UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-K





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





For the
fiscal year ended December 31, 2008





OR





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from _______ to _______.





COMMISSION
FILE NUMBER 000-32951





CRESCENT
FINANCIAL CORPORATION


(Exact
name of registrant as specified in its charter)





NORTH
      CAROLINA
                56-2259050(State
      or Other Jurisdiction of
                (I.R.S.
      EmployerIncorporation
      or Organization)
                Identification
      No.)





1005 High House Road, Cary,
North Carolina


27513


(Address
of Principal Executive Offices)


(Zip
Code)





Registrant’s
Telephone number, including area code:  (919) 460-7770





Securities
registered pursuant to Section 12(b) of the Act





NONE





Securities
registered pursuant to Section 12(g) of the Act:





COMMON STOCK, PAR VALUE
$1.00 PER SHARE





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


 ̈
Yes    x No





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.


 ̈
Yes    x No





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  x
Yes     ̈  No





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K   ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act (Check one):




Large accelerated filer
            o
            Accelerated filer
            oNon-accelerated filer
            o (Do not check if a smaller reporting company)
            Smaller reporting company
            þ





Indicate by check
mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).


 ̈ Yes  x No





State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant's most recently completed second fiscal
quarter: $47,667,052.





Indicate
the number of shares outstanding of each of the registrant’s classes of Common
Stock as of the latest practicable date:  9,626,559 shares of Common
Stock outstanding as of March 20, 2009.





Documents
Incorporated by Reference.


Portions
of the registrant’s definitive proxy statement as filed with the Securities
Exchange Commission in connection with its 2009 annual meeting are incorporated
into Part III of this report.








PART
      I
                  FORM
      10-K
                  PROXY
                    STATEMENT
                  ANNUAL
                    REPORTItem
      1 – Business
                  3Item
      2 – Properties
                  18Item
      3 – Legal Proceedings
                  20Item
      4 – Submission of Matters to a Vote
                    of
      Security Holders
                  20PART
      IIItem
      5 – Market for Registrant’s
                    Common
      Equity, Related
                    Stockholder
      Matters and Issuer
                    Purchases
      of Equity Securities
                  20Item
      6 – Selected Financial Data
                  21Item
      7 – Management’s Discussion and
                    Analysis
      of Financial Condition
                    and
      Results of Operation
                  23Item
      7A – Quantitative and Qualitative
                    Disclosures
      About Market
                    Risk
                  42Item
      8 – Financial Statements and
                    Supplementary
      Data
                  43Item
      9 – Changes in and Disagreements
                    with
      Accountants on
                    Accounting
      and Financial
                    Disclosure
                  81Item
      9A – Controls and Procedures
                  81Item
      9B – Other Information
                  82PART
      IIIItem
      10 – Directors and Executive
                    Officers and Corporate
                    Governance
                  82
                  XItem
      11 – Executive Compensation
                  
                  XItem
      12 – Security Ownership of Certain
                    Beneficial
      Owners and
                    Management
      and Related
                    Stockholder
      Matters
                  82
                  XItem
      13 – Certain Relationships and
                    Related Transactions, and
                    Director Independence
                  84
                  XItem
      14 – Principal Accountant Fees and
                    Services
                  84
                  XPART
      IVItem
      15 – Exhibits and Financial
                    Statement
      Schedules
                  84


2





PART
I





ITEM
1 – BUSINESS





General





Crescent
Financial Corporation (referred to as the “Registrant,” the “Company” or by the
use of “we,” “our” or “us”) was incorporated under the laws of the State of
North Carolina on April 27, 2001, at the direction of the Board of Directors of
Crescent State Bank (“CSB” or the “Bank”), for the purpose of serving as the
bank holding company for CSB and became the holding company for CSB on June 29,
2001.  To become CSB’s holding company, Registrant received approval
of the Federal Reserve Board as well as CSB’s shareholders.  Upon
receiving such approval, each share of $5.00 par value common stock of CSB was
exchanged on a one-for-one basis for the $1.00 par value common stock of the
Registrant.  On August 31, 2006, the Registrant acquired Port City
Capital Bank (“PCCB”) for cash and stock valued at $40.2 million.  The
Company was a multi-bank holding company from August 31, 2006 through June 15,
2007.  Effective the close of business June 15, 2007, PCCB was merged
into CSB and the Company reverted to a one bank holding company.





CSB was
incorporated on December 22, 1998 as a North Carolina-chartered commercial bank
and opened for business on December 31, 1998.  Including its main
office, CSB operates thirteen (13) full service branch offices in Cary (2),
Apex, Clayton, Holly Springs, Pinehurst, Raleigh, Southern Pines, Sanford,
Garner, Wilmington (2) and Knightdale, North Carolina and one loan production
office in Raleigh, North Carolina.  The Southern Pines and Pinehurst
offices were acquired through a merger with Centennial Bank of Southern Pines in
August, 2003.





The
Registrant operates for the primary purpose of serving as the holding company
for CSB. The Registrant’s headquarters are located at 1005 High House Road,
Cary, North Carolina 27513.





CSB
operates for the primary purpose of serving the banking needs of individuals,
and small- to medium-sized businesses in its market area. The Bank offers a
range of banking services including checking and savings accounts, commercial,
consumer and personal loans, and mortgage services and other associated
financial services.





Lending
Activities





General.  We
provide a wide range of short- to medium-term commercial and personal loans,
both secured and unsecured.  We also make real estate mortgage and
construction loans and Small Business Administration guaranteed loans. Many of
our commercial loans are collateralized with real estate in our market but such
collateral is mainly a secondary, not primary, source of
repayment.  We have maintained a balance between variable and fixed
rate loans within our portfolio.  Variable rate loans accounted for
49% of the loan balances outstanding at December 31, 2008 while fixed rate loans
accounted for 51% of the balances.





Our loan
policies and procedures establish the basic guidelines governing our lending
operations.  Generally, the guidelines address the types of loans that
we seek, target markets, underwriting and collateral requirements, terms,
interest rate and yield considerations and compliance with laws and
regulations.  All loans or credit lines are subject to approval
procedures and amount limitations.  These limitations apply to the
borrower’s total outstanding indebtedness to us, including the indebtedness of
any guarantor.  The policies are reviewed and approved annually by the
board of directors of the Bank.  We supplement our own supervision of
the loan underwriting and approval process with periodic loan audits by internal
loan examiners and outside professionals experienced in loan review
work.





Commercial Mortgage
Loans.We originate and maintain a significant amount of
commercial real estate loans.  This lending involves loans secured
principally by commercial office buildings, both investment and owner
occupied.  We require the personal guaranty of principals where
prudent and a demonstrated cash flow capability sufficient to service the
debt.  The real estate collateral is a secondary source of
repayment.  Loans secured by commercial real estate may be in greater
amount and involve a greater degree of risk than one to four family residential
mortgage loans.  Payments on such loans are often dependent on
successful operation or management of the properties.  We also make
loans secured by commercial/investment properties provided the subject property
is typically either pre-leased or pre-sold before the Bank commits to finance
its construction.


3


Construction
Loans.Another of our primary lending focuses is
construction/development lending.  We originate one to four family
residential construction loans for custom homes (where the home buyer is the
borrower and general contractor) and provide financing to builders who construct
homes for re-sale.  We finance “starter” homes as well as “high-end”
homes.  We generally receive a pre-arranged permanent financing
commitment from an outside banking entity prior to financing the construction of
pre-sold homes.  The Bank is active in the construction market and
makes construction loans to builders of homes that are not pre-sold, but limits
the number of such loans to any one builder.  This type of lending is
only done with local, well-established builders and not with large or national
tract builders.  We lend to builders in our market who have
demonstrated a favorable record of performance and profitable
operations.  We limit the number of unsold homes for each builder but
there is no limit for pre-sold homes.  We will also finance small
tract developments and sub-divisions; however, we seek to be only one of a
number of financial institutions making construction loans in any one tract or
sub-division.  We endeavor to further limit our construction lending
risk through adherence to established underwriting procedures and the
requirement of documentation for all draw requests.  We require
personal guarantees of the principals, when appropriate, and demonstrated
secondary sources of repayment on construction loans.  Construction
loan repayments are sensitive to general economic conditions, the housing market
and population migration patterns.





Commercial
Loans.  Commercial business lending is another focus of our
lending activities. Commercial loans include secured loans for working capital,
expansion and other business purposes.  Short-term working capital
loans generally are secured by accounts receivable, inventory and/or
equipment.  Lending decisions are based on an evaluation of the
financial strength, cash flow, management and credit history of the borrower,
and the quality of the collateral securing the loan.  With few
exceptions, we require personal guarantees of the principals and secondary
sources of repayment, primarily a deed of trust on local real
estate.  Commercial loans generally provide greater yields and reprice
more frequently than other types of loans, such as commercial mortgage
loans.  More frequent repricing means that yields on our commercial
loans adjust more quickly with changes in interest rates.





Loans to Individuals, Home Equity
Lines of Credit and Residential Real Estate Loans.Loans to
individuals (consumer loans) include automobile loans, boat and recreational
vehicle financing, home equity and home improvement loans and miscellaneous
secured and unsecured personal loans.  Consumer loans generally can
carry significantly greater risks than other loans, even if secured, if the
collateral consists of rapidly depreciating assets such as automobiles and
equipment. Repossessed collateral securing a defaulted consumer loan may not
provide an adequate secondary source of repayment of the
loan.  Consumer loan collections are sensitive to job loss, illness
and other personal factors.  We attempt to manage the risks inherent
in consumer lending by following established credit guidelines and underwriting
practices designed to minimize risk of loss.





Residential
real estate loans are made for purchasing and refinancing one to four family
properties.  We offer fixed and variable rate options, but generally
limit the maximum fixed rate term to five years.  We provide customers
access to long-term conventional real estate loans through our mortgage loan
department, which originates loans and brokers them for sale in the secondary
market.  Such loans are closed by mortgage brokers and are not funded
by us.  We anticipate that we will continue to be an active originator
of mortgage loans and only hold for our own account a small number of
well-collateralized, non-conforming residential loans. Residential real estate
loan collections are sensitive to economic market conditions, job loss and home
valuation pressures.


4


The
following table describes our loan portfolio composition by
category:





At December 31,2008
                  
                  
                  2007
                  
                  
                  2006% of Total
                  
                  
                  
                  
                  
                  % of Total
                  
                  
                  
                  
                  
                  % of TotalAmount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans(Dollars
      in thousands)Real
      estate - commercial
                  
                  $
                  470,433
                  
                  
                  
                  59.82
                  %
                  
                  $
                  350,961
                  
                  
                  
                  51.85
                  %
                  
                  $
                  304,823
                  
                  
                  
                  55.36
                  %Real
      estate - residential
                  
                  
                  19,145
                  
                  
                  
                  2.44
                  %
                  
                  
                  18,257
                  
                  
                  
                  2.70
                  %
                  
                  
                  20,224
                  
                  
                  
                  3.67
                  %Construction
      loans
                  
                  
                  160,967
                  
                  
                  
                  20.47
                  %
                  
                  
                  184,019
                  
                  
                  
                  27.18
                  %
                  
                  
                  110,033
                  
                  
                  
                  19.99
                  %Commercial
      and industrial loans
                  
                  
                  76,134
                  
                  
                  
                  9.68
                  %
                  
                  
                  72,930
                  
                  
                  
                  10.77
                  %
                  
                  
                  67,822
                  
                  
                  
                  12.32
                  %Home
      equity loans and lines of credit
                  
                  
                  54,374
                  
                  
                  
                  6.91
                  %
                  
                  
                  45,258
                  
                  
                  
                  6.69
                  %
                  
                  
                  42,704
                  
                  
                  
                  7.76
                  %Loans
      to individuals
                  
                  
                  5,370
                  
                  
                  
                  0.68
                  %
                  
                  
                  5,489
                  
                  
                  
                  0.81
                  %
                  
                  
                  4,977
                  
                  
                  
                  0.90
                  %Total
      loans
                  
                  
                  786,423
                  
                  
                  
                  100.00
                  %
                  
                  
                  676,914
                  
                  
                  
                  100.00
                  %
                  
                  
                  550,583
                  
                  
                  
                  100.00
                  %Less:  Net
      deferred loan fees
                  
                  
                  (1,046
                  )
                  
                  
                  
                  
                  
                  
                  (998
                  )
                  
                  
                  
                  
                  
                  
                  (764
                  )Total
      loans, net
                  
                  $
                  785,377
                  
                  
                  
                  
                  
                  
                  $
                  675,916
                  
                  
                  
                  
                  
                  
                  $
                  549,819





At December 31,2005
                  
                  
                  2004% of Total
                  
                  
                  
                  
                  
                  % of TotalAmount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans(Dollars
      in thousands)Real
      estate - commercial
                  
                  $
                  174,039
                  
                  
                  
                  52.92
                  %
                  
                  $
                  121,825
                  
                  
                  
                  47.24
                  %Real
      estate - residential
                  
                  
                  14,914
                  
                  
                  
                  4.54
                  %
                  
                  
                  11,604
                  
                  
                  
                  4.50
                  %Construction
      loans
                  
                  
                  46,607
                  
                  
                  
                  14.17
                  %
                  
                  
                  38,916
                  
                  
                  
                  15.09
                  %Commercial
      and industrial loans
                  
                  
                  52,708
                  
                  
                  
                  16.03
                  %
                  
                  
                  48,757
                  
                  
                  
                  18.90
                  %Home
      equity loans and lines of credit
                  
                  
                  34,921
                  
                  
                  
                  10.62
                  %
                  
                  
                  30,960
                  
                  
                  
                  12.00
                  %Loans
      to individuals
                  
                  
                  5,670
                  
                  
                  
                  1.72
                  %
                  
                  
                  5,846
                  
                  
                  
                  2.27
                  %Total
      loans
                  
                  
                  328,859
                  
                  
                  
                  100.00
                  %
                  
                  
                  257,908
                  
                  
                  
                  100.00
                  %Less:  Net
      deferred loan fees
                  
                  
                  (537
                  )
                  
                  
                  
                  
                  
                  
                  (447
                  )Total
      loans, net
                  
                  $
                  328,322
                  
                  
                  
                  
                  
                  
                  $
                  257,461





The
following table presents at December 31, 2008 (i) the aggregate maturities of
loans in the named categories of our loan portfolio and (ii) the aggregate
amounts of such loans, by variable and fixed rates that mature after one
year:




Within
                  
                  
                  1-5
                  
                  
                  After 51 Year
                  
                  
                  Years
                  
                  
                  Years
                  
                  
                  Total(In
      thousands)Commercial
      mortgage
                  
                  $
                  145,765
                  
                  
                  $
                  280,044
                  
                  
                  $
                  44,624
                  
                  
                  $
                  470,433Residential
      mortgage
                  
                  
                  6,217
                  
                  
                  
                  12,199
                  
                  
                  
                  729
                  
                  
                  
                  19,145Construction
      loans
                  
                  
                  118,961
                  
                  
                  
                  28,328
                  
                  
                  
                  13,678
                  
                  
                  
                  160,967Commercial
      and industrial
                  
                  
                  52,747
                  
                  
                  
                  22,571
                  
                  
                  
                  816
                  
                  
                  
                  76,134Home
      equity lines and loans
                  
                  
                  1,885
                  
                  
                  
                  4,653
                  
                  
                  
                  47,836
                  
                  
                  
                  54,374Individuals
                  
                  
                  3,043
                  
                  
                  
                  1,623
                  
                  
                  
                  704
                  
                  
                  
                  5,370Total
                  
                  $
                  328,618
                  
                  
                  $
                  349,418
                  
                  
                  $
                  108,387
                  
                  
                  $
                  786,423Fixed
      rate loans
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  309,339Variable
      rate loans
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  148,466$
                  457,805


5





Loan Approvals.Our loan
policies and procedures establish the basic guidelines governing lending
operations.  Generally, the guidelines address the type of loans that
we seek, target markets, underwriting and collateral requirements, terms,
interest rate and yield considerations and compliance with laws and
regulations.  All loans and credit lines are subject to approval
procedures and amount limitations.  Depending upon the loan requested,
approval may be granted by the individual loan officer, our officers’ loan
committee or, for the largest relationships, the directors’ loan
committee.  The Bank’s full board is required to approve any single
transaction of $5.0 million or more.  These amount limitations apply
to the borrower’s total outstanding indebtedness to us, including the
indebtedness of any guarantor. The policies are reviewed and approved at least
annually by the board of directors.





Responsibility
for loan review, underwriting, compliance and document monitoring resides with
the senior credit officer.  He is responsible for loan processing and
approval.  On an annual basis, the board of directors of the Bank
determines the president’s lending authority, who then delegates lending
authorities to the senior credit officer and other lending officers of the
bank.  Delegated authorities may include loans, letters of credit,
overdrafts, uncollected funds and such other authorities as determined by the
board of directors or the president within his delegated authority.





Credit Cards.We
offer a credit card on an agency basis as an accommodation to our
customers.  We assume none of the underwriting risk.





Loan
Participations.From time to time we purchase and sell loan
participations to or from other banks within and outside our market
area.  All loan participations purchased have been underwritten using
our standard and customary underwriting criteria.





Commitments
and Contingent Liabilities





In the
ordinary course of business, we enter into various types of transactions that
include commitments to extend credit.  We apply the same credit
standards to these commitments as we use in all of our lending activities and
have included these commitments in our lending risk evaluations.  Our
exposure to credit loss under commitments to extend credit is represented by the
amount of these commitments.  See Note N of the “Notes to Consolidated
Financial Statements.”





Asset
Quality





We
consider asset quality to be of primary importance, and employ a third party
loan reviewer to ensure adherence to the lending policy as approved by our board
of directors.  It is the responsibility of each lending officer to
assign an appropriate risk grade to every loan originated.  Credit
administration, through the loan review process, validates the accuracy of the
initial risk grade assessment.  In addition, as a given loan’s credit
quality improves or deteriorates, it is credit administration’s responsibility
to change the borrower’s risk grade accordingly.  At least annually,
we undergo loan review by an outside third party who reviews compliance with our
underwriting standards and risk grading and provides a report detailing the
conclusions of that review to our board of directors and senior
management.  The Bank’s board requires management to address any
criticisms raised during the loan review and to take appropriate actions where
warranted.





Investment
Activities





Our
investment portfolio plays a major role in management of liquidity and interest
rate sensitivity and, therefore, is managed in the context of the overall
balance sheet.  The securities portfolio generates a nominal
percentage of our interest income and serves as a necessary source of
liquidity.  Debt and equity securities that will be held for
indeterminate periods of time, including securities that we may sell in response
to changes in market interest or prepayment rates, needs for liquidity and
changes in the availability of and the yield of alternative investments, are
classified as available for sale.  We carry these investments at
market value, which we generally determine using published quotes or a pricing
matrix obtained at the end of each month.  Unrealized gains and losses
are excluded from our earnings and are reported, net of applicable income tax,
as a component of accumulated other comprehensive income in stockholders’ equity
until realized.


6


Deposit
Activities





We
provide a range of deposit services, including non-interest bearing checking
accounts, interest bearing checking and savings accounts, money market accounts
and certificates of deposit.  These accounts generally earn interest
at rates established by management based on competitive market factors and
management’s desire to increase or decrease certain types or maturities of
deposits.  We use brokered deposits to supplement our funding
sources.  However, we strive to establish customer relations to
attract core deposits in non-interest bearing transactional accounts and thus
reduce our cost of funds.





The
following table sets forth for the years indicated the average balances
outstanding and average interest rates for each major category of
deposits:




For the Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006(Dollars in thousands)Average
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    AverageBalance
                    
                    
                    Rate
                    
                    
                    Balance
                    
                    
                    Rate
                    
                    
                    Balance
                    
                    
                    RateNon-interest
      bearing deposits
                    
                    $
                    64,938
                    
                    
                    
                    -
                    
                    
                    $
                    70,660
                    
                    
                    
                    -
                    
                    
                    $
                    56,376
                    
                    
                    
                    -Interest
      bearing demand deposits
                    
                    
                    34,073
                    
                    
                    
                    0.19
                    %
                    
                    
                    33,453
                    
                    
                    
                    0.97
                    %
                    
                    
                    37,876
                    
                    
                    
                    1.46
                    %Money
      market deposits
                    
                    
                    79,145
                    
                    
                    
                    2.80
                    %
                    
                    
                    58,214
                    
                    
                    
                    3.48
                    %
                    
                    
                    51,926
                    
                    
                    
                    3.52
                    %Savings
      deposits
                    
                    
                    78,759
                    
                    
                    
                    2.26
                    %
                    
                    
                    105,107
                    
                    
                    
                    4.29
                    %
                    
                    
                    40,694
                    
                    
                    
                    4.51
                    %Time
      deposits over $100,000
                    
                    
                    338,193
                    
                    
                    
                    4.50
                    %
                    
                    
                    254,533
                    
                    
                    
                    5.11
                    %
                    
                    
                    154,538
                    
                    
                    
                    4.82
                    %Time
      deposits under $100,000
                    
                    
                    80,397
                    
                    
                    
                    4.73
                    %
                    
                    
                    70,710
                    
                    
                    
                    5.03
                    %
                    
                    
                    72,440
                    
                    
                    
                    3.51
                    %Total
      interest bearing deposits
                    
                    
                    610,567
                    
                    
                    
                    3.78
                    %
                    
                    
                    522,017
                    
                    
                    
                    4.49
                    %
                    
                    
                    357,474
                    
                    
                    
                    3.97
                    %Total
      average deposits
                    
                    $
                    675,505
                    
                    
                    
                    3.41
                    %
                    
                    $
                    592,677
                    
                    
                    
                    3.95
                    %
                    
                    $
                    413,850
                    
                    
                    
                    3.43
                    %





For the Year Ended December 31,2005
                      
                      
                      2004(Dollars in thousands)Average
                      
                      
                      Average
                      
                      
                      Average
                      
                      
                      AverageBalance
                      
                      
                      Rate
                      
                      
                      Balance
                      
                      
                      RateNon-interest
      bearing deposits
                      
                      $
                      42,641
                      
                      
                      
                      -
                      
                      
                      $
                      37,898
                      
                      
                      
                      -Interest
      bearing demand deposits
                      
                      
                      39,609
                      
                      
                      
                      1.05
                      %
                      
                      
                      40,931
                      
                      
                      
                      0.79
                      %Money
      market deposits
                      
                      
                      41,548
                      
                      
                      
                      2.16
                      %
                      
                      
                      31,537
                      
                      
                      
                      1.29
                      %Savings
      deposits
                      
                      
                      4,952
                      
                      
                      
                      1.79
                      %
                      
                      
                      2,758
                      
                      
                      
                      0.36
                      %Time
      deposits over $100,000
                      
                      
                      110,312
                      
                      
                      
                      3.30
                      %
                      
                      
                      85,961
                      
                      
                      
                      2.57
                      %Time
      deposits under $100,000
                      
                      
                      58,787
                      
                      
                      
                      3.13
                      %
                      
                      
                      56,445
                      
                      
                      
                      2.68
                      %Total
      interest bearing deposits
                      
                      
                      255,208
                      
                      
                      
                      2.70
                      %
                      
                      
                      217,632
                      
                      
                      
                      2.04
                      %Total
      average deposits
                      
                      $
                      297,849
                      
                      
                      
                      2.31
                      %
                      
                      $
                      255,530
                      
                      
                      
                      1.73
                      %





The
following table sets forth the amounts and maturities of certificates of deposit
with balances of $100,000 or more at December 31, 2008:





Remaining maturity:
                  
                  (in
      thousands)Three
      months or less
                  
                  $
                  35,202Over
      three months through one year
                  
                  
                  144,483Over
      one year through three years
                  
                  
                  156,174Over three years through five years
                  
                  
                  23,768Total
                  
                  $
                  359,627


7


Borrowings





As
additional sources of funding, we use advances from the Federal Home Loan Bank
of Atlanta under a line of credit equal to 30% of CSB’s total assets ($290.5
million at December 31, 2008).  Outstanding advances at December 31,
2008 were $128.0 million. Pursuant to collateral agreements with the Federal
Home Loan Bank, at December 31, 2008 advances were secured by investment
securities available for sale with a fair value of $46.5 million and by loans
with a carrying amount of $222.9 million, which approximates market
value.





We may
purchase federal funds through four unsecured federal funds lines of credit
aggregating $59.0 million.  These lines are intended for short-term
borrowings and are subject to restrictions limiting the frequency and terms of
the advances.  These lines of credit are payable on demand and bear
interest based upon the daily federal funds rate (0.50% at December 31,
2008).  There were $8.7 million in federal funds purchased at December
31, 2008.





Junior
Subordinated Debt





In August
of 2003, $8.3 million in trust preferred securities were placed through Crescent
Financial Capital Trust I.  The trust has invested the total proceeds
from the sale of its trust preferred securities in junior subordinated
deferrable interest debentures issued by us.  The trust preferred
securities pay cumulative cash distributions quarterly at an annual rate, reset
quarterly, equal to three-month LIBOR plus 310 basis points.  The
dividends paid to holders of the trust preferred securities, which are recorded
as interest expense, are deductible by us for income tax
purposes.  The trust preferred securities mature on October 7, 2033
and are redeemable, subject to approval by the Federal Reserve, on January 7,
April 7, July 7 or October 7 on or after October 7, 2008.  We have
fully and unconditionally guaranteed the trust preferred securities through the
combined operation of the debentures and other related documents.  Our
obligation under the guarantee is unsecured and subordinate to senior and
subordinated indebtedness.  The principal reason for issuing trust
preferred securities is that the proceeds from their sale qualify as Tier 1
capital for regulatory capital purposes (subject to certain limitations),
thereby enabling us to enhance our regulatory capital positions without diluting
the ownership of our stockholders.





Subordinated
Debt





On
September 26, 2008, the Company entered into an unsecured subordinated term loan
agreement in the amount of $7.5 million.  The agreement calls for the
Company to make quarterly payments of interest at an annual rate, reset
quarterly, equal to three-month LIBOR plus 400 basis points.  The
subordinated term loan is deemed to be Tier 2 capital for regulatory capital
purposes.  The subordinated term loan agreement matures on October 18,
2018 and can be prepaid, subject to the approval of the FDIC and other
Governmental Authorities (if applicable), in incremental amounts not less than
$500,000, by giving five business days notice prior to prepayment.  We
do not have the right to prepay all or any portion of the loan prior to October
1, 2013 unless the loan ceases to be deemed Tier 2 capital for regulatory
capital purposes.  Should the loan cease to be considered Tier 2
capital for regulatory capital purposes, the debt can either be structured as
senior debt of the Company or be repaid.  The principal reason for
entering into the subordinated term loan agreement was to enhance our regulatory
capital position without diluting our shareholders.





Investment
Services





Crescent
State Bank has entered into a revenue sharing agreement with Capital Investment
Group, Raleigh, North Carolina, under which it receives revenue for securities
and annuity sales generated by brokers located in our offices.  We
offer this investment service under the name “Crescent Investment
Services.”





Courier
Services





We
offer courier services to our customers free-of-charge as a
convenience and a demonstration of our commitment to superior
customer-service.  Our couriers travel to the customer’s
location, pick-up non-cash deposits from the customer and deliver those deposits
to the bank.  We feel our couriers serve as ambassadors for our bank and
enhance our presence in the communities we serve.


8


Banking
Technology





Because
of the level of sophistication of our markets, we commenced operations with a
full array of technology available for our customers.  Our customers
have the ability to perform on-line banking and bill paying, access on-line
check images, make transfers, initiate wire transfers, ACH originations and stop
payment orders of checks.  We provide our customers with imaged check
statements, thereby eliminating the cost of returning checks to customers and
eliminating the clutter of canceled checks.  Through branch image
capture technology, CSB offers same day credit for deposits made prior to 5:00
pm.  During 2008, we implemented remote merchant capture which is a
relatively new technology that allows our customers to run check deposits
through a scanner and deliver the image to the Bank
electronically.  In March 2009 we anticipate offering electronic
statements to accountholders.





Strategy





Our
strategy is three-fold: we are committed to achieving growth and performance
through exceptional customer service and sound asset quality; we provide a
comprehensive array of products and services; and we are able to adapt to a
rapidly changing banking environment.  We place the highest priority
on providing professional, highly personalized service – it’s the driving force
behind our business.  Over the first ten years of our Company, we
focused on loan growth as being the key to our short-term success, and although
we have historically created earnings that compare favorably to a peer group of
banks started in the late 1990’s, financial performance was not the main
driver.  As we begin our eleventh year of business, the Company is
slowly converting to a more mature bank whose strategy and goals are centered on
becoming a high performance bank among our peer group.  As we begin
this new direction, asset growth will not be at the levels previously seen, but
performance metrics should begin to improve.  We feel the strategy and
actions over the past ten years have helped to create a Company of size which
was important in becoming a significant participant in the markets we serve. The
future strategy and actions to create a high performing bank will leverage that
size to create a Company of extraordinary long-term shareholder
value.





Primary
Market Area





CSB’s
market area includes the four central north Carolina counties of Wake, Johnston,
Lee and Moore Counties and the coastal county of New Hanover.





According
to the U.S. Census Bureau, the estimated 2007 population for the contiguous four
county central North Carolina area was over 1.1 million reflecting a 30%
increase over the last actual census data population conducted in
2000.   The largest of the four, Wake County, includes the state
capital of Raleigh as well as the area known as Research Triangle Park, one of
the nation’s leading technology centers.  Our market area is home to
several universities and institutions of higher learning, including North
Carolina State University.  Wake County has a diverse economy centered
on state government, the academic community, the technology industry, the
medical and pharmaceuticals sectors and the many small businesses that support
these enterprises as well as the people that live and work in this
area.  The estimated 2007 population in Wake County of almost 833,000
is the second most populous county in the state and experienced a 5% increase
between estimates for 2006 and those for 2007.  Johnston County is the
second largest county in CSB’s central North Carolina footprint with a
population estimate for 2007 of 157,000.  Johnston County is one of
the fastest growing counties in the state and is contiguous to the southeast of
Wake County.  Lee and Moore Counties are located to the south of
Raleigh in the region referred to as the Sandhills area, which is home to the
towns of Pinehurst, Sanford and Southern Pines.  Moore County has an
estimated 2007 population of 84,000 and Lee County is estimated to have a
population of 58,000.  Both counties experienced 2% growth compared
with 2006 estimates.  The region’s economy benefits from an emphasis
on the golf industry due to the many world class golf courses located in the
vicinity and also from a growing retiree population drawn to the mild climate
and recreational activities afforded by the Sandhills area.





CSB is
headquartered in Cary, the second largest city in Wake County and the seventh
largest in North Carolina.  Cary has an estimated population of
131,000 as of July 1, 2008. The Town of Cary is served by several major
highways, Interstates 40, 440 and 540, US 1, US 64, and NC 55. International,
national, and regional airlines offer service from the Raleigh-Durham
International Airport, which is less than five miles from Cary.  The
people located in CSB’s central North Carolina footprint are relatively diverse,
young and highly educated.  As of 2000, the latest date for which
actual census data is available, over 60% of Cary’s population and over 37% of
the estimated four county population 25 years or older had at least a bachelor’s
degree. This educational level is due to the number of higher education
institutions located in our market area as well as the Research Triangle Park’s
high technology employee base.


9


The
economic strength of the area is also reflected by the per capita
income.  Per capita income for 2007 for the Raleigh-Cary metropolitan
statistical area, as estimated by the Bureau of Economic Analysis, was $38,648
compared to $33,636 for North Carolina.  The median family income in
the Raleigh-Cary metropolitan statistical area in 2008 was $74,800 according to
the Federal Reserve Bank of Richmond compared to $62,710 for the State of North
Carolina as shown by the Federal Home Loan Mortgage Corporation.  Cary
is home to the world’s largest privately held software company, SAS Institute,
and it has attracted prominent companies such as American Airlines, Western Wake
Medical Center, Austin Quality Foods and Lucent Technologies.  The
Research Triangle Park houses major facilities of IBM, GlaxoSmithKline, Nortel,
the U.S. Environmental Protection Agency, Quintiles and numerous other
technology and bio-medical firms.





New
Hanover County is home to Wilmington, North Carolina as well as the University
of North Carolina at Wilmington.  According to the Chamber of
Commerce, Wilmington has a 2008 estimated population of approximately 101,000
while New Hanover County has a population of approximately
190,000.  Wilmington is the eighth largest city in North
Carolina.  The median family income estimate for 2008 according to the
Department of Housing and Urban Development was $56,600 and per capita income
per the Bureau of Economic Analysis for 2007 was $32,300.  Wilmington
has a sizable seaport and is the most eastern point in the United States of
Interstate 40.  The area has become an important destination for the
entertainment industry as over 200 movies or television shows have been produced
in Wilmington.  The largest employers in Wilmington include the New
Hanover Regional Medical Center, New Hanover Public Schools, General Electric,
The University of North Carolina at Wilmington and PPD, Inc., a large
pharmaceutical and biotech company.





Competition





Commercial
banking in North Carolina is extremely competitive in large part due to early
adoption of statewide branching.  We compete in our market areas with
large regional and national banking organizations, other federally and state
chartered financial institutions such as savings and loan institutions and
credit unions, consumer finance companies, mortgage companies and other lenders
engaged in the business of extending credit. Many of our competitors have
broader geographic markets and higher lending limits than we do and are also
able to provide more services and make greater use of media advertising. All
markets in which we have a banking office are also served by branches of the
largest banks in North Carolina.





For
example, as of June 30, 2008 there were 423 offices of 43 different financial
institutions across our five county footprint.  CSB ranked eighth in
market share across that five county area with a combined 3.80% of the total
combined deposit market.  There were 241 offices of 31 different
financial institutions in Wake County, 80 offices of 21 different financial
institutions in New Hanover County, 41 offices of 12 different financial
institutions in Johnston County, 39 offices of 12 different financial
institutions in Moore County and 22 offices of 11 different financial
institutions in Lee County.  CSB’s market share in the individual
counties we serve was 2.77%, 3.24%, 1.49%, 5.16% and 2.30%,
respectively.  While we typically do not compete directly for loans
with larger banks, they do influence our deposit products.  We do
compete more directly with mid-size and small community banks that have offices
in our market areas.





The
enactment of legislation authorizing interstate banking has led to increases in
the size and financial resources of some of our competitors. In addition, as a
result of interstate banking, out-of-state commercial banks have acquired North
Carolina banks and heightened the competition among banks in North
Carolina.  For example, SunTrust Bank, Atlanta, Georgia, a large
multi-state financial institution, has branches throughout North Carolina,
including Wake County.





Despite
the competition in our market areas, we believe that we have certain competitive
advantages that distinguish us from our competition. We offer customers modern
banking services without forsaking prompt, personal service and friendliness. We
also have established a local advisory board in each of our communities to help
us better understand their needs and to be “ambassadors” of the
Bank.  It is our intention to further develop advisory boards as we
expand into additional communities in our market area.  We offer many
personalized services and attract customers by being responsive and sensitive to
their individualized needs. We believe our approach to business builds goodwill
among our customers, stockholders, and the communities we serve that results in
referrals from stockholders and satisfied customers.  We also rely on
traditional marketing to attract new customers. To enhance a positive image in
the community, we support and participate in local events and our officers and
directors serve on boards of local civic and charitable
organizations.


10





Employees





At
December 31, 2008, the Registrant employed 140 full-time and 14 part-time
employees. None of the Registrant’s employees are covered by a collective
bargaining agreement. The Registrant believes its relations with its employees
to be good.





REGULATION





Regulation
of the Bank





The Bank
is extensively regulated under both federal and state law. Generally, these laws
and regulations are intended to protect depositors and borrowers, not
shareholders. To the extent that the following information describes statutory
and regulatory provisions, it is qualified in its entirety by reference to the
particular statutory and regulatory provisions. Any change in applicable law or
regulation may have a material effect on the business of the Registrant and the
Bank.





State Law. The Bank
is subject to extensive supervision and regulation by the North Carolina
Commissioner of Banks (the “Commissioner”). The Commissioner oversees state laws
that set specific requirements for bank capital and regulate deposits in, and
loans and investments by, banks, including the amounts, types, and in some
cases, rates. The Commissioner supervises and performs periodic examinations of
North Carolina-chartered banks to assure compliance with state banking statutes
and regulations, and the Bank is required to make regular reports to the
Commissioner describing in detail the resources, assets, liabilities and
financial condition of the Bank. Among other things, the Commissioner regulates
mergers and consolidations of state-chartered banks, the payment of dividends,
loans to officers and directors, record keeping, types and amounts of loans and
investments, and the establishment of branches.




Deposit
Insurance.The Bank’s deposits are insured up to applicable limits, currently
$250,000, by the Deposit Insurance Fund, or DIF, of the FDIC. The DIF is the
successor to the Bank Insurance Fund and the Savings Association Insurance Fund,
which were merged in 2006. The Bank’s deposits, therefore, are subject to FDIC
deposit insurance assessment.




The FDIC
recently amended its risk-based deposit assessment system for 2007 to implement
authority granted by the Federal Deposit Insurance Reform Act of 2005, or the
Reform Act. Under the revised system, insured institutions are assigned to one
of four risk categories based on supervisory evaluations, regulatory capital
levels and certain other factors. An institution’s assessment rate depends upon
the category to which it is assigned. Risk Category I, which contains the least
risky depository institutions, was expected to include more than 90% of all
institutions. Unlike the other categories, Risk Category I contains further risk
differentiation based on the FDIC’s analysis of financial ratios, examination
component ratings and other information. Assessment rates are determined by the
FDIC and for the period effective January 1, 2009 through March 31, 2009
(payment dated June 30, 2009 based on March 31, 2009 data) range from 12 to 14
basis points for the healthiest institutions (Risk Category I) to 50 basis
points of assessable deposits for the riskiest (Risk Category IV). Effective
April 1, 2009, the FDIC has introduced three adjustments that could be made to
an institution's initial base assessment rate: (1) a potential decrease for
long-term unsecured debt, including senior and subordinated debt and, for small
institutions, a portion of Tier 1 capital; (2) a potential increase for secured
liabilities above a threshold amount; and (3) for non-Risk Category I
institutions, a potential increase for brokered deposits above a threshold
amount.  The new rates will range from seven to 24 basis points for
the healthiest institutions (Risk Category I) to 43 to 77.5 basis points of
assessable deposits for the riskiest (Risk Category IV).


11




On
October 3, 2008, Congress enacted into law the Emergency Economic Stabilization
Act of 2008 (EESA).  The EESA established two major initiative
programs; the Capital Purchase Program (CPP) and the Temporary Liquidity
Guarantee Program (TLG). The TLG provided for two separate FDIC guarantee
programs in which the Company chose to participate.   For the
first program, the FDIC will guarantee newly issued senior unsecured debt issued
between October 14, 2008, and June 30, 2009, including promissory notes,
commercial paper, inter-bank funding, and any unsecured portion of secured debt.
The amount of debt covered by the guarantee may not exceed 125 percent of debt
that was outstanding as of September 30, 2008 and scheduled to mature before
June 30, 2009. If  an insured depository institution had no eligible
debt outstanding at September 30, 2008, the debt guarantee limit was established
at 2% of total liabilities at September 30, 2008.  For eligible debt
issued on or before June 30, 2009, coverage would only be provided until June
30, 2012, even if the liability has not matured.  The second program
guarantees non-interest bearing transaction accounts to an unlimited
amount.  Additional assessment fees apply to funds guaranteed under
these programs.




For
eligible senior unsecured debt, an annualized fee will be collected equal to 75
basis points multiplied by the amount of debt guaranteed under this program. The
Company has not issued any debt under this program.  For non-interest
bearing transaction deposit accounts, a 10 basis point surcharge on the
institution's current assessment rate would be applied to deposits not otherwise
covered by the existing deposit insurance limit of $250,000. Fees for the 10
basis point surcharge on the non-interest bearing transaction accounts over
$250,000 will be collected through the normal assessment cycle.  The
Company anticipates paying assessments under this program.




On
February 27, 2009, the FDIC proposed amendments to the restoration plan for the
DIF.  This amendment proposes the imposition of a 20 basis point
emergency special assessment on insured depository institutions as of June 30,
2009.  The assessment is proposed to be collected on September 30,
2009.  The interim rule would also permit the FDIC to impose an
emergency special assessment after June 30, 2009, of up to ten basis points if
necessary to maintain public confidence in federal deposit insurance. Based on
average deposits for the fourth quarter, this special assessment, if implemented
as proposed, would equal approximately $1.4 million.  This
special assessment, if implemented as proposed, will have a significant impact
on the results of operations of the Company for 2009.





On
March 5, 2009, the FDIC Chairman announced that the FDIC intends to lower
the special assessment from 20 basis points to 10 basis points. The approval of
the cutback is contingent on whether Congress clears legislation that would
expand the FDIC’s line of credit with the Treasury to $100 billion.
Legislation to increase the FDIC’s borrowing authority on a permanent basis is
also expected to advance to Congress, which should aid in reducing the burden on
the industry.  The assessment rates, including the special assessment,
are subject to change at the discretion of the Board of Directors of the
FDIC.




The FDIC
is authorized to set the reserve ratio for the DIF annually at between 1.15% and
1.5% of estimated insured deposits, in contrast to the statutorily fixed ratio
of 1.25% under the old system. The ratio, which is viewed by the FDIC as the
level that the funds should achieve, was established by the agency at 1.25% for
2007. The Reform Act also provided for the possibility that the FDIC may pay
dividends to insured institutions once the DIF reserve ratio equals or exceeds
1.35% of estimated insured deposits.




Capital Requirements.
The federal banking regulators have adopted certain risk-based capital
guidelines to assist in the assessment of the capital adequacy of a banking
organization’s operations for both transactions reported on the balance sheet as
assets and transactions, such as letters of credit, and recourse arrangements,
which are recorded as off balance sheet items. Under these guidelines, nominal
dollar amounts of assets and credit equivalent amounts of off balance sheet
items are multiplied by one of several risk adjustment percentages which range
from 0% for assets with low credit risk, such as certain U.S. Treasury
securities, to 100% for assets with relatively high credit risk, such as
business loans.





A banking
organization’s risk-based capital ratios are obtained by dividing its qualifying
capital by its total risk- adjusted assets. The regulators measure risk-adjusted
assets, which include off balance sheet items, against both total qualifying
capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
Tier 1 capital. “Tier 1,” or core capital, includes common equity, qualifying
noncumulative perpetual preferred stock and minority interests in equity
accounts of consolidated subsidiaries, less goodwill and other intangibles,
subject to certain exceptions. “Tier 2,” or supplementary capital, includes
among other things, limited-life preferred stock, hybrid capital instruments,
mandatory convertible securities, qualifying subordinated debt, and the
allowance for loan and lease losses, subject to certain limitations and less
required deductions. The inclusion of elements of Tier 2 capital is subject to
certain other requirements and limitations of the federal banking agencies.
Banks and bank holding companies subject to the risk-based capital guidelines
are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at
least 4% and a ratio of total capital to risk-weighted assets of at least 8%.
The appropriate regulatory authority may set higher capital requirements when
particular circumstances warrant. As of December 31, 2008, CSB was classified as
“well-capitalized” with Tier 1 and Total Risk-Based Capital of 8.71% and 10.87%,
respectively.


12





The
federal banking agencies have adopted regulations specifying that they will
include, in their evaluations of a bank’s capital adequacy, an assessment of the
bank’s interest rate risk exposure. The standards for measuring the adequacy and
effectiveness of a banking organization’s interest rate risk management include
a measurement of board of directors and senior management oversight, and a
determination of whether a banking organization’s procedures for comprehensive
risk management are appropriate for the circumstances of the specific banking
organization.





Failure
to meet applicable capital guidelines could subject a banking organization to a
variety of enforcement actions, including limitations on its ability to pay
dividends, the issuance by the applicable regulatory authority of a capital
directive to increase capital and, in the case of depository institutions, the
termination of deposit insurance by the FDIC, as well as the measures described
under the “Federal Deposit Insurance Corporation Improvement Act of 1991” below,
as applicable to undercapitalized institutions. In addition, future changes in
regulations or practices could further reduce the amount of capital recognized
for purposes of capital adequacy. Such a change could affect the ability of the
Bank to grow and could restrict the amount of profits, if any, available for the
payment of dividends to the shareholders.





Federal Deposit Insurance
Corporation Improvement Act of 1991.  In December 1991,
Congress enacted the Federal Deposit Insurance Corporation Improvement Act of
1991 (the “FDIC Improvement Act”), which substantially revised the bank
regulatory and funding provisions of the Federal Deposit Insurance Act and made
significant revisions to several other federal banking statutes. The FDIC
Improvement Act provides for, among other things:





-
            publicly
      available annual financial condition and management reports for certain
      financial institutions, including audits by independent
      accountants,





-
            the
      establishment of uniform accounting standards by federal banking
      agencies,





-
            the
      establishment of a “prompt corrective action” system of regulatory
      supervision and intervention, based on capitalization levels, with greater
      scrutiny and restrictions placed on depository institutions with lower
      levels of capital,





-
            additional
      grounds for the appointment of a conservator or receiver,
    and





-
            restrictions
      or prohibitions on accepting brokered deposits, except for institutions
      which significantly exceed minimum capital
  requirements.





The FDIC
Improvement Act also provides for increased funding of the FDIC insurance funds
and the implementation of risk-based premiums.





A central
feature of the FDIC Improvement Act is the requirement that the federal banking
agencies take “prompt corrective action” with respect to depository institutions
that do not meet minimum capital requirements. Pursuant to the FDIC Improvement
Act, the federal bank regulatory authorities have adopted regulations setting
forth a five-tiered system for measuring the capital adequacy of the depository
institutions that they supervise. Under these regulations, a depository
institution is classified in one of the following capital categories: “well
capitalized,” “adequately capitalized,” “undercapitalized,” “significantly
undercapitalized” and “critically undercapitalized.” An institution may be
deemed by the regulators to be in a capitalization category that is lower than
is indicated by its actual capital position if, among other things, it receives
an unsatisfactory examination rating with respect to asset quality, management,
earnings or liquidity.


13


The FDIC
Improvement Act provides the federal banking agencies with significantly
expanded powers to take enforcement action against institutions which fail to
comply with capital or other standards. Such action may include the termination
of deposit insurance by the FDIC or the appointment of a receiver or conservator
for the institution. The FDIC Improvement Act also limits the circumstances
under which the FDIC is permitted to provide financial assistance to an insured
institution before appointment of a conservator or receiver.





International Money
Laundering Abatement and Financial Anti-Terrorism Act of
2001.  On October 26, 2001, the USA Patriot Act of 2001 was
enacted.  This act contains the International Money Laundering
Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money
laundering measures affecting insured depository institutions, broker-dealers
and other financial institutions.  The Act requires U.S. financial
institutions to adopt new policies and procedures to combat money laundering and
grants the Secretary of the Treasury broad authority to establish regulations
and to impose requirements and restrictions on the operations of financial
institutions.





Miscellaneous. The
dividends that may be paid by each bank are subject to legal limitations. In
accordance with North Carolina banking law, dividends may not be paid unless a
bank’s capital surplus is at least 50% of its paid-in capital.





The
earnings of the Bank will be affected significantly by the policies of the
Federal Reserve Board, which is responsible for regulating the United States
money supply in order to mitigate recessionary and inflationary pressures. Among
the techniques used to implement these objectives are open market transactions
in United States government securities, changes in the rate paid by banks on
bank borrowings, and changes in reserve requirements against bank deposits.
These techniques are used in varying combinations to influence overall growth
and distribution of bank loans, investments, and deposits, and their use may
also affect interest rates charged on loans or paid for deposits.





The
monetary policies of the Federal Reserve Board have had a significant effect on
the operating results of commercial banks in the past and are expected to
continue to do so in the future. In view of changing conditions in the national
economy and money markets, as well as the effect of actions by monetary and
fiscal authorities, no prediction can be made as to possible future changes in
interest rates, deposit levels, loan demand or the business and earnings of the
Bank.





We cannot
predict what legislation might be enacted or what regulations might be adopted,
or if enacted or adopted, the effect thereof on the Bank’s
operations.





Regulation
of the Registrant





Federal Regulation.
The Registrant is subject to examination, regulation and periodic reporting
under the Bank Holding Company Act of 1956, as administered by the Federal
Reserve Board. The Federal Reserve Board has adopted capital adequacy guidelines
for bank holding companies on a consolidated basis.





The
Registrant is required to obtain the prior approval of the Federal Reserve Board
to acquire all, or substantially all, of the assets of any bank or bank holding
company. Prior Federal Reserve Board approval is required for the Registrant to
acquire direct or indirect ownership or control of any voting securities of any
bank or bank holding company if, after giving effect to such acquisition, it
would, directly or indirectly, own or control more than five percent of any
class of voting shares of such bank or bank holding company.





The
merger or consolidation of the Bank with another bank, or the acquisition by the
Registrant of assets of another bank, or the assumption of liability by the
Registrant to pay any deposits in another bank, will require the prior written
approval of the primary federal bank regulatory agency of the acquiring or
surviving bank under the federal Bank Merger Act.  The decision is
based upon a consideration of statutory factors similar to those outlined above
with respect to the Bank Holding Company Act.  In addition, in certain
such cases an application to, and the prior approval of, the Federal Reserve
Board under the Bank Holding Company Act and/or the North Carolina Banking
Commission may be required.


14


The
Registrant is required to give the Federal Reserve Board prior written notice of
any purchase or redemption of its outstanding equity securities if the gross
consideration for the purchase or redemption, when combined with the net
consideration paid for all such purchases or redemptions during the preceding 12
months, is equal to 10% or more of the Registrant’s consolidated net worth. The
Federal Reserve Board may disapprove such a purchase or redemption if it
determines that the proposal would constitute an unsafe and unsound practice, or
would violate any law, regulation, Federal Reserve Board order or directive, or
any condition imposed by, or written agreement with, the Federal Reserve Board.
Such notice and approval is not required for a bank holding company that would
be treated as “well capitalized” and “well managed” under applicable regulations
of the Federal Reserve Board, that has received a composite “1” or “2” rating at
its most recent bank holding company inspection by the Federal Reserve Board,
and that is not the subject of any unresolved supervisory issues.





The
status of the Registrant as a registered bank holding company under the Bank
Holding Company Act does not exempt it from certain federal and state laws and
regulations applicable to corporations generally, including, without limitation,
certain provisions of the federal securities laws.





In
addition, a bank holding company is prohibited generally from engaging in, or
acquiring five percent or more of any class of voting securities of any company
engaged in, non-banking activities. One of the principal exceptions to this
prohibition is for activities found by the Federal Reserve Board to be so
closely related to banking or managing or controlling banks as to be a proper
incident thereto. Some of the principal activities that the Federal Reserve
Board has determined by regulation to be so closely related to banking as to be
a proper incident thereto are:





-  making
or servicing loans;


-  performing
certain data processing services;


-  providing
discount brokerage services;


-  acting
as fiduciary, investment or financial advisor;


-  leasing
personal or real property;


-  making
investments in corporations or projects designed primarily to promote community
welfare; and


-  acquiring
a savings and loan association.





In
evaluating a written notice of such an acquisition, the Federal Reserve Board
will consider various factors, including among others the financial and
managerial resources of the notifying bank holding company and the relative
public benefits and adverse effects which may be expected to result from the
performance of the activity by an affiliate of such company. The Federal Reserve
Board may apply different standards to activities proposed to be commenced de novo and activities
commenced by acquisition, in whole or in part, of a going concern. The required
notice period may be extended by the Federal Reserve Board under certain
circumstances, including a notice for acquisition of a company engaged in
activities not previously approved by regulation of the Federal Reserve Board.
If such a proposed acquisition is not disapproved or subjected to conditions by
the Federal Reserve Board within the applicable notice period, it is deemed
approved by the Federal Reserve Board.





However,
with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act
of 1999, which became effective on March 11, 2000, the types of activities in
which a bank holding company may engage were significantly expanded. Subject to
various limitations, the Modernization Act generally permits a bank holding
company to elect to become a “financial holding company.” A financial holding
company may affiliate with securities firms and insurance companies and engage
in other activities that are “financial in nature.”  Among the
activities that are deemed “financial in nature” are, in addition to traditional
lending activities, securities underwriting, dealing in or making a market in
securities, sponsoring mutual funds and investment companies, insurance
underwriting and agency activities, certain merchant banking activities and
activities that the Federal Reserve Board considers to be closely related to
banking.





A bank
holding company may become a financial holding company under the Modernization
Act if each of its subsidiary banks is “well capitalized” under the Federal
Deposit Insurance Corporation Improvement Act prompt corrective action
provisions, is well managed and has at least a satisfactory rating under the
Community Reinvestment Act.  In addition, the bank holding company
must file a declaration with the Federal Reserve Board that the bank holding
company wishes to become a financial holding company.  A bank holding
company that falls out of compliance with these requirements may be required to
cease engaging in some of its activities.  The Registrant has not yet
elected to become a financial holding company.


15


Under the
Modernization Act, the Federal Reserve Board serves as the primary “umbrella”
regulator of financial holding companies, with supervisory authority over each
parent company and limited authority over its subsidiaries.  Expanded
financial activities of financial holding companies generally will be regulated
according to the type of such financial activity: banking activities by banking
regulators, securities activities by securities regulators and insurance
activities by insurance regulators.  The Modernization Act also
imposes additional restrictions and heightened disclosure requirements regarding
private information collected by financial institutions.





Sarbanes-Oxley Act of
2002.  On July 30, 2002, the Sarbanes-Oxley Act of 2002 was
signed into law and became some of the most sweeping federal legislation
addressing accounting, corporate governance and disclosure issues. The impact of
the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and
imposes significant new requirements for public company governance and
disclosure requirements.




In
general, the Sarbanes-Oxley Act mandates important new corporate governance and
financial reporting requirements intended to enhance the accuracy and
transparency of public companies’ reported financial results. It establishes new
responsibilities for corporate chief executive officers, chief financial
officers and audit committees in the financial reporting process and creates a
new regulatory body to oversee auditors of public companies. It backs these
requirements with new SEC enforcement tools, increases criminal penalties for
federal mail, wire and securities fraud, and creates new criminal penalties for
document and record destruction in connection with federal investigations. It
also increases the opportunity for more private litigation by lengthening the
statute of limitations for securities fraud claims and providing new federal
corporate whistleblower protection.




The
economic and operational effects of this new legislation on public companies,
including us, is significant in terms of the time, resources and costs
associated with complying with the new law. Because the Sarbanes-Oxley Act, for
the most part, applies equally to larger and smaller public companies, we are
presented with additional challenges as a smaller, community-oriented financial
institution seeking to compete with larger financial institutions in our
market.





Recent Regulatory
Initiatives.  Beginning in late 2008 and continuing into 2009,
the federal government took sweeping actions in response to the deepening
economic recession.  As mentioned above, President Bush signed the
Emergency Economic Stabilization Act of 2008 or “EESA” into law on October 3,
2008.  Pursuant to EESA, the Department of the Treasury created the
Troubled Asset Relief Program of “TARP” for the purpose of stabilizing the U.S.
financial markets.  On October 14, 2008, the Treasury announced the
creation of the TARP Capital Purchase Program.  The Capital Purchase
Program was designed to invest up to $250 billion (later increased to $350
billion) in certain eligible financial institutions in the form of nonvoting
senior preferred stock initially paying quarterly dividends at a five percent
annual rate.  In connection with its investment in senior preferred
stock, the Treasury also received ten-year warrants to purchase common shares of
participating institutions.





The
Company applied and was approved for participation in the Capital Purchase
Program in late 2008.  On January 9, 2009, the Company issued and sold
to the Treasury (1) 24,900 shares of the Company’s Fixed Rate Cumulative
Perpetual Preferred Stock, Series A, and (2) a warrant to purchase 833,705
shares of the Company’s common stock for an aggregate purchase price of $24.9
million in cash.  The preferred stock qualifies as Tier 1
capital.





As a
result of its participation in the Capital Purchase Program, the Company has
become subject to a number of new regulations and restrictions.  The
ability of the Company to declare or pay dividends or distributions on, or
purchase, redeem or otherwise acquire for consideration shares of its common
stock is subject to restrictions.  The Company is also required to
have in place certain limitations on the compensation of its senior executive
officers.





On
February 17, 2009, President Obama signed the American Recovery and Reinvestment
Act of 2009 into law.  This law includes additional restrictions on
executive compensation applicable to the Company as a participant in the TARP
Capital Purchase Program.





For
additional information about this transaction and the Company’s participation in
the Capital Purchase Program, please see Note S to the Company’s audited
consolidated financial statements included with this report and the Company’s
current report on Form 8-K filed with the Securities and Exchange Commission on
January 14, 2009.


16





Capital Requirements.
The Federal Reserve Board uses capital adequacy guidelines in its examination
and regulation of bank holding companies. If capital falls below minimum
guidelines, a bank holding company may, among other things, be denied approval
to acquire or establish additional banks or non-bank businesses.





The
Federal Reserve Board’s capital guidelines establish the following minimum
regulatory capital requirements for bank holding companies:





-           a
leverage capital requirement expressed as a percentage of adjusted total
assets;





-           a
risk-based requirement expressed as a percentage of total risk-weighted assets;
and





-           a
Tier 1 leverage requirement expressed as a percentage of adjusted total
assets.





The
leverage capital requirement consists of a minimum ratio of total capital to
total assets of 4%, with an expressed expectation that banking organizations
generally should operate above such minimum level. The risk-based requirement
consists of a minimum ratio of total capital to total risk-weighted assets of
8%, of which at least one-half must be Tier 1 capital (which consists
principally of shareholders’ equity). The Tier 1 leverage requirement consists
of a minimum ratio of Tier 1 capital to total assets of 3% for the most
highly-rated companies, with minimum requirements of 4% to 5% for all
others.  As of December 31, 2008, the Registrant was classified as
“well-capitalized” with Tier 1 and Total Risk-Based Capital of 8.53% and 10.68%,
respectively.





The
risk-based and leverage standards presently used by the Federal Reserve Board
are minimum requirements, and higher capital levels will be required if
warranted by the particular circumstances or risk profiles of individual banking
organizations. Further, any banking organization experiencing or anticipating
significant growth would be expected to maintain capital ratios, including
tangible capital positions (i.e., Tier 1 capital less all intangible
assets),


well
above the minimum levels.





Source of Strength for
Subsidiaries.  Bank holding companies are required to serve as
a source of financial strength for their depository institution subsidiaries,
and, if their depository institution subsidiaries become undercapitalized, bank
holding companies may be required to guarantee the subsidiaries’ compliance with
capital restoration plans filed with their bank regulators, subject to certain
limits.





Dividends.  As
a bank holding company that does not, as an entity, currently engage in separate
business activities of a material nature, the Registrant’s ability to pay cash
dividends depends upon the cash dividends the Registrant receives from the
Bank.  At present, the Registrant’s only source of income is dividends
paid by the Bank and interest earned on any investment securities the Registrant
holds.  The Registrant must pay all of its operating expenses from
funds it receives from the Bank.  Therefore, shareholders may receive
dividends from the Registrant only to the extent that funds are available after
payment of our operating expenses and the board decides to declare a
dividend.  In addition, the Federal Reserve Board generally prohibits
bank holding companies from paying dividends except out of operating earnings,
and the prospective rate of earnings retention appears consistent with the bank
holding company’s capital needs, asset quality and overall financial
condition.  We expect that, for the foreseeable future, any dividends
paid by the Bank to us will likely be limited to amounts needed to pay any
separate expenses of the Registrant and/or to make required payments on our debt
obligations, including the interest payments on our junior subordinated
debt.





The FDIC
Improvement Act requires the federal bank regulatory agencies biennially to
review risk-based capital standards to ensure that they adequately address
interest rate risk, concentration of credit risk and risks from non-traditional
activities and, since adoption of the Riegle Community Development and
Regulatory Improvement Act of 1994, to do so taking into account the size and
activities of depository institutions and the avoidance of undue reporting
burdens. In 1995, the agencies adopted regulations requiring as part of the
assessment of an institution’s capital adequacy the consideration of (a)
identified concentrations of credit risks, (b) the exposure of the institution
to a decline in the value of its capital due to changes in interest rates and
(c) the application of revised conversion factors and netting rules on the
institution’s potential future exposure from derivative
transactions.


17


In
addition, the agencies in September 1996 adopted amendments to their respective
risk-based capital standards to require banks and bank holding companies having
significant exposure to market risk arising from, among other things, trading of
debt instruments, (1) to measure that risk using an internal value-at-risk model
conforming to the parameters established in the agencies’ standards and (2) to
maintain a commensurate amount of additional capital to reflect such risk. The
new rules were adopted effective January 1, 1997, with compliance mandatory from
and after January 1, 1998.





Subsidiary
banks of a bank holding company are subject to certain quantitative and
qualitative restrictions imposed by the Federal Reserve Act on any extension of
credit to, or purchase of assets from, or letter of credit on behalf of, the
bank holding company or its subsidiaries, and on the investment in or acceptance
of stocks or securities of such holding company or its subsidiaries as
collateral for loans. In addition, provisions of the Federal Reserve Act and
Federal Reserve Board regulations limit the amounts of, and establish required
procedures and credit standards with respect to, loans and other extensions of
credit to officers, directors and principal shareholders of the Bank, the
Registrant, and any subsidiary of the Registrant and related interests of such
persons. Moreover, subsidiaries of bank holding companies are prohibited from
engaging in certain tie-in arrangements (with the holding company or any of its
subsidiaries) in connection with any extension of credit, lease or sale of
property or furnishing of services.





Any loans
by a bank holding company to a subsidiary bank are subordinate in right of
payment to deposits and to certain other indebtedness of the subsidiary bank. In
the event of a bank holding company’s bankruptcy, any commitment by the bank
holding company to a federal bank regulatory agency to maintain the capital of a
subsidiary bank would be assumed by the bankruptcy trustee and entitled to a
priority of payment. This priority would also apply to guarantees of capital
plans under the FDIC Improvement Act.





Interstate
Branching





Under the
Riegle-Neal Interstate Banking and Branching Act (the “Riegle-Neal Act”), the
Federal Reserve Board may approve bank holding company acquisitions of banks in
other states, subject to certain aging and deposit concentration limits. As of
June 1, 1997, banks in one state may merge with banks in another state, unless
the other state has chosen not to implement this section of the Riegle-Neal Act.
These mergers are also subject to similar aging and deposit concentration
limits.





North
Carolina “opted-in” to the provisions of the Riegle-Neal Act. Since July 1,
1995, an out-of-state bank that did not already maintain a branch in North
Carolina was permitted to establish and maintain a de novo branch in North
Carolina, or acquire a branch in North Carolina, if the laws of the home state
of the out-of-state bank permit North Carolina banks to engage in the same
activities in that state under substantially the same terms as permitted by
North Carolina. Also, North Carolina banks may merge with out-of-state banks,
and an out-of-state bank resulting from such an interstate merger transaction
may maintain and operate the branches in North Carolina of a merged North
Carolina bank, if the laws of the home state of the out-of-state bank involved
in the interstate merger transaction permit interstate merger.





We cannot
predict what legislation might be enacted or what regulations might be adopted,
or if enacted or adopted, the effect thereof on our operations.





ITEM
2 – PROPERTIES





The
following table sets forth the location of the Registrant’s main office and
branch offices, as well as certain information relating to these offices to
date.


18





Office Locations
                
                Year Opened
                
                Approximate
                  Square Footage
                
                Owned or LeasedMain Office
                  1005
      High House Road
                  Cary,
      NC
                
                2000
                
                8,100
                
                LeasedCary
      Office
                  1155
      Kildaire Farm Road
                  Cary,
      NC
                
                1998
                
                2,960
                
                LeasedApex
      Office
                  303
      South Salem Street
                  Apex,
      NC
                
                1999
                
                3,500
                
                LeasedClayton
      Office
                  315
      East Main Street
                  Clayton,
      NC
                
                2000
                
                2,990
                
                LeasedHolly
      Springs Office
                  700
      Holly Springs Road
                  Holly
      Springs, NC
                
                2003
                
                3,500
                
                OwnedPinehurst
      Office
                  211-M
      Central Park Avenue
                  Pinehurst,
      NC
                
                2003
                
                2,850
                
                LeasedSouthern
      Pines Office
                  185
      Morganton Road
                  Southern
      Pines, NC
                
                2003
                
                3,500
                
                LeasedSanford
      Office
                  870
      Spring Lane
                  Sanford,
      NC
                
                2004
                
                3,500
                
                Structure owned with
                  ground leaseGarner
      Office
                  945
      Vandora Springs Road
                  Garner,
      NC
                
                2007
                
                3,500
                
                LeasedRaleigh
      Loan Production Office
                  4601
      Six Forks Road
                  Raleigh,
      NC
                
                2005
                
                3,774
                
                LeasedFalls
      of Neuse Office
                  6408
      Falls of Neuse Road
                  Raleigh,
      NC
                
                2006
                
                2,442
                
                OwnedWilmington
      Main Office
                  1508
      Military Cutoff Road
                  Wilmington,
      NC  28403
                
                2006
                
                6,634
                
                LeasedKnightdale
      Office
                  7120
      Knightdale Boulevard
                  Knightdale,
      NC
                
                2007
                
                2,518
                
                OwnedWilmington
      Independence Office
                  2506
      Independence Boulevard
                  Wilmington,
      NC
                
                2008
                
                3,712
                
                Structure
      owned with
                  ground
      leaseRaleigh
      Creedmoor Office
                  7100
      Creedmoor Road
                  Raleigh,
      NC
                
                2008
                
                3,712
                
                OwnedRaw
      land
                  Zebulon,
      NC
                
                2006
                
                1.38
      acres
                
                OwnedRaw
      land
                  Sanford,
      NC
                
                2007
                
                1.37
      acres
                
                Owned


19





Operations Locations
                                          
                                          Year
      Opened
                                          
                                          Approximate
                                            Square Footage
                                          
                                          Owned or Leased206
      High House Road
                                            Cary,
      NC
                                          
                                          2005
                                          
                                          12,535
                                          
                                          Leased




The total
net book value of the Company’s real property used for business purposes,
furniture, fixtures, and equipment on December 31, 2008 was
$10,845,049.  All properties are considered by Company management to
be in good condition and adequately covered by insurance.





ITEM
3 - LEGAL PROCEEDINGS





There are
no pending legal proceedings to which the Registrant is a party, or of which any
of its property is the subject other than routine litigation that is incidental
to its business.





ITEM
4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





No
matters were submitted to a vote of shareholders in the fourth quarter of
2008.





PART
II





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





The
Registrant’s stock is listed on the NASDAQ Global Market under the symbol
“CRFN.”  There were 9,626,559 shares outstanding at December 31, 2008
owned by approximately 2,800 shareholders.  The table below lists the
high and low prices at which trades were completed during each quarter for the
last two years.  The Company’s stock is considered thinly traded with
less than ten thousand shares traded, on average, per day.  Our
ability to pay cash dividends depends on the cash dividends we receive from the
Bank.  However, the Bank is restricted in the amount of dividends it
may pay.  See the section entitled Regulation in Item 1 for further
disclosure regarding cash dividend payments.  Moreover, we do not
expect to pay cash dividends on our common stock in the foreseeable future, as
we intend to retain earnings in order to enhance our capital
position.





Low
                
                
                HighJanuary
      1, 2007 to March 31, 2007
                
                $
                11.77
                
                
                $
                12.95April
      1, 2007 to June 30, 2007
                
                
                11.15
                
                
                
                12.79July
      1, 2007 to September 30, 2007
                
                
                9.25
                
                
                
                11.70October
      1, 2007 to December 31, 2007
                
                
                8.97
                
                
                
                11.11January
      1, 2008 to March 31, 2008
                
                
                7.94
                
                
                
                9.50April
      1, 2008 to June 30, 2008
                
                
                5.71
                
                
                
                8.43July
      1, 2008 to September 30, 2008
                
                
                5.70
                
                
                
                6.80October
      1, 2008 to December 31, 2008
                
                
                3.12
                
                
                
                6.30





See Item
12 of this Report for disclosure regarding securities authorized for issuance
under equity compensation plans.


20


ITEM
6 – SELECTED FINANCIAL DATA




At
      or for the Years Ended
                                  December
      31,2008
                                
                                
                                2007
                                
                                
                                2006
                                
                                
                                2005
                                
                                
                                2004(Dollars
      in thousands, except share and per share data)Summary
      of OperationsInterest
      income
                                
                                $
                                54,405
                                
                                
                                $
                                54,872
                                
                                
                                $
                                36,707
                                
                                
                                $
                                22,827
                                
                                
                                $
                                15,896Interest
      expense
                                
                                
                                29,070
                                
                                
                                
                                28,217
                                
                                
                                
                                17,257
                                
                                
                                
                                8,872
                                
                                
                                
                                5,466Net
      interest income
                                
                                
                                25,335
                                
                                
                                
                                26,655
                                
                                
                                
                                19,450
                                
                                
                                
                                13,955
                                
                                
                                
                                10,430Provision
      for loan losses
                                
                                
                                6,485
                                
                                
                                
                                1,684
                                
                                
                                
                                991
                                
                                
                                
                                807
                                
                                
                                
                                736Net
      interest income after the provisionfor
      loan losses
                                
                                
                                18,850
                                
                                
                                
                                24,971
                                
                                
                                
                                18,459
                                
                                
                                
                                13,148
                                
                                
                                
                                9,694Non-interest
      income
                                
                                
                                3,732
                                
                                
                                
                                2,621
                                
                                
                                
                                2,612
                                
                                
                                
                                2,417
                                
                                
                                
                                2,342Non-interest
      expense
                                
                                
                                19,972
                                
                                
                                
                                17,823
                                
                                
                                
                                13,387
                                
                                
                                
                                10,762
                                
                                
                                
                                8,531Income
      before income taxes
                                
                                
                                2,610
                                
                                
                                
                                9,769
                                
                                
                                
                                7,684
                                
                                
                                
                                4,803
                                
                                
                                
                                3,505Income
      taxes
                                
                                
                                599
                                
                                
                                
                                3,520
                                
                                
                                
                                2,780
                                
                                
                                
                                1,659
                                
                                
                                
                                1,172Net
      income
                                
                                $
                                2,011
                                
                                
                                $
                                6,249
                                
                                
                                $
                                4,904
                                
                                
                                $
                                3,144
                                
                                
                                $
                                2,333Per Share and Shares Outstanding(1)Net income, basic(2)
                                
                                $
                                0.21
                                
                                
                                $
                                0.68
                                
                                
                                $
                                0.67
                                
                                
                                $
                                0.58
                                
                                
                                $
                                0.45Net income, diluted(2)
                                
                                $
                                0.21
                                
                                
                                $
                                0.65
                                
                                
                                $
                                0.64
                                
                                
                                $
                                0.55
                                
                                
                                $
                                0.43Book
      value at end of period
                                
                                $
                                9.88
                                
                                
                                $
                                9.75
                                
                                
                                $
                                9.13
                                
                                
                                $
                                6.52
                                
                                
                                $
                                5.16Tangible
      book value
                                
                                $
                                6.64
                                
                                
                                $
                                6.42
                                
                                
                                $
                                5.67
                                
                                
                                $
                                5.93
                                
                                
                                $
                                4.43Weighted
      average shares outstanding:Basic
                                
                                
                                9,500,103
                                
                                
                                
                                9,211,779
                                
                                
                                
                                7,281,016
                                
                                
                                
                                5,402,390
                                
                                
                                
                                5,146,464Diluted
                                
                                
                                9,680,484
                                
                                
                                
                                9,635,694
                                
                                
                                
                                7,614,804
                                
                                
                                
                                5,682,447
                                
                                
                                
                                5,417,790Shares
      outstanding at period end
                                
                                
                                9,626,559
                                
                                
                                
                                9,404,579
                                
                                
                                
                                9,091,649
                                
                                
                                
                                6,358,388
                                
                                
                                
                                5,188,931Balance
      Sheet DataTotal
      assets
                                
                                $
                                968,311
                                
                                
                                $
                                835,540
                                
                                
                                $
                                697,909
                                
                                
                                $
                                410,788
                                
                                
                                $
                                331,227Total investments(3)
                                
                                
                                113,278
                                
                                
                                
                                97,858
                                
                                
                                
                                89,069
                                
                                
                                
                                57,752
                                
                                
                                
                                54,935Total
      loans, net
                                
                                
                                772,792
                                
                                
                                
                                667,643
                                
                                
                                
                                542,874
                                
                                
                                
                                323,971
                                
                                
                                
                                253,793Total
      deposits
                                
                                
                                714,883
                                
                                
                                
                                605,431
                                
                                
                                
                                541,881
                                
                                
                                
                                322,081
                                
                                
                                
                                273,649Borrowings
                                
                                
                                154,454
                                
                                
                                
                                135,003
                                
                                
                                
                                69,699
                                
                                
                                
                                45,212
                                
                                
                                
                                29,555Stockholders’
      equity
                                
                                
                                95,092
                                
                                
                                
                                91,659
                                
                                
                                
                                83,034
                                
                                
                                
                                41,457
                                
                                
                                
                                26,777Selected
      Performance RatiosReturn
      on average assets
                                
                                
                                0.22
                                %
                                
                                
                                0.80
                                %
                                
                                
                                0.93
                                %
                                
                                
                                0.84
                                %
                                
                                
                                0.76
                                %Return
      on average stockholders’ equity
                                
                                
                                2.13
                                %
                                
                                
                                7.15
                                %
                                
                                
                                8.72
                                %
                                
                                
                                10.34
                                %
                                
                                
                                9.14
                                %Net interest spread(4)
                                
                                
                                2.55
                                %
                                
                                
                                3.08
                                %
                                
                                
                                3.29
                                %
                                
                                
                                3.51
                                %
                                
                                
                                3.26
                                %Net interest margin(5)
                                
                                
                                2.99
                                %
                                
                                
                                3.72
                                %
                                
                                
                                3.95
                                %
                                
                                
                                3.94
                                %
                                
                                
                                3.61
                                %Non-interest
      income as a percentage oftotal
      revenue(6)
                                
                                
                                12.85
                                %
                                
                                
                                8.95
                                %
                                
                                
                                11.84
                                %
                                
                                
                                14.76
                                %
                                
                                
                                18.34
                                %Non-interest
      income as a percentage ofaverage
      assets
                                
                                
                                0.41
                                %
                                
                                
                                0.34
                                %
                                
                                
                                0.49
                                %
                                
                                
                                0.64
                                %
                                
                                
                                0.76
                                %Non-interest
      expense to averageassets
                                
                                
                                2.18
                                %
                                
                                
                                2.29
                                %
                                
                                
                                2.53
                                %
                                
                                
                                2.86
                                %
                                
                                
                                2.76
                                %Efficiency ratio(7)
                                
                                
                                68.71
                                %
                                
                                
                                60.88
                                %
                                
                                
                                60.68
                                %
                                
                                
                                65.73
                                %
                                
                                
                                66.79
                                %Average
      stockholders’ equity toaverage
      total assets
                                
                                
                                10.32
                                %
                                
                                
                                11.24
                                %
                                
                                
                                10.64
                                %
                                
                                
                                8.08
                                %
                                
                                
                                8.27
                                %Asset
      Quality RatiosNet
      charge-offs to average loansoutstanding
                                
                                
                                0.29
                                %
                                
                                
                                0.06
                                %
                                
                                
                                0.02
                                %
                                
                                
                                0.04
                                %
                                
                                
                                0.15
                                %Allowance
      for loan losses to period endLoans
                                
                                
                                1.60
                                %
                                
                                
                                1.22
                                %
                                
                                
                                1.26
                                %
                                
                                
                                1.33
                                %
                                
                                
                                1.42
                                %Allowance
      for loan losses to non-performing
      loans
                                
                                
                                96
                                %
                                
                                
                                303
                                %
                                
                                
                                5,145
                                %
                                
                                
                                16,960
                                %
                                
                                
                                73,360
                                %Non-performing
      loans to period endloans
                                
                                
                                1.67
                                %
                                
                                
                                0.40
                                %
                                
                                
                                0.02
                                %
                                
                                
                                0.01
                                %
                                
                                
                                0.00
                                %Non-performing assets to total assets(8)
                                
                                
                                1.53
                                %
                                
                                
                                0.36
                                %
                                
                                
                                0.03
                                %
                                
                                
                                0.01
                                %
                                
                                
                                0.09
                                %


21





At
      or for the Years Ended
                  December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004(Dollars
      in thousands, except share and per share data)Capital
      RatiosTotal
      risk-based capital ratio
                
                
                10.68
                %
                
                
                10.51
                %
                
                
                11.03
                %
                
                
                13.68
                %
                
                
                11.61
                %Tier
      1 risk-based capital ratio
                
                
                8.53
                %
                
                
                9.37
                %
                
                
                9.88
                %
                
                
                12.51
                %
                
                
                10.38
                %Leverage
      ratio
                
                
                7.67
                %
                
                
                8.56
                %
                
                
                9.13
                %
                
                
                11.51
                %
                
                
                9.49
                %Equity
      to assets ratio
                
                
                9.82
                %
                
                
                10.97
                %
                
                
                11.90
                %
                
                
                10.09
                %
                
                
                8.08
                %Other
      DataNumber
      of full-service banking offices
                
                
                13
                
                
                
                12
                
                
                
                11
                
                
                
                9
                
                
                
                8Number
      of full-time equivalentemployees
                
                
                147
                
                
                
                126
                
                
                
                122
                
                
                
                90
                
                
                
                78





(1)
            Adjusted
      to reflect the 10 % stock dividend distributed in 2007 and stock splits
      effected in the form of 15% stock dividends in each of the years 2006 and
      2005.


(2)
            Computed
      based on the weighted average number of shares outstanding during each
      period.


(3)
            Consists
      of interest-earning deposits, federal funds sold, investment securities
      and FHLB stock.


(4)
            Net
      interest spread is the difference between the average yield on
      interest-earning assets and the average cost of interest-bearing
      liabilities.


(5)          Net
interest margin is net interest income divided by average interest-earning
assets.


(6)          Total
revenue consists of net interest income and non-interest income.


(7)
            Efficiency
      ratio is non-interest expense divided by the sum of net interest income
      and non-interest income.


(8)
            Non-performing
      assets consist of non-accrual loans, restructured loans, and foreclosed
      assets, where applicable.


22


ITEM
7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





Management’s
discussion and analysis is intended to assist readers in the understanding and
evaluation of the financial condition and consolidated results of operations of
Crescent Financial Corporation (“Crescent” or the “Company”). The analysis
includes detailed discussions for each of the factors affecting Crescent
Financial Corporation’s operating results and financial condition for the years
ended December 31, 2008 and 2007. It should be read in conjunction with the
audited consolidated financial statements and accompanying notes included in
this report and the supplemental financial data appearing throughout this
discussion and analysis.





The
following discussion and analysis contains the consolidated financial results
for the Company and Crescent State Bank for the years ended December 31, 2008
and December 31, 2007, and the Company, Crescent State Bank and Port City
Capital Bank for the year ended December 31, 2006. The Company had previously
discontinued the consolidation of Crescent Financial Capital Trust I and began
reporting the junior subordinated debentures that the Company issued in exchange
for the proceeds that resulted from the issuance of the trust preferred
securities.  The trust preferred securities are classified as
long-term debt obligations.  Except for the accounting treatment, the
relationship between the Company and Crescent Financial Capital Trust I has not
changed.   Crescent Financial Capital Trust I continues to be a
wholly owned subsidiary of the Company and the full and unconditional guarantee
of the Company for the repayment of the trust preferred securities remains in
effect.  The financial statements presented contain the consolidation
of Crescent Financial Corporation and the Banks only.  The Company and
its consolidated subsidiaries are collectively referred to herein as the Company
unless otherwise noted.





COMPARISON
OF FINANCIAL CONDITION AT DECEMBER 31, 2008 AND 2007





At
December 31, 2008, the Company reported total assets of $968.3 million compared
with $835.5 million at December 31, 2007.  Total assets increased by
$132.8 million or 16% during the twelve month period.  Total earning
assets increased by $124.9 million or 16% to $898.7 million compared with $773.8
million at the prior year end.  Earning assets at December 31, 2008
consisted of $785.4 million in gross loans, $105.6 million in investment
securities, $7.3 million in Federal Home Loan Bank (FHLB) stock and $366,000 in
overnight investments and interest bearing deposits.  Total deposits
increased to $714.9 million at December 31, 2008 from $605.4 million reflecting
a $109.5 million or 18% increase.  Borrowings increased by $19.5
million or 14% from $135.0 million to $154.5 million.  Stockholders’
equity increased by 4% or $3.4 million to $95.1 million compared with $91.7
million.





The
Company’s loan portfolio is the largest component of earning
assets.  During 2008, total gross loans increased by $109.5 million or
16% growing to $785.4 million at year end compared to $675.9 at December 31,
2007.  Our commercial real estate portfolio experienced the largest
dollar and percentage increase growing by $119.4 million or
34%.  Total commercial real estate loans at December 31, 2008 were
$470.4 million compared to $351.0 million twelve months ago.  Home
equity loans and lines of credit increased by $9.1 million or 20% to $54.4
million from $45.3 million.  Our commercial and industrial loan
portfolio increased by $3.2 million or 4% to $76.1 million at year end from
$72.9 million.  The residential mortgage loan category increased by
$888,000 or 5% to close the year at $19.1 million.  Current economic
conditions and a softening of the housing market in those communities we serve
resulted in a net decline of $23.0 million or 13% in our construction,
acquisition and development portfolio.  At December 31, 2008, the
Company’s construction, acquisition and development portfolio was $161.0 million
compared to $184.0 million at the prior year end.  The consumer loan
portfolio decreased slightly from $5.5 million to $5.4 million.





The
composition of the loan portfolio, by category, as of December 31, 2008 is as
follows: 60% commercial mortgage loans, 20% construction/acquisition and
development loans, 10% commercial and industrial loans, 7% home equity loans and
lines of credit, 2% residential mortgage loans and 1% consumer loans. The
composition of the loan portfolio, by category, as of December 31, 2007 is as
follows: 52% commercial mortgage loans, 27% construction/acquisition and
development loans, 11% commercial and industrial loans, 6% home equity loans and
lines of credit, 3% residential mortgage loans and 1% consumer
loans.





We track
each loan we originate using the North American Industry Classification System
(NAICS) code.  Through the use of this code, we can monitor those
industries for which we have a significant concentration of
exposure.  At December 31, 2008, there were three industry codes for
which our concentration exposure equaled or exceeded 10% of the total loan
portfolio.  Loans to investors who lease non-residential buildings
other than miniwarehouses comprised 16% of our loan portfolio and loans to
residential home builders comprised 13% of the loan portfolio and loans for land
development comprised 10% of the loan portfolio.  We have a
significant concentration in the residential real estate market which requires
continuous monitoring.  While the markets we operate in have not
experienced the same extent of problems experienced in other markets nationally,
the impact of the housing slowdown has and could continue to impact the
financial performance of the Company.


23


The
allowance for loan losses was $12.6 million or 1.60% of total outstanding loans
at December 31, 2008 compared to $8.3 million or 1.22% of total outstanding
loans at December 31, 2007.  The current economic climate, and
its impact on the housing market and general business conditions, has resulted
in some deterioration of quality within certain sectors of our loan
portfolio.  Additionally, management makes adjustments to its loan
loss reserve methodology to account for a variety of factors such as loan
concentration, current delinquency levels, adverse conditions that might affect
a borrower’s ability to repay the loan, prevailing economic conditions and all
other relevant factors derived from our history of operations. There is a more
detailed discussion of the methodology in the section entitled “Analysis of
Allowance for Loan Losses.”





At
December 31, 2008, there were fifty loans totaling approximately $13.1 million
in non-accrual status.  Thirty-five of those loans totaling
approximately $5.7 million represent one relationship with a residential
builder. Of the remaining $7.4 million, an additional $4.5 million of loans were
to land developers or residential builders.  The remaining $2.9
million of non-accrual loans were spread between commercial loans and
residential investment properties.  The percentage of non-performing
loans to total loans at December 31, 2008 was 1.67%.  There were
twelve performing loans aggregating $738,000 that were 30 days or more past due
and no loans past due 90 days or more and still accruing interest at December
31, 2008.  At December 31, 2007, there were twelve loans totaling $2.7
million in non-accrual status.  The percentage of non-performing loans
to total loans at December 31, 2007 was 0.40%.  There were ten loans
aggregating $1.4 million that were 30 days or more past due and no loans past
due 90 days or more and still accruing interest at December 31,
2007.    See the section entitled “Non Performing Assets”
for more details.





The
amortized cost and fair market value of the Company’s investment securities
portfolio at December 31, 2008 were $104.6 million and $105.6 million,
respectively compared to $90.7 million and $90.8 million, respectively, at
December 31, 2007.  All investments are accounted for as available for
sale under Financial Accounting Standards Board ("FASB") No. 115 and are
presented at their fair market value. Over the past twelve months, the portfolio
experienced a net increase of $14.9 million or 16%.  The Company’s
investment in debt securities at December 31, 2008, consisted of U.S. Government
agency securities, collateralized mortgage obligations (CMOs), mortgage-backed
securities (MBSs), municipal bonds and common stock of two publicly traded
entities.   Increases in the portfolio during 2008 were
attributed to new securities purchases of $28.1 million, a $958,000 increase in
the fair market value of the portfolio, a net premium accretion of $80,000 and a
$16,000 gain on the disposal of available for sale
securities.  Decreases in the portfolio were attributed to the receipt
of $12.7 million in principal re-payments on CMOs and MBSs and $1.5 million in
proceeds from the disposal of available for sale securities.  The
Company also owned $7.3 million of Federal Home Loan Bank stock at
December 31, 2008 compared with $6.8 million at December 31,
2007.





The
Company does not own, and has never owned, any equity investments in Government
Sponsored Enterprises (GSEs) such as Federal Home Loan Mortgage Corporation
(Freddie Mac) or the Federal National Mortgage Association (Fannie
Mae).  All of our mortgage-backed and collateralized mortgage
obligation securities are issued through either a GSE or the government-owned
Government National Mortgage Association (Ginnie Mae).  Prior to
September 7, 2008, only those securities issued by Ginnie Mae were backed by the
full faith of the US Government.  There was an implied guarantee on
securities issued through the other two GSEs, but not an explicit guarantee. On
September 7, 2008, the US Department of Treasury and the Federal Housing Finance
Agency announced that Freddie Mac and Fannie Mae were being placed into
conservatorship.  As a result, the US Government effectively has
guaranteed the securities issued by the GSEs.  Therefore, the credit
risk associated with owning debt securities issued through these two entities
has been significantly mitigated.





Non-interest
earning assets totaled $82.2 million at December 31, 2008, increasing by $12.2
million or 17% over the past year.  The other asset category
experiencing the largest increase was bank owned life insurance which grew by
$7.7 million during the year.  Of the total increase, $7.0 million
represented an additional investment and $689,000 was attributable to the
increase in cash surrender value.  Premises and equipment experienced
a net increase of $2.7 million resulting from the purchase of $3.5 million in
new assets less $787,000 of depreciation expense.  Other real estate
owned increased by $1.4 million during the year as the Company foreclosed on
real estate collateral used to secure certain loans.  The net deferred
income tax asset increased by $1.4 million due primarily to the significant
increase in the loan loss provision.  For tax purposes, the amount
provided for loan losses is only deductible when a loan is actually
charged-off.  Therefore, the tax benefit to be derived is
deferred.   Accrued interest receivable decreased by $420,000 due
primarily to the lower interest rate environment despite the higher volume of
earning assets.  Cash and due from banks, which represents cash on
hand in branches and amounts represented by checks in the process of being
collected through the Federal Reserve payment system, declined by $2.1 million
from $12.0 million to $9.9 million.  For more details regarding the
decrease in cash and cash equivalents, see the Consolidated Statements of Cash
Flows.  Goodwill is the single largest asset of total non-earning
assets at $30.2 million.  Goodwill was not impaired at December 31,
2008.


24





Total
deposits at December 31, 2008 were $714.9 million compared to $605.4 million at
December 31, 2007 increasing by $109.5 million or 18% during the past twelve
months.  Time deposits increased by $116.3 million or 34% from $345.2
million to $461.5 million.  Of the total $116.3 million increase,
$89.6 million represented net growth in brokered time deposits and $26.7 million
represented net growth in retail time deposits.  Money market accounts
increased $39.6 million or 82% to $87.9 million at December 31,
2008.  During the course of 2008, the Company ran a promotional,
introductory money market rate that was well received in our
markets.  A mid-year North Carolina legislative change relating to
real estate settlement deposit accounts impacted both non-interest bearing
demand and interest-bearing demand account balances.   As of June
30, 2008, all real estate settlement trust accounts were required to be interest
bearing IOLTAs (Interest on Lawyer Trust Accounts).   Prior to
this date, settlement attorneys could choose whether to maintain their trust
funds in either an interest bearing or non-interest bearing
account.   Non interest-bearing demand deposits declined by $5.4
million during the year from $69.4 million to $63.9 million and interest bearing
demand deposits increased by $10.7 million or 33% from $31.9 million to $42.6
million at year end.  Savings account balances declined by $51.7
million during 2008.  The decline is attributed to various factors
including a transition of funds from lower yielding, liquid account types into
higher yielding time deposits, some disintermediation resulting from the
promotional money market campaign and the termination in February 2008 of a
$20.4 million escrow account relationship established for a de novo financial
institution.





The
composition of the deposit base, by category, at December 31, 2008 was as
follows:  65% in time deposits, 12% in money market, 9% in non
interest-bearing demand deposits, 8% in statement savings, and 6% in
interest-bearing deposits.  The composition of the deposit base, by
category, at December 31, 2007 was as follows:  57% in time deposits,
18% in statement savings, 12% in non interest-bearing demand deposits, 8% in
money market deposits, and 5% in interest-bearing deposits.





As
indicated in the narrative above, a significant portion of the deposit increases
in 2008 to fund loan growth came in the form of brokered
deposits.  Management is actively implementing new processes,
procedures and products designed to enhance retail, core
deposits.  Over the years we have grown the Company largely due to
relationships established with commercial customers.  Certain types of
commercial customers typically do not have the significant deposit
levels.  We are making an investment in a new core data processing
system that we believe will allow us to better monitor our expectations for
commercial customer relationships.  We have implemented a new checking
account product aimed at attracting more consumer customers.  The
product offers a higher rate of interest provided the customer meets certain
criteria designed to move processing to a more cost efficient service
level.  The Company will be more focused on making profitable loan
pricing decisions as opposed to making loans for the sake of increasing
volume.  Those profitable loans ideally will be funded by a larger
percentage of locally generated core deposits thus reducing our reliance on
brokered time deposits.





At
December 31, 2008 the Company had $359.3 million in time deposits of $100,000 or
more compared to $276.6 million at December 31, 2007. The Company uses brokered
certificates of deposit as an alternative funding source.  Brokered
deposits represent a source of fixed rate funds that do not need to be
collateralized like Federal Home Loan Bank borrowings.  The Company
expects to continue to utilize the brokered deposit market in the
future.  While we anticipate being more focused on increasing our
market share of local deposits, the Company is also focused on improving our
earnings. There are times when obtaining money in the brokered arena is less
expensive than offering high rate specials in our markets.  The
Company will aim to balance the need for a higher concentration of local money
against the cost of funds. Brokered deposits at December 31, 2008 were $256.1
million compared to $166.6 million at December 31, 2006.


25


Total
borrowings increased by 14% or $19.5 million from $135.0 million at December 31,
2007 to $154.5 million at December 31, 2008.  Borrowings at December
31, 2008 consisted of $99.0 million in long-term FHLB advances, $29.0 million in
short-term FHLB advances, $8.2 million in junior subordinated debt issued to an
unconsolidated subsidiary, $7.5 million in subordinated term loans secured from
a non-affiliated financial institution, $2.0 million outstanding on a holding
company line of credit and $8.7 million in Federal funds purchased from a
correspondent bank.  The adoption of FASB Interpretation Number (FIN)
46, Consolidation of Variable
Interest Equities,resulted in the deconsolidation of the trust
subsidiary, Crescent Financial Capital Trust I (“Trust”), formed for the purpose
of issuing trust preferred securities.  As a result, the subordinated
debt issued to the Trust for the proceeds of the trust preferred securities is
included in long-term debt.  Borrowings at December 31, 2007 consisted
of $113.0 million in long-term FHLB advances, $10.0 million in short-term FHLB
advances, $8.2 million in junior subordinated debt issued to an unconsolidated
subsidiary, and $3.8 million in Federal funds purchased from a correspondent
bank.





Accrued
expenses and other liabilities increased by $435,000 to $3.9 million at December
31, 2008 compared with $3.4 million at December 31, 2007.  The
increase is due primarily to higher levels of interest-bearing
liabilities.





Total
stockholders’ equity increased by $3.4 million between December 31, 2007 and
December 31, 2008. The increase was the net result of net income for the year of
$2.0 million, plus $766,000 in additional capital from the exercise of stock
options, a $589,000 increase in the after-tax value of investment securities and
$209,000 in stock based compensation expense.





COMPARISON
OF RESULTS OF OPERATIONS FOR THE YEARS ENDED


DECEMBER
31, 2008 AND 2007





Net
Income. For the year ended December 31, 2008, the Company reported net income of
$2.0 million compared to $6.2 million for the year ended December 31,
2007.  The 68% decline in net income resulted in a decrease of diluted
earnings per share of $0.44 to $0.21 for the year ended December 31, 2008
compared to $0.65 for the prior year period.  The decrease in earnings
year over year was primarily the result of a higher provision for loan losses
and a compressing net interest rate margin due to the falling interest rate
environment.  Returns on average assets and average equity were 0.22%
and 2.13%, respectively, for the year ended December 31, 2008 compared to 0.80%
and 7.15% for the prior year period.





Net
Interest Income.  Net interest income was $25.3 million for the
current year compared to $26.7 million for the prior year reflecting a 5%
decrease. Increases to be expected from the significant increase in total
earning assets were more than offset by the impact of falling interest rates on
the spread between rates earned on the assets and the cost of funding those
assets.





Net
interest margin is interest income earned on loans, securities and other earning
assets, less interest expense paid on deposits and borrowings, expressed as a
percentage of total average earning assets.  The net interest margin
for the year ended December 31, 2008 was 2.99% compared to 3.72% for the prior
year. The average yield on earning assets for the current period was 6.41%
compared to 7.66% from the year ended December 31, 2007 and the average cost of
interest-bearing funds was 3.86% compared to 4.58%. The impact on net interest
income from the decline in interest rate spread from 3.08% to 2.55% was
exasperated by a decline in the ratio of average interest earning assets to
average interest bearing liabilities from 116.21% to 112.74%.





The
interest rate environment over the past 15 months has had a significant impact
on the Company’s net interest margin.  Beginning on September 19,
2007, the Federal Reserve (the “Fed”) began cutting short-term interest
rates.  The most recent cut, which occurred on December 17, 2008, was
the tenth such reduction and placed the total interest rate cuts at 500 basis
points.   During the course of 2008, the percentage of our total
loan portfolio that carried variable rates of interest based on the Prime rate
or LIBOR (London Inter Bank Offered Rate) ranged from a high of 52% a year ago
to 49% at December 31, 2008.  As short-term rates have declined, the
interest rates on variable rate loans fall resulting in a lower yield on average
earning assets.  Whereas this segment of our loan portfolio is subject
to immediate repricing, large portions of our funding liabilities are subject to
repricing over some length of time.  Many of the Company’s borrowings
and all time deposits carry a fixed rate of interest to a fixed future maturity
date.  The rates on those fixed rate, fixed maturity instruments
become subject to change only at maturity.  Therefore, it takes a
longer period of time to realize decreases in our cost of
funds.  Other non-maturity deposits such as interest-bearing demand
deposits, savings and money market carry variable rates of interest which we can
change at our discretion.  Typically rates on those instruments do not
change at the same magnitude as a change in the Prime rate of interest
might.  These factors resulted in a decline in the net interest margin
for 2008.  The Company believes that short-term interest rates have
stabilized and we should continue to see our funding costs decline in future
months.  As a result, we would expect the net interest margin should
improve during the year.


26


Total
average interest earning assets were $848.8 million for the year ended December
31, 2008, increasing by $132.9 million or 19% when compared to an average of
$716.0 million for the year ended December 31, 2007. Increases in average
balances by earning asset category are as follows: average loans increased by
$126.5 million or 21% from $615.3 million for 2007 to $741.8 million for 2008,
investment securities grew by $10.5 million or 11% from $92.6 million to $103.1
million and Federal funds sold and other earning assets decreased from $8.0
million to $3.9 million.  Total average interest-bearing liabilities
increased by $136.8 million with interest-bearing deposits increasing by $88.6
million or 17% and borrowings increasing by $48.3 million or 51%.





Total
interest income for 2008 decreased by $467,000 from $54.9 million to $54.4
million. The decrease was the net result of a $9.6 million increase in interest
income from the higher volume of earning asset and a $10.1 million decrease due
to the falling interest rate environment. Total interest expense grew by
$853,000 which resulted from a net increase of $6.3 million from higher interest
bearing liability volumes and a $5.5 million decrease due to lower interest
rates.





Provision
for Loan Losses. The Company’s provision for loan losses for 2008 was $6.5
million compared to $1.7 recorded in the prior year. The increase in the loan
loss provision was due to the net increase in the loan portfolio and the
deterioration of loan quality due to current economic conditions.  Net
loan growth was $109.5 million during 2008 compared to $126.1 million in
2007.  Economic conditions in communities we serve stemming primarily
from the weakening housing market have caused us to be more aggressive in
monitoring the quality of our loan assets and to take proactive steps to
identify loans that are impaired.  Once a loan is deemed to be
impaired, we must evaluate what degree of impairment exists, if any, and
recognize that deficiency as a specific reserve.  Provisions for loan
losses are charged to income to bring the allowance for loan losses to a level
deemed appropriate by management.   For a more detailed
discussion of the provision of loan losses and the established reserve, see the
section entitled “Analysis of Allowance for Loan Losses.”





Non-Interest
Income. Non-interest income increased by $1.1 million or 42% to $3.7 million for
2008 compared to $2.6 million for the prior year period. The largest components
of non-interest income in 2008 were $1.4 million in customer service fees,
$736,000 in earnings on cash value of bank owned life insurance, $718,000 in
mortgage loan origination fees, and $254,000 in service charges and fees on
deposit accounts. For the year ended December 31, 2007, the largest components
of non-interest income included $1.1 million in customer service fees, $512,000
in mortgage loan origination fees, $380,000 in earnings on cash value of bank
owned life insurance and $227,000 in service charges and fees on deposit
accounts.  During 2008, the Company recognized $16,000 in gains on the
disposal of available for sale securities and $74,000 in losses on the disposal
of real estate owned and other fixed assets.   The Company
recognized net losses on the disposal of real estate owned and other assets of
$66,000 in 2007





Non-Interest
Expenses. Non-interest expenses were $20.0 million for year ended December 31,
2008 compared to $17.8 million for the prior year period.  The $2.1
million or 12% increase reflects the continuing efforts to expand the Company’s
infrastructure and branch network.  Of the total increase, $1.7
million was in personnel, occupancy and data processing which are the areas most
impacted by the branch network and infrastructure improvements.





Total
compensation for the year ended December 31, 2008 was $11.1 million reflecting a
13% increase when compared to $9.9 million for the year ended December 31,
2007.  As of December 31, 2008, the Company employs 147 full-time
equivalent employees in thirteen full-service branch offices, one loan
production office and various administrative support departments.  In
comparison, at December 31, 2007, the Company employed 126 full-time equivalent
employees in twelve full-service branch offices, one loan production office and
various administrative support departments.





Occupancy
expenses were $2.7 million for 2008 compared to $2.3 million in 2007 increasing
by $431,000 or 19%.  During 2008, the Company opened one new
full-service office in March.  Additionally, in December 2007, one new
branch office was opened and another was relocated to a more desirable
location.  Occupancy expense will continue to increase in 2009 as we
plan to open two additional branch offices in Raleigh, North
Carolina.


27


Data
processing expenses were $1.1 million for 2008 increasing by only $26,000 or
2%.  While data processing expense, which includes data lines to new
offices, is closely tied to both account volume growth and branch expansion, the
introduction of remote merchant capture in 2008 and branch item capture in 2007
helped contain total data processing expenses.  We are converting our
core data processing systems during the first quarter of 2009 and would
anticipate some one-time charges related to that conversion.  While we
believe that the new provider will offer us some cost savings over systems in
place prior to the conversion, we are implementing some new technologies to
streamline processes and enhance customer experience.  These new
technologies will cause our data processing expense to increase in
2009.





Professional
fees and services totaled $1.6 million in 2008, up $109,000 or 7% over the $1.5
million for 2007.  The largest components of professional fees and
services were directors’ fees, legal expenses, and accounting and audit
expenses. The company’s non-affiliated market capitalization at the end of the
most recent second quarter (measurement date) fell below $50.0 million and
therefore we are not subject to the auditor reporting requirements of Section
404 of Sarbanes-Oxley Act (SOX) at December 31, 2008 due to our non-accelerated
filer status.  As a small reporting company, we are subject to the
management reporting requirements of SOX as of December 31, 2008 and will once
again be subject to auditor reporting requirements beginning in
2009.





The total
of all other non-interest expenses for the year ended December 31, 2008 was $3.4
million compared to $3.1 million for the prior year. The increase was primarily
the result of the Company’s continued growth. The largest components of other
non-interest expenses include office supplies and printing, advertising, and
loan related fees. Management expects that as the Company continues to expand,
expenses associated with these categories will increase.





Provision
for Income Taxes. For 2008, the Company’s provision for income taxes was
$599,000 compared to $3.5 million for the prior year. The effective tax rates
for 2008 and 2007 were 22.9% and 36.0%, respectively.  The effective
tax rate decreased significantly due to a higher percentage of tax-exempt income
as a percentage of total income.





COMPARISON
OF RESULTS OF OPERATIONS FOR THE YEARS ENDED


DECEMBER
31, 2007 AND 2006





Net
Income. Net income for 2007 was $6.2 million compared with $4.9 million for the
prior year, reflecting a $1.3 million or 27% increase in net
earnings.  Net income per diluted share was $0.65 compared to $0.64
for the prior year.  The percentage increase in earnings per share was
not comparable to that of the increase in net income because average diluted
shares outstanding in 2007 were over 2.0 million shares higher than 2006 due in
part to the issuance of 2.7 million shares for the acquisition of PCCB in August
2006.    Per share data for 2006 data has been adjusted for
the 10% stock dividend distributed on May 22, 2007 to shareholders of record on
May 11, 2007. The returns on average assets at December 31, 2007 and 2006 were
0.80% and 0.93%, respectively, and the returns on average equity were 7.15% and
8.72%, respectively.





Net
Interest Income.  Net interest income increased by $7.2 million or 37%
from $19.4 million for the prior year to $26.6 million for the year ended
December 31, 2007. The increase in net interest income was due primarily to
significant growth in average earning assets.





The net
interest margin for the year ended December 31, 2007 was 3.72% compared to 3.95%
for the prior year. The average yield on earning assets for the current period
was 7.66% compared to 7.46% for the prior year and the average cost of
interest-bearing funds was 4.58% compared to 4.17%. The higher funding costs, as
reflected in the decline in interest rate spread from 3.29% to 3.08%, and the
increased reliance on interest-bearing liabilities to fund asset growth, as
shown by a decline in the ratio of average interest-earning assets to average
interest-bearing liabilities from 118.88% to 116.21%, is responsible for the
margin compression.  There are many factors that influence net
margin.





The
Federal Open Market Committee (FOMC) of the Federal Reserve Bank sets monetary
policy by raising and lowering short-term interest rates.  After a two
year period of rising short-term interest rates, rates stabilized and remained
unchanged from early July 2006 through mid September 2007.  Between
mid-September 2007 and December 31, 2007, the FOMC lowered short-term interest
rates on three occasions by a total of 100 basis points.


28


Approximately
52% of the Company’s loan portfolio carry variable rate pricing based on the
Prime lending rate or LIBOR (London Inter Bank Offered Rate).  As
short-term rates fell in the later part of 2007, variable rate loans have
repriced to lower rates resulting in a lower yield on average earning
assets.  Prior to the rate cuts, rates on new loans were trending
lower based on competitive forces.  The volume of new loan
originations outpaced the generation of lower cost core deposits causing the
Company to rely more heavily on higher cost savings and brokered
deposits.  This resulted in a higher cost of
funds.  Furthermore, as short-term interest rates began to fall, rates
being charged on brokered deposits did not respond lower by the same magnitude
as other short-term rates.





Total
average interest earning assets were $716.0 million for the year ended December
31, 2007, increasing by $224.2 million or 46% when compared to an average of
$491.8 million for the year ended December 31, 2006. Increases in average
balances by earning asset category are as follows: average loans increased by
$200.7 million or 48% from $414.6 million for 2006 to $615.3 million for 2007,
investment securities grew by $21.4 million or 30% from $71.2 million for 2006
to $92.6 million for 2007 and Federal funds sold and other earning assets
increased $2.0 million or 34% from $6.0 million for 2006 to $8.0 million in
2007.  Total average interest-bearing liabilities increased by $202.4
million with interest-bearing deposits increasing by $164.6 million or 46% and
borrowings increasing by $37.8 million.





Total
interest income for 2007 increased by $18.2 million to $54.9 million compared to
$36.7 million for the prior year. The increase in total interest income was the
result of a $17.4 million improvement from increased earning asset levels and a
$735,000 increase due to higher rates.  Interest income from the loan
portfolio contributed the largest portion of the increase growing by $16.9
million to $50.0 million for the year.  Total interest expense grew by
$11.0 million, which was attributed to a $9.5 million increase from higher
interest-bearing liability volumes and $1.5 million due to higher interest
rates.





Provision
for Loan Losses. The loan loss provision for 2007 was $1.7 million compared to
$991,000 in the prior year. The increase in the loan loss provision was
primarily due to the 23% increase in net loan
growth.   Provisions for loan losses are charged to income to
bring the allowance for loan losses to a level deemed appropriate by
management.   While net growth in the loan portfolio is the
primary driver in determining the loan loss provision, there are other factors
which are more fully discussed under the section entitled “Analysis of Allowance
for Loan Losses.”





Non-Interest
Income. For both years ended December 31, 2007 and 2006, non-interest income was
$2.6 million.  Non-interest income from service charges on deposit
accounts and other customer service fees increased by 6% or
$73,000.  Earnings on cash value of life insurance increased by 66% or
$151,000.  While not to the same extent as experienced nationally, our
markets did have a slowing in home sales activity during
2007.  Revenue from fees on mortgage loan originations declined by
$130,000 or 20%.  The Company recognized net losses on the disposal of
real estate owned and other assets of $66,000 in 2007 compared to a gain of
$3,000 in 2006.  Finally, in 2006, we recorded $46,000 in
non-recurring revenue from the final consideration on the sale of our interest
in a mortgage origination company in 2005.





Non-Interest
Expenses. Non-interest expenses increased by 33% or $4.4 million to $17.8
million for 2007 compared to $13.4 million for the prior year
period.  The increase was due primarily to the acquisition of
PCCB.  Non-interest expenses for 2007 include a full year of expenses
related to our Wilmington operation, whereas 2006 non-interest expenses included
expenses from September through December only.   Of the $4.4
million increase, $3.1 million was in personnel, occupancy and data processing
which are the areas most impacted by the acquisition.





Total
compensation for the year ended December 31, 2007 was $9.9 million reflecting a
35% increase compared to $7.3 million for the year ended December 31,
2006.  Occupancy expenses were $2.3 million for 2007 compared to $2.0
million in 2006 increasing by $278,000 or 14%.  The Company opened one
new full-service branch location and relocated another during
2007.  During 2006, the Company opened one new full-service office as
well as acquired PCCB in August.  We continue to look for strategic
opportunities to expand our branch network.





Data
processing expenses increased by $223,000 or 27% to $1.1 million compared to
$834,000 for the prior year. The increase was due to growth in account volumes,
contractual increases in data processing costs and the additional data line
expenses for the new offices.  Because data processing expense is tied
closely to transaction and account volumes, these expenses should increase as
the Company continues to grow.





Professional
fees and services increased by $612,000 or 68% in 2007 to $1.5 million compared
to $899,000 in 2006.  The largest components of professional fees and
services were directors’ fees, legal expenses, and accounting and audit
expenses.  The Company was subject to SOX at December 31, 2007 and
incurred significant expense to document, review and test internal controls over
financial reporting.  The FDIC significantly increased deposit
insurance assessments during 2007.  We incurred $148,000 in
non-recurring expenses to merge PCCB’s data processing systems into
CSB’s.  And finally, we experienced increases in the use of
professional recruiting services and temporary employment
staffing.


29





The total
of all other non-interest expenses for the year ended December 31, 2007 was $3.1
million compared to $2.3 million for the prior year. The increase was primarily
the result of the Company’s continued growth. The largest components of other
non-interest expenses include office supplies and printing, advertising, and
loan related fees. Management expects that as the Company continues to expand,
expenses associated with these categories will increase.





Provision
for Income Taxes. The Company’s provision for income taxes for 2007 was $3.5
million compared to $2.8 million for the prior year. The effective tax rates for
2007 and 2006 were 36.0% and 36.2%, respectively.


30


NET
INTEREST INCOME
 
 Net
interest income represents the difference between income derived from
interest-earning assets and interest expense incurred on interest-bearing
liabilities. Net interest income is affected by both (1) the difference between
the rates of interest earned on interest-earning assets and the rates paid on
interest-bearing liabilities (“interest rate spread”) and (2) the relative
amounts of interest-earning assets and interest-bearing liabilities (“net
interest-earning balance”). The following table sets forth information relating
to average balances of the Company's assets and liabilities for the years ended
December 31, 2008, 2007 and 2006. The table reflects the average yield on
interest-earning assets and the average cost of interest-bearing liabilities
(derived by dividing income or expense by the daily average balance of
interest-earning assets or interest-bearing liabilities, respectively) as well
as the net interest margin. In preparing the table, non-accrual loans are
included in the average loan balance.
 
 For
      the Years Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Average
                    
                    
                    
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    
                    
                    
                    Average
                    
                    
                    Average
                    
                    
                    
                    
                    
                    AverageBalance
                    
                    
                    Interest
                    
                    
                    rate
                    
                    
                    balance
                    
                    
                    Interest
                    
                    
                    rate
                    
                    
                    balance
                    
                    
                    Interest
                    
                    
                    rate(Dollars
      in thousands)Interest-earning
      assets:Loan
      portfolio
                    
                    $
                    741,829
                    
                    
                    $
                    49,479
                    
                    
                    
                    6.67
                    %
                    
                    $
                    615,322
                    
                    
                    $
                    50,022
                    
                    
                    
                    8.13
                    %
                    
                    $
                    414,644
                    
                    
                    $
                    33,093
                    
                    
                    
                    7.98
                    %Investment
      securities
                    
                    
                    103,101
                    
                    
                    
                    4,843
                    
                    
                    
                    4.70
                    %
                    
                    
                    92,629
                    
                    
                    
                    4,454
                    
                    
                    
                    4.81
                    %
                    
                    
                    71,151
                    
                    
                    
                    3,303
                    
                    
                    
                    4.64
                    %Federal
      funds and other interest-earning assets
                    
                    
                    3,896
                    
                    
                    
                    83
                    
                    
                    
                    2.13
                    %
                    
                    
                    8,015
                    
                    
                    
                    396
                    
                    
                    
                    4.94
                    %
                    
                    
                    5,996
                    
                    
                    
                    310
                    
                    
                    
                    5.17
                    %Total
      interest-earning assets
                    
                    
                    848,826
                    
                    
                    
                    54,405
                    
                    
                    
                    6.41
                    %
                    
                    
                    715,966
                    
                    
                    
                    54,872
                    
                    
                    
                    7.66
                    %
                    
                    
                    491,791
                    
                    
                    
                    36,706
                    
                    
                    
                    7.46
                    %Non-interest-earning
      assets
                    
                    
                    66,746
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    61,425
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    36,654Total
      assets
                    
                    $
                    915,572
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    777,391
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    528,445Interest-bearing
      liabilities:Deposits:Interest-bearing
      NOW
                    
                    $
                    34,073
                    
                    
                    
                    64
                    
                    
                    
                    0.19
                    %
                    
                    $
                    33,453
                    
                    
                    
                    324
                    
                    
                    
                    0.97
                    %
                    
                    $
                    37,876
                    
                    
                    
                    553
                    
                    
                    
                    1.46
                    %Money
      market and savings
                    
                    
                    157,904
                    
                    
                    
                    3,995
                    
                    
                    
                    2.53
                    %
                    
                    
                    163,321
                    
                    
                    
                    6,536
                    
                    
                    
                    4.00
                    %
                    
                    
                    92,620
                    
                    
                    
                    3,664
                    
                    
                    
                    3.96
                    %Time
      deposits
                    
                    
                    418,590
                    
                    
                    
                    19,003
                    
                    
                    
                    4.54
                    %
                    
                    
                    325,243
                    
                    
                    
                    16,569
                    
                    
                    
                    5.09
                    %
                    
                    
                    226,978
                    
                    
                    
                    9,990
                    
                    
                    
                    4.40
                    %Short-term
      borrowings
                    
                    
                    17,830
                    
                    
                    
                    657
                    
                    
                    
                    3.68
                    %
                    
                    
                    16,398
                    
                    
                    
                    830
                    
                    
                    
                    5.06
                    %
                    
                    
                    16,318
                    
                    
                    
                    844
                    
                    
                    
                    5.17
                    %Long-term
      debt
                    
                    
                    124,493
                    
                    
                    
                    5,351
                    
                    
                    
                    4.30
                    %
                    
                    
                    77,670
                    
                    
                    
                    3,958
                    
                    
                    
                    5.10
                    %
                    
                    
                    39,906
                    
                    
                    
                    2,206
                    
                    
                    
                    5.53
                    %Total
      interest-bearing liabilities
                    
                    
                    752,890
                    
                    
                    
                    29,070
                    
                    
                    
                    3.86
                    %
                    
                    
                    616,085
                    
                    
                    
                    28,217
                    
                    
                    
                    4.58
                    %
                    
                    
                    413,698
                    
                    
                    
                    17,257
                    
                    
                    
                    4.17
                    %Other
      liabilities
                    
                    
                    68,156
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    73,899
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    58,542Total
      liabilities
                    
                    
                    821,046
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    689,984
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    472,240Stockholders’
      equity
                    
                    
                    94,526
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    87,407
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    56,205Total
      liabilities and stockholders’ equity
                    
                    $
                    915,572
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    777,391
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    528,445Net
      interest income and interest rate spread
                    
                    
                    
                    
                    
                    $
                    25,335
                    
                    
                    
                    2.55
                    %
                    
                    
                    
                    
                    
                    $
                    26,655
                    
                    
                    
                    3.08
                    %
                    
                    
                    
                    
                    
                    $
                    19,449
                    
                    
                    
                    3.29
                    %Net
      interest margin
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2.99
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.72
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3.95
                    %Ratio
      of average interest-earning  assets to average interest- bearing
      liabilities
                    
                    
                    112.74
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    116.21
                    %
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    118.88
                    %
  31
  VOLUME/RATE
VARIANCE ANALYSIS
 
 The
following table analyzes the dollar amount of changes in interest income and
interest expense for major components of interest-earning assets and
interest-bearing liabilities.  The table distinguishes between (i)
changes attributable to volume (changes in volume multiplied by the prior
period’s rate), (ii) changes attributable to rate (changes in rate multiplied by
the prior period’s volume), and (iii) net change (the sum of the previous
columns). The change attributable to both rate and volume (changes in rate
multiplied by changes in volume) has been allocated proportionately to both the
changes attributable to volume and the changes attributable to
rate.
 
 Year Ended
                  
                  
                  Year EndedDecember 31, 2008 vs. 2007
                  
                  
                  December 31, 2007 vs. 2006Increase (Decrease) Due to
                  
                  
                  Increase (Decrease) Due toVolume
                  
                  
                  Rate
                  
                  
                  Total
                  
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  Total(Dollars
      in thousands)Interest
      income:Loan
      portfolio
                  
                  $
                  9,299
                  
                  
                  $
                  (9,842
                  )
                  
                  $
                  (543
                  )
                  
                  $
                  16,303
                  
                  
                  $
                  626
                  
                  
                  $
                  16,929Investment
      securities
                  
                  
                  494
                  
                  
                  
                  (105
                  )
                  
                  
                  389
                  
                  
                  
                  1,029
                  
                  
                  
                  122
                  
                  
                  
                  1,151Federal
      funds and other interest-earning assets
                  
                  
                  (149
                  )
                  
                  
                  (164
                  )
                  
                  
                  (313
                  )
                  
                  
                  99
                  
                  
                  
                  (13
                  )
                  
                  
                  86Total
      interest income
                  
                  
                  9,644
                  
                  
                  
                  (10,111
                  )
                  
                  
                  (467
                  )
                  
                  
                  17,431
                  
                  
                  
                  735
                  
                  
                  
                  18,166Interest
      expense:Deposits:Interest-bearing
      NOW
                  
                  
                  6
                  
                  
                  
                  (266
                  )
                  
                  
                  (260
                  )
                  
                  
                  (59
                  )
                  
                  
                  (170
                  )
                  
                  
                  (229
                  )Money
      market and savings
                  
                  
                  (210
                  )
                  
                  
                  (2,331
                  )
                  
                  
                  (2,541
                  )
                  
                  
                  2,829
                  
                  
                  
                  43
                  
                  
                  
                  2,872Time
      deposits
                  
                  
                  4,380
                  
                  
                  
                  (1,946
                  )
                  
                  
                  2,434
                  
                  
                  
                  4,824
                  
                  
                  
                  1,755
                  
                  
                  
                  6,579Short-term
      borrowings
                  
                  
                  67
                  
                  
                  
                  (240
                  )
                  
                  
                  (173
                  )
                  
                  
                  4
                  
                  
                  
                  (18
                  )
                  
                  
                  (14
                  )Long-term
      debt
                  
                  2090
                  
                  
                  
                  (697
                  )
                  
                  
                  1,393
                  
                  
                  
                  1,909
                  
                  
                  
                  (157
                  )
                  
                  
                  1,752Total
      interest expense
                  
                  
                  6,333
                  
                  
                  
                  (5,480
                  )
                  
                  
                  853
                  
                  
                  
                  9,507
                  
                  
                  
                  1,453
                  
                  
                  
                  10,960Net
      interest income increase (decrease)
                  
                  $
                  3,311
                  
                  
                  $
                  (4,631
                  )
                  
                  $
                  (1,320
                  )
                  
                  $
                  7,924
                  
                  
                  $
                  (718
                  )
                  
                  $
                  7,206
 
 NONPERFORMING
ASSETS
 
 Our
financial statements are prepared on the accrual basis of accounting, including
the recognition of interest income on loans, unless we place a loan in
nonaccrual status.  We account for loans on a nonaccrual basis when we
have serious doubts about the collectability of principal or
interest.  Generally, our policy is to place a loan on nonaccrual
status when the loan becomes past due 90 days.  We also place loans on
nonaccrual status in cases where we are uncertain whether the borrower can
satisfy the contractual terms of the loan agreement.  Amounts received
on nonaccrual loans generally are applied first to principal and then to
interest only after all principal has been collected.  Restructured
loans are those for which concessions, including the reduction of interest rates
below a rate otherwise available to that borrower or the deferral of interest or
principal have been granted due to the borrower’s weakened financial
condition.  We accrue interest on restructured loans at the
restructured rates when we anticipate that no loss of original principal will
occur.  Potential problem loans are loans which are currently
performing and are not included as nonaccrual or restructured loans above, but
about which we have serious doubts as to the borrower’s ability to comply with
present repayment terms.  These loans are likely to be included later
in nonaccrual, past due or restructured loans, so they are considered by our
management in assessing the adequacy of our allowance for loan
losses.  At December 31, 2008, we identified 34 loans in the aggregate
amount of $7.9 million as potential problem loans.  The loans possess
certain unfavorable characteristics which cause management some concern such a
past due trends, the deteriorating financial condition of the borrower and
softness in the residential real estate market.  Of these 34 loans, 16
loans totaling approximately $5.9 million are related to the land development
and residential construction industries.  These loans will continue to
be closely monitored.  At December 31, 2007, we identified 13 loans in
the aggregate amount of $1.2 million as potential problem
loans.
  32
  At
December 31, 2008, there were eight foreclosed properties valued at $1.7 million
and fifty nonaccrual loans totaling $13.1 million.  Foreclosed
property is valued at the lower of appraised value or the outstanding loan
balance.  Interest foregone on nonaccrual loans for the year ended
December 31, 2008 was approximately $554,500. At December 31, 2007, there were
four foreclosed properties valued at $272,000 and twelve nonaccrual loans
totaling $2.7 million.  Interest foregone on nonaccrual loans for the
year ended December 31, 2007 was approximately $73,700.   There
were no loans at December 31, 2008 or 2007 that were 90 days or more past due
and still accruing interest.  There were no repossessed assets at
December 31, 2008 or 2007.
 
 The table
sets forth, for the period indicated, information about our nonaccrual loans,
loans past due 90 days or more and still accruing interest, total nonperforming
loans (nonaccrual loans plus loans past due 90 days or more and still accruing
interest), and total nonperforming assets.
 
 At
      December 31,2008
                        
                        
                        2007
                        
                        
                        2006
                        
                        
                        2005
                        
                        
                        2004(Dollars
      in thousands)Nonaccrual
      loans
                        
                        $
                        13,094
                        
                        
                        $
                        2,726
                        
                        
                        $
                        135
                        
                        
                        $
                        26
                        
                        
                        $
                        5Restructured
      loans
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Total
      nonperforming loans
                        
                        
                        13,094
                        
                        
                        
                        2,726
                        
                        
                        
                        135
                        
                        
                        
                        26
                        
                        
                        
                        5Real
      estate owned
                        
                        
                        1,716
                        
                        
                        
                        272
                        
                        
                        
                        98
                        
                        
                        
                        22
                        
                        
                        
                        245Repossessed
      assets
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        48Total
      nonperforming assets
                        
                        $
                        14,810
                        
                        
                        $
                        2,998
                        
                        
                        $
                        233
                        
                        
                        $
                        48
                        
                        
                        $
                        298Accruing
      loans past due 90 days or more
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -Allowance
      for loan losses
                        
                        
                        12,585
                        
                        
                        
                        8,273
                        
                        
                        
                        6,945
                        
                        
                        
                        4,351
                        
                        
                        
                        3,668Nonperforming
      loans to  period end loans
                        
                        
                        1.53
                        %
                        
                        
                        0.40
                        %
                        
                        
                        0.02
                        %
                        
                        
                        0.01
                        %
                        
                        
                        0.00
                        %Nonperforming
      loans and loans past due 90 days or more to period end
    loans
                        
                        
                        1.53
                        %
                        
                        
                        0.40
                        %
                        
                        
                        0.02
                        %
                        
                        
                        0.01
                        %
                        
                        
                        0.00
                        %Allowance
      for loan losses to period end loans
                        
                        
                        1.60
                        %
                        
                        
                        1.22
                        %
                        
                        
                        1.26
                        %
                        
                        
                        1.33
                        %
                        
                        
                        1.42
                        %Allowance
      for loan losses to nonperforming loans
                        
                        
                        96.12
                        %
                        
                        
                        303.45
                        %
                        
                        
                        5,144.96
                        %
                        
                        
                        16,960.60
                        %
                        
                        
                        73,360.00
                        %Allowance
      for loan losses to nonperforming loans and loans past due 90 days or
      more
                        
                        
                        96.12
                        %
                        
                        
                        303.45
                        %
                        
                        
                        5,144.96
                        %
                        
                        
                        16,960.60
                        %
                        
                        
                        73,360.00
                        %Nonperforming
      assets to total assets
                        
                        
                        1.67
                        %
                        
                        
                        0.36
                        %
                        
                        
                        0.03
                        %
                        
                        
                        0.01
                        %
                        
                        
                        0.09
                        %Nonperforming
      assets and loanspast
      due 90 days or more tototal
      assets
                        
                        
                        1.67
                        %
                        
                        
                        0.36
                        %
                        
                        
                        0.03
                        %
                        
                        
                        0.01
                        %
                        
                        
                        0.09
                        %
  33
  ANALYSIS
OF ALLOWANCE FOR LOAN LOSSES
 
 The
allowance for loan losses is established through periodic charges to earnings in
the form of a provision for loan losses.  Increases to the allowance
for loan losses occur as a result of provisions charged to operations and
recoveries of amounts previously charged-off, and decreases to the allowance
occur when loans are charged-off.  Management evaluates the adequacy
of our allowance for loan losses on a monthly basis.  The evaluation
of the adequacy of the allowance for loan losses involves the consideration of
loan growth, loan portfolio composition and industry diversification, historical
loan loss experience, current delinquency levels, adverse conditions that might
affect a borrower’s ability to repay the loan, estimated value of underlying
collateral, prevailing economic conditions and all other relevant factors
derived from our history of operations.  Additionally, as an important
component of their periodic examination process, regulatory agencies review our
allowance for loan losses and may require additional provisions for estimated
losses based on judgments that differ from those of management.
 
 We use an
internal grading system to assign the degree of inherent risk on each individual
loan.  The grade is initially assigned by the lending officer and
reviewed by the loan administration function.  The internal grading
system is reviewed and tested periodically by an independent third party credit
review firm.  The testing process involves the evaluation of a sample
of new loans, loans having been identified as possessing potential weakness in
credit quality, past due loans and nonaccrual loans to determine the ongoing
effectiveness of the internal grading system.  The loan grading system
is used to assess the adequacy of the allowance for loan losses.
 
 Management
has developed a model for evaluating the adequacy of the allowance for loan
losses.  The model uses the Company’s internal loan grading system to
segment each category of loans by risk class. Using the various evaluation
factors mentioned above, management predetermined allowance percentages for each
risk class within each loan category.  The total aggregate balance of
loans in each risk class is multiplied by the associated allowance percentage to
determine an adequate level of allowance for loan losses.
 
 Those
loans that are identified through the Company’s internal loan grading system as
possessing characteristics which in the opinion of management suggest the
highest degree of inherent risk are evaluated individually in accordance with
Statement of Financial
Accounting Standards (SFAS) 114, Accounting by Creditors for
Impairment of a Loan.  Each loan is analyzed to determine the
net value of collateral, probability of charge-off and finally a potential
estimate of loss.  Loans meeting the criteria for individual
evaluation are specifically reserved for based on management’s
analysis.
 
 Using the
data gathered during the monthly evaluation process, the model calculates an
acceptable range for allowance for loan losses.  Management and the
Board of Directors are responsible for determining the appropriate level of the
allowance for loan losses within that range.
 
 The
primary reason for increases to the allowance for loan losses has been growth in
total outstanding loans, however, there were other factors influencing the
provision.  Other factors influencing the level of the allowance of
loan losses included the volume of net charge-offs experienced through the year
and the current level of nonperforming loans.  At or for the year
ended December 31, 2008, there were $2.2 million in net loan charge-offs and
$13.1 million in non-accrual loans compared with $356,000 in net loan
charge-offs and $2.7 million in nonaccrual loans at or for the year ended
December 31, 2007.  The allowance for loan losses at December 31, 2008
was $12.6 million, which represents 1.60% of total outstanding loans compared to
$8.3 million and 1.22% for the prior year.
 
 The
allowance for loan losses represents management’s estimate of an amount adequate
to provide for known and inherent losses in the loan portfolio in the normal
course of business.  While management believes the methodology used to
establish the allowance for loan losses incorporates the best information
available at the time, future adjustments to the level of the allowance may be
necessary and the results of operations could be adversely affected should
circumstances differ substantially from the assumptions initially
used.  We believe that the allowance for loan losses was established
in conformity with generally accepted accounting principles; however, there can
be no assurances that the regulatory agencies, after reviewing the loan
portfolio, will not require management to increase the level of the
allowance.  Likewise, there can be no assurance that the existing
allowance for loan losses is adequate should there be deterioration in the
quality of any loans or changes in any of the factors discussed
above.  Any increases in the provision for loan losses resulting from
such deterioration or change in condition could adversely affect our financial
condition and results of operations.
  34
  The
following table describes the allocation of the allowance for loan losses among
various categories of loans for the dates indicated:
 
 At December 31,2008
                  
                  
                  2007
                  
                  
                  2006% of Total
                  
                  
                  
                  
                  
                  % of Total
                  
                  
                  
                  
                  
                  % of TotalAmount
                  
                  
                  Loans (1)
                  
                  
                  Amount
                  
                  
                  Loans (1)
                  
                  
                  Amount
                  
                  
                  Loans (1)(Dollars
      in thousands)Real
      estate - commercial
                  
                  $
                  6,003
                  
                  
                  
                  59.82
                  %
                  
                  $
                  3,771
                  
                  
                  
                  51.85
                  %
                  
                  $
                  3,920
                  
                  
                  
                  55.36
                  %Real
      estate - residential
                  
                  
                  103
                  
                  
                  
                  2.43
                  %
                  
                  
                  130
                  
                  
                  
                  2.70
                  %
                  
                  
                  121
                  
                  
                  
                  3.67
                  %Construction
      loans
                  
                  
                  3,694
                  
                  
                  
                  20.47
                  %
                  
                  
                  2,362
                  
                  
                  
                  27.18
                  %
                  
                  
                  1,379
                  
                  
                  
                  19.99
                  %Commercial
      and industrial loans
                  
                  
                  1,953
                  
                  
                  
                  9.68
                  %
                  
                  
                  1,536
                  
                  
                  
                  10.77
                  %
                  
                  
                  1,161
                  
                  
                  
                  12.32
                  %Home
      equity loans and lines of credit
                  
                  
                  469
                  
                  
                  
                  6.91
                  %
                  
                  
                  334
                  
                  
                  
                  6.69
                  %
                  
                  
                  269
                  
                  
                  
                  7.76
                  %Loans
      to individuals
                  
                  
                  363
                  
                  
                  
                  0.69
                  %
                  
                  
                  140
                  
                  
                  
                  0.81
                  %
                  
                  
                  95
                  
                  
                  
                  0.90
                  %Total
      allowance
                  
                  $
                  12,585
                  
                  
                  
                  100.00
                  %
                  
                  $
                  8,273
                  
                  
                  
                  100.00
                  %
                  
                  $
                  6,945
                  
                  
                  
                  100.00
                  %
 
 At December 31,2005
                          
                          
                          2004% of Total
                          
                          
                          
                          
                          
                          % of TotalAmount
                          
                          
                          Loans (1)
                          
                          
                          Amount
                          
                          
                          Loans (1)(Dollars
      in thousands)Real
      estate - commercial
                          
                          $
                          1,876
                          
                          
                          
                          52.92
                          %
                          
                          $
                          1,290
                          
                          
                          
                          47.24
                          %Real
      estate - residential
                          
                          
                          90
                          
                          
                          
                          4.54
                          %
                          
                          
                          44
                          
                          
                          
                          4.50
                          %Construction
      loans
                          
                          
                          735
                          
                          
                          
                          14.17
                          %
                          
                          
                          718
                          
                          
                          
                          15.09
                          %Commercial
      and industrial loans
                          
                          
                          1,138
                          
                          
                          
                          16.03
                          %
                          
                          
                          1,105
                          
                          
                          
                          18.90
                          %Home
      equity loans and lines of credit
                          
                          
                          201
                          
                          
                          
                          10.62
                          %
                          
                          
                          173
                          
                          
                          
                          12.00
                          %Loans
      to individuals
                          
                          
                          311
                          
                          
                          
                          1.72
                          %
                          
                          
                          338
                          
                          
                          
                          2.27
                          %Total
      allowance
                          
                          $
                          4,351
                          
                          
                          
                          100.00
                          %
                          
                          $
                          3,668
                          
                          
                          
                          100.00
                          %
 
 (1)
              Represents
      total of all outstanding loans in each category as a percent of total
      loans outstanding.
  35
  The
following table presents information regarding changes in the allowance for loan
losses for the years indicated:
 
 At or for the Year Ended December
      31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004(Dollars
      in thousands)Balance
      at beginning of period
                  
                  $
                  8,273
                  
                  
                  $
                  6,945
                  
                  
                  $
                  4,351
                  
                  
                  $
                  3,668
                  
                  
                  $
                  3,304Charge-offs:Construction
      loans
                  
                  
                  277
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  15Commercial
      real estate
                  
                  
                  503
                  
                  
                  
                  213
                  
                  
                  
                  -
                  
                  
                  
                  34
                  
                  
                  
                  21Commercial
      and industrial loans
                  
                  
                  1,363
                  
                  
                  
                  89
                  
                  
                  
                  14
                  
                  
                  
                  140
                  
                  
                  
                  345Residential
      real estate
                  
                  
                  -
                  
                  
                  
                  45
                  
                  
                  
                  64
                  
                  
                  
                  -
                  
                  
                  
                  34Loans
      to individuals
                  
                  
                  44
                  
                  
                  
                  15
                  
                  
                  
                  8
                  
                  
                  
                  9
                  
                  
                  
                  16Total
      charge-offs
                  
                  
                  2,187
                  
                  
                  
                  362
                  
                  
                  
                  86
                  
                  
                  
                  183
                  
                  
                  
                  431Recoveries:Commercial
      and industrial loans
                  
                  
                  4
                  
                  
                  
                  5
                  
                  
                  
                  1
                  
                  
                  
                  22
                  
                  
                  
                  57Commercial
      real estate
                  
                  
                  3
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Construction
      loans
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  27
                  
                  
                  
                  -Loans
      to individuals
                  
                  
                  7
                  
                  
                  
                  1
                  
                  
                  
                  1
                  
                  
                  
                  10
                  
                  
                  
                  2Total
      recoveries
                  
                  
                  14
                  
                  
                  
                  6
                  
                  
                  
                  2
                  
                  
                  
                  59
                  
                  
                  
                  59Net
      charge-offs
                  
                  
                  2,173
                  
                  
                  
                  356
                  
                  
                  
                  84
                  
                  
                  
                  124
                  
                  
                  
                  372Allowance
      acquired from Port City Capital Bank merger
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,687
                  
                  
                  
                  -
                  
                  
                  
                  -Provision
      for loan losses
                  
                  
                  6,485
                  
                  
                  
                  1,684
                  
                  
                  
                  991
                  
                  
                  
                  807
                  
                  
                  
                  736Balance
      at the end of the year
                  
                  $
                  12,585
                  
                  
                  $
                  8,273
                  
                  
                  $
                  6,945
                  
                  
                  $
                  4,351
                  
                  
                  $
                  3,668Total
      loans outstanding at year-end
                  
                  $
                  785,377
                  
                  
                  $
                  675,916
                  
                  
                  $
                  549,819
                  
                  
                  $
                  328,322
                  
                  
                  $
                  257,908Average
      loans outstanding for the year
                  
                  $
                  741,629
                  
                  
                  $
                  615,322
                  
                  
                  $
                  414,644
                  
                  
                  $
                  297,045
                  
                  
                  $
                  240,346Allowance
      for loan losses to loans outstanding
                  
                  
                  1.60
                  %
                  
                  
                  1.22
                  %
                  
                  
                  1.26
                  %
                  
                  
                  1.33
                  %
                  
                  
                  1.42
                  %Ratio
      of net loan charge-offs to average loans outstanding
                  
                  
                  0.29
                  %
                  
                  
                  0.06
                  %
                  
                  
                  0.02
                  %
                  
                  
                  0.04
                  %
                  
                  
                  0.15
                  %
 
 INVESTMENT
ACTIVITIES
 
 The
Company’s investment portfolio plays a major role in management of liquidity and
interest rate sensitivity and, therefore, is managed in the context of the
overall balance sheet.  The securities portfolio generates a nominal
percentage of our interest income and serves as a necessary source of
liquidity.  We account for investment securities as
follows:
 
 Available for
sale.  Debt and equity securities that will be held for
indeterminate periods of time, including securities that we may sell in response
to changes in market interest or prepayment rates, needs for liquidity and
changes in the availability of and the yield of alternative investments are
classified as available for sale.  The Company carries these
investments at market value, which we generally determine using published quotes
as of the close of business.  Unrealized gains and losses are excluded
from our earnings and are reported, net of applicable income tax, as a component
of accumulated other comprehensive income in stockholders’ equity until
realized.
  36
 The
following table summarizes the amortized costs and market value of available for
sale securities at the dates indicated:
 
 At December 31, 2008
                  
                  
                  At December 31, 2007
                  
                  
                  At December 31, 2006Amortized
                  
                  
                  Fair
                  
                  
                  Amortized
                  
                  
                  Fair
                  
                  
                  Amortized
                  
                  
                  Faircost
                  
                  
                  value
                  
                  
                  cost
                  
                  
                  value
                  
                  
                  cost
                  
                  
                  value(In
      thousands)Securities
      available for sale:U.S.
      government securities and obligations of U.S. government
      agencies
                  
                  $
                  10,665
                  
                  
                  $
                  10,832
                  
                  
                  $
                  8,364
                  
                  
                  $
                  8,312
                  
                  
                  $
                  7,493
                  
                  
                  $
                  7,385Mortgage-backed
      securities
                  
                  
                  67,309
                  
                  
                  
                  68,976
                  
                  
                  
                  56,986
                  
                  
                  
                  57,234
                  
                  
                  
                  54,949
                  
                  
                  
                  54,274Municipal
                  
                  
                  26,089
                  
                  
                  
                  25,350
                  
                  
                  
                  24,810
                  
                  
                  
                  24,695
                  
                  
                  
                  22,321
                  
                  
                  
                  22,182Other
                  
                  
                  565
                  
                  
                  
                  491
                  
                  
                  
                  536
                  
                  
                  
                  517
                  
                  
                  
                  779
                  
                  
                  
                  882Total
      securities available for sale
                  
                  $
                  104,628
                  
                  
                  $
                  105,649
                  
                  
                  $
                  90,696
                  
                  
                  $
                  90,758
                  
                  
                  $
                  85,542
                  
                  
                  $
                  84,723
 
 LIQUIDITY
AND CAPITAL RESOURCES
 
 Maintaining
adequate liquidity while managing interest rate risk is the primary goal of the
Company’s asset and liability management strategy. Liquidity is the ability to
fund the needs of the Company’s borrowers and depositors, pay operating
expenses, and meet regulatory liquidity requirements. Maturing investments, loan
and mortgage-backed securities principal repayments, deposit growth, the
brokered deposit market, and borrowings from the Federal Home Loan Bank are
presently the main sources of the Company’s liquidity. The Company’s primary
uses of liquidity are to fund loans and to make investments.
 
 At
December 31, 2008, liquid assets (cash and due from banks, interest-earning
deposits with banks, federal funds sold and investment securities available for
sale) were approximately $123.2 million, which represents 13% of total assets
and 17% of total deposits. Supplementing this liquidity, the Company has
available lines of credit from various correspondent banks of approximately
$349.4 million of which $136.7 million was outstanding. At December 31, 2008,
outstanding commitments for undisbursed lines of credit and letters of credit
amounted to $157.4 million and outstanding commitments to make additional
investments in a Small Business Investment Corporation was $413,000. Management
believes that the combined aggregate liquidity position of the Company is
sufficient to meet the funding requirements of loan demand and deposit
maturities and withdrawals in the near term. Certificates of deposit represented
65% of the Company’s total deposits at December 31, 2008. The Company’s strategy
will include efforts focused at increasing the relative volume of transaction
deposit accounts. Certificates of deposit of $100,000 or more represented 50% of
the Company’s total deposits at year-end. While these deposits are generally
considered rate sensitive and the Company will need to pay competitive rates to
retain these deposits at maturity, there are other subjective factors that will
determine the Company’s continued retention of those deposits.
 
 Under
federal capital regulations, the Company must satisfy certain minimum leverage
ratio requirements and risk-based capital requirements. At December 31, 2008,
the Company’s equity to asset ratio was 9.82%. All capital ratios place the Bank
in excess of the minimum required to be deemed a well-capitalized bank by
regulatory measures. CSB’s ratio of Tier 1 capital to risk-weighted assets
at December 31, 2008 was 8.53%.
 
 ASSET/LIABILITY
MANAGEMENT
 
 The
primary objective of asset and liability management is to provide sustainable
and growing net interest income under varying economic environments, while
protecting the economic values of our balance sheet assets and liabilities from
the adverse effects of changes in interest rates.  Our overall
interest-rate risk position is maintained within a series of policies approved
by the Board and guidelines established and monitored by the Asset Liability
Committee (“ALCO”).
  37
 
 Because
no one individual measure can accurately assess all of our risks to changes in
rates, we use several quantitative measures in our assessment of current and
potential future exposures to changes in interest rates and their impact on net
interest income and balance sheet values. Net interest income simulation is the
primary tool used in our evaluation of the potential range of possible net
interest income results that could occur under a variety of interest-rate
environments. We also use market valuation and duration analysis to assess
changes in the economic value of balance sheet assets and liabilities caused by
assumed changes in interest rates. Finally, gap analysis — the difference
between the amount of balance sheet assets and liabilities repricing within a
specified time period — is used as a measurement of our interest-rate risk
position.
 
 To
measure, monitor, and report on our interest-rate risk position, we begin with
two models: (1) net interest income at risk which measures the impact on net
interest income over the next twelve months to immediate, or “rate shock,” and
slow, or “rate ramp,” changes in market interest rates; and (2) net economic
value of equity that measures the impact on the present value of all net
interest income-related principal and interest cash flows of an immediate change
in interest rates. Net interest income at risk is designed to measure the
potential impact of changes in market interest rates on net interest revenue in
the short term. Net economic value of equity, on the other hand, is a long-term
view of interest-rate risk, but with a liquidation view of the Company. Both of
these models are subject to ALCO-established guidelines, and are monitored
regularly.
 
 In
calculating our net interest income at risk, we start with a base amount of net
interest revenue that is projected over the next twelve months, assuming that
the then-current yield curve remains unchanged over the period. Our existing
balance sheet assets and liabilities are adjusted by the amount and timing of
transactions that are forecasted to occur over the next twelve months. That
yield curve is then “shocked,” or moved immediately, ±200 basis points in a
parallel fashion, or at all points along the yield curve. Two new twelve-month
net interest income projections are then developed using the same balance sheet
and forecasted transactions, but with the new yield curves, and compared to the
base scenario. We also perform the calculations using interest rate ramps, which
are ±100, ±200 and ±300 basis point changes in interest rates that are assumed
to occur gradually over the next twelve-month period, rather than immediately as
we do with interest-rate shocks.
 
 Net
economic value of equity is based on the change in the present value of all net
interest income-related principal and interest cash flows for changes in market
rates of interest. The present value of existing cash flows with a then-current
yield curve serves as the base case. We then apply an immediate parallel shock
to that yield curve of ±100 and ±200 basis points and recalculate the cash flows
and related present values.
 
 Key
assumptions used in the models described above include the timing of cash flows;
the maturity and repricing of balance sheet assets and liabilities, especially
option-embedded financial instruments like mortgage-backed securities and FHLB
advances; changes in market conditions; and interest-rate sensitivities of our
customer liabilities with respect to the interest rates paid and the level of
balances. These assumptions are inherently uncertain and, as a result, the
models cannot precisely calculate future net interest income or predict the
impact of changes in interest rates on net interest income and economic value.
Actual results could differ from simulated results due to the timing, magnitude
and frequency of changes in interest rates and market conditions, changes in
spreads and management strategies, among other factors. Projections of potential
future streams of net interest income are assessed as part of our forecasting
process.
 
 Net Interest Income at Risk Analysis.The following table presents the estimated exposure of net interest
income for the next twelve months, calculated as of December 31, 2008 and 2007,
due to an immediate and gradual ± 200 basis point shift in then-current interest
rates. Estimated incremental exposures set forth below are dependent on
management’s assumptions about asset and liability sensitivities under various
interest-rate scenarios, such as those previously discussed, and do not reflect
any actions management may undertake in order to mitigate some of the adverse
effects of interest-rate changes on the Company’s financial
performance.
  38
 
 
 Net Interest Income at Risk(dollars in thousands)
                          
                          Estimated Exposure toNet Interest IncomeRate change
                          
                          2008
                          
                          
                          2007+200
      basis points shock
                          
                          $
                          847
                          
                          
                          $
                          1,534-200
      basis point shock
                          
                          
                          (2,098
                          )
                          
                          
                          (2,175
                          )+200
      basis point ramp
                          
                          
                          31
                          
                          
                          
                          1,448-200
      basis point ramp
                          
                          
                          (230
                          )
                          
                          
                          (1,584
                          )
 
 Net Economic Value of Equity
Analysis.The following table presents estimated EVE exposures,
calculated as of December 31, 2008 and 2007, assuming an immediate and prolonged
shift in interest rates, the impact of which would be spread over a number of
years.
 
 Net Economic Value of Equity
                    
                    Estimated Exposure toNet Economic Value of Equity(dollars
      in thousands)Rate
      Change
                    
                    2008
                    
                    
                    2007+100
      basis point shock
                    
                    $
                    (2,594
                    )
                    
                    $
                    (257
                    )-100
      basis point shock
                    
                    
                    7,531
                    
                    
                    
                    (1,180
                    )+200 basis point shock
                    
                    
                    (7,868
                    )
                    
                    
                    (3,114
                    )-200
      basis point shock
                    
                    
                    10,931
                    
                    
                    
                    (3,674
                    )
  While the
measures presented in the tables above are not a prediction of future net
interest income or valuations, they do suggest that if all other variables
remained constant, in the short term, falling interest rates would lead to net
interest income that is lower than it would otherwise have been, and rising
rates would lead to higher net interest income. Other important factors that
impact the levels of net interest income are balance sheet size and mix;
interest-rate spreads; the slope, how quickly or slowly market interest rates
change and management actions taken in response to the preceding
conditions.
 
 Interest Rate Gap Analysis.As
a part of its interest rate risk management policy, the Company calculates an
interest rate “gap.” Interest rate “gap” analysis is a common, though imperfect,
measure of interest rate risk, which measures the relative dollar amounts of
interest-earning assets and interest-bearing liabilities which reprice within a
specific time period, either through maturity or rate adjustment. The “gap” is
the difference between the amounts of such assets and liabilities that are
subject to repricing. A “positive” gap for a given period means that the amount
of interest-earning assets maturing or otherwise repricing within that period
exceeds the amount of interest-bearing liabilities maturing or otherwise
repricing within the same period. Accordingly, in a declining interest rate
environment, an institution with a positive gap would generally be expected,
absent the effects of other factors, to experience a decrease in the yield on
its assets greater than the decrease in the cost of its liabilities and its net
interest income should be negatively affected. Conversely, the yield on its
assets for an institution with a positive gap would generally be expected to
increase more quickly than the cost of funds in a rising interest rate
environment, and such institution’s net interest income generally would be
expected to be positively affected by rising interest rates. Changes in interest
rates generally have the opposite effect on an institution with a “negative
gap.”
 
 The table
below sets forth the amounts of interest-earning assets and interest-bearing
liabilities outstanding at December 31, 2008 that are projected to reprice
or mature in each of the future time periods shown. Except as stated below, the
amounts of assets and liabilities shown which reprice or mature within a
particular period were determined in accordance with the contractual terms of
the assets or liabilities. Loans with adjustable rates are shown as being due at
the end of the next upcoming adjustment period. Money market deposit accounts
and negotiable order of withdrawal or other transaction accounts are assumed to
be subject to immediate repricing and depositor availability and have been
placed in the shortest period. In making the gap computations, none of the
assumptions sometimes made regarding prepayment rates and deposit decay rates
have been used for any interest-earning assets or interest-bearing liabilities.
In addition, the table does not reflect scheduled principal payments that will
be received throughout the lives of the loans or investments. The interest rate
sensitivity of the Company’s assets and liabilities illustrated in the following
table would vary substantially if different assumptions were used or if actual
experience differs from that indicated by such assumptions.
  39





Terms to Repricing at December 31, 2008More Than
                
                
                More Than1 Year
                
                
                1 Year to
                
                
                3 Years to
                
                
                More Thanor Less
                
                
                3 Years
                
                
                5 Years
                
                
                5 Years
                
                
                Total(Dollars in thousands)INTEREST-EARNING
      ASSETS:Loans
      receivable:Commercial
      mortgage loans
                
                $
                215,168
                
                
                $
                112,573
                
                
                $
                102,243
                
                
                $
                40,449
                
                
                $
                470,433Residential
      mortgage loans
                
                
                7,232
                
                
                
                9,455
                
                
                
                1,934
                
                
                
                523
                
                
                
                19,144Construction
      and development
                
                
                138,009
                
                
                
                3,590
                
                
                
                8,881
                
                
                
                10,487
                
                
                
                160,967Commercial
      and industrial loans
                
                
                61,770
                
                
                
                11,484
                
                
                
                2,619
                
                
                
                261
                
                
                
                76,134Home
      equity lines and loans
                
                
                51,437
                
                
                
                1,291
                
                
                
                1,570
                
                
                
                76
                
                
                
                54,374Loans
      to individuals
                
                
                3,913
                
                
                
                1,058
                
                
                
                397
                
                
                
                2
                
                
                
                5,370Interest-earning
      deposits with banks
                
                
                267
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                267Fed
      funds sold
                
                
                99
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                99Investment
      securities available for sale
                
                
                38,308
                
                
                
                27,767
                
                
                
                13,175
                
                
                
                26,399
                
                
                
                104,628Federal
      Home Loan Bank stock
                
                
                7,264
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                7,264Total
      interest-earning assets
                
                $
                523,467
                
                
                $
                167,218
                
                
                $
                130,819
                
                
                $
                78,197
                
                
                $
                899,701INTEREST-BEARING
      LIABILITIES:Deposits:Money
      market, NOW and savings
                
                $
                189,376
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                189,376Time
                
                
                244,909
                
                
                
                184,131
                
                
                
                32,521
                
                
                
                -
                
                
                
                461,561Short-term
      borrowings
                
                
                37,706
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                37,706Long-term
      borrowings
                
                
                39,748
                
                
                
                15,000
                
                
                
                62,000
                
                
                
                -
                
                
                
                116,748Total
      interest-bearing liabilities
                
                $
                324,213
                
                
                $
                202,526
                
                
                $
                278,652
                
                
                $
                -
                
                
                $
                805,391INTEREST
      SENSITIVITY GAP PER PERIOD
                
                $
                11,728
                
                
                $
                (31,913
                )
                
                $
                36,298
                
                
                $
                78,197
                
                
                $
                94,310CUMULATIVE
      INTEREST SENSITIVITY GAP
                
                $
                11,728
                
                
                $
                (20,185
                )
                
                $
                16,113
                
                
                $
                94,310
                
                
                $
                94,310CUMULATIVE
      GAP AS A PERCENTAGE OF TOTAL INTEREST-EARNING ASSETS
                
                
                1.30
                %
                
                
                (2.24
                )%
                
                
                1.79
                %
                
                
                10.48
                %
                
                
                10.48
                %CUMULATIVE
      INTEREST-EARNING ASSETS AS A PERCENTAGE OF CUMULATIVE INTEREST-BEARING
      LIABILITIES
                
                
                102.29
                %
                
                
                97.16
                %
                
                
                102.00
                %
                
                
                111.71
                %
                
                
                111.71
                %


40


CRITICAL
ACCOUNTING POLICY





The
Company's most significant critical accounting policies are the determination of
its allowance for loan losses, evaluation of investment securities for other
than temporary impairment and the impairment testing of its goodwill. A critical
accounting policy is one that is both very important to the portrayal of the
Company's financial condition and results, and requires management's most
difficult, subjective or complex judgments. What makes these judgments
difficult, subjective and/or complex is the need to make estimates about the
effects of matters that are inherently uncertain.





QUARTERLY
FINANCIAL INFORMATION




The
following table sets forth, for the periods indicated, certain of our
consolidated quarterly financial information. This information is derived from
our unaudited financial statements, which include, in the opinion of management,
all normal recurring adjustments which management considers necessary for a fair
presentation of the results for such periods. This information should be read in
conjunction with our consolidated financial statements included elsewhere in
this report. The results for any quarter are not necessarily indicative of
results for any future period. Due to rounding, the sum of the results for the
four quarters of a given year may not agree with the annual results for that
year.





Year Ended December 31, 2008
                
                
                Year Ended December 31, 2007Fourth
                
                
                Third
                
                
                Second
                
                
                First
                
                
                Fourth
                
                
                Third
                
                
                Second
                
                
                FirstQuarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                QuarterOperating
      Data:Total
      interest income
                
                $
                13,711
                
                
                $
                13,794
                
                
                $
                13,177
                
                
                $
                13,722
                
                
                $
                14,418
                
                
                $
                14,095
                
                
                $
                13,602
                
                
                $
                12,757Total
      interest expense
                
                
                7,536
                
                
                
                7,451
                
                
                
                6,885
                
                
                
                7,198
                
                
                
                7,385
                
                
                
                7,286
                
                
                
                7,033
                
                
                
                6,513Net
      interest income
                
                
                6,175
                
                
                
                6,343
                
                
                
                6,292
                
                
                
                6,524
                
                
                
                7,033
                
                
                
                6,809
                
                
                
                6,569
                
                
                
                6,244Provision
      for loan losses
                
                
                3,937
                
                
                
                1,282
                
                
                
                459
                
                
                
                806
                
                
                
                337
                
                
                
                666
                
                
                
                322
                
                
                
                359Net
      interest income after provision
                
                
                2,238
                
                
                
                5,061
                
                
                
                5,833
                
                
                
                5,718
                
                
                
                6,696
                
                
                
                6,143
                
                
                
                6,247
                
                
                
                5,885Non-interest
      income
                
                
                1,050
                
                
                
                1,057
                
                
                
                817
                
                
                
                808
                
                
                
                655
                
                
                
                690
                
                
                
                647
                
                
                
                629Non-interest
      expense
                
                
                4,792
                
                
                
                5,066
                
                
                
                5,093
                
                
                
                5,021
                
                
                
                4,577
                
                
                
                4,402
                
                
                
                4,623
                
                
                
                4,220Income
      (loss) before income taxes
                
                
                (1,504
                )
                
                
                1,052
                
                
                
                1,557
                
                
                
                1,505
                
                
                
                2,774
                
                
                
                2,431
                
                
                
                2,271
                
                
                
                2,294Provision
      for income taxes
                
                
                (738
                )
                
                
                306
                
                
                
                526
                
                
                
                505
                
                
                
                1,002
                
                
                
                868
                
                
                
                823
                
                
                
                828Net
      income (loss)
                
                $
                (766
                )
                
                $
                746
                
                
                $
                1,031
                
                
                $
                1,000
                
                
                $
                1,772
                
                
                $
                1,563
                
                
                $
                1,448
                
                
                $
                1,466Securities
      gains/(losses)
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Per
      Share Data:Earnings
      (loss) per share- basic
                
                $
                (0.08
                )
                
                $
                0.08
                
                
                $
                0.11
                
                
                $
                0.19
                
                
                $
                0.19
                
                
                $
                0.17
                
                
                $
                0.16
                
                
                $
                0.16Earnings
      (loss) per share - diluted
                
                
                (0.08
                )
                
                
                0.08
                
                
                
                0.11
                
                
                
                0.18
                
                
                
                0.18
                
                
                
                0.16
                
                
                
                0.15
                
                
                
                0.15




RECENT
ACCOUNTING PRONOUNCEMENTS





For
recently issued accounting pronouncements that may affect the Company, see Note
B of Notes to Consolidated Financial Statements.





OFF-BALANCE
SHEET ARRANGEMENTS





The
Company has various financial instruments (outstanding commitments) with
off-balance sheet risk that are issued in the normal course of business to the
meet the financing needs of its customers. See Note O to the consolidated
financial statements for more information regarding these commitments and
contingent liabilities.


41


FORWARD-LOOKING
INFORMATION





This
annual report may contain, in addition to historical information, certain
“forward-looking statements” that represent management’s judgment concerning the
future and are subject to risks and uncertainties that could cause the Company’s
actual operating results and financial position to differ materially from those
projected in the forward-looking statements. Such forward-looking statements can
be identified by the use of forward-looking terminology such as “may,” “will,”
“expect,” “anticipate,” “estimate” or “continue” or the negative thereof or
other variations thereof or comparable terminology. Factors that could influence
the estimates include changes in national, regional and local market conditions,
legislative and regulatory conditions, and the interest rate
environment.





ITEM
7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Market
risk reflects the risk of economic loss resulting from adverse changes in market
price and interest rates. This risk of loss can be reflected in diminished
current market values and/or reduced potential net interest income in future
periods. Our market risk arises primarily from interest rate risk inherent in
our lending and deposit-taking activities. The structure of our loan and deposit
portfolios is such that a significant decline in interest rates may adversely
impact net market values and net interest income. We do not maintain a trading
account nor are we subject to currency exchange risk or commodity price risk.
Interest rate risk is monitored as part of the Bank’s asset/liability management
function.




See the
section entitled Asset/Liability Management in Item 7 for a more detailed
discussion of market risk.


42


ITEM
8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY




CONSOLIDATED
FINANCIAL STATEMENTS





Years
Ended December 31, 2008, 2007 and 2006


43


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY


INDEX TO THE CONSOLIDATED
FINANCIAL STATEMENTS





Page No.Reports
      of Independent Registered Public Accounting Firm
                45Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                46Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007 and
      2006
                47Consolidated
      Statements of Changes in Stockholders’ Equity for the years ended December
      31, 2008, 2007 and 2006
                48Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007 and
      2006
                49Notes
      to Consolidated Financial Statements
                50




44








REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Stockholders and the Board of Directors


Crescent
Financial Corporation and Subsidiary


Cary,
North Carolina





We have
audited the accompanying consolidated balance sheets of Crescent Financial
Corporation and Subsidiary as of December 31, 2008 and 2007, and the related
consolidated statements of operations, changes in stockholders’ equity and cash
flows for each of the years in the three-year period ended December 31, 2008.
These consolidated financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. We were not engaged to perform an
audit of the Company’s internal control over financial reporting. Our audit
included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements, as well as the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Crescent Financial
Corporation and Subsidiary at December 31, 2008 and 2007 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2008 in conformity with accounting principles
generally accepted in the United States of America.











Raleigh,
North Carolina


March
27, 2009


45


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 CONSOLIDATED
BALANCE SHEETS
 December
31, 2008 and 2007





2008
                    
                    
                    2007ASSETSCash
      and due from banks
                    
                    $
                    9,917,277
                    
                    
                    $
                    12,047,600Interest-earning
      deposits with banks
                    
                    
                    266,512
                    
                    
                    
                    211,804Federal
      funds sold
                    
                    
                    99,000
                    
                    
                    
                    97,000Investment
      securities available for sale, at fair value (Note C)
                    
                    
                    105,648,618
                    
                    
                    
                    90,758,467Loans
      (Note D)
                    
                    
                    785,377,283
                    
                    
                    
                    675,916,228Allowance
      for loan losses (Note D)
                    
                    
                    (12,585,000
                    )
                    
                    
                    (8,273,000
                    )NET
      LOANS
                    
                    
                    772,792,283
                    
                    
                    
                    667,643,228Accrued
      interest receivable
                    
                    
                    3,341,258
                    
                    
                    
                    3,761,600Federal
      Home Loan Bank stock, at cost
                    
                    
                    7,264,000
                    
                    
                    
                    6,790,700Bank
      premises and equipment (Note E)
                    
                    
                    10,845,049
                    
                    
                    
                    8,094,521Investment
      in life insurance
                    
                    
                    16,811,918
                    
                    
                    
                    9,122,697Goodwill
      (Note F)
                    
                    
                    30,233,049
                    
                    
                    
                    30,233,049Other
      assets
                    
                    
                    11,091,784
                    
                    
                    
                    6,779,390TOTAL
      ASSETS
                    
                    $
                    968,310,748
                    
                    
                    $
                    835,540,056LIABILITIES
      AND STOCKHOLDERS’ EQUITYDeposits:Demand
                    
                    $
                    63,945,717
                    
                    
                    $
                    69,367,630Savings
                    
                    
                    58,833,876
                    
                    
                    
                    110,516,217Money
      market and NOW
                    
                    
                    130,542,569
                    
                    
                    
                    80,316,251Time
      (Note G)
                    
                    
                    461,560,593
                    
                    
                    
                    345,231,215TOTAL
      DEPOSITS
                    
                    
                    714,882,755
                    
                    
                    
                    605,431,313Short-term
      borrowings (Note H)
                    
                    
                    37,706,000
                    
                    
                    
                    13,755,000Long-term
      debt (Note H)
                    
                    
                    116,748,000
                    
                    
                    
                    121,248,000Accrued
      expenses and other liabilities
                    
                    
                    3,882,385
                    
                    
                    
                    3,446,931TOTAL
      LIABILITIES
                    
                    
                    873,219,140
                    
                    
                    
                    743,881,244Commitments
      (Notes D, I and O)Stockholders’
      Equity (Note Q)Common
      stock, $1 par value, 20,000,000 shares authorized; 9,626,559 shares and
      9,404,579 shares issued and outstanding at December 31, 2008 and 2007,
      respectively
                    
                    
                    9,626,559
                    
                    
                    
                    9,404,579Additional
      paid-in capital
                    
                    
                    74,349,299
                    
                    
                    
                    73,596,427Retained
      earnings
                    
                    
                    10,488,628
                    
                    
                    
                    8,619,617Accumulated
      other comprehensive income
                    
                    
                    627,122
                    
                    
                    
                    38,189TOTAL
      STOCKHOLDERS’ EQUITY
                    
                    
                    95,091,608
                    
                    
                    
                    91,658,812TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                    
                    $
                    968,310,748
                    
                    
                    $
                    835,540,056





See
accompanying notes.


46


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF OPERATIONS


Years
Ended December 31, 2008, 2007 and 2006





2008
                
                
                2007
                
                
                2006INTEREST
      AND FEE INCOMELoans
                
                $
                49,478,663
                
                
                $
                50,022,082
                
                
                $
                33,093,487Investment
      securities available for sale
                
                
                4,842,624
                
                
                
                4,453,955
                
                
                
                3,302,639Interest-earning
      deposits with banks
                
                
                10,653
                
                
                
                38,161
                
                
                
                23,837Federal
      funds sold
                
                
                72,878
                
                
                
                357,878
                
                
                
                286,473TOTAL
      INTEREST AND FEE INCOME
                
                
                54,404,818
                
                
                
                54,872,076
                
                
                
                36,706,436INTEREST
      EXPENSEMoney
      market, NOW and savings deposits
                
                
                4,059,475
                
                
                
                6,860,622
                
                
                
                4,216,641Time
      deposits
                
                
                19,002,942
                
                
                
                16,568,529
                
                
                
                9,989,995Short-term
      borrowings
                
                
                656,549
                
                
                
                830,302
                
                
                
                843,995Long-term
      debt
                
                
                5,351,459
                
                
                
                3,957,782
                
                
                
                2,206,229TOTAL
      INTEREST EXPENSE
                
                
                29,070,425
                
                
                
                28,217,235
                
                
                
                17,256,860NET
      INTEREST INCOME
                
                
                25,334,393
                
                
                
                26,654,841
                
                
                
                19,449,576PROVISION
      FOR LOAN LOSSES (Note D)
                
                
                6,484,543
                
                
                
                1,684,219
                
                
                
                990,786NET
      INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
                
                
                18,849,850
                
                
                
                24,970,622
                
                
                
                18,458,790NON-INTEREST
      INCOMEMortgage
      origination revenue
                
                
                718,433
                
                
                
                512,152
                
                
                
                642,188Fees
      on deposit accounts
                
                
                1,606,062
                
                
                
                1,360,301
                
                
                
                1,287,476Earnings
      on life insurance
                
                
                735,770
                
                
                
                379,927
                
                
                
                228,573Gain
      on sale of securities
                
                
                15,535
                
                
                
                -
                
                
                
                -Gain
      (loss) on sale or disposal of assets
                
                
                (74,032
                )
                
                
                (65,685
                )
                
                
                2,782Other
      (Note K)
                
                
                730,218
                
                
                
                434,163
                
                
                
                450,873TOTAL
      NON-INTEREST INCOME
                
                
                3,731,986
                
                
                
                2,620,858
                
                
                
                2,611,892NON-INTEREST
      EXPENSESalaries
      and employee benefits
                
                
                11,110,281
                
                
                
                9,875,748
                
                
                
                7,307,183Occupancy
      and equipment
                
                
                2,726,669
                
                
                
                2,295,675
                
                
                
                2,018,079Data
      processing
                
                
                1,081,290
                
                
                
                1,055,640
                
                
                
                833,923Other
      (Note K)
                
                
                5,054,077
                
                
                
                4,595,461
                
                
                
                3,227,363TOTAL
      NON-INTEREST EXPENSE
                
                
                19,972,317
                
                
                
                17,822,524
                
                
                
                13,386,548INCOME
      BEFORE INCOME TAXES
                
                
                2,609,519
                
                
                
                9,768,956
                
                
                
                7,684,134INCOME
      TAXES (Note J)
                
                
                598,700
                
                
                
                3,520,200
                
                
                
                2,780,600NET
      INCOME
                
                $
                2,010,819
                
                
                $
                6,248,756
                
                
                $
                4,903,534NET
      INCOME PER COMMON SHAREBasic
                
                $
                0.21
                
                
                $
                0.68
                
                
                $
                0.67Diluted
                
                $
                0.21
                
                
                $
                0.65
                
                
                $
                0.64WEIGHTED
      AVERAGE COMMON SHARES OUTSTANDINGBasic
                
                
                9,500,103
                
                
                
                9,211,779
                
                
                
                7,281,016Diluted
                
                
                9,680,484
                
                
                
                9,635,694
                
                
                
                7,614,807





See
accompanying notes.


47


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


Years
Ended December 31, 2008, 2007 and 2006





AccumulatedAdditional
                    
                    
                    
                    
                    
                    otherCommon
      stock
                    
                    
                    paid-in
                    
                    
                    Retained
                    
                    
                    comprehensive
                    
                    
                    TotalShares
                    
                    
                    Amount
                    
                    
                    capital
                    
                    
                    earnings
                    
                    
                    income
      (loss)
                    
                    
                    equityBalance
      at December 31, 2005
                    
                    
                    5,026,394
                    
                    
                    $
                    5,026,394
                    
                    
                    $
                    29,405,559
                    
                    
                    $
                    7,707,054
                    
                    
                    $
                    (681,793
                    )
                    
                    $
                    41,457,214Comprehensive
      income:Net
      income
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    4,903,534
                    
                    
                    
                    -
                    
                    
                    
                    4,903,534Net
      unrealized holding gain on available for sale securities
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    180,846
                    
                    
                    
                    180,846Total
      comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    5,084,380Common
      stock issued pursuant to:Stock
      options exercised
                    
                    
                    44,029
                    
                    
                    
                    44,029
                    
                    
                    
                    211,768
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    255,797Stock
      option related tax benefits
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    45,401
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    45,401Expense
      recognized in connection with stock options and restricted
      stock
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    202,246
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    202,246Issuance
      of restricted stock, net of deferred compensation
                    
                    
                    7,387
                    
                    
                    
                    7,387
                    
                    
                    
                    (7,387
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Shares
      issued in connection with business combination
                    
                    
                    2,432,374
                    
                    
                    
                    2,432,374
                    
                    
                    
                    33,566,001
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    35,998,375Stock
      split effected in the form of a fifteen percent stock dividend with net
      cash paid for fractional shares
                    
                    
                    754,952
                    
                    
                    
                    754,952
                    
                    
                    
                    (764,387
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (9,435
                    )Balance
      at December 31, 2006
                    
                    
                    8,265,136
                    
                    
                    
                    8,265,136
                    
                    
                    
                    62,659,201
                    
                    
                    
                    12,610,588
                    
                    
                    
                    (500,947
                    )
                    
                    
                    83,033,978Comprehensive
      income:Net
      income
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    6,248,756
                    
                    
                    
                    -
                    
                    
                    
                    6,248,756Net
      unrealized holding gain on available for sale securities
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    539,136
                    
                    
                    
                    539,136Total
      comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    6,787,892Common
      stock issued pursuant to:Stock
      options exercised
                    
                    
                    292,790
                    
                    
                    
                    292,790
                    
                    
                    
                    920,948
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,213,738Stock
      option related tax benefits
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    451,950
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    451,950Expense
      recognized in connection with stock options and restricted
      stock
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    178,940
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    178,940Issuance
      of restricted stock, net of deferred compensation
                    
                    
                    17,050
                    
                    
                    
                    17,050
                    
                    
                    
                    (17,050
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Forfeiture
      of restricted stock
                    
                    
                    (3,406
                    )
                    
                    
                    (3,406
                    )
                    
                    
                    3,406
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Ten
      percent stock dividend with net cash paid for fractional
      shares
                    
                    
                    833,009
                    
                    
                    
                    833,009
                    
                    
                    
                    9,399,032
                    
                    
                    
                    (10,239,727
                    )
                    
                    
                    -
                    
                    
                    
                    (7,686
                    )Balance
      at December 31, 2007 9,404,579
                    
                    
                    9,404,579
                    
                    
                    
                    73,596,427
                    
                    
                    
                    8,619,617
                    
                    
                    
                    38,189
                    
                    
                    
                    91,658,812Cumulative
      adjustment for split dollar pursuant to adoption of EITF
    06-04
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (141,808
                    )
                    
                    
                    -
                    
                    
                    
                    (141,808
                    )Comprehensive
      income:Net
      income
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    2,010,819
                    
                    
                    
                    -
                    
                    
                    
                    2,010,819Net
      unrealized holding gain on available for sale securities
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    588,933
                    
                    
                    
                    588,933Total
      comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    2,599,752Common
      stock issued pursuant to:Stock
      options exercised
                    
                    
                    186,480
                    
                    
                    
                    186,480
                    
                    
                    
                    483,774
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    670,254Stock
      option related tax benefits
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    95,500
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    95,500Expense
      recognized in connection with stock options and restricted
      stock
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    209,098
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    209,098Issuance
      of restricted stock, net of deferred compensation
                    
                    
                    35,500
                    
                    
                    
                    35,500
                    
                    
                    
                    (35,500
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Balance
      at December 31, 2008
                    
                    
                    9,626,559
                    
                    
                    $
                    9,626,559
                    
                    
                    $
                    74,349,299
                    
                    
                    $
                    10,488,628
                    
                    
                    $
                    627,122
                    
                    
                    $
                    95,091,608





See
accompanying notes.


48


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS


Years
Ended December 31, 2008, 2007 and 2006





2008
                            
                            
                            2007
                            
                            
                            2006CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
                            
                            $
                            2,010,819
                            
                            
                            $
                            6,248,756
                            
                            
                            $
                            4,903,534Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
                            
                            
                            786,668
                            
                            
                            
                            694,559
                            
                            
                            
                            698,754Provision
      for loan losses
                            
                            
                            6,484,543
                            
                            
                            
                            1,684,219
                            
                            
                            
                            990,786Amortization
      of core deposit intangible
                            
                            
                            133,349
                            
                            
                            
                            133,349
                            
                            
                            
                            58,384Accretion
      of fair value discount on loans
                            
                            
                            (439,820
                            )
                            
                            
                            (439,820
                            )
                            
                            
                            (109,955
                            )Amortization
      of fair value premium on deposits
                            
                            
                            185,550
                            
                            
                            
                            406,277
                            
                            
                            
                            102,846Deferred
      income taxes
                            
                            
                            (1,788,197
                            )
                            
                            
                            (502,749
                            )
                            
                            
                            (210,710
                            )(Gain)
      loss on disposition of assets
                            
                            
                            74,032
                            
                            
                            
                            65,685
                            
                            
                            
                            (2,782
                            )(Gain)
      on sale of securities
                            
                            
                            (15,535
                            )
                            
                            
                            -
                            
                            
                            
                            -Net
      (accretion) of premiums on securities
                            
                            
                            (80,314
                            )
                            
                            
                            (98,609
                            )
                            
                            
                            (20,023
                            )Net
      increase in cash surrender value life insurance
                            
                            
                            (689,221
                            )
                            
                            
                            (339,204
                            )
                            
                            
                            (200,180
                            )Stock
      based compensation
                            
                            
                            209,098
                            
                            
                            
                            178,940
                            
                            
                            
                            202,246Change
      in assets and liabilities:(Increase)
      decrease in accrued interest receivable
                            
                            
                            420,342
                            
                            
                            
                            (715,760
                            )
                            
                            
                            (592,718
                            )Increase
      in other assets
                            
                            
                            (1,621,319
                            )
                            
                            
                            (303,339
                            )
                            
                            
                            (579,977
                            )Increase
      in accrued interest payable
                            
                            
                            275,916
                            
                            
                            
                            444,620
                            
                            
                            
                            136,282Increase
      (decrease) in accrued expenses and other liabilities
                            
                            
                            17,730
                            
                            
                            
                            (292,252
                            )
                            
                            
                            269,732NET
      CASH PROVIDED BY OPERATING ACTIVITIES
                            
                            
                            5,963,641
                            
                            
                            
                            7,164,672
                            
                            
                            
                            5,646,219CASH
      FLOWS FROM INVESTING ACTIVITIESPurchase
      of investment securities available for sale
                            
                            
                            (28,064,996
                            )
                            
                            
                            (14,360,641
                            )
                            
                            
                            (25,248,980
                            )Proceeds
      from maturities and repayments of investment securities available for
      sale
                            
                            
                            12,685,891
                            
                            
                            
                            9,305,441
                            
                            
                            
                            6,646,100Proceeds
      from sale of securities available for sale
                            
                            
                            1,543,197
                            
                            
                            
                            -
                            
                            
                            
                            6,106,354Loan
      originations and principal collections, net
                            
                            
                            (113,399,801
                            )
                            
                            
                            (126,014,080
                            )
                            
                            
                            (93,267,698
                            )Purchases
      of premises and equipment
                            
                            
                            (3,538,541
                            )
                            
                            
                            (2,947,101
                            )
                            
                            
                            (1,679,226
                            )Proceeds
      from disposals of premises and equipment
                            
                            
                            -
                            
                            
                            
                            20,050
                            
                            
                            
                            800Proceeds
      from sales of foreclosed assets
                            
                            
                            727,648
                            
                            
                            
                            247,996
                            
                            
                            
                            127,450Purchases
      of Federal Home Loan Bank stock
                            
                            
                            (473,300
                            )
                            
                            
                            (3,207,900
                            )
                            
                            
                            (1,163,300
                            )Investment
      in life insurance
                            
                            
                            (7,000,000
                            )
                            
                            
                            (3,100,000
                            )
                            
                            
                            -Net
      cash (paid)/acquired in business combination
                            
                            
                            -
                            
                            
                            
                            (7,500
                            )
                            
                            
                            8,221,923NET
      CASH USED BY INVESTING ACTIVITIES
                            
                            
                            (137,519,902
                            )
                            
                            
                            (140,063,735
                            )
                            
                            
                            (100,256,577
                            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits accounts
                            
                            
                            109,265,892
                            
                            
                            
                            63,143,356
                            
                            
                            
                            75,510,351Net
      increase (decrease) in short-term borrowings
                            
                            
                            23,951,000
                            
                            
                            
                            (10,696,000
                            )
                            
                            
                            9,486,847Net
      increase (decrease) in long-term debt
                            
                            
                            (4,500,000
                            )
                            
                            
                            76,000,000
                            
                            
                            
                            15,000,000Proceeds
      from stock options exercised
                            
                            
                            670,254
                            
                            
                            
                            1,213,738
                            
                            
                            
                            255,797Net
      cash paid for fractional shares
                            
                            
                            -
                            
                            
                            
                            (7,687
                            )
                            
                            
                            (9,435
                            )Excess
      tax benefits from stock options exercised
                            
                            
                            95,500
                            
                            
                            
                            451,950
                            
                            
                            
                            45,401NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                            
                            
                            129,482,646
                            
                            
                            
                            130,105,357
                            
                            
                            
                            100,288,961NET
      INCERASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                            
                            
                            (2,073,615
                            )
                            
                            
                            (2,793,706
                            )
                            
                            
                            5,678,603CASH
      AND CASH EQUIVALENTS, BEGINNING
                            
                            
                            12,356,404
                            
                            
                            
                            15,150,110
                            
                            
                            
                            9,471,507CASH
      AND CASH EQUIVALENTS, ENDING
                            
                            $
                            10,282,789
                            
                            
                            $
                            12,356,404
                            
                            
                            $
                            15,150,110





Supplemental information (Notes N
and S)See accompanying
notes.





See
accompanying notes.


49


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
A - ORGANIZATION AND OPERATIONS





On June
29, 2001, Crescent Financial Corporation (the “Company”) was formed as a holding
company for Crescent State Bank (“CSB”). Upon formation, one share of the
Company’s $1 par value common stock was exchanged for each of the outstanding
shares of CSB’s $5 par value common stock.





CSB was
incorporated December 22, 1998 and began banking operations on December 31,
1998. CSB is engaged in general commercial and retail banking in Wake, Johnston,
Lee, Moore and New Hanover Counties, North Carolina, operating under the banking
laws of North Carolina and the rules and regulations of the Federal Deposit
Insurance Corporation and the North Carolina Commissioner of Banks. The Bank’s
operations in Moore and New Hanover Counties are the result of the 2003
acquisition of Centennial Bank and Trust and the 2006 acquisition of Port City
Capital Bank, respectively. CSB undergoes periodic examinations by those
regulatory authorities.





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Basis
of Presentation





The
accompanying consolidated financial statements include the accounts and
transactions of Crescent Financial Corporation and its wholly-owned subsidiary
Crescent State Bank. All significant intercompany transactions and balances have
been eliminated in consolidation.





Use
of Estimates





The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. Material estimates that are particularly susceptible to significant
change relate to the determination of the allowance for loan losses and
evaluation of goodwill for impairment .





Cash
and Cash Equivalents





For
purposes of the consolidated statements of cash flows, cash and cash equivalents
include cash and due from banks, interest-earning deposits with banks and
federal funds sold.





Securities
Available for Sale





Available
for sale securities are carried at fair value and consist of bonds, notes, and
marketable equity securities not classified as trading securities or as held to
maturity securities. Unrealized holding gains and losses on available for sale
securities are reported as a net amount in other comprehensive income, net of
related tax effects. Gains and losses on the sale of available for sale
securities are determined using the specific-identification method. Declines in
the fair value of individual held to maturity and available for sale securities
below their cost that are other than temporary would result in write-downs of
the individual securities to their fair value. Such write-downs would be
included in earnings as realized losses. Premiums and discounts are recognized
in interest income using the interest method over the period to
maturity.





Loans





Loans
that management has the intent and ability to hold for the foreseeable future,
or until maturity, are reported at their outstanding principal adjusted for any
charge-offs, the allowance for loan losses, and any deferred fees or costs on
originated loans and unamortized premiums or discounts on purchased or acquired
loans. Loan origination fees and certain direct origination costs are
capitalized and recognized as an adjustment of the yield of the related loan.
Interest on loans is recorded based on the principal amount outstanding. The
accrual of interest on impaired loans is discontinued when, in management’s
opinion, the borrower may be unable to meet payments as they become due.
Generally, loans are placed on nonaccrual when they are past due 90 days. While
a loan is classified as nonaccrual and the future collectability of the recorded
loan balance is doubtful, collections of interest and principal are generally
applied as a reduction to the principal outstanding. When the future
collectability of the recorded loan balance is not in doubt, interest income may
be recognized on a cash basis. When a loan is charged-off, all unpaid accrued
interest is reversed.


50


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Allowance
for Loan Losses





The
allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. The provision
for loan losses is based upon management’s best estimate of the amount needed to
maintain the allowance for loan losses at an adequate level. Loan losses are
charged against the allowance when management believes the uncollectability of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance.





The
allowance for loan losses is evaluated on a regular basis by management and is
based upon management’s periodic review of the collectability of the loans in
light of the current status of the portfolio, historical experience, the nature
and volume of the loan portfolio, adverse situations that may affect the
borrower’s ability to repay, estimated value of any underlying collateral, and
prevailing economic conditions. Management segments the loan portfolio by loan
type in considering each of the aforementioned factors and their impact upon the
level of the allowance for loan losses.





A loan is considered impaired when,
based on current information and events, it is probable that the Company will be
unable to collect the scheduled payments of principal or interest when due
according to the contractual terms of the loan agreement. Factors considered by
management in determining impairment include payment status, collateral value,
and the probability of collecting scheduled principal and interest payments when
due. Loans that experience insignificant payment delays and payment shortfalls
generally are not classified as impaired.





Management
determines the significance of payment delays and payment shortfalls on a
case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrower’s prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan by loan basis by either the present value of expected future
cash flows discounted at the loan’s effective interest rate, the loan’s
obtainable market price, or the fair value of the collateral if the loan is
collateral dependent.





Premises
and Equipment





Land is
carried at cost. Other components of premises and equipment are stated at cost
less accumulated depreciation. Depreciation is calculated on the straight-line
method over the estimated useful lives of the assets which are 37 - 40 years for
buildings and 3 - 10 years for furniture and equipment. Leasehold improvements
are amortized over the terms of the respective leases or the estimated useful
lives of the improvements, whichever is shorter. Repairs and maintenance costs
are charged to operations as incurred, and additions and improvements to
premises and equipment are capitalized. Upon sale or retirement, the cost and
related accumulated depreciation are removed from the accounts and any gains or
losses are reflected in current operations.





Foreclosed
Assets





Assets
acquired through, or in lieu of, loan foreclosure are held for sale and are
initially recorded at fair value at the date of foreclosure, establishing a new
cost basis. Subsequent to foreclosure, valuations are periodically performed by
management and the assets are carried at the lower of carrying amount or fair
value less cost to sell. Revenue and expenses from operations and changes in the
valuation allowance are included in net expenses from foreclosed
assets.


51


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Stock
in Federal Home Loan Bank of Atlanta





As a
requirement for membership, the Company invests in stock of the Federal Home
Loan Bank of Atlanta (“FHLB”). This investment is carried at cost. Due to the
redemption provisions of the FHLB, the Company estimated that fair value equals
cost and that this investment was not impaired at December 31,
2008.





Income
Taxes





Deferred
income taxes are recognized for the tax consequences of temporary differences
between financial statement carrying amounts and the tax bases of existing
assets and liabilities that will result in taxable or deductible amounts in
future years. These temporary differences are multiplied by the enacted income
tax rate expected to be in effect when the taxes become payable or receivable.
The effect on deferred taxes of a change in tax rates is recognized in income in
the period that includes the enactment date. Deferred tax assets are reduced, if
necessary, by the amount of such benefits that are not expected to be realized
based on available evidence.





The
Company adopted the provisions of FIN 48, Accounting for Uncertainty in Income
Taxes, on January 1, 2007 with no impact on the consolidated financial
statements. The Company did not recognize any interest or penalties related to
income tax during the years ended December 31, 2007 and 2008, and did no accrue
any interest or penalties as of December 31, 2008 or 2007. The Company did not
have an accrual for uncertain tax positions as deductions taken and benefits
accrued are based on widely understood administrative practices and procedures,
and are based on clear and unambiguous tax law. Tax returns for all years 2005
and thereafter are subject to possible future examinations by tax
authorities.





Goodwill
and Other
Intangibles





In July
2001, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible
Assets. SFAS No. 142 required companies to cease amortizing goodwill and
established a new method for testing goodwill for impairment on an annual basis.
The Company historically performed its annual test of goodwill impairment at
December 31, but elected to accelerate the testing for 2008 and future years to
October 31. In accordance with provisions of SFAS No. 142, all goodwill
resulting from business a combination is not being amortized. Other intangible
assets, consisting of premiums on purchased core deposits, are being amortized
over ten years principally using the straight-line method. The carrying amount
of goodwill and other intangible assets at December 31, 2008 amounted to
$30,233,049 and $959,641, respectively. The carrying amount of goodwill and
other intangible assets at December 31, 2007 amounted to $30,233,049 and
$1,092,990, respectively.





Impairment
or Disposal of Long-Lived Assets





The
Company’s long-lived assets are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used, such as bank
premises and equipment, is measured by a comparison of the carrying amount of an
asset to future net cash flows expected to be generated by the asset. If the
carrying amount of an asset exceeds its estimated future cash flows, an
impairment charge is recognized in the amount by which the carrying amount of
the asset exceeds the fair value of the asset. Assets to be disposed of, such as
foreclosed properties, are reported at the lower of the carrying amount or fair
value less costs to sell.





Stock
Compensation Plans





Effective
January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), Share-Based Payment ("SFAS
No. 123R"), which was issued by the FASB in December 2004. SFAS No. 123R revises
SFAS No. 123 Accounting for
Stock Based Compensation, and supersedes Accounting Principles Board
Opinion (“APB”) No. 25, Accounting for Stock Issued to
Employees, and its related interpretations. SFAS No. 123R requires
recognition of the cost of employee services received in exchange for an award
of equity instruments in the financial statements over the period the employee
is required to perform the services in exchange for the award (usually the
vesting period).


52


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Stock
Compensation Plans (Continued)





SFAS No.
123R also requires measurement of the cost of employee services received in
exchange for an award based on the grant-date fair value of the award. SFAS No.
123R also amends SFAS No. 95, Statement of Cash Flows, to
require that excess tax benefits be reported as financing cash inflows, rather
than as a reduction of taxes paid, which is included within operating cash
flows.





Per
Share Results





Basic and
diluted net income per share are computed by dividing net income available to
common shareholders by the weighted average number of common shares outstanding
during each period after retroactively adjusting for a 10% stock dividend
distributed on May 22, 2007. Diluted net income per share reflects the potential
dilution that could occur if common stock options and warrants were exercised,
resulting in the issuance of common stock that then shared in the net income of
the Company.





Basic and
diluted net income per share have been computed based upon net income available
to common shareholders as presented in the accompanying consolidated statements
of operations divided by the weighted average number of common shares
outstanding or assumed to be outstanding as summarized below:





2008
                    
                    
                    2007
                    
                    
                    2006Weighted
      average number of common shares used in computing basic net income per
      share
                    
                    
                    9,500,103
                    
                    
                    
                    9,211,779
                    
                    
                    
                    7,281,016Effect
      of dilutive stock options
                    
                    
                    174,540
                    
                    
                    
                    400,665
                    
                    
                    
                    331,632Effects
      of restricted stock
                    
                    
                    5,841
                    
                    
                    
                    23,250
                    
                    
                    
                    2,159Weighted
      average number of common shares and dilutive potential common shares used
      in computing diluted net income per share
                    
                    
                    9,680,484
                    
                    
                    
                    9,635,694
                    
                    
                    
                    7,614,807





For the
years ended December 31, 2008, 2007 and 2006, there were 90,109, 62,627 and
40,791 outstanding stock options, respectively, which were not included in the
computation of diluted earnings per share because they had no dilutive
effect.





Comprehensive
Income





The
Company reports as comprehensive income all changes in stockholders’ equity
during the year from sources other than shareholders. Other comprehensive income
refers to all components (revenues, expenses, gains, and losses) of
comprehensive income that are excluded from net income. The Company’s only
component of other comprehensive income is unrealized gains and losses on
investment securities available for sale.


53


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Comprehensive
Income (Continued)





The
components of other comprehensive income and related tax effects are as
follows:





2008
                  
                  
                  2007
                  
                  
                  2006Change
      in unrealized holding gains (losses) on available for sale
      securities
                  
                  $
                  973,930
                  
                  
                  $
                  881,765
                  
                  
                  $
                  289,891Tax
      effect
                  
                  $
                  (375,451
                  )
                  
                  $
                  (342,629
                  )
                  
                  $
                  (109,045
                  )Reclassification
      of gain on available for sale securities in net income
                  
                  
                  (15,535
                  )
                  
                  
                  -
                  
                  
                  
                  -Tax
      effect
                  
                  
                  5,989
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      unrealized holding gain on available for for sale
    securities
                  
                  $
                  588,933
                  
                  
                  $
                  539,136
                  
                  
                  $
                  180,846





Mortgage
Loan Origination and Other Fees





Mortgage
loan origination fees represent fees received for the origination of loans for
sale in the secondary market through the Company’s relationship with various
mortgage brokers. These fees are recognized in income as they are earned upon
the closing of each loan.





Fees
derived from leasing and investment transactions with Technology Capital
Partners and the Capital Investment Group,
Inc., respectively, are recognized in income as these transactions are
consummated.





Segment
Reporting





SFAS No.
131, Disclosure about Segments
of an Enterprise and Related Information, requires that public entities
disclose information about products and services provided by operating segments,
geographic areas and major customers, differences between the measurements used
in reporting segment information and those used in the entity’s general-purpose
financial statements, and changes in the measurement of segment amounts from
period to period.





Operating
segments are components of an enterprise with separate financial information
available for use by the chief operating decision maker to allocate resources
and to assess performance. The Company has determined that it has one
significant operating segment, the providing of financial services, including
commercial and retail banking, mortgage, and investment services, to customers
located in its market areas. The various products are those generally offered by
community banks, and the allocation of resources is based on the overall
performance of the Company, rather than the performance of individual branches
or products.





Recently
Adopted and Issued Accounting Standards





In
September 2006, the FASB ratified the consensuses reached by the FASB’s Emerging
Issues Task Force (“EITF”) relating to EITF 06-4, Accounting for the Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements. EITF 06-4 states that an employer accounting for
endorsement split-dollar life insurance arrangements that provide a benefit to
an employee that extends to postretirement periods should recognize a liability
for future benefits in accordance with SFAS No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, or Accounting Principles
Board (“APB”) Opinion No. 12, Omnibus Opinion—1967. The
Company adopted EITF 06-4 on January 1, 2008, and in connection therewith
recorded a liability of $141,808 as a reduction of retained earnings. Subsequent
increases in this liability will be reflected as an expense in determining
operating results.


54


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Recently
Adopted and Issued Accounting Standards (Continued)





SFAS
No. 157, Fair Value
Measurements, was issued in September 2006. In defining fair value, SFAS
No. 157 retains the exchange price notion in earlier definitions of fair value.
However, the definition of fair value under SFAS No. 157 focuses on the price
that would be received to sell an asset or paid to transfer a liability (an exit
price), not the price that would be paid to acquire the asset or received to
assume the liability (an entry price). SFAS No. 157 applies whenever other
accounting pronouncements require or permit assets or liabilities to be measured
at fair value. Accordingly, SFAS No. 157 does not expand the use of fair value
in any new circumstances. SFAS No. 157 also establishes a fair value hierarchy
that prioritizes the information used to develop assumptions used to determine
the exit price. Under this standard, fair value measurements would be disclosed
separately by level within the fair value hierarchy. The Company adopted SFAS
No. 157 effective January 1, 2008. The adoption of SFAS No. 157 had no
effect on the Company’s financial condition or results of operations. For
additional information on the fair value of certain financial assets and
liabilities, see Note B to the consolidated financial statements.





In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 creates a fair value
option allowing an entity irrevocably to elect fair value as the initial and
subsequent measurement attribute for certain financial assets and financial
liabilities, with changes in fair value recognized in earnings as they occur.
SFAS No. 159 requires an entity to report those financial assets and
financial





liabilities
measured at fair value in a manner that separates those reported fair values
from the carrying amounts of assets and liabilities measured using another
measurement attribute on the face of the statement of financial position. SFAS
No. 159 also requires an entity to provide information that would allow users to
understand the effect on earnings of changes in the fair value on those
instruments selected for the fair value election. The Company adopted SFAS No.
159 effective January 1, 2008. There was no initial effect of adoption
since the Company did not elect the fair value option for any existing asset or
liability. In addition, the Company did not elect the fair value option for any
financial assets originated or purchased, or for liabilities issued, through
December 31, 2008.





In
December 2007, the FASB issued SFAS No. 141(revised 2007), Business Combinations, (“SFAS
No. 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) establishes
principles and requirements for recognition and measurement of assets,
liabilities and any noncontrolling interest acquired due to a business
combination. SFAS No. 141(R) expands the definitions of a business and a
business combination, resulting in an increased number of transactions or other
events that will qualify as business combinations. Under SFAS No. 141(R) the
entity that acquires the business (the “acquirer”) will record 100 percent
of all assets and liabilities of the acquired business, including goodwill,
generally at their fair values. As such, an acquirer will not be permitted to
recognize the allowance for loan losses of the acquiree. SFAS No. 141(R)
requires the acquirer to recognize goodwill as of the acquisition date, measured
as a residual. In most business combinations, goodwill will be recognized to the
extent that the consideration transferred plus the fair value of any
noncontrolling interests in the acquiree at the acquisition date exceeds the
fair values of the identifiable net assets acquired. Under SFAS No. 141(R),
acquisition-related transaction and restructuring costs will be expensed as
incurred rather than treated as part of the cost of the acquisition and included
in the amount recorded for assets acquired. SFAS No. 141(R) is effective for
fiscal years beginning after December 15, 2008. Accordingly, for
acquisitions completed after December 31, 2008, the Company will apply the
provisions of SFAS No. 141(R).





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB 51, which defines
noncontrolling interest as the portion of equity in a subsidiary not
attributable, directly or indirectly, to the parent. SFAS No. 160 requires the
ownership interests in subsidiaries held by parties other than the parent
(previously referred to as minority interest) to be clearly presented in the
consolidated statement of financial position within equity, but separate from
the parent’s equity. The amount of consolidated net income attributable to the
parent and to any noncontrolling interest must be clearly presented on the face
of the consolidated statement of income. Changes in the parent’s ownership
interest while the parent retains its controlling financial interest (greater
than 50 percent ownership) are to be accounted for as equity transactions. Upon
a loss of control, any gain or loss on the interest sold will be recognized in
earnings. Additionally, any ownership interest retained will be remeasured at
fair value on the date control is lost, with any gain or loss recognized in
earnings. SFAS No. 160 is effective for fiscal years beginning after
December 15, 2008. Accordingly, the Company will adopt the provisions of
SFAS No. 160 in the first quarter 2009. The Company does not expect the adoption
of the provisions of SFAS No. 160 to have a material effect on its financial
condition and results of operations.


55


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)





Recently
Adopted and Issued Accounting Standards (Continued)




SFAS
No. 161, Disclosures
about Derivative Instruments and Hedging Activities, an amendment of FASB
Statement No. 133, issued in March 2008, requires enhanced
disclosures about an entity’s derivative and hedging activities. These enhanced
disclosures will discuss (a) how and why an entity uses derivative
instruments; (b) how derivative instruments and related hedged items are
accounted for under SFAS No. 133, and its related interpretations; and
(c) how derivative instruments and related hedged items affect an entity’s
financial position, financial performance, and cash flows. SFAS No. 161 is
effective for financial statements issued for fiscal years beginning after
November 15, 2008 with earlier adoption allowed. The Company does not
believe that the adoption of SFAS No. 161 will have a material effect on its
financial condition or results of operations.





FSP No.
FAS 157-3, Determining the
Fair Value of a Financial Asset When the Market for That Asset Is Not
Active (“FSP FAS 157-3”), issued in October 2008, clarifies the
application of SFAS No. 157 in a market that is not active and provides an
example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not active. FSP FAS
157-3 was effective upon issuance, including prior periods for which financial
statements have not been issued. Revisions resulting from a change in the
valuation technique or its application should be accounted for as a change in
accounting estimate following the guidance in SFAS No. 154, Accounting Changes and Error
Corrections. However, the disclosure provisions in SFAS No. 154 for a
change in accounting estimate are not required for revisions resulting from a
change in valuation technique or its application. As FSP FAS 157-3 clarified but
did not change the application of SFAS No. 157, the adoption of FSP FAS 157-3
had no effect on the Company’s financial condition or results of
operations.





Other
accounting standards that have been issued or proposed by the FASB or other
standards-setting bodies are not expected to have a material impact on the
Company’s financial position, results of operations and cash flows.





From time
to time the FASB issues exposure drafts for proposed statements of financial
accounting standards. Such exposure drafts are subject to comment from the
public, to revisions by the FASB and to final issuance by the FASB as statements
of financial accounting standards. Management considers the effect of the
proposed statements on the consolidated financial statements of the Company and
monitors the status of changes to and proposed effective dates of exposure
drafts.





NOTE
C - INVESTMENT SECURITIES





The
following is a summary of the securities portfolios by major
classification:





December 31, 2008Gross
                
                
                GrossAmortized
                
                
                unrealized
                
                
                unrealized
                
                
                Faircost
                
                
                gains
                
                
                losses
                
                
                valueSecurities
      available for sale:U.S.
      government securities and obligations of U.S. government
      agencies
                
                $
                10,664,833
                
                
                $
                169,315
                
                
                $
                2,313
                
                
                $
                10,831,835Mortgage-backed
                
                
                67,308,567
                
                
                
                1,707,655
                
                
                
                39,863
                
                
                
                68,976,359Municipals
                
                
                26,089,420
                
                
                
                177,788
                
                
                
                917,537
                
                
                
                25,349,671Other
      equity securities
                
                
                565,255
                
                
                
                4,989
                
                
                
                79,491
                
                
                
                490,753$
                104,628,075
                
                
                $
                2,059,747
                
                
                $
                1,039,204
                
                
                $
                105,648,618


56


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
C - INVESTMENT SECURITIES (Continued)





December 31, 2007Gross
                  
                  
                  GrossAmortized
                  
                  
                  unrealized
                  
                  
                  unrealized
                  
                  
                  Faircost
                  
                  
                  gains
                  
                  
                  losses
                  
                  
                  valueSecurities
      available for sale:U.S.
      government securities and obligations of U.S.government
      agencies
                  
                  $
                  8,363,741
                  
                  
                  $
                  18,464
                  
                  
                  $
                  69,981
                  
                  
                  $
                  8,312,224Mortgage-backed
                  
                  
                  56,986,240
                  
                  
                  
                  565,175
                  
                  
                  
                  317,786
                  
                  
                  
                  57,233,629Municipals
                  
                  
                  24,810,061
                  
                  
                  
                  136,974
                  
                  
                  
                  251,986
                  
                  
                  
                  24,695,049Other
      equity securities
                  
                  
                  536,278
                  
                  
                  
                  -
                  
                  
                  
                  18,713
                  
                  
                  
                  517,565$
                  90,696,320
                  
                  
                  $
                  720,613
                  
                  
                  $
                  658,466
                  
                  
                  $
                  90,758,467





Proceeds
from sales of available for sale securities in 2008 totaled $1,543,197 resulting
in gross gains of $15,535 and no losses.  There were no sales of available
for sale securities in 2007 or 2006.





The
following tables show investments’ gross unrealized losses and fair values,
aggregated by investment category and length of time that the individual
securities have been in a continuous unrealized loss position, at December 31,
2008 and 2007. The 2008 unrealized losses on investment securities relate to two
U.S. Government agency securities, nine mortgage-backed securities, twenty-six
municipal securities and one marketable equity security. The 2007 unrealized
losses on investment securities relate to eleven U.S. Government agency
securities, forty-one mortgage-backed securities, twenty-six municipal
securities and one marketable equity security. The unrealized losses relate to
debt securities that have incurred fair value reductions due to higher market
interest rates since the securities were purchased. The unrealized losses will
reverse at maturity or prior to maturity if market interest rates decline to
levels that existed when the securities were purchased. Since none of the
unrealized losses relate to the marketability of the securities or the issuer’s
ability to honor redemption obligations, none of the securities are deemed to be
other than temporarily impaired.





December 31, 2008Less Than 12 Months
                
                
                12 Months or More
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealizedvalue
                
                
                losses
                
                
                value
                
                
                losses
                
                
                value
                
                
                lossesSecurities
      available for sale:U.S.
      government securities and obligations of U.S. government
      agencies
                
                $
                972,624
                
                
                $
                2,313
                
                
                $
                -
                
                
                $
                -
                
                
                $
                972,624
                
                
                $
                2,313Mortgage-backed
                
                
                1,768,974
                
                
                
                22,558
                
                
                
                1,097,179
                
                
                
                17,305
                
                
                
                2,866,153
                
                
                
                39,863Municipals
                
                
                13,246,896
                
                
                
                755,550
                
                
                
                986,586
                
                
                
                161,987
                
                
                
                14,233,482
                
                
                
                917,537Other
      equity securities
                
                
                -
                
                
                
                -
                
                
                
                206,366
                
                
                
                79,491
                
                
                
                206,366
                
                
                
                79,491Total
      temporarily impaired securities
                
                $
                15,988,494
                
                
                $
                780,421
                
                
                $
                2,290,131
                
                
                $
                258,783
                
                
                $
                18,278,625
                
                
                $
                1,039,204




57


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
C - INVESTMENT SECURITIES (Continued)





December 31, 2007Less Than 12 Months
                
                
                12 Months or More
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealizedvalue
                
                
                losses
                
                
                value
                
                
                losses
                
                
                value
                
                
                lossesSecurities
      available for sale:U.S.
      government securities and obligations of U.S. government
      agencies
                
                $
                1,203,508
                
                
                $
                3,656
                
                
                $
                5,061,756
                
                
                $
                66,325
                
                
                $
                6,265,264
                
                
                $
                69,981Mortgage-backed
                
                
                631,014
                
                
                
                1,868
                
                
                
                20,335,222
                
                
                
                315,918
                
                
                
                20,966,236
                
                
                
                317,786Municipals
                
                
                11,201,733
                
                
                
                206,927
                
                
                
                4,175,358
                
                
                
                45,059
                
                
                
                15,377,091
                
                
                
                251,986Other
      equity securities
                
                
                517,565
                
                
                
                18,713
                
                
                
                -
                
                
                
                -
                
                
                
                517,565
                
                
                
                18,713Total
      temporarily impaired securities
                
                $
                13,553,820
                
                
                $
                231,164
                
                
                $
                29,572,336
                
                
                $
                427,302
                
                
                $
                43,126,156
                
                
                $
                658,466





At
December 31, 2008 and 2007, investment securities with a carrying value of
$63,602,694 and $52,731,007, respectively, were pledged to secure public
deposits, borrowings and for other purposes required or permitted by
law.





The
amortized cost and fair values of securities available for sale at December 31,
2008 by expected maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.





Amortized
                  
                  
                  Faircost
                  
                  
                  valueDue
      within one year
                  
                  $
                  20,454,872
                  
                  
                  $
                  20,783,177Due
      after one year through five years
                  
                  
                  35,911,568
                  
                  
                  
                  36,680,193Due
      after five years through ten years
                  
                  
                  29,190,006
                  
                  
                  
                  29,354,205Due
      after ten years
                  
                  
                  18,506,374
                  
                  
                  
                  18,340,289Other
      equity securities
                  
                  
                  565,255
                  
                  
                  
                  490,754$
                  104,628,075
                  
                  
                  $
                  105,648,618




58


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
C - INVESTMENT SECURITIES (Continued)





The
following table presents the carrying values, intervals of maturities or
repricings, and weighted average tax equivalent yields of our investment
portfolio at December 31, 2008:





Repricing or MaturingLess than
                
                
                One to
                
                
                Five to
                
                
                Over tenone year
                
                
                five years
                
                
                ten years
                
                
                years
                
                
                Total(Dollars
      in thousands)Securities
      available for sale:U.
      S. government agenciesBalance
                
                $
                501
                
                
                $
                1,428
                
                
                $
                8,903
                
                
                $
                -
                
                
                $
                10,832Weighted
      average yield
                
                
                3.52
                %
                
                
                4.62
                %
                
                
                4.98
                %
                
                
                %
                
                
                4.87
                %Mortgage-backed
      securitiesBalance
                
                $
                19,005
                
                
                $
                29,825
                
                
                $
                9,397
                
                
                $
                10,749
                
                
                $
                68,976Weighted
      average yield
                
                
                5.14
                %
                
                
                5.13
                %
                
                
                5.25
                %
                
                
                5.31
                %
                
                
                5.18
                %Municipal
      securitiesBalance
                
                $
                1,277
                
                
                $
                5,427
                
                
                $
                11,054
                
                
                $
                7,591
                
                
                $
                25,349Weighted
      average yield
                
                
                3.87
                %
                
                
                3.59
                %
                
                
                4.19
                %
                
                
                4.27
                %
                
                
                3.88
                %OtherBalance
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                491
                
                
                $
                491Weighted
      average yield
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -TotalBalance
                
                $
                20,783
                
                
                $
                36,680
                
                
                $
                29,354
                
                
                $
                18,831
                
                
                $
                105,648Weighted
      average yield
                
                
                5.02
                %
                
                
                4.88
                %
                
                
                4.76
                %
                
                
                4.72
                %
                
                
                4.84
                %





NOTE
D - LOANS





Following
is a summary of loans at December 31, 2008 and 2007.





2008
                  
                  
                  2007Real
      estate - commercial
                  
                  $
                  470,433,295
                  
                  
                  $
                  350,961,251Real
      estate - residential
                  
                  
                  19,144,388
                  
                  
                  
                  18,256,566Construction
      loans
                  
                  
                  160,967,248
                  
                  
                  
                  184,019,364Commercial
      and industrial loans
                  
                  
                  76,134,300
                  
                  
                  
                  72,930,108Home
      equity loans and lines of credit
                  
                  
                  54,374,120
                  
                  
                  
                  45,258,071Loans
      to individuals
                  
                  
                  5,369,606
                  
                  
                  
                  5,488,818Total
      loans
                  
                  
                  786,422,957
                  
                  
                  
                  676,914,178Less:Deferred
      loan fees
                  
                  
                  (1,045,674
                  )
                  
                  
                  (997,948
                  )Allowance
      for loan losses
                  
                  
                  (12,585,000
                  )
                  
                  
                  (8,273,000
                  )Total
                  
                  $
                  772,792,283
                  
                  
                  $
                  667,643,228





Loans are
primarily made in the Company’s market area of North Carolina, principally Wake,
Johnston, Lee, Moore, and New Hanover counties. Real estate loans can be
affected by the condition of the local real estate market. Commercial and
consumer and other loans can be affected by the local economic
conditions.


59


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
D - LOANS (Continued)





No loans
have been restructured during 2008 or 2007. At December 31, 2008, the recorded
investment in loans considered impaired in accordance with SFAS No. 114 totaled
$16.7 million. Of the total investment in loans considered impaired, $14.4
million were found to show specific impairment for which $4.1 million in
valuation allowance was recorded; no valuation allowance for the other impaired
loans was considered necessary. For the year ended December 31, 2008, the
average recorded investment in impaired loans was approximately $3.6 million.
The amount of interest recognized on impaired loans during the portion of the
year that they were considered impaired was not material.





At
December 31, 2007, the recorded investment in loans considered impaired in
accordance with SFAS No. 114 totaled $4.2 million. The corresponding valuation
allowance for impaired loans with a recorded investment of $3.9 million amounted
to $1.1 million. For the year ended December 31, 2007, the average recorded
investment in impaired loans was approximately $3.8 million. The amount of
interest recognized on impaired loans during the portion of the year that they
were considered impaired was not material.





The
Company has granted loans to certain directors and executive officers of the
Company and their related interests. Such loans are made on substantially the
same terms, including interest rates and collateral, as those prevailing at the
time for comparable transactions with other borrowers and, in management’s
opinion, do not involve more than the normal risk of collectability. All loans
to directors and executive officers or their related interests are submitted to
the Board of Directors for approval. A summary of loans to directors, executive
officers and their interests follows:





Loans
      to directors and officers as a group at December 31, 2007
                  
                  $
                  30,369,411Net
      disbursements during year ended December 31, 2008
                  
                  
                  12,811,378Loans
      to directors and officers as a group at December 31, 2008
                  
                  $
                  43,180,789





At
December 31, 2008, the Company had pre-approved but unused lines of credit
totaling $6.6 million to executive officers, directors and their related
interests. No additional funds were committed to be advanced at December 31,
2008.





An
analysis of the allowance for loan losses follows:





2008
                  
                  
                  2007
                  
                  
                  2006Balance
      at beginning of year
                  
                  $
                  8,273,000
                  
                  
                  $
                  6,945,000
                  
                  
                  $
                  4,351,000Provision
      for loan losses
                  
                  
                  6,484,543
                  
                  
                  
                  1,684,219
                  
                  
                  
                  990,786Charge-offs
                  
                  
                  (2,187,104
                  )
                  
                  
                  (362,363
                  )
                  
                  
                  (85,571
                  )Recoveries
                  
                  
                  14,561
                  
                  
                  
                  6,144
                  
                  
                  
                  2,168Net
      charge-offs
                  
                  
                  (2,172,543
                  )
                  
                  
                  (356,219
                  )
                  
                  
                  (83,403
                  )Allowance
      recorded related to loans acquired in acquisition of Port City Capital
      Bank
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,686,617Balance
      at end of year
                  
                  $
                  12,585,000
                  
                  
                  $
                  8,273,000
                  
                  
                  $
                  6,945,000




60


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
E - PREMISES AND EQUIPMENT





Following
is a summary of premises and equipment at December 31, 2008 and
2007:





2008
                  
                  
                  2007Land
                  
                  $
                  4,280,213
                  
                  
                  $
                  2,997,306Buildings
      and leasehold improvements
                  
                  
                  4,940,581
                  
                  
                  
                  3,937,770Furniture
      and equipment
                  
                  
                  5,354,601
                  
                  
                  
                  4,360,112Less
      accumulated depreciation
                  
                  
                  (3,730,346
                  )
                  
                  
                  (3,200,667
                  )Total
                  
                  $
                  10,845,049
                  
                  
                  $
                  8,094,521





Depreciation
and amortization amounting to $786,668 in 2008, $694,559 in
2007 and $698,754 in 2006 is included in occupancy and equipment
expense.





NOTE
F - GOODWILL AND OTHER INTANGIBLES





The
following is a summary of goodwill and other intangible assets at December 31,
2008 and 2007:





2008
                    
                    
                    2007(Amounts
      in thousands)Goodwill,
      beginning of year
                    
                    $
                    30,233,049
                    
                    
                    $
                    30,225,549Goodwill
      acquired during the year
                    
                    
                    -
                    
                    
                    
                    7,500Goodwill,
      end of year
                    
                    $
                    30,233,049
                    
                    
                    $
                    30,233,049Other
      intangibles – gross
                    
                    $
                    1,333,493
                    
                    
                    $
                    1,333,493Less
      accumulated amortization
                    
                    
                    373,852
                    
                    
                    
                    240,503Other
      intangibles – net
                    
                    $
                    959,641
                    
                    
                    $
                    1,092,990





Other
intangibles amortization expense for the years ended December 31, 2008, 2007 and
2006 amounted to $133,349, $133,349 and $58,384, respectively. The following
table presents estimated amortization expense for other
intangibles.





Estimated
      Amortization Expense(Amounts
      in thousands)For
      the Year Ending December 31:2009
                
                $
                133,3492010
                
                
                133,3492011
                
                
                133,3492012
                
                
                133,3492013
                
                
                126,383Thereafter
                
                
                299,862$
                959,641





Management
tests goodwill for impairment on an annual basis, or more often if events or
circumstances indicate there may be impairment. If the carrying amount of a
reporting unit’s goodwill exceeds its implied fair value, the Company would
recognize an impairment loss in an amount equal to that excess.


61


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
F - GOODWILL AND OTHER INTANGIBLES (Continued)





Fair
value of the reporting unit in 2008 was determined using two methods, one based
on the price as a multiple of tangible equity capital for which similar units
have sold and one based on discounted cash flow models with estimated cash flows
based on internal forecasts of net income. These two methods provided a range of
valuations that Management used in evaluating goodwill for possible impairment.
Our goodwill impairment testing for 2008, which was updated at December 31,
2008 as a result of the recent decline in our common stock price and net
earnings, indicated that our goodwill was not impaired. As a result of the
recent decline in our stock price, the excess of the fair value over carrying
value narrowed in our assessment. If our stock price continues to decline, if
the Company does not produce anticipated cash flows, or if similar units begin
selling at significantly lower prices than in the past, our goodwill may be
impaired in the future.





NOTE
G - DEPOSITS





The
weighted average cost of time deposits was 4.54% and 5.09% at December
31, 2008 and 2007, respectively.





At
December 31, 2008, the scheduled maturities of certificates of deposit are as
follows:





Less
      than
                    
                    
                    $100,000$100,000
                    
                    
                    or more
                    
                    
                    Total(In
      thousands)Three
      months or less
                    
                    $
                    22,181
                    
                    
                    $
                    35,202
                    
                    
                    $
                    57,383Over
      three months through one year
                    
                    
                    43,043
                    
                    
                    
                    144,483
                    
                    
                    
                    187,526Over
      one year through three years
                    
                    
                    27,957
                    
                    
                    
                    156,174
                    
                    
                    
                    184,131Over
      three years to five years
                    
                    
                    8,753
                    
                    
                    
                    23,768
                    
                    
                    
                    32,521Total
                    
                    $
                    101,934
                    
                    
                    $
                    359,627
                    
                    
                    $
                    461,561





NOTE
H - BORROWINGS





Borrowings
are comprised of the following at December 31, 2008 and 2007:





2008
                  
                  
                  2007Short-term
      borrowings:Federal
      funds purchased
                  
                  $
                  8,706,000
                  
                  
                  $
                  3,755,000Federal
      Home Loan Bank advances maturing within one year
                  
                  
                  29,000,000
                  
                  
                  
                  10,000,000Total
      short-term borrowings
                  
                  $
                  37,706,000
                  
                  
                  $
                  13,755,000Long-term
      debt:Federal
      Home Loan Bank advances maturing beyond one year
                  
                  $
                  99,000,000
                  
                  
                  $
                  113,000,000Junior
      subordinated debentures
                  
                  
                  8,248,000
                  
                  
                  
                  8,248,000Subordinated
      term loan
                  
                  
                  7,500,000
                  
                  
                  
                  -Holding
      company line of credit
                  
                  
                  2,000,000
                  
                  
                  
                  -Total
      long-term debt
                  
                  $
                  116,748,000
                  
                  
                  $
                  121,248,000




62


CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006





NOTE
H - BORROWINGS (Continued)





Short-term
Borrowings





The
Company may purchase federal funds through unsecured federal funds guidance
lines of credit totaling $59.0 million at December 31, 2008. These lines are
intended for short-term borrowings and are subject to restrictions limiting the
frequency and terms of advances. These lines of credit are payable on demand and
bear interest based upon the daily federal funds rate. The Company had
$8,706,000 outstanding balance on the lines of credit as of December 31, 2008
compared to $3,755,000 at December 31, 2007.





A summary
of selected data related to short-term borrowed funds follows:





For the Year Ended December
    31,2008
                
                
                2007(Dollars
      in thousands)Short-term
      borrowings:Federal
      funds purchased:Balance
      outstanding at end of year
                
                $
                8,706
                
                
                $
                3,755Maximum
      amount outstanding at any month end during the year
                
                
                20,894
                
                
                
                6,652Average
      balance outstanding during the year
                
                
                4,010
                
                
                
                3,661Weighted-average
      interest rate during the year
                
                
                2.87
                %
                
                
                5.40
                %Weighted-average
      interest rate at end of year
                
                
                1.00
                %
                
                
                4.57
                %





Junior
Subordinated Debentures





In 2003,
the Company issued $8,248,000 of junior subordinated debentures to Crescent
Financial Capital Trust I (the “Trust”) in exchange for the proceeds of trust
preferred securities issued by the Trust. The junior subordinated debentures are
included in long-term debt and the Company’s equity interest in the trust is
included in other assets.





The
junior subordinated debentures pay interest quarterly at an annual rate, reset
quarterly, equal to three month LIBOR plus 3.10%. The debentures are redeemable
on October 7, 2008 or afterwards, in whole or in part, on any January 7, April
7, July 7, or October 7. Redemption is mandatory at October 7, 2033. The Company
guarantees the trust preferred securities through the combined operation of the
junior subordinated debentures and other related documents. The Company’s
obligation under the guarantee is unsecured and subordinate to senior and
subordinated indebtedness of the Company.





The trust
preferred securities presently qualify as Tier 1 regulatory capital and are
reported in Federal Reserve regulatory reports as a minority interest in a
consolidated subsidiary. The junior subordinated debentures do not qualify as
Tier 1 regulatory capital. On March 1, 2005, the Board of Governors of the
Federal Reserve issued a final rule stating that trust preferred securities will
continue to be included in Tier 1 capital, subject to stricter quantitative and
qualitative standards.  For Bank Holding Companies, trust preferred
securities will continue to be included in Tier 1 capital up to 25% of core
capital elements (including trust preferred securities) net of goodwill less any
associate deferred tax liability.





Subordinated
Term Loan Agreement





On
September 26, 2008, the Company entered into a $7.5 million subordinated term
loan agreement with a non-affiliated financial institution.  The
subordinated term loan is included in long-term debt.





The
subordinated term loan pays interest quarterly at an annual rate, reset
quarterly, equal to three month LIBOR plus 4.00%.The subordinated term loan
agreement matures on October 18, 2018 and can be prepaid, subject to the
approval of the FDIC and other Governmental Authorities (if applicable), in
incremental amounts not less than $500,000, by giving five business days notice
prior to prepayment.  The Company does not have the right to prepay
all or any portion of the loan prior to October 1, 2013 unless the loan ceases
to be deemed Tier 2 capital for regulatory capital
purposes.


63




CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
H - BORROWINGS (Continued)
 
 Should
the loan cease to be considered Tier 2 capital for regulatory capital purposes,
the debt can either be structured as senior debt of the Company or be
repaid.  The principal reason for entering into the subordinated term
loan agreement was to enhance our regulatory capital position.
 
 Federal
Home Loan Bank Advances
 
 The
Company has a $290.4 million credit line available with the Federal Home Loan
Bank for advances.  These advances are secured by a blanket floating
lien on qualifying commercial real estate, first mortgage loans and pledged
investment securities with a market value of $269.3 million.
 
 At
December 31, 2008 and 2007, the Company had the following advances outstanding
from the Federal Home Loan Bank of Atlanta:
 
 Maturity
                    
                    Interest Rate
                    
                    Rate Type
                    
                    2008
                    
                    
                    2007December
      6, 2012
                    
                    
                    4.22
                    %
                    Fixed
                    
                    $
                    5,000,000
                    
                    
                    $
                    5,000,000July
      16, 2012
                    
                    
                    3.84
                    %
                    Convertible
                    
                    
                    5,000,000
                    
                    
                    
                    5,000,000April
      12, 2010
                    
                    
                    4.58
                    %
                    Fixed
                    
                    
                    7,000,000
                    
                    
                    
                    7,000,000June
      9, 2010
                    
                    
                    3.58
                    %
                    Fixed
                    
                    
                    7,000,000
                    
                    
                    
                    -June
      9, 2011
                    
                    
                    3.94
                    %
                    Fixed
                    
                    
                    8,000,000
                    
                    
                    
                    -October
      21, 2009
                    
                    
                    4.72
                    %
                    Fixed
                    
                    
                    9,000,000
                    
                    
                    
                    9,000,000July
      28, 2008
                    
                    
                    4.40
                    %
                    Prime
      Based
                    
                    
                    -
                    
                    
                    
                    10,000,000August
      21, 2009
                    
                    
                    4.71
                    %
                    Fixed
                    
                    
                    10,000,000
                    
                    
                    
                    10,000,000September
      10, 2009
                    
                    
                    4.62
                    %
                    Fixed
                    
                    
                    10,000,000
                    
                    
                    
                    10,000,000March
      9, 2012
                    
                    
                    4.29
                    %
                    Convertible
                    
                    
                    10,000,000
                    
                    
                    
                    10,000,000March
      25, 2019
                    
                    
                    0.97
                    %
                    Convertible
                    
                    
                    10,000,000
                    
                    
                    
                    10,000,000January
      28, 2019
                    
                    
                    0.05
                    %
                    Convertible
                    
                    
                    12,000,000
                    
                    
                    
                    12,000,000August
      29, 2012
                    
                    
                    4.00
                    %
                    Convertible
                    
                    
                    15,000,000
                    
                    
                    
                    15,000,000May
      18, 2012
                    
                    
                    4.49
                    %
                    Convertible
                    
                    
                    20,000,000
                    
                    
                    
                    20,000,000Totals
                    
                    
                    
                    
                    
                    
                    $
                    128,000,000
                    
                    
                    $
                    123,000,000
 
 Borrowings
maturing on March 9, 2012, May 18, 2012 and August 29, 2012 are fixed rate
advances, convertible quarterly, at the discretion of the Federal Home Loan
Bank, to a variable rate based on 3-month LIBOR.  The borrowing
maturing on July 16, 2012 is a fixed rate advance, convertible quarterly to a
variable rate based on 3-month LIBOR, only if 3-month LIBOR is greater than or
equal to 7%.  The borrowing maturing on January 28, 2019 is currently
based on 1-month LIBOR minus 42.5 basis points until January 27, 2009 at which
time it becomes fixed at 3.90%.  The borrowing maturing on March 25,
2019 is currently a variable rate based on 3-month LIBOR minus 50 basis points
until March 25, 2009, at which time it becomes fixed at 4.26%.
 
 Holding
Company Line of Credit
 
 On June
27, 2008, the Company entered into a $10.0 million holding company line of
credit with a correspondent financial institution.There was $2.0
million outstanding on this line at December 31, 2008 and is included in
long-term debt.  The line is revolving and pays interest quarterly at
an annual rate, reset daily, equal to the Prime rate of interest minus
1.125%.  The line matures on June 27, 2010 and is secured by 258,000
shares of Crescent State Bank stock.
  64
  CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
I - LEASES
 
 The
Company has entered into fourteen non-cancelable operating leases for its main
office, operations center, and branch facilities. Future minimum lease payments
under these leases for the years ending December 31 are approximately as
follows:
 
 2009
                    
                    $
                    1,600,0002010
                    
                    
                    1,598,0002011
                    
                    
                    1,505,0002012
                    
                    
                    1,373,0002013
                    
                    
                    1.298,000Thereafter
                    
                    
                    9,524,000Total
                    
                    $
                    16,898,000
 
 The
leases contain renewal options for various additional terms after the expiration
of the initial term of each lease.  The cost of such renewals is not
included above.  Total rent expense for the years ended December 31,
2008, 2007 and 2006  amounted to $1,308,210, $1,090,669 and $892,734,
respectively.
 
 NOTE
J - INCOME TAXES
 
 The
significant components of the provision for income taxes for the years ended
December 31, 2008, 2007 and 2006 are as follows:
 2008
                    
                    
                    2007
                    
                    
                    2006Current
      tax provision:Federal
                    
                    $
                    1,910,369
                    
                    
                    $
                    3,246,706
                    
                    
                    $
                    2,422,394State
                    
                    
                    476,528
                    
                    
                    
                    776,243
                    
                    
                    
                    568,9162,386,897
                    
                    
                    
                    4,022,949
                    
                    
                    
                    2,991,310Deferred
      tax provision (benefit):Federal
                    
                    
                    (1,473,490
                    )
                    
                    
                    (404,347
                    )
                    
                    
                    (153,224
                    )State
                    
                    
                    (314,707
                    )
                    
                    
                    (98,402
                    )
                    
                    
                    (57,486
                    )(1,788,197
                    )
                    
                    
                    (502,749
                    )
                    
                    
                    (210,710
                    )Provision
      for income taxes
                    
                    $
                    598,700
                    
                    
                    $
                    3,520,200
                    
                    
                    $
                    2,780,600
 
 The
difference between the provision for income taxes and the amounts computed by
applying the statutory federal income tax rate of 34% to income before income
taxes is summarized below:
 
 2008
                    
                    
                    2007
                    
                    
                    2006Tax
      computed at statutory rate of 34%
                    
                    $
                    887,237
                    
                    
                    $
                    3,321,445
                    
                    
                    $
                    2,612,868Effect
      of state income taxes
                    
                    
                    106,802
                    
                    
                    
                    447,375
                    
                    
                    
                    337,544Non-taxable
      income
                    
                    
                    (279,751
                    )
                    
                    
                    (256,218
                    )
                    
                    
                    (217,265
                    )Non-taxable
      Bank Owned Life Insurance
                    
                    
                    (234,335
                    )
                    
                    
                    (115,329
                    )
                    
                    
                    (77,169
                    )Other
                    
                    
                    118,747
                    
                    
                    
                    122,927
                    
                    
                    
                    124,622$
                    598,700
                    
                    
                    $
                    3,520,200
                    
                    
                    $
                    2,780,600
  65
  CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
J - INCOME TAXES (Continued)
 
 Significant
components of deferred taxes at December 31, 2008 and 2007 are as
follows:
 
 2008
                    
                    
                    2007Deferred
      tax assets:Allowance
      for loan losses
                    
                    $
                    4,792,148
                    
                    
                    $
                    3,082,684Premises
      and equipment
                    
                    
                    180,587
                    
                    
                    
                    158,062Rent
      abatement
                    
                    
                    3,711
                    
                    
                    
                    7,759Fair
      value adjustments
                    
                    
                    110,567
                    
                    
                    
                    250,521Deferred
      compensation
                    
                    
                    475,521
                    
                    
                    
                    342,897Other
                    
                    
                    155,802
                    
                    
                    
                    115,268Net
      deferred tax assets
                    
                    
                    5,718,336
                    
                    
                    
                    3,957,191Deferred
      tax liabilities:Intangible
      assets
                    
                    
                    (369,980
                    )
                    
                    
                    (421,391
                    )Deferred
      loan costs
                    
                    
                    (76,280
                    )
                    
                    
                    (80,021
                    )Unrealized
      gain on securities
                    
                    
                    (393,420
                    )
                    
                    
                    (23,958
                    )Prepaid
      expenses
                    
                    
                    (163,217
                    )
                    
                    
                    (135,117
                    )Net
      deferred tax liabilities
                    
                    
                    (1,002,897
                    )
                    
                    
                    (660,487
                    )Net
      deferred tax asset included in other assets
                    
                    $
                    4,715,439
                    
                    
                    $
                    3,296,704
 
 It is
management’s opinion that realization of the net deferred tax asset is more
likely than not based on the Company’s history of taxable income and estimates
of future taxable income.
 
 Effective
January 1, 2007, the Company adopted Financial Accounting Standards Board
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, an interpretation of FASB Statement 109 (FIN 48). FIN 48 provides
guidance on financial statement recognition and measurements of tax positions
taken, or expected to be taken, in tax returns.  The initial adoption
of FIN 48 had no impact on the Company’s financial statements.  As of
January 1, 2008, there were no unrecognized tax benefits.
 
 When tax
returns are filed, it is highly certain that some positions taken would be
sustained upon examination by the taxing authorities, while others are subject
to uncertainty about the merits of the position taken or the amount of the
position that would be ultimately sustained.  The benefit of a tax
position is recognized in the financial statements in the period during which,
based on all available evidence, management believes it is more likely than not
that the position will be sustained upon examination, including the resolution
of appeals or litigation processes, if any.   Tax positions taken
are not offset or aggregated with other positions.  Tax positions that
meet the more-likely-than-not recognition threshold are measured as the largest
amount of tax benefit that is more than 50 percent likely of being realized upon
settlement with the applicable taxing authority.  The portion of the
benefits associated with tax positions taken that exceeds the amount measured as
described above is reflected as a liability for unrecognized tax benefits in the
accompanying consolidated balance sheet along with any associated interest and
penalties that would be payable to the taxing authorities upon
examination.
 
 Crescent’s
federal and state income tax returns are open and subject to examination from
the 2005 tax return year and forward.
  66
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
K - NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE
 
 The major
components of non-interest income for the years ended December 31, 2008, 2007
and 2006 are as follows:
 2008
                    
                    
                    2007
                    
                    
                    2006Distribution
      from mortgage company
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    46,099Brokerage
      referral fees
                    
                    
                    172,159
                    
                    
                    
                    164,665
                    
                    
                    
                    78,510Other
                    
                    
                    558,059
                    
                    
                    
                    269,498
                    
                    
                    
                    326,264Total
                    
                    $
                    730,218
                    
                    
                    $
                    434,163
                    
                    
                    $
                    450,873
 
 The major
components of other non-interest expense for the years ended December 31, 2008,
2007 and 2006 are as follows:
 
 2008
                    
                    
                    2007
                    
                    
                    2006Postage,
      printing and office supplies
                    
                    $
                    560,192
                    
                    
                    $
                    550,724
                    
                    
                    $
                    472,542Advertising
      and promotions
                    
                    
                    639,129
                    
                    
                    
                    606,667
                    
                    
                    
                    517,015Professional
      fees and services
                    
                    
                    1,620,339
                    
                    
                    
                    1,511,404
                    
                    
                    
                    899,389Other
                    
                    
                    2,234,397
                    
                    
                    
                    1,926,666
                    
                    
                    
                    1,328,417Total
                    
                    $
                    5,054,057
                    
                    
                    $
                    4,595,461
                    
                    
                    $
                    3,227,363
 
 NOTE
L - RESERVE REQUIREMENTS
 
 The
aggregate net reserve balance maintained under the requirements of the Federal
Reserve, which is currently interest bearing, was $187,000 at December 31, 2008.
During 2008, Crescent began utilizing a deposit reclassification program. This
program, incomplaince with Federal Reserve Bank regulations, allowed a portion
of Crescent’s reservable transaction accounts to be reclassified as savings
which are not subject to reserve requirements.
 
 NOTE
M - REGULATORY MATTERS
 
 The
Company (on a consolidated basis) and the Bank are subject to various regulatory
capital requirements administered by the federal banking agencies. Failure to
meet minimum capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could have a
direct material effect on the Company’s and Bank’s financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Company and the Bank must meet specific capital guidelines that
involve quantitative measures of their assets, liabilities and certain
off-balance sheet items as calculated
under regulatory accounting practices. The capital amounts and classification
are also subject to qualitative judgments by the regulators about components,
risk weightings, and other factors. Prompt corrective action provisions are not
applicable to bank holding companies.
 
 The Bank,
as  a North Carolina banking corporation, may pay dividends to the
Company only out of undivided profits as determined pursuant to North Carolina
General Statutes Section 53-87. However, regulatory authorities may limit
payment of dividends by any bank when it is determined that such a limitation is
in the public interest and is necessary to ensure the financial soundness of the
bank.
 
 Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios (set forth in the
following table) of total and Tier I capital (as defined) to average assets (as
defined). Management believes, as of December 31, 2008 and 2007, that the
Company and the Bank met all capital adequacy requirements to which they are
subject.
  67
  CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
M - REGULATORY MATTERS (Continued)
 
 As of
December 31, 2008, the most recent notification from the Federal Deposit
Insurance Corporation categorized Crescent State Bank as well capitalized under
the regulatory framework for prompt corrective action. To be categorized as well
capitalized, an institution must maintain minimum total risk-based, Tier 1
risk-based and Tier 1 leverage ratios as set forth in the following tables.
There are no conditions or events since the notification that management
believes have changed the Bank’s category. The Banks’ actual capital amounts and
ratios as of December 31, 2008 and 2007 are presented in the table
below.
 
 Minimum to be wellMinimum for capital
                    
                    
                    capitalized under promptActual
                    
                    
                    adequacy purposes
                    
                    
                    corrective action provisionsAmount
                    
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    Ratio(Dollars in thousands)Crescent State BankAs
      of December 31, 2008:Total
      Capital (to Risk-Weighted Assets)
                    
                    $
                    90,644
                    
                    
                    
                    10.87
                    %
                    
                    $
                    66,740
                    
                    
                    
                    8.00
                    %
                    
                    $
                    83,425
                    
                    
                    
                    10.00
                    %Tier
      I Capital (to Risk-Weighted Assets)
                    
                    
                    72,693
                    
                    
                    
                    8.71
                    %
                    
                    
                    33,370
                    
                    
                    
                    4.00
                    %
                    
                    
                    50,055
                    
                    
                    
                    6.00
                    %Tier
      I Capital (to Average Assets)
                    
                    
                    72,693
                    
                    
                    
                    7.83
                    %
                    
                    
                    37,122
                    
                    
                    
                    4.00
                    %
                    
                    
                    46,402
                    
                    
                    
                    5.00
                    %As
      of December 31, 2007:Total
      Capital (to Risk-Weighted Assets)
                    
                    $
                    75,165
                    
                    
                    
                    10.32
                    %
                    
                    $
                    58,253
                    
                    
                    
                    8.00
                    %
                    
                    $
                    72,216
                    
                    
                    
                    10.00
                    %Tier
      I Capital (to Risk-Weighted Assets)
                    
                    
                    66,892
                    
                    
                    
                    9.19
                    %
                    
                    
                    29,126
                    
                    
                    
                    4.00
                    %
                    
                    
                    43,689
                    
                    
                    
                    6.00
                    %Tier
      I Capital (to Average Assets)
                    
                    
                    66,892
                    
                    
                    
                    8.39
                    %
                    
                    
                    31,913
                    
                    
                    
                    4.00
                    %
                    
                    
                    39,877
                    
                    
                    
                    5.00
                    %
 
 The
Company is also subject to these requirements.  At December 31, 2008,
the Company’s total capital to risk-weighted assets, Tier I capital to
risk-weighted assets and Tier I capital to average assets were 10.68%, 8.53% and
7.67%, respectively.  At December 31, 2007, the Company’s total
capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier
I capital to average assets were 10.51%, 9.37% and 8.56%,
respectively.
 
 On
February 27, 2009, the Board of Directors of the FDIC voted to amend
the restoration plan for the Deposit Insurance Fund. The Board took action by
imposing a special assessment on insured institutions of 20 basis points,
implementing changes to the risk-based assessment system, and increased regular
premium rates for 2009, which banks must pay on top of the special assessment.
The 20 basis point special assessment on the industry will be as of
June 30, 2009 payable on September 30, 2009. As a result of the
special assessment and increased regular assessments, the Company projects it
will pay approximately $1.5 million for the special assessment.  This
would be in addition to increases epxected due to deposit volume growth and the
new assessment percentages implemented in the risk-based deposit assessment
system.
 
 On
March 5, 2009, the FDIC Chairman announced that the FDIC intends to lower
the special assessment from 20 basis points to 10 basis points. The approval of
the cutback is contingent on whether Congress clears legislation that would
expand the FDIC’s line of credit with the Treasury to $100 billion.
Legislation to increase the FDIC’s borrowing authority on a permanent basis is
also expected to advance to Congress, which should aid in reducing the burden on
the industry.  The additional expense anticipated under a 10% special
assessment would be approximately $750,000.
 
 The
assessment rates, including the special assessment, are subject to change at the
discretion of the Board of Directors of the FDIC.
  68
  
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
N - BUSINESS COMBINATION
 
 On April
6, 2006, the Company entered into a definitive agreement to acquire Port City
Capital Bank in Wilmington, North Carolina. The acquisition was approved at the
annual shareholders’ meeting on July 11, 2006 and the transaction took place
effective with the close of business on August 31, 2006. Port City Capital Bank
operated under its current name as a wholly-owned subsidiary of Crescent
Financial Corporation, and with its current board of directors and management,
through June 15, 2007.  After close of business June 15, 2007, Port
City Capital Bank was merged into Crescent State Bank.  Port City
Capital Bank shareholders received $3.30 in cash for each share of Port City
Capital Bank stock they owned, and exchanged each share of Port City Capital
Bank stock for 2.262 shares of Crescent Financial Corporation common
stock.  As a result of the acquisition, the Company paid $3.6 million
in cash and issued 2,675,611 (adjusted for the 11-for-10 split) additional
shares of stock.  The acquisition was accounted for using the purchase
method of accounting, with the operating results of Port City Capital Bank
subsequent to August 31, 2006 included in the Company’s financial
statements.
 
 The
following table reflects the unaudited proforma combined results of operations
for the year ended December
31, 2006, assuming the acquisition had occurred at the beginning of fiscal year
2006.
 
 2006Net
      interest income
                    
                    $
                    26,250,692Net
      income
                    
                    
                    6,833,502Net
      income per share:Basic
                    
                    $
                    0.68Diluted
                    
                    
                    0.65
 
 The
proforma net income for the year ended December 31, 2006 does not reflect
approximately $1,575,000 in merger related costs incurred by Port City Capital
Bank.  In management’s opinion, these unaudited results are not
necessarily indicative of what actual combined results of operations might have
been if the acquisition had been effective at the beginning of fiscal
2005.
 
 A summary
of the total purchase price of the transaction is as follows:
 
 Fair
      value of common stock issued
                    
                    $
                    31,669,470Fair
      value of common stock options issued
                    
                    
                    4,328,905Cash
      paid for shares
                    
                    
                    3,550,620Transaction
      costs paid in cash
                    
                    
                    617,005Total
      purchase price
                    
                    $
                    40,166,000
  69
  CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
N - BUSINESS COMBINATION (Continued)
 
 A summary
of the fair value of assets acquired and liabilities assumed is as
follows:
 
 Cash
      and cash equivalents
                    
                    $
                    12,382,048Investment
      securities available for sale
                    
                    
                    16,366,192Stock
      in FHLB of Atlanta
                    
                    
                    286,100Loans
      receivable, net
                    
                    
                    126,715,970Premises
      and equipment
                    
                    
                    84,775Deferred
      tax asset
                    
                    
                    817,430Goodwill
                    
                    
                    26,632,751Core
      deposit intangible
                    
                    
                    1,124,481Other
      assets
                    
                    
                    794,477Deposits
                    
                    
                    (144,187,695
                    )Other
      liabilities
                    
                    
                    (850,529
                    )Net
      assets acquired
                    
                    $
                    40,166,000
 
 NOTE
O - OFF-BALANCE SHEET RISK
 
 The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit and standby letters
of credit. Those instruments involve, to varying degrees, elements of credit and
interest rate risk in excess of the amount recognized in the balance sheet. The
contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments. The
Company uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments.
 
 Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of conditions established in the contract. Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee. Since some of the commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements. The Company evaluates each customer’s creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the Bank, upon extension of credit is based on management’s credit evaluation of
the borrower. Collateral obtained varies but may include real estate, stocks,
bonds, and certificates of deposit.
 
 A summary
of the contract amount of the Company’s exposure to off-balance sheet credit
risk as of December 31, 2008 is as follows (amounts in
thousands):
 
 Financial
      instruments whose contract amounts represent credit risk:Commitments
      to extend credit
                    
                    $
                    106,544Undisbursed
      equity lines of credit
                    
                    
                    45,196Financial
      standby letters of credit
                    
                    
                    5,674Commitment
      to invest in Small Business Investment Corporation
                    
                    
                    413
  70
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
P – ESTIMATED FAIR VALUES
 
 As
discussed in Note A to the consolidated financial statements, the Company
adopted SFAS No. 157 and SFAS No. 159 on January 1, 2008. SFAS No. 157
defines fair value, establishes a framework for measuring fair value under GAAP
and expands disclosures about fair value measurements. SFAS 157 applies whenever
other accounting pronouncements require or permit assets or liabilities to be
measured at fair value. Accordingly, SFAS No. 157 does not expand the use of
fair value in any new circumstances. SFAS No. 159 provides companies with an
option to report selected financial assets and liabilities at fair value. As of
December 31, 2008, the Company had not elected to measure any financial assets
or liabilities using the fair value option under SFAS No. 159; therefore the
adoption of SFAS No. 159 had no effect on the Company’s financial condition or
results of operations.
 
 The
Company records securities available for sale at fair value on a recurring
basis. Fair value is a market-based measurement and is defined as the price that
would be received to sell an asset, or paid to transfer a liability, in an
orderly transaction between market participants at the measurement date. The
transaction to sell the asset or transfer the liability is a hypothetical
transaction at the measurement date, considered from the perspective of a market
participant that holds the assets or owes the liability. In general, the
transaction price will equal the exit price and, therefore, represent the fair
value of the asset or liability at initial recognition. In determining whether a
transaction price represents the fair value of the asset or liability at initial
recognition, each reporting entity is required to consider factors specific to
the transaction and the asset or liability, the principal or most advantageous
market for the asset or liability, and market participants with whom the entity
would transact in the market. SFAS No. 157 establishes a fair value hierarchy to
prioritize the inputs of valuation techniques used to measure fair value. The
inputs are evaluated and an overall level for the fair value measurement is
determined. This overall level is an indication of how market-observable the
fair value measurement is and defines the level of disclosure. SFAS No. 157
clarifies fair value in terms of the price in an orderly transaction between
market participants to sell an asset or transfer a liability in the principal
(or most advantageous) market for the asset or liability at the measurement date
(an exit price). In order to determine the fair value or the exit price,
entities must determine the unit of account, highest and best use, principal
market, and market participants. These determinations allow the reporting entity
to define the inputs for fair value and level of hierarchy.
 
 Outlined
below is the application of the fair value hierarchy established by SFAS No. 157
to the Company’s financial assets that are carried at fair value.
 
 Level 1 – inputs to the
valuation methodology are quoted prices (unadjusted) for identical assets
or liabilities in active markets. An active market for the asset or liability is
a market in which the transactions for the asset or liability occur with
sufficient frequency and volume to provide pricing information on an ongoing
basis. As of December 31, 2008, the Company carried certain marketable equity
securities at fair value hierarchy Level 1.
 
 Level 2 – inputs to the
valuation methodology include quoted prices for similar assets and liabilities
in active markets, and inputs that are observable for the asset or liability,
either directly or indirectly, for substantially the full term of the financial
instrument. As of December 31, 2008, the types of financial assets and
liabilities the Company carried at fair value hierarchy Level 2 included
securities available for sale and impaired loans secured by real
estate.
 
 Level 3 – inputs to the
valuation methodology are unobservable and significant to the fair value
measurement. Unobservable inputs are supported by little or no market activity
or by the entity’s own assumptions. As of December 31, 2008, while the Company
did not carry any financial assets or liabilities, measured on a recurring
basis, at fair value hierarchy Level 3, the Company did value certain financial
assets, measured on a non-recurring basis, at fair value hierarchy Level
3.
  Fair Value on a Recurring
Basis.  The Company measures certain assets at fair value on a
recurring basis, as described below.
  71
  CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
P – ESTIMATED FAIR VALUES (Continued)
 
 Investment
Securities Available-for-Sale
 Investment
securities available-for-sale are recorded at fair value on a recurring basis.
Fair value measurement is based upon quoted prices, if available. If quoted
prices are not available, fair values are measured using independent pricing
models or other model-based valuation techniques such as the present value of
future cash flows, adjusted for the security’s credit rating, prepayment
assumptions and other factors such as credit loss assumptions. Level 1
securities include those traded on an active exchange, such as the New York
Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers
in active over-the-counter markets and money market funds.  Level 2
securities include mortgage-backed securities issued by government sponsored
entities, municipal bonds and corporate debt securities. Securities classified
as Level 3 include asset-backed securities in less liquid markets.
 
 The
Company utilizes valuation techniques that maximize the use of observable inputs
and minimize the use of unobservable inputs.
 
 Fair Value on a Nonrecurring
Basis.  The Company measures certain assets at fair value on a
nonrecurring basis, as described below.
 
 Loans
 The
Company does not record loans at fair value on a recurring basis. However, from
time to time, a loan is considered impaired and an allowance for loan losses is
established. Loans for which it is probable that payment of interest and
principal will not be made in accordance with the contractual terms of the loan
agreement are considered impaired. Once a loan is identified as individually
impaired, management measures impairment in accordance with SFAS No. 114,
“Accounting by Creditors for Impairment of a Loan.” The fair value of impaired
loans is estimated using one of several methods, including collateral value,
market value of similar debt, enterprise value, liquidation value and discounted
cash flows. Those impaired loans not requiring an allowance represent loans for
which the fair value of the expected repayments or collateral exceed the
recorded investments in such loans. At December 31, 2008, substantially all of
the total impaired loans were evaluated based on the fair value of the
collateral. In accordance with SFAS No. 157, impaired loans where an allowance
is established based on the fair value of collateral require classification in
the fair value hierarchy. When the fair value of the collateral is based on an
observable market price or a current appraised value, the Company records the
impaired loan as nonrecurring Level 2. When current appraised value is not
available or management determines the fair value of the collateral is further
impaired below the appraised value and there is no observable market price, the
Company records the impaired loan as nonrecurring Level 3. Impaired loans
totaled $16.7 million at December 31, 2008.  Of such loans, $11.6
million had specific loss allowances aggregating $4.1 million at that
date.
 
 Below is
a table that presents information about assets measured at fair value at
December 31, 2008:
  Fair Value Measurements atTotal Carrying
                                          
                                          
                                          
                                          
                                          
                                          December 31, 2008, UsingAmount in The
                                          
                                          
                                          
                                          
                                          
                                          Quoted Prices
                                          
                                          
                                          SignificantConsolidated
                                          
                                          
                                          Assets/Liabilities
                                          
                                          
                                          in Active
                                          
                                          
                                          Other
                                          
                                          
                                          SignificantBalance
                                          
                                          
                                          Measured at
                                          
                                          
                                          Markets for
                                          
                                          
                                          Observable
                                          
                                          
                                          UnobservableSheet
                                          
                                          
                                          Fair Value
                                          
                                          
                                          Identical Assets
                                          
                                          
                                          Inputs
                                          
                                          
                                          InputsDescription
                                          
                                          12/31/2008
                                          
                                          
                                          12/31/2008
                                          
                                          
                                          (Level 1)
                                          
                                          
                                          (Level 2)
                                          
                                          
                                          (Level 3)Securities
      available for sale
                                          
                                          $
                                          105,648,618
                                          
                                          
                                          $
                                          105,648,618
                                          
                                          
                                          $
                                          490,753
                                          
                                          
                                          $
                                          105,157,865
                                          
                                          
                                          $
                                          -Impaired
      loans
                                          
                                          
                                          7,556,644
                                          
                                          
                                          
                                          7,556,644
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          6,787,739
                                          
                                          
                                          
                                          768,905
  72
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
P – ESTIMATED FAIR VALUES (Continued)
 
 SFAS No.
107, Disclosures About Fair
Value of Financial Instruments, requires disclosure of fair value
information about financial instruments, whether or not recognized in the
balance sheet, for which it is practicable to estimate that value. In cases
where quoted market prices are not available, fair values are based on estimates
using present value or other valuation techniques.
 
 Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instruments. SFAS 107 excludes certain financial instruments and all
nonfinancial instruments from its disclosure requirements. Accordingly, the
aggregate fair value amounts presented do not represent the underlying value of
the Company. In addition to the valuation methods previously described for
investments available for sale and derivative assets and liabilities, the
following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments:
 
 Cash
and Cash Equivalents
 
 The
carrying amounts for cash and cash equivalents approximate fair value because of
the short maturities of those instruments.
 
 Investment
Securities
 
 Fair
value for investment securities equals quoted market price if such information
is available. If a quoted market price is not available, fair value is estimated
using quoted market prices for similar securities.
 
 Loans
 
 For
certain homogenous categories of loans, such as residential mortgages, fair
value is estimated using the quoted market prices for securities backed by
similar loans, adjusted for differences in loan characteristics. The fair value
of other types of loans is estimated by discounting the future cash flows using
the current rates at which similar loans would be made to borrowers with similar
credit ratings and for the same remaining maturities.
 
 Federal
Home Loan Bank Stock
 
 The
carrying value of Federal Home Loan Bank stock approximates fair value based on
the redemption provisions of the Federal Home Loan Bank.
 
 Investment
in Life Insurance
 
 The
carrying value of life insurance approximates fair value because this investment
is carried at cash surrender value, as determined by the insurers.
 
 Deposits
 
 The fair
value of demand deposits, savings, money market and NOW accounts is the amount
payable on demand at the reporting date. The fair value of time deposits is
estimated using the rates currently offered for instruments of similar remaining
maturities.
 
 Short-term
Borrowings and Long-term Debt
 
 The fair
value of short-term borrowings and long-term debt are based upon the discounted
value when using current rates at which borrowings of similar maturity could be
obtained.
  73
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
P – ESTIMATED FAIR VALUES (Continued)
 
 Accrued
Interest Receivable and Accrued Interest Payable
 
 The
carrying amounts of accrued interest receivable and payable approximate fair
value, because of the short maturities of these instruments.
 
 The
carrying amounts and estimated fair values of the Company’s financial
instruments, none of which are held for trading purposes, are as follows at
December 31, 2008 and 2007:
 
 2008
                  
                  
                  2007Carrying
                  
                  
                  Estimated
                  
                  
                  Carrying
                  
                  
                  Estimatedamount
                  
                  
                  fair value
                  
                  
                  amount
                  
                  
                  fair valueFinancial
      assets:Cash
      and cash equivalents
                  
                  $
                  10,282,789
                  
                  
                  $
                  10,282,789
                  
                  
                  $
                  12,356,404
                  
                  
                  $
                  12,356,404Investment
      securities
                  
                  
                  105,648,618
                  
                  
                  
                  105,648,618
                  
                  
                  
                  90,758,467
                  
                  
                  
                  90,758,467Federal
      Home Loan Bank stock
                  
                  
                  7,264,000
                  
                  
                  
                  7,264,000
                  
                  
                  
                  6,790,700
                  
                  
                  
                  6,790,700Loans,
      net
                  
                  
                  772,792,283
                  
                  
                  
                  784,667,000
                  
                  
                  
                  667,643,228
                  
                  
                  
                  667,893,000Investment
      in life insurance
                  
                  
                  16,811,918
                  
                  
                  
                  16,811,918
                  
                  
                  
                  9,122,697
                  
                  
                  
                  9,122,697Accrued
      interest receivable
                  
                  
                  3,341,258
                  
                  
                  
                  3,341,258
                  
                  
                  
                  3,761,600
                  
                  
                  
                  3,761,600Financial
      liabilities:Deposits
                  
                  
                  714,882,755
                  
                  
                  
                  718,590,000
                  
                  
                  
                  605,431,312
                  
                  
                  
                  593,257,000Short-term
      borrowings
                  
                  
                  37,706,000
                  
                  
                  
                  39,925,000
                  
                  
                  
                  13,755,000
                  
                  
                  
                  13,755,000Long-term
      borrowings
                  
                  
                  116,748,000
                  
                  
                  
                  121,748,000
                  
                  
                  
                  121,248,000
                  
                  
                  
                  134,589,000Accrued
      interest payable
                  
                  
                  1,958,344
                  
                  
                  
                  1,958,344
                  
                  
                  
                  1,682,428
                  
                  
                  
                  1,682,428
 
 NOTE
Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS
 
 All
information presented under this caption has been adjusted for the effects of
the stock dividend and the stock splits effected in the form of stock dividends
discussed in Note B under the caption Per Share
Results. During 1999 the Company adopted, with shareholder approval, an
Employee Stock Option Plan (the “Employee Plan”) and a Director Stock Option
Plan (the “Director Plan”). During 2002 and 2005, with shareholder approval, the
Company amended the Employee plan to increase the number of shares available
under the plan. In 2003, in conjunction with the merger between Crescent and
Centennial Bank of Southern Pines, stock options approved under Centennial’s
Plan were acquired by Crescent. Certain of the options granted under the
Director Plan vested immediately at the time of grant. All other options granted
vested twenty-five percent at the grant date, with the remainder vesting over a
three-year period. All unexercised options expire ten years after the date of
grant.
 
 At the
time of the PCCB merger, PCCB had two stock option plans, the 2002 Incentive
Stock Option Plan and the 2002 Nonstatutory Stock Option Plans, whose options
were converted to options to purchase Crescent Financial Corporation stock at an
exchange rate of 2.5133.  There were 225,954 incentive stock options
and 228,459 non-statutory stock options converted.  Since all options
authorized under the PCCB plans had been granted, there will be no more options
granted under either of these plans.
 
 At the
Company’s annual meeting on July 11, 2006, the shareholders approved the 2006
Omnibus Stock Ownership and Long Term Incentive Plan (the “Omnibus Plan”) to
replace the previous plans.  This plan authorizes 368,500 shares of
the common stock of Crescent to be issued in the form of incentive stock option
grants, non-statutory stock option grants, restricted stock grants, long term
incentive compensation units, or stock appreciation rights.   The
company declared and distributed a 10% stock dividend in 2007 which increased
the shares available for issuance to 405,350. In the event that the number of
shares of common stock that remain available for future issuance under the Plan
as of December 31, 2008 and as of the last day of each calendar year commencing
thereafter, is less than 1.5% of the total number of shares of common stock
issued and outstanding as of such date (the “Replacement
Amount”),
  74
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
 
 then the
Plan Pool shall be increased as of such date by a number of shares of common
stock equal to the Replacement Amount.  At December 31, 2008, there
were 295,729 unissued options in this plan.  Vesting provisions for
granted stock options are at the discretion of the Compensation Committee of the
Board of Directors.  At December 31, 2008, all outstanding options
were granted with a three year vesting schedule; 25% at date of grant and 25% at
each of the next three grant date anniversaries.
 
 The
share-based awards granted under the aforementioned plans have similar
characteristics, except that some awards have been granted in options and
certain awards have been granted in restricted stock. Therefore, the following
disclosures have been disaggregated for the stock option and restricted stock
awards of the plans due to their dissimilar characteristics. Vesting provisions
for granted restricted stock awards are at the discretion of the Compensation
Committee of the Board of Directors. At December 31, 2008, all outstanding
restricted stock awards vest in full at either the three year of five year
anniversary date of the grant. The Company funds the option shares and
restricted stock from authorized but un-issued shares.
 
 Stock
Option Plans
 
 A summary
of the Company’s option plans as of and for the year ended December 31, 2008,
adjusted for the stock split effected in the form of a 10% stock dividend
distributed in May 2007, is as follows:
 
 Outstanding Options
                    
                    
                    Exercisable OptionsWeighted
                    
                    
                    
                    
                    
                    WeightedAverage
                    
                    
                    
                    
                    
                    AverageOption
                    
                    
                    
                    
                    
                    OptionNumber
                    
                    
                    Price
                    
                    
                    Number
                    
                    
                    PriceOptions
      outstanding, beginning of year
                    
                    
                    754,539
                    
                    
                    $
                    5.22
                    
                    
                    
                    728,933
                    
                    
                    $
                    5.00Granted/vested
                    
                    
                    9,000
                    
                    
                    
                    6.83
                    
                    
                    
                    2,250
                    
                    
                    
                    6.83Exercised
                    
                    
                    (207,130
                    )
                    
                    
                    4.10
                    
                    
                    
                    (207,130
                    )
                    
                    
                    4.10Forfeited
                    
                    
                    ( 13,056
                    )
                    
                    
                    10.33
                    
                    
                    
                    (4,851
                    )
                    
                    
                    11.20Options
      outstanding, end of year
                    
                    
                    543,352
                    
                    
                    $
                    5.55
                    
                    
                    
                    528,904
                    
                    
                    $
                    5.45
 
 The
weighted average remaining life of options outstanding and options exercisable
at December 31, 2008 is 3.66 years and 3.52 years, respectively.
 
 The
following table provides the range of exercise prices for options outstanding
and exercisable at December 31, 2008:
  Range of Exercise Prices
                      
                      
                      Stock Options Outstanding
                      
                      
                      Stock Options Exercisable$         
      3.94
                      
                      $
                      6.13
                      
                      
                      
                      453,244
                      
                      
                      
                      450,944$          6.14
                      
                      $
                      8.33
                      
                      
                      
                      26,751
                      
                      
                      
                      22,071$         
      8.34
                      
                      $
                      10.53
                      
                      
                      
                      10,911
                      
                      
                      
                      10,911$       
      10.54
                      
                      $
                      12.71
                      
                      
                      
                      52,627
                      
                      
                      
                      44,928543,352
                      
                      
                      
                      528,904
 
 The fair
market value of each option award is estimated on the date of grant using the
Black-Scholes option pricing model. The risk-free interest rate is based upon a
U.S. Treasury instrument with a life that is similar to the expected life of the
option grant.  Expected volatility is based upon the historical
volatility of the Company’s stock price based upon the previous 3 years trading
history.  The expected term of the options is based upon the average
life of previously issued stock options.
  75
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
 
 The
assumptions used in estimating fair values, together with the estimated per
share value of options granted are displayed below:
 2008
                  
                  
                  2007
                  
                  
                  2006Assumptions
      in estimating option values:Risk-free
      interest rate
                  
                  
                  3.12
                  %
                  
                  
                  4.68
                  %
                  
                  
                  4.58
                  %Dividend
      yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %
                  
                  
                  0
                  %Volatility
                  
                  
                  26.80
                  %
                  
                  
                  31.63
                  %
                  
                  
                  34.24
                  %Expected
      life
                  
                  7 years
                  
                  
                  7 years
                  
                  
                  7 yearsThe
      weighted average grant date fair value of options
                  
                  $
                  2.44
                  
                  
                  $
                  4.88
                  
                  
                  $
                  5.48
 
 Stock
Option Plans (Continued)
 
 Compensation
cost charged to income was approximately $72,000 and $99,000 for the years ended
December 31, 2008 and 2007 in accordance with SFAS No. 123R.  SFAS No.
123R was adopted beginning in 2006 and therefore no compensation expense was
recognized in 2005.  Cash received from option exercise under all
share-based payment arrangements for the years ended December 31, 2008, 2007 and
2006 were $670,000, $1,214,000 and $256,000, respectively.  The actual
tax benefit in stockholders equity realized for the tax deductions from option
exercise of the share-based payment arrangements for the years ended December
31, 2008, 2007 and 2006 totaled $95,500, $452,000 and $45,000,
respectively.
 
 The total
intrinsic value of options exercised during the years ended December 31, 2008,
2007 and 2006 was $650,047, $1,987,000 and $351,000,
respectively.  Since all options outstanding under the Company’s stock
option plans had an exercise price which exceeded the market price at December
31, 2008, there was no intrinsic value of both total options outstanding and
exercisable options.  As of December 31, 2008, there was $53,000 of
unrecognized compensation cost related to the nonvested stock option
plans.  That cost is expected to be recognized as follows: $34,000 in
2009, $16,000 in 2010 and $2,000 in 2011.
 
 Stock
Award Plans
 
 A summary
of the status of the Company’s non-vested stock awards as of December 31, 2008,
and changes during the year then ended is presented below:
 Weightedaveragegrant dateShares
                    
                    
                    fair valueNon-vested
      – December 31, 2007
                    
                    
                    21,769
                    
                    
                    $
                    12.54Granted
                    
                    
                    35,500
                    
                    
                    
                    8.75Vested
                    
                    
                    -
                    
                    
                    
                    -Forfeited
                    
                    
                    -
                    
                    
                    
                    -Non-vested
      – December 31, 2008
                    
                    
                    57,269
                    
                    
                    $
                    10.19
 
 The total
fair value of restricted stock grants issued during the year ended December 31,
2008 was $310,625.  There were no restricted stock grants vested
during the year.
 
 As of
December 31, 2008, there was $366,408 of unrecognized compensation cost related
to the nonvested stock award plan.  That cost is expected to be
recognized over a weighted average period of 3.09 years.
  76
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
 
 Supplemental
Retirement
 
 During
2003, the Company adopted a Supplemental Executive Retirement Plan (SERP) for
its senior executives. The Company has purchased life insurance policies in
order to provide future funding of benefit payments. Plan benefits will accrue
and vest during the period of employment and will be paid in monthly benefit
payments over the officer’s remaining life commencing with the officer’s
retirement at any time after attainment of age sixty to sixty-five, depending on
the officer. Expenses for the years ended December 31, 2008, 2007 and 2006 were
$372,062, $241,934 and $87,657, respectively. The accrued liability of the plan
at December 31, 2008 and 2007 was $877,880 and $505,818,
respectively.
 
 Defined
Contribution Plan
 
 The
Company sponsors a contributory profit-sharing plan which provides for
participation by substantially all employees. Participants may make voluntary
contributions resulting in salary deferrals in accordance with
Section
 
 Defined
Contribution Plan (continued)
 
 401(k) of
the Internal Revenue Code. The plans provide for employee contributions up to
$15,500 of the participant's annual salary and an employer contribution of 100%
matching of the first 6% of pre-tax salary contributed by each participant.
Anyone who turned 50 years old in 2008 could also add a catch-up contribution of
$5,000 above the normal limit bringing the maximum contribution to $10,500 for
those employees. The Company may make additional discretionary profit sharing
contributions to the plan on behalf of all participants. There were no
discretionary contributions for 2008, 2007 or 2006. Amounts deferred above the
first 6% of salary are not matched by the Company. Expenses related to these
plans for the years ended December 31, 2008, 2007 and 2006 were $369,939,
$286,778 and $269,058, respectively.
 
 Employment
Agreements
 
 The
Company has entered into employment agreements with certain of its executive
officers to ensure a stable and competent management base. The agreements
provide for benefits as spelled out in the contracts and cannot be terminated by
the Board of Directors, except for cause, without prejudicing the officers’
rights to receive certain vested rights, including compensation. In the event of
a change in control of the Company, as outlined in the agreements, the acquirer
will be bound to the terms of the contracts.
  77
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
R - PARENT COMPANY FINANCIAL DATA
 
 Condensed
balance sheets as of December 31, 2008 and 2007, and related condensed
statements of operations and cash flows for each of the years in the three-year
period ended December 31, 2008 are as follows:
 
 Condensed
Balance Sheets
 December
31, 2008 and 2007
 
 2008
                  
                  
                  2007ASSETSCash
      and due from banks
                  
                  $
                  550,126
                  
                  
                  $
                  1,475,753Investment
      in subsidiaries
                  
                  
                  104,840,989
                  
                  
                  
                  98,514,864Other
      assets
                  
                  
                  124,558
                  
                  
                  
                  96,046TOTAL
      ASSETS
                  
                  $
                  105,515,673
                  
                  
                  $
                  100,086,663LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Accrued
      interest payable
                  
                  $
                  170,972
                  
                  
                  $
                  164,377Due
      to former Centennial Shareholders
                  
                  
                  5,093
                  
                  
                  
                  15,474Accrued
      expenses and other liabilities
                  
                  
                  2,000,000
                  
                  
                  
                  -Subordinated
      debentures
                  
                  
                  8,248,000
                  
                  
                  
                  8,248,000TOTAL
      LIABILITIES
                  
                  
                  10,424,065
                  
                  
                  
                  8,427,851Stockholders'
      equity:Common
      stock
                  
                  
                  9,626,558
                  
                  
                  
                  9,404,579Additional
      paid-in capital
                  
                  
                  74,349,299
                  
                  
                  
                  73,596,427Retained
      earnings
                  
                  
                  8,477,809
                  
                  
                  
                  8,619,617Accumulated
      other comprehensive income/(loss)
                  
                  
                  2,637,942
                  
                  
                  
                  38,189TOTAL
      STOCKHOLDERS’ EQUITY
                  
                  
                  95,091,608
                  
                  
                  
                  91,658,812TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                  
                  $
                  105,515,673
                  
                  
                  $
                  100,086,663
  Condensed
Statements of Operations
 Years
Ended December 31, 2008, 2007 and 2006
 
 2008
                  
                  
                  2007
                  
                  
                  2006Equity
      in earnings of subsidiaries
                  
                  $
                  2,467,201
                  
                  
                  $
                  6,688,256
                  
                  
                  $
                  4,988,649Interest
      income
                  
                  
                  39,808
                  
                  
                  
                  169,130
                  
                  
                  
                  630,505Dividend
      income
                  
                  
                  17,026
                  
                  
                  
                  21,200
                  
                  
                  
                  20,669Other
      miscellaneous income
                  
                  
                  5,024
                  
                  
                  
                  -
                  
                  
                  
                  23,286Interest
      expense
                  
                  
                  (623,487
                  )
                  
                  
                  (738,485
                  )
                  
                  
                  (720,822
                  )Other
      operating expenses
                  
                  
                  (132,853
                  )
                  
                  
                  (118,245
                  )
                  
                  
                  (81,853
                  )Income
      tax benefit (expense)
                  
                  
                  238,100
                  
                  
                  
                  226,900
                  
                  
                  
                  43,100Net
      income
                  
                  $
                  2,010,819
                  
                  
                  $
                  6,248,756
                  
                  
                  $
                  4,903,534
  78
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
R - PARENT COMPANY FINANCIAL DATA (Continued)
 
 Condensed
Statements of Cash Flows
 Years
Ended December 31, 2008, 2007 and 2006
 
 2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows from operating activities:Net
      income
                  
                  $
                  2,010,819
                  
                  
                  $
                  6,248,756
                  
                  
                  $
                  4,903,534Adjustments
      to reconcile net income to net cash provided (used) by operating
      activities:Amortization
                  
                  
                  22,266
                  
                  
                  
                  33,400
                  
                  
                  
                  33,400Stock
      based compensation
                  
                  
                  209,098
                  
                  
                  
                  178,940
                  
                  
                  
                  202,246Equity
      in earnings of Crescent State Bank
                  
                  
                  (2,467,201
                  )
                  
                  
                  (6,688,256
                  )
                  
                  
                  (4,194,284
                  )Equity
      in earnings of Port City Capital Bank
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (794,365
                  )Changes
      in assets and liabilities:Increase
      in other assets
                  
                  
                  (50,779
                  )
                  
                  
                  (55,752
                  )
                  
                  
                  5,068Increase
      (decrease) in accrued interest payable
                  
                  
                  6,595
                  
                  
                  
                  (2,586
                  )
                  
                  
                  24,112Increase
      (decrease) in accrued expenses and other liabilities
                  
                  
                  1,989,619
                  
                  
                  
                  (16,292
                  )
                  
                  
                  (17,660
                  )Net
      cash provided (used) by operating activities
                  
                  
                  1,720,418
                  
                  
                  
                  (301,790
                  )
                  
                  
                  162,051Cash
      flows from investing activities:Investment
      in Subsidiaries
                  
                  
                  (3,411,798
                  )
                  
                  
                  (4,098,938
                  )
                  
                  
                  (8,770,879
                  )Cash
      flows from financing activities:Proceeds
      from exercise of stock options
                  
                  
                  670,254
                  
                  
                  
                  1,213,738
                  
                  
                  
                  255,797Excess
      tax benefits from stock options exercised
                  
                  
                  95,500
                  
                  
                  
                  451,950
                  
                  
                  
                  45,401Cash
      (paid) received in lieu of fractional shares
                  
                  
                  -
                  
                  
                  
                  (7,686
                  )
                  
                  
                  (9,435
                  )Net
      cash provided by financing activities
                  
                  
                  765,754
                  
                  
                  
                  1,658,002
                  
                  
                  
                  291,763Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  (925,627
                  )
                  
                  
                  (2,742,726
                  )
                  
                  
                  (8,317,065
                  )Cash
      and cash equivalents, beginning
                  
                  
                  1,475,753
                  
                  
                  
                  4,218,479
                  
                  
                  
                  12,535,544Cash
      and cash equivalents, ending
                  
                  $
                  550,126
                  
                  
                  $
                  1,475,753
                  
                  
                  $
                  4,218,479
 
 NOTE
S - SUPPLEMENTAL DISCLOSURE FOR STATEMENT OF CASH FLOWS
 
 2008
                  
                  
                  2007
                  
                  
                  2006Supplemental
      Disclosure of Cash Flow Information:Cash
      paid during the year for:Interest
                  
                  $
                  28,794,509
                  
                  
                  $
                  27,772,615
                  
                  
                  $
                  17,120,578Income
      taxes
                  
                  $
                  2,559,000
                  
                  
                  $
                  3,928,000
                  
                  
                  $
                  2,655,001Supplemental
      Disclosure of Noncash Investing and Financing Activities:Transfer
      of loans to foreclosed assets
                  
                  $
                  2,206,023
                  
                  
                  $
                  479,814
                  
                  
                  $
                  199,900Increase
      in fair value of securities available for sale, net of tax
                  
                  $
                  588,933
                  
                  
                  $
                  539,136
                  
                  
                  $
                  180,846
 
 The fair
value of assets acquired and liabilities assumed in the PCCB merger are
presented in Note N.
  79
 
 CRESCENT
FINANCIAL CORPORATION AND SUBSIDIARY
 Notes
to Consolidated Financial Statements
 December
31, 2008, 2007 and 2006
 
 NOTE
T – SUBSEQUENT EVENT
 
 Under the
United States Treasury’s Capital Purchase Program (CPP), the Company issued
$24.9 million in Fixed Rate Cumulative Perpetual Preferred Stock, Series A, on
January 9, 2009.  In addition, the Company provided warrants to the
Treasury to purchase 833,705 shares of the Company’s common stock at an exercise
price of $4.48 per share.  These warrants are immediately exercisable
and expire ten years from the date of issuance.  The preferred stock
is non-voting, other than having class voting rights on certain matters, and
pays cumulative dividends quarterly at a rate of 5% per annum for the first five
years and 9% per annum thereafter.  The preferred shares are
redeemable at the option of the Company subject to regulatory
approval.
 
 Based on
a Black-Scholes options pricing model, the common stock warrants have been
assigned a fair value of $2.28 per share or $2.4 million in the aggregate as of
January 8, 2009.  As a result, $2.09 million has been recorded as the
discount on the preferred stock and will be accreted as a reduction in net
income available for common shareholders over the next five years at
approximately $0.5 million per year.  Correspondingly, $22.5 million
has been assigned to the preferred stock.  Through the discount
accretion over the next five years, the preferred stock will be accreted up to
the redemption amount of $24.9 million.  For purposes of these
calculations, the fair value of the common stock warrants as of December 5, 2008
was estimated using the Black-Scholes option pricing model and the following
assumptions:
 
 Risk-free
      interest rate
                    
                    
                    2.49
                    %Expected
      life of warrants
                    
                    10 yearsExpected
      dividend yield
                    
                    
                    0.00
                    %Expected
      volatility
                    
                    
                    37.27
                    %
  The
Company’s computation of expected volatility is based on daily historical
volatility since January 1999.  The risk-free interest rate is based
on the market yield for ten year U.S. Treasury securities as of January 9,
2009.
 
 As a
condition of the CPP, the Company must obtain consent from the United States
Department of the Treasury to repurchase its common stock or to pay a cash
dividend on its common stock.  Furthermore, the Company has agreed to
certain restrictions on executive compensation and corporate
governance.
  80
  ITEM
9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
 
 none.
 
 ITEM
9A - CONTROLS AND PROCEDURES
 
 Evaluation
of Disclosure Controls and Procedures
 
 The
Registrant’s Chief Executive Officer and Chief Financial Officer have conducted
an evaluation of the Registrant’s disclosure controls and procedures as of
December 31, 2008.  Based on their evaluation, the Registrant’s Chief
Executive Officer and Chief Financial Officer have concluded that the
Registrant’s disclosure controls and procedures are effective to ensure that
information required to be disclosed by the Registrant in reports that it files
or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the applicable
Securities and Exchange Commission rules and forms.
 
 Management’s
Report on Internal Control Over Financial Reporting
 
 Management
is responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act of 1934, as amended. The Registrant’s internal control
over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with accounting
principles generally accepted in the United States of America. The Registrant’s
internal control over financial reporting includes those written policies and
procedures that:
 
 ·
              pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of
  assets;
 ·
              provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with accounting
      principles generally accepted in the United States of
    America;
 ·
              provide
      reasonable assurance that receipts and expenditures are being made only in
      accordance with management and director authorization;
  and
 ·
              provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of assets that could have a
      material effect on the consolidated financial
  statements.
 
 Internal
control over financial reporting includes the controls themselves, monitoring
and internal auditing practices and actions taken to correct deficiencies as
identified.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
 
 Management
assessed the effectiveness of the Registrant’s internal control over financial
reporting as of December 31, 2008. Management based this assessment on
criteria for effective internal control over financial reporting described in
Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (“COSO”). Management’s assessment included an evaluation of
the design of the Registrant’s internal control over financial reporting and
testing of the operational effectiveness of its internal control over financial
reporting.
 
 Management
reviewed the results of its assessment with the Audit Committee of the Board of
Directors. Based on this assessment, management determined that, as of
December 31, 2008, it maintained effective internal control over financial
reporting.
 
 This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permits the Company to provide only
management’s report in this annual report.
  81
  Changes
in Internal Control Over Financial Reporting
 
 There
were no changes in the Registrant’s internal controls or in other factors that
could materially affect these controls during the three-month period ended
December 31, 2008.
 
 ITEM
9B – OTHER INFORMATION
 
 None.
 
 PART
III
 
 ITEM
10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
 Incorporated
by reference from the discussion under the headings “Proposal 1: Election of
Directors,” “Executive Compensation – Executive Officers,” “Director
Relationships,” “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Meetings and Committees of the Board of Directors – Audit Committee” in the
Registrant’s Proxy Statement for the 2009 Annual Meeting of Shareholders to be
filed with the SEC.
 
 The
Registrant has adopted a Code of Ethics that applies, among others, to its
principal executive officer and principal financial officer. The Registrant’s
Code of Ethics is available at www.crescentstatebank.com.
 
 ITEM
11 - EXECUTIVE COMPENSATION
 
 Incorporated
by reference from the discussion under the heading “Executive Compensation,”
“Director Compensation,” “Compensation Committee Interlocks and Insider
Participation” and “Compensation Committee Report” in the Registrant’s Proxy
Statement for the 2009 Annual Meeting of Shareholders to be filed with the
SEC.
 
 ITEM
12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
 
 Incorporated
by reference from the discussion under the heading “Beneficial Ownership of
Voting Securities” in the Registrant’s Proxy Statement for the 2009 Annual
Meeting of Shareholders to be filed with the SEC.
 
 Stock
Option Plans
 
 Set forth
below is certain information regarding the Registrant’s various stock option
plans.
 
 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, andrights
                  (b)
                
                
                Number of securities
                  remaining available for
                  future issuance underequitycompensation plans
                  (excluding securities
                  reflected in column (a))
                  (c)Equity compensation plans approved by
      security holders
                
                
                543,352
                
                
                $
                5.55
                
                
                
                295,729Equity
      compensation plans not approved by security holders
                
                None
                
                
                None
                
                
                NoneTotal
                
                
                543,352
                
                
                $
                5.55
                
                
                
                295,729
  82
  See
additional information in Note Q under the heading "Employee and Director
Benefit Plans - Stock Option Plans" in Item 8 of this report.
  83
  ITEM
13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
 
 Incorporated
by reference from the discussion under the headings “Director Independence” and
“Indebtedness of and Transactions with Management” in the Registrant’s Proxy
Statement for the 2009 Annual Meeting of Shareholders to be filed with the
SEC.
 
 ITEM
14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 Incorporated
by reference from pages the discussion under the heading “Proposal 2:
Ratification of Independent Public Accountants” and “Audit Committee Report” in
the Registrant’s Proxy Statement for the 2009 Annual Meeting of Shareholders to
be filed with the SEC.
 
 ITEM
15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
 (a)
 
 (1)
and
(2)            Lists
of Financial Statements and Schedules
 
 The
following consolidated financial statements of the Registrant are filed as a
part of this report:
 
 ·
              Consolidated
      Balance Sheets as of December 31, 2008 and December 31,
    2007
 ·
              Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007 and
      2006
 ·
              Consolidated
      Statements of Changes in Stockholders’ Equity for the years ended December
      31, 2008, 2007 and 2006
 ·
              Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007 and
      2006
 ·
              Notes
      to Consolidated Financial
Statements
 ·
              Report
      of Independent Registered Public Accounting
Firm
 
 (3)
              Listing
      of Exhibits
 
 Exhibits
filed with this report are listed in the Index to Exhibits.  The
following management contracts or compensatory plans or arrangements are
required to be filed as exhibits to this report:
 
 ·
              1999
      Incentive Stock Option Plan
 ·
              1999
      Nonqualified Stock Option Plan for
Directors
 ·
              Form
      of Employment Agreement between the Registrant and Michael G.
      Carlton
 ·
              Form
      of Employment Agreement between the Registrant and Bruce W.
      Elder
 ·
              Form
      of Employment Agreement between the Registrant and Thomas E. Holder,
      Jr.
 ·
              Form
      of Employment Agreement between the Registrant and Ray D.
      Vaughn
 ·
              Form
      of Employment Agreement between the Registrant and W. Keith
      Betts
 ·
              Form
      of Salary Continuation Agreement with Michael G.
  Carlton
 ·
              Salary
      Continuation Agreement with Bruce W.
Elder
 ·
              Salary
      Continuation Agreement with Thomas E. Holder,
  Jr.
 ·
              Form
      of Salary Continuation Agreement with Ray D.
  Vaughn
 ·
              Salary
      Continuation Agreement with W. Keith
Betts
 ·
              Endorsement
      Split Dollar Agreement with Michael G.
Carlton
 ·
              Endorsement
      Split Dollar Agreement with Bruce W.
Elder
 ·
              Endorsement
      Split Dollar Agreement with Thomas E. Holder,
  Jr.
 ·
              Endorsement
      Split Dollar Agreement with Ray D.
Vaughn
 ·
              Endorsement
      Split Dollar Agreement with W. Keith
Betts
 ·
              Crescent
      State Bank Directors’ Compensation
Plan
 ·
              2006
      Omnibus Stock Ownership and Long Term Incentive
  Plan
 
 (b)
              Exhibits
 
 Exhibits
filed with this report are listed in the Index to Exhibits.
  84
  SIGNATURES
 
 Pursuant
to the 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
the undersigned, thereunto duly authorized.
 
 CRESCENT FINANCIAL
    CORPORATIONRegistrantBy:
                  /s/ Michael G. CarltonMichael
      G. CarltonDate:
      March 27, 2009
                  
                  President
      and Chief Executive
Officer
 
 In
accordance with the Securities Exchange Act of 1934, this Report has been signed
below by the following persons on behalf of the Registrant and in the capacities
and on the dates indicated.
 
 /s/ Michael G.
    Carlton
                  March
      27, 2009Michael
      G. Carlton, President and Chief Executive Officer,Director (Principle
      Executive Officer)/s/  Bruce W.
      Elder
                  March
      27, 2009Bruce
      W. Elder, Vice President(Principal
      Financial Officer and Principle Accounting Officer)/s/ Brent D.
    Barringer
                  March
      27, 2009Brent
      D. Barringer, Director/s/ William H.
    Cameron
                  March
      27, 2009William
      H. Cameron, Director/s/ Bruce I. Howell
                  March
      27, 2009Bruce
      I. Howell, Director/s/ James A. Lucas
                  March
      27, 2009James
      A. Lucas, Director/s/ Kenneth A. Lucas
                  March
      27, 2009Kenneth
      A. Lucas, Director/s/ Sheila Hale Ogle
                  March
      27, 2009Sheila
      Hale Ogle, Director/s/ Charles A. Paul
                  March
      27, 2009Charles
      A. Paul, Director/s/ Francis R. Quis,
    Jr.
                  March
      27, 2009Francis
      R. Quis, Jr., Director/s/ Jon S. Rufty
                  March
      27, 2009Jon
      S. Rufty, Director/s/ Jon T. Vincent
                  March
      27, 2009Jon
      T. Vincent, Director/s/ Stephen K.
    Zaytoun
                  March
      27, 2009Stephen
      K. Zaytoun, Director
  85
  Exhibit Number
                  
                  Exhibit3(i)
                  
                  Articles
      of Incorporation(1)3(ii)
                  
                  Bylaws(1)4
                  
                  Form
      of Stock Certificate(1)10(i)
                  
                  1999
      Incentive Stock Option Plan(2)10(ii)
                  
                  1999
      Nonqualified Stock Option Plan(2)10(iii)
                  
                  Employment
      Agreement Michael G. Carlton (Filed herewith)10(iv)
                  
                  Employment
      Agreement of Bruce W. Elder (Filed herewith)10(v)
                  
                  Employment
      Agreement of Thomas E. Holder, Jr. (Filed herewith)10(vi)
                  
                  Amended
      and Restated Trust Agreement of Crescent Financial Capital Trust I(3)10(vii)
                  
                  Indenture(3)10(viii)
                  
                  Junior
      Subordinated Debenture(3)10(ix)
                  
                  Guarantee
      Agreement(3)10(x)
                  
                  Salary
      Continuation Agreement with Michael G. Carlton (Filed
      herewith)10(xi)
                  
                  Salary
      Continuation Agreement with Bruce W. Elder(6)10(xii)
                  
                  Salary
      Continuation Agreement with Thomas E. Holder, Jr.(6)10(xiii)
                  
                  Endorsement
      Split Dollar Agreement with Michael G. Carlton(3)10(xiv)
                  
                  Endorsement
      Split Dollar Agreement with Bruce W. Elder(3)10(xv)
                  
                  Endorsement
      Split Dollar Agreement with Thomas E. Holder, Jr.(3)10(xvi)
                  
                  Crescent
      State Bank Directors’ Compensation Plan(4)10(xvii)
                  
                  Salary
      Continuation Agreement with Ray D. Vaughn (Filed
  herewith)10(xviii)
                  
                  Salary
      Continuation Agreement with W. Keith Betts(7)10(xix)
                  
                  Employment
      Agreement with Ray D. Vaughn (Filed herewith)10(xx)
                  
                  Employment
      Agreement of W. Keith Betts(7)10(xxi)
                  
                  Endorsement
      Split Dollar Agreement with Ray D. Vaughn(6)10(xxii)
                  
                  Endorsement
      Split Dollar Agreement with W. Keith Betts(6)10(xxiii)
                  
                  Subordinated
      Term Loan Agreement dated September 26, 2008, by and between Crescent
      State Bank and United Community Bank(8)
  86
 
 10(xxiv)
                
                2006
      Omnibus Stock Ownership and Long Term Incentive Plan(9)21
                
                Subsidiaries
      (Filed herewith)23
                
                Consent
      of Dixon Hughes PLLC (Filed herewith)31(i)
                
                Certification
      of Principal Executive Officer Pursuant to Section 302 of the Sarbanes
      Oxley Act (Filed herewith)31(ii)
                
                Certification
      of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes
      Oxley Act (Filed herewith)32(i)
                
                Certification
      of Principal Executive Officer Pursuant to Section 906 of the Sarbanes
      Oxley Act (Filed herewith)32(ii)
                
                Certification
      of Principal Accounting Officer Pursuant to Section 906 of the Sarbanes
      Oxley Act (Filed herewith)99(i)
                
                Registrant’s
      Proxy Statement for the 2009 Annual Meeting of Shareholders(5)
 
 1.
              Incorporated
      by reference to the Registrant’s 10-KSB for the year ended December 31,
      2001, as filed with the Securities and Exchange Commission on March 27,
      2002.
 
 2.
              Incorporated
      by reference to the Registrant’s Registration Statement on Form S-8 as
      filed with the Securities and Exchange Commission on September 5,
      2001.
 
 3.
              Incorporated
      by reference from Annual Report on Form 10-KSB filed with the Securities
      and Exchange Commission on March 30,
2004.
 
 4.
              Incorporated
      by reference from Annual Report on Form 10-K filed with the Securities and
      Exchange Commission on March 28,
2006.
 
 5.
              Filed
      with the Securities and Exchange Commission pursuant to Rule
      14a-6.
 
 6.
              Incorporated
      by reference from Annual Report on Form 10-K filed with the Securities and
      Exchange Commission on March 11,
2008.
 
 7.
              Incorporated
      by reference from the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on December 31,
    2008.
 
 8.
              Incorporated
      by reference from the Registrant’s Current Report on Form 8-K filed with
      the Securities and Exchange Commission on September 30,
    2008.
 
 9.
                Incorporated
      by reference from Exhibit 99.1 to the Registration Statement on Form S-8,
      filed with the Securities and Exchange Commission on August 11,
      2006.
  87