements.  The funded portion is reflected on our balance sheet.  The unfunded portion of these commitments is not recorded on our balance sheet until a draw is made under the loan facility.  Since many of the commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash flow requirements.

A summary of the total unfunded, or off-balance sheet, credit extension commitments follows:


   
March 31,
 
Dollars in thousands
 
2011
 
Commitments to extend credit:
     
    Revolving home equity and
     
        credit card lines
  $ 43,346  
    Construction loans
    20,329  
    Other loans
    34,488  
Standby letters of credit
    5,991  
Total
  $ 104,154  


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  We evaluate each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if we deem necessary upon extension of credit, is based on our credit evaluation.  Collateral held varies but may include accounts receivable, inventory, equipment or real estate.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party.

Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.

NOTE 13.  REGULATORY MATTERS

We and our subsidiaries are subject to various regulatory capital requirements administered by the banking regulatory agencies.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we and each of our subsidiaries must meet specific capital guidelines that involve quantitative measures of our and our subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.  We and each of our subsidiaries’ capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us and each of our subsidiaries to maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  We believe, as of March 31, 2011, that we and each of our subsidiaries met all capital adequacy requirements to which they were subject.

The most recent notifications from the banking regulatory agencies categorized us and each of our subsidiaries as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, we and each of our subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.

Our actual capital amounts and ratios as well as our subsidiary, Summit Community Bank’s (“Summit Community”) are presented in the following table.

 
35

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)

 
                           
To be Well Capitalized
 
               
Minimum Required
   
under Prompt Corrective
 
   
Actual
   
Regulatory Capital
   
Action Provisions
 
 Dollars in thousands
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
 As of March 31, 2011
                                   
 Total Capital (to risk weighted assets)
                                   
     Summit
  $ 125,201       11.7 %   $ 85,453       8.0 %   $ 106,817       10.0 %
     Summit Community
    134,073       12.6 %     85,437       8.0 %     106,797       10.0 %
 Tier I Capital (to risk weighted assets)
                                               
     Summit
    96,834       9.1 %     42,727       4.0 %     64,090       6.0 %
     Summit Community
    120,506       11.3 %     42,719       4.0 %     64,078       6.0 %
 Tier I Capital (to average assets)
                                               
     Summit
    96,834       6.6 %     43,834       3.0 %     73,057       5.0 %
     Summit Community
    120,506       8.3 %     43,796       3.0 %     72,994       5.0 %
                                                 
 As of December 31, 2010
                                               
 Total Capital (to risk weighted assets)
                                               
     Summit
    129,610       11.8 %     87,543       8.0 %     109,428       10.0 %
     Summit Community
    138,164       12.6 %     87,558       8.0 %     109,447       10.0 %
 Tier I Capital (to risk weighted assets)
                                               
     Summit
    100,840       9.2 %     43,771       4.0 %     65,657       6.0 %
     Summit Community
    124,192       11.3 %     43,779       4.0 %     65,668       6.0 %
 Tier I Capital (to average assets)
                                               
     Summit
    100,840       6.9 %     43,869       3.0 %     73,116       5.0 %
     Summit Community
    124,192       8.5 %     43,851       3.0 %     73,085       5.0 %



Summit Financial Group, Inc. (“Summit”) and its bank subsidiary, Summit Community Bank, Inc. (the “Bank”), have entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.  Among other things, under the MOU’s, Summit’s management team has agreed to:

§  
The Bank achieving and maintaining a minimum Tier 1 leverage capital ratio of at least 8% and a total risk-based capital ratio of at least 11%;
 
§  
The Bank providing 30 days prior notice of any declaration of intent to pay cash dividends to provide the Bank’s regulatory authorities an opportunity to object;
 
§  
Summit suspending all cash dividends on its common stock until further notice.  Dividends on all preferred stock, as well as interest payments on subordinated notes underlying Summit’s trust preferred securities, continue to be permissible; and,
 
§  
Summit not incurring any additional debt, other than trade payables, without the prior written consent of the principal banking regulators.

Additional information regarding the MOU’s is included in Part I. Item 1A – Risk Factors on our Form 10-K for the year ended December 31, 2010.

 
36

 
Summit Financial Group, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)



NOTE  14.  SEGMENT INFORMATION

We operate two business segments:  community banking and insurance services.  These segments are primarily identified by the products or services offered.  The community banking segment consists of our full service banks which offer customers traditional banking products and services through various delivery channels.  The insurance services segment consists of three insurance agency offices that sell insurance products.  The accounting policies discussed throughout the notes to the consolidated financial statements apply to each of our business segments.

Intersegment revenue and expense consists of management fees allocated to the bank and Summit Insurance Services, LLC for all centralized functions that are performed by the parent, including overall direction in the areas of credit policy and administration, strategic planning, marketing, investment portfolio management and other financial and administrative services.  Information for each of our segments is included below:


   
Three Months Ended March 31, 2011
 
   
Community
   
Insurance
                   
In thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
 
                               
Net interest income
  $ 10,553     $ -     $ (451 )   $ -     $ 10,102  
Provision for loan losses
    3,000       -       -       -       3,000  
Net interest income after provision for loan losses
    7,553       -       (451 )     -       7,102  
Other income
    (2,960 )     1,237       1,359       (248 )     (612 )
Other expenses
    5,738       1,027       459       (248 )     6,976  
Income (loss) before income taxes
    (1,145 )     210       449       -       (486 )
Income tax expense (benefit)
    (547 )     90       219       -       (238 )
Net income (loss)
    (598 )     120       230       -       (248 )
Dividends on preferred shares
    -       -       74       -       74  
Net income (loss) applicable to common shares
  $ (598 )   $ 120     $ 156     $ -     $ (322 )
Intersegment revenue (expense)
  $ (219 )   $ (29 )   $ 248     $ -     $ -  
Average assets
  $ 1,535,822     $ 6,680     $ 140,288     $ (210,555 )   $ 1,472,235  


   
Three Months Ended March 31, 2010
 
   
Community
   
Insurance
                   
In thousands
 
Banking
   
Services
   
Parent
   
Eliminations
   
Total
 
                               
Net interest income
  $ 10,716     $ -     $ (484 )   $ -     $ 10,232  
Provision for loan losses
    5,350       -       -       -       5,350  
Net interest income after provision for loan losses
    5,366       -       (484 )     -       4,882  
Other income
    1,108       1,218       530       (340 )     2,516  
Other expenses
    6,455       1,038       457       (340 )     7,610  
Income (loss) before income taxes
    19       180       (411 )     -       (212 )
Income tax expense (benefit)
    (231 )     68       (169 )     -       (332 )
Net income (loss)
    250       112       (242 )     -       120  
Dividends on preferred shares
    -       -       74       -       74  
Net income (loss) applicable to common shares
  $ 250     $ 112     $ (316 )   $ -     $ 46  
Intersegment revenue (expense)
  $ (312 )   $ (28 )   $ 340     $ -     $ -  
Average assets
  $ 1,572,527     $ 6,895     $ 143,544     $ (170,149 )   $ 1,552,817  


 
37

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


INTRODUCTION

The following discussion and analysis focuses on significant changes in our financial condition and results of operations of Summit Financial Group, Inc. (“Company” or “Summit”) and our operating segments, Summit Community Bank (“Summit Community”), and Summit Insurance Services, LLC for the periods indicated.  See Note 14 of the accompanying consolidated financial statements for our segment information.  This discussion and analysis should be read in conjunction with our 2010 audited financial statements and Annual Report on Form 10-K.

The Private Securities Litigation Act of 1995 indicates that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by us.  Our following discussion and analysis of financial condition and results of operations contains certain forward-looking statements that involve risk and uncertainty.  In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in those forward-looking statements.

OVERVIEW

Our primary source of income is net interest income from loans and deposits.  Business volumes tend to be influenced by the overall economic factors including market interest rates, business spending, and consumer confidence, as well as competitive conditions within the marketplace.

Interest earning assets declined by 6.65% for the first three months in 2011 compared to the same period of 2010 while our net interest earnings on a tax equivalent basis decreased only 1.34%.  Our tax equivalent net interest margin increased 16 basis points.  Historically high levels of nonaccrual loans continue to negatively impact our net interest earnings.

BUSINESS SEGMENT RESULTS

We are organized and managed along two major business segments, as described in Note 14 of the accompanying consolidated financial statements.  The results of each business segment are intended to reflect each segment as if it were a stand alone business.  Net income by segment follows:


   
Three Months Ended March 31,
 
Dollars in thousands
 
2011
   
2010
 
Community banking
  $ (598 )   $ 250  
Insurance
    120       112  
Parent and other
    156       (316 )
Consolidated net income (loss)
  $ (322 )   $ 46  


CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the financial services industry.  Application of these principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.
 

 
38

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Our most significant accounting policies are presented in the notes to the consolidated financial statements of our 2010 Annual Report on Form 10-K.  These policies, along with the other disclosures presented in the financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, we have identified the determination of the allowance for loan losses, the valuation of goodwill, fair value measurements and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

Allowance for Loan Losses:  The allowance for loan losses represents our estimate of probable credit losses inherent in the loan portfolio.  Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on our consolidated balance sheet.  To the extent actual outcomes differ from our estimates, additional provisions for loan losses may be required that would negatively impact earnings in future periods.  Note 8 to the consolidated financial statements of our 2010 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Asset Quality section of the financial review of the 2010 Annual Report on Form 10-K.

Goodwill:  Goodwill is subject to a two-step impairment test by reporting unit at least annually to determine whether write-downs of the recorded balances are necessary.  During the third quarter, we completed the required annual impairment test for 2010 for each of our reporting units, community banking and insurance services.  The first step (Step 1) of impairment testing requires a comparison of each reporting unit’s fair value to its carrying value to identify potential impairment.  If the fair value equals or exceeds the related unit’s carrying value, no write-down of recorded goodwill is necessary.  If the fair value is less than the carrying value, an expense may be required on our books to write down the goodwill to the proper carrying value.  The second step (Step 2) of impairment testing is necessary only if the reporting unit does not pass Step 1.  Step 2 compares the implied fair value of the reporting unit goodwill with the carrying amount of the goodwill for the reporting unit.  The implied fair value of goodwill is determined in the same manner as goodwill that is recognized in a business combination.

The fair value, carrying amount and allocated goodwill with regard to each of our reporting units as of September 30, 2010 (date of our most recent goodwill impairment test) were as follows:


(in thousands)
 
Community Banking
   
Insurance Services
 
             
Fair value
  $ 159,510     $ 7,000  
Carrying amount
    126,755       6,651  
Allocated goodwill
    1,488       4,710  


Neither of our reporting units failed Step 1 of the goodwill impairment tests conducted as of September 30, 2010.  For purposes of these goodwill impairment tests, the following methodologies were utilized and key assumptions were made in determining the fair value of each reporting unit:

Community Banking – We performed an internal valuation utilizing the income approach to determine the fair value of our Community Banking reporting unit.  The income approach was based on discounted cash flows derived from assumptions of balances sheet and income statement activity based upon an internally developed forecast considering several long-term key business drivers such as anticipated loan and deposit growth.  The long term growth rate used in determining the terminal value was estimated at 3.5%, and a discount rate of 11% based upon the Capital Asset Pricing Model was applied to the Bank’s estimated future cash flow streams.
 

 
39

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Insurance Services – We performed an internal valuation utilizing the income approach to determine the fair value of our Insurance Services reporting unit.  This methodology consisted of discounting the expected future cash flows of this unit based upon a forecast of its operations considering long-term key business drivers such as anticipated commission revenue growth.  The long term growth rate used in determining the terminal value was estimated at 0%, and a discount rate of 10% was applied to the Insurance Services unit’s estimated future cash flows.

We cannot assure you that future goodwill impairment tests will not result in a charge to earnings. See Note 11 of the consolidated financial statements of our Annual Report on Form 10-K for further discussion of our intangible assets, which include goodwill.
 
Fair Value Measurements:  ASC Topic 820 Fair Value Measurements and Disclosures provides a definition of fair value, establishes a framework for measuring fair value, and requires expanded disclosures about fair value measurements. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Based on the observability of the inputs used in the valuation techniques, we classify our financial assets and liabilities measured and disclosed at fair value in accordance with the three-level hierarchy (e.g., Level 1, Level 2 and Level 3) established under ASC Topic 820. Fair value determination in accordance with this guidance requires that we make a number of significant judgments. In determining the fair value of financial instruments, we use market prices of the same or similar instruments whenever such prices are available. We do not use prices involving distressed sellers in determining fair value. If observable market prices are unavailable or impracticable to obtain, then fair value is estimated using modeling techniques such as discounted cash flow analyses. These modeling techniques incorporate our assessments regarding assumptions that market participants would use in pricing the asset or the liability, including assumptions about the risks inherent in a particular valuation technique and the risk of nonperformance.
 
 
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Additionally, fair value is used on a non-recurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with ASC Topic 825 Financial Instruments.
 
Deferred Income Tax Assets:  At March 31, 2011, we had net deferred tax assets of $12.3 million. Based on our ability to offset the net deferred tax asset against taxable income in carryback years and expected future taxable income in carryforward years, there was no impairment of the deferred tax asset at March 31, 2011.  All available evidence, both positive and negative, was considered to determine whether, based on the weight of that evidence, impairment should be recognized. However, our forecast process includes judgmental and quantitative elements that may be subject to significant change. If our forecast of taxable income within the carryback/carryforward periods available under applicable law is not sufficient to cover the amount of net deferred tax assets, such assets may become impaired.

RESULTS OF OPERATIONS

Earnings Summary

Net income applicable to common shares for the three months ended March 31, 2011 declined to a loss of $322,000, or $0.04 per diluted shares as compared to income of $46,000 or $0.01 per diluted share for the same period of 2010.  Earnings were negatively impacted for both periods by continued high provisions for loan losses due to our increased nonperforming loans.  The provision for loan losses was $3.0 million and $5.35 million for the three months ended March 31, 2011 and 2010, respectively.  Included in earnings for the three months ended March 31, 2011 was $1.6 million of realized securities gains, $3.4 million of charges resulting from the write down of a portion of our OREO properties to fair value and $1.2 million in other than temporary impairment charges on securities.  Returns on average equity and assets for the first three months of 2011 were (1.14%) and (0.07%), respectively, compared with 0.20% and 0.01% for the same period of 2010.
 

 
40

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Net Interest Income

Net interest income is the principal component of our earnings and represents the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds.  Fluctuations in interest rates as well as changes in the volume and mix of earning assets and interest bearing liabilities can materially impact net interest income.

Our net interest income on a fully tax-equivalent basis totaled $10,367,000 for the three months ended March 31, 2011 compared to $10,508,000 for the same period of 2010, representing a decrease of $141,000 or 1.34%.  This decrease is primarily the result of a decrease in loans, which was partially offset by a reduction in the cost of interest bearing liabilities (see Table II).  Average interest earning assets decreased 6.65% from $1,446,523,000 during the first three months of 2010 to $1,350,338,000 for the first three months of 2011.  Average interest bearing liabilities declined 6.42% from $1,383,018,000 at March 31, 2010 to $1,294,179,000 at March 31, 2011, at an average yield for the first three months of 2011 of 2.54% compared to 3.05% for the same period of 2010.

Our consolidated net interest margin increased to 3.11% for the three months ended March 31 2011, compared to 2.95% for the same period in 2010. The margin continues to be affected by elevated levels of nonaccruing loans.  The present continued low interest rate environment has served to positively impact our net interest margin due to our liability sensitive balance sheet.  For the three months ended March 31, 2011 compared to March 31, 2010, the yields on earning assets decreased 32 basis points, while the cost of our interest bearing funds decreased by 51 basis points.  The decrease in the cost of interest bearing funds is primarily the result of our reducing or repricing over $100 million of our higher-rate long-term borrowings in late 2010.

Assuming no significant change in market interest rates, we anticipate a stable net interest margin in the near term as a result of our anticipated lower cost of funds, we do not expect interest rates to rise in the near future, we do not expect significant growth in our interest earning assets, nor do we expect our nonperforming asset balances to decline significantly in the near future.  We continue to monitor the net interest margin through net interest income simulation to minimize the potential for any significant negative impact.  See the “Market Risk Management” section for further discussion of the impact changes in market interest rates could have on us.  Further analysis of our yields on interest earning assets and interest bearing liabilities are presented in Tables I and II below.


 
41

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Table I - Average Balance Sheet and Net Interest Income Analysis
           
 Dollars in thousands
           
   
 For the Three Months Ended
   
March 31, 2011
 
March 31, 2010
   
Average
 
 Earnings/
 
Yield/
 
Average
 
 Earnings/
 
Yield/
   
 Balance
 
 Expense
 
 Rate
 
 Balance
 
 Expense
 
 Rate
 Interest earning assets
                       
     Loans, net of unearned income (1)
                       
         Taxable
 
 $1,001,347
 
 $15,083
 
6.11%
 
 $1,145,202
 
 $16,957
 
6.01%
         Tax-exempt (2)
 
 4,940
 
 98
 
8.05%
 
 6,685
 
 126
 
7.64%
     Securities
                       
         Taxable
 
 269,858
 
 2,609
 
3.92%
 
 252,500
 
 3,138
 
5.04%
         Tax-exempt (2)
 
 37,827
 
 658
 
7.05%
 
 41,797
 
 689
 
6.69%
     Federal funds sold and interest
                       
         bearing deposits with other banks
 
 36,366
 
 17
 
0.19%
 
 339
 
 11
 
13.16%
 Total interest earning assets
 
 1,350,338
 
 18,465
 
5.55%
 
 1,446,523
 
 20,921
 
5.87%
                         
 Noninterest earning assets
                       
     Cash & due from banks
 
 4,036
         
 15,645
       
     Premises and equipment
 
 22,977
         
 24,146
       
     Other assets
 
 113,000
         
 84,777
       
     Allowance for loan losses
 
 (18,116)
         
 (18,274)
       
 Total assets
 
 $1,472,235
         
 $1,552,817
       
                         
 Interest bearing liabilities
                       
     Interest bearing demand deposits
 
 $148,263
 
 $100
 
0.27%
 
 $146,700
 
 $173
 
0.48%
     Savings deposits
 
 197,638
 
 501
 
1.03%
 
 194,828
 
 691
 
1.44%
     Time deposits
 
 623,318
 
 4,142
 
2.69%
 
 595,837
 
 4,634
 
3.15%
     Short-term borrowings
 
 1,734
 
 1
 
0.23%
 
 44,966
 
 57
 
0.51%
     Long-term borrowings
                       
        and capital trust securities
 
 323,226
 
 3,354
 
4.21%
 
 400,687
 
 4,858
 
4.92%
 Total interest bearing liabilities
 
 1,294,179
 
 8,098
 
2.54%
 
 1,383,018
 
 10,413
 
3.05%
                         
 Noninterest bearing liabilities
                       
     and shareholders' equity
                       
     Demand deposits
 
 78,023
         
 70,569
       
     Other liabilities
 
 9,634
         
 7,872
       
     Total liabilities
 
 1,381,836
         
 1,461,459
       
                         
     Shareholders' equity - preferred
 
 3,519
         
 3,519
       
     Shareholders' equity - common
 
 86,880
         
 87,839
       
 Total liabilities and
                       
    shareholders' equity
 
 $1,472,235
         
 $1,552,817
       
 Net interest earnings
     
 $10,367
         
 $10,508
   
 Net yield on interest earning assets
         
3.11%
         
2.95%
                         
 (1)  For purposes of this table, nonaccrual loans are included in average loan balances.
           
                         
(2) - Interest income on tax-exempt securities has been adjusted assuming an effective tax rate of 34% for all periods presented.
   
        The tax equivalent adjustment resulted in an increase in interest income of $265,000 and $466,000 for the periods ended
   
        March 31, 2011 and March 31 2010, respectively.
                   


 
42

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Table II - Changes in Interest Margin Attributable to Rate and Volume
 
                   
   
For the Three Months Ended
 
   
March 31, 2011 versus March 31, 2010
 
   
Increase (Decrease) Due to Change in:
 
In thousands
 
Volume
   
Rate
   
Net
 
Interest earned on:
                 
Loans
                 
  Taxable
  $ (2,162 )   $ 288     $ (1,874 )
  Tax-exempt
    (34 )     6       (28 )
Securities
                       
  Taxable
    205       (734 )     (529 )
  Tax-exempt
    (67 )     36       (31 )
Federal funds sold and interest
                       
  bearing deposits with other banks
    27       (21 )     6  
Total interest earned on
                       
  interest earning assets
    (2,031 )     (425 )     (2,456 )
                         
Interest paid on:
                       
Interest bearing demand
                       
  deposits
    2       (75 )     (73 )
Savings deposits
    10       (200 )     (190 )
Time deposits
    207       (699 )     (492 )
Short-term borrowings
    (36 )     (20 )     (56 )
Long-term borrowings and capital
                       
   trust securities
    (861 )     (643 )     (1,504 )
  Total interest paid on
                       
    interest bearing liabilities
    (678 )     (1,637 )     (2,315 )
                         
Net interest income
  $ (1,353 )   $ 1,212     $ (141 )

Noninterest Income

Total noninterest income decreased to a loss of $612,000 for the first three months of 2011, compared to income of $2,516,000 for the same period of 2010, with other-than-temporary impairment charges on securities and writedowns of OREO properties to their estimated fair value being the primary negative components.  Further detail regarding noninterest income is reflected in the following table.


Noninterest Income
           
   
For the Quarter Ended March 31,
 
Dollars in thousands
 
2011
   
2010
 
Insurance commissions
  $ 1,242     $ 1,209  
Service fees
    621       707  
Realized securities gains (losses)
    1,628       264  
Other-than-temporary impairment of securities
    (1,228 )     (29 )
Gain (loss) on sale of assets
    71       12  
Writedown of OREO
    (3,443 )     -  
Other
    497       353  
Total
  $ (612 )   $ 2,516  
 

 
43

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Other-than-temporary impairment of securities:  During the first three months of 2011, we recorded non-cash other-than temporary impairment charges of $1,228,000 related to certain residential mortgage-backed securities which we continue to own.

Writedown of OREO:  During the first three months of 2011, we recorded $3,443,000 in charges to writedown certain OREO properties to estimated fair value as part of our normal, ongoing re-appraisal process.  $2,719,000 of this writedown is attributable to one developer of three residential subdivisions.

Noninterest Expense

Total noninterest expense decreased approximately 8.3% for the three months ended March 31, 2011, as compared to the same period in 2010.  While OREO expenses continue to increase due to higher levels of foreclosed properties, FDIC premiums are lower in 2011 due to our lower deposit base, and other expenses are down as a result of an anticipated refund of Virginia business franchise taxes paid or accrued for due to an allowable credit for OREO property taxes paid in Virginia being an allowable offset to taxable capital for business franchise tax calculation purposes.  Table III below shows the breakdown of the changes.


Table III - Noninterest Expense
                       
   
For the Quarter Ended March 31,
 
         
Change
       
Dollars in thousands
 
2011
     $       %       2010  
    Salaries, commissions, and employee benefits
  $ 3,842     $ 118       3.2 %   $ 3,724  
    Net occupancy expense
    509       (12 )     -2.3 %     521  
    Equipment expense
    580       (49 )     -7.8 %     629  
    Supplies
    78       (31 )     -28.4 %     109  
    Professional fees
    196       (78 )     -28.5 %     274  
    Amortization of intangibles
    88       -       0.0 %     88  
    FDIC premiums
    693       (132 )     -16.0 %     825  
    OREO expense
    434       202       87.1 %     232  
    Other
    556       (652 )     -54.0 %     1,208  
Total
  $ 6,976     $ (634 )     -8.3 %   $ 7,610  

Credit Experience

Due to continued recessionary economic conditions, borrowers have in many cases been unable to meet their current debt obligation due to a range of factors including declining property values and elevated unemployment levels.  As a result, we have experienced higher delinquencies and nonperforming assets, particularly in our residential real estate loan portfolios and in commercial construction loans to residential real estate developers.  It is not known when the housing market will stabilize.  Management anticipates loan delinquencies will generally trend lower than those experienced over the past two years, and we anticipate that nonperforming assets will remain elevated in the near term.

The provision for loan losses represents charges to earnings necessary to maintain an adequate allowance for probable credit losses inherent in the loan portfolio. Our determination of the appropriate level of the allowance is based on an ongoing analysis of credit quality and loss potential in the loan portfolio, change in the composition and risk characteristics of the loan portfolio, and the anticipated influence of national and local economic conditions.  The adequacy of the allowance for loan losses is reviewed quarterly and adjustments are made as considered necessary.

We recorded $3,000,000 and $5,350,000 provisions for loan losses for the first three months of 2011 and 2010, respectively.  This decline is a result of lower levels of impaired loans at March 31, 2011 compared to March 31, 2010.  At March 31, 2010, the allowance for loan losses totaled $16,933,000 or 1.70% of loans, net of unearned income, compared to $17,224,000 or 1.70% of loans, net of unearned income, at December 31, 2010.
 
 
44

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


As illustrated in Table IV below, our non-performing assets have decreased during the past 12 months.


Table IV - Summary of Non-Performing Assets
                 
         
 Dollars in thousands
 
March 31,
   
December 31,
 
   
2011
   
2010
   
2010
 
 Accruing loans past due 90 days or more
  $ 9     $ 170     $ 1,442  
 Nonaccrual loans
                       
 Commercial
    2,186       511       1,318  
 Commercial real estate
    5,284       33,907       2,686  
 Commercial construction and development
    131       9,668       -  
 Residential construction and development
    8,428       7,018       10,049  
 Residential real estate
    6,343       4,053       6,075  
 Consumer
    197       206       141  
     Total nonaccrual loans
    22,569       55,363       20,269  
Foreclosed properties
                       
 Commercial
    597       -       597  
 Commercial real estate
    13,738       5,086       14,745  
 Commercial construction and development
    16,918       4,814       17,021  
 Residential construction and development
    32,002       36,447       34,377  
 Residential real estate
    3,706       4,215       3,495  
 Consumer
    -       -       -  
     Total foreclosed properties
    66,961       50,562       70,235  
 Repossessed assets
    262       291       289  
 Total nonperforming assets
  $ 89,801     $ 106,386     $ 92,235  
 Total nonperforming loans as a
                       
    percentage of total loans
    2.26 %     4.90 %     2.14 %
 Total nonperforming assets as a
                       
    percentage of total assets
    6.06 %     6.92 %     6.24 %



The following table presents a summary of our 30 to 89 days past due performing loans.


Loans Past Due 30-89 Days
                             
   
For the Quarter Ended
 
 Dollars in thousands
 
3/31/2011
   
12/31/2010
   
9/30/2010
   
6/30/2010
   
3/31/2010
 
                               
Commercial
  $ 910     $ 695     $ 817     $ 516     $ 1,239  
Commercial real estate
    2,514       4,651       1,933       9,246       10,003  
Construction and development
    1,948       3,156       1,711       819       11,652  
Residential real estate
    6,561       20,120       7,050       10,846       8,829  
Consumer
    494       586       691       536       438  
   Total
  $ 12,427     $ 29,208     $ 12,202     $ 21,963     $ 32,161  



 
45

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

The following table details our most significant nonperforming loan relationships at March 31, 2011.


Significant Nonperforming Loan Relationships
                       
March 31, 2011
                           
In thousands
                           
Location by Region
Underlying Collateral
Loan Origination Date
Loan Nonaccrual Date
Current Loan Balance
 
Method Used to Measure Impairment
Most Recent Appraised Value
   
Amount Allocated to Allowance for Loan Losses
   
Amount Previously Charged-off
 
Rockingham Co., VA & Hardy Co., WV
Residential subdivision & undeveloped acreage
Nov. 2007 & Oct. 2005
Mar. 2009 & Mar. 2011
$ 2,126  
Collateral value
$ 2,493   (1 ) $ 11     $ 904  
Northern VA
Commercial building
Jan. 2009
Jun. 2010
$ 1,326  
Collateral value
$ 1,265   (1 ) $ 246     $ -  
Jefferson Co., WV
Residential building lots, single familty residence & undeveloped acreage
Aug. 2006 & Dec. 2007
Oct. 2010
$ 1,082  
Collateral value
$ 808   (1 ) $ 355     $ 643  
Rockingham Co., VA
Convenience store
Apr. 2004
Mar. 2011
$ 1,095  
Collateral value
$ 2,766   (2 ) $ -     $ -  
Shenandoah Co., Spotsylvania Co., and Fauquier Co., VA
Single family rentals & residential lots
Mar. 2007 & May 2008
Jan. 2011 & Mar. 2011
$ 1,584  
Collateral value
$ 2,118   (2 ) $ -     $ -  
Western MD and Florida
Residential development, undeveloped acreage, 2 residential condos, a single family residence and a residential building lot
Various
2003-2007
Jun. 2010
$ 4,552  
Collateral value
$ 7,937   (1 ) $ 320     $ 1,290  
                                       
(1) - Values based upon recent external appraisal.
 
(2) - Values based upon appraisal obtained at loan origination. New appraisal has been ordered.
 
 
As a result of our internal loan review process, the ratio of internally criticized loans to total loans increased from 10.47% at December 31, 2010 to 10.83% at March 31, 2011.  Our internal loan review process includes a watch list of loans that have been specifically identified through the use of various sources, including past due loan reports, previous internal and external loan evaluations, classified loans identified as part of regulatory agency loan reviews and reviews of new loans representative of current lending practices.  Once this watch list is reviewed to ensure it is complete, we review the specific loans for collectability, performance and collateral protection.  In addition, a grade is assigned to the individual loans utilizing internal grading criteria, which is somewhat similar to the criteria utilized by our subsidiary bank's primary regulatory agency.  The decrease in the land development and construction category was primarily the result of foreclosures.  Refer to the Asset Quality section of the financial review of the 2010 Annual Report on Form 10-K for further discussion of the processes related to internally classified loans.

 
46

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Internally Criticized Loans
                             
                               
In thousands
 
3/31/2011
   
12/31/2010
   
9/30/2010
   
6/30/2010
   
3/31/2010
 
Commerical
  $ 6,605     $ 5,979     $ 7,272     $ 8,113     $ 7,342  
Commercial real estate
    38,487       36,395       35,401       45,971       63,079  
Land development & construction
    33,039       34,751       27,544       27,216       30,145  
Residential real estate
    29,689       29,045       27,788       24,714       22,705  
Consumer
    38       40       -       -       -  
Total
  $ 107,858     $ 106,210     $ 98,005     $ 106,014     $ 123,271  

Included in the above table of internally criticized loans are approximately $5.6 million of performing loans which we have identified as potential problem loans at March 31, 2011.  These loans are performing at March 31, 2011, but known information about possible credit problems of the related borrowers causes management to have concerns as to the ability of such borrowers to comply with the current loan repayment terms and which may result in disclosure of such loans as nonperforming at some time in the future.  Management cannot predict the extent to which economic conditions may worsen or other factors which may impact borrowers and the potential problem loans.  Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, or require increased allowance coverage and provision for loan losses.

We maintain the allowance for loan losses at a level considered adequate to provide for estimated probable credit losses inherent in the loan portfolio.  The allowance is comprised of three distinct reserve components:  (1) specific reserves related to loans individually evaluated, (2) quantitative reserves related to loans collectively evaluated, and (3) qualitative reserves related to loans collectively evaluated.  A summary of the methodology we employ on a quarterly basis with respect to each of these components in order to evaluate the overall adequacy of our allowance for loan losses is as follows:

Specific Reserve for Loans Individually Evaluated

First, we identify loan relationships having aggregate balances in excess of $500,000 and that may also have credit weaknesses.  Such loan relationships are identified primarily through our analysis of internal loan evaluations, past due loan reports, and loans adversely classified by regulatory authorities.  Each loan so identified is then individually evaluated to determine whether it is impaired – that is, based on current information and events, it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement.  Substantially all of our impaired loans are and historically have been collateral dependent, meaning repayment of the loan is expected to be provided solely from the sale of the loan’s underlying collateral.  For such loans, we measure impairment based on the fair value of the loan’s collateral, which is generally determined utilizing current appraisals.  A specific reserve is established in an amount equal to the excess, if any, of the recorded investment in each impaired loan over the fair value of its underlying collateral, less estimated costs to sell. Our policy is to re-evaluate the fair value of collateral dependent loans at least every twelve months unless there is a known deterioration in the collateral’s value, in which case a new appraisal is obtained.
 
Quantitative Reserve for Loans Collectively Evaluated
 
Second, we stratify the loan portfolio into the following ten loan pools:  land and land development, construction, commercial, commercial real estate -- owner-occupied, commercial real estate -- non-owner occupied, conventional residential mortgage, jumbo residential mortgage, home equity, consumer, and other.  Loans within each pool are then further segmented between larger-balance loan relationships exceeding $2 million loans which were individually evaluated for impairment and not deemed to be impaired and smaller-balance homogenous loans.
 
Quantitative reserves relative to each loan pool are established  by assigning an allocation equaling 100% of the respective pool’s average 12 month historical net loan charge-off rate (determined based upon the most recent twelve quarters) is applied to the aggregate recorded investment in the smaller-balance homogenous pool of loans.
 

 
47

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

Qualitative Reserve for Loans Collectively Evaluated
 
Third, we consider the necessity to adjust our average historical net loan charge-off rates relative to each of the above ten loan pools for potential risks factors that could result in actual losses deviating from prior loss experience.  For example, if we observe a significant increase in delinquencies within the conventional mortgage loan pool above historical trends, an additional allocation to the average historical loan charge-off rate is applied.  Such qualitative risk factors considered are:  (1) levels of and trends in delinquencies and impaired loans, (2) levels of and trends in charge-offs and recoveries, (3) trends in volume and term of loans, (4) effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practice, (5) experience, ability, and depth of lending management and other relevant staff, (6) national and local economic trends and conditions, (7) industry conditions, and (8) effects of changes in credit concentrations.
 
Relationship between Allowance for Loan Losses, Net Charge-offs and Nonperforming Loans
 
In analyzing the relationship between the allowance for loan losses, net loan charge-offs and nonperforming loans, it is helpful to understand the process of how loans are treated as they deteriorate over time. Reserves for loans are established at origination through the quantitative and qualitative reserve process discussed above. If the quality of a loan which is reviewed as part of our normal internal loan review procedures deteriorates to a point causing us to deem the loan impaired, the loan is then evaluated for specific reserves under FAS 114, and a reserve, if necessary, is assigned.

Charge-offs, if necessary, are typically recognized in a period after the reserves were established. If the previously established reserves exceed that needed to satisfactorily resolve the problem credit, a reduction in the overall level of the reserve could be recognized. In summary, if loan quality deteriorates, the typical credit sequence is periods of reserve building, followed by periods of higher net charge-offs.

Consumer loans are generally charged off to the allowance for loan losses upon reaching specified stages of delinquency, in accordance with the Federal Financial Institutions Examination Council policy.  For example, credit card loans are charged off by the end of the month in which the account becomes 180 days past due or within 60 days from receiving notification about a specified event (e.g., bankruptcy of the borrower), whichever is earlier.  Residential mortgage loans are generally charged off to net realizable value no later than when the account becomes 180 days past due.  Other consumer loans, if collateralized, are generally charged off to net realizable value at 120 days past due.

Commercial-related loans (which are risk-rated) are charged off to the allowance for loan losses when the loss has been confirmed. This determination includes many factors, including the prioritization of our claim in bankruptcy, expectations of the workout/restructuring of the loan and valuation of the borrower’s equity.

Substantially all of our nonperforming loans are secured by real estate. The substantial majority of these loans were underwritten in accordance with our loan-to-value policy guidelines which range from 70-85% at the time of origination. Although property values have deteriorated across our market areas, the fair values of the underlying collateral value remains in excess of the recorded investment in many of our nonperforming loans, and therefore, no specific reserve allocation is required; as of March 31, 2011, approximately 75% of our impaired loans required no reserves or have been charged down to their fair value. Accordingly, our allowance for loan losses has not increased proportionately as our nonperforming loans have increased. The allowance for loan loss will, however, increase as a result of an increase in net loan charge-offs due to the incremental higher historical net charge-off rate applied to the loans which are collectively evaluated for impairment.

 
48

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


At March 31, 2011, December 31, 2010, and March 31, 2010, our allowance for loan losses totaled $16,933,000, or 1.70% of total loans, $17,224,000, or 1.70% of total loans and $17,843,000, or 1.58% of total loans, respectively, and is considered adequate to cover inherent losses in our loan portfolio.

At March 31, 2011, December 31, 2010, and March 31, 2010, we had approximately $66,961,000, $70,235,000 and $50,562,000, respectively, in other real estate owned which was obtained as the result of foreclosure proceedings.  Although foreclosed property is recorded at fair value less estimated costs to sell, the prices ultimately realized upon their sale may or may not result in us recognizing loss.

FINANCIAL CONDITION

Our total assets were $1,482,195,000 at March 31, 2011, compared to $1,478,470,000 at December 31, 2010, representing a 0.25% increase.  Table V below serves to illustrate significant changes in our financial position between December 31, 2010 and March 31, 2011.


Table V - Summary of Significant Changes in Financial Position
 
                         
   
Balance
               
Balance
 
   
December 31,
   
Increase (Decrease)
   
March 31,
 
 Dollars in thousands
 
2010
   
Amount
   
Percentage
   
2011
 
 Assets
                       
   Securities available for sale
  $ 271,730       21,510       7.9 %   $ 293,240  
   Loans, net of unearned interest
    1,012,543       (16,223 )     -1.6 %     996,320  
                                 
 Liabilities
                               
   Deposits
  $ 1,036,939     $ 25,180       2.4 %   $ 1,062,119  
   Short-term borrowings
    1,582       297       18.8 %     1,879  
   Long-term borrowings
    304,109       (20,593 )     -6.8 %     283,516  
   Subordinated debentures
    16,800       -       0.0 %     16,800  
   Subordinated debentures owed to
                               
       unconsolidated subsidiary trusts
    19,589       -       0.0 %     19,589  


Loans decreased 1.6% and securities increased 7.9% during the first three months of 2011.  We have restricted our growth in order to improve our capital ratios.
 
Deposits increased approximately $25.2 million during the first three months of 2011, primarily in retail deposits.

The decrease in long term borrowings is primarily attributable to maturities and repayments of long-term FHLB advances during the first three months of 2011 funded by increased deposits.

Refer to Notes 6, 7, 9, and 10 of the notes to the accompanying consolidated financial statements for additional information with regard to changes in the composition of our securities, loans, deposits and borrowings between March 31, 2010 and December 31, 2010.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity reflects our ability to ensure the availability of adequate funds to meet loan commitments and deposit withdrawals, as well as provide for other transactional requirements.  Liquidity is provided primarily by funds invested in cash and due from banks (net of float and reserves), Federal funds sold, non-pledged securities, and available lines of credit with the Federal Home Loan Bank of Pittsburgh (“FHLB”), which totaled approximately $393.3 million or 26.5% of total consolidated assets at March 31, 2011.

 
49

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


Our liquidity strategy is to fund loan growth with deposits and other borrowed funds while maintaining an adequate level of short- and medium-term investments to meet normal daily loan and deposit activity.  As a member of the FHLB, we have access to approximately $448 million.  As of March 31, 2011 and December 31, 2010, these advances totaled approximately $162 million and $182 million, respectively.  At March 31, 2011, we had additional borrowing capacity of $218 million through FHLB programs.  We have established a line with the Federal Reserve Bank to be used as a contingency liquidity vehicle.  The amount available on this line at March 31, 2011 was approximately $63 million, which is secured by a pledge of our consumer and commercial and industrial loan portfolios.  Also, we classify all of our securities as available for sale to enable us to liquidate them if the need arises.
 
Liquidity risk represents the risk of loss due to the possibility that funds may not be available to satisfy current or future commitments based on external market issues, customer or creditor perception of financial strength, and events unrelated to Summit such as war, terrorism, or financial institution market specific issues.  The Asset/Liability Management Committee (“ALCO”), comprised of members of senior management and certain members of the Board of Directors, oversees our liquidity risk management process.   The ALCO develops and recommends policies and limits governing our liquidity to the Board of Directors for approval with the objective of ensuring that we can obtain cost-effective funding to meet current and future obligations, as well as maintain sufficient levels of on-hand liquidity, under both normal and “stressed” circumstances.
 
One aspect of our liquidity management process is establishing contingency liquidity funding plans under various scenarios in order to prepare for unexpected liquidity shortages or events.  The following represents three “stressed” liquidity circumstances and our related contingency plans with respect to each.
 
Scenario 1 – Summit Community’s capital status becomes less than “well capitalized”.  Banks which are less than “well capitalized” in accordance with regulatory capital guidelines are prohibited from issuing new brokered deposits without first obtaining a waiver from the FDIC to do so.  In the event Summit Community’s capital status were to fall below well capitalized and was not successful in obtaining the FDIC’s waiver to issue new brokered deposits, Summit Community:

·  
Would have limited amounts of maturing brokered deposits to replace in the short-term, as we have limited our brokered deposits maturing in any one quarter to no more than $50 million.
·  
Presently has $420 million in available sources of liquid funds which could be drawn upon to fund maturing brokered deposits until Summit Community had restored its capital to well capitalized status.
·  
Would first seek to restore its capital to well capitalized status through capital contributions from Summit, its parent holding company.  Summit has present cash reserves in excess of $4 million available for capital infusion into Summit Community.
·  
Would generally have no more than $100 million in brokered deposits maturing in any one year time frame, which is well within its presently available sources of liquid funds, if in the event Summit does not have the capital resources to restore Summit Community’s capital to well capitalized status.  One year would give Summit Community ample time to raise alternative funds either through retail deposits or the sale of assets, and obtain capital resources to restore it to well capitalized status.

Scenario 2 – Summit Community’s credit quality deteriorates such that the FHLB restricts further advances.  If in the event that the Bank’s credit quality deteriorated to the point that further advances under its line with the FHLB were restricted, Summit Community:

·  
Would severely curtail lending and other growth activities until such time as access to this line could be restored, thus eliminating the need for net new advances, and
·  
Would still have available current liquid funding sources secured by unemcumbered loans and securities totaling $227 million aside from its FHLB line, which would result in a funding source of approximately $175 million.
 

 
50

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations

 
Scenario 3 – A competitive financial institution offers a retail deposit program at interest rates significantly above current market rates in the Summit Community’s market areas.  If a competitive financial institution offered a retail deposit program at rates well in excess of current market rates in the Summit Community’s market area, the Bank:

·  
Presently has $420 million in available sources of liquid funds which could be drawn upon immediately to fund any “net run off” of deposits from this activity.
·  
Would severely curtail lending and other growth activities so as to preserve the availability of as much contingency funds as possible.
·  
Would begin offering its own competitive deposit program when deemed prudent so as to restore the retail deposits lost to the competition.
 
 
We continuously monitor our liquidity position to ensure that day-to-day as well as anticipated funding needs are met.  We are not aware of any trends, commitments, events or uncertainties that have resulted in or are reasonably likely to result in a material change to our liquidity.

One of our continuous goals is maintenance of a strong capital position.  Through management of our capital resources, we seek to provide an attractive financial return to our shareholders while retaining sufficient capital to support future growth.  Shareholders’ equity at March 31, 2011 totaled $89,328,000 compared to $89,821,000 at December 31, 2010.

Summit and Summit Community have each entered into informal Memoranda of Understanding (“MOU’s”) with their respective regulatory authorities.  A memorandum of understanding is characterized by the regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order.  Among other things, under the MOU’s, Summit’s management team has agreed to:

·  
Summit Community achieving and maintaining a minimum Tier 1 leverage capital ratio of at least 8% and a total risk-based capital ratio of at least 11%;
 
·  
Summit Community providing 30 days prior notice of any declaration of intent to pay cash dividends to provide the Bank’s regulatory authorities an opportunity to object;
 
·  
Summit suspending all cash dividends on its common stock until further notice.  Dividends on all preferred stock, as well as interest payments on subordinated notes underlying Summit’s trust preferred securities, continue to be permissible; and,
 
·  
Summit not incurring any additional debt, other than trade payables, without the prior written consent of the banking regulators.

Management presently believes Summit and the Bank are in compliance with all provisions of the MOUs.

Refer to Note 13 of the notes to the accompanying consolidated financial statements for additional information regarding regulatory restrictions on our capital as well as our subsidiaries’ capital.

CONTRACTUAL CASH OBLIGATIONS

During our normal course of business, we incur contractual cash obligations.  The following table summarizes our contractual cash obligations at March 31, 2011.

 
51

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


.
   
Long
   
Capital
       
   
Term
   
Trust
   
Operating
 
Dollars in thousands
 
Debt
   
Securities
   
Leases
 
2011
  $ 14,801     $ -     $ 137  
2012
    66,720       -       151  
2013
    41,885       -       138  
2014
    83,416       -       125  
2015
    11,894       -       21  
         Thereafter
    81,600       19,589       -  
Total
  $ 300,316     $ 19,589     $ 572  




OFF-BALANCE SHEET ARRANGEMENTS

We are involved with some off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, liquidity, or capital.  These arrangements at March 31, 2011 are presented in the following table.

   
March 31,
 
Dollars in thousands
 
2011
 
Commitments to extend credit:
     
    Revolving home equity and
     
        credit card lines
  $ 43,346  
    Construction loans
    20,329  
    Other loans
    34,488  
Standby letters of credit
    5,991  
Total
  $ 104,154  



 
52

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


MARKET RISK MANAGEMENT

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices.  Interest rate risk is our primary market risk and results from timing differences in the repricing of assets, liabilities and off-balance sheet instruments, changes in relationships between rate indices and the potential exercise of imbedded options.  The principal objective of asset/liability management is to minimize interest rate risk and our actions in this regard are taken under the guidance of our Asset/Liability Management Committee (“ALCO”), which is comprised of members of senior management and members of the Board of Directors.  The ALCO actively formulates the economic assumptions that we use in our financial planning and budgeting process and establishes policies which control and monitor our sources, uses and prices of funds.

Some amount of interest rate risk is inherent and appropriate to the banking business.  Our net income is affected by changes in the absolute level of interest rates.  Our interest rate risk position is liability sensitive.  The nature of our lending and funding activities tends to drive our interest rate risk position to being liability sensitive.  That is, absent any changes in the volumes of our interest earning assets or interest bearing liabilities, liabilities are likely to reprice faster than assets, resulting in a decrease in net income in a rising rate environment.  Net income would increase in a falling interest rate environment.  Net income is also subject to changes in the shape of the yield curve.  In general, a flattening yield curve would result in a decline in our earnings due to the compression of earning asset yields and funding rates, while a steepening would result in increased earnings as margins widen.

Several techniques are available to monitor and control the level of interest rate risk.  We primarily use earnings simulations modeling to monitor interest rate risk.  The earnings simulation model forecasts the effects on net interest income under a variety of interest rate scenarios that incorporate changes in the absolute level of interest rates and changes in the shape of the yield curve.  Each increase or decrease in interest rates is assumed to gradually take place over the next 12 months, and then remain stable, except for the up 400 scenario, which assumes a gradual increase in rates over 24 months.  Assumptions used to project yields and rates for new loans and deposits are derived from historical analysis.  Securities portfolio maturities and prepayments are reinvested in like instruments.  Mortgage loan prepayment assumptions are developed from industry estimates of prepayment speeds.  Noncontractual deposit repricings are modeled on historical patterns.

The following table presents the estimated sensitivity of our net interest income to changes in interest rates, as measured by our earnings simulation model as of March 31, 2011.  The sensitivity is measured as a percentage change in net interest income given the stated changes in interest rates (gradual change over 12 months, stable thereafter for the up and down 100 and the up 200 scenarios, and gradual change over 24 months for the up 400 scenario) compared to net interest income with rates unchanged in the same period.  The estimated changes set forth below are dependent on the assumptions discussed above and are well within our ALCO policy limit, which is a 10% reduction in net interest income over the ensuing twelve month period.



Change in
Estimated % Change in Net
Interest Rates
Interest Income Over:
(basis points)
0-12 Months
13-24 Months
Down 100 (1)
1.53%
8.16%
Up 100 (1)
-1.90%
2.42%
Up 200 (1)
-3.97%
-0.92%
Up 400 (2)
-3.94%
-2.99%
     
(1)  assumes a parallel shift in the yield curve
 
(2)  assumes 400 bp increase over 24 months
 


 
53

 
Summit Financial Group, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and
Results of Operations


CONTROLS AND PROCEDURES

Our management, including the Chief Executive Officer and Chief Financial Officer, has conducted as of March 31, 2011, an evaluation of the effectiveness of disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures as of March 31, 2011 were effective.  There were no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
54

 
Summit Financial Group, Inc. and Subsidiaries
Part II.  Other Information


Item 1.  Legal Proceedings

We are involved in various legal actions arising in the ordinary course of business.  In the opinion of management, the outcome of these matters will not have a significant adverse effect on the consolidated financial statements.


Item 1A.  Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010.


 
55

 


 
SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



 
SUMMIT FINANCIAL GROUP, INC.
 
(registrant)
       
       
       
       
 
By:
 /s/ H. Charles Maddy, III
 
 
H. Charles Maddy, III,
 
President and Chief Executive Officer
       
       
       
 
By:
 /s/ Robert S. Tissue
 
 
Robert S. Tissue,
 
Senior Vice President and Chief Financial Officer
       
       
       
 
By:
 /s/ Julie R. Cook
 
 
Julie R. Cook,
 
Vice President and Chief Accounting Officer
       
       
Date:  May 2 , 2011
     



 
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