NEW PEOPLES BANKSHARES INC Management’s Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q/A)

Caution About Forward-Looking Statements




We make forward-looking statements in this quarterly report on Form 10-Q that
are subject to risks and uncertainties. These forward-looking statements include
statements regarding expectations, intentions, projections and beliefs
concerning our profitability, liquidity, and allowance for loan losses, interest
rate sensitivity, market risk, growth strategy, and financial and other goals.
The words "believes," "expects," "may," "will," "should," "projects,"
"contemplates," "anticipates," "forecasts," "intends," or other similar words or
terms are intended to identify forward looking statements. The forward-looking
information is based on various factors and was derived using numerous
assumptions. Important factors that may cause actual results to differ from
projections include:

º the success or failure of our efforts to implement our business plan;

º any required increase in our regulatory capital ratios;

º satisfying other regulatory requirements that may arise from examinations,

     changes in the law and other similar factors;
   º deterioration of asset quality;
   º changes in the level of our nonperforming assets and charge-offs;
   º fluctuations of real estate values in our markets;
   º our ability to attract and retain talent;

º demographical changes in our markets which negatively impact the local

economy;

º the uncertain outcome of current or future legislation or regulations or

policies of state and federal regulators;

º the successful management of interest rate risk;

º the successful management of liquidity;

º changes in general economic and business conditions in our market area and

the United States in general;

º credit risks inherent in making loans such as changes in a borrower’s

ability to repay and our management of such risks;

º competition with other banks and financial institutions, and companies

outside of the banking industry, including online lenders and those

companies that have substantially greater access to capital and other

resources;

º demand, development and acceptance of new products and services we have

offered or may offer;

º the effects of, and changes in, trade, monetary and fiscal policies and

laws, including interest rate policies of the Federal Reserve, inflation,

interest rate, market and monetary fluctuations;

º the occurrence of significant natural disasters, including severe weather

conditions, floods, health related issues (including the ongoing novel

coronavirus (COVID-19) outbreak and the associated efforts to limit the

     spread of the disease), and other catastrophic events;
   º technology utilized by us;
   º our ability to successfully manage cybersecurity;
   º our reliance on third-party vendors and correspondent banks;
   º changes in generally accepted accounting principles;

º changes in governmental regulations, tax rates and similar matters; and,

º other risks, which may be described, from time to time, in our filings with

the Securities and Exchange Commission.

Because of these uncertainties, our actual future results may be materially
different from the results indicated by these forward-looking statements. In
addition, our past results of operations do not necessarily indicate our future
results. We expressly disclaim any obligation to update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise, except as required by law.





                                       25





Critical Accounting Policies



For discussion of our significant accounting policies, see our Annual Report on
Form 10-K for the year ended December 31, 2021 (the 2021 Form 10-K). Certain
critical accounting policies affect the more significant judgments and estimates
used in the preparation of our financial statements. Our most critical
accounting policies relate to our provision for loan losses and the calculation
of our deferred tax asset.



The allowance represents an amount that, in the Company's judgment, will be
adequate to absorb probable and estimable losses inherent in the loan portfolio.
The judgment in determining the level of the allowance is based on evaluations
of the collectability of loans while taking into consideration such factors as
trends in delinquencies and charge-offs for relevant periods of time, changes in
the nature and volume of the loan portfolio, current economic conditions that
may affect a borrower's ability to repay and the value of collateral, overall
portfolio quality and review of specific potential losses. This evaluation is
inherently subjective because it requires estimates that are susceptible to
significant revision as more information becomes available.



Deferred tax assets or liabilities are computed based upon the difference
between financial statement and income tax bases of assets and liabilities using
the enacted marginal tax rate. In the past, the Company provided a valuation
allowance on its net deferred tax assets where it was deemed more likely than
not such assets would not be realized. At September 30, 2022 and December 31,
2021, the Company had no valuation allowance on its net deferred tax assets.



The Company recognizes the tax benefit from an uncertain tax position only if it
is more likely than not the tax position will be sustained on examination by the
taxing authorities, based on the technical merits of the position. The tax
benefits recognized in the financial statements from such positions are then
measured based on the largest benefit that has a greater than 50% likelihood of
being realized upon settlement.



For further discussion of the deferred tax asset and valuation allowance, we
refer you to the section on “Deferred Tax Asset and Income Taxes” below.





Overview and Highlights



For the three months ended September 30, 2022, net income of $2.0 million was
recorded; an increase of $141,000, or 7.6%, from the same period in 2021. The
primary driver for the improved earnings was a decrease in total noninterest
expense of $1.5 million due largely to the $1.0 million decline in occupancy
expenses. This year-over-year decrease in occupancy expenses offset decreases in
net interest income and noninterest income of $218,000 and $781,000,
respectively. Net interest income decreased $218,000, a result of deferred loan
fees earned from the forgiveness of Paycheck Protection Program (PPP) loans of
$1.1 million during the third quarter of 2021 not being replicated in 2022,
resulting in a net decrease in interest and fees on loans of $592,000, or 7.8%.
The decrease in loan fees was largely offset by increased earnings on interest
bearing deposits in banks and investments, which increased $531,000 and
$117,000, respectively. For the comparative three-month periods of 2022 and
2021, interest expense increased $284,000, as interest on borrowed funds
increased $388,000, offset by a decrease in interest expense on deposits of
$104,000.



For the nine months ended September 30, 2022, net income totaled $5.8 million or
$0.24 per share compared to $5.1 million or $0.21 per share for the same
nine-month period in 2021. Interest income was slightly higher and interest
expense was slightly lower, resulting in an improvement of $183,000 in net
interest income. Other drivers of the improvement were reduced noninterest
expense, which declined $1.4 million, due largely to charges foe the write down
of closed and former branch office sites during the third quarters of 2022 and
2021. Updated valuations of the two branch offices closed in 2022, resulted in a
charge of $195,000 that is included in noninterest expense. During the same
period in 2021, three former branch office sites were sold, resulting in gains
of $190,000, and three more former branch office sites were transferred to other
real estate owned, resulting in a combined loss of $1.1 million.



On June 15, 2022, we experienced a cybersecurity incident that temporarily
interrupted the operability of our computer systems. Limited operations were
restored June 17, 2022, and full operations were restored June 21, 2022. On June
29, 2022, we issued a press release outlining the timeline, restoration efforts
and communications, services and safeguards being offered to our customers in
response to this incident, and filed a Current Report on Form 8-K relating to
the incident. Since that date, restoration efforts have been completed and
normal operations have resumed. Reference to the cybersecurity event is made
throughout this Management's Discussion and Analysis of Financial Condition
and
Results of Operations.



The balance sheet grew to $828.6 million as of September 30, 2022, from $794.6
million as of December 31, 2021, due to Federal Home Loan Bank advances taken,
in the second quarter of 2022, as a precautionary measure in response to the
cybersecurity incident. Total deposits increased $16.4 million to $723.9 million
at September 30, 2022 from $707.5 million at December 31, 2021. Loans decreased
$13.9 million to $579.9 million during the first nine months of 2022, due to
repayments of several large commercial real estate loans combined with PPP loan
repayments of approximately $6.1 million.

                                       26




In August of 2022, branch offices in Big Stone Gap and Chilhowie, Virginia were
closed and the loan and deposit accounts were transferred to nearby office
locations. Affected personnel were reassigned to other branches or departments.

During the second quarter of 2022, we initiated a previously announced stock
repurchase program. Through September 30, 2022, 44,485 shares have been
repurchased at an average price of $2.30 per share.

Comparison of the Three Months ended September 30, 2022 and 2021

Quarter-to-date highlights include:

· Returns on average assets and equity of 0.94% and 13.70 % for the third quarter

of 2022, compared to 0.91% and 11.75% for the third quarter of 2021,

respectively;

· Net interest income was $7.2 million for the third quarter of 2022, a decrease

of $218 thousand, or 2.9%, compared to the third quarter of 2021;

· Provision for loan losses was $225,000 for the third quarter of 2022, and $0

for the third quarter of 2021;

· Noninterest income was $2.2 million, a decrease of $781 thousand, or 26.3%,

during the third quarter of 2022 compared to the third quarter of 2021; and

· Noninterest expense was $6.6 million, a decrease of $1.5 million, or 18.2%, for

   the third quarter of 2022 compared to the third quarter of 2021.




The Company's primary source of income is net interest income, which decreased
by $218 thousand, or 2.9%, to $7.2 million for the third quarter of 2022
compared to $7.4 million for the third quarter of 2021. Interest income
increased $66 thousand due to a $56 million increase in the average balance of
earning assets, a shift of funds to higher-yielding investment securities; and
increased interest earning deposits with banks funded from FHLB advances as we
maintained additional liquidity as we monitored customer reaction to the
cybersecurity incident. Additionally, the 2022 increases in the fed funds rate
partially offset the decline in accelerated fee recognition when PPP loans are
forgiven. Total interest expense increased $284 thousand driven primarily by a
$388 thousand increase in interest on borrowed funds due to the FHLB advances
combined with increased interest rates paid on trust preferred securities.
Increased borrowing expenses were partially offset by a decrease in interest on
deposits which decreased $104 thousand, or 19.9%, for the three months ended
September 30, 2022 compared to the three months ended September 30, 2021. The
lower deposit interest expense resulted largely from reduced time deposit
interest expense due to a decrease in both volume and interest rates. Overall
there was a 12 basis-point increase in the cost of funds to 46 bps while the net
interest margin decreased 38 bps to 3.55%. During the third quarter of 2022, the
Federal Reserve's Open Market Committee (FOMC) increased the discount rate two
times for a total of 150 bps, bringing the number of rate increases for the
first nine months of 2022 to five, totaling 300 bps. The Company experienced
benefits of the rate increases during the third quarter, but the full impact
will be somewhat lagging as certain loans, investments, and trust preferred
securities will not reprice until the individual instruments next interest rate
repricing date. Deposit rates have not yet been significantly impacted by the
rate increases, but the Company continues to evaluate rate adjustments for
factors, including competitive pressure within the local markets, funding needs
to support growth and other needs. During the third quarter of 2022, in response
to rising interest rates, we initiated some promotional time deposit products.



                                       27


The following table shows the rates paid on earning assets and interest-bearing
liabilities for the periods indicated:



                                            Net Interest Margin Analysis
                             Average Balances, Income and Expense, and Yields and Rates

                                               (Dollars in thousands)
                                          Three Months Ended September 30,
                                                          2022                                 2021
                                               Average   Income/   Yields/       Average       Income/      Yields/
                                               Balance   Expense    Rates        Balance       Expense       Rates
ASSETS
  Loans (1) (2) (3)                          $ 590,090 $   7,010     4.72%  

$ 581,517 $ 7,602 5.19%

  Federal funds sold                               353         2     2.34%              209          -          0.12%

Interest bearing deposits in other banks 98,657 559 2.25%

72,549 28 0.15%

  Taxable investment securities                117,628       539     1.83%  

96,136 414 1.72%

  Total earning assets                         806,728     8,110     3.99%  

750,411 8,044 4.26%

  Less: Allowance for loans losses             (6,738)                              (6,778)
  Non-earning assets                            41,134                               58,972
      Total Assets                           $ 841,124                      $       802,605

LIABILITIES AND SHAREHOLDERS’ EQUITY

  Interest-bearing demand deposits           $  75,151 $      23     0.12%  

$ 60,289 $ 15 0.10%

  Savings and money market deposits            192,550        52     0.11%  

184,155 36 0.08%

  Time deposits                                181,480       343     0.75%  

212,712 471 0.88%

    Total interest-bearing deposits            449,181       418     0.37%          457,156        522          0.45%
  Short-term borrowings                         46,793       287     2.40%                -          -             -%
  Trust preferred securities                    16,496       205     4.85%           16,496        104          2.47%

Total interest-bearing liabilities 512,470 910 0.70%

473,652 626 0.52%

  Non-interest-bearing deposits                262,244         -        -%          258,251          -            - %

Total deposit liabilities and cost of

  funds                                        774,714       910     0.46%  

731,903 626 0.34%

  Other liabilities                              8,904                                8,399
      Total Liabilities                        783,618                              740,302
  Shareholders' Equity                          57,506                               62,303

Total Liabilities and Shareholders’

      Equity                                 $ 841,124                      $       802,605
  Net Interest Income                                  $   7,200                             $   7,418
  Net Interest Margin                                                3.55%                                 3.93%
  Net Interest Spread                                                3.29%                                 3.74%
(1) Nonaccrual loans and loans held for sale have been included in average loan balances
(2) Tax exempt income is not significant and has been treated as fully taxable
(3) Includes mortgage loans held for sale





Net interest income is affected by changes in both average interest rates and
average volumes (balances) of interest-earning assets and interest-bearing
liabilities. The following table sets forth the amounts of the total changes in
interest income and interest expense which can be attributed to rates and volume
for the three months ended September 30, 2022, as compared to the three months
ended September 30, 2021.



                                       28





                            Volume and Rate Analysis
                              Increase (decrease)


                                                  Three Months Ended

September 30, 2022 versus 2021

                                                                                            Change in
                                                                                            Interest
                                                                                             Income/
(Dollars in thousands)                         Volume Effect          Rate Effect            Expense
Interest Income:
Loans                                         $       (972 )        $        380          $      (592 )
Federal funds sold                                      -                      2                    2
Interest bearing deposits in other banks                13                 
 518                  531
Taxable investment securities                           92                    33                  125
Total Earning Assets                                  (867 )                 933                   66
Interest Expense:
Interest-bearing demand deposits                         5                     3                    8
Savings and money market deposits                        3                 
  13                   16
Time deposits                                          (65 )                 (63 )               (128 )
Short-term borrowings                                  287                    -                   287
Trust preferred securities                              -                    101                  101
Total Interest-bearing Liabilities                     230                 
  54                  284
Change in Net Interest Income                 $     (1,097 )        $        879          $      (218 )



Based on our current assessment of the loan portfolio, a provision of $225
thousand was made in the third quarter of 2022, compared to zero for the third
quarter of 2021, due to a combination of factors, including the rising interest
rate environment, overdraft charge-offs related to the cybersecurity incident
realized during the third quarter of 2022, and uncertain economic trends. The
allowance for loan losses as a percentage of loans increased from 1.13% at
December 31, 2021 to 1.14% as of September 30, 2022. For a discussion of the
factors affecting the allowance for loan losses, including provision expense,
refer to Note 7, Allowance for Loan Losses, in Item 1 of this Form 10-Q.



Total noninterest income decreased $781,000 in the third quarter of 2022
compared to the third quarter of 2021. The primary drivers of the
quarter-over-quarter decline were $322,000 of gains on sales of investment
securities and $190,000 of gains on sale of bank premises in 2021 that were not
repeated in 2022. In addition, the Company recorded a $100,000 write-down of
bank owned life insurance (BOLI) and a period-over-period decrease in gains and
commissions on mortgage loan originations of $82,000, during the third quarter
of 2022. The BOLI charge resulted from a decrease in the market value of the
underlying investments supporting the policy due to increased interest rates.
Service charge revenue increased $68 thousand, or 6.8%, to $1.1 million for the
comparative three-month periods ended September 30, 2022 and 2021 as operations
returned to normal operations after the cybersecurity incident. Card processing
and interchange revenue decreased $67 thousand for the three months ended
September 30, 2022, as compared to the same period in 2021, due to a decline in
transaction volume. The increased interest rate environment also contributed to
the reduced mortgage revenue as mortgage originations and refinancings have
slowed.



Total noninterest expense decreased $1.5 million in the third quarter of 2022
compared to the same period of 2021, due primarily to charges recorded in 2021
of $1.1 million related to the transfer of three former branch office locations
to other real estate owned, which is reflected in occupancy and equipment
expense, and $395,000 of write-downs on OREO, which is reflected in other
operating expense. These charges more than exceeded the $195,000 charge related
to the closure of two branch offices during the third quarter of 2022, which is
included in occupancy expenses. Salaries and benefits remained virtually flat
for the comparative three-month period in 2022 versus 2021. This was due in part
to an adjustment to reduce the liability for our self-insured insurance plan of
$100,000 during the third quarter of 2022, based on a rolling assessment of
claims made against the plan. This liability adjustment offset employee
appreciation bonus payments, totaling $89,000, during the third quarter in
recognition of employee response to the cybersecurity incident in June of 2022.



The efficiency ratio, a non-GAAP measure, which is defined as noninterest
expense divided by the sum of net interest income plus noninterest income,
improved to 70.3% for third quarter of 2022 from 77.6% for the third quarter of
2021. We continue to assess our operational procedures and structure to improve
efficiencies and contain costs. A review of deposit operations was performed
during the third quarter of 2022, and based on this assessment, several
processes will be modified or reassigned to improve operational efficiencies.



                                       29



In August 2022, the Bank closed branch offices in Big Stone Gap and Chilhowie,
Virginia. Accounts serviced at these offices were transferred to nearby
branches, and employees were reassigned to other positions or offices, as
available. Interactive teller machines at these locations will remain in service
for the foreseeable future. This restructuring of the branch network should
improve the efficiency of services to the customers of these communities.



Income tax expense for the third quarter of 2022 totaled $579 thousand, an
increase of $103 thousand, or 21.6% from the $476 thousand recorded during the
same period in 2021. The effective tax rate for the three months ended September
30, 2022, was 22.6%, compared to 20.5% for the same period in 2021. The
year-over-year, quarterly increase generally approximates the percentage
increase of pre-tax earnings.





Comparison of the Nine Months ended September 30, 2022 and 2021

Year-to-date highlights include:

· Net interest income improved to $20.7 million for the first nine months of

2022, an improvement of $183 thousand, or 0.9%, compared to the first nine

months of 2021;

· Net interest margin was 3.53% for the first nine months of 2022, a decrease of

15 bps compared to 3.68% for the first nine months of 2021;

· Provision for loans losses was $400 thousand for the first nine months of 2022,

an increase of $28 thousand, or 7.5%, compared to the first nine months of

2021;

· Noninterest income was $6.9 million, a decrease of $571 thousand, or 7.6%,

compared to the first nine months of 2021;

· Salaries and employee benefits expense was $9.9 million, an increase of $530

thousand, or 5.6%, compared to the first nine months of 2021; and

· Total noninterest expense was $19.7 million, a decrease of $1.4 million, or

   6.8%, compared to the first nine months of 2021.




Overall, during the nine months ended September 30, 2022, compared to the same
period in 2021, net income improved 14.5% to $5.8 million from $5.1 million.
Although interest income was virtually unchanged, increasing $116 thousand,
reduced interest expense of $67 thousand contributed to an improvement of $183
thousand in net interest income. The following table presents the rates earned
on earning assets and paid on interest-bearing liabilities for the periods
indicated.





                                       30





                                            Net Interest Margin Analysis
                             Average Balances, Income and Expense, and Yields and Rates

                                               (Dollars in thousands)
                                           Nine Months Ended September 30,
                                                          2022                                 2021
                                               Average   Income/   Yields/       Average       Income/      Yields/
                                               Balance   Expense    Rates        Balance       Expense       Rates
ASSETS
  Loans (1) (2) (3)                          $ 594,593 $  20,476     4.61%  

$ 588,083 $ 21,483 4.89%

  Federal funds sold                               254         3     1.36%              208          -          0.09%

Interest bearing deposits in other banks 73,752 738 1.34%

83,153 69 0.11%

  Taxable investment securities                115,349     1,510     1.74%  

72,958 1,059 1.94%

  Total earning assets                         783,948    22,727     3.88%  

744,402 22,611 4.06%

  Less: Allowance for loans losses             (6,824)                              (7,143)
  Non-earning assets                            44,582                               59,984
      Total Assets                           $ 821,706                      $       797,243

LIABILITIES AND SHAREHOLDERS’ EQUITY

  Interest-bearing demand deposits           $  71,420 $      58     0.11%  

$ 57,606 $ 45 0.10%

  Savings and money market deposits            194,691       130     0.09%  

175,668 109 0.08%

  Time deposits                                188,497     1,064     0.75%  

222,186 1,626 0.98%

Total interest-bearing liabilities 454,608 1,252 0.37%

        455,460      1,780          0.52%
  Short-term borrowings                         20,000       358     2.36%            3,308         33          1.35%
  Trust preferred securities                    16,496       452     3.61%           16,496        316          2.52%

Total interest-bearing liabilities 491,104 2,062 0.56%

475,264 2,129 0.60%

  Non-interest-bearing deposits                263,083         -        -%          252,985          -            - %

Total deposit liabilities and cost of

  funds                                        754,187     2,062     0.36%  

728,249 2,129 0.39%

  Other liabilities                              8,235                                8,726
      Total Liabilities                        762,422                              736,975
  Shareholders' Equity                          59,284                               60,268

Total Liabilities and Shareholders’

      Equity                                 $ 821,706                      $       794,243
  Net Interest Income                                  $  20,665                             $  20,482
  Net Interest Margin                                                3.53%                                 3.68%
  Net Interest Spread                                                3.32%                                 3.46%

(1) Nonaccrual loans and loans held for sale have been included in average loan balances
(2) Tax exempt income is not significant and has been treated as fully taxable

(3) Includes mortgage loans held for sale




Net interest income is affected by changes in both average interest rates and
average volumes (balances) of interest-earning assets and interest-bearing
liabilities. The following table sets forth the amounts of the total changes in
interest income and interest expense which can be attributed to rates and volume
for the nine months ended September 30, 2022, as compared to the nine months
ended September 30, 2021.





                                       31





                            Volume and Rate Analysis
                              Increase (decrease)


                                                     Nine Months Ended

September 30, 2022 versus 2021

                                                                                               Change in
                                                                                            Interest Income/
(Dollars in thousands)                          Volume Effect           Rate Effect             Expense
Interest Income:
Loans                                         $        (1,382 )       $         375         $       (1,007 )
Federal funds sold                                         -                      3                      3
Interest bearing deposits in other banks                   (9 )                 678                    669
Taxable investment securities                             484                   (33 )                  451
Total Earning Assets                                     (907 )               1,023                    116
Interest Expense:
Interest-bearing demand deposits                           13                    -                      13
Savings and money market deposits                          15              
      6                     21
Time deposits                                            (226 )                (336 )                 (562 )
Short-term borrowings                                     284                    41                    325
Trust preferred securities                                 -                    136                    136
Total Interest-bearing Liabilities                         86                  (153 )                  (67 )
Change in Net Interest Income                 $          (993 )       $    
  1,176         $          183




During the first nine months of 2022 compared to the same period of 2021, net
interest income increased $183 thousand primarily due to a reduction in interest
expense on deposits of $528 thousand, largely offset by increases to the cost of
borrowed funds of $461 thousand. The increase in expense for borrowed funds was
due to $95 million of FHLB advances taken during the second quarter, combined
with rate increases on trust preferred securities. The reduction in interest
expense on deposits was driven mainly by a reduction in the average cost of
retail time deposits, which declined 23 basis points, to 0.75% from 0.98%, plus
a decrease in average balances of $33.7 million. There was a modest increase in
interest income of $116 thousand due to increases to the investment portfolio
and increased rates paid on deposits with other banks. These improvements offset
reductions in loan interest and fees due principally to the reduction in fees
from PPP loan repayments as these fees fell $1.6 million during the comparative
nine-month periods. As a result, the net interest margin for the first nine
months of 2022 was 3.53%, a reduction of 15 bps compared to 3.68% for the first
nine months of 2021.


During the first nine months of 2022, the FOMC increased the discount rate five
times for a total of 300 bps. This increased interest rate environment has
improved returns on certain assets that immediately adjust as these changes are
made, such as interest-bearing deposits in other banks, credit cards, home
equity lines of credit and certain commercial and commercial real estate loans.
It is anticipated that yields on these assets will improve moving forward.
Conversely, it is expected that there will be a need to adjust, upward, rates
paid on deposit accounts, which will increase our overall cost of funds.
Additionally, in response to the June 2022 cybersecurity incident, during the
third quarter of 2022, we began offering a customer appreciation time deposit
product to recognize the patience and loyalty of our customers. This promotional
product pays a higher rate than is currently offered on similar non-promotional
products and is expected to contribute to an increased cost of funds going
forward.



Based on our current assessment of the loan portfolio, $400 thousand was
provided to the allowance for loan losses during the first nine months of 2022
compared to $372 thousand provided during the same period in 2021. For more
information on the factors affecting the allowance for loan losses, including
provision expense, refer to Note 7, Allowance for loan Losses, in Item 1 of this
Form 10-Q. Depending on changes to economic conditions and the impact those
changes may have on individual borrowers, it is possible that additional
provisions may be needed beyond those necessary to support organic growth of the
loan portfolio.



Total noninterest income decreased $571,000 for the first nine months of 2022,
compared to the same period in 2021, to $6.9 million. Net gains on the sale of
investment securities and a gain on the sale of bank premises in 2021 account
for $322,000 and $190,000, respectively, of the decrease, as those earnings were
not replicated in 2022. Additionally, a BOLI adjustment of $100,000 was recorded
in 2022, as previously discussed. Aside from these individual events, financial
services and secondary market mortgage lending activities were impacted by the
cybersecurity event and the rising interest rate environment, showing
year-over-year revenue declines of $74,000 and $116,000, respectively. These
declines were offset by increased service charge revenue which increased
$299,000, despite a period during the cybersecurity event where service charges
were waived for all accounts.

                                       32





For the nine months ended September 30, 2022, compared to the same period in
2021, total noninterest expense decreased $1.4 million to $19.7 million,
primarily due to a $1.4 million decrease in occupancy and equipment expense that
was driven nearly entirely by the $1.1 million in losses on three former branch
office locations discussed above, which were transferred into other real estate
owned in 2021, partially offset by a similar $195,000 charge recorded in 2022.
Due to the reduction in the number of branch office locations, year-over-year
depreciation expense decreased $286,000. Salaries and benefits increased
$530,000, or 5.6%, to $9.9 million for the comparative nine-month period of 2022
versus 2021, as salary adjustments, accruals for performance bonus and profit
sharing programs, along with costs for new or amended benefits, accounted for
approximately $485,000 of the increase, along with approximately $89,000 of
employee appreciation bonus payments, made to all employees, as a result of
their efforts in addressing the cybersecurity incident.



Income taxes increased $291,000, or 21.5%, to $1.6 million, which generally
correlates to the increase in pretax earnings.

The efficiency ratio, a non-GAAP measure, improved to 71.4% for the first nine
months of 2022 from 77.6.% for the same period of 2021.



Balance Sheet



Total assets increased $33.9 million, or 4.3%, to $828.6 million at September
30, 2022 from $794.6 million at December 31, 2021. This growth was primarily
driven by the FHLB advances, now totaling $25.0 million, and total deposits
which increased $16.4 million, as noninterest-bearing deposits increased $17.8
million while interest-bearing deposits decreased $1.4 million. The year-to-date
deposit activity is due to a combination of factors including customer reaction
to the cybersecurity incident, time deposit customers seeking higher interest
rates and actions taken by customers at the two branch locations closed in
August 2022. The FHLB advance funds were transferred to interest bearing
deposits with other banks which increased $51.6 million year-to-date.



Total investments decreased $8.5 million, or 7.9%, to $98.8 million at September
30, 2022 due primarily to an increase of $16.4 million in net unrealized losses
and $11.5 million of repayments and maturities, which more than offset purchases
of $19.8 million. Future purchases of investment securities will depend on a
number of factors, including changes in loans and deposits, liquidity needs and
the results of the Company's interest rate risk modeling.



Loans decreased $13.9 million, or 2.3% during the first nine months of 2022.
Commercial real estate and multifamily loans decreased $8.1 million or 3.9% and
$4.0 million or 12.1% to $198.1 million and $29.1 million, respectively at
September 30, 2022, as several large commercial loan borrowers liquidated their
holdings in projects we financed and repaid the corresponding loans. These
repayments were partially offset by increases in construction and development
loans, and residential real estate which increased $6.3 million, or 19.4%, and
$2.2 million, or 1.0%, respectively. Commercial loans decreased $9.2 million or
16.9% to $45.1 million at September 30, 2022, due largely to repayments and
forgiveness of PPP loans which declined $6.1 million during the first nine
months of 2022. At September 30, 2022, PPP loans totaled $298 thousand and no
longer represent a significant component of our loan portfolio. Loan
originations, specifically commercial real estate and multi-family loans,
continue to be positively impacted by our Boone, NC, loan production office, as
well as originations in the Kingsport and Johnson City, Tennessee markets.



Total deposits increased $16.4 million, or 2.3%, to $723.9 million at September
30, 2022 from $707.5 million at December 31, 2021, as noninterest bearing
deposits increased $17.8 million, or 7.1%. The increase in noninterest bearing
deposits more than offset a decrease in interest bearing deposits which declined
$1.4 million, or 0.3% during the first nine months of 2022. Despite the net
increase in deposits, we experienced some deposit runoff in response to the
cybersecurity incident. Additionally, other factors also influenced customers'
deposit activities, including interest rates available for time deposits and the
closure of two branch offices in August 2022. Since the closure of the two
branch offices, runoff of accounts from those offices has been minimal, totaling
approximately $555 thousand through September 30, 2022. Additionally, some of
this deposit activity is due to normal churn of deposit accounts and depositors.
Specifically, time deposit runoff totaled $16.6 million, or 8.4%, during the
first nine months of 2022. The decrease in time deposits was offset by increases
in non-interest bearing and interest-bearing transaction accounts which
increased $17.8 million, or 7.1%, and $15.3 million, or 5.9%, during the nine
months ended September 30, 2022. Another factor influencing deposit retention is
the dissipation of liquidity experienced by depositors, as stimulus and other
economic support funds distributed during the height of the COVID-19 pandemic
are spent or otherwise distributed. While it is likely that recent and expected
increases to the federal funds rate will, at some point, impact liquidity, we
continue to maintain core deposits through attractive consumer and commercial
deposit products and strong ties with our customer base and communities.



                                       33


At September 30, 2022, FHLB advances totaling $25 million were outstanding. As
previously discussed, overnight and term advances totaling $95 million were
taken in June 2022, as a precautionary measure related to the cybersecurity
incident with $60 million outstanding as of June 30, 2022. During the third
quarter of 2022, an advance totaling $20.0 million matured and was repaid, and a
$15.0 million partial prepayment was made on the remaining $40.0 million advance
which matures in December 2022. We anticipate repaying the $25.0 million
outstanding advance at maturity. Trust preferred securities of $16.5 million at
September 30, 2022 were unchanged compared to December 31, 2021.



Total equity at September 30, 2022 was $55.2 million, a decrease of $8.4
million, or 13.2%, compared to $63.6 million at December 31, 2021. As discussed
previously and in the Capital Resources section below, the primary driver of the
decline was the $12.9 million net increase in the accumulated other
comprehensive loss, related to the unrealized loss on available for sale
investment securities, along with a cash dividend payment and repurchases of
common shares. The increase in other accumulated comprehensive loss is related
to the recent increase in interest rates and is not related to any deterioration
in the credit quality of any investment securities held.



Asset Quality



Nonperforming assets include nonaccrual loans, other real estate owned (OREO)
and loans past due more than 90 days which are still accruing interest. Our
policy is to place loans on nonaccrual status once they reach 90 days past due.
The makeup of the nonaccrual loans is primarily those secured by residential
mortgages and commercial real estate. OREO is primarily made up of farmland
and
residential lots.



Nonperforming assets decreased $275 thousand, or 6.4%, during the first nine
months of 2022, driven by a decrease in OREO of $1.0 million, which offset an
increase in nonaccrual loans of $765 thousand. The increase in nonaccrual loans
is attributed to a single credit for a commercial construction loan. This
account has been assessed as part of our determination of the adequacy of the
allowance for loan losses, and collection efforts are ongoing. No loans 90 days
or more past due are accruing interest. As a result, the ratio of nonperforming
assets to total assets decreased to 0.49% at September 30, 2022 compared to
0.54% at December 31, 2021.



At September 30, 2022, OREO is primarily made up of farmland and land acquired
through foreclosure. During 2022, two former branch sites that had been
transferred to OREO in 2021, were sold bringing our OREO balance down to $321
thousand. We continue extensive and aggressive measures to work through problem
credits and liquidate foreclosed properties in an effort to reduce nonperforming
assets. We remain mindful of the impact on earnings and capital as we work to
achieve our goal to reduce nonperforming assets. However, we may recognize some
losses and reductions in the allowance for loan loss as we expedite the
resolution of these problem assets.



For detailed information for nonaccrual loans and other real estate owned as of
September 30, 2022, and December 31, 2021, refer to Note 6 Loans and Note 9
Other Real Estate Owned in Item 1 of this Form 10-Q.




Loans rated substandard or below totaled $3.7 million at September 30, 2022, an
increase of $788 thousand from $2.9 million at December 31, 2021. Total past due
loans increased slightly to $3.8 million at September 30, 2022 from $3.4 million
at December 31, 2021. The past due loans at September 30, 2022, represent a
decrease of $6.3 million, or 62.4%, from the $10.0 million reported at June 30,
2022, as delays in loan billing and notice presentation related to the
cybersecurity incident, during the second quarter of 2022, were addressed during
the third quarter.



Our allowance for loan losses at September 30, 2022 was $6.6 million, or 1.14%
of total loans, as compared to $6.7 million, or 1.13% of total loans, at
December 31, 2021. Impaired loans totaled $3.1 million with an estimated related
specific allowance of $269 thousand at September 30, 2022, as compared to $2.8
million of impaired loans with an estimated related allowance of $166 thousand
at the end of 2021. A provision of $400 thousand was recorded for the first nine
months of 2022 compared to $372 thousand during the first nine months of 2021.



In the first nine months of 2022, net charge-offs totaled $542 thousand, or
0.12% of average loans, annualized, as compared to $906 thousand, or 0.21% of
average loans, for the same period in 2021. Of the net charge-offs recorded in
2022, approximately $320 thousand represents overdraft charge-offs resulting
from customer activity during the several days of the cybersecurity event when
we increased daily transaction limits for debit card and ATM activity to meet
customer needs while core services were restored. The allowance for loan losses
is maintained at a level that management deems appropriate to absorb any
potential future losses and known impairments within the loan portfolio, whether
or not the losses are actually ever realized. Through our quarterly assessment,
we continue to adjust the allowance for loan loss model to best reflect the
risks in the portfolio and the improvements made in our internal policies and
procedures; however, future provisions may be deemed necessary. During the first
nine months of 2022, we adjusted our external qualitative factors to reflect
positive employment and home sales statistics, along with adjusting for the
impact of historically high inflation. Those changes along with the assessment
of the inherent and specific risks associated with the loan portfolio resulted
in a provision to the allowance of $400 thousand for the first nine months 2022.
The following table summarizes components of the allowance for loan losses and
related loans as of September 30, 2022 and December 31, 2021:

                                       34







                             Selected Credit Ratios



                                                     September 30,           December 31,
(Dollars in thousands)                                    2022                   2021
Allowance for loan losses                           $        6,593          $       6,735
Total loans                                                579,874                593,744
Allowance for loan losses to total loans                      1.14 %                 1.13 %
Nonaccrual loans                                    $        3,706          $       2,941
Nonaccrual loans to total loans                               0.64 %       

0.50 %


Ratio of allowance for loan losses to
nonaccrual loans                                              1.78 X                 2.29 X

Charge-offs net of recoveries                       $          542          $         828
Average loans                                       $      594,534          $     586,963
Net charge-offs to average loans                              0.12 %       
         0.14 %






We are in the process of implementing the Current Expected Credit Loss (CECL)
model to replace our legacy loan loss model. While we had estimated we would be
running concurrent models by June 30, 2022, due to the cybersecurity incident,
we delayed the start of parallel runs, which began late in the third quarter of
2022. Initial CECL model runs have occurred using only historical loss
information. Initial assumptions have been input and are being layered onto the
initial runs of historical loan and loss activity. The Company will run the new
methodology parallel to the current allowance methodology for the first three
quarters of 2022 before full implementation. In addition, we have retained a
third-party vendor to perform a validation of the CECL model implementation.



Deferred Tax Asset and Income Taxes

Due to timing differences between book and tax treatment of several income and
expense items, a net deferred tax asset, excluding the deferred tax asset on the
unrealized loss on securities available for sale, of $916 thousand and $1.5
million existed at September 30, 2022 and December 31, 2021, respectively. Our
income tax expense was computed at the corporate income tax rate of 21% of
taxable income. We have no significant nontaxable income or nondeductible
expenses.



Capital Resources


Total shareholders' equity at September 30, 2022 was $55.2 million compared to
$63.6 million at December 31, 2021, a decrease of $8.4 million, or 13.2%. As
previously discussed, this decline was driven by the $12.9 million net increase
in the accumulated other comprehensive loss related to the unrealized loss on
investment securities available-for-sale. Excluding the impact of the unrealized
loss, equity increased $4.5 million, due to net income of $5.8 million less the
cash dividend payment of $1.2 million and $103 thousand used for share
repurchases.



The Company meets the eligibility criteria to be classified as a small bank
holding company in accordance with the Federal Reserve's Small Bank Holding
Company Policy Statement issued in February 2015 and is therefore not obligated
to report consolidated regulatory capital. The Bank continues to be subject to
various capital requirements administered by banking agencies.



The Bank’s capital ratios along with the minimum regulatory thresholds to be
considered well-capitalized are presented at Note 4 in Item 1 of this Form 10-Q.




At September 30, 2022, the Bank remains well capitalized under the regulatory
framework for prompt corrective action. The ratios mentioned above for the Bank
comply with the Federal Reserve rules to align with the Basel III Capital
requirements.



Book value per common share was $2.31 at September 30, 2022, and $2.66 at
December 31, 2021. Excluding the impact of the accumulated other comprehensive
loss, book value per share was $2.89 and $2.69 at September 30, 2022 and
December 31, 2021, respectively. Other key performance indicators are as
follows:





                                       35







                                 Three months ended September 30,     Nine months ended September 30,
                                       2022             2021               2022             2021
Return on average assets1             0.94%            0.91%              0.95%            0.85%
Return on average equity1             13.70%           11.75%             13.15%           11.30%
Average equity to average assets      6.84%            7.76%              7.21%            7.56%




1 - Annualized


Under current economic conditions, we believe it is prudent to continue to
retain capital sufficient to support planned asset growth while being able to
absorb potential losses that may occur if asset quality deteriorates, and based
upon projections, we believe our current capital levels will be sufficient.



During the first quarter of 2022, the Company paid its first cash dividend of
$0.05 per common share to our shareholders. Earnings will continue to be
retained to provide capital to support the planned growth and operations of the
Company and to continue to pay any future dividends to shareholders.



During the second quarter of 2022, the board of directors of the Company
authorized the repurchase of up to 500,000 shares of the Company's outstanding
common stock through March 31, 2023. The actual means and timing of any
purchases, number of shares and prices or range of prices will be determined by
the Company in its discretion and will depend on a number of factors, including
the market price of the Company's common stock, general market and economic
conditions, and applicable legal and regulatory requirements. During the third
quarter of 2022, 26,831 shares were purchased at an average price of $2.32 per
share; bringing the total shares repurchased through September 30, 2022 to
44,485 at an average price of $2.30 per share. There is no assurance that the
Company will purchase any additional shares under this program.



Liquidity


As discussed previously, in response to the cybersecurity incident, during the
second quarter of 2022, we took efforts to increase on balance sheet liquidity
through a series of FHLB advances transferred to our account at Federal Reserve
Bank and pledging additional investment securities as collateral against unused
funding sources for emergency needs. The deposit runoff since the cybersecurity
incident has not been significant. Based on the customer response and an
assessment of our overall liquidity, during the third quarter of 2022, we repaid
a maturing FHLB advance totaling $20.0 million, and partially prepaid $15.0
million on the remaining $40.0 million advance. We closely monitor our liquidity
and our liquid assets in the form of cash, due from banks, federal funds sold,
and unpledged available for sale investments. Collectively, those balances were
$185.5 million at September 30, 2022, an increase of $26.2 million from $159.3
million at December 31, 2021. A surplus of short-term assets is maintained at
levels management deems adequate to meet potential liquidity needs during 2022.



At September 30, 2022, all of our investment securities were classified as
available-for-sale. These investments provide a source of liquidity in the
amount of $70.5 million, which is net of the $28.3 million of securities pledged
as collateral. Investment securities available for sale serve as a source of
liquidity while yielding a higher return versus other short-term investment
options, such as federal funds sold and overnight deposits with the Federal
Reserve Bank. Due to the increase in the unrealized loss on securities available
for sale, the sale of investments would not be considered a primary source of
liquidity due to the immediate impact on regulatory capital; however, the
majority of the portfolio is considered high credit quality investments and
would be available to pledge against borrowings.



Our loan to deposit ratio was 80.1% at September 30, 2022 and 83.9% at December
31, 2021. We anticipate this ratio to remain at or below 90% for the foreseeable
future.



Available third-party sources of liquidity at September 30, 2022 include the
following: a line of credit with the FHLB, access to brokered certificates of
deposit markets and the discount window at the Federal Reserve Bank. We also
have the ability to borrow $30.0 million in unsecured federal funds through
credit facilities extended by correspondent banks.



The Bank's line of credit with the FHLB is $211.7 million, with unused
availability at September 30, 2022 of $179.7 million. FHLB advances totaling $25
million were outstanding at September 30, 2022, but the credit line also secures
a letter of credit totaling $7.0 million. The available line and the outstanding
letters of credit are secured by a blanket lien on our residential real estate
loans which amounted to $123.2 million at September 30, 2022.

                                       36





The Bank also has access to the brokered deposits market and the Certificate of
Deposit Registry Service (CDARS). At September 30, 2022, we held no brokered
deposits while $2.8 million in CDARS reciprocal time deposits and $23.1 million
in ICS reciprocal interest-bearing demand deposits are outstanding.



Additional liquidity is available through the Federal Reserve Bank discount
window for overnight funding needs. We may collateralize this line with
investment securities and loans at our discretion; however, while we do not
anticipate using this as a primary funding source, securities with an estimated
market value of $24.4 million were pledged at September 30, 2022.

With the on-balance sheet liquidity and other external sources of funding, we
believe the Bank has adequate liquidity and capital resources to meet our
requirements and needs for the foreseeable future. However, liquidity can be
further affected by a number of factors such as counterparty willingness or
ability to extend credit, regulatory actions and customer preferences, etc.,
some of which are beyond our control.



The bank holding company has approximately $371 thousand in cash on deposit at
the Bank at September 30, 2022. The holding company receives periodic dividend
payments from the Bank which are used to pay operating expenses, to pay trust
preferred interest payments, and to fund dividend payments to shareholders and
repurchase shares. The Company makes quarterly interest payments on the trust
preferred securities.



As discussed in the Capital Resources section, the Company authorized the
repurchase of up to 500,000 shares of the Company's outstanding common stock
through March 31, 2023. Payments for any repurchases will be distributed from
available funds, or from dividend payments from the Bank, and are not expected
to have a material impact on available liquidity.



Off Balance Sheet Items and Contractual Obligations

There have been no material changes during the nine months ended September 30,
2022, to the off-balance sheet items and the contractual obligations disclosed
in our 2021 Form 10-K.

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