**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K**

 

**(Mark One)**

 

**ý**** ****ANNUAL REPORT PURSUANTTO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2005**

 

**OR**

 

**o**** TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from              to              .**

 

**Commission File Number 000-51281**

 

**TennesseeCommerce Bancorp, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Tennessee**                                                 | ** ** | **62-1815881**       |
|---------------------------------------------------------------|------------|----------------------|
| (State or  other jurisdiction                                 |       | (I.R.S.  Employer    |
| of  incorporation or organization)                            |       | Identification  No.) |
|                                                          |       |                 |
| **381  Mallory Station Road, Suite 207, Franklin, Tennessee** | ** ** | **37067**            |
| (Address of  principal executive offices)                     |       | (Zip Code)           |

 

Registrant’s telephone number, including areacode  **(615)599-2274**

 

Securities registered pursuant to Section12(b) of the Act:  **None**

 

Securities registered pursuant to Section12(g) of the Act:  **CommonStock, $0.50 par value per share**

 

Indicate by check mark if the registrant is awell-known, seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý

 

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) of theAct. Yes o No ý

 

Indicate by check mark whether registrant (1)has filed reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:  Yes ý  No o.

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K.  ý

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, or a non-accelerated filer.See definition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

(Check one): Large accelerated filer  o   Accelerated filer  o    Non-accelerated filer ý

 

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

 

The aggregate market value of the registrant’svoting stock held by non-affiliates of the registrant at March 8, 2006 was $34.7million, based upon the average sale price on that date.

 

 

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TABLE OFCONTENTS

 
| **PART I**    |
|---------------|
|          |
| ITEM 1.       | BUSINESS | 1 |
| ITEM 1A.      | RISK FACTORS | 16 |
| ITEM 1B.      | UNRESOLVED  STAFF COMMENTS | 20 |
| ITEM 2.       | PROPERTIES | 21 |
| ITEM 3.       | LEGAL  PROCEEDINGS | 21 |
| ITEM 4.       | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS | 21 |
|          |
| **PART II**   |
|          |
| ITEM 5.       | MARKET FOR  REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES  OF EQUITY SECURITIES | 21 |
| ITEM 6.       | SELECTED  FINANCIAL DATA | 24 |
| ITEM 7.       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION | 26 |
| ITEM 7A.      | QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISK | 45 |
| ITEM 8.       | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA | 48 |
| ITEM 9.       | CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE | 48 |
| ITEM 9A.      | CONTROLS AND PROCEDURES | 48 |
| ITEM 9B.      | OTHER INFORMATION | 48 |
|          |   |   |
| **PART  III** |
|          |   |   |
| ITEM 10.      | DIRECTORS AND EXECUTIVE OFFICERS OF THE  REGISTRANT | 49 |
| ITEM 11.      | EXECUTIVE COMPENSATION | 49 |
| ITEM 12.      | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS | 49 |
| ITEM 13.      | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS | 49 |
| ITEM 14.      | PRINCIPAL ACCOUNTANT FEES AND SERVICES | 49 |
|          |   |   |
| **PART  IV**  |
|          |   |   |
| ITEM 15.      | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES | 49 |

 

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**PARTI**

 

**ITEM 1.**                  BUSINESS

 

**General**

 

Tennessee Commerce Bancorp, Inc. (the “Corporation”)is a one bank holding company formed as a Tennessee corporation to own theshares of Tennessee Commerce Bank (the”Bank”). The Bank commenced operations January14, 2000, and is a full service financial institution located in Franklin,Tennessee, fifteen miles south of Nashville. Franklin is in Williamson County,one of the most affluent and rapidly growing counties in the nation and theBank conducts business from a single location in the Cool Springs commercialarea of Franklin. The Bank had total assets at December 31, 2005, of $404million. Although the Bank offers a full range of banking services andproducts, it operates with a focused “Business Bank” strategy.  The Business Bank strategy emphasizes bankingservices for small to medium sized businesses, entrepreneurs, and professionalsin the local market. The Bank competes by combining the personal service and appealof a community bank institution with the sophistication and flexibility of alarger bank.  This strategy distinguishesthe Bank from its competitors in efforts to attract loans and deposits of localbusinesses. In addition, the Bank accesses a national market through a networkof financial service companies and vendor partners that provide indirectfunding opportunities for the Bank nationwide.

 

The Bank does not competebased on the traditional definition of “convenience” and does not have a branchnetwork for that purpose. Business is conducted from a single office with noteller line, drive-through window or extended banking hours.  The Bank competes by providing responsive andpersonalized service to meet customer needs. Convenience is created by technology and by a free courier service whichtransports deposits directly from the local business location to the Bank.  The Bank provides free electronic banking andcash management tools and on-site training for business customers.  The Bank competes for local consumer businessby providing superior products, attractive deposit rates, free Internet Bankingservices, and access to a third party regional ATM network. The Bank targetsservice, manufacturing, and professional customers and avoids retail businesseswith high transaction volume.

 

The Bank offers a full rangeof competitive retail and commercial banking services.  The deposit services offered include varioustypes of checking accounts, savings accounts, money market investment accounts,certificates of deposits, and retirement accounts.  Lending services include consumer installmentloans, various types of mortgage loans, personal lines of credit, home equityloans, credit cards, real estate construction loans, commercial loans to smalland medium size businesses and professionals, and letters of credit. The Bankissues VISA credit cards and is a merchant depository for cardholder draftsunder VISA credit cards.  The Bank alsooffers check cards and debit cards.  TheBank offers its local customers courier services, access to third-partyautomated teller machines (“ATMs”), and state of the art electronic banking.The Bank has trust powers but does not have a trust department.

 

The Business Bank strategyis evident in differences between the financial statements of the Bank and moretraditional financial institutions.   TheBusiness Bank model creates a high degree of leverage.  By avoiding the investment and maintenancecosts of a typical branch network, the Bank is able to maintain Earning Assetsat a higher level than peer institutions. Management targets a minimum Earning Asset Ratio of 97% compared to theaverage of 90 to 92% for all FDIC insured banks. Assets of the Bank arecentered in the loan portfolio which consists primarily of commercial andindustrial loans.  Management targets aloan mix of 60% commercial loans and 40% real estate.  At December 31, 2005, the composition of the$348 million loan portfolio was 67.11% commercial, 30.70% secured by realestate (both commercial and consumer), and 2.19% in consumer and credit card loans.

 

The Bankoffers a full range of loan products to local consumers and businesses.  Consumer products include secured andunsecured lines of credit, term loans, and credit cards.  Loans secured by real estate includeconstruction and acquisition loans in the form of 1st and 2ndmortgage term loans and home equity lines. The Bank specializes in lending to businesses.  Customized business loans include lines ofcredit and term loans secured by accounts receivable, inventory, equipment, andreal estate.  Commercial real estateproducts include acquisition and construction loans for business properties andterm loan financing of commercial real estate. The Bank additionally offers Letters of Credit and business creditcards.

 

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In addition tolending in the local marketplace, the Bank providescollateral-based loans to business borrowers located in other states throughtwo types of indirect funding programs. In both programs, the transactions areoriginated by a third party, such as an equipment vendor or financial servicescompany, who provides the Bank with a borrower’s financial information andarranges for a borrower’s execution of loan documentation. The Bank funds these transactions earningstrong yields and has no servicing expense or residual risk in any transactionoriginated by these financial service companies and vendors. The Bank hasmanagement and personnel who are experienced in the leasing industry and are ableto evaluate and partner effectively with the companies who originate these leasingtransactions. All indirect funding is secured by the business assetfinanced, and is subject to the Bank’s minimum credit score and documentationstandards.  These indirect funding transactions providegeographic and collateral diversity for the portfolio and representapproximately 39.93% of the total loan portfolio at December 31, 2005.

 

The twoindirect funding programs fund different size loans through two differentnetworks. In the first type, the Bank uses an established network of financialservice companies and vendor partners that provide the Bank indirect funding opportunitiesnationwide to national middle-market and investment grade companies. AtDecember 31, 2005, the average size of this type of loan in the loan portfoliowas $156,000 and earned an average yield of 8.32%. This type of indirectfunding represents approximately 14.96% of the $349 million total loanportfolio.  In the second type ofindirect funding program, the Bank partners with a second network of financialservice companies and vendors located in Tennessee, Alabama, Georgia, Californiaand Michigan. This indirect funding program is for smaller transactions. Theseloans that finance business assets are less than $125,000 at origination. Management has installed a standardizedcredit approval process which delivers quick responsive service. AtDecember 31, 2005, the average size of this type of loan in the loan portfoliowas $40,000, ranging from $3,000 to $125,000, and the average yield on theseloans was 9.10%. This type of indirect funding represents approximately 24.98%of the $349 million total loan portfolio.

 

Management believes theBusiness Bank model is highly efficient. The Bank targets the non-retail sector of the commercial market which ischaracterized by lower levels of transactions and processing costs.  The commercial customer mix and the strategicoutsourcing of certain administrative functions, such as data processing, allowthe Bank to operate with a smaller, more highly trained staff.  Management targets an average asset peremployee ratio of $7.5 million compared to the average of less than $2.91million in assets per employee for Tennessee state chartered banks at the endof the third quarter 2005. The Bank also promotes the use of technology, bothinternally and externally, to maximize the efficiency of operations.  Management targets an operating efficiencyratio (total operating expense divided by total revenue) of 40% to 45%.

 

The Bank is subject to theregulatory authority of the Department of Financial Institutions of the Stateof Tennessee (“TDFI”) and the Federal Deposit Insurance Corporation (“FDIC”).

 

The Bank’s principalexecutive offices are located at 381 Mallory Station Road, Suite 207, Franklin,Tennessee 37067, and its telephone number is (615) 599-2274.

 

The Corporation wasincorporated on March 22, 2000, for the purpose of acquiring 100% of the sharesof the Bank by means of a share exchange, and becoming a registered bankholding company under the Federal Reserve Act. The share exchange was completed on May 31, 2000.  The activities of the Corporation are subjectto the supervision of the Boardof Governors of the Federal Reserve System (“Federal Reserve Board”).  The offices of the Corporation are the sameas the principal office of the Bank.  OnMarch 29, 2005, the Corporation formed a wholly owned subsidiary, TennesseeCommerce Bank Statutory Trust I, (the “Trust I”). The Bank and the Trust I arethe only subsidiaries of the Corporation. At this time, the Corporation has no plans to conduct any business apartfrom the activities of the Bank. TheBank commenced operations as a Tennessee state chartered bank on January 14,2000, and is headquartered in Franklin, Tennessee.

 

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# **Market Area and Competition**

 

All phases ofthe Bank’s business are highly competitive. The Bank is subject to intense competition from various financialinstitutions and other companies or firms that offer financial services.  The Bank competes for deposits with othercommercial banks, savings and loan associations, credit unions and issuers ofcommercial paper and other securities, such as money-market and mutualfunds.  In making loans, the Bank isexpected to compete with other commercial banks, savings and loan associations,consumer finance companies, credit unions, leasing companies, and otherlenders.

 

The Bank’sprimary market area is Davidson County and Williamson County in Tennessee.  In Davidson County, as of June 30, 2005,there were 21 banks and no savings and loan institutions, with at least 175offices actively engaged in banking activities, including 9 major state-widefinancial institutions.  Total depositsheld by banks in Davidson County as of June 30, 2005, were approximately $13.9billion.  In Williamson County, as ofJune 30, 2005, there were 18 banks and 2 savings and loan institutions, with atleast 72 offices actively engaged in banking activities, including 9 majorstate-wide financial institutions.  Totaldeposits held by banks and savings and loan associations in Williamson Countyas of June 30, 2005, were approximately $3.7 billion.  In addition, there are numerous creditunions, finance companies, and other financial services providers.

 

Demographicinformation published by Williamson Works, Inc., a privately funded groupaffiliated with the Williamson County Office of Economic Development, shows atotal estimated population of 150,607 for Williamson County in 2005. That is a18.92% increase from 126,638 in 2000. The estimated number of households in thecounty in 2005 is 52,154 up from 44,725 in 2000, averaging 2.89 persons perhousehold. In 2005, the median household income was $69,104, while per capitaincome was $32,496.  At the end of 2005,the unemployment rate was 2.9%.

 

Demographicinformation published by the Tennessee Department of Economic & CommunityDevelopment shows an estimated population of 570,911 for Davidson County in2005. That is a 0.18% increase over the population of 569,891 in 2000. Theestimated number of households in the county in 2005 is 230,513 averaging 2.48persons per household. In 2005, the median household income was $39,797, whileper capita income was $23,069.  At theend of 2005, the unemployment rate was 4.1%.

 

**Employees**

 

At December 31, 2005, theBank employed 41 persons on a full-time basis. The Bank’s employees are notrepresented by any union or other collective bargaining agreement and managementof the Bank believes its employee relations are satisfactory.

 

# **Supervision and Regulation**

#  

**BankHolding Company Regulation**

 

The Corporation is a bankholding company within the meaning of the Bank Holding Company Act of 1956, asamended (the “Holding Company Act”), and is registered with the Federal ReserveBoard.  Its banking subsidiaries aresubject to restrictions under federal law which limit the transfer of funds bythe subsidiary banks to their respective holding companies and nonbankingsubsidiaries, whether in the form of loans, extensions of credit, investments,or asset purchases.  Such transfers byany subsidiary bank to its holding company or any non-banking subsidiary arelimited in amount to 10% of the subsidiary bank’s capital and surplus and, withrespect to the Corporation and all such nonbanking subsidiaries, to anaggregate of 20% of such bank’s capital and surplus.  Furthermore, such loans and extensions ofcredit are required to be secured in specified amounts.  The Holding Company Act also prohibits,subject to certain exceptions, a bank holding company from engaging in oracquiring direct or indirect control of more than 5% of the voting stock of anycompany engaged in non banking activities. An exception to this prohibition is for activities expressly found bythe Federal Reserve Board to be so closely related to banking or managing orcontrolling banks as to be a proper incident thereto or financial in nature.

 

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As a bank holding company,the Corporation is required to file with the Federal Reserve Board semi-annualreports and such additional information as the Federal Reserve Board mayrequire.  The Federal Reserve Board alsomakes examinations of the Corporation.

 

According to Federal ReserveBoard policy, bank holding companies are expected to act as a source offinancial strength to each subsidiary bank and to commit resources to supporteach such subsidiary.  This support maybe required at times when a bank holding company may not be able to providesuch support.  Furthermore, in the eventof a loss suffered or anticipated by the FDIC - either as a result of defaultof a banking or thrift subsidiary of the Corporation or related to FDICassistance provided to a subsidiary in danger of default - the other bankingsubsidiaries of the Corporation may be assessed for the FDIC’s loss, subject tocertain exceptions.

 

Various federal and statestatutory provisions limit the amount of dividends the subsidiary banks can payto their holding companies without regulatory approval.  The payment of dividends by any bank also maybe affected by other factors, such as the maintenance of adequate capital forsuch subsidiary bank.  In addition to theforegoing restrictions, the Federal Reserve Board has the power to prohibitdividends by bank holding companies if their actions constitute unsafe orunsound practices.  The Federal ReserveBoard has issued a policy statement on the payment of cash dividends by bankholding companies, which expresses the Federal Reserve Board’s view that a bankholding company experiencing earnings weaknesses should not pay cash dividendsthat exceed its net income or that could only be funded in ways that weaken thebank holding company’s financial health, such as by borrowing.  Furthermore, the TDFI also has authority toprohibit the payment of dividends by a Tennessee bank when it determines suchpayment to be an unsafe and unsound banking practice.

 

A bank holding company andits subsidiaries are also prohibited from acquiring any voting shares of, orinterest in, any banks located outside of the state in which the operations ofthe bank holding company’s subsidiaries are located, unless the acquisition isspecifically authorized by the statutes of the state in which the target islocated.  Further, a bank holding companyand its subsidiaries are prohibited from engaging in certain tie-inarrangements in connection with the extension of credit or provision of anyproperty or service.  Thus, an affiliateof a bank holding company may not extend credit, lease or sell property, orfurnish any services or fix or vary the consideration for these on thecondition that (i) the customer must obtain or provide some additional credit,property or services from or to its bank holding company or subsidiariesthereof or (ii) the customer may not obtain some other credit, property, orservices from a competitor, except to the extent reasonable conditions areimposed to assure the soundness of the credit extended.

 

In approving acquisitions bybank holding companies of banks and companies engaged in the banking-relatedactivities described above, the Federal Reserve Board considers a number offactors, including the expected benefits to the public such as greaterconvenience, increased competition, or gains in efficiency, as weighed againstthe risks of possible adverse effects such as undue concentration of resources,decreased or unfair competition, conflicts of interest, or unsound bankingpractices.  The Federal Reserve Board isalso empowered to differentiate between new activities and activities commencedthrough the acquisition of a going concern.

 

The Attorney General of theUnited States may, within 30 days after approval by the Federal Reserve Boardof an acquisition, bring an action challenging such acquisition under thefederal antitrust laws, in which case the effectiveness of such approval isstayed pending a final ruling by the courts. Failure of the Attorney General to challenge an acquisition does not,however, exempt the holding company from complying with both state and federalantitrust laws after the acquisition is consummated or immunize the acquisitionfrom future challenge under the anti-monopolization provisions of the ShermanAct.

 

## Capital Guidelines

 

The Federal Reserve Boardhas risk based capital guidelines for bank holding companies and memberbanks.  Under the guidelines, the minimumratio of capital to risk weighted assets (including certain off balance sheetitems, such as standby letters of credit) is 8%.  To be considered a “well capitalized” bank orbank holding company under the guidelines, a bank or bank holding company musthave a total risk based capital ratio in excess of 10%.  At December 31, 2005, on a pro forma basis,the Corporation would have been sufficiently capitalized to be considered “wellcapitalized”.

 

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At least half of the totalcapital is to be comprised of common equity, retained earnings, and a limitedamount of perpetual preferred stock, after subtracting goodwill and certainother adjustments (“Tier I capital”). The remainder may consist of perpetual debt, mandatory convertible debtsecurities, a limited amount of subordinated debt, other preferred stock notqualifying for Tier I capital, and a limited amount of loan loss reserves (“TierII capital”).  The Bank is subject tosimilar capital requirements adopted by the FDIC.  In addition, the Federal Reserve Board andthe FDIC have adopted a minimum leverage ratio (Tier I capital to total assets)of 3%.  Generally, banking organizationsare expected to operate well above the minimum required capital level of 3%unless they meet certain specified criteria, including that they have thehighest regulatory ratings. Most banking organizations are required to maintaina leverage ratio of 3%, plus an additional cushion of at least 1% to 2%.  State regulatory authorities and the FDICencourage most community banks to maintain a leverage ratio of 6.5% to 7.0%;the Bank’s leverage ratio at December 31, 2005, was 9.1%.  The guidelines also provide that bankingorganizations experiencing internal growth or making acquisitions will beexpected to maintain strong capital positions substantially above the minimumsupervisory levels without significant reliance upon intangible assets.

 

Under the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), failureto meet the capital guidelines could subject a banking institution to a varietyof enforcement remedies available to federal regulatory authorities, includingthe termination of deposit insurance by the FDIC.

 

## Sarbanes-Oxley Act of 2002

 

On July 30,2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. Thislegislation represents a comprehensive revision of laws affecting corporategovernance, accounting obligations and corporate reporting. The Sarbanes-OxleyAct is applicable to all companies with equity securities registered, or thatfile reports under the Securities Exchange Act of 1934.  In particular, the act establishes (i) newrequirements for audit committees, including independence, expertise andresponsibilities; (ii) additional responsibilities regarding financialstatements for the chief executive officer and chief financial officer of thereporting company and new requirements for them to certify the accuracy ofperiodic reports; (iii) new standards for auditors and regulation of audits;(iv) increased disclosure and reporting obligations for the reporting companyand its directors and executive officers, including an accelerated time framefor reporting of insider transactions; and (v) new and increased civil andcriminal penalties for violations of the federal securities laws. Thelegislation also established a new accounting oversight board to enforceauditing standards and restrict the scope of services that accounting firms mayprovide to their public company audit clients.

 

Because theCorporation’s common stock is registered with the SEC, it will become subjectto the requirements of this legislation. At the present time, and subject to the final rules and regulations tobe adopted and issued by the SEC, management anticipates that the Corporationwill incur additional expense as a result of the act but does not expect thatthe Corporation’s compliance will have a material impact on its business. Tothe extent that the Corporation has already implemented the requirements ofthis legislation and the related regulations, compliance has been accomplishedwith existing Corporation personnel.

 

TheCorporation files periodic reports with the SEC. The public may read and copyany materials the Corporation files with the SEC at the SEC’s Public ReferenceRoom at 450 Fifth Street, N.W., Washington, D.C. 20549.  Information regarding the PublicReference Room may be obtained by calling the SEC at 1-800-SEC-0330.  The SEC also maintains an Internet site thatcontains reports, proxy and information statements, and other informationregarding the Corporation that the Corporation files electronically with theSEC.  This information may be found at www.sec.govand a link to the same information may be found on the Bank’s website atwww.tncommercebank.com under the Investor Relations heading.

 

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**TennesseeBanking Act; Federal Deposit Insurance Act**

 

The Bank is a Tennesseestate-chartered bank and is subject to the regulations of and supervision bythe FDIC as well as the TDFI, Tennessee’s state banking authority.  The Bank is also subject to variousrequirements and restrictions under federal and state law, includingrequirements to maintain reserves against deposits, restrictions on the typesand amounts of loans that may be granted and the interest that may be chargedthereon and limitations on the types of investments that may be made and thetypes of services that may be offered. Various consumer laws and regulations also affect the operations of theBank.  In addition to the impact ofregulation, commercial banks are affected significantly by the actions of theFederal Reserve Board as it attempts to control the money supply and creditavailability in order to influence the economy.

 

From time to time,legislation is enacted which has the effect of increasing the cost of doingbusiness, limiting or expanding permissible activities or affecting thecompetitive balance between banks and other financial institutions.  Proposals to change the laws and regulationsgoverning the operations and taxation of banks, bank holding companies andother financial institutions are frequently made in Congress, in the Tennesseelegislature and before various bank regulatory and other professionalagencies.  The likelihood of any majorlegislative changes and the impact such changes might have on the Bank areimpossible to predict.

 

## General

 

The Bank, as a Tennesseestate chartered bank, is subject to primary supervision, periodic examinationand regulation by the Commissioner of the TDFI (“Commissioner”) and theFDIC.  If, as a result of an examinationof a bank, the FDIC should determine that the financial condition, capitalresources, asset quality, earnings prospects, management, liquidity or otheraspects of the Bank’s operations are unsatisfactory or that the Bank or itsmanagement is violating or has violated any law or regulation, various remediesare available to the FDIC.  Such remediesinclude the power to enjoin “unsafe or unsound” practices, to requireaffirmative action to correct any conditions resulting from any violation orpractice, to issue an administrative order that can be judicially enforced, todirect an increase in capital, to restrict the growth of the Bank, to assesscivil monetary penalties, to remove officers and directors and ultimately toterminate a Bank’s deposit insurance. The Commissioner has many of the same remedial powers, including thepower to take possession of a bank whose capital becomes impaired.  As of December 31, 2005, the Bank is not thesubject of any such action by the FDIC or the Commissioner.

 

The deposits of the Bank areinsured by the FDIC in the manner and to the extent provided by law.  For this protection, the Bank pays asemiannual statutory assessment. Although the Bank is not a member of the Federal Reserve System, it isnevertheless subject to certain regulations of the Federal Reserve Board.

 

Various requirements andrestrictions under the laws of the State of Tennessee and the United Statesaffect the operations of the Bank.  Stateand federal statutes and regulations relate to many aspects of the Bank’soperations, including reserves against deposits, interest rates payable ondeposits, loans, investments, mergers and acquisitions, borrowings, dividends,locations of branch offices and capital requirements.  Furthermore, the Bank is required to maintaincertain levels of capital.

 

Tennessee lawcontains limitations on the interest rates that may be charged on various typesof loans and restrictions on the nature and amount of loans that may be grantedand on the types of investments which may be made.  The operations of banks are also affected byvarious consumer laws and regulations, including those relating to equal creditopportunity and regulation of consumer lending practices.  All Tennessee banks must become and remaininsured banks under the Federal Deposit Insurance Act (FDIA). (See 12 U.S.C.§1811, et seq.).

 

## Payment of Dividends

 

The Bank is subject to theTennessee Banking Act, which limits a bank’s ability to pay dividends.  The payment of dividends by any bank isdependent upon its earnings and financial condition and subject to thestatutory power of certain federal and state regulatory agencies to act toprevent what they deem unsafe or unsound banking practices.  The payment of dividends could, dependingupon the financial condition of the Bank, be deemed to constitute such anunsafe or unsound banking practice. Under Tennessee law, the board of directors of a state bank may notdeclare dividends in any calendar year that exceeds the total of its retainednet income of the preceding two (2) years without the prior approval of theTDFI.  The FDIA prohibits a state bank,the deposits of which are insured by the FDIC, from paying dividends if it isin default in the payment of any assessments due the FDIC.  The Bank is also subject to the minimumcapital requirements of the FDIC which impact the Bank’s ability to paydividends.  If the Bank fails to meetthese standards, it may not be able to pay dividends or to accept additionaldeposits because of regulatory requirements.

 

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If, in the opinion of theapplicable federal bank regulatory authority, a depository institution isengaged in or is about to engage in an unsafe or unsound practice (which,depending on the financial condition of the depository institution, couldinclude the payment of dividends), such authority may require that suchinstitution cease and desist from such practice.  The federal banking agencies have indicatedthat paying dividends that deplete a depository institution’s capital base toan inadequate level would be such an unsafe or unsound banking practice.  Moreover, the Federal Reserve Board, theComptroller of the Currency and the FDIC have issued policy statements whichprovide that bank holding companies and insured depository institutionsgenerally should only pay dividends out of current operating earnings.

 

The payment of dividends bythe Bank may also be affected or limited by other factors, such as therequirement to maintain adequate capital above regulatory guidelines.

 

## FIRREA

 

Congressenacted the Financial Institutions Reform, Recovery and Enforcement Act of 1989(“FIRREA”) on August 9, 1989.  FIRREAprovides that a depository institution insured by the FDIC can be held liablefor any loss incurred by, or reasonably expected to be incurred by, the FDICafter August 9, 1989 in connection with (i) the default of a commonlycontrolled FDIC insured depository institution or (ii) any assistance providedby the FDIC to a commonly controlled FDIC insured depository institution indanger of default.  FIRREA provides thatcertain types of persons affiliated with financial institutions can be fined bythe federal regulatory agency having jurisdiction over a depository institutionwith federal deposit insurance (such as the Bank) up to $1 million per day foreach violation of certain regulations related (primarily) to lending to and transactionswith executive officers, directors, principal shareholders and the interests ofthese individuals.  Other violations mayresult in civil money penalties of $5,000 to $30,000 per day or in criminalfines and penalties.  In addition, theFDIC has been granted enhanced authority to withdraw or to suspend depositinsurance in certain cases.

 

## FDICIA

 

The Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”) which was enacted onDecember 19, 1991, substantially revised the depository institution regulatoryand funding provisions of the FDIA and made revisions to several other federalbanking statutes.  Among other things,FDICIA requires the federal banking regulators to take “prompt correctiveaction” in respect of FDIC-insured depository institutions that do not meetminimum capital requirements. FDICIA establishes five capital tiers: “wellcapitalized,” “adequately capitalized,” “undercapitalized,” “significantlyundercapitalized” and “critically undercapitalized.”  Under applicable regulations, a FDIC-insureddepository institution is defined to be well capitalized if it maintains aLeverage Ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least6% and a Total Capital Ratio of at least 10% and is not subject to a directive,order or written agreement to meet and maintain specific capital levels.  An insured depository institution is definedto be adequately capitalized if it meets all of its minimum capitalrequirements as described above.  Inaddition, an insured depository institution will be considered undercapitalizedif it fails to meet any minimum required measure, significantlyundercapitalized if it is significantly below such measure and criticallyundercapitalized if it fails to maintain a level of tangible equity equal tonot less than 2% of total assets.  Aninsured depository institution may be deemed to be in a capitalization categorythat is lower than is indicated by its actual capital position if it receivesan unsatisfactory examination rating.

 

The capital-based promptcorrective action provision of FDICIA and their implementing regulations applyto FDIC-insured depository institutions and are not directly applicable toholding companies which control such institutions.  However, the Federal Reserve Board hasindicated that, in regulating bank holding companies, it will take appropriateaction at the holding company level based on an assessment of the effectivenessof supervisory actions imposed upon subsidiary depository institutions pursuantto such provisions and regulations.

 

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FDICIA generally prohibitsan FDIC-insured depository institution from making any capital distribution(including payment of dividends) or paying any management fee to its holdingcompany if the depository institution would thereafter be undercapitalized.  Undercapitalized depository institutions aresubject to restrictions on borrowing from the Federal Reserve System.  In addition, undercapitalized depositoryinstitutions are subject to growth limitations and are required to submitcapital restoration plans.  A depositoryinstitution’s holding company must guarantee the capital plan, up to an amountequal to the lesser of 5% of the depository institution’s assets at the time itbecomes undercapitalized or the amount of the capital deficiency when theinstitution fails to comply with the plan. The federal banking agencies may not accept a capital plan withoutdetermining, among other things, that the plan is based on realistic assumptionsand is likely to succeed in restoring the depository institution’scapital.  If a depository institutionfails to submit an acceptable plan, it is treated as if it is significantlyundercapitalized.

 

Significantlyundercapitalized depository institutions may be subject to a number ofrequirements and restrictions, including orders to sell sufficient voting stockto become adequately capitalized, requirements to reduce total assets andcessation of receipt of deposits from correspondent banks.  Critically undercapitalized depositoryinstitutions are subject to appointment of a receiver or conservator generallywithin 90 days of the date on which they became critically undercapitalized.

 

Management of the Bank believesthat at December 31, 2005, the Bank was well capitalized under the criteriadiscussed above.

 

FDICIA contains numerousother provisions, including accounting, audit and reporting requirements,termination of the “too big to fail” doctrine except in special cases,limitations on the FDIC’s payment of deposits at foreign branches, newregulatory standards in such areas as asset quality, earnings and compensationand revised regulatory standards for, among other things, powers of statebanks, real estate lending and capital adequacy.  FDICIA also requires that a depositoryinstitution provide 90 days prior notice of the closing of any branches.

 

Various other legislation,including proposals to revise the bank regulatory system and to limit theinvestments that a depository institution may make with insured funds, is fromtime to time introduced in Congress.  TheTDFI and FDIC will examine the Bank periodically for compliance with variousregulatory requirements.  Suchexaminations, however, are for the protection of the Bank Insurance Fund (“BIF”)and for depositors, and not for the protection of investors and shareholders.

 

## Interstate Act

 

The Riegle-Neal InterstateBanking and Branching Efficiency Act of 1994 (“Interstate Act”), which wasenacted on September 29, 1994, among other things and subject to certainconditions and exceptions, permits on an interstate basis (i) bank holdingcompany acquisitions commencing one year after enactment of banks of a minimumage of up to five years as established by state law in any state, (ii) mergersof national and state banks after May 31, 1997 unless the home state of eitherbank has opted out of the interstate bank merger provision, (iii) branching denovo by national and state banks if the host state has opted-in to thisprovision of the Interstate Act, and (iv) certain bank agency activities afterone year after enactment.  The InterstateAct contains a 30% intrastate deposit cap, except for the initial acquisitionin the state, restriction that applies to certain interstate acquisitionsunless a different intrastate cap has been adopted by the applicable statepursuant to the provisions of the Interstate Act and a 10% national deposit caprestriction.  Tennessee has opted-in tothe Interstate Act.  Management cannotpredict the extent to which the business of the Bank may be affected.  Tennessee has also adopted legislationallowing banks to acquire branches across state lines subject to certainconditions, including the availability of similar legislation in the otherstate.

 

8

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## Brokered Deposits and Pass-Through Insurance

 

The FDIC has adoptedregulations under FDICIA governing the receipt of brokered deposits andpass-through insurance.  Under theregulations, a bank cannot accept or rollover or renew brokered deposits unless(i) it is well capitalized or (ii) it is adequately capitalized and receives awaiver from the FDIC.  A bank that cannotreceive brokered deposits also cannot offer “pass-through” insurance on certainemployee benefit accounts.  Whether ornot it has obtained such a waiver, an adequately capitalized bank may not payan interest rate on any deposits in excess of 75 basis points over certainindex prevailing market rates specified by regulation.  There are no such restrictions on a bank thatis well capitalized.  Because it believesthat the Bank was well capitalized as of December 31, 2005, the Bank believesthe brokered deposits regulation will have no material effect on the funding orliquidity of the Bank.

 

## FDIC Insurance Premiums

 

The Bank is required to paysemiannual FDIC deposit insurance assessments. As required by FDICIA, the FDIC adopted a risk-based premium schedulewhich increased the assessment rates for most FDIC-insured depository institutions.  Under the schedule, the premiums initiallyrange from $.00 to $.27 for every $100 of deposits.  Each financial institution is assigned to oneof three capital groups - well capitalized, adequately capitalized orundercapitalized - and further assigned to one of three subgroups within acapital group, on the basis of supervisory evaluations by the institution’sprimary federal and, if applicable, state supervisors and other informationrelevant to the institution’s financial condition and the risk posed to theapplicable FDIC deposit insurance fund. The actual assessment rate applicable to a particular institution will,therefore, depend in part upon the risk assessment classification so assignedto the institution by the FDIC.

 

Under the FDIA, insurance ofdeposits may be terminated by the FDIC upon a finding that the institution hasengaged in unsafe or unsound practices, is in an unsafe or unsound condition tocontinue operations or has violated any applicable law, regulation, rule, orderor condition imposed by a federal bank regulatory agency.

 

## Gramm-Leach-Bliley Act

 

The Gramm-Leach-Bliley Actadopted in November 1999 has been referred to as the most important bankingbill in over 60 years.  The mostsignificant provisions ratify new powers for banks and bank holding companies,especially in the areas of securities and insurance.  The Act also includes requirements regardingthe privacy and protection of customer information held by financialinstitutions, as well as many other providers of financial services.  There are provisions providing for functionalregulation of the various services provided by institutions among differentregulators.  There are other provisionswhich limit the future expansion of unitary thrift holding companies which nowprevent companies like Wal-Mart from owning a thrift institution.  Finally, among many other sections of theAct, there is some relief for small banks from the regulatory burden of theCommunity Reinvestment Act.  Theregulatory agencies have been adopting many new regulations to implement theAct.

 

## USA Patriot Act

 

The USAPATRIOT Act of 2001 became law on October 26, 2001. This act contains theInternational Money Laundering Abatement and Financial Anti-Terrorism Act of2001 (the “IMLAFA”).  The IMLAFAsubstantially broadens existing anti-money laundering legislation and theextraterritorial jurisdiction of the United States, imposes new compliance anddue diligence obligations, creates new crimes and penalties, compels theproduction of documents located both inside and outside the United States,including those of foreign institutions that have a correspondent relationshipin the United States, and clarifies the safe harbor from civil liability tocustomers.  The U.S. Treasury Departmenthas issued a number of regulations implementing the USA PATRIOT Act that applycertain of its requirements to financial institutions such as our banking subsidiary.  The regulations impose new obligations onfinancial institutions to maintain appropriate policies, procedures andcontrols to detect, prevent and report money laundering and terroristfinancing.  The Treasury Department isexpected to issue a number of additional regulations which will further clarifythe USA PATRIOT Act’s requirements.

 

9

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The IMLAFArequires all “financial institutions,” as defined, to establish anti-moneylaundering compliance and due diligence programs no later than April 2003.  Such programs must include, among otherthings, adequate policies, the designation of a compliance officer, employeetraining programs, and an independent audit function to review and test theprogram.  The Bank has establishedanti-money laundering compliance and due diligence programs to comply withIMLAFA.

 

## Capital Requirements

 

The federal regulatoryagencies use capital adequacy guidelines in their examination and regulation ofbanks.  If the capital falls below theminimum levels established by these guidelines, the Bank may (i) be deniedapproval to acquire or establish additional banks or non-bank businessesor to open facilities, or (ii) be subject to other regulatory restrictions oractions.

 

Banking organizationshistorically were required to maintain a minimum ratio of primary capital tototal assets of 5.5%, and a minimum ratio of total capital to total assets of6.0%.  The primary and total capitalratio requirements have been replaced by the adoption of risk-based andleverage capital requirements.

 

Risk-Based CapitalRequirements.  The FDIC adopted risk-based capitalguidelines for banks and bank holding companies effective after December 31,1990.  The risk-based capitalguidelines are designed to make regulatory capital requirements more sensitiveto differences in risk profile among banks to account for off-balancesheet exposure and to minimize disincentives for holding liquid assets.  Assets and off-balance sheet items areassigned to broad risk categories each with appropriate weights.  The resulting capital ratios representcapital as a percentage of total risk-weighted assets and off-balancesheet items.  The ratios areminimums.  The guidelines require allfederally regulated banks to maintain a minimum risk-based total capitalratio of 8%, of which at least 4% must be Tier I capital (see the descriptionof Tier I capital and Tier II capital below).

 

A banking organization’squalifying total capital consists of two components:  Tier I capital (core capital) and Tier IIcapital (supplementary capital).  Tier Icapital is an amount equal to the sum of: (i) common shareholders’ equity (including adjustments for any surplusor deficit); (ii) non-cumulative perpetual preferred stock; and (iii) thecompany’s minority interests in the equity accounts of consolidatedsubsidiaries.  Intangible assetsgenerally must be deducted from Tier I capital, subject to limited exceptionsfor goodwill arising from certain supervisory acquisitions.  Other intangible assets may be included in anamount up to 25% of Tier I capital, provided that the asset meets each of thefollowing criteria:  (i) the asset mustbe able to be separated and sold apart from the banking organization or thebulk of its assets; (ii) the market value of the asset must be established onan annual basis through an identifiable stream of cash flows and there must bea high degree of certainty that the asset will hold this market valuenotwithstanding the future prospects of the banking organization; and (iii) thebanking organization must demonstrate that a liquid market exists for theasset.  Intangible assets in excess of25% of Tier I capital generally are deducted from a banking organization’sregulatory capital.  At least 50% of thebanking organization’s total regulatory capital must consist of Tier I capital.

 

Tier II capital is an amountequal to the sum of (i) the allowance for possible credit losses in an amountup to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferredstock with an original maturity of 20 years or more and related surplus; (iii)hybrid capital instruments (instruments with characteristics of both debt andequity), perpetual debt and mandatory convertible debt securities; and (iv) inan amount up to 50% of Tier I capital, eligible term subordinated debt andintermediate-term preferred stock with an original maturity of five yearsor more, including related surplus.  Theinclusion of the foregoing elements of Tier II capital are subject to certainrequirements and limitations of the FDIC.

 

Investments inunconsolidated banking and finance subsidiaries, investments in securitiessubsidiaries and reciprocal holdings of capital instruments must be deductedfrom capital.  The federal bankingregulators may require other deductions on a case-by-case basis.

 

10

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Under the risk-weightedcapital guidelines, balance sheet assets and certain off-balance sheetitems, such as standby letters of credit, are assigned to one of four riskweight categories (0%, 20%, 50%, or 100%) according to the nature of the assetand its collateral or the identity of any obligor or guarantor.  For example, cash is assigned to the 0% riskcategory, while loans secured by one-to-four family residences areassigned to the 50% risk category.  Theaggregate amount of such assets and off-balance sheet items in each riskcategory is adjusted by the risk weight assigned to that category to determineweighted values, which are added together to determine the total risk-weightedassets for the banking organization. Accordingly, an asset, such as a commercial loan, which is assigned to a100% risk category is included in risk-weighted assets at its nominalface value, whereas a loan secured by a single-family home mortgage isincluded at only 50% of its nominal face value. The application ratios are equal to capital, as determined, divided by risk-weightedassets, as determined.

 

Leverage CapitalRequirements.  The FDIC has a regulation requiring certainbanking organizations to maintain additional capital of 1% to 2% above a 3%minimum Tier I Leverage Capital Ratio (Tier I capital, less intangible assets,to total assets).  In order for aninstitution to operate at or near the minimum Tier I leverage capitalrequirement of 3%, the FDIC expects that such institution would have well-diversifiedrisk, no undue rate risk exposure, excellent asset quality, high liquidity andgood earnings.  In general, the Bankwould have to be considered a strong banking organization, rated in the highestcategory under the bank rating system and have no significant plans for expansion.  Higher Tier I leverage capital ratios of upto 5% will generally be required if all of the above characteristics are notexhibited, or if the institution is undertaking expansion, seeking to engage innew activities, or otherwise faces unusual or abnormal risks.

 

The FDIC rule provides thatinstitutions not in compliance with the regulation are expected to be operatingin compliance with a capital plan or agreement with the regulator.  If they do not do so, they are deemed to beengaging in an unsafe and unsound practice and may be subject to enforcementaction.  In addition, failure by aninstitution to maintain capital of at least 2% of assets constitutes an unsafeand unsound practice and may subject the institution to enforcement action.  An institution’s failure to maintain capitalof at least 2% of assets constitutes an unsafe and unsound condition justifyingtermination of FDIC insurance.

 

## Depositor Preference

 

The Omnibus BudgetReconciliation Act of 1993 provides that deposits and certain claims foradministrative expenses and employee compensation against an insured depositaryinstitution would be afforded a priority over other general unsecured claimsagainst such an institution, including federal funds and letters of credit, inthe “liquidation or other resolution” of such an institution by any receiver.

 

## Effect of Governmental Policies

 

The Bank is affected by thepolicies of regulatory authorities, including the Federal Reserve System.  An important function of the Federal ReserveSystem is to regulate the national money supply.  Among the instruments of monetary policy usedby the Federal Reserve are: purchases and sales of U.S. Government securitiesin the marketplace; changes in the discount rate, which is the rate anydepository institution must pay to borrow from the Federal Reserve; and changesin the reserve requirements of depository institutions.  These instruments are effective ininfluencing economic and monetary growth, interest rate levels and inflation.

 

The monetarypolicies of the Federal Reserve System and other governmental policies have hada significant effect on the operating results of commercial banks in the pastand are expected to continue to do so in the future.  Because of changing conditions in thenational economy and in the money market, as well as the result of actions bymonetary and fiscal authorities, it is not possible to predict with certaintyfuture changes in interest rates, deposit levels, loan demand or the businessand earnings of the Bank or whether the changing economic conditions will havea positive or negative effect on operations and earnings.

 

Bills arepending before the United States Congress and the Tennessee General Assemblywhich could affect the business of the Bank, and there are indications thatother similar bills may be introduced in the future.  It cannot be predicted whether or in whatform any of these proposals will be adopted or the extent to which the businessof the Bank may be affected thereby.

 

11

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**Loan Policy**

 

Lendingactivity is conducted under guidelines defined in the Bank’s Loan Policy.  The Loan Policy establishes guidelines foranalyzing financial transactions including an evaluation of the borrower’scredit history, repayment capacity, collateral value, and cash flow.  Loans may be fixed or variable rate, with themaximum maturity of fixed rate loans set at five years.

 

All lending activities ofthe Bank are under the direct supervision and control of the Officers LoanCommittee, The Executive Committee of the Board, and in some cases, the fullBoard of Directors. The Officers Loan Committee consisting of Arthur F. Helf,Michael R. Sapp and H. Lamar Cox approve loans up to one million dollars. TheExecutive Committee consisting of Arthur F. Helf, Michael R. Sapp and H. LamarCox and four outside directors approve loans up to 15% of Tier I capital. Thefull Board of Directors approves all loans above those limits. The full Boardof Directors approves loan authorizations, if any, for each Executive Officer.The Bank’s established maximum loan volume to deposits is 100%. The ExecutiveCommittee of the Board makes a monthly review of loans which are 90 days ormore past due and the full Board of Directors makes a quarterly review of loanswhich are 90 days or more past due.

 

Management of the Bankperiodically reviews the loan portfolio, particularly non-accrual andrenegotiated loans.  The review mayresult in a determination that a loan should be placed on a non-accrual statusfor income recognition.  In addition, tothe extent that management identifies potential losses in the loan portfolio,it reduces the book value of such loans, through charge-offs, to theirestimated collectible value.  The Bank’spolicy is that accrual of interest is discontinued on a loan when management ofthe Bank determines upon consideration of economic and business factorsaffecting collection efforts that collection of interest is doubtful.

 

When a loan is classified asnon-accrual, any unpaid interest is reversed against current income.  Interest is included in income thereafteronly to the extent received in cash.  Theloan remains in a non-accrual classification until such time as the loan isbrought current, when it may be returned to accrual classification.  When principal or interest on a non-accrualloan is brought current, if in management’s opinion future payments arequestionable, the loan would remain classified as non-accrual.  After a non-accrual or renegotiated loan ischarged off, any subsequent payments of either interest or principal areapplied first to any remaining balance outstanding, then to recoveries andlastly to income.

 

The Bank’sunderwriting guidelines are applied to four major categories of loans,commercial and industrial, consumer, agricultural and real estate whichincludes residential, construction and development and certain other realestate loans.  The Bank requires its loanofficers and loan committee to consider the borrower’s character, the borrower’sfinancial condition, the economic environment in which the loan will be repaid,as well as, for commercial loans, the borrower’s management capability and theborrower’s industry. Before approving a loan, the loan officer or committeemust determine that the borrower is basically honest and creditworthy, determinethat the borrower is a capable manager, understand the specific purpose of theloan, understand the source and plan of repayment, determine that the purpose,plan and source of repayment as well as collateral are acceptable, reasonableand practical given the normal framework within which the borrower operates.

 

Themaintenance of an adequate loan loss reserve is one of the fundamental conceptsof risk management for every financial institution.  Management is responsible for ensuring thatcontrols are in place to constantly monitor the adequacy of the loan lossreserve in accordance with generally accepted accounting principals (GAAP), theBank’s stated policies and procedures, and regulatory guidance.  Quantification of the level of reserve whichis prudently conservative, but not excessive, involves a high degree ofjudgment.

 

Management’sassessment of the adequacy of the loan loss reserve considers a wide range offactors including portfolio growth, mix, collateral and geographic diversity,and terms and structure.  Portfolioperformance trends, including past dues and charge-offs, are monitoredclosely.  Management’s assessmentincludes a continuing evaluation of current and expected market conditions andthe potential impact of economic events on borrowers.  Management’s assessment program is monitoredby an ongoing loan review program conducted by an independent accounting firmand periodic examinations by bank regulators.

 

12

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Managementuses a variety of financial methods to quantify the level of the loan lossreserve.  At inception, each loantransaction is assigned a risk rating that ranges from “RR1 — Excellent” to “RR4-Average”.  The risk rating is determined by an analysisof the borrower’s credit history and capacity, collateral, and cash flow.  The weighted average risk rating of theportfolio provides an indication of overall risk and identifies trends.  The portfolio is additionally segmented byloan type, collateral, and purpose.  Loantransactions which have exhibited signs of increased risk are downgraded to a “Watch”,“Critical”, or “Substandard” classification, i.e. RR5, RR6, and RR7,respectively.  These loans are closelymonitored for rehabilitation or potential loss and the loan loss reserve isadjusted accordingly.

 

It ismanagement’s intent to maintain a loan loss reserve which is adequate to absorbcurrent and estimated losses which are inherent in a loan portfolio.  The historical loss ratio (net charge-offs asa percentage of average loans) was 0.20%, 0.89% and 0.76% for the years 2003,2004 and 2005.  The year end loan lossreserve as a percentage of end of period loans was 1.48%, 1.31% and 1.26% forthe same years.  Due to the commercialemphasis of the bank’s operation, management has kept a reserve level in excessof historical results.

 

The provisionfor loan losses in 2005 was $3,700,000, an increase of $1,280,000 over the$2,420,000 provision in 2004.  In 2005, expensereflects the impact of $2,411,000 in charge-offs during the year and theincremental provision required as a result of the $132 million increase in loanvolume.

 

Credit Risk Management and Reserve for Loan Losses

 

Credit risk and exposure toloss are inherent parts of the banking business.  Management seeks to manage and minimize theserisks through its loan and investment policies and loan review procedures.  Management establishes and continuallyreviews lending and investment criteria and approval procedures that it believesreflect the risk sensitive nature of the Bank. The loan review procedures are set to monitor adherence to theestablished criteria and to ensure that on a continuing basis such standardsare enforced and maintained.  Management’sobjective in establishing lending and investment standards is to manage therisk of loss and provide for income generation through pricing policies.

 

The Banktargets small and medium sized businesses as loan customers. Because of theirsize, these borrowers may be less able to withstand competitive or economic pressuresthan larger borrowers in periods of economic weakness. If loan losses occur toa level where the loan loss reserve is not sufficient to cover actual loanlosses, the Bank’s earnings will decrease. The Bank uses an independent accountingfirm to review our loans for quality in addition to the reviews that may beconducted by bank regulatory agencies as part of their usual examinationprocess.

 

The loan portfolio isregularly reviewed and management determines the amount of loans to becharged-off.  In addition, such factorsas the Bank’s previous loan loss experience, prevailing and anticipatedeconomic conditions, industry concentrations and the overall quality of theloan portfolio are considered.  Whilemanagement uses available information to recognize losses on loans and realestate owned, future additions to the allowance may be necessary based onchanges in economic conditions.  Inaddition, various regulatory agencies, as an integral part of their examinationprocess, periodically review the allowances for losses on loans and real estateowned.  Such agencies may require theBank to recognize additions to the allowances based on their judgments aboutinformation available at the time of their examinations.  In addition, any loan or portion thereofwhich is classified as a “loss” by regulatory examiners is charged-off.

 

**Capital Resources /Liquidity**

 

**Liquidity** - Of primary importance to depositors, creditors and regulatorsis the ability to have readily available funds sufficient to repay fully maturingliabilities.  The Bank’s liquidity,represented by cash and cash due from banks, is a result of its operating,investing and financing activities.  Inorder to insure funds are available at all times, the Bank devotes resources toprojecting on a monthly basis the amount of funds which will be required andmaintains relationships with a diversified customer base so funds areaccessible.  Liquidity requirements canalso be met through short-term borrowings or the disposition ofshort-term assets which are generally matched to correspond to the maturity ofliabilities.

 

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Although the Bank has noformal liquidity policy, in the opinion of management, its liquidity levels are consideredadequate.   The Bank is subject togeneral FDIC guidelines which do not require a minimum level of liquidity.  Management believes its liquidity ratios meetor exceed these guidelines.  Management doesnot know of any trends or demands that are reasonably likely to result inliquidity increasing or decreasing in any material manner.

 

**Impactof Inflation and Changing Prices** - The financial statements and related financial data presented hereinhave been prepared in accordance with U.S. generally accepted accountingprinciples which require the measurement of financial position and operatingresults in terms of historical dollars without considering the changes in therelative purchasing power of money over time and due to inflation.  The impact of inflation on operations of theBank is reflected in increased operating costs. Unlike most industrial companies, virtually all of the assets andliabilities of the Bank are monetary in nature. As a result, interest rates have a more significant impact on the Bank’sperformance than the effects of general levels of inflation.  Interest rates do not necessarily move in thesame direction or in the same magnitude as the price of goods and services.

 

**Capital Adequacy**

 

Capital adequacy refers tothe level of capital required to sustain asset growth over time and to absorblosses.  To continue to grow, the Bankmust increase capital by generating earnings, issuing equity securities,borrowing funds, or a combination of those activities. If growth exceedsexpectations, the Bank may need to raise capital in the capital markets. TheBank’s ability to raise capital will depend in part on conditions in thecapital markets which are outside the Bank’s control. If the Bank cannot raisecapital on terms acceptable to it, the Bank’s ability to continue growing wouldbe materially impaired.

 

The objective of the Bank’smanagement is to maintain a level of capitalization that is sufficient to takeadvantage of profitable growth opportunities while meeting regulatoryrequirements including remaining well capitalized. This is achieved byimproving profitability through effectively allocating resources to moreprofitable businesses, improving asset quality, strengthening service quality,and streamlining costs.  The primarymeasures used by management to monitor the results of these efforts are theratios of average equity to average assets, average tangible equity to averagetangible assets, and average equity to net loans.

 

The Federal Reserve Boardhas adopted capital guidelines governing the activities of bank holdingcompanies.  These guidelines require themaintenance of an amount of capital based on risk-adjusted assets so thatcategories of assets with potentially higher credit risk will require morecapital backing than assets with lower risk. In addition, banks and bank holding companies are required to maintaincapital to support, on a risk-adjusted basis, certain off-balance sheetactivities such as loan commitments.

 

The capital guidelinesclassify capital into two tiers, referred to as Tier I andTier II.  Under risk-based capitalrequirements, total capital consists of Tier I capital which is generallycommon stockholders’ equity less goodwill and Tier II capital which isprimarily a portion of the allowance for loan losses and certain qualifyingdebt instruments.  In determiningrisk-based capital requirements, assets are assigned risk-weights of 0% to100%, depending primarily on the regulatory assigned levels of credit riskassociated with such assets.  Off-balancesheet items are considered in the calculation of risk-adjusted assets throughconversion factors established by the regulators.  The framework for calculating risk-basedcapital requires banks and bank holding companies to meet the regulatory minimumsof 4% Tier I and 8% total risk-based capital.  In 1990, regulators added a leveragedcomputation to the capital requirements, comparing Tier I capital to totalaverage assets less goodwill.

 

The Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”) established five capitalcategories for banks and bank holding companies.  The bank regulators adopted regulationsdefining these five capital categories in September 1992.  Under these new regulations each bank isclassified into one of the five categories based on its level of risk-basedcapital as measured by Tier I capital, total risk-based capital, andTier I leverage ratios and its supervisory ratings.

 

14

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The following table liststhe five categories of capital and each of the minimum requirements for thethree risk-based capital ratios.

 
| ** **                     | ** ** | **Total Risk-Based  Capital Ratio** | ** ** | **Tier I Risk-Based  Capital Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|---------------------|------------|
|                           |       |                                |       |                                 |       |                |       |
| Well-capitalized               |       | 10% or above                        |       | 6% or above                          |       | 5% or above         |       |
|                           |       |                                |       |                                 |       |                |       |
| Adequately capitalized         |       | 8% or above                         |       | 4% or above                          |       | 4% or above         |       |
|                           |       |                                |       |                                 |       |                |       |
| Undercapitalized               |       | Less than 8%                        |       | Less than 4%                         |       | Less than 4%        |       |
|                           |       |                                |       |                                 |       |                |       |
| Significantly undercapitalized |       | Less than 6%                        |       | Less than 3%                         |       | Less than 3%        |       |
|                           |       |                                |       |                                 |       |                |       |
| Critically undercapitalized    |       | —                              |       | —                               |       | 2% or less          |       |

 

The followingschedule details the Bank’s risk-based capital at December 31, 2005:

 
| ** **                                                                               | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in Thousands)**                                                               | ** ** | **2005**              | ** ** |
| **Capital:**                                                                             |       |                  |       |
| Tier I capital:                                                                          |       |                  |       |
| Stockholders’ common equity                                                         |       | $                     | 33,479     |   |
| Plus unrealized loss in securities                                                       |       | 372                   |       |
| Total Tier I capital                                                                     |       | 33,851                |       |
|                                                                                     |       |                  |       |
| Tier II capital:                                                                         |       |                  |       |
| Qualifying allowance for loan losses                                                     |       | 4,399                 |       |
| Total capital                                                                            |       | $                     | 38,250     |   |
|                                                                                     |       |                  |       |
| Risk-adjusted assets                                                                     |       | $                     | 364,089    |   |
|                                                                                     |       |                  |       |
| Quarterly average assets                                                                 |       | $                     | 372,607    |   |
|                                                                                     |       |                  |       |
| **Ratios:**                                                                              | ** ** | ** **            | ** ** |
| Tier I capital to risk-adjusted  assets                                                  |       | 9.30                  | %          |
|                                                                                     |       |                  |       |
| Total capital to risk-adjusted assets                                                    |       | 10.51                 | %          |
|                                                                                     |       |                  |       |
| Leverage — Tier I capital to quarterly  average assets minus disallowed intangibles |       | 9.08                  | %          |

 

15

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The followingschedule details the Corporation’s risk-based capital at December 31, 2005:

 
| ** **                                                                          | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in Thousands)**                                                          | ** ** | **2005**              | ** ** |
| **Capital:**                                                                        |       |                  |       |
| Tier I capital:                                                                     |       |                  |       |
| Stockholders’ common equity                                                    |       | $                     | 26,430     |   |
| Plus unrealized loss in securities                                                  |       | 372                   |       |
| Plus qualifying trust preferred securities                                          |       | 8,000                 |       |
| Total Tier I capital                                                                |       | 34,802                |       |
|                                                                                |       |                  |       |
| Tier II capital:                                                                    |       |                  |       |
| Qualifying allowance for loan losses                                                |       | 4,399                 |       |
| Total capital                                                                       |       | $                     | 39,201     |   |
|                                                                                |       |                  |       |
| Risk-adjusted assets                                                                |       | $                     | 363,892    |   |
|                                                                                |       |                  |       |
| Quarterly average assets                                                            |       | $                     | 372,855    |   |
|                                                                                |       |                  |       |
| **Ratios:**                                                                         | ** ** | ** **            | ** ** |
| Tier I capital to risk-adjusted  assets                                             |       | 9.56                  | %          |
|                                                                                |       |                  |       |
| Total capital to risk-adjusted assets                                               |       | 10.77                 | %          |
|                                                                                |       |                  |       |
| Leverage - Tier I capital to quarterly  average assets minus disallowed intangibles |       | 9.33                  | %          |

 

On December 31, 2005, boththe Bank and the Corporation exceeded the regulatory minimums and qualified asa well-capitalized institution under the regulations.

 

** 1A.**                          RISK FACTORS

 

**The Corporation’s businessstrategy includes the continuation of growth plans, and its financial conditionand results of operations could be affected if its business strategies are noteffectively executed.**

 

The Corporation intends to continue pursuing a growthstrategy for its business through organic growth of the loan portfolio. TheCorporation’s prospects must be considered in light of the risks, expenses anddifficulties that can be encountered by financial services companies in rapidgrowth stages, which may include the following:

 

•                  Maintaining loan quality;

 

•                  Maintaining adequate management personneland information systems to oversee such growth; and

 

•                  Maintaining adequate control andcompliance functions.

 

Operating Results. There is no assurance that the Bankwill maintain or achieve deposit levels, loan balances or other operatingresults necessary to avoid losses or produce profits. The Corporation’s growth willcause growth in overhead expenses as it routinely adds staff. The Corporation’shistorical results may not be indicative of future results.

 

16

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Regulatory and EconomicFactors. The Corporationmay be adversely affected by a number of regulatory and economicdevelopments or other events. Failure to obtain required regulatory approvals,changes in laws and regulations or other regulatory developments and changes inprevailing economic conditions or other unanticipated events may preventthe execution of certain business strategies or adversely affect the Corporation.

 

Failure to successfully address the issues identifiedabove could have a material adverse effect on the Corporation’s business,future prospects, financial condition or results of operations.

 

**The Bank could sustain losses ifits asset quality declines.**

 

The Bank’s earnings are affected by its ability toproperly originate, underwrite and service loans. The Bank could sustain lossesif it incorrectly assesses the creditworthiness of its borrowers or fails todetect or respond to deterioration in asset quality in a timely manner. Problemswith asset quality could cause the Bank’s interest income and net interestmargin to decrease and its provisions for loan losses to increase, which couldadversely affect the Bank’s results of operations and financial condition.

 

## **An inadequate allowance for loan losses would reduce the Bank’searnings.**

##  

The risk of credit losses on loans varies with, amongother things, general economic conditions, the type of loan being made, thecreditworthiness of the borrower over the term of the loan and, in the case ofa collateralized loan, the value and marketability of the collateral for theloan. Management maintains an allowance for loan losses based upon, among otherthings, historical experience, an evaluation of economic conditions and regularreviews of delinquencies and loan portfolio quality. Based upon such factors,management makes various assumptions and judgments about the ultimatecollectibility of the loan portfolio and provides an allowance for loan lossesbased upon a percentage of the outstanding balances and takes a charge againstearnings with respect to specific loans when their ultimate collectibility isconsidered questionable. If management’s assumptions and judgments prove to beincorrect and the allowance for loan losses is inadequate to absorb losses, orif the bank regulatory authorities require the Bank to increase the allowancefor loan losses as a part of their examination process, the Bank’s earningsand capital could be significantly and adversely affected.

 

**Liquidityneeds could adversely affect the Bank’s results of operations and financialcondition.**

 

The primary source of funds of the Bank are customerdeposits and loan repayments. While scheduled loan repayments are a relativelystable source of funds, they are subject to the ability of borrowers to repaythe loans. The ability of borrowers to repay loans can be adversely affected bya number of factors, including changes in economic conditions, adverse trendsor events affecting business industry groups, reductions in real estate valuesor markets, business closings or lay-offs, inclement weather, natural disastersand international instability. Additionally, deposit levels may beaffected by a number of factors, including rates paid by competitors, generalinterest rate levels, returns available to customers on alternative investmentsand general economic conditions. Accordingly, the Corporation may berequired from time to time to rely on secondary sources of liquidity to meetwithdrawal demands or otherwise fund operations. Such sources include FederalHome Loan Bank advances and federal funds lines of credit from correspondentbanks. While management of the Bank believes that these sources are currentlyadequate, there can be no assurance they will be sufficient to meet futureliquidity demands. The Bank may be required to slow or discontinue loangrowth, capital expenditures or other investments or liquidate assets shouldsuch sources not be adequate.

 

**Competition from financialinstitutions and other financial service providers may adversely affectthe Bank’s profitability.**

 

The banking business is highly competitive and the Bankexperiences competition in its markets from many other financial institutions.The Bank competes with commercial banks, credit unions, savings and loanassociations, mortgage banking firms, consumer finance companies, securitiesbrokerage firms, insurance companies, money market funds, and other mutualfunds, as well as other community banks and super-regional and nationalfinancial institutions that operate offices in the Bank’s primary market areasand elsewhere.

 

17

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Additionally, the Bank faces competition from de novocommunity banks, including those with senior management who were previouslyaffiliated with other local or regional banks or those controlled by investorgroups with strong local business and community ties. These de novo communitybanks may offer higher deposit rates or lower cost loans in an effort toattract the Bank’s customers, and may attempt to hire the Bank’smanagement and employees.

 

The Bank competes with these other financialinstitutions both in attracting deposits and in making loans. In addition, the Bankhas to attract its customer base from other existing financial institutions andfrom new residents. The Bank expects competition to increase in the future as aresult of legislative, regulatory and technological changes and the continuingtrend of consolidation in the financial services industry. The Bank’sprofitability depends upon its continued ability to successfully compete withan array of financial institutions in its market areas.

 

#### **The Bank’s business is subject to the success of the local economieswhere it operates.**

####  

The Bank’s success significantly depends upon thegrowth in population, income levels, deposits and new businesses in its marketareas. If the communities in which the Bank operates do not grow or ifprevailing economic conditions locally or nationally are unfavorable, the Bank’sbusiness may not succeed. Adverse economic conditions in the Bank’sspecific market areas could reduce its growth rate, affect the ability of itscustomers to repay their loans to the Bank and generally affect its financialcondition and results of operations. Moreover, the Bank cannot give anyassurance that it will benefit from any market growth or favorable economicconditions in its primary market areas if they do occur.

 

**Changes in interest rates couldadversely affect the Corporation’s results of operations and financial condition.**

 

Changes in interest rates may affect the Bank’slevel of interest income, the primary component of its gross revenue, as wellas the level of its interest expense. Interest rates are highly sensitive tomany factors that are beyond the Bank’s control, including general economicconditions and the policies of various governmental and regulatory authorities.Accordingly, changes in interest rates could decrease the Bank’s net interestincome. Changes in the level of interest rates also may negatively affectthe Bank’s ability to originate loans, the value of the Bank’s assets and the Bank’sability to realize gains from the sale of its assets, all of which ultimatelyaffects the Bank’s earnings.

 

##### **The Corporation relies heavily on theservices of key personnel****.**

#####  

The Corporation depends substantially on thestrategies and management services of its executive officers, Arthur F. Helf,Chairman and Chief Executive Officer, Michael R. Sapp, President, H. Lamar Cox,Chief Administrative Officer and George W. Fort, Chief Financial Officer. Althoughthe Corporation has entered into an employment agreement with these executiveofficers, the loss of their services could have a material adverse effect onthe Corporation’s business, results of operations and financial condition. The Corporationis also dependent on certain other key officers who have important customerrelationships or are instrumental to its operations. Changes in key personneland their responsibilities may be disruptive to the Corporation’s businessand could have a material adverse effect on the Corporation’s business,financial condition and results of operations.

 

The Corporation believes that its future results willalso depend in part upon its attracting and retaining highly skilled andqualified management, as well as sales and marketing personnel. Competition forsuch personnel is intense, and the Corporation cannot assure you that it willbe successful in attracting or retaining such personnel.

 

18

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##### **The Bank is subject to extensive regulationthat could limit or restrict its activities.**

 

The Bank operates in a highly regulated industry andis subject to examination, supervision, and comprehensive regulation by variousfederal and state agencies including the Federal Reserve Board, the FDIC andthe TDFI. The Bank’s regulatory compliance is costly and restricts certain ofits activities, including payment of dividends, mergers and acquisitions,investments, loans and interest rates charged, and interest rates paid ondeposits. The Bank is also subject to capitalization guidelines established byits regulators, which require it to maintain adequate capital to support itsgrowth.

 

The laws and regulations applicable to the bankingindustry could change at any time, and the Bank cannot predict the effects ofthese changes on its business and profitability. Because government regulationgreatly affects the business and financial results of all commercial banks andbank holding companies, the Bank’s cost of compliance could adversely affectits ability to operate profitably.

 

The Sarbanes-Oxley Act of 2002, and the relatedrules and regulations promulgated by the Securities and ExchangeCommission and Nasdaq that are now applicable to the Corporation, haveincreased the scope, complexity and cost of corporate governance, reporting anddisclosure practices. As a result, the Corporation has experienced, andmay continue to experience, greater compliance costs.

 

#### **The Corporation’s recent results may not be indicative of itsfuture results.**

####  

The Corporation may not be able to sustain itshistorical rate of growth or may not even be able to grow its business atall. In addition, the Corporation’s recent growth may distort some of itshistorical financial ratios and statistics. In the future, the Corporationmay not have the benefit of several recently favorable factors, such as agenerally stable interest rate environment and a strong local businessenvironment. Various factors, such as economic conditions, regulatory andlegislative considerations and competition, may also impede or prohibitthe Corporation’s ability to grow.

 

**TheCorporation’s ability to maintain adequate capital may restrict its activities.**

 

The Corporation’s continued pace of growthmay require it to raise additional capital in the future, but that capitalmay not be available when it is needed.

 

The Corporation is required by federal and stateregulatory authorities to maintain adequate levels of capital to support itsoperations. While the Corporation’s capital resources will satisfy its capitalrequirements for the foreseeable future, the Corporation may at somepoint, however, need to raise additional capital to support its continuedgrowth.

 

The Corporation’s ability to raise additional capital,if needed, will depend on conditions in the capital markets at that time, whichare outside its control, and on its financial performance. Accordingly, the Corporationcannot assure its shareholders that it will be able to raise additional capitalif needed on terms acceptable to it. If the Corporation cannot raise additionalcapital when needed, its ability to continue its growth could be materiallyimpaired.

 

**The success and growth of the Corporation’sbusiness will depend on its ability to adapt to technological changes.**

 

The banking industry and the ability to deliverfinancial services is becoming more dependent on technological advancement,such as the ability to process loan applications over the Internet, acceptelectronic signatures, provide process status updates instantly and on-linebanking capabilities and other customer expected conveniences that are costefficient to the Corporation’s business processes. As these technologies areimproved in the future, the Corporation may, in order to remain competitive, berequired to make significant capital expenditures.

 

**Even though the Corporation’scommon stock is currently traded on the Nasdaq Over the Counter Bulletin Board Market,the trading volume in its common stock has been thin and the sale ofsubstantial amounts of the Corporation’s common stock in the public marketcould depress the price of its common stock.**

 

19

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The Corporation cannot say with any certainty when amore active and liquid trading market for its common stock will develop or besustained. Because of this, the Corporation’s shareholders may not be ableto sell their shares at the volumes, prices, or times that they desire.

 

The Corporation cannot predict the effect, if any,that future sales of its common stock in the market, or availability of sharesof its common stock for sale in the market, will have on the market price ofthe Corporation’s common stock. The Corporation, therefore, can give noassurance that sales of substantial amounts of its common stock in the market,or the potential for large amounts of sales in the market, would not cause theprice of its common stock to decline or impair its ability to raise capitalthrough sales of its common stock.

 

The market price of the Corporation’s common stockmay fluctuate in the future, and these fluctuations may be unrelatedto its performance. General market price declines or overall market volatilityin the future could adversely affect the price of our common stock, and the currentmarket price may not be indicative of future market prices.

 

**The Corporation may issueadditional common stock or other equity securities in the future which coulddilute the ownership interest of existing shareholders.**

 

In order to maintain its capital at desired levels orrequired regulatory levels, or to fund future growth, the Corporation’s boardof directors may decide from time to time to issue additional shares ofcommon stock, or securities convertible into, exchangeable for or representingrights to acquire shares of its common stock. The sale of these sharesmay significantly dilute the Corporation’s shareholder’s ownershipinterest as a shareholder and the per share book value of its common stock. Newinvestors in the future may also have rights, preferences and privilegessenior to its current shareholders which may adversely impact its currentshareholders.

 

**The Corporation’s ability todeclare and pay dividends is limited by law and it may be unable to payfuture dividends.**

 

The Corporation derives its income solely fromdividends on the shares of common stock of the Bank. The Bank’s ability todeclare and pay dividends is limited by its obligations to maintain sufficientcapital and by other general restrictions on its dividends that are applicableto banks that are regulated by the FDIC and the TDFI. In addition, the FederalReserve Board may impose restrictions on the Corporation’s ability to paydividends on its common stock. As a result, the Corporation cannot assure itsshareholders that it will declare or pay dividends on shares of its commonstock in the future.

 

**Holders of the Corporation’ssubordinated debentures have rights that are senior to those of its commonshareholders.**

 

The Corporation has supported its continued growththrough the issuance of trust preferred securities from a special purpose trustand accompanying subordinated debentures. At December 31, 2005, the Corporationhad outstanding trust preferred securities and accompanying subordinateddebentures totaling $8.2 million. Payments of the principal and interest on thetrust preferred securities of these trusts are conditionally guaranteed by the Corporation.Further, the accompanying subordinated debentures the Corporation issued to thetrust are senior to its shares of common stock. As a result, the Corporationmust make payments on the subordinated debentures before any dividends can bepaid on its common stock and, in the event of its bankruptcy, dissolution orliquidation, the holders of the subordinated debentures must be satisfiedbefore any distributions can be made on its common stock. The Corporation hasthe right to defer distributions on its subordinated debentures (and therelated trust preferred securities) for up to five years, during which time nodividends may be paid on its common stock.

 

**ITEM 1B.**                                            UNRESOLVED STAFF COMMENTS

 

None

 

20

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| **ITEM  2.** | **PROPERTIES** |
|--------------|----------------|

 

The mainoffice of the Corporation is located in Williamson County at 381 MalloryStation Road, Suite 207, Franklin, Tennessee 37067, which is also the mainoffice of the Bank.  This location iscentrally located and in a high traffic/exposure area. The Bank leases 21,200square feet at competitive rates. The term of the lease extends until December2010.  The Bank provides servicesthroughout the community by use of a network of couriers, third party automatedteller machines, and state of the art electronic banking. The Bank alsooperates a loan production office located in Jefferson County at One Chase CorporateCenter, Suite 400, Birmingham, AL 35244.  The Bank leases 280 square feet at competitiverates under the terms of a lease that extends until February 2007.

 
| **ITEM  3.** | **LEGAL PROCEEDINGS** |
|--------------|-----------------------|

 

To the best ofthe Corporation’s knowledge, there are no pending legal proceedings, other thanroutine litigation incidental to the business, to which the Corporation or theBank is a party or of which any of the Corporation’s or the Bank’s property isthe subject.

 
| **ITEM  4.** | **SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS** |
|--------------|----------------------------------------------------------|

 

No matter wassubmitted to a vote of security holders during the fourth quarter of 2005through the solicitation of proxies or otherwise.

 

**PARTII**

 
| **ITEM  5.** | **MARKET FOR REGISTRANT’S COMMON EQUITY,  RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|--------------|-------------------------------------------------------------------------------------------------------------------------|

 

The commonstock of the Corporation is traded on the NASDAQ Over-The-Counter BulletinBoard Market, starting on December 16, 2005. Prior to that time, the common stock of the Corporation was not tradedthrough an organized exchange. The number of shareholders of record at February28, 2006, was 607. Holders of the Corporation’s common stock are entitled toreceive dividends when declared by the Board of Directors out of funds legallyavailable. Dividends will be affected by other factors including applicablegovernment regulations and policies.  Thefollowing table shows the quarterly range of high and low sale prices for theCorporation’s stock during the fiscal years 2005 and 2004. These sale pricesrepresent known transactions and do not necessarily represent all tradingtransactions for the periods.

 

| **Year** | ** ** | **High**           | ** ** | **Low**  | ** ** |
|----------|------------|--------------------|------------|----------|------------|
|     |       |               |       |     |       |   |   |
| 2004:    |       | First Quarter      |       | $        | 11.00      |   | $ | 11.00 |   |
|     |       | Second Quarter     |       | $        | 11.00      |   | $ | 11.00 |   |
|     |       | Third Quarter      |       | $        | 14.00      |   | $ | 14.00 |   |
|     |       | Fourth Quarter     |       | No sales |       | No sales |   |
|     |       |               |       |     |       |   |   |
| 2005:    |       | First Quarter      |       | $        | 15.00      |   | $ | 15.00 |   |
|     |       | Second Quarter     |       | $        | 15.00      |   | $ | 15.00 |   |
|     |       | Third Quarter      |       | $        | 16.00      |   | $ | 16.00 |   |
|     |       | Fourth Quarter (1) |       | $        | 35.00      |   | $ | 16.00 |   |

 

----

(1) The high sales price of $35.00 wasachieved in December after trading began on the NASDAQ Over-The-CounterBulletin Board Market on December 16, 2005.

 

21

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**Dividends**

 

The payment ofcash dividends is subject to the discretion of the Corporation’s Board ofDirectors and the Bank’s ability to pay dividends.  The Bank’s ability to pay dividends isrestricted by applicable regulatory requirements. For more information on theserestrictions, please see PART I, ITEM 1 “DESCRIPTION OF BUSINESS - Payment ofDividends”.  No assurances can be giventhat any dividend will be declared or, if declared, what the amount of suchdividend would be or whether such dividends would continue in future periods.

 

**Securities Authorized for Issuance UnderEquity Compensation Plans**

 

The Bankissued Stock Option agreements to certain officers and employees (“Options”),at various times beginning on January 14, 2000. These Options were not approved by the shareholders, as such approval isnot necessary for these non-qualified option agreements.  Upon consummation of the Share Exchange, theCorporation became party to these options issued by the Bank.

 

The followingtable reflects the number of shares to be issued upon the exercise of optionsgranted under the Option agreements, the weighted-average exercise price of allsuch options, and the total number of shares of common stock reserved forissuance upon the exercise of authorized, not-yet-granted options as ofDecember 31, 2005:

 

**Equity Compensation Plan Information**

 
| **Plan Category**                                                                                                                | ** ** | **Number of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights  (a)** | ** ** | **Weighted-average Exercise  Price of Outstanding Options,  Warrants, and Rights  (b)** | ** ** | **Number of Securities  Remaining Available for  Future Issuance Under Equity  Compensation Plans  (Excluding Securities  Reflected in Column (a))  (c)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                       | ** ** | ** **                                                                                              | ** ** | ** **                                                                              | ** ** | ** **                                                                                                                                                | ** ** |
| Equity Compensation Plans Approved by Shareholders                                                                               |       | —                                                                                                  |       | —                                                                                  |       | —                                                                                                                                                    |       |
|                                                                                                                             |       |                                                                                                    |       |                                                                                    |       |                                                                                                                                                      |       |
| Equity Compensation Plans Not Approved by Shareholders (incentive  options for executive officers, directors, and incorporators) |       | 937,842                                                                                                 |       | $                                                                                       | 8.85       |                                                                                                                                                      | 0          |   |
|                                                                                                                             |       |                                                                                                    |       |                                                                                    |       |                                                                                                                                                      |       |
| Total                                                                                                                            |       | 937,842                                                                                                 |       | $                                                                                       | 8.85       |                                                                                                                                                      | 0          |   |

 

The originalfourteen (14) incorporators and members of the Board of Directors were grantedan aggregate of 122,500 options to purchase shares at $5.00 a share. 10,000options were exercised in 2002 leaving an outstanding amount of options topurchase 112,500 shares.

 

In August2003, the Board of Directors approved an option plan for active directors andincorporators in recognition of their four years of service to the Corporationwithout compensation. An aggregate of 320,000 options to purchase shares at aprice of $10.50 were included in this plan.

 

Pursuant to employment agreements, executiveofficers received options equal to 14% of the shares sold in the originaloffering at an exercise price of $5.00. Based on the initial sale of 1,817,440shares, executive officer options totaled 254,440. Of this total, 24,232options were exercised and 12,116 options were forfeited in 2002, and 2,000options were exercised in 2004, leaving an outstanding balance of 216,092options to purchase shares. In February 2003, executive officers Arthur F.Helf, Michael R. Sapp, and H. Lamar Cox were granted 30,000 options each at anexercise price of $7.50 to vest over 3 years. In March 2004, executive officersArthur F. Helf, Michael R. Sapp, and H. Lamar Cox were granted 20,000 optionseach at an exercise price of $11.00 to vest immediately. In August 2005,executive officer George W. Fort was granted 5,000 options. Of these 2,500options immediately vested and the remaining 2,500 vest in August 2006. InNovember 2005, George W. Fort was granted 6,250 options that immediatelyvested.

 

22

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The Board of Directors has granted incentiveoptions to various employees who are not executive officers. Incentive optionsare used for recruiting and retention purposes and to recognize performance.Employee incentive options include 13,000 options to purchase shares at $5.00 ashare granted in 2000 and 2001. Of these, 5,000 options to purchase shares havebeen forfeited by former employees, 3,000 options were exercised on December31, 2003, and 1,000 options were exercised in 2004. The remaining 4,000 arefully vested. In March 2003, 9,000 options to purchase shares at $7.50 a sharewere granted. In December 2003, 31,000 options to purchase shares at $10.50 pershare were granted. All of these incentive options vest in 2 years and areexercisable in 10 years. Of these, 5,000 options were forfeited in 2004. InJuly 2005 and August 2005, 69,000 and 10,000 options were granted respectively.On each grant date half immediately vested with the remaining options vestingone year later. In November 2005, 10,000 options were granted to employees andwere immediately vested.

 

The totalnumber of options outstanding in all programs is 937,842 of which 865,842 arefully vested at December 31, 2005. In the event the Corporation merges orconsolidates with or into any other corporation, or sells or otherwisetransfers its property, assets, and business substantially in its entirety to asuccessor corporation, there shall thereafter be deliverable upon any exerciseof an option the number of shares of stock or other securities or property(including cash) to which a holder of the number of shares of common stockwhich would otherwise have been deliverable upon the exercise of such optionwould have been entitled upon such merger, consolidation, sale or transfer ifsuch option had been exercised in full immediately prior thereto.

 

**Recent Sales of Unregistered Securities**

 

During 2005,the Corporation did not offer any shares of its common stock for sale and no optionholders exercised their options to purchase shares.

 

During 2004,the Corporation sold 775,000 shares of its common stock in a public offering ata per share price of $11.00.  Theproceeds were used for general corporate purposes.  This offering was limited to residents of theState of Tennessee, and the Corporation relied on the exemption provided bySection 3(a)(11) of the Securities Act of 1933, relating to securities issuedonly in the state where the issuer is located.

 

Also during2004, H. Lamar Cox, the Chief Financial Officer exercised the option topurchase 2,000 shares of common stock at an exercise price of $11.00 per share.This exercise of stock options was a transaction by the Corporation that didnot involve a public offering. The Corporation relied on the exemption providedby Section 4(2) of the Securities Act of 1933.

 

Also during2004, options to purchase 1,000 shares of common stock at an exercise price of$7.00 per share were exercised. This exercise of stock options was atransaction by the Corporation that did not involve a public offering. TheCorporation relied on the exemption provided by Section 4(2) of the SecuritiesAct of 1933.

 

During 2003, theCorporation sold 437,346 shares of its common stock in a public offering at aper share price of $9.00. The proceeds were used for general corporatepurposes. This offering was limited to residents of the State of Tennessee, andthe Corporation relied on the exemption provided by Section 3(a)(11) of theSecurities Act of 1933, relating to securities issued only in the state wherethe issuer is located.

 

Also during2003, options to purchase 3,000 shares at an exercise price of $11.00 per sharewere exercised. This exercise of stock options was a transaction by theCorporation that did not involve a public offering. The Corporation relied onthe exemption provided by Section 4(2) of the Securities Act of 1933.

 

23

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During 2002,the Corporation sold 166,656 shares of its common stock in a public offering ata per share price of $7.00. The proceeds were used for general corporatepurposes. This offering was limited to residents of the State of Tennessee, andthe Corporation relied on the exemption provided by Section 3(a)(11) of theSecurities Act of 1933, relating to securities issued only in the state wherethe issuer is located.

 

Also during2002, options to purchase 34,232 shares at an exercise price of $6.25 per sharewere exercised. This exercise of stock options was a transaction by theCorporation that did not involve a public offering. The Corporation relied onthe exemption provided by Section 4(2) of the Securities Act of 1933.

 

**Purchases of Equity Securities by theRegistrant and Affiliated Purchasers**

 

TheCorporation made no repurchases of its equity securities, and no AffiliatedPurchasers (as defined in Rule 10b - 18(a)(3) under the Securities Exchange Actof 1934) purchased any shares of the Corporation’s equity securities during thefourth quarter of the fiscal year ended December 31, 2005.

 

**ITEM 6.**                                                     SELECTED FINANCIAL DATA

 

The followingselected financial data for the years ended December 31, 2005, 2004, 2003,2002 and 2001 should be read in conjunction with the financial statementsincluded in Item 8:

 

**SELECTED FINANCIAL DATA**

 
| ** **                                           | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                           | ** ** | **(Dollars in Thousands except share data)** | ** ** |
| **Operating Data:**                                  |       |                                                                  |       |     |       |     |       |     |       |     |       |
| Total interest income                                |       | $                                                                     | 23,633     |     | $          | 13,185   |       | $        | 8,205      |     | $          | 5,181 |   | $ | 4,357 |   |
| Total interest expense                               |       | 10,006                                                                |       | 4,265    |       | 2,976    |       | 2,452    |       | 2,437    |       |
| Net interest income                                  |       | 13,627                                                                |       | 8,920    |       | 5,229    |       | 2,729    |       | 1,920    |       |
| Provision for loan losses                            |       | (3,700                                                                | )          | (2,420   | )          | (1,115   | )          | (318     | )          | (815     | )          |
| Net interest income after provision for  loan losses |       | 9,927                                                                 |       | 6,500    |       | 4,114    |       | 2,411    |       | 1,105    |       |
| Non-interest income:                                 |       |                                                                  |       |     |       |     |       |     |       |     |       |
| Investment securities gains                          |       | 4                                                                     |       | 33       |       | 132      |       | 139      |       | 203      |       |
| Gain on sale of loans                                |       | 1,106                                                                 |       | 504      |       | —   |       | —   |       | —   |       |
| Other income                                         |       | 201                                                                   |       | 263      |       | 300      |       | 119      |       | 71       |       |
| Non-interest expense                                 |       | (6,246                                                                | )          | (4,552   | )          | (3,459   | )          | (2,183   | )          | (1,908   | )          |
| Income before income taxes                           |       | 4,992                                                                 |       | 2,748    |       | 1,087    |       | 486      |       | (529     | )          |
| Income tax (expense) benefit                         |       | (1,925                                                                | )          | (1,082   | )          | (188     | )          | 650      |       | 100      |       |
| Net income                                           |       | $                                                                     | 3,067      |     | $          | 1,666    |       | $        | 899        |     | $          | 1,136 |   | $ | (429 | ) |
|                                                 |       |                                                                  |       |     |       |     |       |     |       |     |       |
| **Per Share Data :**                                 |       |                                                                  |       |     |       |     |       |     |       |     |       |
| Net income, basic                                    |       | $                                                                     | 0.95       |     | $          | 0.57     |       | $        | 0.40       |     | $          | 0.62 |   | $ | (0.24 | ) |
| Net income, assuming dilution(1)                     |       | $                                                                     | 0.87       |     | $          | 0.53     |       | $        | 0.38       |     | $          | 0.59 |   | $ | (0.24 | ) |
| Book value                                           |       | $                                                                     | 8.16       |     | $          | 7.29     |       | $        | 5.44       |     | $          | 4.78 |   | $ | 3.32 |   |

 

24

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| ** **                                                  | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                  | ** ** | **(Dollars in Thousands except share data)** | ** ** |
| **Financial Condition Data:**                               |       |                                                                  |       |     |       |     |       |     |       |     |       |
| Assets                                                      |       | $                                                                     | 404,040    |     | $          | 245,917  |       | $        | 156,075    |     | $          | 97,779 |   | $ | 62,919 |   |
| Loans, net                                                  |       | 344,187                                                               |       | 213,326  |       | 133,187  |       | 76,258   |       | 44,117   |       |
| Investments                                                 |       | 31,992                                                                |       | 18,690   |       | 12,978   |       | 15,567   |       | 15,333   |       |
| Cash and due from financial institutions                    |       | 6,877                                                                 |       | 3,838    |       | 5,224    |       | 2,287    |       | 1,586    |       |
| Federal funds sold                                          |       | 12,535                                                                |       | 6,582    |       | 2,498    |       | 1,918    |       | 946      |       |
| Premises and equipment, net                                 |       | 769                                                                   |       | 609      |       | 673      |       | 420      |       | 284      |       |
| Deposits                                                    |       | 367,705                                                               |       | 221,394  |       | 142,293  |       | 87,261   |       | 56,700   |       |
| Federal funds purchased                                     |       | —                                                                |       | —   |       | —   |       | 1,500    |       | —   |       |
| Long term debt                                              |       | 8,248                                                                 |       | —   |       | —   |       | —   |       | —   |       |
| Other liabilities                                           |       | 1,657                                                                 |       | 923      |       | 384      |       | 218      |       | 179      |       |
| Shareholders’ equity                                   |       | 26,430                                                                |       | 23,600   |       | 13,398   |       | 8,800    |       | 6,040    |       |
|                                                        |       |                                                                  |       |     |       |     |       |     |       |     |       |
| **Selected Ratios:**                                        |       |                                                                  |       |     |       |     |       |     |       |     |       |
| Overhead ratio (2)                                          |       | 1.98                                                                  | %          | 2.26     | %          | 2.70     | %          | 2.90     | %          | 3.41     | %          |
| Efficiency ratio (3)                                        |       | 41.81                                                                 | %          | 46.83    | %          | 61.11    | %          | 73.10    | %          | 86.96    | %          |
| Net yield on earning assets                                 |       | 7.70                                                                  | %          | 6.74     | %          | 6.62     | %          | 7.28     | %          | 8.12     | %          |
| Cost of funds                                               |       | 3.66                                                                  | %          | 2.54     | %          | 2.75     | %          | 3.80     | %          | 5.25     | %          |
| Net Interest margin                                         |       | 4.44                                                                  | %          | 4.56     | %          | 4.22     | %          | 3.83     | %          | 3.58     | %          |
| Operating expenses to average earning  assets               |       | 2.03                                                                  | %          | 2.33     | %          | 2.79     | %          | 3.06     | %          | 3.55     | %          |
| Return on average assets                                    |       | 0.97                                                                  | %          | 0.83     | %          | 0.70     | %          | 1.51     | %          | -0.77    | %          |
| Return on average equity                                    |       | 12.29                                                                 | %          | 8.92     | %          | 8.00     | %          | 16.52    | %          | -6.44    | %          |
| Average equity to average assets                            |       | 7.90                                                                  | %          | 9.28     | %          | 8.78     | %          | 9.14     | %          | 11.91    | %          |
| Ratio of nonperforming assets to average  assets            |       | 1.40                                                                  | %          | 1.90     | %          | 1.99     | %          | 1.47     | %          | 1.77     | %          |
| Ratio of allowance for loan losses to  average assets       |       | 1.39                                                                  | %          | 1.41     | %          | 1.56     | %          | 1.47     | %          | 1.64     | %          |
| Ratio of allowance for loan losses to  nonperforming assets |       | 99.43                                                                 | %          | 74.45    | %          | 78.59    | %          | 99.91    | %          | 92.83    | %          |
|                                                             |            |                                                                       |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

----

(1) Options are not antidilutive in 2001

(2) Operating expenses divided by averageassets

(3) Operating expenses divided by netinterest income and noninterest income

 

25

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| **ITEM 7.** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION** |
|-------------|------------------------------------------------------------------------------------------------|

 

**Forward-Looking Statements**

 

Management’sdiscussion of the Corporation and management’s analysis of the Corporation’soperations and prospects, and other matters, may include forward-lookingstatements within the meaning of the provisions of various federal and statesecurities laws.  Although theCorporation believes that the assumptions underlying such forward-lookingstatements contained in this Report are reasonable, any of the assumptionscould be inaccurate and, accordingly, there can be no assurance that theforward-looking statements included herein will prove to be accurate. The useof such words as expect, anticipate, forecast, and comparable terms should beunderstood by the reader to indicate that the statement is “forward-looking”and thus subject to change in a manner that can be unpredictable.  Factors that could cause actual results todiffer from the results anticipated, but not guaranteed, in this Report,include (without limitation) economic and social conditions, competition forloans, mortgages, and other financial services and products, changes ininterest rates, unforeseen changes in liquidity, results of operations, andfinancial conditions affecting the Corporation’s customers, as well as otherrisks that cannot be accurately quantified or completely identified.  Many factors affecting the Corporation’sfinancial condition and profitability, including changes in economicconditions, the volatility of interest rates, political events and competitionfrom other providers of financial services simply cannot be predicted and becausethese factors are unpredictable and beyond the Corporation’s control, earningsmay fluctuate from period to period.  Thepurpose of this type of information is to provide readers with informationrelevant to understanding and assessing the financial condition and results ofoperations of the Corporation, and not to predict the future or to guaranteeresults.  The Corporation is unable topredict the types of circumstances, conditions, and factors that can causeanticipated results to change.  TheCorporation undertakes no obligation to publish revised forward-lookingstatements to reflect the occurrence of changes or unanticipated events,circumstances, or results.

 

**Overview**

 

**(dollars in thousands except share data inthe remainder of this Item 7)**

 

The results ofoperations for the year 2005 compared to 2004 reflected an 84.09% increase innet income and a 64.15% increase in earnings per share, assuming dilution.  The increase in earnings resulted primarilyfrom a 52.77% increase in net interest income due to higher average loanbalances.  The net interest margin for2005 was 4.44%. The increased revenue was partially offset by increases innon-interest expense and the provision for loan losses.  The year 2005 reflected a continuation of theBank’s trend of rapid asset growth.  Theasset growth is a result of the strength of the Middle Tennessee economy andthe success of the Corporation’s Business Bank operating strategy.

 

TheCorporation’s growth in assets is a result of growth in the market area andeffective marketing. The improvement in results including net income andearnings per share is a result of the business focus of the Bank. From 2000 to2005, the Bank’s market area experienced explosive growth. In Williamson County,demographic information shows a 16.61% growth in the number of households from2000 to 2005.  Estimates are that by 2010the number of households will have grown by another 13.74%. Although estimatesof growth are not guaranteed and actual growth may be affected by factorsbeyond the Corporation’s control, Management believes that the projected growthof our market area will positively impact the Bank’s future growth.

 

The Bank hasalso grown by marketing to business owners that have been left without a longstanding banking relationship. The Middle Tennessee area has experiencedseveral bank mergers or acquisitions in the last ten years resulting in manylong standing relationships being terminated. These acquisitions also resultedin loan funding decisions being made out of state creating confusion for locallending personnel and uncertainty for local businesses. The Bank has takenadvantage of this confusion by offering loans at a fair rate and funded locallyin a timely manner. Management believes the competitive advantage created bythis environment will continue to positively impact results from operations.

 

26

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The BusinessBank operating strategy has enabled management to focus on managing results. Ratherthan focusing on building a multi-branch infrastructure including hiring andconstruction of buildings, management focuses on managing net interest marginaggressively and controlling non-interest expense. This has resulted in a 24.02%increase in the net interest margin from 2001 to 2005. Non-interest expense iscontrolled by efficiently staffing the Bank’s operations. In 2005, thatresulted in $9.8 million in assets per employee at year end. Managementbelieves that the Business Bank operating strategy will continue to be aneffective model in the future.

 

**Changes in Results of Operations**

 

(dollars inthousands except share data)

 

**Net Income**- Net income for 2005 was $3,067, an increase of $1,401 or 84.09%, compared tothe $1,666 earned in 2004. The increase is attributable to a 52.77% increase innet interest income from $8,920 in 2004 to $13,627 in 2005. The increase of$4,707 in net interest income was the result of higher average loan balances.Non-interest income increased by $511 from $800 to $1,311, or 63.88%, primarilydue to gains on loan sales. These positive effects were partially offset by a52.89% increase in the provision for loan losses, from $2,420 in 2004 to $3,700in 2005 and an increase of $1,694 in non-interest expense, up 37.21% to $6,246in 2005 compared to $4,552 in 2004. The increase in the provision for loanlosses was the result of funding the loan loss reserve to match the growth inthe loan portfolio and loan charge-offs. The increase in non-interest expensewas due to the increase in personnel and general operating expenses due to the Corporation’sgrowth.

 

Net income for2004 was $1,666 an increase of $767 or 85.32%, compared to the $899 earned in2003.  The increase is attributable to a70.59% increase in net interest income from $5,229 in 2003 to $8,920 in2004.  The increase of $3,691 in netinterest income was the result of higher average loan balances.  Non-interest income increased by $368 from$432 to $800, or 85.19%, primarily due to gains on loan sales.  These positive effects were partially offsetby a 117.04% increase in the provision for loan losses, from $1,115 in 2003 to$2,420 in 2004 and an increase of $1,093 in non-interest expense, up 31.60% to$4,552 in 2004 compared to $3,459 in 2003. The increase in the provision for loan losses was the result of fundingthe loan loss reserve to match the growth in the loan portfolio and loancharge-offs.  The increase innon-interest expense was due to the increase in personnel and general operatingexpenses due to the Corporation’s growth.

 

**Net InterestIncome** - The primary source of earnings for theBank is net interest income which is the difference between the interest earnedon interest earning assets and the interest paid on interest bearing liabilities.  The major factors which affect net interestincome are changes in volumes, the yield on earning assets, and the cost ofinterest bearing liabilities.  Management’sability to respond to changes in interest rates by effective asset-liabilitymanagement techniques is critical to maintaining the stability of the netinterest margin and the momentum of the Bank’s primary source of earnings.

 

In mid-2004,the Federal Reserve Open Market Committee (FOMC) began a series of increases inshort-term interest rates.  By year-end2005, the FOMC had increased rates by 300 basis points. In anticipation of continuedrising interest rates, management has placed the Bank in a moderately assetsensitive position.  This means that moreassets are scheduled to reprice within the next year than liabilities, therebytaking advantage of the anticipated rise in interest rates. During 2005, $10,726of the net loan growth occurred in floating rate construction loans andapproximately 25% of the $94,100 increase in commercial loans were floatingrate transactions. Management expects to continue its practice of competing forloans based on providing superior service rather than the lowest price.

 

Net interest income for 2005 was $13,627 compared to$8,920, a gain of $4,707 or 52.77%. The increase in net interest income waslargely attributable to strong loan growth. Net loans increased from $213,326at December 31, 2004 to $344,187 at December 31, 2005—an increase of$130,861, or 61.34%. Net interest income was favorably impacted by the increasein the Bank’s indirect funding program for small transactions. These loans,which are purchased at a minimum rate of 8%, increased from $50.3 million atyear-end 2004 to $87.0 million at the end of 2005. The loan growth was matchedby an increase in deposits from $221,394 at December 31, 2004 to $367,705in 2005—an increase of $146,311 or 66.09%.

 

27

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Net interestincome for 2004 was $8,920 compared to $5,229 in 2003, a gain of $3,691 or70.59%.  The increase in net interestincome was largely attributable to strong loan growth.  Net loans increased from $133,187 at December31, 2003 to $213,326 at December 31, 2004 — an increase of $80,139, or 60.17%.Net interest income was favorably impacted by the expansion of the Bankindirect funding program for small transactions. These loans, which arepurchased at a minimum rate of 8%, increased from $27.4 million at year-end2003 to $50.3 million at the end of 2004. This high yielding portfolio is a key component in the stability andstrength of net interest income.  Theloan growth was matched by an increase in deposits from $142,293 at December31, 2003 to $221,394 in 2004 — an increase of $79,101 or 55.59%.

 

**Investments**- The Bank views the investment portfolio as a source of income and liquidity.Management’s investment strategy is to accept a lower immediate yield in theinvestment portfolio by targeting shorter term investments.   The Investment Policy requires a minimumportfolio level equal to 7.00% of total assets and a maximum portfolio level of20.00% of total assets.  Management hasmaintained the portfolio at the lower end of the policy guidelines with theportfolio at 7.91%, 7.60% and 8.32% of total assets at end of year in 2005, 2004and 2003 respectively.

 

The investmentportfolio at December 31, 2005 was $31,992 compared to $18,690 at year end2004. The interest earned on investments rose from $616 in 2004 to $967 in2005. That was a result of higher average portfolio balances as well asincreased yields. The average yield on the investment portfolio investmentsrose from 3.79% in 2004 to 4.19% in 2005 or 40 basis points.

 

The investmentportfolio at December 31, 2004 was $18,690 compared to $12,898 at year-end2003.    The average yield on theinvestment portfolio was 3.79% in 2004 compared to 3.58% in 2003.

 

**NetInterest Margin Analysis** -  The net interest margin is impacted by theaverage volumes of interest sensitive assets and interest sensitive liabilitiesand by the difference between the yield on interest sensitive assets and thecost of interest sensitive liabilities (spread).  Loan fees collected at origination representan additional adjustment to the yield on loans. The Bank’s spread can beaffected by economic conditions, the competitive environment, loan demand, anddeposit flows.  The net yield on earningassets is an indicator of the effectiveness of a bank’s ability to manage thenet interest margin by managing the overall yield on assets and the cost offunding those assets.

 

The twofactors that make up the spread are the interest rates received on loans andthe interest rates paid on deposits. The Bank has been disciplined in raisinginterest rates on deposits only as the market demanded and thereby managing thecost of funds. Also, the Bank has not competed for new loans on interest ratealone but has relied on effective marketing to business customers. Businesscustomers are not influenced by interest rates alone but are influenced byother factors such as timely funding. By working to positively impact bothfactors that make up the spread, the Bank has been able to improve its netinterest margin by 0.86% from the end of 2001 to the end of 2005. That is animprovement of 24.02% over a four-year period. While the Bank continues tostrive to improve its net interest margin, it is not reasonable to assume thatthe spread will continue to improve at the same rate.

 

The net interest margin declined from 4.56% in 2004 to4.44% in 2005 due to the cost of funds rising faster than the yield on earningassets during the year. Interest income increased by $10,448, or 79.24%, from$13,185 in 2004 to $23,633 in 2005. The increase was primarily due to increasedvolume. Average earning assets increased from $195,449 in 2004 to $ 306,765 in2005, an increase of $111,316 or 56.95%. The increase in earning assets was dueto loan growth. Average loans increased $103,522 or 59.39%. The average yieldon earning assets increased from 6.74% in 2004 to 7.70% in 2005 or 96 basispoints.The increasein the Bank’s indirect funded small loan portfolio favorably impacted theaverage yield on earning assets. The average yield on this type of loan in 2005was 9.10%.These loans increased73.02% from $50.3 million at year-end 2004 to $87.1 million at the end of 2005.   Interestexpense increased from $4,265 in 2004 to $10,006 in 2005. The $5,741, or134.60%, increase in expense was due to increases in the volume of deposits aswell as an increase in the cost of funds. Average deposits increased from$167,647 in 2004 to $273,040 in 2005, an increase of $105,393 or 62.86%. Thecost of funds increased from 2.54% in 2004 to 3.66% in 2005 or 112 basispoints.

 

28

----

 

The netinterest margin improved from 4.22% in 2003 to 4.56% in 2004 due to an improvedyield on earning assets and a lower cost of funding.  Interest income increased by $4,980, or60.69%, from $8,205 in 2003 to $13,185 in 2004. The increase was primarily due to increased volume.  Average earning assets increased from $123,888in 2003 to $195,449 in 2004, an increase of $71,561 or 57.76%.  The increase in earning assets was due toloan growth. Average loans increased $68,463 or 64.68%.  The average yield on earning assets increasedfrom 6.62% in 2003 to 6.74% in 2004 or 12 basis points. The net interest marginwas favorably impacted by the expansion of the Bank’s indirect funded smallloan portfolio.  These loans increasedfrom $27.4 million at year-end 2003 to $50.3 million at the end of 2004.  This high yielding portfolio is a keycomponent in the strength of the net interest margin. During 2004, a period ofhistorically low interest rates, the market for quality loans was highlycompetitive.  Management emphasizedpricing discipline throughout the year to ensure that growth was not achievedby competing on reduced pricing. The Bank will continue to focus its marketingefforts on customers who are more sensitive to service than price.

 

Interestexpense increased from $4,265 in 2004 to $10,006 in 2005.  The $5,741, or 134.61%, increase in expensewas due to increases in the volume of deposits as well as interest rates. Averageinterest bearing deposits increased from $167,647 in 2004 to $273,040 in 2005,an increase of $105,393 or 62.87%. Additionally, the cost of funds increasedfrom 2.54% in 2004 to 3.66% in 2005.

 

Interestexpense increased from $2,976 in 2003 to $4,265 in 2004.  The $1,289, or 43.31%, increase in expensewas due to increases in the volume of deposits.   Average interest bearing deposits increasedfrom $108,140 in 2003 to $167,647 in 2004, an increase of $59,507 or55.02%.  Despite the fact that ratesstarted increasing in the last half of 2004, management was aggressive inlowering interest rates on savings accounts and other products during theyear.  As a result, the cost of funds wasreduced from 2.75% in 2003 to 2.54% in 2004, a decline of 21 basis points. Thelocal deposit market is highly competitive and rates tend to lead nationalaverages.  The Bank partially offsets thehigher cost of local deposits by acquisition of wholesale funding in thenational market.

 

**Provisionfor Loan Losses** - Management assesses the adequacyof the allowance for loan losses with a combination of qualitative andquantitative factors.  At inception, eachloan is assigned a risk rating that ranges from “RR1 to RR4”.  An RR1 assignment indicates a “Superior”credit, RR2 represents an “Excellent” credit, RR3 represents an “Above-Average”loan, and RR4 designates an “Average” credit. The assignment of a risk rating is based on an evaluation of the creditrisk in the transaction.  The evaluationincludes consideration of the borrower’s financial capacity, collateral, cashflows, liquidity, and alternative sources of repayment.  If a loan deteriorates and the level of riskincreases, management downgrades the loan to RR5-”Watch”, RR6-”Criticized”, orRR7-”Substandard”, depending on the circumstances.  A review by an independent accounting firm ofthe assigned risk ratings is an integral part of the Bank’s external LoanReview program.

 

Management reviewsthe loan portfolio regularly to determine if loans should be placed onnon-accrual for revenue recognition. If a loan is placed on non-accrual, allinterest earned since the last current payment is immediately reversed.  Loans may remain on non-accrual status untilthe underlying collateral is repossessed and valued or until the amount of lossin the credit can be reasonably determined. Once collateral is repossessed and appraised, the collateral is recordedas a repossession at the lower fair value or the investment in the relatedloan.  Any difference between theestimated fair value of the collateral and the loan balance is chargedoff.  Variances in fair value estimatesare recorded as a gain or loss on sale when the collateral is sold.   Non-accrual loans totaled $2,928, $2,161 and$1,136 at year-end 2005, 2004 and 2003. These amounts represented 0.85%, 1.01% and 0.85% of net loans at the endof each year.

 

Managementuses the weighted average risk rating to monitor the overall credit quality andtrends in the loan portfolio. At December 31, 2005, the weighted average riskrating of the $344,187 net loan portfolio was 3.62. At December 31, 2004, theweighted average risk rating of the $213,326 net loan portfolio was 3.63.  The Board of Directors reviews the weightedaverage risk rating of loans booked during the previous month.  In addition, the Board reviews all creditsclassified RR5 or higher monthly.  Managementclosely monitors other key loan quality indicators including delinquencies,changes in the portfolio mix and general economic conditions.  These actions provide a degree of objectivityin assessing the risk in the portfolio and establishing an adequate loan lossreserve.  To the extent that actual andanticipated losses differ, adjustments are made to the loan loss provision orto the level of the allowance for loan losses. At December 31, 2005, the loanloss reserve of $4,399 was 1.26% of gross loans of $348,586.

 

29

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The provision for loan losses in 2005 was $3,700, anincrease of $1,280, or 52.89%, above the provision of $2,420 expensed in 2004.$1,558 of the provision, or 42.11%, was attributable to loan growth recordedduring 2005. The remainder of the loan loss provision in 2005 funded net chargeoffs of $2,142.

 

The provisionfor loan losses in 2004 was $2,420, an increase of $1,305, or 117.04%, abovethe provision expensed in 2003.  $841 ofthe provision, or 34.75%, was attributable to maintaining a general reserve forthe loan growth recorded during 2004. The remainder of the loan loss provision in 2004 funded net charge offsof $1,579 of which $819 was attributable to a single loan. On the collateralfor this loan, the Bank’s recovery was minimal and far below the cost and theappraised value of the equipment.

 

The Banktargets small and medium sized businesses as loan customers. Because of theirsize, these borrowers may be less able to withstand competitive or economicpressures than larger borrowers in periods of economic weakness. If loan lossesoccur to a level where the loan loss reserve is not sufficient to cover actualloan losses, the Bank’s earnings will decrease. The Bank uses an independent accountingfirm to review our loans quarterly for quality in addition to the reviews thatmay be conducted by bank regulatory agencies as part of their usual examinationprocess.

 

The following table presentsinformation regarding non-accrual, past due and restructured loans at December31, 2005, 2004, 2003, 2002 and 2001:

 
| ** **                                                                                              | ** ** | **December 31,**          | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                              | ** ** | **($ in thousands)** | ** ** |
| Non-accrual loans                                                                                       |       |                           |       |   |   |   |   |   |   |   |   |
| Number                                                                                                  |       | 46                             |       | 17 |   | 12 |   | 10 |   | 5 |   |
| Amount                                                                                                  |       | $                              | 2,928      |   | $ | 2,161 |   | $ | 1,136 |   | $ | 1,104 |   | $ | 990 |   |
|                                                                                                    |       |                           |       |   |   |   |   |   |   |   |   |
| Accruing loans which are contractually past  due 90 days or more as to principal and interest payments: |       |                           |       |   |   |   |   |   |   |   |   |
| Number                                                                                                  |       | 9                              |       | 4 |   | 6 |   | — |   | — |   |
| Amount                                                                                                  |       | $                              | 352        |   | $ | 111 |   | $ | 308 |   | $ | — |   | $ | — |   |
|                                                                                                    |       |                           |       |   |   |   |   |   |   |   |   |
| Loans defined as “troubled debt  restructurings”                                              |       |                           |       |   |   |   |   |   |   |   |   |
| Number                                                                                                  |       | 3                              |       | 2 |   | 1 |   | — |   | — |   |
| Amount                                                                                                  |       | $                              | 1,144      |   | $ | 1,544 |   | $ | 1,101 |   | $ | — |   | $ | — |   |
|                                                                                                    |       |                           |       |   |   |   |   |   |   |   |   |
| Gross interest income lost on the above  loans                                                          |       | $                              | 133        |   | $ | 82 |   | $ | 193 |   | $ | 158 |   | $ | 78 |   |
|                                                                                                    |       |                           |       |   |   |   |   |   |   |   |   |
| Interest income included in net income on  the above loans                                              |       | $                              | 31         |   | $ | 48 |   | $ | 29 |   | $ | 24 |   | $ | 87 |   |

 

As of December 31, 2005,there are no loans classified for regulatory purposes as doubtful orsubstandard that have not been disclosed in the above table, which (i)represent or result from trends or uncertainties which management reasonablyexpects will materially impact future operating results, liquidity, or capitalresources, or (ii) represent material credits about which management is awareof any information which causes management to have serious doubts as to theability of such borrowers to comply with the loan repayment terms.

 

30

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The Bank had no tax-exemptloans during the period ended December 31, 2005.  The Bank had no loans outstanding to foreignborrowers at December 31, 2005.

 

An analysis of the Bank’sloss experience is furnished in the following table for December 31, 2005,2004, 2003, 2002 and 2001, and the periods then ended (dollars in thousands): 

 
| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| **($ in thousands)**                         | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                              |       |                  |       |   |   |   |   |   |   |   |   |
| Allowance for loan losses at beginning of  period |       | $                     | 2,841      |   | $ | 2,000 |   | $ | 1,103 |   | $ | 919 |   | $ | 736 |   |
| Charge-offs:                                      |       |                  |       |   |   |   |   |   |   |   |   |
| Real estate:                                      |       |                  |       |   |   |   |   |   |   |   |   |
| Construction                                      |       | —                |       | — |   | — |   | — |   | — |   |
| 1 to 4 family residential                         |       | —                |       | 101 |   | — |   | — |   | — |   |
| Other                                             |       | —                |       | 131 |   | — |   | — |   | — |   |
| Commercial, financial and agricultural            |       | 2,379                 |       | 1,366 |   | 235 |   | 105 |   | 641 |   |
| Consumer                                          |       | 32                    |       | 57 |   | 48 |   | 31 |   | — |   |
| Other                                             |       | —                |       | — |   | — |   | — |   | — |   |
| Total Charge-offs                                 |       | 2,411                 |       | 1,655 |   | 283 |   | 136 |   | 641 |   |
|                                              |       |                  |       |   |   |   |   |   |   |   |   |
| Recoveries:                                       |       |                  |       |   |   |   |   |   |   |   |   |
| Real estate:                                      |       |                  |       |   |   |   |   |   |   |   |   |
| Construction                                      |       | —                |       | — |   | — |   | — |   | — |   |
| 1 to 4 family residential                         |       | 1                     |       | — |   | — |   | — |   | — |   |
| Other                                             |       | —                |       | 3 |   | — |   | — |   | — |   |
| Commercial, financial and agricultural            |       | 245                   |       | 68 |   | 64 |   | 3 |   | 9 |   |
| Consumer                                          |       | 23                    |       | 5 |   | 1 |   | — |   | — |   |
| Other                                             |       | —                |       | — |   | — |   | — |   | — |   |
| Total Recoveries                                  |       | 269                   |       | 76 |   | 65 |   | 3 |   | 9 |   |
|                                              |       |                  |       |   |   |   |   |   |   |   |   |
| Net Charge-offs                                   |       | 2,142                 |       | 1,579 |   | 218 |   | 133 |   | 632 |   |
|                                              |       |                  |       |   |   |   |   |   |   |   |   |
| Provision for loan losses charged to  expense     |       | 3,700                 |       | 2,420 |   | 1,115 |   | 317 |   | 815 |   |
|                                              |       |                  |       |   |   |   |   |   |   |   |   |
| Allowance for loan losses at end of period        |       | $                     | 4,399      |   | $ | 2,841 |   | $ | 2,000 |   | $ | 1,103 |   | $ | 919 |   |

 
| ** **                                                                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                  | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|                                                                                        |       |                  |       |   |   |   |   |   |   |   |   |
| Net charge-offs as a percentage of average  total loans outstanding during the year         |       | 0.76                  | %          | 0.89 | % | 0.20 | % | 0.23 | % | 1.56 | % |
|                                                                                        |       |                  |       |   |   |   |   |   |   |   |   |
| Ending allowance for loan losses as a  percentage of total loans outstanding at end of year |       | 1.26                  | %          | 1.31 | % | 1.48 | % | 1.43 | % | 2.04 | % |

 

The allowance for loanlosses is established by charges to operations based on management’s evaluationof the loan portfolio, past due loan experience, collateral values, currenteconomic conditions and other factors considered necessary to maintain theallowance at an adequate level. Management feels that the allowance is adequateat December 31, 2005.

 

31

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At December 31, 2005, 2004,2003, 2002 and 2001, the allowance was allocated as follows (dollars inthousands):

 
| ** **                              | ** ** | **2005**   | ** ** | **2004**                                                    | ** ** | **2003**   | ** ** | **2002**                                                    | ** ** | **2001**   | ** ** |
|-----------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|------------|------------|
| **($ in thousands)**               | ** ** | **Amount** | ** ** | **Percentage  of loans in  each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage  of loans in  each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage  of loans in  each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage  of loans in  each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage  of loans in  each  category to  total loans** | ** ** |
| Real estate:                            |       |       |       |                                                        |       |       |       |                                                        |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Construction                            |       | $          | 383        |                                                        | 10.98      | %          | $          | 175                                                         |       | 10.55      | %          | $ | 71 |   | 7.68 | % | $ | 83 |   | 8.59 | % | $ | 52 |   | 9.21 | % |
| 1 to 4 family  residential              |       | 225        |       | 5.27                                                        | %          | 75         |       | 7.38                                                        | %          | 57         |       | 10.00 | % | 167 |   | 17.28 | % | 121 |   | 21.54 | % |
| Other                                   |       | 504        |       | 14.45                                                       | %          | 265        |       | 15.59                                                       | %          | 331        |       | 14.85 | % | 131 |   | 13.59 | % | 108 |   | 19.32 | % |
| Commercial,  financial and agricultural |       | 3,197      |       | 67.11                                                       | %          | 2,272      |       | 64.68                                                       | %          | 1,510      |       | 65.03 | % | 697 |   | 58.00 | % | 619 |   | 46.63 | % |
| Consumer                                |       | 45         |       | .90                                                         | %          | 54         |       | 1.80                                                        | %          | 31         |       | 2.44 | % | 25 |   | 2.54 | % | 19 |   | 3.30 | % |
| Other                                   |       | 45         |       | 1.29                                                        | %          | —     |       | 0.00                                                        | %          | —     |       | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % |
|                                    |       |       |       |                                                        |       |       |       |                                                        |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Total                                   |       | $          | 4,399      |                                                        | 100.00     | %          | $          | 2,841                                                       |       | 100.00     | %          | $ | 2,000 |   | 100.00 | % | $ | 1,103 |   | 100.00 | % | $ | 919 |   | 100.00 | % |
|                                         |            |            |            |                                                             |            |            |            |                                                             |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Non-interestIncome** - Non-interest income is income that is notrelated to interest-earning assets.  In atypical retail bank, non-interest income consists primarily of service chargesand fees on deposit accounts and mortgage origination fees.  Due to the business focus of the Bank and thelack of a large retail customer base, revenues from these traditional sourceswill remain modest.

 

The Bank earned $105 in mortgage origination fees in2005 compared to $130 earned in 2004, a decline of $25 or 19.23%. The declinein mortgage loan demand and mortgage origination income is attributed to the continuedrising interest rates in 2005. Management believes that rates will continue torise for part of 2006 and that the mortgage unit will provide a value-addedservice with modest revenue results.

 

The Bankearned $1,106 in 2005 on a series of loan sale transactions compared to $504 in2004. The Bank is located in a vibrant market area and can generate qualityassets at a faster rate than it can adequately fund them. In addition tolending in the local marketplace, the Bank provides collateral-based loans tobusiness borrowers in other states through two types of indirect fundingprograms. During 2004, management identified a network of community banks eagerto purchase quality assets, and four loan sale transactions were completed thatyear.  Management has installedappropriate systems and processes to sell assets to other banks located inslower growing markets and believes that loan sales will be a recurring sourceof revenue.

 

In 2004, theBank earned $504 on a series of loan sale transactions, the first year of thisactivity.  The Bank earned $130 inmortgage origination fees in 2004 compared to $148 earned in 2003, a decline of$18 or 12.16%.  The decline in mortgageorigination income is attributed to rising interest rates starting in mid-2004and the slowing of refinancing activity. Income earned in the form of service charges on deposits totaled $24, again of $7, or 41.18% above the $17 earned in 2003.  Gain on sales of securities declined by $99or 75.00% from $132 in 2003 to $33 in 2004. This decline was due to the rise in interest rates in 2004 and thesubsequent lack of opportunities to recognize market gains in the investmentportfolio.

 

**Non-interestExpense** - Non-interest expense includes salariesand benefits expense, occupancy costs, and other operating expenses includingdata processing, professional fees, supplies, postage, telephone, and otheritems.  Management views the control ofoperating expense as a critical element in the success of the Business Bankstrategy.  The Bank operates moreefficiently than peer banks because it conducts business from a single locationand does not provide banking services for many retail customers with hightransaction volume.

 

Managementtargets $7.5 million in assets per full time employee as a measure of staffingefficiency. Management believes that the growth of the Bank will offeradditional opportunities to leverage personnel resources.  The Bank does expect to hire employees in2006 so salaries and benefits expense will increase, but the target for AverageAssets per Employee will remain at $7.5 million per employee.

 

32

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Non-interest expense for 2005 was $6,246, an increaseof $1,694 or 37.21%, over the $4,552 expensed in 2004. Approximately 65% of theincrease was due to the addition of new employees during the year. The Bankended 2005 with 41 full time employees. Assets per employee was $9.8 million atyear-end 2005 compared to $7.7 million at year-end 2004.

 

Non-interestexpense for 2004 was $4,552, an increase of $1,093 or 31.60%, over the $3,459expensed in 2003.  Approximately half ofthe increase was due to the addition of five new employees during theyear.  The Bank ended 2004 with 32 fulltime employees.  Assets per employee was$7.7 million at year-end 2004 and $5.8 million at year-end 2003.

 

**IncomeTaxes** - The Corporation’s effective tax rate in2005 was 38.56% compared to 39.37% in 2004 and 17.30% in 2003.  The change in the applicable tax ratereflects the Corporation’s progression from initial operating losses to currentprofits.  Management anticipates that taxrates in future years will approximate the rates paid in 2005.

 

**Changes in Financial Condition**

 

(dollars inthousands except share data)

 

**Assets-** Total assets at December 31, 2005, were $404,040, an increase of$158,123 or 64.29%, over total assets of $245,917 at December 31, 2004.Average assets for 2005 were $315,974, an increase of $114,835, or 57.09% overaverage assets in 2004. Loan growth was the primary reason for the increase.Year-end 2005 net loans were $344,187, up $130,861, or 61.34% over the year-end2004 total net loans of $213,326.

 

Total assetsat December 31, 2004, were $245,917, an increase of $89,842 or 57.56%, overtotal assets of $156,075 at December 31, 2003. Average assets for 2004 were $201,139, an increase of $73,072, or 57.05%over average assets in 2003.  Loan growthwas the primary reason for the increase. Year-end 2004 net loans were $213,326, up $80,139, or 60.17% over theyear-end 2003 total net loans of $133,187.

 

The Bank’sBusiness Bank model of operation results in a higher level of earning assetsthan peer banks.  Earning assets aredefined as assets which earn interest income. Earning assets include short-term investments, the investment portfolio,and net loans.  The Bank maintains ahigher level of earning assets because fewer assets are allocated tofacilities, cash, and due-from bank accounts used for transaction processing. Earningassets at December 31, 2005, were $388,714, or 96.20% of total assets of$404,040. Earning assets at December 31, 2004, were $238,598, or 97.02%of total assets of $245,917.  Managementtargets an earning asset to total asset ratio of 97% or higher. This ratio isexpected to generally continue at these levels although this may be affected byeconomic factors beyond the Bank’s control.

 

**Liabilities-** The Bank relies on increasing its deposit base to fund loan and otherasset growth.  The Williamson Countymarketplace is highly competitive with 20 financial institutions and 72 bankingfacilities (as of June 30, 2005). The Bank competes for local deposits byoffering attractive products with premium rates.  The Bank expects to have a higher averagecost of funds for local deposits than competitor banks due to its singlelocation and lack of a branch network. Management’s strategy is to offset the higher cost of funding with alower level of operating expense and firm pricing discipline for loanproducts.  The Bank has promotedelectronic banking services by providing them without charge and by offeringin-bank customer training.

 

The Bank alsoobtains funding in the wholesale deposit market which is accessed by means ofan electronic bulletin board.  Thiselectronic market links banks and sellers of deposits to deposit purchaserssuch as credit unions, school districts, labor unions, and other organizationswith excess liquidity.  Deposits may beraised in ninety-nine thousand dollar ($99,000) or one hundred thousand dollar($100,000) increments in maturities from two weeks to five years.  Management believes the utilization of theelectronic bulletin board is highly efficient and the average rate has been generallyless than rates paid in the local market. Participants in the electronic marketpay a modest annual licensing fee and there are no transaction charges.  Management has established policies andprocedures to govern the acquisition of funding through the wholesalemarket.  Wholesale deposits arecategorized as “Purchased Time Deposits” on the detail of deposits shown inthis Item 7. Management may also, from time to time, engage the services of adeposit broker to raise a block of funding at a specified maturity date.

 

33

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Total average deposits in 2005 were $284,977, anincrease of $103,417, or 56.96% over the total average deposits of $181,560 in2004. Average non-interest bearing deposits increased by $4,471, or 31.28%,from $14,292 in 2004 to $18,763 in 2005. Average savings deposits decreased by$11,721 from $34,506 in 2004 to $22,785 in 2005. Average purchased depositsincreased by $47,811, or 48.53%, from $98,515 in 2004 to $146,326 in 2005. Theaverage rate paid on purchased deposits in 2005 was 3.55% compared to 2.68% in2004. Purchased time deposit funding represented 51.34% of total funding in2005 compared to 54.26% in 2004.

 

Total averagedeposits in 2004 were $181,560, an increase of $65,282, or 56.14% over thetotal average deposits of $116,278 in 2003. Average non-interest bearing deposits increased by $5,916, or 70.63%,from $8,376 in 2003 to $14,292 in 2004. Average savings deposits grew by $7,508 from $26,998 in 2003 to $34,506in 2004.  Average purchased depositsincreased by $41,393, or 72.46%, from $57,122 in 2003 to $98,515 in 2004.  The average rate paid on purchased timedeposits in 2004 was 2.68% compared to 2.90% in 2003.  Purchased time deposit funding represented54.26% of total funding in 2004 compared to 49.13% in 2003.

 

**Off-balancesheet arrangements** - The Bank is a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit and standby letters of credit.  Those instruments involve, to varyingdegrees, elements of credit risk in excess of the amount recognized in thebalance sheet.  The contract or notionalamounts of those instruments reflect the extent of involvement the Bank has inthose particular financial instruments.

 

The Bank’sexposure to credit loss in the event of nonperformance by the other party tothe financial instrument for commitments to extend credit and standby lettersof credit is represented by the contractual or notional amount of thoseinstruments.  The Bank uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments.

 

Financialinstruments whose contract amounts represent credit risk:

 
| ** **                    | ** ** | **2005**        | ** ** | **2004**           | ** ** | **2003**        | ** ** |
|-------------------------------|------------|-----------------|------------|--------------------|------------|-----------------|------------|
| **($ in thousands)**     | ** ** | **Fixed  Rate** | ** ** | **Variable  Rate** | ** ** | **Fixed  Rate** | ** ** | **Variable  Rate** | ** ** | **Fixed  Rate** | ** ** | **Variable  Rate** | ** ** |
|                          |       |            |       |               |       |            |       |   |   |   |   |   |   |
| Commitments  to extend credit |       | $               | 2,404      |               | $          | 38,859          |       | $ | 4,014 |   | $ | 29,638 |   | $ | 2,605 |   | $ | 15,529 |   |
| Standby  letters of credit    |       | —          |       | 5,686              |       | —          |       | 2,139 |   | — |   | 1,558 |   |
|                               |            |                 |            |                    |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Commitments tomake loans are generally made for periods of one year or less.  The fixed rate loan commitments have interestrates ranging from 5.75% to 10.00% and maturities ranging from 6 months to 5years.

 

Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected toexpire without being drawn upon, the total commitment amounts do notnecessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case–by-casebasis.  The amount of collateral obtainedif deemed necessary by the Bank upon extension of credit is based on management’scredit evaluation. Collateral held varies but may include accounts receivable,inventory, property, plant and equipment, and income-producing commercialproperties.

 

Standbyletters of credit are conditional commitments issued by the Bank to guaranteethe performance of a customer to a third party. Those guarantees are primarily issued to support public and privateborrowing arrangements, including commercial paper, bond financing, and similartransactions.  All letters of credit aredue within one year or less of the original commitment date.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loan facilitiesto customers.

 

34

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The Bankprimarily serves customers located in Middle Tennessee.  As such, the Bank’s loans, commitments andletters of credit have been granted to customers in that area.

 

**ContractualObligations** — At December 31, 2005, the Bank hadcertain contractual obligations as shown below. 

 
| ** **                              | ** ** | **Payments due by Period** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **Total**                                 | ** ** | **LessThan  1 Year** | ** ** | **1-3  Years** | ** ** | **3-5  Years** | ** ** | **More than  5 Years** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)**      | ** ** |
| Contractual Obligations (1)             |       |                                      |       |   |   |   |   |   |   |   |   |
| Deposits without a stated maturity |       | $                                         | 113,361    |   | $ | 113,361 |   | $ | — |   | $ | — |   | $ | — |   |
| Certificates of deposit                 |       | 255,350                                   |       | 151,948 |   | 59,377 |   | 44,025 |   | — |   |
| Subordinated long term debt             |       | 8,248                                     |       | — |   | — |   | — |   | 8,248 |   |
| Capital lease obligations               |       | —                                    |       | — |   | — |   | — |   | — |   |
| Operating lease obligations             |       | 1,326                                     |       | 247 |   | 526 |   | 553 |   | — |   |
| Purchase obligations                    |       | —                                    |       | — |   | — |   | — |   | — |   |
| Other long term liabilities             |       | —                                    |       | — |   | — |   | — |   | — |   |
| Total                                   |       | $                                         | 378,285    |   | $ | 265,556 |   | $ | 59,903 |   | $ | 44,578 |   | $ | 8,248 |   |

 

----

(1)    excludes interest

 

35

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**Financial Tables**

 

The followingfinancial information regarding the Corporation and the Bank should be read inconjunction with the Corporation’s financial statements included in Item 8 ofthis Report.

 

**Average Balance Sheets, Net Interest Incomeand Changes in Interest Income and Interest Expense**

 

The followingtables show the average monthly balances of each principal category of assets,liabilities and stockholders’ equity of the Bank, and an analysis of netinterest revenue, and the change in interest income and interest expensesegregated into amount attributable to changes in volume and changes inrates.  The table is presented on taxableequivalent basis, if applicable.

 
| ** **                        | ** ** | **12 months Ended December 31, 2005** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| **(dollars in thousands)**        | ** ** | **Average  Balance**                  | ** ** | **Interest** | ** ** | **Average  Rate** | ** ** |
| **ASSETS**                        |       |                                  |       |   |   |   |   |
|                              |       |                                  |       |   |   |   |   |
| Interest earning assets           |       |                                  |       |   |   |   |   |
| Securities                        |       |                                  |       |   |   |   |   |
| Taxable (1)                       |       | $                                     | 23,034     |   | $ | 980 |   | 4.19 | % |
| Tax-exempt                        |       | —                                |       | — |   | — |   |
| Total securities                  |       | 23,034                                |       | 980 |   | 4.19 | % |
|                              |       |                                  |       |   |   |   |   |
| Loans (2) (3)                     |       | 277,821                               |       | 22,488 |   | 8.09 | % |
| Federal funds sold                |       | 5,910                                 |       | 165 |   | 2.79 | % |
| Total interest earning assets     |       | 306,765                               |       | 23,633 |   | 7.70 | % |
|                              |       |                                  |       |   |   |   |   |
| Non-interest earning assets       |       |                                  |       |   |   |   |   |
| Cash and due from banks           |       | 4,097                                 |       |   |   |   |   |
| Net fixed assets and equipment    |       | 731                                   |       |   |   |   |   |
| Accrued interest and other assets |       | 4,381                                 |       |   |   |   |   |
|                              |       |                                  |       |   |   |   |   |
| Total assets                      |       | $                                     | 315,974    |   |   |   |   |   |
|                                   |            |                                       |            |  |  |  |  |  |  |

 

36

----

 
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**   |   |    |    |   |   |   |   |
|-------------------------------------------------|--------|---------|---------|--------|--------|--------|--------|
|                                            |   |    |    |   |   |   |   |
| Interest bearing liabilities                    |   |    |    |   |   |   |   |
| Deposits (other than demand)                    |   | $       | 266,214 |   | 9,568  |   | 3.59   | % |
| Federal funds purchased                         |   | 589     |    | 22     |   | 3.74   | %      |
| Subordinated debt                               |   | 6,237   |    | 416    |   | 6.68   | %      |
| Total interest bearing liabilities              |   | 273,040 |    | 10,006 |   | 3.66   | %      |
|                                            |   |    |    |   |   |   |   |
| Non-interest bearing liabilities                |   |    |    |   |   |   |   |
| Non-interest bearing demand deposits            |   | 16,489  |    |   |   |   |   |
| Other liabilities                               |   | 1,481   |    |   |   |   |   |
| Shareholders’ equity                       |   | 24,964  |    |   |   |   |   |
|                                            |   |    |    |   |   |   |   |
| Total liabilities and shareholders’ equity |   | $       | 315,974 |   |   |   |   |   |

 
| Net Interest Spread |   | 4.03   | %      |
|---------------------|--------|--------|--------|
|                |   |   |   |
| Net Interest Margin |   | 4.44   | %      |

 

----

(1)   Unrealized loss of $357 is excluded from yieldcalculation.

(2)   Non-accrual loans are included in average loanbalances and loan fees of $1,438 are included in interest income.

(3)   Loans are presented net of allowance for loanloss

 
| ** **                        | ** ** | **12 months Ended December 31, 2004** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **Average**                           | ** ** | **Average** | ** ** | ** ** | ** ** |
| **(dollars in thousands)**        | ** ** | **Balance**                           | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| **ASSETS**                        |       |                                  |       |   |   |   |   |
| ** **                        |       |                                  |       |   |   |   |   |
| Interest  earning assets          |       |                                  |       |   |   |   |   |
| Securities                        |       |                                  |       |   |   |   |   |
| Taxable (1)                       |       | $                                     | 15,987     |   | $ | 616 |   | 3.79 | % |
| Tax-exempt                        |       | —                                |       | — |   | — |   |
| Total securities                  |       | 15,987                                |       | 616 |   | 3.79 | % |
|                              |       |                                  |       |   |   |   |   |
| Loans (2)  (3)                    |       | 174,296                               |       | 12,496 |   | 7.17 | % |
| Federal  funds sold               |       | 5,166                                 |       | 73 |   | 1.41 | % |
| Total  interest earning assets    |       | 195,449                               |       | 13,185 |   | 6.74 | % |
|                              |       |                                  |       |   |   |   |   |
| Non-interest  earning assets      |       |                                  |       |   |   |   |   |
| Cash and due from banks           |       | 3,045                                 |       |   |   |   |   |
| Net fixed assets and equipment    |       | 644                                   |       |   |   |   |   |
| Accrued interest and other assets |       | 2,001                                 |       |   |   |   |   |
|                              |       |                                  |       |   |   |   |   |
| Total assets                      |       | $                                     | 201,139    |   |   |   |   |   |
|                                   |            |                                       |            |  |  |  |  |  |  |

 

37

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| **LIABILITIES AND SHAREHOLDERS’ EQUITY**    |   |    |    |   |   |   |   |
|--------------------------------------------------|--------|---------|---------|--------|--------|--------|--------|
| ** **                                       |   |    |    |   |   |   |   |
| Interest  bearing liabilities                    |   |    |    |   |   |   |   |
| Deposits (other than demand)                     |   | $       | 167,268 |   | 4,257  |   | 2.55   | % |
| Federal funds purchased                          |   | 379     |    | 8      |   | 2.11   | %      |
| Total interest bearing liabilities               |   | 167,647 |    | 4,265  |   | 2.54   | %      |
|                                             |   |    |    |   |   |   |   |
| Non-interest  bearing liabilities                |   |    |    |   |   |   |   |
| Non-interest bearing demand deposits             |   | 14,292  |    |   |   |   |   |
| Other liabilities                                |   | 525     |    |   |   |   |   |
| Shareholders’ equity                        |   | 18,675  |    |   |   |   |   |
|                                             |   |    |    |   |   |   |   |
| Total  liabilities and shareholders’ equity |   | $       | 201,139 |   |   |   |   |   |

 
| Net Interest  Spread |   | 4.20   | %      |
|----------------------|--------|--------|--------|
|                 |   |   |   |
| Net Interest  Margin |   | 4.56   | %      |

 

----

(1)   Unrealized loss of $253 is excluded from yieldcalculation.

(2)   Non-accrual loans are included in average loanbalances and loan fees of $858 are included in interest income.

(3)   Loans are presented net of allowance for loanloss

 
| ** **                        | ** ** | **12 months Ended December 31, 2003** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **Average**                           | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(dollars in thousands)**        | ** ** | **Balance**                           | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| **ASSETS**                        |       |                                  |       |   |   |   |   |
| ** **                        |       |                                  |       |   |   |   |   |
| Interest  earning assets          |       |                                  |       |   |   |   |   |
| Securities                        |       |                                  |       |   |   |   |   |
| Taxable (1)                       |       | $                                     | 13,562     |   | $ | 486 |   | 3.58 | % |
| Tax-exempt                        |       | —                                |       | — |   | — |   |
| Total securities                  |       | 13,562                                |       | 486 |   | 3.58 | % |
|                              |       |                                  |       |   |   |   |   |
| Loans (2)  (3)                    |       | 105,833                               |       | 7,654 |   | 7.23 | % |
| Federal  funds sold               |       | 4,493                                 |       | 65 |   | 1.45 | % |
| Total  interest earning assets    |       | 123,888                               |       | 8,205 |   | 6.62 | % |
|                              |       |                                  |       |   |   |   |   |
| Non-interest  earning assets      |       |                                  |       |   |   |   |   |
| Cash and due from banks           |       | 2,151                                 |       |   |   |   |   |
| Net fixed assets and equipment    |       | 552                                   |       |   |   |   |   |
| Accrued interest and other assets |       | 1,476                                 |       |   |   |   |   |
|                              |       |                                  |       |   |   |   |   |
| Total assets                      |       | $                                     | 128,067    |   |   |   |   |   |
|                                   |            |                                       |            |  |  |  |  |  |  |

 

38

----

 
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**    |   |    |    |   |   |   |   |
|--------------------------------------------------|--------|---------|---------|--------|--------|--------|--------|
| ** **                                       |   |    |    |   |   |   |   |
| Interest  bearing liabilities                    |   |    |    |   |   |   |   |
| Deposits (other than demand)                     |   | $       | 107,902 |   | 2,973  |   | 2.76   | % |
| Federal funds purchased                          |   | 238     |    | 3      |   | 1.26   | %      |
| Total interest bearing liabilities               |   | 108,140 |    | 2,976  |   | 2.75   | %      |
|                                             |   |    |    |   |   |   |   |
| Non-interest  bearing liabilities                |   |    |    |   |   |   |   |
| Non-interest bearing demand deposits             |   | 8,376   |    |   |   |   |   |
| Other liabilities                                |   | 309     |    |   |   |   |   |
| Shareholders’ equity                        |   | 11,242  |    |   |   |   |   |
|                                             |   |    |    |   |   |   |   |
| Total  liabilities and shareholders’ equity |   | $       | 128,067 |   |   |   |   |   |

 
| Net Interest  Spread |   | 3.87   | %      |
|----------------------|--------|--------|--------|
|                 |   |   |   |
| Net Interest  Margin |   | 4.22   | %      |

 

----

(1)   Unrealized loss of $2 is excluded from yieldcalculation.

(2)   Non-accrual loans are included in average loanbalances and loan fees of $561are included in interest income.

(3)   Loans are presented net of allowance for loanloss

 

The followingTables outline the components of the net interest margin for the years 2005,2004, and 2003 and identifies the impact of changes in volume and the changesin rate.

 
| ** **                   | ** ** | **December 31, 2005 change from** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | **December 31, 2004 due to:**     | ** ** |
| **(dollars in thousands)**   | ** ** | **Volume**                        | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest  income             |       |                              |       |   |   |   |   |
| Loans                        |       | $                                 | 8,209      |   | $ | 1,783 |   | $ | 9,992 |   |
| Securities – taxable    |       | 290                               |       | 74 |   | 364 |   |
| Federal funds sold           |       | 12                                |       | 80 |   | 92 |   |
| Total  interest income       |       | 8,511                             |       | 1,937 |   | 10,448 |   |
|                         |       |                              |       |   |   |   |   |
| Interest  expense            |       |                              |       |   |   |   |   |
| Deposits (other than demand) |       | 3,130                             |       | 2,181 |   | 5,311 |   |
| Federal funds purchased      |       | 6                                 |       | 8 |   | 14 |   |
| Subordinated debt            |       | 416                               |       | — |   | 416 |   |
| Total  interest expense      |       | 3,552                             |       | 2,189 |   | 5,741 |   |
|                         |       |                              |       |   |   |   |   |
| Net interest  income         |       | $                                 | 4,959      |   | $ | (252 | ) | $ | 4,707 |   |

 

39

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| ** **                   | ** ** | **December 31, 2004 change from** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | **December 31, 2003 due to:**     | ** ** |
| **(dollars in thousands)**   | ** ** | **Volume**                        | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest  income             |       |                              |       |   |   |   |   |
| Loans                        |       | $                                 | 4,909      |   | $ | (66 | ) | $ | 4,843 |   |
| Securities – taxable    |       | 91                                |       | 39 |   | 130 |   |
| Federal funds sold           |       | 9                                 |       | (2 | ) | 7 |   |
| Total  interest income       |       | 5,009                             |       | (29 | ) | 4,980 |   |
|                         |       |                              |       |   |   |   |   |
| Interest  expense            |       |                              |       |   |   |   |   |
| Deposits (other than demand) |       | 1,526                             |       | (242 | ) | 1,284 |   |
| Federal funds purchased      |       | 2                                 |       | 3 |   | 5 |   |
| Total  interest expense      |       | 1,528                             |       | (239 | ) | 1,289 |   |
|                         |       |                              |       |   |   |   |   |
| Net interest  income         |       | $                                 | 3,481      |   | $ | 210 |   | $ | 3,691 |   |

 

**Liability and Asset Management**

 

The matching of assets andliabilities may be analyzed by examining the extent to which such assets andliabilities are “interest rate sensitive” and by monitoring an institution’sinterest rate sensitivity “gap.”  Anasset or liability is said to be interest rate sensitive within a specific timeperiod if it will mature or reprice within that time period.  The interest rate sensitivity gap isdefined as the difference between the dollar amount of rate sensitive assetsrepricing during a period and the volume of rate sensitive liabilitiesrepricing during the same period. Agap is considered positive when the amount of interest rate sensitive assetsexceeds the amount of interest rate sensitive liabilities.  A gap is considered negative when the amountof interest rate sensitive liabilities exceeds the amount of interest ratesensitive assets.  During a period ofrising interest rates, a negative gap would tend to adversely affect netinterest income while a positive gap would tend to result in an increase in netinterest income.  During a period offalling interest rates, a negative gap would tend to result in an increase innet interest income while a positive gap would tend to adversely affect netinterest income.

 

The Bank’s asset liabilityand investment committee, which consists of the Executive Officers, Arthur F.Helf, Michael R. Sapp, H. Lamar Cox and George W. Fort, is charged withmonitoring the liquidity and funds position of the Bank.  The Committee regularly reviews (a) therate sensitivity position on a three-month, six-month, and one-year timehorizon; (b) loans to deposit ratios; and (c) average maturity forcertain categories of liabilities.  TheBank operates an asset/liability management model.  At December 31, 2005, the Bank had a positivecumulative repricing gap within one year of approximately $27,081 orapproximately  6.97% of total year endearning assets. See Quantitative and Qualitative Analysis of Market Risk foradditional information.

 

40

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**Deposits**

 

The Bank’s primary sourcesof funds are interest-bearing deposits. The following tables present theaverage amount of and average rate paid on each of the following depositcategories for 2005, 2004 and 2003:

** **

Deposits

 
| ** **                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | ** **                  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(dollars in thousands)**            | ** ** | **Average  Balance**        | ** ** | **Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Rate  Paid** | ** ** |
| Types of  Deposits                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing  demand deposits |       | $                           | 18,763     |   | — |   | $ | 14,292 |   | — |   | $ | 8,376 |   | — |   |
| Interest-bearing  demand deposits     |       | 3,097                       |       | 1.90 | % | 1,640 |   | 0.24 | % | 1,266 |   | 0.02 | % |
| Money market  accounts                |       | 39,485                      |       | 3.88 | % | 16,316 |   | 2.07 | % | 6,324 |   | 0.88 | % |
| Savings  accounts                     |       | 22,785                      |       | 2.61 | % | 34,506 |   | 2.43 | % | 26,998 |   | 2.84 | % |
| IRA accounts                          |       | 2,183                       |       | 4.31 | % | 1,040 |   | 3.56 | % | 874 |   | 3.99 | % |
| Purchased  time deposits              |       | 146,326                     |       | 3.55 | % | 98,515 |   | 2.68 | % | 57,122 |   | 2.90 | % |
| Time  deposits                        |       | 52,338                      |       | 4.00 | % | 15,251 |   | 2.65 | % | 15,318 |   | 3.01 | % |
| Total deposits                        |       | $                           | 284,977    |   |   |   | $ | 181,560 |   |   |   | $ | 116,278 |   |   |   |

 

The followingtable indicates amount outstanding of time certificates of deposit of $100,000or more and respective maturities as of December 31, 2005 (in thousands):

 
| ** **                        | ** ** | **2005** | ** ** |
|-----------------------------------|------------|----------|------------|
|                              |       |     |       |
| Three months  or less             |       | $        | 29,504     |   |
|                              |       |     |       |
| Over three  through twelve months |       | 34,778   |       |
|                              |       |     |       |
| More than  twelve months          |       | 58,722   |       |
| Total                             |       | $        | 123,004    |   |

 

41

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**Investment Portfolio**

 

At year end 2005,obligations of the United States Government or its agencies and collateralizedmortgage obligations represented 100% of the investment portfolio. The Bank’sinvestment portfolio at December 31, 2005, 2004 and 2003 consisted of thefollowing (dollars in thousands):

 
| ** **                    | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | **Estimated** | ** ** |
|-------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------|------------|
| ** **                    | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market**    | ** ** |
| ** **                    | ** ** | **Cost**      | ** ** | **Gain**       | ** ** | **Loss**       | ** ** | **Value**     | ** ** |
| As of December 31, 2005       |       |          |       |           |       |           |       |          |       |
| Securities available for sale |       |          |       |           |       |           |       |          |       |
| U.S. Government agencies      |       | $             | 22,195     |           | $          | 7              |       | $             | (411       | ) | $ | 21,791 |   |
| Mortgage-backed securities    |       | 8,059         |       | —         |       | (254           | )          | 7,805         |       |
| Corporate debt securities     |       | 1,958         |       | —         |       | (22            | )          | 1,936         |       |
| Other                         |       | 380           |       | 80             |       | —         |       | 460           |       |
| Total                         |       | $             | 32,592     |           | $          | 87             |       | $             | (687       | ) | $ | 31,992 |   |
|                          |       |          |       |           |       |           |       |          |       |
| As of December 31, 2004       |       |          |       |           |       |           |       |          |       |
| Securities available for sale |       |          |       |           |       |           |       |          |       |
| U.S. Government agencies      |       | $             | 9,958      |           | $          | 5              |       | $             | (111       | ) | $ | 9,852 |   |
| Mortgage-backed securities    |       | 8,569         |       | —         |       | (111           | )          | 8,458         |       |
| Other                         |       | 380           |       | —         |       | —         |       | 380           |       |
| Total                         |       | $             | 18,907     |           | $          | 5              |       | $             | (222       | ) | $ | 18,690 |   |
|                          |       |          |       |           |       |           |       |          |       |
| As of December 31, 2003       |       |          |       |           |       |           |       |          |       |
| Securities available for sale |       |          |       |           |       |           |       |          |       |
| U.S. Government agencies      |       | $             | 5,477      |           | $          | 1              |       | $             | (135       | ) | $ | 5,343 |   |
| Mortgage-backed securities    |       | 6,163         |       | 1              |       | (77            | )          | 6,087         |       |
| Corporate debt securities     |       | 1,160         |       | 8              |       | —         |       | 1,168         |       |
| Other                         |       | 380           |       | —         |       | —         |       | 380           |       |
| Total                         |       | $             | 13,180     |           | $          | 10             |       | $             | (212       | ) | $ | 12,978 |   |

 

42

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The followingschedule presents the estimated maturities and weighted average yields ofinvestment securities of the Bank at December 31, 2005:

 
| ** **                                     | ** ** | ** **    | ** ** | **Estimated** | ** ** | **Weighted** | ** ** |
|------------------------------------------------|------------|---------------|------------|---------------|------------|--------------|------------|
| ** **                                     | ** ** | **Amortized** | ** ** | **Market**    | ** ** | **Average**  | ** ** |
| ** **                                     | ** ** | **Cost**      | ** ** | **Value**     | ** ** | **Yield**    | ** ** |
| Obligations  of U.S. Government agencies       |       |          |       |          |       |         |       |
| Due in one year or less                        |       | $             | —     |          | $          | —       |       | 0.00 | % |
| Due after one through five years               |       | 8,257         |       | 8,109         |       | 3.71         | %          |
| Due after five through ten years               |       | 13,938        |       | 13,682        |       | 4.88         | %          |
| Due after ten years                            |       | —        |       | —        |       | 0.00         | %          |
| Total  obligations of U.S. Government agencies |       | 22,195        |       | 21,791        |       |         |       |
|                                           |       |          |       |          |       |         |       |
| Mortgage-backed  securities                    |       | 8,059         |       | 7,805         |       | 3.77         | %          |
|                                           |       |          |       |          |       |         |       |
| Corporate  debt securities                     |       |          |       |          |       |         |       |
| Due in one year or less                        |       | 417           |       | 399           |       | 4.94         | %          |
| Due after one through five years               |       | —        |       | —        |       | 0.00         | %          |
| Due after five through ten years               |       | 1,541         |       | 1,537         |       | 4.94         | %          |
| Due after ten years                            |       | —        |       | —        |       | 0.00         | %          |
| Total  corporate debt securiites               |       | 1,958         |       | 1,936         |       |         |       |
|                                           |       |          |       |          |       |         |       |
| Other  securities                              |       | 380           |       | 460           |       | 0.00         | %          |
| Total  securities available for sale           |       | $             | 32,592     |          | $          | 31,992       |       |   |   |

 

The Bank owned no tax-exempt securities during the period endedDecember 31, 2005.

 

**Investment Policy**

 

The objective of the Bank’sinvestment policy is to invest funds not otherwise needed to meet the loandemand of its market area to earn the maximum return for the Bank, yet stillmaintain sufficient liquidity to meet fluctuations in the Bank’s loan demandand deposit structure.  In doing so, theBank balances the market and credit risks against the potential investmentreturn, makes investments compatible with the pledge requirements of the Bank’sdeposits of public funds, maintains compliance with regulatory investmentrequirements, and assists the various public entities with their financingneeds.  The asset liability andinvestment committee has full authority over the investment portfolio and makesdecisions on purchases and sales of securities. The entire portfolio, along with all investment transactions occurringsince the previous Board of Director’s meeting, is reviewed by the Board at itsnext monthly meeting.  The investmentpolicy allows portfolio holdings to include short-term securities purchased toprovide the Bank’s needed liquidity and longer term securities purchased togenerate level income for the Bank over periods of interest rate fluctuations.

 

43

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**LoanPortfolio**

 

The Bank had total loans of$349 million at December 31, 2005.  Asthe loan portfolio is concentrated in Davidson County and Williamson County,there is risk that the borrowers’ ability to repay the loans could be affectedby changes in local economic conditions.

 

The following scheduledetails the loans of the Bank at December 31, 2005, 2004, 2003, 2002 and 2001:

 
| **(dollars  in thousands)**             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Real estate                             |       |     |       |     |       |     |       |     |       |     |       |
| Construction                            |       | $        | 38,279     |     | $          | 22,813   |       | $        | 10,386     |     | $          | 6,646 |   | $ | 4,146 |   |
| 1-4 family residential                  |       | 18,358   |       | 15,963   |       | 13,520   |       | 13,372   |       | 9,701    |       |
| Other                                   |       | 50,371   |       | 33,694   |       | 20,072   |       | 10,513   |       | 8,702    |       |
| Commercial,  financial and agricultural |       | 233,948  |       | 139,799  |       | 87,908   |       | 44,867   |       | 21,000   |       |
| Consumer                                |       | 3,149    |       | 3,898    |       | 3,301    |       | 1,963    |       | 1,487    |       |
| Other                                   |       | 4,481    |       | —   |       | —   |       | —   |       | —   |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |
| Total loans                             |       | 348,586  |       | 216,167  |       | 135,187  |       | 77,361   |       | 45,036   |       |
| Less:  allowance for loan losses        |       | (4,399   | )          | (2,841   | )          | (2,000   | )          | (1,103   | )          | (919     | )          |
|                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net loans                               |       | $        | 344,187    |     | $          | 213,326  |       | $        | 133,187    |     | $          | 76,258 |   | $ | 44,117 |   |

 

Composition of loan portfolio by type

 
| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| **(dollars in thousands)**              | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Real estate:                            |       |                   |       |   |   |   |   |   |   |   |   |
| Construction                            |       | 10.98                  | %          | 10.55 | % | 7.68 | % | 8.59 | % | 9.21 | % |
| 1 to 4 family residential               |       | 5.27                   | %          | 7.38 | % | 10.00 | % | 17.28 | % | 21.54 | % |
| Other                                   |       | 14.45                  | %          | 15.59 | % | 14.85 | % | 13.59 | % | 19.32 | % |
| Commercial,  financial and agricultural |       | 67.11                  | %          | 64.68 | % | 65.03 | % | 58.00 | % | 46.63 | % |
| Consumer                                |       | 0.90                   | %          | 1.80 | % | 2.44 | % | 2.54 | % | 3.30 | % |
| Other                                   |       | 1.29                   | %          | 0.00 | % | 0.00 | % | 0.00 | % | 0.00 | % |
| Total                                   |       | 100                    | %          | 100 | % | 100 | % | 100 | % | 100 | % |

 

Composition of commercial loan portfolio byfunding program type

 
| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** |
| **(dollars in thousands)**              | ** ** | **Amount**             | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial, financial and agricultural: |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Direct funding                          |       | $                      | 94,742     |   | 40.50 | % | $ | 60,471 |   | 43.26 | % | $ | 54,835 |   | 62.38 | % |
| Indirect funding                        |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Large                                   |       | 52,144                 |       | 22.29 | % | 29,010 |   | 20.75 | % | 5,602 |   | 6.37 | % |
| Small                                   |       | 87,062                 |       | 37.21 | % | 50,318 |   | 35.99 | % | 27,471 |   | 31.25 | % |
| Total                                   |       | 233,948                |       | 100.00 | % | 139,799 |   | 100.00 | % | 87,908 |   | 100.00 | % |
|                                         |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

44

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The following scheduledetails maturities and sensitivity to interest rates changes for commercialloans of the Bank at December 31, 2005:

 
| ** **                              | ** ** | **Due in 1**              | ** ** | **Due in 1**   | ** ** | **Due after** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|----------------|------------|---------------|------------|------------|------------|
| **Type of Loan (1)**                    | ** ** | **year or less**          | ** ** | **to 5 years** | ** ** | **5 Years**   | ** ** | **Total**  | ** ** |
| ** **                              | ** ** | **($ in thousands)** | ** ** |
| Real estate:                            |       |                      |       |           |       |          |       |       |       |
| Construction                            |       | $                         | 30,736     |           | $          | 7,543         |       | $          | —     |   | $ | 38,279 |   |
| 1 to 4 family residential               |       | 6,901                     |       | 11,159         |       | 298           |       | 18,358     |       |
| Other                                   |       | 18,088                    |       | 28,702         |       | 3,581         |       | 50,371     |       |
| Commercial,  financial and agricultural |       | 58,554                    |       | 172,899        |       | 2,495         |       | 233,948    |       |
| Consumer                                |       | 1,176                     |       | 1,815          |       | 158           |       | 3,149      |       |
| Other                                   |       | —                    |       | —         |       | 4,481         |       | 4,481      |       |
| Total                                   |       | $                         | 115,455    |           | $          | 222,118       |       | $          | 11,013     |   | $ | 348,586 |   |
|                                    |       |                      |       |           |       |          |       |       |       |
| Less:  allowance for loan loss          |       |                      |       |           |       |          |       | (4,399     | )          |
|                                    |       |                      |       |           |       |          |       |       |       |
| Net loans                               |       |                      |       |           |       |          |       | $          | 344,187    |   |
|                                    |       |                      |       |           |       |          |       |       |       |
| Interest  rate sensitivity:             |       |                      |       |           |       |          |       |       |       |
| Fixed interest rates                    |       | 14,899                    |       | 221,504        |       | 10,332        |       | 246,735    |       |
| Floating or adjustable rates            |       | 100,556                   |       | 614            |       | 681           |       | 101,851    |       |
|                                    |       |                      |       |           |       |          |       |       |       |
| Total                                   |       | $                         | 115,455    |           | $          | 222,118       |       | $          | 11,013     |   | $ | 348,586 |   |

 

----

(1) includes non-accrualloans

 

**ITEM 7A.**               QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**Quantitative and Qualitative Analysis ofMarket Risk**

 

Like allfinancial institutions, the Corporation is subject to market risk from changesin interest rates.  Interest rate risk isinherent in the balance sheet due to the mismatch between the maturities ofrate sensitive assets and rate sensitive liabilities.  If rates are rising, and the level of ratesensitive liabilities exceed the level of rate sensitive assets, the netinterest margin will be negatively impacted. Conversely, if rates are falling, and the level of rate sensitiveliabilities is greater than the level of rate sensitive assets, the impact onthe net interest margin will be favorable. Managing interest rate risk is further complicated by the fact that allrates do not change at the same pace, in other words, short term rates may berising while longer term rates remain stable. In addition, different types of rate sensitive assets and rate sensitiveliabilities react differently to changes in rates.

 

To manageinterest rate risk, the Corporation must take a position on the expected futuretrend of interest rates.  Rates may rise,fall, or remain the same.  TheAsset-Liability Committee develops its view of future rate trends by monitoringeconomic indicators, examining the views of economists and other experts, andunderstanding the current status of the Corporation’s Balance Sheet.   The Corporation’s annual budget reflects theanticipated rate environment for the next twelve months.  The Asset Liability Committee conducts aquarterly analysis of the rate sensitivity position.  The results of the analysis are reported tothe board.

 

The AssetLiability Committee uses a computer model to analyze the maturities of ratesensitive assets and liabilities.  Themodel measures the “gap” which is defined as the difference between the dollaramount of rate sensitive assets repricing during a period and the volume ofrate sensitive liabilities repricing during the same period. Gap is alsoexpressed as the ratio of rate sensitive assets divided by rate sensitive liabilities.  If the ratio is greater than “one”, thedollar value of assets exceeds the dollar value of liabilities; the balancesheet is “asset sensitive”.

 

45

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Conversely, if the value ofliabilities exceeds the value of assets, the ratio is less than one and thebalance sheet is “liability sensitive”. Policy requires management to maintain the gap within a range of 0.75 to1.25.

 

The modelmeasures scheduled maturities in periods of three months, four to twelvemonths, one to five years, and over five years. The chart below illustrates therate sensitive position of the Corporation at December 31, 2005. Managementuses the one year gap as the appropriate time period for setting strategy. 

 

Rate Sensitivity Gap Analysis

 

Maturities:

 
| **(dollars  in thousands)**                                    | ** ** | **Floating** | ** ** | **1-3  Months** | ** ** | **4-12  Months** | ** ** | **1-5  Years** | ** ** | **Over  5 years** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|----------------|------------|-------------------|------------|-----------|------------|
| Interest Earnings Assets                                       |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Federal Funds sold                                             |       | $            | 12,535     |            | $          | —           |       | $              | —     |              | $          | —    |       | $ | — |   | $ | 12,535 |   |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Securities                                                     |       |         |       |            |       |             |       |           |       |              |       |      |       |
| U.S. government agencies                                       |       | —       |       | —          |       | —           |       | 8,109          |       | 15,519            |       | 23,628    |       |
| Mortgage-backed securities                                     |       | —       |       | 1,000           |       | 3,049            |       | 2,851          |       | 1,304             |       | 8,204     |       |
| Total securities                                               |       | —       |       | 1,000           |       | 3,049            |       | 10,960         |       | 16,823            |       | 31,832    |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Total loans                                                    |       | 96,249       |       | 42,678          |       | 102,501          |       | 101,089        |       | 6,069             |       | 348,586   |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Total Interest Earning Assets                                  |       | 108,784      |       | 43,678          |       | 105,550          |       | 112,049        |       | 22,892            |       | 392,953   |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Other Assets                                                   |       | —       |       | —          |       | —           |       | —         |       | 11,087            |       | 11,087    |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Total Assets                                                   |       | $            | 108,784    |            | $          | 43,678           |       | $              | 105,550    |              | $          | 112,049   |       | $ | 33,979 |   | $ | 404,040 |   |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Interest Bearing Liabilities                                   |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Deposits                                                       |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Interest checking                                              |       | $            | 6,112      |            | $          | —           |       | $              | —     |              | $          | —    |       | $ | — |   | $ | 6,112 |   |
| Money market and savings                                       |       | 73,077       |       | —          |       | —           |       | —         |       | —            |       | 73,077    |       |
| Time deposits                                                  |       | —       |       | 53,601          |       | 98,141           |       | 103,402        |       | —            |       | 255,144   |       |
| Total deposits                                                 |       | 79,189       |       | 53,601          |       | 98,141           |       | 103,402        |       | —            |       | 334,333   |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Subordinated long term debt                                    |       | —       |       | —          |       | —           |       | —         |       | 8,248             |       | 8,248     |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Total Interest Bearing Liabilities                             |       | 79,189       |       | 53,601          |       | 98,141           |       | 103,402        |       | 8,248             |       | 342,581   |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Other Liabilities                                              |       | —       |       | —          |       | —           |       | —         |       | 35,029            |       | 35,029    |       |
| Shareholders’ Equity                                      |       | —       |       | —          |       | —           |       | —         |       | 26,430            |       | 26,430    |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Total Liabilities and Shareholders’ Equity                |       | $            | 79,189     |            | $          | 53,601           |       | $              | 98,141     |              | $          | 103,402   |       | $ | 69,707 |   | $ | 404,040 |   |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Rate Sensitive Gap by Period                                   |       | $            | 29,595     |            | $          | (9,923           | )          | $              | 7,409      |              | $          | 8,647     |       | $ | 14,644 |   |   |   |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Cumulative Gap                                                 |       |         |       | $               | 19,672     |             | $          | 27,081         |       | $                 | 35,728     |      | $          | 50,372 |   |   |   |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Cumulative Gap as a Percent of Total Assets                    |       |         |       | 4.87            | %          | 6.70             | %          | 8.84           | %          | 12.47             | %          |      |       |
|                                                           |       |         |       |            |       |             |       |           |       |              |       |      |       |
| Rate sensitive assets/Rate sensitive  liabilities (cumulative) |       | 1.37         |       | 1.15            |       | 1.12             |       | 1.11           |       | 1.15              |       |      |       |

 

46

----

 

In mid-2004,the Federal Reserve Open Market Committee began a series of interest rateincreases which the FOMC indicated would continue “at a measured pace”.  From mid year 2004 to the end of 2005, shortterm interest rates had increased by 300 basis points.  Management has positioned the Corporation fora rising rate environment by maintaining a moderately “asset sensitive” balancesheet in which more assets will reprice than liabilities.  Management achieved this position duringfourth quarter, 2004, by offering higher rates of interest on depositliabilities in the two to three year maturity range.  At year-end 2005, the Corporation’s one yearGAP ratio was 1.12.

 

The interestrate risk model that defines the gap position also performs a “rate shock” testof the balance sheet.  The rate shockprocedure measures the impact on the economic value of equity (EVE) which is ameasure of long term interest rate risk. EVE is the difference between themarket value of the assets and the liabilities and is the liquidation value ofthe bank. In this analysis, the model calculates the discounted cash flow ormarket value of each category on the balance sheet. The percent change in EVEis a measure of the volatility of risk. Regulatory guidelines specify a maximumchange of 30% for a 200bps rate change. At December 31, 2005, the percentchange at plus or minus 200bps is well within that range at 13.6% and 8.2%respectively.

 

The chartbelow identifies the EVE impact of a shift in rates of 100, 200 and 300 basispoints in either direction.

 

EconomicValue of Equity Under Rate Shock

(dollarsin thousands)

 

AtDecember 31, 2005

 
| **Rate Change**           | ** ** | **-300bp** | ** ** | **-200bp** | ** ** | **-100bp** | ** ** | **0bp** | ** ** | **+100bp** | ** ** | **+200bp** | ** ** | **+300bp** | ** ** |
|---------------------------|------------|------------|------------|------------|------------|------------|------------|---------|------------|------------|------------|------------|------------|------------|------------|
|                      |       |       |       |       |       |       |       |    |       |       |       |       |       |       |       |
| Economic  value of equity |       | $          | 29,544     |       | $          | 28,587     |       | $       | 27,608     |       | $          | 26,430     |       | $          | 24,790     |   | $ | 22,827 |   | $ | 20,827 |   |
|                      |       |       |       |       |       |       |       |    |       |       |       |       |       |       |       |
| Actual  dollar change     |       | 3,114      |       | 2,157      |       | 1,178      |       | —  |       | (1,640     | )          | (3,603     | )          | (5,603     | )          |
|                      |       |       |       |       |       |       |       |    |       |       |       |       |       |       |       |
| Percent  change           |       | 11.8       | %          | 8.2        | %          | 4.5        | %          | —  |       | (6.2       | )%         | (13.6      | )%         | (21.2      | )%         |
|                           |            |            |            |            |            |            |            |         |            |            |            |            |            |            |            |  |  |  |  |  |  |  |

 

Although the one year gap of 1.12 indicates that the Bank would show anincrease in net interest income in a rising rate environment, the EVE rateshock shows that the EVE would decline in a rising rate environment. This isbecause the EVE model does not simulate activity so that maturing balances arereplaced with new balances at new rate levels or repricing balances areadjusted to the new rate shock level but is a measure of long term interestrate risk applied in a static model which provides information only at acertain point in time. Given that limitation, it is still useful is assessingthe impact of an unanticipated movement in interest rates.

 

The aboveanalysis may not on its own be an entirely accurate indicator of how netinterest income or EVE will be affected by changes in interest rates. Incomeassociated with interest earning assets and costs associated with interestbearing liabilities may not be affected uniformly by changes in interest rates.In addition, the magnitude and duration of changes in interest rates may have asignificant impact on net interest income. Interest rates on certain types ofassets and liabilities fluctuate in advance of changes in general market rates,while interest rates on other types may lag behind changes in general marketrates. The Asset-Liability Committee develops its view of future rate trends bymonitoring economic indicators, examining the views of economists and otherexperts, and understanding the current status of the Corporation’s BalanceSheet and conducts a quarterly analysis of the rate sensitivity position.  The results of the analysis are reported tothe board.

 

47

----

 
| **ITEM 8.** | **FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA** |
|-------------|-------------------------------------------------|

 

The report ofIndependent Accountants, Consolidated Financial Statements and supplementarydata required by Item 8 are set forth on pages F-1 through F-28 of this Reportand are incorporated herein by reference.

 

Index toFinancial Statements

 
| REPORT OF  INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM         | F-1    |
|------------------------------------------------------------------|--------|
|                                                             |   |
| FINANCIAL STATEMENTS                                             |   |
|                                                             |   |
| CONSOLIDATED BALANCE  SHEETS                                     | F-2    |
|                                                             |   |
| CONSOLIDATED  STATEMENTS OF INCOME                               | F-3    |
|                                                             |   |
| CONSOLIDATED  STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY | F-4    |
|                                                             |   |
| CONSOLIDATED  STATEMENTS OF CASH FLOWS                           | F-5    |
|                                                             |   |
| NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS                      | F-6    |

 
| **ITEM 9.** | **CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

 

None.

 
| **ITEM 9A.** | **CONTROLS AND PROCEDURES** |
|--------------|-----------------------------|

 

a)             Evaluationof Disclosure Controls and Procedures. The Corporation maintains disclosurecontrols and procedures, as defined in Rule 13a-15(a) promulgated under theSecurities Exchange Act of 1934 (the “Exchange Act”), that are designed toensure that information required to be disclosed by it in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time period specified in the SEC’s rules and forms and thatsuch information is accumulated and communicated to the Corporation’smanagement, including its Chief Executive Officer and Chief Financial Officer.The Corporation carried out an evaluation, under the supervision and with theparticipation of its management, including its Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofits disclosure controls and procedures as of the end of the period covered bythis report.  Based on the evaluation ofthese disclosure controls and procedures, the Chief Executive Officer and ChiefFinancial Officer concluded that the Corporation’s disclosure control andprocedures were effective.

 

b)            Changesin Internal Controls and Procedures. There were no changes in theCorporation’s internal control over financial reporting during the Corporation’sfiscal quarter ended December 31, 2005 that have materially affected, or arereasonably likely to materially affect, its internal control over financialreporting.

 
| **ITEM 9B.** | **OTHER INFORMATION** |
|--------------|-----------------------|

 

None.

 

48

----

 

**PARTIII**

 
| **ITEM 10.** | **DIRECTORS AND EXECUTIVE OFFICERS OF THE  REGISTRANT** |
|--------------|---------------------------------------------------------|

 

Informationrelating to our directors and executive officers will be contained in adefinitive Proxy Statement involving the election of directors at the annualmeeting of shareholders to be held May 3, 2006, and such information isincorporated herein by reference.

 
| **ITEM 11.** | **EXECUTIVE COMPENSATION** |
|--------------|----------------------------|

 

Informationrelating to executive compensation will be contained in the Proxy Statementreferred to above in Item 10, and such information is incorporated herein byreference.

 
| **ITEM 12.** | **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS** |
|--------------|-----------------------------------------------------------------------------------------------------|

 

Informationrelating to security ownership of certain beneficial owners and management willbe contained in the Proxy Statement referred to above in Item 10, and suchinformation is incorporated herein by reference.

 
| **ITEM 13.** | **CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS** |
|--------------|-----------------------------------------------------|

 

Informationrelating to certain relationships and related transactions will be contained inthe Proxy Statement referred to above in Item 10, and such information isincorporated herein by reference.

 
| **ITEM 14.** | **PRINCIPAL ACCOUNTANT FEES AND SERVICES** |
|--------------|--------------------------------------------|

 

Informationrelating to the principal accountant fees and services will be contained in theProxy Statement referred to above in Item 10, and such information isincorporated herein by reference.

 

**PART IV**

 
| **ITEM 15.** | **EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES** |
|--------------|-------------------------------------------------|

 

(a)(1)       FinancialStatements:

 

(2)           Schedulesrequired by Article 12 of Regulation S-X are either omitted because they arenot applicable or because the required information is shown in the financialstatements or the notes thereto.

 

(3)           Exhibits:

 
| **Exhibit No.** | ** ** | **Description** |
|-----------------|------------|-----------------|
| ** **      | ** ** | ** **      |
| 2.1             |       |            | Articles of Share Exchange of Tennessee Commerce Bank and Tennessee  Commerce Bancorp, Inc. * |
|            |       |            |   |
| 2.2             |       |            | Plan of Share Exchange of Tennessee Commerce Bank and Tennessee  Commerce Bancorp, Inc. * |
|            |       |            |   |
| 3.1             |       |            | Charter of Tennessee Commerce Bancorp, Inc. * |
|            |       |            |   |
| 3.2             |       |            | Bylaws of Tennessee Commerce Bancorp, Inc. * |
|            |       |            |   |
| 4.1             |       |            | Shareholders’ Agreement * |
|            |       |            |   |
| 10.1            |       |            | Tennessee Commerce Bancorp, Inc. Stock Option Plan - Employees * |

 

49

----

 
| 10.2   |   |   | Tennessee Commerce Bancorp, Inc. 1999 Stock Option - Directors *                     |
|--------|--------|--------|--------------------------------------------------------------------------------------|
|   |   |   |                                                                                 |
| 10.3   |   |   | Tennessee Commerce Bancorp, Inc. 1999 Stock Option - Incorporators *                 |
|   |   |   |                                                                                 |
| 10.4   |   |   | Tennessee commerce Bancorp, Inc. 2003 Stock Option - Directors *                     |
|   |   |   |                                                                                 |
| 10.5   |   |   | Tennessee Commerce Bancorp, Inc. 1999 Stock Option Agreement with  Arthur F. Helf *  |
|   |   |   |                                                                                 |
| 10.6   |   |   | Tennessee Commerce Bancorp, Inc. 1999 Stock Option Agreement with  Michael R. Sapp * |
|   |   |   |                                                                                 |
| 10.7   |   |   | Tennessee Commerce Bancorp, Inc. 1999 Stock Option Agreement with H.  Lamar Cox *    |
|   |   |   |                                                                                 |
| 10.8   |   |   | Employment Agreement between Tennessee Commerce Bancorp, Inc. and  Arthur F. Helf *  |
|   |   |   |                                                                                 |
| 10.9   |   |   | Employment Agreement between Tennessee Commerce Bancorp, Inc. and  Michael R. Sapp * |
|   |   |   |                                                                                 |
| 10.10  |   |   | Employment Agreement between Tennessee Commerce Bancorp, Inc. and H.  Lamar Cox *    |
|   |   |   |                                                                                 |
| 21.1   |   |   | Subsidiaries *                                                                       |
|   |   |   |                                                                                 |
| 23.1   |   |   | Report of Independent Registered Public Accounting Firm                              |
|   |   |   |                                                                                 |
| 31.1   |   |   | Certification pursuant to Rule  13a-14a/15d-14(a)                                    |
|   |   |   |                                                                                 |
| 31.2   |   |   | Certification pursuant to Rule  13a-14a/15d-14(a)                                    |
|   |   |   |                                                                                 |
| 32.1   |   |   | Certification pursuant to Rule 18 USC  Section 1350-Sarbanes-Oxley Act of 2002       |
|   |   |   |                                                                                 |
| 32.2   |   |   | Certification pursuant to Rule 18 USC  Section 1350-Sarbanes-Oxley Act of 2002       |

 

----

*  Previously filed as an exhibit to TennesseeCommerce Bancorp, Inc.’s Registration Statement on Form 10, as filed with theSecurities and Exchange Commission on April 29, 2005.

 

50

----

 

**Signatures**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | TENNESSEE COMMERCE BANCORP, INC. |
|--------|----------------------------------|
|   |                             |
|   |                             |
|   | By:                              | /s/ Arthur F. Helf |
|   |                             | Arthur F. Helf, Chairman and Chief Executive Officer |
|   | Date:                            | March 28, 2006 |
|        |                                  |  |  |

 

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant in theircapacities as directors.

 

 
| By:                        | /s/ Dorris E. (Eli) Bennett |                 | By:    | /s/ H. Lamar Cox         |
|----------------------------|-----------------------------|----------------------|--------|--------------------------|
| Dorris E. (Eli) Bennett    |                        | H. Lamar Cox         |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Paul W. Dierksen        |                 | By:    | /s/ Dennis L. Grimaud    |
| Paul W. Dierksen           |                        | Dennis L. Grimaud    |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Arthur F. Helf          |                 | By:    | /s/ Winston C. Hickman   |
| Arthur F. Helf             |                        | Winston C. Hickman   |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Fowler H. Low           |                 | By:    | /s/ William W. McInnes   |
| Fowler H. Low              |                        | William W. McInnes   |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Thomas R. Miller        |                 | By:    | /s/ Darrel Reifschneider |
| Thomas R. Miller           |                        | Darrel Reifschneider |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Michael R. Sapp         |                 | By:    | /s/ Regg E. Swanson      |
| Michael R. Sapp            |                        | Regg E. Swanson      |
| Date: March 28, 2006       |                        | Date: March 28, 2006 |
|                       |                        |                 |
|                       |                        |                 |
| By:                        | /s/ Dr. Paul A. Thomas      |                 |   |
| Dr. Paul A. Thomas         |                        |                 |
|                       |                        |                 |
| Date:  March 28, 2006 |                        |                 |

 

51

----

 

**TENNESSEECOMMERCE BANCORP, INC.**

 

##### **CONSOLIDATEDFINANCIAL STATEMENTS**

##### ** **

### ***December 31, 2005 and 2004***

 

----

 

##### **CONSOLIDATEDFINANCIAL STATEMENTS**

**December31, 2005 and 2004**

 

CONTENTS

 
| REPORT OF INDEPENDENT REGISTERED  PUBLIC ACCOUNTING FIRM         | F-1    |
|------------------------------------------------------------------|--------|
|                                                             |   |
| FINANCIAL STATEMENTS                                             |   |
|                                                             |   |
| CONSOLIDATED BALANCE SHEETS                                      | F-2    |
|                                                             |   |
| CONSOLIDATED STATEMENTS OF  INCOME                               | F-3    |
|                                                             |   |
| CONSOLIDATED STATEMENTS OF  CHANGES IN SHAREHOLDERS’ EQUITY | F-4    |
|                                                             |   |
| CONSOLIDATED  STATEMENTS OF CASH FLOWS                           | F-5    |
|                                                             |   |
| NOTES  TO CONSOLIDATED FINANCIAL STATEMENTS                      | F-6    |

 

----

 

 

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

TheBoard of Directors

TennesseeCommerce Bancorp, Inc.

Franklin,Tennessee

 

Wehave audited the consolidated balance sheet of Tennessee Commerce Bancorp, Inc.(the “Corporation”) and subsidiaries as of December 31, 2005, and the relatedconsolidated statements of income, changes in shareholders’ equity and cashflows for the year then ended. These financial statements are theresponsibility of the Corporation’s management. Our responsibility is toexpress an opinion on these financial statements based on our audit. Thefinancial statements of the Corporation for the years ended December 31, 2004and 2003 were audited by other auditors whose report dated March 31, 2005,expressed an unqualified opinion on those statements.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

Inour opinion, the 2005 financial statements referred to above present fairly, inall material respects, the consolidated financial position of TennesseeCommerce Bancorp, Inc. and subsidiaries as of December 31, 2005, and theconsolidated results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

 
| /s/  KraftCPAs PLLC |   |
|---------------------|--------|

Nashville,Tennessee

January20, 2006

 

 

555 Great Circle Road,Suite 200 • Nashville, TN 37228 • Phone615-242-7351 • Fax 615-256-1952 • www.kraftcpas.com610 North Garden St. Suite 200, Columbia, Tennessee 38401 • Phone931-388-3711105 Bay Court, Lebanon, Tennessee 37087 • Phone 615-449-2334An independently owned member of the RSM McGladrey Network

 

F-1

----

 

**TENNESSEE COMMERCEBANCORP, INC.**

**CONSOLIDATED BALANCE SHEETS**

**December31, 2005 and 2004**

 
| **(dollars in thousands except  share data)**                                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                     |       |       |       |       |       |
| Cash and due from  financial institutions                                                      |       | $          | 6,877      |       | $          | 3,838 |   |
| Federal funds sold                                                                             |       | 12,535     |       | 6,582      |       |
| Cash and cash equivalents                                                                      |       | 19,412     |       | 10,420     |       |
|                                                                                           |       |       |       |       |       |
| Securities available  for sale                                                                 |       | 31,992     |       | 18,690     |       |
| Loans                                                                                          |       | 348,586    |       | 216,167    |       |
| Allowance for loan  losses                                                                     |       | (4,399     | )          | (2,841     | )          |
| Net loans                                                                                      |       | 344,187    |       | 213,326    |       |
|                                                                                           |       |       |       |       |       |
| Premises and equipment,  net                                                                   |       | 769        |       | 609        |       |
| Accrued interest  receivable                                                                   |       | 2,148      |       | 1,103      |       |
| Restricted equity  securities                                                                  |       | 383        |       | 241        |       |
| Deferred tax asset                                                                             |       | 490        |       | 598        |       |
| Other assets                                                                                   |       | 4,659      |       | 930        |       |
|                                                                                           |       |       |       |       |       |
| Total assets                                                                                   |       | $          | 404,040    |       | $          | 245,917 |   |
|                                                                                           |       |       |       |       |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Liabilities                                                                                    |       |       |       |       |       |
| Deposits                                                                                       |       |       |       |       |       |
| Non-interest bearing                                                                           |       | $          | 33,372     |       | $          | 15,239 |   |
| Interest bearing                                                                               |       | 334,333    |       | 206,155    |       |
| Total deposits                                                                                 |       | 367,705    |       | 221,394    |       |
|                                                                                           |       |       |       |       |       |
| Subordinated long term debt                                                                    |       | 8,248      |       | —     |       |
| Accrued interest payable                                                                       |       | 1,126      |       | 445        |       |
| Accrued bonuses                                                                                |       | 430        |       | 125        |       |
| Other liabilities                                                                              |       | 101        |       | 353        |       |
| Total liabilities                                                                              |       | 377,610    |       | 222,317    |       |
|                                                                                           |       |       |       |       |       |
| Shareholders’ equity                                                                      |       |       |       |       |       |
| Preferred stock, no par value. Authorized 1,000,000 shares;  none issued                       |       | —     |       | —     |       |
| Common stock, $0.50 par value. Authorized 5,000,000 shares;  issued 3,238,674 in 2005 and 2004 |       | 1,619      |       | 1,619      |       |
| Additional paid-in capital                                                                     |       | 21,401     |       | 21,401     |       |
| Retained Earnings                                                                              |       | 3,781      |       | 714        |       |
| Accumulated other comprehensive loss                                                           |       | (371       | )          | (134       | )          |
| Total shareholders’ equity                                                                |       | 26,430     |       | 23,600     |       |
|                                                                                           |       |       |       |       |       |
| Total liabilities and shareholders’ equity                                                |       | $          | 404,040    |       | $          | 245,917 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-2

----

 

**TENNESSEE COMMERCEBANCORP, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

**YearsEnded December 31, 2005, 2004, and 2003**

 
| **(dollars in thousands except  share data)**        | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Interest income                                      |       |      |       |      |       |      |       |
| Loans, including fees                                |       | $         | 22,488     |      | $          | 12,497    |       | $ | 7,655 |   |
| Securities                                           |       | 967       |       | 616       |       | 486       |       |
| Federal funds sold and other                         |       | 178       |       | 72        |       | 64        |       |
| Total interest income                                |       | 23,633    |       | 13,185    |       | 8,205     |       |
|                                                 |       |      |       |      |       |      |       |
| Interest expense                                     |       |      |       |      |       |      |       |
| Deposits                                             |       | 9,567     |       | 4,257     |       | 2,974     |       |
| Other                                                |       | 439       |       | 8         |       | 2         |       |
| Total interest expense                               |       | 10,006    |       | 4,265     |       | 2,976     |       |
|                                                 |       |      |       |      |       |      |       |
| Net interest income                                  |       | 13,627    |       | 8,920     |       | 5,229     |       |
|                                                 |       |      |       |      |       |      |       |
| Provision for loan  losses                           |       | 3,700     |       | 2,420     |       | 1,115     |       |
|                                                 |       |      |       |      |       |      |       |
| Net interest income  after provision for loan losses |       | 9,927     |       | 6,500     |       | 4,114     |       |
|                                                 |       |      |       |      |       |      |       |
| Non-interest income                                  |       |      |       |      |       |      |       |
| Service charges on deposit accounts                  |       | 114       |       | 24        |       | 17        |       |
| Mortgage banking                                     |       | 105       |       | 130       |       | 148       |       |
| Securities gains                                     |       | 4         |       | 33        |       | 132       |       |
| Gain on sale of loans                                |       | 1,106     |       | 504       |       | —    |       |
| Other                                                |       | (18       | )          | 109       |       | 135       |       |
| Total non-interest income                            |       | 1,311     |       | 800       |       | 432       |       |
|                                                 |       |      |       |      |       |      |       |
| Non-interest expense                                 |       |      |       |      |       |      |       |
| Salaries and employee benefits                       |       | 3,700     |       | 2,604     |       | 2,006     |       |
| Occupancy and equipment                              |       | 629       |       | 473       |       | 440       |       |
| Data processing fees                                 |       | 474       |       | 350       |       | 242       |       |
| Professional fees                                    |       | 398       |       | 314       |       | 250       |       |
| Other                                                |       | 1,045     |       | 811       |       | 521       |       |
| Total non-interest expenses                          |       | 6,246     |       | 4,552     |       | 3,459     |       |
|                                                 |       |      |       |      |       |      |       |
| Income before income  taxes                          |       | 4,992     |       | 2,748     |       | 1,087     |       |
|                                                 |       |      |       |      |       |      |       |
| Income tax expense                                   |       | 1,925     |       | 1,082     |       | 188       |       |
|                                                 |       |      |       |      |       |      |       |
| Net income                                           |       | $         | 3,067      |      | $          | 1,666     |       | $ | 899 |   |
|                                                 |       |      |       |      |       |      |       |
| Earnings per share  (EPS):                           |       |      |       |      |       |      |       |
| Basic EPS                                            |       | $         | 0.95       |      | $          | 0.57      |       | $ | 0.40 |   |
| Diluted EPS                                          |       | 0.87      |       | 0.53      |       | 0.38      |       |
|                                                 |       |      |       |      |       |      |       |
| Weighted average shares  outstanding:                |       |      |       |      |       |      |       |
| Basic                                                |       | 3,238,674 |       | 2,933,818 |       | 2,253,928 |       |
| Diluted                                              |       | 3,517,408 |       | 3,166,794 |       | 2,379,861 |       |

 

See accompanying notes to consolidatedfinancial statements.

 

F-3

----

 

**TENNESSEE COMMERCEBANCORP, INC.**

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**YearsEnded December 31, 2005, 2004, and 2003**

 
| ** **                                                                       | ** ** | ** ** | ** ** | ** **     | ** ** | ** **    | ** ** | **Accumulated**        | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|---------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | ** ** | ** ** | **Additional** | ** ** | **Retained**  | ** ** | **Other**              | ** ** | **Total**              | ** ** |
| ** **                                                                       | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **Earnings**  | ** ** | **Comprehensive**      | ** ** | **Shareholders’** | ** ** |
| **(dollars  in thousands except share data)**                                    | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **(Deficit)** | ** ** | **Income (Loss)** | ** ** | **Equity**             | ** ** |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Balance at January 1, 2003                                                       |       | $          | 1,010      |           | $          | 9,508         |       | $                      | (1,851     | )                      | $          | 133 |   | $ | 8,800 |   |
| Comprehensive income                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Net income                                                                       |       | —     |       | —         |       | 899           |       | —                 |       | 899                    |       |
| Other comprehensive income, net of income taxes                                  |       |       |       |           |       |          |       |                   |       |                   |       |
| Unrealized losses on securities available for sale  during the period            |       | —     |       | —         |       | —        |       | (177                   | )          | (177                   | )          |
| Reclassification adjustment for gains included in  net income, net of $50 in tax |       | —     |       | —         |       | —        |       | (82                    | )          | (82                    | )          |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Total comprehensive income                                                       |       |       |       |           |       |          |       |                   |       | 640                    |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Issuance of 437,346 common shares                                                |       | 219        |       | 3,718          |       | —        |       | —                 |       | 3,937                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Exercise of stock options to purchase  3,000 common shares                  |       | 1          |       | 20             |       | —        |       | —                 |       | 21                     |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Balance at December 31, 2003                                                |       | 1,230      |       | 13,246         |       | (952          | )          | (126                   | )          | 13,398                 |       |
| Comprehensive income                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Net income                                                                       |       | —     |       | —         |       | 1,666         |       | —                 |       | 1,666                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Other comprehensive income, net of income taxes                                  |       |       |       |           |       |          |       |                   |       |                   |       |
| Unrealized gains on securities available for sale  during the period             |       | —     |       | —         |       | —        |       | 12                     |       | 12                     |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Reclassification adjustment for gains included in  net income, net of $13 in tax |       | —     |       | —         |       | —        |       | (20                    | )          | (20                    | )          |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Total comprehensive income                                                       |       |       |       |           |       |          |       |                   |       | 1,658                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Issuance of 775,000 common shares                                                |       | 388        |       | 8,137          |       | —        |       | —                 |       | 8,525                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Exercise of stock options to purchase 3,000 common  shares                       |       | 1          |       | 18             |       | —        |       | —                 |       | 19                     |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Balance at December 31, 2004                                                |       | 1,619      |       | 21,401         |       | 714           |       | (134                   | )          | 23,600                 |       |
| Comprehensive income                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Net income                                                                       |       | —     |       | —         |       | 3,067         |       | —                 |       | 3,067                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Other comprehensive income, net of income taxes                                  |       |       |       |           |       |          |       |                   |       |                   |       |
| Unrealized losses on securities available for sale  during the period            |       | —     |       | —         |       | —        |       | (234                   | )          | (234                   | )          |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Reclassification adjustment for gains included in  net income, net of $1 in tax  |       | —     |       | —         |       | —        |       | (3                     | )          | (3                     | )          |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Total comprehensive  income                                                      |       |       |       |           |       |          |       |                   |       | 2,830                  |       |
|                                                                             |       |       |       |           |       |          |       |                   |       |                   |       |
| Balance at  December 31, 2005                                               |       | $          | 1,619      |           | $          | 21,401        |       | $                      | 3,781      |                   | $          | (371 | ) | $ | 26,430 |   |

 

See accompanying notesto consolidated financial statements.

 

F-4

----

 

**TENNESSEE COMMERCEBANCORP, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| **(dollars in thousands except  share data)**                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Cash flows from operating  activities**                                         |       |     |       |     |       |     |       |
| Net income                                                                        |       | $        | 3,067      |     | $          | 1,666    |       | $ | 899 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities |       |     |       |     |       |     |       |
| Depreciation                                                                      |       | 171      |       | 165      |       | 131      |       |
| Provision for loan losses                                                         |       | 3,700    |       | 2,420    |       | 1,115    |       |
| FHLB stock dividends                                                              |       | (17      | )          | (9       | )          | (6       | )          |
| Deferred income taxes                                                             |       | 254      |       | 56       |       | 178      |       |
| Net amortization of investment securities                                         |       | 40       |       | 52       |       | 106      |       |
| Gain on sales of securities                                                       |       | (4       | )          | (33      | )          | (132     | )          |
| Change in:                                                                        |       |     |       |     |       |     |       |
| Accrued interest receivable                                                       |       | (1,045   | )          | (481     | )          | (195     | )          |
| Accrued interest payable                                                          |       | 681      |       | 276      |       | (18      | )          |
| Other assets                                                                      |       | (3,729   | )          | (837     | )          | 93       |       |
| Other liabilities                                                                 |       | 53       |       | 264      |       | 185      |       |
| Net cash provided by activities                                                   |       | 3,171    |       | 3,539    |       | 2,356    |       |
|                                                                              |       |     |       |     |       |     |       |
| **Cash flows from investing activities**                                          |       |     |       |     |       |     |       |
| Purchases of securities available for sale                                        |       | (17,315  | )          | (13,938  | )          | (18,647  | )          |
| Proceeds from sales of securities available for sale                              |       | 1,489    |       | 4,909    |       | 12,992   |       |
| Proceeds from maturities, prepayments and calls of  securities available for sale |       | 2,104    |       | 3,284    |       | 7,772    |       |
| Net change in loans                                                               |       | (134,561 | )          | (82,559  | )          | (58,044  | )          |
| Purchases of Federal Home Loan Bank stock                                         |       | (125     | )          | (82      | )          | (15      | )          |
| Net purchases of premises and equipment                                           |       | (330     | )          | (101     | )          | (384     | )          |
| Net cash used in investing activities                                             |       | (148,738 | )          | (88,487  | )          | (56,326  | )          |
|                                                                              |       |     |       |     |       |     |       |
| **Cash flows from financing activities**                                          |       |     |       |     |       |     |       |
| Net change in deposits                                                            |       | 146,311  |       | 79,101   |       | 55,032   |       |
| Net change in federal funds purchased                                             |       | —   |       | —   |       | (1,500   | )          |
| Proceeds from long term debt                                                      |       | 8,248    |       | —   |       | —   |       |
| Proceeds from issuance of common stock                                            |       | —   |       | 8,525    |       | 3,936    |       |
| Proceeds from exercise of stock options                                           |       | —   |       | 19       |       | 21       |       |
| Net cash provided by financing activities                                         |       | 154,559  |       | 87,645   |       | 57,489   |       |
|                                                                              |       |     |       |     |       |     |       |
| **Net change in cash and cash equivalents**                                       |       | 8,992    |       | 2,697    |       | 3,519    |       |
|                                                                              |       |     |       |     |       |     |       |
| Cash and cash equivalents at beginning of year                                    |       | 10,420   |       | 7,723    |       | 4,204    |       |
|                                                                              |       |     |       |     |       |     |       |
| **Cash and cash equivalents at end of year**                                      |       | $        | 19,412     |     | $          | 10,420   |       | $ | 7,723 |   |
|                                                                              |       |     |       |     |       |     |       |
| **Supplemental cash flow information:**                                           |       |     |       |     |       |     |       |
| Cash paid during year for interest                                                |       | $        | 9,325      |     | $          | 3,989    |       | $ | 2,994 |   |
| Cash paid during year for income taxes                                            |       | 2,089    |       | 780      |       | 38       |       |

 

See accompanying notes to consolidatedfinancial statements.

 

F-5

----

 

**TENNESSEE COMMERCE BANCORP, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1 -SUMMARY OF SIGNIFICANT ACCOUNTING****POLICIES**

 

The accounting principlesfollowed and the methods of applying those principles conform with accountingprinciples generally accepted in the United States of America and to generalpractices in the banking industry. The significant policies are summarized asfollows:

 

Principles ofConsolidation:  Theaccompanying consolidated financial statements include the accounts ofTennessee Commerce Bancorp, Inc. (the Corporation) and its wholly-ownedsubsidiary, Tennessee Commerce Bank (the Bank). Tennessee Commerce StatutoryTrust I is not consolidated and is accounted for under the equity method.Material intercompany accounts and transactions have been eliminated.

 

Nature of Operations:  Tennessee Commerce Bancorp, Inc. was formedin July 2000. Tennessee Commerce Bank received its charter as a state bank andopened for business in January 2000. Substantially all of the assets,liabilities, and operations presented in the consolidated financial statementsare attributable to Tennessee Commerce Bank. The Bank provides a variety ofbanking services to individuals and businesses in Middle Tennessee. Its primarydeposit products are demand and savings deposits and certificates of deposit,and its primary lending products are commercial, lease financing, real estatemortgage and installment loans.

 

The Bank’s loans aregenerally secured by specific items of collateral including real property,consumer assets, and business assets. Although the Bank has a diversified loanportfolio, a substantial portion of its debtors’ ability to honor theircontracts is dependent on local economic conditions.

 

Use of Estimates:  To prepare financial statements in conformitywith accounting principles generally accepted in the United States of America,management makes estimates and assumptions based on available information. Theseestimates and assumptions affect the amounts reported in the financialstatements and the disclosures provided, and future results could differ. Theallowance for loan losses and fair value of financial instruments areparticularly subject to change.

 

Statement of Cash Flows:  For purposes of presentation in thestatements of cash flows, cash and cash equivalents include amounts due fromfinancial institutions and federal funds sold. Net cash flows are reported forloan and deposit transactions.

 

Securities:  In accordance with Statement of FinancialAccounting Standards No. 115, *Accounting for CertainDebt and Equity Securities* (SFAS 115), all securities are classifiedas available for sale. The Corporation currently has no trading securities orheld to maturity securities.

 

Securities classified asavailable for sale may be sold in response to changes in interest rates,liquidity needs, and for other purposes. Available for sale securities arereported at fair value and include securities not classified as held tomaturity or trading.

 

F-6

----

 

Unrealized holding gainsand losses for available for sale securities are reported in othercomprehensive income. Realized gains (losses) on securities available for saleare included in other income (expense) and, when applicable, are reported as areclassification adjustment, net of tax, in other comprehensive income. Gainsand losses on sales of securities are determined on the specific-identificationmethod.

 

Interest income includesamortization of purchase premium or discount. Gains and losses on sales arebased on the amortized cost of the security sold. Securities are written downto fair value when a decline in fair value is not temporary. Any such lossesare charged to earnings.

 

###### ***Mortgage Banking Activities***: The Bank originates mortgage loans for sale and these loans are carriedat the lower of cost or fair value, determined on an aggregate basis. Generally,a commitment is obtained from investors at origination in order to minimizemarket risk directly related to interest rate movements. Origination fees arerecorded as income when the loans are sold to third party investors. At the endof the year for each period presented there were no loans held for sale.

###### *** ***

Loans:  Loans that the Bank has the positive intentand ability to hold to maturity are stated at the principal amount outstanding.Interest on loans is computed daily based on the principal amount outstanding. Loanorigination fees are deferred, to the extent they exceed direct originationcosts, and recognized over the life of the related loans as yield adjustments.

 

Loans are generallyplaced on nonaccrual when a loan is specifically determined to be impaired orwhen principal or interest is delinquent for 90 days or more. Any unpaidinterest previously accrued on those loans is reversed from income. Interestincome generally is not recognized on specific impaired loans unless thelikelihood of further loss is remote. Interest payments received on such loansare applied as a reduction of the loan principal balance. Interest income onother nonaccrual loans is recognized only to the extent of interest paymentsreceived.

 

***Allowance for Loan Losses***: The allowance for loan losses is maintained at a level that, inmanagement’s judgment, is adequate to absorb credit losses inherent in the loanportfolio. The amount of the allowance is based on management’s evaluation ofthe collectibility of the loan portfolio, including the nature of theportfolio, credit concentrations, trends in historical loss experience,impaired loans, and economic conditions. Allowances for impaired loans aregenerally determined based on collateral values or the present value ofestimated cash flows. Because of uncertainties associated with the regionaleconomic conditions, collateral values, and future cash flows on impairedloans, it is reasonably possible that management’s estimate of credit lossesinherent in the loan portfolio and the related allowance may change materiallyin the near term. The allowance is increased by the provision for loan lossesand reduced by charge-offs, net of recoveries.

 

F-7

----

 

The allowance consists ofspecific and general components. The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful. The general component covers non-classified loans andis based on historical loss experience adjusted for current factors.

 

Management periodicallyreviews the loan portfolio. A loan is placed on non-accrual status when it is90 days or more past due and immediate collection is doubtful. The non-accrualloans are reviewed periodically for impairment. A loan is impaired when fullpayment under the loan terms is not expected. Commercial and commercial realestate loans are individually evaluated for impairment. If a loan is impaired,a portion of the allowance is allocated so that the loan is reported, net, atthe present value of estimated future cash flows using the loan’s existing rateor at the fair value of collateral if repayment is expected solely from thecollateral. Large groups of smaller balance homogeneous loans, such as consumerand residential real estate loans, are collectively evaluated for impairment,and accordingly, they are not separately identified for impairment disclosures.

 

Premises and Equipment:  Premises and equipment are stated at cost,less accumulated depreciation and amortization. The provision for depreciationis computed principally on the straight-line method over the estimated usefullives of the assets. Leasehold improvements are amortized over the shorter of thelease term or useful life of the asset. Costs of major additions andimprovements are capitalized. Expenditures for maintenance and repairs arecharged to operations as incurred.

 

Other Real Estate:  Real estate acquired by foreclosure iscarried at the lower of the recorded investment in the property or its fairvalue at the date of foreclosure, determined by appraisal. Declines in valueindicated by reappraisals as well as losses resulting from disposition arecharged to operations.

 

Gain on Sale of Loans:The Bank records a transfer of financial assets as a sale when it surrenderscontrol over those financial assets to the extent that consideration other thanbeneficial interests in the assets is received in exchange. The Bank considerscontrol surrendered when all conditions prescribed by Statement of FinancialAccounting Standards No. 140, *Accounting For Transfersand Servicing of Financial Assets and Extinguishments of Liabilities,*a replacement of SFAS No. 125, are met. These conditions focus on whether thetransferred financial assets are isolated beyond the reach of the Bank and itscreditors, the constraints on the transferee or beneficial interest holders,and the Bank’s rights or obligations to reacquire transferred financial assets.In accordance with SFAS No. 140, the Bank records the transfer by allocatingthe carrying amount of the financial asset between the assets sold, and theretained interests, if any, based on their relative fair values at the date oftransfer. Estimates of expected future cash flows are used to determine fairvalue on the date of transfer. The gain on sale is presented as a component ofnon-interest income.

 

F-8

----

 

Interest-Only StripsReceivable: Interest-only strips receivable are related to loans originated and soldto others, and represent the difference between the loan’s coupon rate and therate “passed through” to investors. The initial amount recorded asinterest-only strips receivable (I/O) is computed by applying present valuefactors to the investors’ expected cash flows compared to expected cash flowsfrom the borrowers. I/Os are carried at fair value and unrealized losses orgains are recognized into income. I/Os are included in other assets on thebalance sheet.

 

Servicing Asset:In accordance with Statement of Financial Accounting Standards No. 140 - *Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities*, servicing assets are recognized asseparate assets when rights are acquired through purchase or through sale offinancial assets. When the Bank sells loans to others that it continues toservice, a servicing asset is recorded at fair value. Capitalized servicingrights are reported in other assets and are amortized over the life of the loanbeing serviced.

 

Stock-Based Compensation:  Employee compensation expense under stockoptions is reported using the intrinsic value method. No stock-basedcompensation cost is reflected in net income, as all options granted had anexercise price equal to or greater than the market price of the underlyingcommon stock at date of grant. The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*.

 
| **(dollars in thousands except  share data)**                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |     |       |
| Net income as reported                                                             |       | $        | 3,067      |     | $          | 1,666    |       | $ | 899 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |       | 245      |       | 141      |       | 615      |       |
|                                                                               |       |     |       |     |       |     |       |
| Pro forma net income                                                               |       | $        | 2,822      |     | $          | 1,525    |       | $ | 284 |   |
|                                                                               |       |     |       |     |       |     |       |
| Basic earnings per  share as reported                                              |       | $        | 0.95       |     | $          | 0.57     |       | $ | 0.40 |   |
| Pro forma basic  earnings per share                                                |       | 0.87     |       | 0.52     |       | 0.13     |       |
|                                                                               |       |     |       |     |       |     |       |
| Diluted earnings per  share as reported                                            |       | 0.87     |       | 0.53     |       | 0.38     |       |
| Pro forma diluted  earnings per share                                              |       | 0.80     |       | 0.48     |       | 0.12     |       |

 

The pro forma effects arecomputed using option pricing models, using the following weighted-averageassumptions as of grant date.

 
| ** **              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|----------|------------|
|                    |       |     |       |     |       |     |       |
| Risk-free interest rate |       | 3.96     | %          | 3.23     | %          | 3.82     | %          |
| Expected option life    |       | 5 years  |       | 7 years  |       | 7 years  |       |
| Dividend yield          |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

The weighted average fairvalue of options granted during the year was $4.03 for 2005, $2.23 for 2004 and$2.29 for 2003.

 

F-9

----

 

Stock Issuance:In 2004, the Corporation offered 775,000 shares for sale at a price of $11.00.The offering expired July 31, 2004 with all shares sold pursuant to theoffering.

 

***Income Taxes***: Income tax expense is the total of the current year income tax due orrefundable and the change in deferred tax assets and liabilities. Deferred taxassets and liabilities are the expected future tax amounts for the temporarydifferences between carrying amounts and tax bases of assets and liabilities,computed using enacted tax rates. A valuation allowance, if needed, reducesdeferred tax assets to the amount expected to be realized.

*** ***

Advertising Costs:  Advertising costs are generally charged tooperations in the year incurred and totaled $140,000, $35,000, and $37,000 in2005, 2004, and 2003.

 

Off-BalanceSheet Financial Instruments:  Financial instruments include off-balancesheet credit instruments, such as commitments to make loans and standby lettersof credit, issued to meet customer financing needs. The face amount for theseitems represents the exposure to loss, before considering customer collateralor ability to repay. Such financial instruments are recorded when they arefunded.

 

Restrictionson Cash:  Cash on hand or on deposit with other banksof $101,000 and $19,000 was required to meet regulatory reserve and clearingrequirements at year-end 2005 and 2004 respectively. These balances do not earninterest.

 

DividendRestrictions:  Banking regulations require maintainingcertain capital levels and may limit the dividends paid by the Bank.

 

ComprehensiveIncome:  Comprehensive income consists of net incomeand other comprehensive income. Other comprehensive income includes unrealizedgains and losses on securities available for sale which are also recognized asseparate components of equity.

 

FairValue of Financial Instruments:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed in a separate note. Fair value estimates involve uncertaintiesand matters of significant judgment regarding interest rates, credit risk,prepayments, and other factors, especially in the absence of broad markets forparticular items. Changes in assumptions or in market conditions couldsignificantly affect the estimates.

 

F-10

----

 

Recently Issued accounting Standards: The Financial Accounting Standards Board (FASB) recently issued newaccounting on share-based payments (FAS 123R). The Accounting StandardsExecutive Committee issued a new accounting standard on purchased loans(Statement of Position 03-3). FAS 123R addresses accounting for share-basedpayments, including the Corporation’s stock option plan. The Corporation willadopt FAS 123R in the first quarter 2006, as required by the standard. Compensationexpense will be based on the fair value of options granted, determined at thedate of grant, spread over the vesting or service period. Under previous rules,compensation expense was based on the intrinsic value of options granted. Previouslyreported net income and earnings per share will not be restated.

 

Management does not believe that any of the recentlyissued but not yet effective accounting standards, except for FAS 123R, willhave a material effect on the Corporation’s financial position or results ofoperation.

 

OperatingSegments:  While the chief decision-makers monitor therevenue streams of the various products and services, the identifiable segmentsare not material and operations are managed and financial performance isevaluated on a Corporation-wide basis. Accordingly, all of the financialservice operations are considered by management to be aggregated in onereportable operating segment.

 

Reclassifications:  Some items in the prior year financialstatements were reclassified to conform to the current presentation.

 

F-11

----

 

**NOTE 2 - SECURITIES**

 

The fair value ofavailable for sale securities and the related gross unrealized gains and lossesrecognized in accumulated other comprehensive income (loss) were as follows:

 
| ** **                           | ** ** | ** ** | ** ** | **Gross**      | ** ** | **Gross**      | ** ** |
|--------------------------------------|------------|------------|------------|----------------|------------|----------------|------------|
| ** **                           | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** |
| **(dollars in thousands)** | ** ** | **Value**  | ** ** | **Gains**      | ** ** | **Losses**     | ** ** |
|                                 |       |       |       |           |       |           |       |
| 2005                                 |       |       |       |           |       |           |       |
|                                 |       |       |       |           |       |           |       |
| U.S. Government agencies             |       | $          | 21,791     |           | $          | 7              |       | $ | (411 | ) |
| Mortgage-backed securities           |       | 7,805      |       | —         |       | (254           | )          |
| Corporate debt securities            |       | 399        |       | —         |       | (18            | )          |
| Corporate bonds                      |       | 1,537      |       | —         |       | (4             | )          |
| Other                                |       | 460        |       | 80             |       | —         |       |
|                                 |       |       |       |           |       |           |       |
|                                 |       | $          | 31,992     |           | $          | 87             |       | $ | (687 | ) |
|                                 |       |       |       |           |       |           |       |
| 2004                                 |       |       |       |           |       |           |       |
|                                 |       |       |       |           |       |           |       |
| U.S. Government agencies             |       | $          | 9,851      |           | $          | 5              |       | $ | (111 | ) |
| Mortgage-backed securities           |       | 8,459      |       | —         |       | (111           | )          |
| Other                                |       | 380        |       | —         |       | —         |       |
|                                 |       |       |       |           |       |           |       |
|                                 |       | $          | 18,690     |           | $          | 5              |       | $ | (222 | ) |

 

Contractual maturities ofdebt securities at December 31, 2005 are shown below. Expected maturities willdiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without prepayment penalties.

 
| **(dollars in thousands)** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------|------------|-----------------|------------|
|                                 |       |            |       |
| Due after one through five years     |       | $               | 8,304      |   |
| Due after five through ten years     |       | 15,423          |       |
| Due after ten years                  |       | 460             |       |
| Mortgage-backed securities           |       | 7,805           |       |
|                                 |       |            |       |
|                                 |       | $               | 31,992     |   |

 

Grossgains of $4,000, $33,000, and $132,000 on sales of securities were recognizedin 2005, 2004, and 2003. Securities carried at $7,112,000 and $7,433,000 atDecember 31, 2005 and 2004 were pledged to secure deposits and for otherpurposes as required or permitted by law.

 

Restricted equitysecurities consist of securities which are restricted as to transferability. Thesesecurities are recorded at cost.

 
| **(dollars in thousands)** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |
| Federal Home Loan Bank  stock        |       | $        | 383        |     | $          | 241 |   |
|                                      |            |          |            |          |            |  |  |

 

F-12

----

 

Securities withunrealized losses at year-end 2005 and 2004, and the length of time they havebeen in continuous loss positions are as follows:

 
| ** **                  | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|-----------------------------|------------|-------------------------|------------|-----------------------|------------|-----------|------------|
| ** **                  | ** ** | **Fair**                | ** ** | **Unrealized**        | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **(dollars in thousands)**  | ** ** | **Value**               | ** ** | **Loss**              | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| 2005                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| U.S.Government agencies     |       | $                       | 14,558     |                  | $          | 155       |       | $ | 7,233 |   | $ | 256 |   | $ | 21,791 |   | $ | 411 |   |
| Corporate Bonds             |       | 1,537                   |       | 4                     |       | —    |       | — |   | 1,537 |   | 4 |   |
| Corporate Debt  Securities  |       | —                  |       | —                |       | 399       |       | 18 |   | 399 |   | 18 |   |
| Mortgage-backed  securities |       | 1,873                   |       | 35                    |       | 5,932     |       | 219 |   | 7,805 |   | 254 |   |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| Total temporarily  impaired |       | $                       | 17,968     |                  | $          | 194       |       | $ | 13,564 |   | $ | 493 |   | $ | 31,532 |   | $ | 687 |   |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| 2004                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| U.S.Government agencies     |       | $                       | 5,426      |                  | $          | 48        |       | $ | 2,429 |   | $ | 63 |   | $ | 7,855 |   | $ | 111 |   |
| Mortgage-backed  securities |       | 5,712                   |       | 57                    |       | 2,522     |       | 54 |   | 8,234 |   | 111 |   |
|                        |       |                    |       |                  |       |      |       |   |   |   |   |   |   |
| Total temporarily impaired  |       | $                       | 11,138     |                  | $          | 105       |       | $ | 4,951 |   | $ | 117 |   | $ | 16,089 |   | $ | 222 |   |

 

Unrealizedlosses on securities have not been recognized into income because thesecurities are backed by the U.S. government or its agencies, management hasthe intent and ability to hold for the foreseeable future, and the decline infair value is largely due to increases in market interest rates. The fair valueis expected to recover as the securities approach their maturity dates and/ormarket rates decline.

 

F-13

----

 

## **NOTE3 - LOANS**

 

A summary of loansoutstanding by category at December 31:

 
| **(dollars in thousands)**   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Real estate:                           |       |     |       |     |       |
| Construction                           |       | $        | 38,279     |     | $          | 22,813 |   |
| 1 to 4 family residential              |       | 18,358   |       | 15,963   |       |
| Other                                  |       | 50,371   |       | 33,694   |       |
| Commercial, financial and agricultural |       | 233,948  |       | 139,799  |       |
| Consumer                               |       | 3,149    |       | 3,898    |       |
| Other                                  |       | 4,481    |       | —   |       |
|                                   |       | 348,586  |       | 216,167  |       |
| Less: Allowance for loan losses        |       | (4,399   | )          | (2,841   | )          |
|                                   |       |     |       |     |       |
| Net loans                              |       | $        | 344,187    |     | $          | 213,326 |   |

 

The Bank records a transfer of financialassets as a sale when it surrenders control over those financial assets to theextent that consideration other than beneficial interests in the assets isreceived in exchange. The amount of the proceeds for loans that were transferredwith recourse that were recorded as sales for each period follows.

 
| **(dollars in thousands)**           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                           |       |     |       |     |       |     |       |
| Proceeds from loans  transferred with recourse |       | $        | 19,571     |     | $          | 2,302    |       | $ | — |   |
|                                                |            |          |            |          |            |          |            |  |  |  |

 

The Bank services loansfor the benefit of others. The amount of loans being serviced for the benefitof others at year end for each period follows.

 
| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|
| **(dollars in thousands)** | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**              | ** ** |
|                                 |       |       |       |       |       |                  |       |
| Amount of loans being  serviced      |       | $          | 36,094     |       | $          | 19,157                |       | $ | 4,363 |   |
|                                      |            |            |            |            |            |                       |            |  |  |  |

 

Certain parties (principally executiveofficers and directors of the Bank including their related interests) werecustomers of, and had loans with the Bank in the ordinary course of business. Theseloan transactions were made on substantially the same terms as those prevailingat the time for comparable loans to other persons. They did not involve morethan the normal risk of collectibility or present other unfavorable features.

 

F-14

----

 

Loansto principal officers, directors, and their affiliates in 2005 were as follows.

 
| **(dollars in thousands)** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|
|                                 |       |     |       |
| Beginning balance                    |       | $        | 3,684      |   |
| New loans                            |       | 3,981    |       |
|                                 |       |     |       |
| Repayments                           |       | (1,200   | )          |
|                                 |       |     |       |
| Ending balance                       |       | $        | 6,465      |   |

 

**NOTE 4 – ALLOWANCE FOR LOAN LOSSES**

 

Changesin the allowance for loan losses were as follows:

 
| **(dollars in thousands)**    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |     |       |
| Balance at beginning of year            |       | $        | 2,841      |     | $          | 2,000    |       | $ | 1,103 |   |
| Provision charged to operating expenses |       | 3,700    |       | 2,420    |       | 1,115    |       |
| Loans charged-off                       |       | (2,411   | )          | (1,655   | )          | (283     | )          |
| Recoveries                              |       | 269      |       | 76       |       | 65       |       |
|                                    |       |     |       |     |       |     |       |
| Balance at end of year                  |       | $        | 4,399      |     | $          | 2,841    |       | $ | 2,000 |   |

 

Impaired loans were as follows:

 
| **(dollars in thousands)**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |
| Loans with allocated  allowance for loan losses    |       | $        | 2,928      |     | $          | 1,344 |   |
|                                               |       |     |       |     |       |
| Amount of the allowance  for loan losses allocated |       | $        | 942        |     | $          | 202 |   |

 
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                       |       |     |       |     |       |     |       |
| Average of impaired  loans during the year |       | $        | 4,444      |     | $          | 1,430    |       | $ | 1,250 |   |
|                                            |            |          |            |          |            |          |            |  |  |  |

 

The amount of interestincome recognized for the time that these loans were impaired during 2005,2004, and 2003 was not material to the financial statements.

 

Nonperformingloans were as follows:

 
| **(dollars in thousands)**         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                         |       |     |       |     |       |     |       |
| Loans past due over 90 days still on accrual |       | $        | 352        |     | $          | 111      |       | $ | 308 |   |
| Nonaccrual loans                             |       | 2,928    |       | 2,161    |       | 1,136    |       |
|                                              |            |          |            |          |            |          |            |  |  |  |

 

Nonperforming loansinclude both smaller balance homogeneous loans that are collectively evaluatedfor impairment and individually classified impaired loans.

 

F-15

----

 

**NOTE 5 –PREMISES AND EQUIPMENT**

 

The following is asummary of premises and equipment as of December 31, 2005 and 2004. Depreciationexpense for 2005, 2004, and 2003 was $171,000, $165,000, and $131,000.

 
| **(dollars in thousands)** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |
| Leasehold improvements               |       | $        | 440        |     | $          | 272 |   |
| Furniture and equipment              |       | 983      |       | 820      |       |
|                                 |       | 1,423    |       | 1,092    |       |
| Less: Allowance for depreciation     |       | 654      |       | 483      |       |
|                                 |       |     |       |     |       |
|                                 |       | $        | 769        |     | $          | 609 |   |

 

The Bank leases officespace, furniture and equipment under operating leases. Rent expense recognizedin 2005, 2004, and 2003 amounted to $268,000, $226,000, and $192,000. Theremaining minimum lease payments related to the leases are as follows, beforeconsidering renewal options that generally are present.

 
| **(dollars in thousands)** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| 2006                                 |       | $          | 247        |   |
| 2007                                 |       | 258        |       |
| 2008                                 |       | 268        |       |
| 2009                                 |       | 274        |       |
| 2010                                 |       | 279        |       |
|                                 |       |       |       |
|                                 |       | $          | 1,326      |   |

 

## **NOTE6 - DEPOSITS**

 

Time deposits greaterthan $100,000 amounted to $122,798,000 in 2005 and $68,590,000 in 2004.

 

At December 31, 2005,scheduled maturities of time deposits are as follows:

 
| **(dollars in thousands)** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
|                                 |       |       |       |
| 2006                                 |       | $          | 151,948    |   |
| 2007                                 |       | 26,279     |       |
| 2008                                 |       | 33,098     |       |
| 2009                                 |       | 13,986     |       |
| 2010                                 |       | 29,440     |       |
| 2011 and later                       |       | 598        |       |
|                                      |            |            |            |  |

 

Depositsheld at the Bank by directors, executive officers, and their related interestswere approximately $8,867,000 and $8,250,000 at December 31, 2005 and 2004.

 

F-16

----

 

**NOTE 7 - ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER DEBT**

 

TheFederal Home Loan Bank (FHLB) of Cincinnati advances funds to the Bank with therequirement that the advances are secured by securities and qualifying loans,essentially home mortgages (1-4 family residential). The Bank has an availableline of $8,838,000 with FHLB. To participate in this program, the Bank isrequired to be a member of the Federal Home Loan Bank and own stock in the FHLB.The Corporation has $383,000 of such stock at December 31, 2005 to satisfythis requirement.

 

AtDecember 31, 2005, the Bank had received no advances from the FHLB andtherefore had pledged no securities or qualifying loans.

 

The Bank has approximately $12,000,000 inavailable federal funds lines (or the equivalent thereof) with correspondentbanks.

 

**NOTE 8 – INCOME TAXES**

 

Incometax expense (benefit) recognized in each year is made up of current and deferredFederal and State tax amounts shown below:

 
| **(dollars in thousands)** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |     |       |
| Current Federal                      |       | $        | 1,385      |     | $          | 852      |       | $ | — |   |
| Current State                        |       | 286      |       | 174      |       | 10       |       |
| Deferred Federal                     |       | 213      |       | 46       |       | 148      |       |
| Deferred State                       |       | 41       |       | 10       |       | 30       |       |
|                                 |       |     |       |     |       |     |       |
|                                 |       | $        | 1,925      |     | $          | 1,082    |       | $ | 188 |   |

 

Thetax effect of each type of temporary difference that results in net deferredtax assets and liabilities is as follows:

 
| **(dollars in thousands)**    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Asset (liability)             |       |     |       |     |       |
| Allowance for loan losses     |       | $        | 936        |     | $          | 675 |   |
| Tax leases                    |       | (302     | )          | —   |       |
| Unrealized loss on securities |       | 228      |       | 82       |       |
| Depreciation                  |       | (60      | )          | (85      | )          |
| SFAS 140 income adjustments   |       | (382     | )          | (98      | )          |
| Other, net                    |       | 70       |       | 24       |       |
|                          |       |     |       |     |       |
| Balance at end of year        |       | $        | 490        |     | $          | 598 |   |

 

F-17

----

 

Areconciliation of the amount computed by applying the federal statutory rate(34%) to pretax income with income tax expense (benefit) follows:

 
| **(dollars in thousands)**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                               |       |     |       |     |       |     |       |
| Tax expense at statutory rate                                                                      |       | $        | 1,698      |     | $          | 934      |       | $ | 370 |   |
| Increase (decrease) in taxes resulting from  Change in valuation allowance for deferred tax assets |       | —   |       | —   |       | (237     | )          |
| State income tax effect                                                                            |       | 216      |       | 120      |       | 48       |       |
| Other                                                                                              |       | 11       |       | 28       |       | 7        |       |
|                                                                                               |       |     |       |     |       |     |       |
| Income tax expense                                                                                 |       | $        | 1,925      |     | $          | 1,082    |       | $ | 188 |   |

 

## **NOTE9 – COMMITMENTS AND CONTINGENCIES**

 

The Bank is a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its customers. These financialinstruments include commitments to extend credit and standby letters of credit.Those instruments involve, to varying degrees, elements of credit risk inexcess of the amount recognized in the balance sheet. The contract or notionalamounts of those instruments reflect the extent of involvement the Bank has inthose particular financial instruments.

 

The Bank’s exposure tocredit loss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit and standby letters of credit isrepresented by the contractual or notional amount of those instruments. TheBank uses the same credit policies in making commitments and conditionalobligations as it does for on-balance sheet instruments.

 

Financialinstruments whose contract amounts represent credit risk:

 
| ** **                           | ** ** | **2005**  | ** ** | **2004**     | ** ** |
|--------------------------------------|------------|-----------|------------|--------------|------------|
| ** **                           | ** ** | **Fixed** | ** ** | **Variable** | ** ** | **Fixed** | ** ** | **Variable** | ** ** |
| **(dollars in thousands)** | ** ** | **Rate**  | ** ** | **Rate**     | ** ** | **Rate** | ** ** | **Rate** | ** ** |
|                                 |       |      |       |         |       |   |   |   |   |
| Commitments to extend credit         |       | $         | 2,404      |         | $          | 38,859 |   | $ | 4,014 |   | $ | 29,638 |   |
| Standby letters of credit            |       | —    |       | 5,686        |       | — |   | 2,139 |   |
|                                      |            |           |            |              |            |  |  |  |  |  |  |  |  |

 

Commitments to make loansare generally made for periods of 60 days or less. The fixed rate loancommitments have interest rates ranging from 5.75% to 10.00% and maturitiesranging from 6 months to 5 years.

 

F-18

----

 

## **Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. The Bank evaluates each customer’s creditworthinesson a case-by-case basis. The amount of collateral obtained if deemed necessaryby the Bank upon extension of credit is based on management’s creditevaluation. Collateral held varies but may include accounts receivable,inventory, property, plant and equipment, and income-producing commercialproperties.**

 

Standbyletters of credit are conditional commitments issued by the Bank to guaranteethe performance of a customer to a third party. Those guarantees are primarilyissued to support public and private borrowing arrangements, includingcommercial paper, bond financing, and similar transactions. All letters ofcredit are due within one year or less of the original commitment date. Thecredit risk involved in issuing letters of credit is essentially the same asthat involved in extending loan facilities to customers.

 

TheBank primarily serves customers located in Middle Tennessee. As such, the Bank’sloans, commitments and letters of credit have been granted to customers in thatarea. Concentration of credit by type of loan is presented in Note 3.

 

## **NOTE 10 – EMPLOYEE BENEFITS**

 

TheBank maintains a 401(k) plan for all employees who have satisfied the minimumage and service requirements. The Bank may make discretionary contributions andemployees vest in employer contributions over five years. The Bank made nocontributions to the plan during 2005, 2004, and 2003.

 

F-19

----

 

**NOTE 11 – REGULATORY MATTERS**

 

Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Corporation and the Bank are required to meet specific capital adequacyguidelines that involve quantitative measures of a bank’s assets, liabilities,and certain off-balance sheet items as calculated under regulatory accountingpractices. Failure to meet minimum capital requirements can initiate certainmandatory and possible additional discretionary actions by regulators that, ifundertaken, could have a material effect on the Bank’s financial condition.

 

TheCorporation and the Bank’s capital amounts and classifications are also subjectto qualitative judgments by the regulators about components, risk weightings,and other factors. The risk-based guidelines are based on the assignment ofrisk weights to assets and off-balance sheet items depending on the level ofcredit risk associated with them. In addition to minimum capital requirements,under the regulatory framework for prompt corrective action, regulatoryagencies have specified certain ratios an institution must maintain to beconsidered “undercapitalized”, “adequately capitalized”, and “well capitalized”.As of December 31, 2005 and 2004, the most recent notification from the Bank’sregulatory authority categorized the Corporation and the Bank as “wellcapitalized”. There are no conditions or events since that notification thatmanagement believes have changed the Corporation and the Bank’s category.

 

The Bank and theCorporation’s capital amounts and ratios at December 31, 2005 and 2004 are asfollows:

 
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(dollars in thousands)** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| 2005                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based                     |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 38,250     |                       | 10.5       | %                          | $          | 29,132                     |       | 8.0                        | %          | $ | 36,415 |   | 10.0 | % |
| Corporation                          |       | $          | 39,201     |                       | 10.8       | %                          | $          | 29,111                     |       | 8.0                        | %          | n/a |   |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 to risk-based                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 33,851     |                       | 9.3        | %                          | $          | 14,566                     |       | 4.0                        | %          | $ | 21,849 |   | 6.0 | % |
| Corporation                          |       | $          | 34,802     |                       | 9.6        | %                          | $          | 14,566                     |       | 4.0                        | %          | n/a |   |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 leverage                      |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 33,851     |                       | 9.1        | %                          | $          | 14,559                     |       | 4.0                        | %          | $ | 18,599 |   | 5.0 | % |
| Corporation                          |       | $          | 34,802     |                       | 9.3        | %                          | $          | 14,969                     |       | 4.0                        | %          | n/a |   |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| 2004                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based                     |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 26,251     |                       | 12.0       | %                          | $          | 17,559                     |       | 8.0                        | %          | $ | 21,949 |   | 10.0 | % |
| Corporation                          |       | $          | 26,479     |                       | 12.1       | %                          | $          | 17,559                     |       | 8.0                        | %          | n/a |   |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 to risk-based                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 23,506     |                       | 10.7       | %                          | $          | 8,780                      |       | 4.0                        | %          | $ | 13,169 |   | 6.0 | % |
| Corporation                          |       | $          | 23,734     |                       | 10.8       | %                          | $          | 8,780                      |       | 4.0                        | %          | n/a |   |   |   |
|                                 |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 leverage                      |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Bank                                 |       | $          | 23,506     |                       | 9.7        | %                          | $          | 9,693                      |       | 4.0                        | %          | $ | 12,116 |   | 5.0 | % |
| Corporation                          |       | $          | 23,734     |                       | 9.8        | %                          | $          | 9,687                      |       | 4.0                        | %          | n/a |   |   |   |

 

F-20

----

 

**NOTE 12 – STOCK OPTIONS**

 

The following is a summary of certainrights and provisions of the options the Corporation has issued. All optionsand the related strike price reflect the impact of the two-for-one stock spliton December 31, 2003. All options expire ten years from the date of grant.

 

The original fourteen incorporatorsand members of the Board of Directors were granted an aggregate of 122,500options to purchase shares at $5.00 per share in connection with organizationactivities. 10,000 options were exercised in 2002, leaving 112,500 optionsoutstanding to purchase shares. Each of the 122,500 options were immediatelyvested on the date of grant.

 

In August 2003, the Board of Directorsapproved an option plan for active directors and incorporators in recognitionof their four years of service to the Bank without compensation. An aggregateof 320,000 options to purchase shares at a price of $10.50 per share wereincluded in this plan. Each of the 320,000 options were immediately vested onthe date of grant.

 

Pursuant toemployment agreements, executive officers received options equal to 14% of theshares sold in the original offering at an exercise price of $5.00 per share. Basedon the initial sale of 1,817,440 shares, executive officer options totaled254,440 and vest over three years. Of this total, 24,232 options were exercisedand 12,116 options were forfeited in 2002, and 2,000 options were exercised in2004, leaving an outstanding balance of 216,092 options to purchase shares. InFebruary 2003, three executive officers were granted 30,000 options each at anexercise price of $7.50 to vest over three years. In March 2004, threeexecutive officers were granted 20,000 options each at an exercise price of$11.00. These options were immediately vested on the date of grant. In August2005, one executive officer was granted 5,000 options. Of these 2,500 optionsimmediately vested and the remaining 2,500 vest in August 2006. In November 2005,one executive officer was granted 6,250 options that immediately vested.

 

The Board of Directors has granted incentive options tovarious employees who are not executive officers. Incentive options are usedfor recruiting and retention purposes and to recognize performance. Employeeincentive options include 13,000 options to purchase shares at $5.00 per sharegranted in 2000 and 2001. 5,000 options to purchase shares have been forfeitedby former employees, 3,000 options were exercised on December 31, 2003, and1,000 options were exercised in 2004. The remaining 4,000 are fully vested. 9,000options to purchase shares at $7.50 per share were granted in March 2003.31,000 options to purchase shares at $10.50 per share were granted in December2003. Of these, 5,000 options were forfeited in 2004. All of these incentiveoptions vest in two years. In July 2005 and August 2005, 69,000 and 10,000options were granted respectively. On each grant date half immediately vestedwith the remaining options vesting one year later. In November 2005, 10,000options were granted to employees and were immediately vested.

 

F-21

----

 

A summary of the activity in the plan isas follows:

 
| ** **                        | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**   | ** ** |
|-----------------------------------|------------|------------|------------|--------------|------------|------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                              |       |       |       |         |       |       |       |   |   |   |   |   |   |
| Outstanding at  beginning of year |       | 837,592    |       | $            | 7.99       |       | 785,592    |   | $ | 7.77 |   | 338,592 |   | $ | 5.00 |   |
| Granted                           |       | 100,250    |       | 16.00        |       | 60,000     |       | 11.00 |   | 450,000 |   | 9.84 |   |
| Exercised                         |       | —     |       | 0.00         |       | (3,000     | )          | 5.00 |   | (3,000 | ) | 5.00 |   |
| Forfeited or expired              |       | —     |       | 0.00         |       | (5,000     | )          | 10.50 |   | — |   | — |   |
|                              |       |       |       |         |       |       |       |   |   |   |   |   |   |
| Outstanding at end  of year  |       | 937,842    |       | $            | 8.85       |       | 837,592    |   | $ | 7.99 |   | 785,592 |   | $ | 7.77 |   |
|                              |       |       |       |         |       |       |       |   |   |   |   |   |   |
| Options exercisable at  year-end  |       | 865,842    |       |         |       | 757,592    |       |   |   | 655,592 |   |   |   |

 

**Optionsoutstanding at year-end 2005 were as follows:**

 
| ** **              | ** ** | **Outstanding** | ** ** | **Exerciseable** | ** ** |
|-------------------------|------------|-----------------|------------|------------------|------------|
| ** **              | ** ** | ** **      | ** ** | **Weighted**     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **      | ** ** | **Average**      | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **      | ** ** | **Remaining**    | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Exercise**            | ** ** | ** **      | ** ** | **Contractual**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Prices**              | ** ** | **Number**      | ** ** | **Life**         | ** ** | **Number** | ** ** | **Price** | ** ** |
|                    |       |            |       |             |       |   |   |   |   |
| $  5.00       |       | 332,592         |       | 4.0 years        |       | 332,592 |   | $ | 5.00 |   |
| $  7.50       |       | 99,000          |       | 7.0 years        |       | 69,000 |   | $ | 7.50 |   |
| $10.50                  |       | 346,000         |       | 7.0 years        |       | 346,000 |   | $ | 10.50 |   |
| $11.00                  |       | 60,000          |       | 8.0 years        |       | 60,000 |   | $ | 11.00 |   |
| $16.00                  |       | 100,250         |       | 10.0 years       |       | 58,250 |   | $ | 16.00 |   |
|                    |       |            |       |             |       |   |   |   |   |
| Outstanding at year-end |       | 937,842         |       |             |       | 865,842 |   | $ | 8.85 |   |

 

F-22

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## **NOTE13 – FAIR VALUES OF FINANCIAL INSTRUMENTS**

 

The methods andassumptions used to estimate fair value are described as follows:

 

Carrying amount is theestimated fair value for cash and due from financial institutions, federalfunds sold and purchased, accrued interest receivable and payable, demanddeposits, and variable rate loans or deposits that reprice frequently and fully.Security fair values are based on market prices or dealer quotes, and if nosuch information is available, on the rate and term of the security and informationabout the issue. For fixed rate loans or deposits and for variable rate loansor deposits with infrequent repricing or repricing limits, fair value is basedon discounted cash flows using current market rates applied to the estimatedlife and credit risk. The fair value of the subordinated long term debt isbased on discounted cash flows using current market rates applied to theestimated life of the debt. Other assets and accrued liabilities are carried atfair value. The fair value of off-balance-sheet loan commitments is considerednominal.

 

The estimated fair valuesof the Bank’s financial instruments at December 31, 2005 and 2004 were asfollows:

 
| ** **                               | ** ** | **2005**     | ** ** | **2004**  | ** ** |
|------------------------------------------|------------|--------------|------------|-----------|------------|
| ** **                               | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| **(dollars in thousands)**               | ** ** | **Amount**   | ** ** | **Value** | ** ** | **Amount** | ** ** | **Value** | ** ** |
| Financial assets                         |       |         |       |      |       |   |   |   |   |
| Cash and due from financial institutions |       | $            | 6,877      |      | $          | 6,877 |   | $ | 3,838 |   | $ | 3,838 |   |
| Federal funds sold                       |       | 12,535       |       | 12,535    |       | 6,582 |   | 6,582 |   |
| Securities available for sale            |       | 31,992       |       | 31,992    |       | 18,690 |   | 18,690 |   |
| Loans, net                               |       | 344,187      |       | 347,646   |       | 213,326 |   | 210,806 |   |
| Accrued interest receivable              |       | 2,148        |       | 2,148     |       | 1,103 |   | 1,103 |   |
| Restricted equity securities             |       | 383          |       | 383       |       | 241 |   | 241 |   |
| Financial liabilities                    |       |         |       |      |       |   |   |   |   |
| Deposits                                 |       | $            | 367,705    |      | $          | 367,544 |   | $ | 221,394 |   | $ | 221,621 |   |
| Accrued interest payable                 |       | 1,126        |       | 1,126     |       | 445 |   | 445 |   |
| Subordinated long term debt              |       | 8,248        |       | 8,316     |       | — |   | — |   |

 

F-23

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**NOTE 14 –EMPLOYMENT AGREEMENTS**

 

The Bank has entered intotwo-year automatically renewable employment agreements with four executiveofficers. In the event of a change in control of the Bank, or an officer isterminated without cause, the Bank has an obligation to pay 2.99 times theofficer’s annual salary and bonus which combined is not to be less than theprevious year’s salary and bonus.

 

**NOTE 15– SHAREHOLDERS’ EQUITY**

 

The Corporation’s charterauthorizes 1,000,000 shares of preferred stock, no par value. Shares of thepreferred stock may be issued from time to time in one or more series, eachsuch series to be so designated as to distinguish the shares from the shares ofall other series and classes. The Board of Directors has the authority todivide any or all classes of preferred stock into series and to fix anddetermine the relative rights and preferences of the shares of any series soestablished. The Board currently has no intent to issue such preferred stock.

 

The Corporation’s charterauthorizes 5,000,000 shares of common stock at a $.50 par value (aftertwo-for-one stock split). A two-for-one stock split was distributed toshareholders of record on December 31, 2003 resulting in the issuance of1,230,337 shares of common stock. The stock split increased the number ofoutstanding shares of Common Stock to 2,460,674 and reduced the par value pershare to $0.50. Share data and all relevant portions of the presented financialstatements and notes have been adjusted to reflect the stock split.

 

In January 2000,1,819,440 common shares were issued at $5.00 per share. In December 2002,166,656 common shares were issued at $7.50 per share and 34,232 common shareswere purchased through the exercise of stock options. In June through August2003, 437,346 common shares were issued at $9.00 per share and 3,000 commonshares were purchased through the exercise of stock options. In March throughAugust 2004, 775,000 common shares were issued at $11.00 per share and 3,000common shares were purchased through the exercise of stock options. At December31, 2005, 3,238,674 common shares are outstanding.

 

F-24

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**NOTE 16 – PARENT COMPANY ONLYCONDENSED FINANCIAL INFORMATION**

 

Condensed financialinformation of Tennessee Commerce Bancorp, Inc. follows.

 

**CONDENSEDBALANCE SHEETS**

 
| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ASSETS                            |       |                  |       |   |   |
| Cash and cash  equivalents        |       | $                     | 800        |   | $ | 227 |   |
| Investment in banking  subsidiary |       | 33,479                |       | 23,373 |   |
| Interest Receivable               |       | 1                     |       | — |   |
| Other                             |       | 421                   |       | — |   |
|                              |       |                  |       |   |   |
| Total assets                      |       | $                     | 34,701     |   | $ | 23,600 |   |
|                              |       |                  |       |   |   |
| LIABILITIES AND EQUITY            |       |                  |       |   |   |
| Interest Payable                  |       | $                     | 23         |   | $ | — |   |
|                              |       |                  |       |   |   |
| Subordinated long term  debt      |       | 8,248                 |       | — |   |
| Shareholders’ equity         |       | 26,430                |       | 23,600 |   |
|                              |       |                  |       |   |   |
| Total liabilities and  equity     |       | $                     | 34,701     |   | $ | 23,600 |   |

 

**CONDENSEDSTATEMENTS OF INCOME**

 
| ** **                                                           | ** ** | **For Years ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                 |       |                                  |       |   |   |   |   |
| Dividend and interest  income                                        |       | $                                     | 12         |   | $ | — |   | — |   |
| Interest expense                                                     |       | (416                                  | )          | — |   | — |   |
| Non-interest expense                                                 |       | (46                                   | )          | (34 | ) | (8 | ) |
|                                                                 |       |                                  |       |   |   |   |   |
| Income (loss) before  income tax and undistributed subsidiary income |       | (450                                  | )          | (34 | ) | (8 | ) |
| Income Tax (Expense)  Benefit                                        |       | 173                                   |       |   |   |   |   |
| Equity in undistributed  subsidiary income                           |       | 3,344                                 |       | 1,700 |   | 907 |   |
|                                                                 |       |                                  |       |   |   |   |   |
| Net income                                                           |       | $                                     | 3,067      |   | $ | 1,666 |   | $ | 899 |   |
|                                                                      |            |                                       |            |  |  |  |  |  |  |  |

 

F-25

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**CONDENSEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                | ** ** | **For Years ended December 31,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities     |       |                                                 |       |   |   |   |   |
| Net income                                |       | $                                                    | 3,067      |   | $ | 1,666 |   | $ | 899 |   |
| Adjustments:                              |       |                                                 |       |   |   |   |   |
| Change in Other Assets and Liabilities    |       | (150                                                 | )          | — |   | — |   |
| Equity in undistributed subsidiary income |       | (3,344                                               | )          | (1,700 | ) | (907 | ) |
| Net cash from operating activities        |       | (427                                                 | )          | (34 | ) | (8 | ) |
|                                      |       |                                                 |       |   |   |   |   |
| Cash flows from  investing activities     |       |                                                 |       |   |   |   |   |
| Investments in subsidiaries               |       | (7,000                                               | )          | (8,325 | ) | (3,957 | ) |
| Other assets                              |       | (248                                                 | )          | — |   | — |   |
|                                      |       |                                                 |       |   |   |   |   |
| Net cash from investing activities        |       | (7,248                                               | )          | (8,325 | ) | (3,957 | ) |
|                                      |       |                                                 |       |   |   |   |   |
| Cash flows from  financing activities     |       |                                                 |       |   |   |   |   |
| Proceeds from subordinated long term debt |       | 8,248                                                |       | — |   | — |   |
| Proceeds from stock issue                 |       | —                                               |       | 8,525 |   | 3,936 |   |
| Proceeds from exercise of stock options   |       | —                                               |       | 19 |   | 21 |   |
| Net cash from financing activities        |       | 8,248                                                |       | 8,544 |   | 3,957 |   |
|                                      |       |                                                 |       |   |   |   |   |
| Net change in cash and  cash equivalents  |       | 573                                                  |       | 185 |   | (8 | ) |
|                                      |       |                                                 |       |   |   |   |   |
| Beginning cash and cash  equivalents      |       | 227                                                  |       | 42 |   | 50 |   |
|                                      |       |                                                 |       |   |   |   |   |
| Ending cash and cash  equivalents         |       | $                                                    | 800        |   | $ | 227 |   | $ | 42 |   |

 

F-26

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**NOTE 17 –EARNINGS PER SHARE**

 

The factors used in theearnings per share computation follow.

 
| **(dollars in thousands except share data)**                                    | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|---------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic                                                                           |       |      |       |      |       |      |       |
| Net income                                                                      |       | $         | 3,067      |      | $          | 1,666     |       | $ | 899 |   |
|                                                                            |       |      |       |      |       |      |       |
| Weighted average common shares outstanding                                      |       | 3,238,674 |       | 2,933,818 |       | 2,253,928 |       |
|                                                                            |       |      |       |      |       |      |       |
| Basic earnings per common share                                                 |       | $         | 0.95       |      | $          | 0.57      |       | $ | 0.40 |   |
|                                                                            |       |      |       |      |       |      |       |
| Diluted                                                                         |       |      |       |      |       |      |       |
| Net income                                                                      |       | $         | 3,067      |      | $          | 1,666     |       | $ | 899 |   |
|                                                                            |       |      |       |      |       |      |       |
| Weighted average common shares outstanding for basic  earnings per common share |       | 3,238,674 |       | 2,933,818 |       | 2,253,928 |       |
| Add: Dilutive effects of assumed exercises of stock  options                    |       | 278,734   |       | 232,976   |       | 125,933   |       |
|                                                                            |       |      |       |      |       |      |       |
| Average shares and dilutive potential common shares                             |       | 3,517,408 |       | 3,166,794 |       | 2,379,861 |       |
|                                                                            |       |      |       |      |       |      |       |
| Diluted earnings per common share                                               |       | $         | 0.87       |      | $          | 0.53      |       | $ | 0.38 |   |
|                                                                                 |            |           |            |           |            |           |            |  |  |  |  |  |  |  |  |  |  |

 

No options wereantidilutive for 2005, 2004 and 2003.

 

F-27

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**NOTE 18– TRUST PREFERRED SECURITIES**

 

In March 2005, theCorporation formed a financing subsidiary, Tennessee Commerce Statutory TrustI, a Delaware statutory trust (the Trust). In March 2005, the Trust issued andsold 8,000 of the Trust’s fixed/floating rate capital securities, with aliquidation amount of $1,000 per capital security, to First Tennessee BankNational Association. The securities pay a fixed rate of 6.73% payablequarterly for the first five years and a floating rate based on a 3 month Liborrate plus 1.98% thereafter. At the same time, the Corporation issued to theTrust $8,248,000 of fixed/floating rate junior subordinated deferrable interestdebentures due 2035. The Corporation guarantees the payment of distributions andpayments for redemptions or liquidation of the capital securities. The TrustPreferred Securities qualify as “Tier I Capital” under current regulatorydefinitions subject to certain limitations.

 

The debentures pay afixed rate of 6.73% payable quarterly for the first five years and a floatingrate based on a 3 month Libor rate plus 1.98% thereafter. The distributions onthe capital securities are accounted for as interest expense by the Corporation.Interest payments on the debentures and the corresponding distributions on thecapital securities may be deferred at any time at the election of theCorporation for up to 20 consecutive quarterly periods (5 years). The capitalsecurities and debentures are redeemable at any time commencing in 2010 at par.The Corporation will report as liabilities the subordinated debentures issuedby the Corporation and held by the Trust.

 

**NOTE 19 – QUARTERLY FINANCIAL RESULTS (UNAUDITED)**

 

Asummary of selected consolidated quarterly financial data for the years endedDecember 31, 2005 and 2004 follows:

 
| ** **                                               | ** ** | **First**   | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|----------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| **(in thousands except share data)** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| 2005                                                     |       |        |       |        |       |        |       |        |       |
| Interest income                                          |       | $           | 4,673      |        | $          | 5,548       |       | $           | 6,373      |   | $ | 7,039 |   |
| Net interest income                                      |       | 3,048       |       | 3,342       |       | 3,606       |       | 3,631       |       |
| Provision for loan  losses                               |       | 650         |       | 1,150       |       | 1,000       |       | 900         |       |
| Income before taxes                                      |       | 1,081       |       | 1,096       |       | 1,272       |       | 1,543       |       |
| Net income                                               |       | 662         |       | 621         |       | 720         |       | 1,064       |       |
| Basic earnings per  share                                |       | $           | .20        |        | $          | .19         |       | $           | .22        |   | $ | .34 |   |
| Diluted earnings per  share                              |       | $           | .19        |        | $          | .18         |       | $           | .21        |   | $ | .29 |   |
|                                                     |       |        |       |        |       |        |       |        |       |
| 2004                                                     |       |        |       |        |       |        |       |        |       |
| Interest income                                          |       | $           | 2,572      |        | $          | 2,914       |       | $           | 3,514      |   | $ | 4,185 |   |
| Net interest income                                      |       | 1,728       |       | 1,992       |       | 2,368       |       | 2,832       |       |
| Provision for loan  losses                               |       | 480         |       | 425         |       | 625         |       | 890         |       |
| Income before taxes                                      |       | 410         |       | 545         |       | 778         |       | 1,015       |       |
| Net income                                               |       | 250         |       | 328         |       | 473         |       | 615         |       |
| Basic earnings per  share                                |       | $           | .10        |        | $          | .12         |       | $           | .15        |   | $ | .20 |   |
| Diluted earnings per  share                              |       | $           | .10        |        | $          | .12         |       | $           | .15        |   | $ | .16 |   |
|                                                          |            |             |            |             |            |             |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-28

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