UNITED STATES


SECURITIES AND EXCHANGE
COMMISSION


Washington, D.C.
20549





FORM 10-Q





þQUARTERLY REPORT PURSUANT TO
SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF
1934




For the Quarterly Period Ended September
30, 2008


or


 ̈TRANSITION REPORT PURSUANT TO SECTION
13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF
1934





For the Transition Period fromto













CAPITAL BANK
CORPORATION


(Exact name of registrant as specified
in its charter)





North
    Carolina
            
            000-30062
            
            56-2101930(State or other jurisdiction of
      incorporation)
            
            (Commission
              File
Number)
            
            (IRS Employer
              Identification
      No.)





333 Fayetteville Street, Suite
700


Raleigh, North Carolina
27601


(Address of principal executive
offices)





(919) 645-6400


(Registrant’s telephone number,
including area code)





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





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





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





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


Yes   ̈  No  þ





As of November7, 2008 therewere11,227,085shares outstanding of the registrant’s
common stock, no par value.





CAPITAL BANK
CORPORATION


Form 10-Q for the Quarterly Period Ended
September 30, 2008








INDEX





PART I – FINANCIAL
      INFORMATION
            Page
      No.Item 1.
            Financial
      StatementsCondensed Consolidated Balance
      Sheets as of September 30, 2008 (Unaudited) and December 31,
      2007
            3Condensed Consolidated Statements
      of Operations for the Three and Nine Months Ended September 30, 2008 and
      2007 (Unaudited)
            4Condensed Consolidated Statements
      of Changes in Shareholders’ Equity for the Nine Months Ended September 30,
      2008 and 2007 (Unaudited)
            5Condensed Consolidated Statements
      of Cash Flows for the Nine Months Ended September 30, 2008 and 2007
      (Unaudited)
            6Notes to Condensed Consolidated
      Financial Statements (Unaudited)
            8Item
      2.
            Management’s Discussion and
      Analysis of Financial Condition and Results of
      Operations
            16Item
      3.
            Quantitative and Qualitative
      Disclosures about Market Risk
            30Item 4.
            Controls and
      Procedures
            30PART II – OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            31Item
      1A.
            Risk
Factors
            31Item
      2.
            Unregistered Sales of Equity
      Securities and Use of Proceeds
            36Item 3.
            Defaults upon Senior
      Securities
            36Item
      4.
            Submission of Matters to a Vote of
      Security Holders
            36Item
      5.
            Other
      Information
            36Item
      6.
            Exhibits
            37Signatures


- 2
-
 Index
 PART I – FINANCIAL
INFORMATION





Item 1.Financial
Statements





CAPITAL BANK
CORPORATION


CONDENSED CONSOLIDATED BALANCE
SHEETS


September30, 2008 and December 31,
2007





September 30,
      2008
            
            December
      31, 2007(Dollars
      in thousands)
            
            (Unaudited)AssetsCash
      and due from banks:Interest
      earning
            
            $
            6,245
            
            $
            7,815Noninterest
      earning
            
            
            29,255
            
            
            32,347Federal
      funds sold and short term investments
            
            
            23
            
            
            10Total
      cash and cash equivalents
            
            
            35,523
            
            
            40,172Investment
      securities – available for sale, at fair value
            
            
            238,963
            
            
            249,094Investment
      securities – held to maturity, at amortized cost
            
            
            5,347
            
            
            10,022Loans –
      net of unearned income and deferred fees
            
            
            1,194,149
            
            
            1,095,107Allowance
      for loan losses
            
            
            (14,017
            )
            
            (13,571
            )Net
      loans
            
            
            1,180,132
            
            
            1,081,536Premises
      and equipment, net
            
            
            20,701
            
            
            23,863Bank-owned
      life insurance
            
            
            22,215
            
            
            21,589Goodwill
      and deposit premium, net
            
            
            62,575
            
            
            63,345Deferred
      income tax
            
            
            7,396
            
            
            5,829Accrued
      interest receivable
            
            
            6,683
            
            
            7,789Other
      assets
            
            
            14,867
            
            
            14,364Total
      assets
            
            $
            1,594,402
            
            $
            1,517,603LiabilitiesDeposits:Demand,
      noninterest bearing
            
            $
            109,056
            
            $
            114,780Savings
      and interest bearing checking
            
            
            176,396
            
            
            151,698Money
      market deposit accounts
            
            
            198,391
            
            
            229,560Time
      deposits less than $100,000
            
            
            463,498
            
            
            370,416Time
      deposits $100,000 and greater
            
            
            250,380
            
            
            232,244Total
      deposits
            
            
            1,197,721
            
            
            1,098,698Repurchase
      agreements and federal funds purchased
            
            
            22,290
            
            
            45,295Borrowings
            
            
            164,000
            
            
            163,347Subordinated
      debentures
            
            
            30,930
            
            
            30,930Other
      liabilities
            
            
            12,940
            
            
            15,033Total
      liabilities
            
            
            1,427,881
            
            
            1,353,303Commitments
      and contingenciesShareholders’
      EquityCommon
      stock, no par value; 20,000,000 shares authorized; 11,227,085 and
      11,169,777 shares issued and outstanding as of September 30, 2008 and
      December 31, 2007, respectively
            
            
            136,771
            
            
            136,154Retained
      earnings
            
            
            31,682
            
            
            27,985Accumulated
      other comprehensive (loss) income
            
            
            (1,932
            )
            
            161Total
      shareholders’ equity
            
            
            166,521
            
            
            164,300Total
      liabilities and shareholders’ equity
            
            $
            1,594,402
            
            $
            1,517,603





The accompanying notes are an integral
part of these condensed consolidated financial
statements.


- 3
-
 Index


CAPITAL BANK
CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


For the Three andNineMonths EndedSeptember30, 2008 and 2007
(Unaudited)





Three Months EndedSeptember
    30,
            
            Nine Months EndedSeptember
    30,2008
            
            2007
            
            2008
            
            2007(Dollars in thousands except per
      share data)Interest
      income:Loans and loan
      fees
            
            $
            17,875
            
            $
            20,830
            
            $
            55,485
            
            $
            61,231Investment
      securities:Taxable interest
      income
            
            
            2,182
            
            
            2,074
            
            
            6,616
            
            
            5,842Tax-exempt interest
      income
            
            
            801
            
            
            828
            
            
            2,435
            
            
            2,412Dividends
            
            
            58
            
            
            116
            
            
            293
            
            
            329Federal funds and other interest
      income
            
            
            15
            
            
            107
            
            
            103
            
            
            883Total interest
      income
            
            
            20,931
            
            
            23,955
            
            
            64,932
            
            
            70,697Interest
      expense:Deposits
            
            
            7,837
            
            
            9,847
            
            
            24,935
            
            
            29,771Borrowings and repurchase
      agreements
            
            
            2,267
            
            
            2,928
            
            
            7,333
            
            
            7,777Total interest
      expense
            
            
            10,104
            
            
            12,775
            
            
            32,268
            
            
            37,548Net interest
      income
            
            
            10,827
            
            
            11,180
            
            
            32,664
            
            
            33,149Provision for loan
      losses
            
            
            760
            
            
            261
            
            
            2,175
            
            
            507Net interest income after
      provisionfor loan
    losses
            
            
            10,067
            
            
            10,919
            
            
            30,489
            
            
            32,642Noninterest
      income:Service charges and other
      fees
            
            
            1,209
            
            
            963
            
            
            3,405
            
            
            2,769Mortgage fees and
      revenues
            
            
            142
            
            
            549
            
            
            768
            
            
            1,645Other loan
    fees
            
            
            392
            
            
            150
            
            
            892
            
            
            431Brokerage
    fees
            
            
            169
            
            
            156
            
            
            570
            
            
            409Bank card
      services
            
            
            357
            
            
            285
            
            
            1,010
            
            
            755Net gain on sale of investment
      securities
            
            
            109
            
            
            –
            
            
            249
            
            
            –Gain on sale of
      branch
            
            
            426
            
            
            –
            
            
            426
            
            
            –Bank-owned life
      insurance
            
            
            255
            
            
            218
            
            
            817
            
            
            623Other
            
            
            208
            
            
            201
            
            
            617
            
            
            424Total noninterest
      income
            
            
            3,267
            
            
            2,522
            
            
            8,754
            
            
            7,056Noninterest
      expense:Salaries and employee
      benefits
            
            
            5,122
            
            
            4,881
            
            
            15,484
            
            
            15,121Occupancy
            
            
            1,097
            
            
            1,062
            
            
            3,297
            
            
            3,053Furniture and
      equipment
            
            
            778
            
            
            664
            
            
            2,318
            
            
            1,926Data processing and
      telecommunications
            
            
            565
            
            
            416
            
            
            1,525
            
            
            1,201Advertising
            
            
            480
            
            
            394
            
            
            1,000
            
            
            992Office
    expenses
            
            
            298
            
            
            345
            
            
            978
            
            
            1,064Professional
      fees
            
            
            362
            
            
            264
            
            
            1,013
            
            
            869Business development and
      travel
            
            
            360
            
            
            252
            
            
            1,033
            
            
            909Amortization of deposit
      premiums
            
            
            256
            
            
            300
            
            
            770
            
            
            900Miscellaneous loan handling
      costs
            
            
            252
            
            
            247
            
            
            570
            
            
            545Directors
    fees
            
            
            303
            
            
            72
            
            
            702
            
            
            569Insurance
            
            
            138
            
            
            86
            
            
            336
            
            
            263FDIC deposit
      insurance
            
            
            214
            
            
            72
            
            
            442
            
            
            199Other
            
            
            292
            
            
            528
            
            
            908
            
            
            1,025Total noninterest
      expense
            
            
            10,517
            
            
            9,583
            
            
            30,376
            
            
            28,636Net income before tax
      expense
            
            
            2,817
            
            
            3,858
            
            
            8,867
            
            
            11,062Income tax
      expense
            
            
            805
            
            
            1,105
            
            
            2,473
            
            
            3,249Net income
            
            $
            2,012
            
            $
            2,753
            
            $
            6,394
            
            $
            7,813Earnings per share –
      basic
            
            $
            0.18
            
            $
            0.24
            
            $
            0.57
            
            $
            0.68Earnings per share –
      diluted
            
            $
            0.18
            
            $
            0.24
            
            $
            0.57
            
            $
            0.68




The accompanying notes are an integral
part of these condensed consolidated financial statements.




- 4
-
 Index


CAPITAL BANK
CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF
CHANGES IN SHAREHOLDERS’ EQUITY


For theNineMonths EndedSeptember30, 2008 and 2007
(Unaudited)





Shares ofCommonStock
            
            Common
              Stock
            
            Other
      ComprehensiveIncome
    (Loss)
            
            RetainedEarnings
            
            Total(Dollars in thousands exceptpershare data)Balance at January 1,
      2007
            
            
            11,393,990
            
            $
            139,484
            
            $
            (1,557
            )
            $
            23,754
            
            $
            161,681Repurchase of outstanding common
      stock
            
            
            (209,582
            )
            
            (3,181
            )
            
            –
            
            
            –
            
            
            (3,181
            )Issuance of common stock for
      options exercised
            
            
            35,597
            
            
            441
            
            
            –
            
            
            –
            
            
            441Issuance of common stock for
      services
            
            
            32,329
            
            
            497
            
            
            –
            
            
            –
            
            
            497Net income
            
            
            –
            
            
            –
            
            
            –
            
            
            7,813
            
            
            7,813Other comprehensiveloss
            
            
            –
            
            
            –
            
            
            (428
            )
            
            –
            
            
            (428
            )Comprehensive
      income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            7,385Dividends ($0.24per share)
            
            
            –
            
            
            –
            
            
            –
            
            
            (2,734
            )
            
            (2,734
            )Balance atSeptember30, 2007
            
            
            11,252,334
            
            $
            137,241
            
            $
            (1,985
            )
            $
            28,833
            
            $
            164,089Balance at January 1,
      2008
            
            
            11,169,777
            
            $
            136,154
            
            $
            161
            
            $
            27,985
            
            $
            164,300Repurchase of outstanding common
      stock
            
            
            (10,166
            )
            
            (92
            )
            
            –
            
            
            –
            
            
            (92
            )Issuance of common stock for
      options exercised
            
            
            15,591
            
            
            103
            
            
            –
            
            
            –
            
            
            103Issuance of common stock for
      services
            
            
            51,883
            
            
            590
            
            
            –
            
            
            –
            
            
            590Stock option
    expense
            
            
            –
            
            
            16
            
            
            –
            
            
            –
            
            
            16Net income
            
            
            –
            
            
            –
            
            
            –
            
            
            6,394
            
            
            6,394Unrealizedlossoninvestment securities – available
      for sale,net of tax
      of$1,535
            
            
            –
            
            
            –
            
            
            (2,447
            )
            
            –
            
            
            (2,447
            )Unrealized gain oncash flow hedge,net
      of tax of $222
            
            
            –
            
            
            –
            
            
            354
            
            
            –
            
            
            354Comprehensive
      income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,301Dividends ($0.24per share)
            
            
            –
            
            
            –
            
            
            –
            
            
            (2,697
            )
            
            (2,697
            )Balance atSeptember30, 2008
            
            
            11,227,085
            
            $
            136,771
            
            $
            (1,932
            )
            $
            31,682
            
            $
            166,521





The accompanying notes are an integral
part of these condensed consolidated financial
statements.


- 5
-
 Index


CAPITAL BANK
CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS


For the Nine Months Ended September 30,
2008 and 2007 (Unaudited)





2008
            
            2007(Dollars in
      thousands)Cash flows from operating
      activities:Net
      income
            
            $
            6,394
            
            $
            7,813Adjustments
      to reconcile net income to net cash provided by operating
      activities:Amortization
      of deposit premium
            
            
            770
            
            
            900Depreciation
            
            
            2,085
            
            
            1,824Net
      gain on sale of investment securities
            
            
            (249
            )
            
            –Net
      amortization of premium/discount on investment securities
            
            
            67
            
            
            54Increase
      in cash surrender value of BOLI
            
            
            (626
            )
            
            (692
            )Loss
      on disposal of premises, equipment and real estate owned
            
            
            76
            
            
            189Gain
      on sale of branch
            
            
            (426
            )
            
            –Provision
      for loan losses
            
            
            2,175
            
            
            507Net
      funding of loans held-for-sale
            
            
            –
            
            
            562Deferred
      income tax benefit
            
            
            (253
            )
            
            (128
            )Directors
      deferred compensation
            
            
            295
            
            
            497Stock
      option expense
            
            
            16
            
            
            7Changes
      in assets and liabilities:Accrued
      interest receivable and other assets
            
            
            626
            
            
            (1,060
            )Accrued
      interest payable and other liabilities
            
            
            (444
            )
            
            (520
            )Net
      cash provided by operating activities
            
            
            10,506
            
            
            9,953Cash
      flows from investing activities:Loan
      originations, net of principal repayments
            
            
            (103,807
            )
            
            (63,654
            )Additions
      to premises and equipment
            
            
            (3,744
            )
            
            (2,939
            )Proceeds
      from sales of premises, equipment and real estate owned
            
            
            6,001
            
            
            1,450Net
      cash paid in sale of branch
            
            
            (7,684
            )
            
            –Net
      purchases of FHLB and Silverton Bank stock
            
            
            (168
            )
            
            (419
            )Purchase
      of investment securities – available for sale
            
            
            (55,790
            )
            
            (30,386
            )Proceeds
      from principal repayments/calls/maturities of securities – available for
      sale
            
            
            62,292
            
            
            18,805Proceeds
      from principal repayments/calls/maturities of securities – held to
      maturity
            
            
            4,672
            
            
            689Net
      cash used in investing activities
            
            
            (98,228
            )
            
            (76,454
            )(continued
      on next page)





The accompanying notes are an integral
part of these condensed consolidated financial
statements.


- 6
-
 Index


CAPITAL BANK
CORPORATION


CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)


For theNineMonths EndedSeptember 30, 2008 and 2007(Unaudited)





2008
            
            2007(Dollars in
      thousands)Cash
      flows from financing activities:Net
      increase in deposits
            
            $
            109,465
            
            $
            35,380Net
      (decrease) increase in repurchase agreements
            
            
            (17,610
            )
            
            540Proceeds
      from borrowings
            
            
            246,100
            
            
            140,545Principal
      repayments of borrowings
            
            
            (247,100
            )
            
            (110,500
            )Net
      repayments of federal funds borrowed
            
            
            (5,395
            )
            
            –Dividends
      paid
            
            
            (2,693
            )
            
            (2,734
            )Issuance
      of common stock for options and other plans
            
            
            398
            
            
            441Repurchase
      of common stock
            
            
            (92
            )
            
            (3,181
            )Net
      cash provided by financing activities
            
            
            83,073
            
            
            60,491Net
      change in cash and cash equivalents
            
            
            (4,649
            )
            
            (6,010
            )Cash
      and cash equivalents at beginning of period
            
            
            40,172
            
            
            54,332Cash
      and cash equivalents at end of period
            
            $
            35,523
            
            $
            48,322Supplemental
      Disclosure of Cash Flow InformationTransfer
      of loans and premises to other real estate owned
            
            $
            1,664
            
            $
            1,280Dividends
      payable
            
            $
            898
            
            $
            900Cash
      paid for:Income
      taxes
            
            $
            2,081
            
            $
            4,203Interest
            
            $
            32,169
            
            $
            37,507





The accompanying notes are an integral
part of thesecondensedconsolidated financial
statements.


- 7
-
 Index


Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)




1.      Significant Accounting Policies and
Interim Reporting
 
 The accompanying unaudited condensed
consolidated financial statements include the accounts of Capital Bank
Corporation (the “Company”) and its wholly owned subsidiary, Capital Bank (the
“Bank”). In addition, the Company has interests in three trusts, Capital Bank
Statutory Trust I, II, and III (hereinafter collectively referred to as the
“Trusts”). The Trusts have not been consolidated with the financial statements
of the Companypursuant to the provisions of Financial Accounting
Standards Board (“FASB”) Interpretation No. 46R, Consolidation of Variable Interest
Entities.The interim
financial statements have been prepared in accordance with accounting principles
generally accepted in the United States of America(“U.S. GAAP”). They do not include all of the
information and footnotes required by such accounting principles for complete
financial statements, and therefore should be read in conjunction with the
audited consolidated financial statements and accompanying footnotes in
the Company’s Annual Report on Form 10-K for the year ended December 31,
2007.
 
 The preparation of financial statements
in conformity with U.S. GAAP requires management to make estimates and
assumptions that affect reported amounts of assets and liabilities and the
reported amounts of revenues and expenses during the reporting period.
The more significant estimates that are particularly susceptible to significant
change relate to the determination of the allowance for loan losses, valuation
of goodwill and intangible assets, valuation of investments, and tax assets,
liabilities and expense. Actual results could differ from those
estimates.
 
 In the opinion of management, all
adjustments necessary for a fair presentation of the financial position and
results of operations for the periods presented have been included, and all
significant intercompany transactions have been eliminated in consolidation.Certain amounts reported in
prior periods have been reclassified to conform to the current presentation.
Such reclassifications have no effect ontotal assets,net income or shareholders’ equity as
previously reported.The
results of operations for the nine months ended September 30, 2008 are not
necessarily indicative of the results of operations that may be expected for the
year ended December 31, 2008.
 
 The condensed consolidated balance sheet
at December 31, 2007 has been derived from the audited consolidated financial
statements contained in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2007.
 
 The accounting policies followed by the
Company are as set forth in Note 1 of the Notes to Consolidated Financial
Statements in the Company’s Annual Report on Form 10-K for the year ended
December 31, 2007.
  In
October 2008, the FASB issued FASB Staff Position (“FSP”) Statement of Financial
Accounting Standards (“SFAS”) No. 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset is Not Active (“FSP SFAS
No. 157-3”). The new FSP clarifies the application of SFAS No. 157, Fair Value Measurements,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. This FSP was effective upon
issuance, including prior periods for which financial statements had not been
issued. The adoption of FSP SFAS No. 157-3 did not have a material impact on the
Company’s consolidated financial condition or results of
operations.
 In May
2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles(“SFAS No. 162”). The new standard identifies the sources
of accounting principles and the framework for selecting the principles to be
used in the preparation of financial statements of nongovernmental entities that
are presented in conformity with U.S. GAAP. It is effective60 days following the
SEC’s approval of the Public Company Accounting Oversight Board amendments to AU
Section 411,The
Meaning ofPresent
Fairly in Conformity With Generally Accepted Accounting Principles. The Company is
currently evaluating the effect of SFAS No. 162, but does not expect its
adoption to have a material impact on the Company’s financial condition or
results of operations.
 
 In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No.
133 (“SFAS No. 161”). The new standard is
intended to improve financial reporting about derivative instruments and hedging
activities by requiring enhanced disclosures to enable investors to better
understand their effects on an entity’s financial condition, financial
performance, and cash flows. SFAS No. 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15,
2008. SFAS No. 161 will impact disclosures only and will not have an impact
on the Company’s consolidated financial condition, results of operations or cash
flows.
 - 8
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS
No. 141R”), which replaces SFAS No. 141, Business Combinations(“SFAS
No. 141”) issued in 2001. Whereas its predecessor
applied only to business combinations in which control was obtained by
transferring consideration, the revised standard applies to all transactions or
other events in which one entity obtains control over another. SFAS
No. 141R defines the acquirer as the entity that obtains control over one
or more other businesses and defines the acquisition date as the date the
acquirer achieves control. SFAS No. 141R requires the acquirer to recognize
assets acquired, liabilities assumed and any noncontrolling interest in the
acquiree at their respective fair values as of the acquisition date. The revised
standard changes the treatment of acquisition-related costs, restructuring costs
related to an acquisition that the acquirer expects but is not obligated to
incur, contingent consideration associated with the purchase price and
pre-acquisition contingencies associated with acquired assets and liabilities.
SFAS No. 141R retains the guidance in SFAS No. 141 for identifying and
recognizing intangible assets apart from goodwill. The revised standard applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. The Company will apply the provisions of SFAS
No. 141R to any business acquisition which occurs on or after the date the
standard becomes effective.
 
 Also in
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of ARB No. 51(“SFAS No.
160”). This statement amends Accounting Research Bulletin No. 51, Consolidated Financial
Statements, to establish accounting and reporting standards for the
noncontrolling interests in a subsidiary and for the deconsolidation of a
subsidiary. It clarifies that a
noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as equity in the consolidated
financial statements. SFAS No. 160 is effective for fiscal years, and
interim periods within those fiscal years, beginning on or after
December 15, 2008. Early adoption is prohibited. The Company is currently
evaluating the provisions of SFAS No. 160 and assessing the impact it
may have on the Company.
 
 In February 2007, the FASB
issued SFAS No. 159,The Fair Value
Options for Financial Assets and Financial Liabilities—Including an
amendment of FASB Statement No. 115(“SFAS No. 159”), effective for fiscal
years beginning after November 15, 2007. SFAS No. 159 permits entities to
choose, at specified election dates, to measure eligible items at fair value and
requires unrealized gains and losses on items for which the fair value option
has been elected to be reported in earnings. At this time, the Company does not
expect to elect the fair value option as outlined in the provisions of SFAS No.
159.
 
 In September 2006, the FASB issued SFAS
No. 157,Fair Value
Measurements(“SFAS No.
157”), which defines fair value, establishes a framework for measuring fair
value, and expands disclosures about fair value measurements. SFAS No. 157waseffective for the Company beginning
January 1, 2008.Certain
requirements of SFAS No. 157 are effective for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. The effective
date for other requirements of SFAS No. 157 has been deferred for one year by
the FASB. On January 1, 2008, the Company adopted SFAS No. 157, which has not
had a material impact on the Company’s financial condition or results of
operations.See Part I – Financial Information,
Item 1. Financial Statements, Notes to Condensed Consolidated Financial
Statements – Note 8. Fair Value Measurement for additional
information.
 
 In
September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements
No. 87, 88, 106, and 132(R) (“SFAS No. 158”). SFAS No. 158 requires
employers to recognize a net liability or asset and an offsetting adjustment to
accumulated other comprehensive income to report the funded status of defined
benefit pension and other post-retirement benefit plans. SFAS No. 158 requires
prospective application; thus, the recognition and disclosure requirements are
effective for fiscal years ending after December 31, 2006. Additionally, SFAS
No. 158 requires companies to measure plan assets and obligations at their
year-end balance sheet date. This requirement is effective for the Company’s
fiscal year ending after December 31, 2008. The Company is currently evaluating
the effect of the additional provisions of SFAS No. 158, but does not expect
adoption of the additional provisions to have a material impact on the Company’s
financial condition or results of operations.
 
 2.      Comprehensive Income
 
 Comprehensive income includes net income
and all other changes to the Company’s equity, with the exception of
transactions with shareholders (“other comprehensive income”). The Company’s
other comprehensive income for the nine month periods ended September 30, 2008
and 2007 is as shown in the Company’s Condensed Consolidated Statements of
Changes in Shareholders’ Equity (unaudited).
 - 9
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 The
Company’s other comprehensive income and accumulated other comprehensive income
are comprised of unrealized gains and losses on certain investments in debt
securities and derivatives that qualify as cash flow hedges to the extent that
the hedge is effective. Information concerning the Company’s other comprehensive
income for the three and nine months ended September 30, 2008 and 2007 is as
follows:
 
 Three Month Period Ended September 30,
2008 and 2007 (Unaudited)
 
 2008
              
              2007(Dollars in
      thousands)Unrealized (losses) gains on
      available-for-sale investment securities
              
              $
              (543
              )
              $
              3,293Unrealized gain on change in fair
      value of cash flow hedge
              
              
              31
              
              
              1,549Income tax benefit
      (expense)
              
              
              197
              
              
              (1,867
              )Other comprehensive (loss)
      income
              
              $
              (315
              )
              $
              2,975
 
 
 Nine Month Period Ended September 30,
2008 and 2007 (Unaudited)
 
 2008
              
              2007(Dollars in
      thousands)Unrealized losses on
      available-for-sale investment securities
              
              $
              (3,982
              )
              $
              (1,222
              )Unrealized gain on change in fair
      value of cash flow hedge
              
              
              576
              
              
              607Income tax
      benefit
              
              
              1,313
              
              
              187Other comprehensive
      loss
              
              $
              (2,093
              )
              $
              (428
              )
 
 3.      Earnings Per Share
 
 The Company is required to report both
basic and diluted earnings per share (“EPS”). Basic EPS excludes dilution and is
computed by dividing income available to common shareholders by the weighted
average number of common shares outstanding for the period. Diluted EPS assumes
the conversion, exercise or issuance of all potential common stock instruments,
such as stock options, unless the effect is to reduce a loss or increase
earnings per share. For the Company, EPS is adjusted for outstanding stock
options using the treasury stock method in order to compute diluted EPS. The
following table provides a computation and reconciliation of basic and diluted
EPS for the three and nine month periods ended September 30, 2008 and 2007,
respectively.
 
 Three Month Period Ended September 30,
2008 and 2007 (Unaudited)
 
 2008
              
              2007(Dollars in thousands)Income available to shareholders –
      basic and diluted
              
              $
              2,012
              
              $
              2,753Shares used in the computation of
      earnings per share:Weighted average number of shares
      outstanding – basic
              
              
              11,302,008
              
              
              11,451,322Incremental shares from assumed
      exercise of stock options
              
              
              11,380
              
              
              58,805Weighted average number of shares
      outstanding – diluted
              
              
              11,313,388
              
              
              11,510,127
 
 For the
three month periods ended September 30, 2008 and 2007, options to purchase
approximately 90,411 shares and 260,768 shares, respectively, of common stock
were used in the diluted calculation. For the three month periods ended
September 30, 2008 and 2007, options to purchase 251,823 shares and 136,350
shares, respectively, of common stock were not included in the diluted
calculation because the option price exceeded the average fair market value of
the associated shares of common stock.
 
 - 10
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
  Nine Month Period Ended September 30,
2008 and 2007 (Unaudited)
 
 2008
              
              2007(Dollars in thousands)Income available to shareholders –
      basic and diluted
              
              $
              6,394
              
              $
              7,813Shares used in the computation of
      earnings per share:Weighted average number of shares
      outstanding – basic
              
              
              11,300,623
              
              
              11,482,352Incremental shares from assumed
      exercise of stock options
              
              
              13,570
              
              
              69,325Weighted average number of shares
      outstanding – diluted
              
              
              11,314,193
              
              
              11,551,677
 
 For the
nine month periods ended September 30, 2008 and 2007, options to purchase
approximately 90,411 shares and 317,368 shares, respectively, of common stock
were used in the diluted calculation. For the nine month periods ended September
30, 2008 and 2007, options to purchase 251,823 shares and 79,750 shares,
respectively, of common stock were not included in the diluted calculation
because the option price exceeded the average fair market value of the
associated shares of common stock.
 4.      Stock-Based
Compensation
 
 The Company
accounts for stock-based compensation in accordance with SFAS No. 123R,Share-Based
Payments(“SFAS No.
123R”). The Company has stock option plans providing for the issuance of up to
650,000 options to purchase shares of the Company’s common stock to officers and
directors, of which
608,700 have been granted, with 257,850 remaining outstanding as of September
30, 2008.In addition, there were566,071options, which were assumed under
various plans from previously acquired financial institutions, of which84,384remain outstanding.
 
 The following is a summary of stock
option information and the weighted average exercise price (“WAEP”) for the nine
months endedSeptember 30,
2008.
  Number
                    of Shares
                  
                  Weighted
                    Average
                    Exercise
    Price
                  
                  Weighted
      Average
                    Remaining
      Contractual
                    Term in
    Years
                  
                  Aggregate
                    Intrinsic
    Value(Dollars in thousands except per share
      data)Outstanding at January 1,
      2008
                  
                  
                  384,075
                  
                  $
                  12.56Granted
                  
                  
                  3,500
                  
                  
                  10.42Exercised
                  
                  
                  (15,591
                  )
                  
                  6.62Forfeited
                  
                  
                  (1,000
                  )
                  
                  10.74Expired
                  
                  
                  (29,750
                  )
                  
                  14.00Outstanding at September 30,
      2008
                  
                  
                  341,234
                  
                  $
                  12.69
                  
                  
                  4.34
                  
                  $
                  167Options exercisable at September
      30, 2008
                  
                  
                  295,534
                  
                  $
                  12.30
                  
                  
                  3.64
                  
                  $
                  167
 
 The following table summarizes
information about the Company’s stock options atSeptember 30, 2008.
 
 Exercise
    Price
                  Number
                    Outstanding
                  
                  Weighted
      Average
                    Remaining
      Contractual
                    Life in
    Years
                  
                  Number
                    Exercisable$6.62 –
    $9.00
                  80,631
                  
                  1.63
                  
                  80,631$9.01 –
    $12.00
                  90,202
                  
                  3.09
                  
                  87,702$12.01 –
    $15.00
                  20,000
                  
                  7.88
                  
                  5,600$15.01 –
    $18.00
                  96,151
                  
                  5.99
                  
                  67,351$18.01 –
    $18.37
                  54,250
                  
                  6.24
                  
                  54,250341,234
                  
                  4.34
                  
                  295,534
 - 11
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 The fair
values of the options were estimated on the date of grant using the
Black-Scholes option-pricing model. Option pricing models require the use of
highly subjective assumptions, including expected stock volatility, which, if
changed, can materially affect fair value estimates. The expected life of the
options used in this calculation was the period the options are expected to be
outstanding. Expected stock price volatility was based on the historical
volatility of the Company’s common stock for a period approximating the expected
life; the expected dividend yield was based on the Company’s historical annual
dividend payout; and the risk-free rate was based on the implied yield available
on U.S. Treasury issues.
 
 The Company also administers the Capital
Bank Corporation Deferred Compensation Plan forOutsideDirectors (the “Deferred Compensation
Plan”). Under the Deferred Compensation Plan, eligible directors may elect to
defer all or part of their directors’ fees for a calendar year, in exchange for
common stock of the Company, based on the year-end share price. The amount
deferred, if elected, is equal to 125 percent of the total director’s fees. Each
participant is fully vested in his or her account balance. The Deferred
Compensation Plan generally provides for payment of share units either in shares
of Company common stock or cash (at the Company’s discretion). The Deferred
Compensation Plan is classified as a liability-based plan under SFAS No. 123R.
Accordingly, changes in the Company’s stock price affect the amount of expense
recognized during the period. For the nine month periods ended September 30,
2008 and 2007, the Company recognized $384 thousand and $292
thousand,respectively, of share-based expense
related to the Deferred Compensation Plan.
 
 5.      Investment
Securities
 
 The following table shows the gross
unrealized losses and fair value of the Company’s investments with unrealized
losses that are not deemed to be other-than-temporarily impaired, aggregated by
investment category and length of time that individual securities have been in a
continuous unrealized loss position, atSeptember 30, 2008.
 
 Less than 12
      Months
                
                12 Months or
      Greater
                
                Total(Dollars in
      thousands)
                
                Fair Value
                
                Unrealized
                  Losses
                
                Fair Value
                
                Unrealized
      Losses
                
                Fair Value
                
                Unrealized
      LossesAvailable for SaleMunicipal bonds and
      other
                
                $
                58,090
                
                $
                4,740
                
                $
                5,721
                
                $
                669
                
                $
                63,811
                
                $
                5,409Mortgage-backed
      securities
                
                
                49,827
                
                
                572
                
                
                8,350
                
                
                420
                
                
                58,177
                
                
                992107,917
                
                
                5,312
                
                
                14,071
                
                
                1,089
                
                
                121,988
                
                
                6,401Held to MaturityMunicipal bonds and
      other
                
                $
                300
                
                $
                –
                
                $
                –
                
                $
                –
                
                $
                300
                
                $
                –Mortgage-backed
      securities
                
                
                2,419
                
                
                26
                
                
                2,398
                
                
                203
                
                
                4,817
                
                
                2292,719
                
                
                26
                
                
                2,398
                
                
                203
                
                
                5,117
                
                
                229Total at September 30,
      2008
                
                $
                110,636
                
                $
                5,338
                
                $
                16,469
                
                $
                1,292
                
                $
                127,105
                
                $
                6,630
 
 
 The unrealized losses on the Company’s
investments were primarily the result of interest rate changes. The Company has
the ability and intent to hold these investments until a recovery of fair value,
which may be at maturity. Accordingly, the Company does not consider these
investments to be other-than-temporarily impaired at September 30,
2008.
 
 6.      Loans
 
 The composition of the loan portfolio by
loan classification at September 30, 2008 and December 31, 2007 is as
follows:
 
 September 30,
      2008
                
                December 31,
      2007(Dollars in
      thousands)
                
                (Unaudited)Commercial
                
                $
                702,776
                
                $
                640,355Construction
                
                
                337,639
                
                
                301,799Consumer
                
                
                10,918
                
                
                12,788Home equity
                
                
                87,356
                
                
                79,361Residential
      mortgages
                
                
                55,116
                
                
                60,5961,193,805
                
                
                1,094,899Plus deferred loan costs,
      net
                
                
                344
                
                
                208$
                1,194,149
                
                $
                1,095,107
 - 12
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 There were no loans held for sale at
September 30, 2008 or December 31, 2007.
 
 7.      Financial Instruments with
Off-Balance-Sheet Risk
 
 To meet the financial needs of its
customers, the Company is party to financial instruments with off-balance-sheet
risk in the normal course of business. These financial instruments are
comprised of unused lines of credit, overdraft lines and standby letters of
credit. These instruments involve, to varying degrees, elements of credit risk
in excess of the amount recognized in the balance sheet.
 
 The Company’s exposure to credit loss in
the event of nonperformance by the other party is represented by the contractual
amount of those instruments. The Company uses the same credit policies in making
these commitments as it does for on-balance-sheet instruments. The amount of
collateral obtained, if deemed necessary by the Company, upon extension of
credit is based on management’s credit evaluation of the borrower. Collateral
held varies but may include trade accounts receivable, property, plant and
equipment, and income-producing commercial properties. Since many unused lines
of credit expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements.
 
 The Company’s exposure to
off-balance-sheet credit risk as of September 30, 2008 and December 31, 2007 was
as follows:
 
 September 30,
      2008
                
                December 31,
      2007(Dollars in
      thousands)
                
                (Unaudited)Unused lines of credit and
      overdraft lines
                
                $
                286,371
                
                $
                301,089Standby letters of
      credit
                
                
                9,973
                
                
                7,697Total
      commitments
                
                $
                296,344
                
                $
                308,786
 
 8.      Fair Value
Measurement
 
 On
January 1, 2008, the Company adopted SFAS No. 157, which defines fair
value, establishes a framework for measuring fair value under U.S. GAAP, and
enhances disclosures about fair value measurements. The Company elected to delay
the application of SFAS No. 157 to nonfinancial assets and nonfinancial
liabilities, as allowed by FASB Staff Position SFAS No. 157-2. SFAS No. 157
applies whenever other standards require (or permit) assets or liabilities to be
measured at fair value and, therefore, does not expand the use of fair value in
any new circumstances. Fair value is defined as the exchange price that would be
received to sell an asset or paid to transfer a liability in the principal or
most advantageous market for the asset or liability in an orderly transaction
between market participants on the measurement date. SFAS No. 157 clarifies that
fair value should be based on the assumptions market participants would use when
pricing an asset or liability and establishes a fair value hierarchy that
prioritizes the information used to develop those assumptions. The fair value
hierarchy gives the highest priority to quoted prices in active markets
(observable inputs) and the lowest priority to the Company’s assumptions
(unobservable inputs). SFAS No. 157 requires fair value measurements to be
separately disclosed by level within the fair value hierarchy. For assets and
liabilities recorded at fair value, it is the Company’s policy to maximize the
use of observable inputs and minimize the use of unobservable inputs when
developing fair value measurements, in accordance with the fair value hierarchy
in SFAS No. 157.
 
 Fair
value measurements for assets and liabilities where there exists limited or no
observable market data and, therefore, are based primarily upon estimates, are
often calculated based on the economic and competitive environment, the
characteristics of the asset or liability and other factors. Therefore, the
results cannot be determined with precision and may not be realized in an actual
sale or immediate settlement of the asset or liability. Additionally, there may
be inherent weaknesses in any calculation technique, and changes in the
underlying assumptions used, including discount rates and estimates of future
cash flows, could significantly affect the results of current or future
values.
 
 The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and liabilities and to determine fair value disclosures.
Securities available for sale and derivatives are recorded at fair value on a
recurring basis. Additionally, from time to time, the Company may be required to
record at fair value other assets on a nonrecurring basis, such as loans held
for sale, loans held for investment and certain other assets. These nonrecurring
fair value adjustments typically involve application of lower of cost or market
accounting or write-downs of individual assets.
 - 13
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 Under
SFAS No. 157, the Company groups assets and liabilities at fair value in three
levels, based on the markets in which the assets and liabilities are traded and
the reliability of the assumptions used to determine fair value. An adjustment
to the pricing method used within either Level 1 or Level 2 inputs could
generate a fair value measurement that effectively falls in a lower level in the
hierarchy. These levels are:
 
 Level 1 –
Valuations for assets and liabilities traded in active exchange markets, such as
the New York Stock Exchange.
 
 Level 2 –
Valuations for assets and liabilities that can be obtained from readily
available pricing sources via independent providers for market transactions
involving similar assets or liabilities. The Company’s principal market for
these securities is the secondary institutional markets, and valuations are
based on observable market data in those markets.
 
 Level 3 –
Valuations for assets and liabilities that are derived from other valuation
methodologies, including option pricing models, discounted cash flow models and
similar techniques, and not based on market exchange, dealer, or broker traded
transactions. Level 3 valuations incorporate certain assumptions and projections
in determining the fair value assigned to such assets or
liabilities.
 
 The
following is a description of valuation methodologies used for assets and
liabilities recorded at fair value. The determination of where an asset or
liability falls in the hierarchy requires significant judgment. The Company
evaluates its hierarchy disclosures each quarter and based on various factors,
it is possible that an asset or liability may be classified differently from
quarter to quarter. However, the Company expects changes in classifications
between levels will be rare.
 
 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. Investment securities,
held to maturity, are recorded at amortized cost, not at fair
value.
 
 Derivative Assets and
Liabilities
 Derivative
instruments held or issued by the Company for risk management purposes are
traded in over-the-counter markets where quoted market prices are not readily
available. For those derivatives, the Company measures fair value using models
that use primarily market observable inputs, such as yield curves and option
volatilities, and include the value associated with counterparty credit risk.
The Company classifies derivatives instruments held or issued for risk
management purposes as Level 2. As of September 30, 2008 the Company’s
derivative instruments consisted solely of interest rate swaps.
 
 Loans Held for
Sale
 Loans
held for sale are carried at the lower of cost or market value. The fair value
of loans held for sale is based on what secondary markets are currently offering
for portfolios with similar characteristics. As such, the Company classifies
loans subjected to nonrecurring fair value adjustments as Level 2. The Company
had no loans held for sale as of September 30, 2008.
 
 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 September 30, 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 an 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 $6.6 million at September 30, 2008
with specific loss allowances aggregating $1.4 million at that
date.
  - 14
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
  Foreclosed
Assets
 Foreclosed
assets are adjusted to fair value upon transfer of the loans to foreclosed
assets. Subsequently, foreclosed assets are carried at the lower of carrying
value or fair value. Fair value is based upon independent market prices,
appraised values of the collateral or management’s estimation of the value of
the collateral. When the fair value of the collateral is based on an observable
market price or a current appraised value, the Company records the foreclosed
asset as nonrecurring Level 2. When an 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 foreclosed asset as nonrecurring Level 3. There were no fair value
adjustments related to foreclosed real estate of $1.0 million at September 30,
2008.
 
 Below is
a table that presents information about certain assets and liabilities measured
at fair value on a recurring basis:
 
 Fair Value Measurements at
      September 30, 2008Quoted Prices in Active Markets
      for Identical Assets
                  (Level 1)
                
                Significant Other
      Observable
                  Inputs
                  (Level 2)
                
                Significant
                  Unobservable
                  Inputs
                  (Level 3)
                
                Total(Dollars in
      Thousands)Investment
      securities
                
                $
                8,877
                
                $
                228,086
                
                $
                2,000
                
                $
                238,963Fair value interest rate
      swaps
                
                
                –
                
                
                (37
                )
                
                –
                
                
                (37
                )Cash flow interest rate
      swaps
                
                
                –
                
                
                2,525
                
                
                –
                
                
                2,525
 
 Below is
a table that presents information about certain assets and liabilities measured
at fair value on a nonrecurring basis:
 
 Fair Value Measurements at
      September 30, 2008Quoted Prices in Active Markets
      for Identical Assets
                  (Level 1)
                
                Significant Other
      Observable
                  Inputs
                  (Level 2)
                
                Significant
                  Unobservable
                  Inputs
                  (Level 3)
                
                Total(Dollars in
      Thousands)Loans held for
      sale
                
                $
                –
                
                $
                –
                
                $
                –
                
                $
                –Impaired
    loans
                
                
                –
                
                
                –
                
                
                5,217
                
                
                5,217Foreclosed
      assets
                
                
                –
                
                
                –
                
                
                1,019
                
                
                1,019
 
 9.      Redeemable Common
Stock
 
 The
Company maintains the Capital Bank 401(k) Retirement Plan (the “Plan”) for the
benefit of its employees, through which participants can elect to purchase
Company common stock at market prices. In prior years, the Company had
registered 50,000 shares of its common stock with the Securities and Exchange
Commission (“SEC”) to be available for issuance under the Plan. The Company
recently determined that it may have inadvertently failed to register with the
SEC the issuance of shares under the Plan in excess of the number previously
registered. The Company common stock held in the Plan is not purchased from the
Company; rather, the plan trustee accumulates plan contributions that are then
used to purchase Company common stock in open market transactions. Nevertheless,
because the Company sponsors the Plan, the Company may have
been required to register with the SEC all transactions in the Plan related
to shares of its common stock.
 
 As a
result, certain purchasers of common stock pursuant to the Plan may have the
right to rescind their purchases for an amount equal to the purchase
price paid for the shares, plus interest from the date of purchase. As of
September 30, 2008 and December 31, 2007, the Company had common shares subject
to potential rescission rights that are considered redeemable common stock,
because the redemption features are not within the control of the Company. The
balance of redeemable common stock at September 30, 2008 and December 31, 2007,
however, is not considered material for separate classification on the condensed
consolidated balance sheets. These shares have always been treated as
outstanding for financial reporting purposes.
 - 15
-
 Index
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 10.           Significant
Transactions
 
 On August
29, 2008, the Company completed the sale of its branch located in Greensboro,
North Carolina, to NewBridge Bank, a wholly-owned subsidiary of NewBridge
Bancorp. Property and equipment, loans, and deposits of $1.0 million, $1.4
million, and $10.4 million, respectively, were included in the sale. A gain of
$0.4 million related to this branch sale was recorded to noninterest income for
the quarter ended September 30, 2008.
 
 On September 24, 2008, the Companyentered into a definitive
purchase agreement to acquire the four Fayetteville, North Carolina,area branchesof Omni National Bank in a cash
transaction. Omni National Bank is the banking subsidiary of Omni Financial
Services, Inc., a bank holding company headquartered in Atlanta, Georgia. As a resultof this transaction, the Company will
assumedeposits totaling
approximately $105 million and will purchase approximately $50 million in
selected loan balances. In
addition, the Companywill
acquire the real estate assets and fixed capital equipment associated with the
four branches,plus two
offsite ATMs. Upon
completion of the transaction, the Fayettevilleareabranches will operate as full service
Capital Bank branches.
  11.           Subsequent
Events
 The U.S.
Treasury has announced that it will make funds available to certain banks under
its Troubled Asset Relief Program (the “Program”). The Emergency Economic
Stabilization Act of 2008 authorized the Treasury to establish the Program under
which certain U.S. financial institutions may sell senior preferred stock and
issue warrants to purchase an institution’s common stock to the Treasury in
exchange for a capital infusion. Under the Program, eligible institutions can
generally apply to issue preferred stock to the Treasury in aggregate amounts
between 1% and 3% of the institution’s risk-weighted assets, along with warrants
covering shares of common stock. On October 23, 2008, the Company’s board of
directors (the “Board”) authorized and approved the Company’s participation in
the Program, and the Company filed its application with the Treasury. In order
to participate in the Program, the Board also authorized the Company to sell up
to 42,900 shares of senior preferred stock (“Senior Preferred”) to the Treasury
for $1,000 per share, subject to the pre-approval of this proposal by the
Company’s shareholders.
 
 On
November 6, 2008,
the Treasury notified the Company that it was eligible to participate in the
Program.At this point, however, there is no binding agreement or
commitment with respect to the Company’s participation in the Program. The
Company and the Treasury must still negotiate the terms and conditions of
participation. Although the Company has no reason to believe that it will not be
able to participate in the Program, no assurances can be given that it will be
able to participate. In addition, no assurances can be given regarding the
approximate number of shares of preferred stock that the Company may issue or
the approximate amount of consideration the Company will receive from Treasury
for any such shares that may be issued under the Program.
 Item 2.Management’s Discussion and Analysis of Financial
Condition and Results of Operations
 
 The following discussion presents an
overview of the unaudited financial statements for the three and nine months
ended September 30, 2008 and 2007 for Capital Bank Corporation (the “Company”)
and its wholly owned subsidiary, Capital Bank (the “Bank”). This discussion and
analysis is intended to provide pertinent information concerning financial
condition, results of operations, liquidity, and capital resources for the
periods covered and should be read in conjunction with the unaudited financial
statements and related footnotes contained in Part I, Item 1 of this
report.
 
 Information set forth below contains
various forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended (the “Exchange Act”), which statements represent the
Company’s judgment concerning the future and are subject to risks and
uncertainties that could cause the Company’s actual operating results to differ
materially. Such forward-looking statements can be identified by the use of
forward-looking terminology, such as “may,” “will,” “expect,” “anticipate,”
“estimate,” “believe,” or “continue,” or the negative thereof or other
variations thereof or comparable terminology. The Company cautions that such
forward-looking statements are further qualified by important factors that could
cause the Company’s actual operating results to differ materially from those in
the forward-looking statements, as well as the factors set forth in Part II,
Item 1A of this report, and the Company’s periodic reports and other filings
with the Securities and
Exchange Commission (“SEC”).
 - 16
-
 Index
 Overview
 
 The Bank is a full-service state
chartered community bank conducting business throughout North Carolina. The
Bank’s business consists principally of attracting deposits from the general
public and investing these funds in loans secured by commercial real estate,
secured and unsecured commercial and consumer loans, single-family residential
mortgage loans, and home equity lines. As a community bank, the Bank’s
profitability depends primarily upon its levels of net interest income, which is
the difference between interest income from interest-earning assets and interest
expense on interest-bearing liabilities. When interest-earning assets
approximate or exceed interest-bearing liabilities, any positive interest rate
spread will generate net interest income. The Bank’s profitability is also
affected by its provision for loan losses, noninterest income, and other
operating expenses. Noninterest income primarily consists of service charges,
interchange income and ATM fees, fees generated from originating mortgage loans
that are sold, and the increase in cash surrender value of bank-owned life
insurance. Operating expenses primarily consist of compensation and benefits,
occupancy related expenses, advertising, data processing, professional fees and
other expenses.
 
 The Bank’s operations are influenced
significantly by local economic conditions and by policies of financial
institution regulatory authorities. The Bank’s cost of funds is influenced by
interest rates on competing investments and by rates offered on similar
investments by competing financial institutions in its market area, as well as
general market interest rates. Lending activities are affected by the demand for
financing, which in turn is affected by the prevailing interest
rates.
 
 Impact
of Recent Developments on the Banking Industry
 
 The
banking industry, including the Company, is operating in a challenging and
volatile economic environment. The effects of the downturn in the housing market
has adversely impacted credit markets, consumer confidence and the broader
economy. Along with other financial institutions, the Company’s stock price has
suffered as a result. Management cannot predict when these market difficulties
will subside. While the current economic downturn and the difficulties it
presents for the Company and others in the banking industry are unprecedented,
management believes that the business is cyclical and must be viewed and
measured over time. The Company’s primary focus at this time is to manage the
business safely during the economic downturn and be poised to take advantage of
any market opportunities that may arise.
 
 Because
of the current economic situation, U.S. and foreign governments have acted in
attempt to stabilize the financial system. For example, the U.S. government has
adopted the Emergency Economic Stabilization Act, which, among other things,
authorized the U.S. Treasury to establish the Troubled Asset Relief Program,
under which certain United States financial institutions may sell senior
preferred stock and issue warrants to purchase an institution’s common stock to
the Treasury in exchange for a capital infusion. See “Liquidity and Capital
Resources” below for a more detailed discussion of the Company’s potential
participation in this program. It is not clear at this time what impact these
measures will have on the on the Company or the financial markets as a whole.
Management will continue to monitor the effects of these programs as they relate
to the Company and its financial operations.
 
 Critical Accounting Policies and
Estimates
 
 The Company’scriticalaccounting policies are described in
Note 1of the Company’s Annual Report on Form
10-Kfor the year endedDecember 31, 2007.These policies are important in
understanding management’s
discussion and analysis.Some of the Company’s accounting
policies require the Company to make estimates and judgments regarding
uncertainties that may affect the reported amounts of assets, liabilities,
revenues and expenses.
 
 The Company has identified five
accounting policies as being critical in terms of significant judgments and the
extent to which estimates are used: allowance for loan losses, investments,
valuation allowances, goodwill and the impairment of long-lived assets.In many cases, there are
several alternative judgments that could be used in the estimation process.The Company bases its
estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily
apparent from other sources.Actual results may differ from these
estimates under different
assumptions or conditions.For more information on the Company’s critical accounting policies, refer to Part II, Item
7of the
Company’sAnnual Report on Form 10-K forthe year ended December 31,
2007.
 - 17
-
 Index
 Executive Summary
 
 As discussed in more detail below, the
following is a summary of our significant results for the three and nine months
ended September 30, 2008.
 
  •
                  The
      Company reported net income for the quarter ended September 30, 2008 of
      $2.0 million compared to $2.8 million for the quarter ended September 30,
      2007. Earnings per share on a fully diluted basis was $0.18 for the third
      quarter of 2008 compared to $0.24 for the third quarter of 2007. The
      Company reported net income for the nine months ended September 30, 2008
      of $6.4 million compared to $7.8 million for the nine months ended
      September 30, 2007. Earnings per share on a fully diluted basis was $0.57
      for the first three quarters of 2008 compared to $0.68 for the first three
      quarters of 2007.•
                  Nonperforming
      assets, which includes loans on nonaccrual and other real estate owned,
      decreased to 0.47% of total assets at the end of September 2008 compared
      to 0.50% at the end of December 2007 and 0.71% at the end of September
      2007. In addition, past due loans declined to 0.75% of total loans at the
      end of September 2008 compared to 0.98% at the end of December 2007 and
      1.23% at the end of September 2007. Allowance for loan losses totaled
      1.17% of total loans at the end of September 2008 compared to 1.24% at the
      end of December 2007 and 1.25% at the end of September 2007. The allowance
      for loan losses as a percent of nonperforming loans decreased to 219% at
      end of the third quarter 2008 from 227% at the end of the fourth quarter
      2007 but increased from 131% at the end of the third quarter
      2007.•
                  The provision for loan losses for
      the quarter ended September 30, 2008 was $760 thousand compared to $261
      thousand for the quarter ended September 30, 2007. The provision for loan
      losses for the nine months ended September 30, 2008 was $2.2 million
      compared to $507 thousand for the nine months ended September 30, 2007.
      The increase in the provision was partially due to loan growth but was
      also partially due to higher levels of net charge-offs over the periods
      under comparison. Also contributing to the increased provision were
      enhancements in the methodology for calculating the allowance for loan
      losses, which reduced the allowance and related provision during the nine
      months ended September 30, 2007. The enhancements to the allowance
      methodology were implemented during 2007 based on updated guidance issued
      through an interagency policy statement by the FDIC, Federal Reserve, and
      other regulatory agencies.•
                  Net
      interest income for the third quarter of 2008 decreased $353 thousand
      compared to the third quarter of 2007. This decrease was primarily due to
      the decline in net interest margin from 3.56% in the quarter ended
      September 30, 2007 to 3.13% in the quarter ended September 30, 2008. Net
      interest income for the first three quarters of 2008 decreased $485
      thousand compared to the first three quarters of 2007. This decrease was
      primarily due to the decline in net interest margin from 3.58% in the nine
      months ended September 30, 2007 to 3.18% in the nine months ended
      September 30, 2008. The decline in the net interest margin is largely a
      result of the 2.75% reduction in the prime rate over the last twelve
      months.•
                  In
      the third quarter ended September 30, 2008, noninterest income increased
      $745 thousand compared to the same period one year ago. This increase was
      primarily due to gains recognized on the sale of investments and the sale
      of a branch for $109 thousand and $426 thousand, respectively. For the
      nine month period ended September 30, 2008, noninterest income increased
      $1.7 million compared to the same period one year ago despite an $877
      thousand decline in mortgage fees and revenues. Service charges, other
      loan fees, and bank card services increased a combined $1.4 million
      primarily as a result of management’s continued emphasis on increasing
      income from these sources. Gains recognized on the sale of investments and
      the sale of a branch added $249 thousand and $426 thousand, respectively,
      to noninterest income during this
period.
 - 18
-
 Index
 •
                  Noninterest
      expense increased $934 thousand in the quarter ended September 30, 2008
      from the same quarter one year ago. Salaries and employee benefits, data
      processing and telecommunications, directors fees, and FDIC deposit
      insurance costs contributed a combined $763 thousand to the increase in
      noninterest expense. Salaries and employee benefits increased primarily
      due to routine annual compensation adjustments; data processing and
      communications increased primarily due to system upgrades and enhancements
      to support growth in the Company’s primary business lines; directors fees
      increased primarily due to fluctuations in the Company’s stock price; and
      FDIC deposit insurance costs rose as the regulatory agency increased
      premiums to cover higher monitoring costs and claims. Noninterest expense
      increased $1.7 million in the first nine months of 2008 from the same
      period one year ago. Salaries and employee benefits, occupancy, furniture
      and equipment, data processing and telecommunications, and FDIC insurance
      costs contributed a combined $1.6 million to the increase in noninterest
      expense. Salaries and employee benefits increased primarily due to routine
      annual compensation adjustments; occupancy increased partially due to
      higher rent expense from additional leased branches as well as expanded
      space requirements at the Company’s headquarters; furniture and equipment increased
      partially due toequipment and building upgrades as well as higher
      maintenance costs; data processing and communications increased partially
      due to system upgrades and enhancements to support growth in the Company’s
      primary business lines as well as the implementation of an internet-based
      phone system; and FDIC deposit insurance costs rose as the regulatory
      agency increased premiums to cover higher monitoring costs and
      claims.
 
 Financial Condition
 
 Total assets of the Company as of
September 30, 2008 totaled $1.59 billion, an increase of $76.8 million, or 5.1%,
over total assets of $1.52 billion as of December 31, 2007. The increase in
total assets for the nine months ended September 30, 2008 is primarily due to a
$98.6 million increase in the Bank’s loan portfolio, net of allowance for loan
losses, since December 31, 2007.
 
 Total earning assetswere $1.44 billion as of September 30,
2008 compared to $1.36 billion as of December 31, 2007. Earning assets
represented 90.6% and89.8%
of total assets as of September 30, 2008 and December 31, 2007, respectively. At
September 30, 2008, investment securities were $244.3 million compared to
$259.1million as of
December 31, 2007. Interest-earning cash, federal funds sold and short term
investments were $6.3 million as of September 30, 2008 compared to $7.8 million
as of December 31, 2007.
 
 Allowance for loan losses was $14.0
million as of September 30, 2008 compared to $13.6 million as of December 31,
2007, representing approximately 1.17% and 1.24%, respectively, of total loans
as of both dates. Management believes that the allowance balance is adequate to
absorb estimated losses inherent in the current loan portfolio. See“Asset
Quality”below for further
discussion of the allowance for loan losses.
 
 Total deposits as of September 30, 2008
were $1.20 billion, an increase of $99.0 million, or 9.0%, from December 31,
2007. The increase was primarily due to a $19.0 million increase in demand
deposit accounts, and a $111.2 million increase in time deposits, partially
offset by a $31.2 million decrease in money market deposits. Time deposits
represented 59.6% of total deposits at September 30, 2008 compared to 54.9% at
December 31, 2007.
 
 Total shareholders’ equity was $166.5
million as of September 30, 2008, an increase of $2.2 million from December 31,
2007. Retained earnings increased by $3.7 million, reflecting $6.4 million of
net income for the nine months ended September 30, 2008 less $2.7 million of
dividends declared during the same period. Accumulated other comprehensive
income (loss), which represents the unrealized gains and losses on
available-for-sale securities and derivatives accounted for as cash flow hedges,
net of related tax benefits, was $(1.9) million and $0.2 million as of September
30, 2008 and December 31, 2007, respectively. The decrease in accumulated other
comprehensive income to a loss position during the nine months ended September
30, 2008 was due to a decline in fair value of available-for-sale investment
securities, partially offset by an increase in fair value of the cash flow
hedge. See Item 1. Financial Statements – Condensed Consolidated Statements of
Changes in Shareholders’ Equity for additional information.
 - 19
-
 Index
 Results of
Operations
 
 Quarter endedSeptember 30, 2008compared to quarter endedSeptember 30, 2007
 
 For the quarter ended September 30,
2008, the Company reported net income of $2.0 million, or $0.18 per diluted
share, compared to net income of $2.8 million, or $0.24 per diluted share, for
the quarter ended September 30, 2007. Net income decreased by $741 thousand,
primarily due to a $353 thousand decline in net interest income and $499
thousand increase in provision for loan losses. Additionally, noninterest
expense increased $934 thousand over the quarters under comparison but was
partially offset by a $745 thousand increase in noninterest income. Tax expense
declined $300 thousand over the quarters under comparison, reflecting lower net
income before tax expense.
 
 Net interest income decreased $353
thousand, or 3.2%, from $11.2 million for the quarter ended September 30, 2007
to $10.8 million for the quarter ended September 30, 2008. Average earning
assets increased $122.7 million to $1.4 billion for the quarter ended September
30, 2008 from $1.3 billion for the quarter ended September 30, 2007. Average
interest-bearing liabilities increased $121.4 million to $1.3 billion for the
quarter ended September 30, 2008 from $1.2 billion for the quarter ended
September 30, 2007. The net interest margin on a fully tax equivalent basis
decreased by 43 basis points (“bps”) to 3.13% for the quarter ended September
30, 2008 from 3.56% for the quarter ended September 30, 2007. The earned yield
on average interest-earning assets was 5.94% and 7.45% for the quarters ended
September 30, 2008 and 2007, respectively, while the interest rate on average
interest-bearing liabilities for those periods was 3.12% and 4.36%,
respectively.The decline in the net interest margin was primarily a
result of the 2.75% reduction in the prime rate over the last twelve months
andcompetitive pressures in the
Company’s primary marketsfor retail deposits. The majority of the Company’s loans are prime-based,
while the Company’s interest-bearing deposits are impacted more by competitive
rates in the marketplace offered for time deposits.
 
 The following table shows the Company’s
effective yield on earning assets and cost of funds. Yields and costs are
computed by dividing income or expense for the year by the respective daily
average asset or liability balance.
 - 20
-
 Index
 CAPITAL
BANK CORPORATION
 Average Balances, Interest Earned or
Paid, and Interest Yields/Rates
 For theThreeMonths EndedSeptember 30, 2008, June 30,
2008and September 30,
2007
 Tax Equivalent Basis(1)
 
 September
      30, 2008
                    
                    June
      30, 2008
                    
                    September
      30, 2007(Dollars
      in thousands)
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      Rate
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      Rate
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      RateAssetsLoans
      receivable: (2)Commercial
                    
                    $
                    1,018,947
                    
                    $
                    15,469
                    
                    
                    6.02
                    %
                    $
                    1,010,809
                    
                    $
                    15,713
                    
                    
                    6.23
                    %
                    $
                    880,319
                    
                    $
                    17,621
                    
                    
                    7.94
                    %Consumer
                    
                    
                    46,480
                    
                    
                    875
                    
                    
                    7.47
                    
                    
                    46,344
                    
                    
                    869
                    
                    
                    7.53
                    
                    
                    40,490
                    
                    
                    881
                    
                    
                    8.63Home
      equity
                    
                    
                    84,441
                    
                    
                    1,133
                    
                    
                    5.32
                    
                    
                    80,842
                    
                    
                    1,101
                    
                    
                    5.46
                    
                    
                    78,453
                    
                    
                    1,682
                    
                    
                    8.51Residential
      mortgages
                    
                    
                    26,623
                    
                    
                    398
                    
                    
                    5.98
                    
                    
                    28,710
                    
                    
                    427
                    
                    
                    5.95
                    
                    
                    43,373
                    
                    
                    646
                    
                    
                    5.91Total
      loans
                    
                    
                    1,176,491
                    
                    
                    17,875
                    
                    
                    6.03
                    
                    
                    1,166,795
                    
                    
                    18,111
                    
                    
                    6.23
                    
                    
                    1,042,635
                    
                    
                    20,830
                    
                    
                    7.93Investment
      securities (3)
                    
                    
                    245,408
                    
                    
                    3,452
                    
                    
                    5.63
                    
                    
                    256,406
                    
                    
                    3,555
                    
                    
                    5.55
                    
                    
                    252,090
                    
                    
                    3,543
                    
                    
                    5.58Federal
      funds sold and other interest on short-term investments
                    
                    
                    3,617
                    
                    
                    15
                    
                    
                    1.65
                    
                    
                    6,100
                    
                    
                    33
                    
                    
                    2.18
                    
                    
                    8,134
                    
                    
                    108
                    
                    
                    5.27Total
      interest-earning assets
                    
                    
                    1,425,516
                    
                    $
                    21,342
                    
                    
                    5.94
                    %
                    
                    1,429,301
                    
                    $
                    21,699
                    
                    
                    6.09
                    %
                    
                    1,302,859
                    
                    $
                    24,481
                    
                    
                    7.45
                    %Cash
      and due from banks
                    
                    
                    25,554
                    
                    
                    
                    
                    
                    
                    
                    
                    26,736
                    
                    
                    
                    
                    
                    
                    
                    
                    28,261Other
      assets
                    
                    
                    137,792
                    
                    
                    
                    
                    
                    
                    
                    
                    135,976
                    
                    
                    
                    
                    
                    
                    
                    
                    128,078Allowance
      for loan losses
                    
                    
                    (14,052
                    )
                    
                    
                    
                    
                    
                    
                    
                    (13,656
                    )
                    
                    
                    
                    
                    
                    
                    
                    (13,283
                    )Total
      assets
                    
                    $
                    1,574,810
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,578,357
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,445,915Liabilities
      and EquitySavings
      deposits
                    
                    $
                    30,169
                    
                    $
                    30
                    
                    
                    0.39
                    %
                    $
                    30,540
                    
                    $
                    35
                    
                    
                    0.46
                    %
                    $
                    33,402
                    
                    $
                    51
                    
                    
                    0.61
                    %Interest-bearing
      demand deposits
                    
                    
                    342,575
                    
                    
                    1,802
                    
                    
                    2.09
                    
                    
                    335,851
                    
                    
                    1,635
                    
                    
                    1.95
                    
                    
                    366,824
                    
                    
                    3,230
                    
                    
                    3.49Time
      deposits
                    
                    
                    679,162
                    
                    
                    6,005
                    
                    
                    3.51
                    
                    
                    668,690
                    
                    
                    6,356
                    
                    
                    3.81
                    
                    
                    549,968
                    
                    
                    6,566
                    
                    
                    4.74Total
      interest-bearing deposits
                    
                    
                    1,051,906
                    
                    
                    7,837
                    
                    
                    2.96
                    
                    
                    1,035,081
                    
                    
                    8,025
                    
                    
                    3.11
                    
                    
                    950,194
                    
                    
                    9,847
                    
                    
                    4.11Borrowed
      funds
                    
                    
                    174,735
                    
                    
                    1,786
                    
                    
                    4.06
                    
                    
                    181,841
                    
                    
                    1,820
                    
                    
                    4.01
                    
                    
                    147,843
                    
                    
                    1,946
                    
                    
                    5.22Subordinated
      debt
                    
                    
                    30,930
                    
                    
                    407
                    
                    
                    5.22
                    
                    
                    30,930
                    
                    
                    403
                    
                    
                    5.23
                    
                    
                    30,930
                    
                    
                    599
                    
                    
                    7.68Repurchase
      agreements and fed funds purchased
                    
                    
                    27,039
                    
                    
                    74
                    
                    
                    1.09
                    
                    
                    35,183
                    
                    
                    106
                    
                    
                    1.21
                    
                    
                    34,233
                    
                    
                    383
                    
                    
                    4.44Total
      interest-bearing liabilities
                    
                    
                    1,284,610
                    
                    $
                    10,104
                    
                    
                    3.12
                    %
                    
                    1,283,035
                    
                    $
                    10,355
                    
                    
                    3.24
                    %
                    
                    1,163,200
                    
                    $
                    12,775
                    
                    
                    4.36
                    %Noninterest-bearing
      deposits
                    
                    
                    112,456
                    
                    
                    
                    
                    
                    
                    
                    
                    113,590
                    
                    
                    
                    
                    
                    
                    
                    
                    113,980Other
      liabilities
                    
                    
                    11,174
                    
                    
                    
                    
                    
                    
                    
                    
                    10,787
                    
                    
                    
                    
                    
                    
                    
                    
                    4,885Total
      liabilities
                    
                    
                    1,408,240
                    
                    
                    
                    
                    
                    
                    
                    
                    1,407,412
                    
                    
                    
                    
                    
                    
                    
                    
                    1,282,065Shareholders’
      equity
                    
                    
                    166,570
                    
                    
                    
                    
                    
                    
                    
                    
                    170,945
                    
                    
                    
                    
                    
                    
                    
                    
                    163,850Total
      liabilities and shareholders’ equity
                    
                    $
                    1,574,810
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,578,357
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,445,915Net
      interest spread(4)
                    
                    
                    
                    
                    
                    
                    
                    
                    2.82
                    %
                    
                    
                    
                    
                    
                    
                    
                    2.85
                    %
                    
                    
                    
                    
                    
                    
                    
                    3.10
                    %Tax
      equivalent adjustment
                    
                    
                    
                    
                    $
                    411
                    
                    
                    
                    
                    
                    
                    
                    $
                    416
                    
                    
                    
                    
                    
                    
                    
                    $
                    525Net
      interest income and net interest margin(5)
                    
                    
                    
                    
                    $
                    11,238
                    
                    
                    3.13
                    %
                    
                    
                    
                    $
                    11,344
                    
                    
                    3.18
                    %
                    
                    
                    
                    $
                    11,706
                    
                    
                    3.56
                    %
 
 (1)
                    The tax equivalent basis is
      computed using a blended federal and state tax rate ofapproximately
      34%.
 (2)
                    Loans receivable include
      nonaccrual loans for which accrual of interest has not been
      recorded.
 (3)
                    The average balance for investment
      securities excludes the effect of their mark-to-market adjustment, if
      any.
 (4)
                    Net interest spread represents the
      difference between the average yield on interest-earningassets and the average cost ofinterest-bearing
      liabilities.
 (5)
                    Net interest margin represents net
      interest income divided by average interest-earning
      assets.
 - 21
-
 Index
 Interest income on loans decreased from
$20.8 million for the quarter ended September 30, 2007 to $17.9 million for the
quarter ended September 30, 2008. The decrease is primarily due to lower loan
yields, which decreased from 7.93% in the quarter ended September 30, 2007 to
6.03% in the quarter ended September 30, 2008, the effect of which was partially
offset by higher average loan balances, which increased by $133.9 million. The
declining loan yields are largely due to the decline in the prime rate from
7.75% as of September 30, 2007 to 5.00% as of September 30, 2008. In November
2006, the Company entered into a $100 million (notional) interest rate swap to
help mitigate its exposure to interest rate volatility in the loan portfolio.
This swap increased loan interest income by 23 bps, or $675 thousand, in the
quarter ended September 30, 2008, whereas for the quarter ended September 30,
2007, the swap decreased loan interest income by 5 bps or $137
thousand.
 Interest income on investment securities
remained flat at $3.0 million for the quarters ended September 30, 2008 and
2007. The $6.7 million decline in average balances outstanding between the
periods was offset by an increase in the tax equivalent yieldfrom5.58% for thequarter ended September 30,
2007to 5.63% for the quarter endedSeptember 30, 2008.
 
 Interest expense on deposits decreased
from $9.8 million for the quarter ended September 30, 2007 to $7.8 million for
the quarter ended September 30, 2008. The decrease is primarily due to a
decrease in average deposit rates from 4.11% for the quarter ended September 30,
2007 to 2.96% for the quarter ended September 30, 2008. For time deposits, which
represented 64.6% and 57.9% of total average interest-bearing deposits for the
quarters ended September 30, 2008 and 2007, respectively, the average rate
decreased from 4.74% for the quarter ended September 30, 2007 to 3.51% for the
quarter ended September 30, 2008, reflecting the decreasing interest rate
environment.
 
 Interest expense on borrowings decreased
from $2.9 million for the quarter ended September 30, 2007 to $2.3 million for
the quarter ended September 30, 2008, primarily due to declines in interest
rates, which were partially offset by a $19.7 million increase in average
borrowings.The rate on
average borrowings,includingsubordinateddebt,for the quarter endedSeptember 30, 2008was3.90%, compared to5.50%for thequarter ended September 30,
2007. InJuly 2003, the Companyentered into interest rate swap
agreements on $25.0 million of its outstanding Federal Home Loan Bank advances
to swap fixed rate borrowings to a variable rate. The net effect of the swaps
wasa decrease
tointerest expense of
$39 thousandandan increase to interest expense of$126 thousandfor the quarters endedSeptember 30, 2008and 2007, respectively.
 
 Provision for loan losses was $760
thousand for the quarter ended September 30, 2008 compared to $261 thousand for
the quarter ended September 30, 2007. The increase in the provision was
partially due to loan growth but was also partially due to higher levels of net
charge-offs over the quarters under comparison.Net charge-offsfor the quarter ended September 30, 2008
were $653 thousand, or 0.22% of average loans, compared to net charge-offs of
$234 thousand, or 0.09% of average loans, for the quarter ended September 30,
2007. In spite of the increased net charge-offs, loan quality improved by
several other metrics. For example, total nonperforming assets andpast due loans declined
from $10.5 million and $13.2million, respectively,as of September 30, 2007 to $7.4 million
and $8.9million,
respectively, as ofSeptember 30, 2008.
 
 Noninterest income increased from $2.5
million for the quarter ended September 30, 2007 to $3.3 million for the quarter
ended September 30, 2008. Service charges and other fees increased $246
thousand, partially due to an increase in overdraft and non-sufficient fund
fees. Mortgage fees and revenues decreased $407 thousand, which reflects the
Company’s decision to de-emphasize this business line. Other loan fees increased
$242 thousand, primarily due to an increased focus on charging prepayment
penalties. Brokerage fees and bank card services increased $13 thousand and $72
thousand, respectively. Bank-owned life insurance increased $37 thousand,
primarily due to higher yields on existing policies. In the quarter ended
September 30, 2008, noninterest income includes a $109 thousand gain on sale of
investment securities and a $426 thousand gain on sale of a branch. Other
noninterest income remained relatively flat, increasing $7 thousand over the
quarters under comparison.
 
 Noninterest expense for the quarter
ended September 30, 2008 totaled $10.5 million compared to $9.6 million for the
quarter ended September 30, 2007. Salaries and employee benefits, representing
the largest noninterest expense category, increased $241 thousand, primarily due
to normal compensation adjustments. Occupancy remained relatively flat at $1.1
million for the two quarters under comparison. Furniture and equipment increased
$114 thousand, primarily due toequipment and building upgrades as well
as higher maintenance costs.Data
processing and telecommunications increased $149 thousand, primarily due
to system upgrades and enhancements to support growth in the Company’s primary
business lines. Advertising
increased $86 thousand while office expenses decreased $47 thousand.
Professional fees increased $98 thousand from higher consulting fees. Business
development and travel increased $108 thousand, partially due to higher employee
education and training costs as well as higher travel costs necessary to
complete due diligence procedures for the pending acquisition of four branches
in Fayetteville, North Carolina, from Omni National Bank. Amortization of
deposit premiums acquired during prior acquisitions decreased $44 thousand as
deposit premiums from earlier acquisitions became fully
amortized.
  - 22
-
 Index
 Miscellaneous loan handling costs
remained relatively flat, increasing $5 thousand. Directors fees increased $231
thousand, reflecting a rise in the market value of stock underlying units
allocated to participants in the Deferred Compensation Plan. Insurance increased
$52 thousand, primarily due to higher premiums required to cover OREO
properties. FDIC deposit insurance rose $142 thousand as the regulatory
agency increased premiums to cover higher monitoring costs and claims. Other noninterest expenses declined $236
thousand, primarily due to losses on sales of OREO properties during the quarter
ended September 30, 2007.
 
 Income tax expense for the quarters
ended September 30, 2008 and 2007 was $0.8 million and $1.1 million,
respectively. The Company’s effective tax rate remained flat at 28.6% for the
quarters ended September 30, 2008 and 2007.
 
 Results of
Operations
 
 Nine month period ended September 30,
2008 compared to nine month periodendedSeptember 30, 2007
 
 For the nine months ended September 30,
2008, the Company reported net income of $6.4 million, or $0.57 per diluted
share, compared to net income of $7.8 million, or $0.68 per diluted share, for
the nine months ended September 30, 2007. Net income decreased by $1.4 million,
primarily due to a $485 thousand decline in net interest income and $1.7 million
increase in provision for loan losses. Additionally, noninterest expense
increased $1.7 million over the quarters under comparison but was offset by a
$1.7 million increase in noninterest income. Tax expense declined $776 thousand
over the periods under comparison, reflecting lower net income before tax
expense.
 
 Net interest income decreased $485
thousand, or 1.5%, from $33.1 million for the nine months ended September 30,
2007 to $32.7 million for the nine months ended September 30, 2008. Average
earning assets increased $124.6 million to $1.4 billion for the nine months
ended September 30, 2008 from $1.3 billion for the nine months ended September
30, 2007. Average interest-bearing liabilities increased $119.4 million to $1.3
billion for the nine months ended September 30, 2008 from $1.2 billion for the
nine months ended September 30, 2007. The net interest margin on a fully tax
equivalent basis decreased by 40 bps to 3.18% for the nine months ended
September 30, 2008 from 3.58% for the nine months ended September 30, 2007. The
earned yield on average interest-earning assets was 6.21% and 7.45% for the nine
months ended September 30, 2008 and 2007, respectively, while the interest rate
on average interest-bearing liabilities for those periods was 3.37% and 4.34%,
respectively.The decline in the net interest margin was primarily a
result of the 2.75% reduction in the prime rate over the last twelve months
andcompetitive pressures in the
Company’s primary marketsfor retail deposits. The majority of the Company’s loans are prime-based,
while the Company’s interest-bearing deposits are impacted more by competitive
rates in the marketplace offered for time deposits.
 
 The following table shows the Company’s
effective yield on earning assets and cost of funds. Yields and costs are
computed by dividing income or expense for the year by the respective daily
average asset or liability balance.
 - 23
-
 Index
 Average Balances, Interest Earned or
Paid, and Interest Yields/Rates
 Nine Months Ended September 30, 2008 and
2007
 Tax Equivalent Basis(1)
 
 September 30,
      2008
                        
                        September 30,
      2007(Dollars in thousands)
                        
                        Average
    Balance
                        
                        Amount
    Earned
                        
                        Average
Rate
                        
                        Average
    Balance
                        
                        Amount
    Earned
                        
                        Average
RateAssetsLoans receivable:(2)Commercial
                        
                        $
                        1,005,400
                        
                        $
                        47,959
                        
                        
                        6.35
                        %
                        $
                        859,219
                        
                        $
                        51,383
                        
                        
                        8.00
                        %Consumer
                        
                        
                        46,508
                        
                        
                        2,654
                        
                        
                        7.60
                        
                        
                        39,758
                        
                        
                        2,563
                        
                        
                        8.62Home equity
                        
                        
                        81,626
                        
                        
                        3,555
                        
                        
                        5.80
                        
                        
                        80,829
                        
                        
                        5,135
                        
                        
                        8.49Residential
      mortgages
                        
                        
                        28,524
                        
                        
                        1,317
                        
                        
                        6.15
                        
                        
                        45,739
                        
                        
                        2,150
                        
                        
                        6.28Total Loans
                        
                        
                        1,162,058
                        
                        
                        55,485
                        
                        
                        6.36
                        
                        
                        1,025,545
                        
                        
                        61,231
                        
                        
                        7.98Investment securities(3)
                        
                        
                        252,757
                        
                        
                        10,597
                        
                        
                        5.59
                        
                        
                        248,224
                        
                        
                        10,128
                        
                        
                        5.46Federal funds sold and other
      interest on short-term investments
                        
                        
                        5,924
                        
                        
                        103
                        
                        
                        2.32
                        
                        
                        22,338
                        
                        
                        883
                        
                        
                        5.29Total interest-earnings
      assets
                        
                        
                        1,420,738
                        
                        $
                        66,184
                        
                        
                        6.21
                        %
                        
                        1,296,107
                        
                        $
                        72,243
                        
                        
                        7.45
                        %Cash and due from
      banks
                        
                        
                        26,172
                        
                        
                        
                        
                        
                        
                        
                        
                        27,781Other
assets
                        
                        
                        136,617
                        
                        
                        
                        
                        
                        
                        
                        
                        129,392Allowance for loan
      losses
                        
                        
                        (13,791
                        )
                        
                        
                        
                        
                        
                        
                        
                        (13,369
                        )Total
assets
                        
                        $
                        1,569,736
                        
                        
                        
                        
                        
                        
                        
                        $
                        1,439,911Liabilities and
      EquitySavings
      deposits
                        
                        $
                        30,363
                        
                        $
                        112
                        
                        
                        0.49
                        %
                        $
                        33,812
                        
                        $
                        138
                        
                        
                        0.55
                        %Interest-bearing demand
      deposits
                        
                        
                        337,198
                        
                        
                        5,291
                        
                        
                        2.09
                        
                        
                        362,304
                        
                        
                        9,415
                        
                        
                        3.47Time
    deposits
                        
                        
                        668,526
                        
                        
                        19,532
                        
                        
                        3.89
                        
                        
                        568,604
                        
                        
                        20,218
                        
                        
                        4.75Total interest-bearing
      deposits
                        
                        
                        1,036,087
                        
                        
                        24,935
                        
                        
                        3.21
                        
                        
                        964,720
                        
                        
                        29,771
                        
                        
                        4.13Borrowed
    funds
                        
                        
                        176,069
                        
                        
                        5,628
                        
                        
                        4.26
                        
                        
                        127,169
                        
                        
                        4,923
                        
                        
                        5.18Subordinated
      debt
                        
                        
                        30,930
                        
                        
                        1,336
                        
                        
                        5.75
                        
                        
                        30,930
                        
                        
                        1,777
                        
                        
                        7.68Repurchase agreements and fed
      funds purchased
                        
                        
                        32,575
                        
                        
                        369
                        
                        
                        1.51
                        
                        
                        33,419
                        
                        
                        1,077
                        
                        
                        4.31Total interest-bearing
      liabilities
                        
                        
                        1,275,660
                        
                        $
                        32,268
                        
                        
                        3.37
                        %
                        
                        1,156,238
                        
                        $
                        37,548
                        
                        
                        4.34
                        %Noninterest-bearing
      deposits
                        
                        
                        114,676
                        
                        
                        
                        
                        
                        
                        
                        
                        110,954Other
      liabilities
                        
                        
                        11,032
                        
                        
                        
                        
                        
                        
                        
                        
                        8,713Total
      liabilities
                        
                        
                        1,401,368
                        
                        
                        
                        
                        
                        
                        
                        
                        1,275,905Shareholders’
      equity
                        
                        
                        168,368
                        
                        
                        
                        
                        
                        
                        
                        
                        164,006Total liabilities and
      shareholders’ equity
                        
                        $
                        1,569,736
                        
                        
                        
                        
                        
                        
                        
                        $
                        1,439,911Net interest spread(4)
                        
                        
                        
                        
                        
                        
                        
                        
                        2.84
                        %
                        
                        
                        
                        
                        
                        
                        
                        3.11
                        %Tax equivalent
      adjustment
                        
                        
                        
                        
                        $
                        1,252
                        
                        
                        
                        
                        
                        
                        
                        $
                        1,546Net interest income and net
      interest margin(5)
                        
                        
                        
                        
                        $
                        33,916
                        
                        
                        3.18
                        %
                        
                        
                        
                        $
                        34,695
                        
                        
                        3.58
                        %
 
 (1)
                        The tax equivalent basis is
      computed using a blended federal and state tax rate of approximately34%.
 (2)
                        Loans receivable include
      nonaccrual loans for which accrual of interest has not been
      recorded.
 (3)
                        The average balance for investment
      securities excludes the effect of their mark-to-market adjustment, if
      any.
 (4)
                        Net interest spread represents the
      difference between the average yield on interest-earningassets and the average cost ofinterest-bearing
      liabilities.
 (5)
                        Net interest margin represents net
      interest income divided by average interest-earning
      assets.
 - 24
-
 Index
 Interest income on loans decreased from
$61.2 million for the nine months ended September 30, 2007 to $55.5 million for
the nine months ended September 30, 2008. The decrease is primarily due to lower
loan yields, which decreased from 7.98% in the nine months ended September 30,
2007 to 6.36% in the nine months ended September 30, 2008, the effect of which
was partially offset by higher average loan balances, which increased by $136.5
million. The declining loan yields are largely due to the decline in the prime
rate from 7.75% as of September 30, 2007 to 5.00% as of September 30, 2008. In
November 2006, the Company entered into a $100 million (notional) interest rate
swap to help mitigate its exposure to interest rate volatility in the loan
portfolio. This swap increased loan interest income by 20 bps, or $1.7 million,
in the nine months ended September 30, 2008, whereas for the nine months ended
September 30, 2007, the swap decreased loan interest income by 5 bps, or $388
thousand.
 
 Interest income on investment securities
increased from $8.6 million for the nine months ended September 30, 2007 to $9.3
million for the nine months ended September 30, 2008. The increase was primarily
due to a $4.5 million increase in average balances outstanding between the
periods.Also contributing to the increase in
interest income, theyield
on investment securitieson
a fully tax equivalent basisincreased from5.46% for thenine months ended September 30,
2007to 5.59% for thenine monthsendedSeptember 30, 2008.
 
 Interest expense on deposits decreased
from $29.8 million for the nine months ended September 30, 2007 to $24.9 million
for the nine months ended September 30, 2008. The decrease is primarily due to
decrease in average deposit rates from 4.13% for the nine months ended September
30, 2007 to 3.21% for the nine months ended September 30, 2008. For time
deposits, which represented 64.5% and 58.9% of total average interest-bearing
deposits for the nine months ended September 30, 2008 and 2007, respectively,
the average rate decreased from 4.75% for the nine months ended September 30,
2007 to 3.89% for the nine months ended September 30, 2008, reflecting the
declining interest rate environment.
 
 Interest expense on borrowings decreased
from $7.8 million for the nine months ended September 30, 2007 to $7.3 million
for the nine months ended September 30, 2008, primarily due to a decline in the
rate on average borrowings, which was partially offset by a $48.1 million
increase in average borrowings over the same period.The rate on average
borrowings,includingsubordinateddebt,for thenine monthsendedSeptember 30, 2008was4.08%compared to5.43%for thenine months ended September 30,
2007. InJuly 2003, the Companyentered into interest rate swap
agreements on $25.0 million of its outstanding Federal Home Loan Bank advances
to swap fixed rate borrowings to a variable rate. The net effect of the swaps
wasa decrease
tointerest expense of
$20 thousandandan increase to interest expense of$376 thousandfor thenine monthsendedSeptember 30, 2008and 2007, respectively.
 
 Provision for loan losses was $2.2
million for the nine months ended September 30, 2008 compared to $507 thousand
for the nine months ended September 30, 2007. The increase in the provision was
partially due to loan growth but was also partially due to higher levels of net
charge-offs over the periods under comparison. Also contributing to the
increased provision were enhancements in the methodology for calculating the
allowance for loan losses, which reduced the allowance and related provision
during the nine months ended September 30, 2007. The enhancements to the
allowance methodology were implemented during 2007 based on updated guidance
issued through an interagency policy statement by the FDIC, Federal Reserve, and
other regulatory agencies.Net charge-offsfor the nine months ended September 30,
2008 were $1.7 million, or 0.15% of average loans, compared to net charge-offs
of $488 thousand, or 0.05% of average loans, for the nine months ended September
30, 2007. In spite of the increased net charge-offs, loan quality improved by
several other metrics. For example, total nonperforming assets andpast due loans declined
from $10.5 million and $13.2million, respectively,as of September 30, 2007 to $7.4 million
and $8.9million,
respectively, as ofSeptember 30, 2008.
 
 Noninterest income increased from $7.1
million for the nine months ended September 30, 2007 to $8.8 million for the
nine months ended September 30, 2008. Service charges and other fees increased
$636 thousand, partially due to an increase in overdraft and non-sufficient fund
fees. Mortgage fees and revenues decreased $877 thousand, which reflects the
Company’s decision to de-emphasize this business line. Other loan fees increased
$461 thousand, primarily due to an increased focus on charging prepayment
penalties. Brokerage fees and bank card services increased $161 thousand and
$255 thousand, respectively. Bank-owned life insurance increased $194 thousand,
primarily due to higher yields on existing policies. During the nine months
ended September 30, 2008, noninterest income includes a $249 thousand gain on
sale of investment securities and a $426 thousand gain on sale of a branch.
Other noninterest income increased $193 thousand, partially due to higher rental
income from new subleases at the Company’s headquarters.
 - 25
-
 Index
 Noninterest expense increased from $28.6
million for the nine months ended September 30, 2007 to $30.4 million for the
nine months ended September 30, 2008. Salaries and employee benefits,
representing the largest noninterest expense category, increased $363 thousand,
primarily due to normal compensation adjustments. Occupancy increased $244
thousand, primarilydue to higher rent expense from additional leased
branches as well as expanded space requirements at the Company’s
headquarters. Furniture and
equipment increased $392 thousand, primarily due toequipment and
building upgrades as well as higher maintenance costs.Data processing and telecommunications
increased $324 thousand, partially due to system upgrades and enhancements to
support growth in the Company’s primary business lines as well as the
implementation of an internet-based phone system. Advertising increased $8 thousand while
office expenses decreased $86 thousand. Professional fees increased $144
thousand due to higher recruitment and consulting fees. Business development and
travel increased $124 thousand, partially due to higher travel costs necessary
to complete due diligence procedures for the pending acquisition of four
branches in Fayetteville, North Carolina, from Omni National Bank. Amortization
of deposit premiums acquired as the result of prior acquisitions decreased $130
thousand as deposit premiums from earlier acquisitions became fully amortized.
Miscellaneous loan handling costs remained relatively flat, increasing $25
thousand. Directors fees increased $133 thousand, reflecting a rise in the
market value of stock underlying units allocated to participants in the Deferred
Compensation Plan. Insurance increased $73 thousand, primarily due to higher
premiums required to cover OREO properties. FDIC deposit insurance rose $243
thousandas the regulatory agency increased premiums to cover higher
monitoring costs and claims. Other
noninterest expenses declined $117 thousand, partially due to losses on sales of
OREO properties during the nine months ended September 30,
2007.
 
 Income tax expense for the nine months
ended September 30, 2008 and 2007 was $2.5 million and $3.2 million,
respectively. The Company’s effective tax rate declined from 29.4% for the nine
months ended September 30, 2007 to 27.9% for the nine months ended September 30,
2008, due primarily to an increase in the mixture of tax-exempt income compared
to net income before tax expense over the same period.
 
 Asset Quality
 
 Determining the allowance for loan
losses is based on a number of factors, many of which are subject to judgments
made by management. At the origination of each commercial loan, management
assesses the relative risk of the loan and assigns a corresponding risk grade.
To ascertain that the credit quality is maintained after the loan is booked, a
loan review officer performs an annual review of all unsecured loans over a
predetermined loan amount, a sampling of loans within a lender’s authority, and
a sampling of the entire loan pool. Loans are reviewed for credit quality,
sufficiency of credit and collateral documentation, proper loan approval,
covenant, policy and procedure adherence, and continuing accuracy of the loan
grade. The Loan Review Manager reports directly to the Chief Credit Officer and
the Audit Committee of the Company’s Board of Directors.
 
 The Company estimates the amount of
allowance needed to cover losses inherent in the portfolio by applying a loss
allowance factor to each risk grade.Unless identified as an at-risk
loan,consumer loans and mortgages are not
risk graded, but a loss allocation factor is utilized for these loans based on
historical losses. The loss allocation factors have been developed based on the
Company’s historical losses and industry trends. In addition to this
quantitative analysis, a qualitative assessment of the general economic trends,
portfolio concentration, interest rate movements and the trend of delinquencies
are taken into consideration. The loan loss allowance is adjusted to an amount
that management believes is adequate to absorb losses inherent in the loan
portfolio as of the balance sheet date presented.
 
 The Company provides a specific
allowance for loan losses associated with certain commercial loans rated special
mention and/or classified with outstanding balances greater than $750 thousand,
including all related loans, as well as all loans management has identified as
impaired. Management determines the level of specific allowance based on the
facts and circumstances of each loan, including among other factors, payment
history, collateral values, guarantor liquidity, and net worth. Of the $14.0
million allowance for loan losses as of September 30, 2008, $2.9 million has
been allocated to specific loans, including loans considered to be impaired. As
of September 30, 2008 and December 31, 2007, there were $2.6 million and $2.7
million, respectively, of specific impaired loans with balances greater than
$750 thousand. As of September 30, 2008 and December 31, 2007, there were $4.0
million and $1.7 million, respectively, of impaired loans with balances less
than $750 thousand. As of September 30, 2008 and December 31, 2007, $0.3 million
and $0.2 million, respectively, are included in the allowance for loan losses
for impaired loans less than $750 thousand. At September 30, 2008 and December
31, 2007, there were no impaired loans that did not have an allowance for loan
losses.
 - 26
-
 Index
 A loan is considered impaired, based on
current information and events, if it is probable that the Company will be
unable to collect the scheduled payments of principal and interest when due
according to the contractual terms of the loan agreement. The Company uses
several factors in determining if a loan is impaired. Internal asset
classification procedures include a review of significant loans and lending
relationships by management. The loan reviews include the accumulation of
related data on loan payment status, borrowers’ financial data and borrowers’
operating factors such as cash flows, operating income or loss. Uncollateralized
loans are measured for impairment based on the present value of expected future
cash flows discounted at the historical effective interest rate, while all
collateral-dependent loans are measured for impairment based on the fair value
of the collateral.
 
 The allowance for loan losses is
established through a provision for loan losses charged to expense. Loans are
charged against the allowance for loan losses when management believes that the
collectibility of the principal is unlikely. Based on this allowance
calculation, management recorded a provision of $760 thousand for the quarter
ended September 30, 2008 compared to $261 thousand for the quarter ended
September 30, 2007, and management recorded a provision of $2.2 million for the
nine months ended September 30, 2008 compared to $507 thousand for the nine
months ended September 30, 2007. The increase in the provision was partially due
to loan growth but was also partially due to higher levels of net charge-offs
over the periods under comparison. Also contributing to the increased provision
were enhancements in the methodology for calculating the allowance for loan
losses, which reduced the allowance and related provision during the nine months
ended September 30, 2007. The enhancements to the allowance methodology were
implemented during 2007 based on updated guidance issued through an interagency
policy statement by the FDIC, Federal Reserve, and other regulatory agencies.
Among other refinements, the enhanced methodologyutilizes a greater
dispersion of risk rating classifications based on the collateral backing of the
loans.
 
 Past due loans as a percentage oftotalloans decreased from 0.98% at December 31, 2007 to
0.75% at September 30, 2008.Nonperforming loans, which includes all
loans past due greater than
90 daysor in nonaccrual
status,as a percentage
of total loans declined
from 0.55% at December 31, 2007 to 0.54%atSeptember 30, 2008. Nonperforming assets as a percentage
of total assetsdeclined
from 0.50% at December 31, 2007 to 0.47% at September 30, 2008.Management believes the allowance for
loan losses as ofSeptember
30, 2008is adequate toabsorb the inherent losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of loans and prior
loan loss experience.
 
 At September 30, 2008, nonperforming
loans were $6.4 million, an increase of $0.4 million from December 31, 2007. The
majority of the Company’s nonperforming loans are secured by real estate, and to
a lesser extent, the Company relies on the support of guarantors. The Company
monitors the value of the underlying collateral and the liquidity of the
guarantors on a periodic basis.Based on this review and analysis, the
Company does not currently anticipate any material losses associatedwith the nonperforming loans as
ofSeptember 30, 2008.Nonperforming loans as of September 30,
2008 do not include outstanding loans and loan commitments extended to a
residential builder in Central North Carolina due to a deferred payment plan.
Outstanding principal and unused commitment related to this lending relationship
were $650 thousand and $8 thousand, respectively, as of September 30,
2008.
 
 The following table presents an analysis
of changes in the allowance for loan losses for the three and nine month periods
ended September30, 2008
and 2007, respectively.
 - 27
-
 Index
  Three Months Ended September
      30,
                        
                        Nine Months Ended September
      30,(Dollars in
      thousands)
                        
                        2008
                        
                        2007
                        
                        2008
                        
                        2007Allowance for loan losses,
      beginning of period
                        
                        $
                        13,910
                        
                        $
                        13,339
                        
                        $
                        13,571
                        
                        $
                        13,347Net
      charge-offs:Loans charged
      off:Commercial
                        
                        
                        734
                        
                        
                        100
                        
                        
                        1,288
                        
                        
                        246Construction
                        
                        
                        34
                        
                        
                        –
                        
                        
                        138
                        
                        
                        19Consumer
                        
                        
                        50
                        
                        
                        226
                        
                        
                        780
                        
                        
                        335Home equity
                        
                        
                        –
                        
                        
                        54
                        
                        
                        90
                        
                        
                        79Residential
      mortgages
                        
                        
                        14
                        
                        
                        –
                        
                        
                        14
                        
                        
                        53Total
      charge-offs
                        
                        
                        832
                        
                        
                        380
                        
                        
                        2,310
                        
                        
                        732Recoveries of loans previously
      charged off:Commercial
                        
                        
                        160
                        
                        
                        64
                        
                        
                        483
                        
                        
                        102Construction
                        
                        
                        –
                        
                        
                        –
                        
                        
                        –
                        
                        
                        –Consumer
                        
                        
                        9
                        
                        
                        28
                        
                        
                        85
                        
                        
                        88Home equity
                        
                        
                        –
                        
                        
                        54
                        
                        
                        1
                        
                        
                        54Residential
      mortgages
                        
                        
                        10
                        
                        
                        –
                        
                        
                        12
                        
                        
                        –Total
      recoveries
                        
                        
                        179
                        
                        
                        146
                        
                        
                        581
                        
                        
                        244Total net
      charge-offs
                        
                        
                        653
                        
                        
                        234
                        
                        
                        1,729
                        
                        
                        488Loss provision charged to
      operations
                        
                        
                        760
                        
                        
                        261
                        
                        
                        2,175
                        
                        
                        507Allowance for loan losses, end of
      period
                        
                        $
                        14,017
                        
                        $
                        13,366
                        
                        $
                        14,017
                        
                        $
                        13,366Net charge-offs to average loans
      during the period (annualized)
                        
                        
                        0.22
                        %
                        
                        0.09
                        %
                        
                        0.15
                        %
                        
                        0.06
                        %Allowance as a percent of gross
      loans
                        
                        
                        1.17
                        %
                        
                        1.25
                        %
                        
                        1.17
                        %
                        
                        1.25
                        %
 
 The Company’s determination of the
allowance for loan losses is subject to management’s judgment and analysis of
many internal and external factors. While management is comfortable with the
adequacy of the current allowance for loan losses, it is possible that these
factors and management’s evaluation of the adequacy of the allowance for loan
losses will change.
 
 The following table presents an analysis
of nonperforming assets as of September 30, 2008 and December 31,
2007.
 
 September 30,
      2008
                          
                          December 31,
      2007(Dollars in
      thousands)
                          
                          (Unaudited)Nonperforming
      loans:Commercial
                          
                          $
                          4,343
                          
                          $
                          4,489Construction
                          
                          
                          1,570
                          
                          
                          562Consumer
                          
                          
                          25
                          
                          
                          28Home equity
                          
                          
                          275
                          
                          
                          397Residential
      mortgages
                          
                          
                          198
                          
                          
                          506Total nonperforming
      loans
                          
                          
                          6,411
                          
                          
                          5,982Foreclosed property
      held
                          
                          
                          1,019
                          
                          
                          1,571Total nonperforming
      assets
                          
                          $
                          7,430
                          
                          $
                          7,553Nonperforming loans to total
      loans
                          
                          
                          0.54
                          %
                          
                          0.55
                          %Nonperforming assets to total
      assets
                          
                          
                          0.47
                          %
                          
                          0.50
                          %Allowance coverage of
      nonperforming loans
                          
                          
                          219
                          %
                          
                          227
                          %
 
 Foreclosed property decreased to
$1.0 millionatSeptember30, 2008 from $1.6 million at December
31, 2007. The decrease was primarily due to the disposition of certain
foreclosed commercial and residential properties. The Company is actively
marketing all of its foreclosed property.Foreclosed assets are adjusted to fair
value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed
assets are carried at the lower of carrying value or fair
value.
 - 28
-
 Index
 Liquidity and Capital
Resources
 
 The Company’s liquidity management
involves planning to meet the Company’s anticipated funding needs at a
reasonable cost. Liquidity management is guided by policies formulated by the
Company’s senior management and the Asset and Liability Committee of the Bank’s
Board of Directors. The Company had $35.5million in its most liquid assets, cash
and cash equivalents as ofSeptember30, 2008. The Company’s principal
sources of funds are loan repayments, deposits, Federal Home Loan Bank
borrowings, capital and, to a lesser extent, investment repayments. Core
deposits (total deposits less certificates of deposits in the amount of $100
thousand or more), one of the most stable sources of liquidity, together with
equity capital, which totaled$1.1billionand $1.0 billionatSeptember30, 2008 and December 31,
2007,respectively,funded69.9% of total assets atSeptember30, 2008 compared to 67.9% at December
31, 2007. In addition, the Company has the ability to take advantage of various
otherfunding programs
available from the Federal Home Loan Bank of Atlanta, as well as access to
funding through various brokered deposit programs, federal funds lines and
security repurchase agreements.
 
 The management of equity is a critical
aspect of capital management in any business. The determination of the
appropriate amount of equity is affected by a wide number of factors. The
primary factor for a regulated financial institution is the amount of capital
needed to meet regulatory requirements, although other factors, such as the
“risk equity” the business requires and balance sheet leverage, also affect the
determination.
 
 On
January 24, 2008, the Company’s Board of Directors authorized the repurchase of
up to 1.0 million shares of the Company’s currently outstanding shares of common
stock, and all previous authorizations for the repurchase of the Company’s
currently outstanding shares of common stock were superseded and revoked. During the quarter ended September 30,
2008, the Company repurchased 2,000 shares at a weighted average price of $8.95
per share. See Part II – Other Information, Item 2. Unregistered Sales of Equity
Securities and Use of Proceeds for more information on the Company’s share
repurchases.
 
 To be categorized as well capitalized,
the Company and the Bank each must maintain minimum amounts and ratios. The
Company’s and the Bank’s actual capital amounts and ratios as of September 30,
2008 and the minimum requirements are presented in the following
table.
 
 Actual
                          
                          Minimum
      Requirements
                            To Be Well
      Capitalized(Dollars
      in thousands)
                          
                          Amount
                          
                          
                          Ratio
                          
                          Amount
                          
                          
                          RatioCapital
      Bank CorporationTotal
      capital (to risk-weighted assets)
                          
                          $
                          150,056
                          
                          
                          10.91
                          %
                          $
                          137,599
                          
                          
                          10.00
                          %Tier
      I capital (to risk-weighted assets)
                          
                          
                          135,727
                          
                          
                          9.86
                          
                          
                          82,560
                          
                          
                          6.00Tier
      I capital (to average assets)
                          
                          
                          135,727
                          
                          
                          8.98
                          
                          
                          75,583
                          
                          
                          5.00Capital
      BankTotal
      capital (to risk-weighted assets)
                          
                          $
                          147,392
                          
                          
                          10.74
                          %
                          $
                          137,235
                          
                          
                          10.00
                          %Tier
      I capital (to risk-weighted assets)
                          
                          
                          133,063
                          
                          
                          9.70
                          
                          
                          82,341
                          
                          
                          6.00Tier
      I capital (to average assets)
                          
                          
                          133,063
                          
                          
                          8.82
                          
                          
                          75,439
                          
                          
                          5.00
 
 Shareholders’ equity was $166.5million, or $14.83per share, atSeptember30, 2008. Management believes this
level ofshareholders’
equity provides adequate capital to support the Company’s growth and to maintain
a well capitalized position.
 
 The
Company maintains the Capital Bank 401(k) Retirement Plan (the “Plan”) for the
benefit of its employees, through which participants can elect to purchase
Company common stock at market prices. In prior years, the Company had
registered 50,000 shares of its common stock with the SEC to be available for
issuance under the Plan. The Company recently determined that it may have
inadvertently failed to register with the SEC the issuance of shares under the
Plan in excess of the number previously registered. As a result, certain
purchasers of common stock pursuant to the Plan may have the right to rescind
their purchases for an amount
equal to the purchase price paid for the shares, plus interest from the date of
purchase. As of September 30, 2008 and December 31, 2007, the Company had common
shares subject to potential rescission rights that are considered redeemable
common stock, because the redemption features are not within the control of the
Company. These shares have always been treated as outstanding for financial
reporting purposes.
 - 29
-
 Index
 The U.S.
Treasury has announced that it will make funds available to certain banks under
its Troubled Asset Relief Program (the “Program”). The Emergency Economic
Stabilization Act of 2008 authorized the Treasury to establish the Program under
which certain U.S. financial institutions may sell senior preferred stock and
issue warrants to purchase an institution’s common stock to the Treasury in
exchange for a capital infusion. Under the Program, eligible institutions can
generally apply to issue preferred stock to the Treasury in aggregate amounts
between 1% and 3% of the institution’s risk-weighted assets. On October 23,
2008, the Company’s board of directors (the “Board”) authorized and approved the
Company’s participation in the Program, and the Company filed its application
with the Treasury. In order to participate in the Program, the Board also
authorized the Company to sell up to 42,900 shares of senior preferred stock
(“Senior Preferred”) to the Treasury for $1,000 per share, subject to the
pre-approval of this proposal by the Company’s shareholders.
 
 On
November 6, 2008,
the Treasury notified the Company that it was eligible to participate in the
Program.At this point, however, there is no binding agreement or
commitment with respect to the Company’s participation in the Program. The
Company and the Treasury must still negotiate the terms and conditions of
participation. Although the Company has no reason to believe that it will not be
able to participate in the Program, no assurances can be given that it will be
able to participate. In addition, no assurances can be given regarding the
approximate number of shares of preferred stock that the Company may issue or
the approximate amount of consideration the Company will receive from Treasury
for any such shares that may be issued under the Program.
 
 Item 3.Quantitative and Qualitative Disclosures about Market
Risk
 
 As described in more detail in our
Annual Report on Form 10-K for the year ended December 31, 2007, asset/liability
management involves the evaluation, monitoring and management of interest rate
risk, liquidity and funding. While the Board of Directors has overall
responsibility for the Company’s asset/liability management policies, the Bank’s
Asset and Liability Committee monitors loan, investment, and liability
portfolios to ensure comprehensive management of interest rate risk and
adherence to the Bank’s policies.The Company has not experienced any
material change in the risk of its portfolios of interest-earning assets and
interest-bearing liabilities from December 31, 2007 to September 30,
2008.
 
 Item 4.Controls and
Procedures
 
 The Company maintains disclosure
controls and procedures that are designed to ensure that information required to
be disclosed in the reports it files or submits under the Securities Exchange
Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported
within the time periods specified in the rules and forms of the SEC, and that
such information is accumulated and communicated to the Company’s management,
including its Chief Executive Officer (“CEO”) and Chief Financial Officer
(“CFO”), as appropriate, to allow timely decisions regarding disclosure.
Management necessarily applies its judgment in assessing the costs and benefits
of such controls and procedures, which, by their nature, can provide only
reasonable assurance regarding management’s control
objectives.
 
 As required by paragraph (b) of Rule
13a-15 under the Exchange Act, an evaluation was carried out under the
supervision and with the participation of the Company’s management, including
the CEO and CFO, of the effectiveness of the Company’s disclosure controls and
procedures as of the end of the period covered by this report. Based upon that
evaluation, the CEO and CFO concluded that, as of the period covered by the
report, the Company’s disclosure controls and procedures are effective in that
they provide reasonable assurances that the information the Company is required
to disclose in the reports it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time periods required by
the SEC’s rules and forms.
 
 Changes in Internal Control over
Financial Reporting
 
 There were no changes in the Company’s
internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) of the Exchange Act) that occurred during the period covered by this
report that have materially affected or are reasonably likely to materially
affect, the Company’s internal control over financial reporting. Management has
implemented changes in internal control over financial reporting as a result of
remediation of matters identified through its review of internal control over
financial reporting as required under Section 404 of the Sarbanes-Oxley Act;
however, it does not believe any of the changes implemented were material in
nature.
  - 30
-
 Index
 PART II – OTHER
INFORMATION
 
 Item 1.Legal
Proceedings
 
 There are no material pending legal
proceedings to which the Company or its subsidiaries is a party or to which any
of the Company’s or its subsidiaries’ property is subject. In addition, the
Company is not aware of any threatened litigation, unasserted claims or
assessments that could have a material adverse effect on the Company’s business,
operating results or condition.
 
 Item 1A.Risk
Factors
 
 You should consider the following
material risk factors carefully before deciding to invest in the Company’s
securities. Additional risks and uncertainties not presently known to us, that
we may currently deem to be immaterial or that are similar to those faced by
other companies in our industry or business in general, such as competitive
conditions, may also impact our business operations. If any of the events
described below occur, the Company’s business, financial condition, or results
of operations could be materially adversely affected. In that event, the trading
price of the Company’s common stock may decline, in which case the value of your
investment may decline as well. References herein to “we”, “us”, and “our” refer
to Capital Bank Corporation, a North Carolina corporation, and its subsidiaries,
unless the context otherwise requires.
 
 U.S.
and international credit markets and economic conditions could adversely affect
our liquidity and financial condition.
 
 As
described in Part I, Item 2, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations—Overview,” global market and economic
conditions continue to be disruptive and volatile and the disruption has
particularly had a negative impact on the financial sector. The possible
duration and severity of this adverse economic cycle is unknown. Although the
Company remains well capitalized and has not suffered any liquidity issues as a
result of these recent events, the cost and availability of funds may be
adversely affected by illiquid credit markets. Continued turbulence in U.S. and
international markets and economies may adversely affect our liquidity,
financial condition and profitability.
 
 While the
U.S. and foreign governments have instituted programs to address economic
stabilization, the efficacy of these programs in stabilizing the economy and the
banking system at large are uncertain. Details as to our ultimate participation
in the U.S. Treasury’s Troubled Asset Relief Program and its subsequent impact
on the Company also remain uncertain. Although the final terms of the program
have not been decided, the U.S. Treasury’s program could reduce investment
returns to participating banks’ shareholders by restricting dividends to common
shareholders, diluting existing shareholders interests and restricting capital
management practices.
 
 In
addition, federal and state governments could pass additional legislation
responsive to current credit conditions. We could experience higher credit
losses because of legislation or regulatory action that reduces the amounts
borrowers are contractually required to pay under existing loan contracts or
that limits our ability to foreclose on property or other collateral or
makes foreclosure less economically feasible.
 
 Changes in local economic conditions
could lead to higher loan charge-offs and reduce our net income and
growth.
 
 Our business is subject to periodic
fluctuations based on local economic conditions in Central and Western North
Carolina.These fluctuations are not predictable,
cannot be controlled, and may have a material adverse impact on our operations
and financial condition even if other favorable events occur.Our operations are locally oriented and
community-based.Accordingly, we expect to continue to be
dependent upon local business conditions as well as conditions in the local
residential and commercial real estate markets we serve.For example, an increase in
unemployment, a decrease in real estate values or increases in interest rates,
as well as other factors, could weaken the economies of the communities we
serve.
  - 31
-
 Index
 Weakness in our market areas could
depress our earnings and consequently our financial condition
because:
 
 •
                          customers may not want or need our
      products or services;•
                          borrowers may not be able to repay
      their loans;•
                          the value of the collateral
      securing loans to borrowers may decline; and•
                          the quality of our loan portfolio
      may decline.
 
 Any of the latter three scenarios could
require us to charge-off a higher percentage of loans and/or increase provisions
for credit losses, which would reduce our net income.For an analysis of our recent charge off
experience, please refer to the “Assets” section in Item2. Management’s Discussion and Analysis
of Financial Condition and Results of Operationsabove.
 
 Because the majority of our borrowers
are individuals and businesses located and doing business in Wake, Granville,
Lee, Chatham, Alamance, Buncombe and Catawba Counties, North Carolina, our
success will depend significantly upon the economic conditions in those and the
surrounding counties.Unfavorable economic conditions in those
and the surrounding counties may result in, among other things, a deterioration
in credit quality or a reduced demand for credit and may harm the financial
stability of our customers.Due to our limited market areas, these
negative conditions may have a more noticeable effect on us than would be
experienced by a larger institution that is able to spread these risks of
unfavorable local economic conditions across a large number of diversified
economies.
 
 Weakness in the markets for residential
or commercial real estate could reduce our net income and
profitability.
 
 Recently, the financial markets have
experiencedvolatilityassociated with subprime mortgages,
including adverse impacts on credit quality and liquidity within the financial
markets.The volatility has been exacerbated by a
general decline in the real estate and housing market along with significant
mortgage loan related losses reported by manyother financial institutions.Our financial results may
be adversely affected by changes in real estate values.Decreases in real estate values could
adversely affect the value of property used as collateral for loans and
investments.If poor economic conditions result in
decreased demand for real estate loans, our netincome and profits may
decline.
 
 The declines in home prices in the
markets we serve, along with the reduced availability of mortgage credit, also
may result in increases in delinquencies and losses in our portfolio of loans
related to residential real estate construction and development.Further declines in home prices coupled
with an economic recession and associated rises in unemployment levels could
drive losses beyond that which is provided for in our allowance for loan
losses.In that event, our earnings could be
adversely affected.
 
 Additionally, recent weakness in the
secondary market for residential lending could have an adverse impact upon our
profitability.Significant ongoing disruptions in the
secondary market for residential mortgage loans have limited the market for and
liquidity of most mortgage loans other than conforming Fannie Mae and Freddie
Mac loans.The effects of ongoing mortgage market
challenges, combined with the ongoing correction in residential real estate
market prices and reduced levels of home sales, could result in further price
reductions in single family home values, adversely affecting the value of
collateral securing mortgage loans held, mortgage loan originations and gains on
sale of mortgage loans.As ofSeptember 30, 2008, approximately17.8% of our total loans were secured byresidentialreal estate.Continued declines in real estate values
and home sales volumes, and financial stress on borrowers as a result of job
losses, or other factors, could have further adverse effects on borrowers that
result in higher delinquencies and greater charge-offs in future periods, which
would adversely affect our financial condition or results of
operations.
 
 Changes in interest rates may have an
adverse effect on our profitability.
 
 Our earnings and financial condition are
dependent to a large degree upon net interest income, which is the difference
between interest earned from loans and investments and interest paid on deposits
and borrowings.The narrowing of interest rate spreads,
meaning the difference between interest rates earned on loans and investments
and the interest rates paid on deposits and borrowings, could adversely affect
our earnings and financial condition.We cannot predict with certainty or
control changes in interest rates.Regional and local economic conditions
and the policies of regulatory authorities, including monetary policies of the
Federal Reserve Board, affect interest income and interest expense.We have ongoing policies and procedures
designed to manage the risks associated with changes in market interest
rates.However, changes in interest rates still
may have an adverse effect on our profitability.
  - 32
-
 Index
 Weare exposed to risks in connection with
the loans we make.
 
 A significant source of risk for us
arises from the possibility that losses will be sustained because borrowers,
guarantors and related parties may fail to perform in accordancewith the terms of their loans.We have underwriting and
credit monitoring procedures and credit policies, including the establishment
and review of the allowance for loan losses, that we believe are appropriate to
minimize this risk by assessing the likelihood of nonperformance, tracking loan
performance and diversifying our loan portfolio. Such policies and procedures,
however, may not prevent unexpected losses that could adversely affect our
results of operations.Loan
defaults result in a decrease in interest income resulting from a loan default
or defaults may be for a prolonged period of time as we seek to recover,
primarily through legal proceedings, the outstanding principal balance, accrued
interest and default interest due on a defaulted loan plus the legal costs
incurred in pursuing our legal remedies. No assurance can be given that recent
market conditions will not result in our need to increase loan loss reserves or
charge off a higher percentage of loans, thereby reducing net
income.
 
 We compete with larger companies for
business.
 
 The banking and financial services
business in our market areas continues to be a competitive field and is becoming
more competitive as a result of:
 
 •
                          changes in
      regulations;•
                          changes in technology and product
      delivery systems; and•
                          the accelerating pace of
      consolidation among financial services
  providers.
 
 We may not be able to compete
effectively in our markets, and our results of operations could be adversely
affected by the nature or paceof change in competition.We compete for loans, deposits and
customers with various bank and nonbank financial services providers, many of
which have substantially greater resources,including higher total assets and
capitalization, greater access to capital markets and a broader offering of
financial services.
 
 Ourtrading volume has been low compared
with larger banks.
 
 The trading volume in the
Company’s common stock on the NASDAQGlobal SelectMarket has been comparable
to other similarly-sized
banks.Nevertheless, this
trading is relatively low when compared with more seasoned companies listed on
the NASDAQGlobal
SelectMarket or other
consolidated reporting
systems or stock exchanges.Thus, the market in the
Company’s common stock may be limited in scope
relative to other companies.
 
 Wedepend heavily on our key management
personnel.
 
 The Company’s success depends in part on its ability
to retain key executives and to attract and retain additional qualified
management personnel who have experience both in sophisticated banking matters
and in operating a small-
to mid-size bank.Competition for such personnel is strong
in the banking industry,and we may not be successful in
attracting or retaining the
personnel we require.We
expect to effectively compete in this area by offering financial packages that
include incentive-based compensation and the opportunity to join in the
rewarding work of building a growing bank.
 
 Technologicaladvances impact our
business.
 
 The banking industry is undergoing
technological changes with frequent introductions of new technology-driven products and
services.In addition to
improving customer services, the effective use of technology increases
efficiency and enables financialinstitutions to reduce costs.Our future success will
depend, in part, on our ability to address the needs of our customers by using
technology to provide products and services that will satisfy customer demands
for convenience as well as to create additional efficiencies in our operations.Many of our competitors
have substantially greater resources than we do to investin technological improvements.We may not be able to
effectively implement new technology-driven products and services or
successfully market such products and services to our
customers.
 - 33
-
 Index
 Governmentregulations may prevent or impact our
ability to pay dividends, engage in acquisitions or operate in other
ways.
 
 Current and future legislation and the
policies established by federal and state regulatory authorities will affect our operations.We are subject to
supervision and periodic examination by the Federal Deposit Insurance
Corporation and the North Carolina State Banking Commission. Banking
regulations, designed primarily for the protection of depositors, may limit our
growth and the return to you, our investors, by restricting certain of our
activities, such as:
 
 •
                          the payment of dividends to our
      shareholders;•
                          possible mergers with,or acquisitions of or
      by,other
      institutions;•
                          our desired
      investments;•
                          loans and interest rates on
      loans;•
                          interest rates paid on our
      deposits;•
                          the possible expansion of our
      branch offices; and/or•
                          our ability to provide securities
      or trust services.
 
 We also are subject to capitalization
guidelines set forth in federal legislation, and could be subject to enforcement
actions to the extent that we are found by regulatory examiners to be undercapitalized.We cannot predict what
changes, if any, will be made to existing federal and state legislation and
regulations or the effect that such changes may have on our future
business and earnings
prospects.The cost of
compliance with regulatory requirements including those imposed by the
SECmay adversely affect our ability to
operate profitably.
 
 Thereare potential risks associated with
future acquisitions and expansions.
 
 We intend to continue to explore
expanding our branch system through selective acquisitions of existing banks or
bank branches in the Research Triangle area andother North Carolina markets.We cannot say with any
certainty that we will be able to consummate, or if consummated, successfully
integrate, future acquisitions, or that we will not incur disruptions or
unexpected expenses inintegrating such acquisitions.In the ordinary course of
business, we evaluate potential acquisitions that would bolster our ability to
cater to the small business, individual and residential lending markets in North Carolina.In attempting to make such
acquisitions, we anticipate competing with other financial institutions, many of
which have greater financial and operational resources.In addition, since the
consideration for an acquired bank or branch may involve cash, notes or the
issuance of shares of common stock, existing shareholders could experience
dilution in the value of their shares of our common stock in connection with
suchacquisitions.Any given acquisition, if
and when consummated, may adversely affect our results of operationsor overall financial
condition.In addition, we
may expand our branch network through de novo branches in existing or new markets.These de novo branches will
have expenses in excess of revenues for varying periods after opening, which
could decrease our reported earnings.
 
 Compliancewith changing regulation of corporate
governance and public disclosure may result in additional risks and
expenses.
 
 Changing laws, regulations and standards
relating to corporate governance and public disclosure, including the
Sarbanes-Oxley Act of 2002 and new SEC regulations, are creating
uncertainty for companies
such as ours.These laws,
regulations and standards are subject to varying interpretations in many cases,
and as a result, their application in practice may evolve over time as new
guidance is provided by regulatory and governing bodies, which could result in
continuing uncertainty regarding compliance matters and higher costs
necessitated by ongoing revisions to disclosure and governance practices.We are committed to
maintaining high standards of corporate governance and public disclosure.As a result, our efforts to
comply with evolving laws, regulations and standards have resulted in, and are
likely to continue to result in, increased expenses and a diversion ofmanagement time and
attention.In particular,
our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the
related regulations regarding management’s required assessment of our internal
control over financial reporting and our external auditors’audit of that assessment has required
the commitment of significant financial and managerial
resources.
 - 34
-
 Index
 We expect these efforts to require the
continued commitment of
significant resources.Further, the members of our Board of
Directors, members of the
Audit or Compensation/Human Resources Committees, ourCEO, ourCFOand certain other of our executive
officers could face an increased risk of personal liability in connection with
the performance of their
duties.As a result, our
ability to attract and retain executive officers and qualified Board and
committee members could be
more difficult.In
addition, it may become more difficult and more expensive to obtain director and
officer liability insurance.
 
 We
are subject to environmental liability risk associated with lending
activities.
 
 A
significant portion of our loan portfolio is secured by real property. During
the ordinary course of business, we may foreclose on and take title to
properties securing certain loans. In doing so, there is a risk that hazardous
or toxic substances could be found on these properties. If hazardous or toxic
substances are found, we may be liable for remediation costs, as well as for
personal injury and property damage. Environmental laws may require us to incur
substantial expenses and may materially reduce the affected property’s value or
limit our ability to use or sell the affected property. In addition, future laws
or more stringent interpretations or enforcement policies with respect to
existing laws may increase our exposure to environmental liability. Although we
have policies and procedures to perform an environmental review before
initiating any foreclosure action on nonresidential real property, these reviews
may not be sufficient to detect all potential environmental hazards. The
remediation costs and any other financial liabilities associated with an
environmental hazard could have a material adverse effect on our financial
condition and results of operations.Loan defaults result in a decrease in
interest income and may require the establishment of or an increase in loan loss
reserves. Furthermore, the decrease in interest income resulting from a loan
default or defaults may be for a prolonged period of time as we seek to recover,
primarily through legal proceedings, the outstanding principal balance, accrued
interest and default interest due on a defaulted loan plus the legal costs
incurred in pursuing our
legal remedies.No
assurance can be given that recent market conditions will not result in our need
to increase loan loss reserves or charge-off a higher percentage of loans,
thereby reducing net income.
 
 Our
controls and procedures may fail or be circumvented.
 
 Management
regularly reviews and updates our internal controls, disclosure controls and
procedures, and corporate governance policies and procedures. Any system of
controls, however well designed and operated, is based in part on certain
assumptions and can provide only reasonable, not absolute, assurances that the
objectives of the system are met. Any failure or circumvention of our controls
and procedures or failure to comply with regulations related to controls and
procedures could have a material adverse effect on our business, results of
operations and financial condition.
 
 The
holders of our subordinated debentures have rights that are senior to those of
our shareholders.
 
 We have
issued $30.9 million of subordinated debentures in connection with three trust
preferred securities issuances by our subsidiaries, Trust I, II and III. We
conditionally guarantee payments of the principal and interest on the trust
preferred securities. Our subordinated debentures are senior to our shares of
common stock. As a result, we must make payments on the subordinated debentures
(and the related trust preferred securities) before any dividends can be paid on
our common stock and, in the event of bankruptcy, dissolution or liquidation,
the holders of the debentures must be satisfied before any distributions can be
made to the holders of common stock.
 
 Our information systems may
experience an interruption or breach in security.
 
 We rely
heavily on communications and information systems to conduct our business. Any
failure, interruption or breach in security of these systems could result in
failures or disruptions in our customer relationship management, general ledger,
deposit, loan and other systems. While we have policies and procedures designed
to prevent or limit the effect of the failure, interruption or security breach
of our information systems, there can be no assurance that we can prevent any
such failures, interruptions or security breaches or, if they do occur, that
they will be adequately addressed. The occurrence of any failures, interruptions
or security breaches of our information systems could damage our reputation,
result in a loss of customer business, subject us to additional regulatory
scrutiny, or expose us to civil litigation and possible financial liability, any
of which could have a material adverse effect on our financial condition and
results of operations.
 
 An
investment in our common stock is not an insured deposit.
 
 Our
common stock is not a bank deposit and, therefore, is not insured against loss
by the FDIC, any other deposit insurance fund or by any other public or private
entity. Investment in our common stock is inherently risky for the reasons
described in this “Risk Factors” section and elsewhere in this report and is
subject to the same market forces that affect the price of common stock in any
company. As a result, if you acquire our common stock, you may lose some or all
of your investment.
  - 35
-
 Index
 Consumers
may decide not to use banks to complete their financial
transactions.
 
 Technology
and other changes are allowing parties to complete financial transactions that
historically have involved banks through alternative methods. For example,
consumers can now maintain funds in brokerage accounts or mutual funds that
would have historically been held as bank deposits. Consumers can also complete
transactions such as paying bills and/or transferring funds directly without the
assistance of banks. The process of eliminating banks as intermediaries could
result in the loss of fee income, as well as the loss of customer deposits and
the related income generated from those deposits. The loss of these revenue
streams and the lower cost deposits as a source of funds could have a material
adverse effect on our financial condition and results of
operations.
 
 Item 2.Unregistered Sales of EquitySecurities and Use of
Proceeds
 
 The following table lists all
repurchases (both open market and private transactions) during the three months
ended September 30, 2008 of any of the Company’s securities registered
under Section 12 of the Exchange Act, by or on behalf of the Company, or any
affiliated purchaser of the Company.
  Issuer Purchases of Equity
Securities
 
 Month
                            
                            Total
      Number
                              of
      Shares Purchased
                            
                            Average
      Price
                              Paid
      per Share
                            
                            Total
      Number of Shares Purchased as Part of Publicly Announced Plans or Programs
      (1)
                            
                            Maximum
      Number of Shares that May Yet Be Purchased under the Plans or
      ProgramsJuly
      1, 2008 –July
      31, 2008
                            
                            
                            2,000
                            
                            $
                            8.95
                            
                            
                            2,000
                            
                            
                            989,900August
      1, 2008 –August
      30, 2008
                            
                            
                            –
                            
                            
                            –
                            
                            
                            –
                            
                            
                            989,900September
      1, 2008 – September 30, 2008
                            
                            
                            –
                            
                            
                            –
                            
                            
                            –
                            
                            
                            989,900
 
 (1)
                            On January 24, 2008, the Company’s
      Board of Directors authorized the repurchase of up to 1.0 million shares
      of the Company’s currently outstanding shares of common stock (in the open
      market or in any private transaction). There is no expiration date for the
      repurchase program. As of September 30, 2008, there were an aggregate of
      989,900 shares remaining authorized for future
      repurchases.
 
 Item 3.Defaults upon Senior
Securities
 
 None
 
 Item 4.Submission of Mattersto a Vote of Security
Holders
 
 None
 
 Item 5.Other
Information
 
 None
 - 36
-
 Index
 Item 6.Exhibits
  Exhibit No.
                            
                            DescriptionExhibit 4.1
                            
                            In accordance with Item
      601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting
      long-term debt of the registrant have been omitted but will be furnished
      to the Commission upon request.Exhibit
10.1
                            
                            Purchase
      and Assumption Agreement, dated September 25, 2008, by and between Capital
      Bank, a wholly-owned subsidiary of Capital Bank Corporation, and Omni
      National BankExhibit
10.2
                            
                            Amended
      and Restated Employment Agreement, dated September 17, 2008, by and
      between Capital Bank Corporation and B. Grant Yarber (incorporated by
      reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on September 22,
      2008)Exhibit
10.3
                            
                            Amended
      and Restated Employment Agreement, dated September 17, 2008, by and among
      Capital Bank Corporation, Capital Bank and Mark Redmond (incorporated by
      reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on September 22,
      2008)Exhibit
10.4
                            
                            Real
      Estate Purchase Agreement, dated October 6, 2008, by and between Capital
      Bank, a wholly-owned subsidiary of Capital Bank Corporation, Michael R.
      Moore and Viola V. Moore (incorporated by reference to Exhibit 10.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on October 6, 2008)Exhibit
31.1
                            
                            Certification of B. Grant Yarber
      pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002Exhibit
31.2
                            
                            Certification of Michael R. Moore
      pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002Exhibit
32.1
                            
                            Certification of B. Grant Yarber
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant
      to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to
      the extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for purposes of liability under the
      Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may be.]Exhibit
32.2
                            
                            Certification of Michael R. Moore
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to
      the extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for purposes of liability under the
      Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may
be.]
 - 37
-
 Index
 Signatures
 
 Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in
Raleigh, North Carolina, on the 7th day of November 2008.
  CAPITAL BANK
      CORPORATIONBy:  /s/Michael R.
      MooreMichael R.
      MooreChief Financial
      Officer(Authorized Officer and Principal
      Financial Officer)
 - 38
-
 Index
 Exhibit Index
 
 Exhibit No.
                              
                              DescriptionExhibit 4.1
                              
                              In accordance with Item
      601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting
      long-term debt of the registrant have been omitted but will be furnished
      to the Commission upon request.Exhibit
10.1
                              
                              Purchase
      and Assumption Agreement, dated September 25, 2008, by and between Capital
      Bank, a wholly-owned subsidiary of Capital Bank Corporation, and Omni
      National BankExhibit
10.2
                              
                              Amended
      and Restated Employment Agreement, dated September 17, 2008, by and
      between Capital Bank Corporation and B. Grant Yarber (incorporated by
      reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on September 22,
      2008)Exhibit
10.3
                              
                              Amended
      and Restated Employment Agreement, dated September 17, 2008, by and among
      Capital Bank Corporation, Capital Bank and Mark Redmond (incorporated by
      reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K
      filed with the Securities and Exchange Commission on September 22,
      2008)Exhibit
10.4
                              
                              Real
      Estate Purchase Agreement, dated October 6, 2008, by and between Capital
      Bank, a wholly-owned subsidiary of Capital Bank Corporation, Michael R.
      Moore and Viola V. Moore (incorporated by reference to Exhibit 10.1 to the
      Company’s Current Report on Form 8-K filed with the Securities and
      Exchange Commission on October 6, 2008)Exhibit
31.1
                              
                              Certification of B. Grant Yarber
      pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002Exhibit
31.2
                              
                              Certification of Michael R. Moore
      pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section
      302 of the Sarbanes-Oxley Act of 2002Exhibit
32.1
                              
                              Certification of B. Grant Yarber
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant
      to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to
      the extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for purposes of liability under the
      Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may be.]Exhibit
32.2
                              
                              Certification of Michael R. Moore
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to
      the extent required by that Act, be deemed to be incorporated by reference
      into any document or filed herewith for purposes of liability under the
      Securities Exchange Act of 1934, as amended, or the Securities Act of
      1933, as amended, as the case may
be.]
 - 39
-