UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





þ QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d)


OF THE
SECURITIES EXCHANGE ACT OF 1934





For
the Quarterly Period Ended March 31, 2010





or





 ̈TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d)


OF THE
SECURITIES EXCHANGE ACT OF 1934





For the
Transition Period from  to













CAPITAL
BANK CORPORATION


(Exact
name of registrant as specified in its charter)





North
      Carolina
            
            000-30062
            
            56-2101930(State
      or other jurisdiction ofincorporation or organization)
            
            (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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).  Yes  ̈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
      filer   ̈Non-accelerated filer ̈ (Do not check if a smaller
      reporting company)
            Smaller
      reporting company  þ





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





As
of May 5, 2010 there were 12,881,354 shares outstanding of the
registrant’s common stock, no par value.







CAPITAL BANK CORPORATION


Form
10-Q for the Quarterly Period Ended March 31, 2010








INDEX





PART
      I – FINANCIAL INFORMATION
            Page
      No.Item 1.
            Financial StatementsCondensed
      Consolidated Balance Sheets as of March 31, 2010 (Unaudited) and December
      31, 2009
            3Condensed
      Consolidated Statements of Operations for the Three Months Ended March 31,
      2010 and 2009 (Unaudited)
            4Condensed
      Consolidated Statements of Changes in Shareholders’ Equity and
      Comprehensive Income for the Three Months Ended March 31, 2010 and 2009
      (Unaudited)
            5Condensed
      Consolidated Statements of Cash Flows for the Three Months Ended March 31,
      2010 and 2009
            6Notes
      to Condensed Consolidated Financial Statements (Unaudited)
            7Item 2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            17Item 3.
            Quantitative
      and Qualitative Disclosures about Market Risk
            33Item 4.
            Controls
      and Procedures
            33Item 4T.
            Controls
      and Procedures
            34PART
      II – OTHER INFORMATIONItem 1.
            Legal
      Proceedings
            34Item 1A.
            Risk
      Factors
            34Item 2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            45Item 3.
            Defaults
      upon Senior Securities
            45Item 4.
            (Removed
      and Reserved)
            45Item 5.
            Other
      Information
            45Item 6.
            Exhibits
            46Signatures




- 2
-


PART
I – FINANCIAL INFORMATION





Item 1.Financial
Statements





CAPITAL
BANK CORPORATION
 CONDENSED
CONSOLIDATED BALANCE SHEETS
 March
31, 2010 and December 31, 2009
 March
      31, 2010
              
              December
      31, 2009(Dollars
      in thousands except share data)
              
              (Unaudited)AssetsCash
      and cash equivalents:Cash
      and due from banks
              
              $
              22,342
              
              $
              25,002Interest-bearing
      deposits with banks
              
              
              30,999
              
              
              4,511Total
      cash and cash equivalents
              
              
              53,341
              
              
              29,513Investment
      securities:Investment
      securities – available for sale, at fair value
              
              
              220,955
              
              
              235,426Investment
      securities – held to maturity, at amortized cost
              
              
              3,344
              
              
              3,676Other
      investments
              
              
              8,481
              
              
              6,390Total
      investment securities
              
              
              232,780
              
              
              245,492Loans
      – net of unearned income and deferred fees
              
              
              1,376,085
              
              
              1,390,302Allowance
      for loan losses
              
              
              (29,160
              )
              
              (26,081
              )Net
      loans
              
              
              1,346,925
              
              
              1,364,221Premises
      and equipment, net
              
              
              24,580
              
              
              23,756Bank-owned
      life insurance
              
              
              22,997
              
              
              22,746Deposit
      premium, net
              
              
              2,475
              
              
              2,711Deferred
      income tax
              
              
              11,690
              
              
              12,096Accrued
      interest receivable
              
              
              6,479
              
              
              6,590Other
      assets
              
              
              38,590
              
              
              27,543Total
      assets
              
              $
              1,739,857
              
              $
              1,734,668LiabilitiesDeposits:Demand,
      noninterest-bearing
              
              $
              132,411
              
              $
              141,069Savings
      and interest-bearing checking
              
              
              204,358
              
              
              204,042Money
      market deposit accounts
              
              
              160,087
              
              
              184,146Time
      deposits less than $100,000
              
              
              531,508
              
              
              507,348Time
      deposits $100,000 and greater
              
              
              352,175
              
              
              341,360Total
      deposits
              
              
              1,380,539
              
              
              1,377,965Repurchase
      agreements and federal funds purchased
              
              
              3,227
              
              
              6,543Borrowings
              
              
              172,000
              
              
              167,000Subordinated
      debentures
              
              
              34,323
              
              
              30,930Other
      liabilities
              
              
              10,976
              
              
              12,445Total
      liabilities
              
              
              1,601,065
              
              
              1,594,883Shareholders’
      EquityPreferred
      stock, $1,000 par value; 100,000 shares authorized; 41,279 shares issued
      and outstanding (liquidation preference of $41,279)
              
              
              40,200
              
              
              40,127Common
      stock, no par value; 50,000,000 shares authorized; 12,881,354 and
      11,348,117 shares issued and outstanding
              
              
              145,136
              
              
              139,909Accumulated
      deficit
              
              
              (50,129
              )
              
              (44,206
              )Accumulated
      other comprehensive income
              
              
              3,585
              
              
              3,955Total
      shareholders’ equity
              
              
              138,792
              
              
              139,785Total
      liabilities and shareholders’ equity
              
              $
              1,739,857
              
              $
              1,734,668
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 
 Index
 - 3
-
 CAPITAL
BANK CORPORATION
 CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
 For
the Three Months Ended March 31, 2010 and 2009 (Unaudited)
 March
      31, 2010
                
                March
      31, 2009(Dollars
      in thousands except per share data)Interest
      income:Loans
      and loan fees
                
                $
                17,411
                
                $
                16,092Investment
      securities:Taxable
      interest income
                
                
                2,026
                
                
                2,799Tax-exempt
      interest income
                
                
                601
                
                
                764Dividends
                
                
                18
                
                
                –Federal
      funds and other interest income
                
                
                10
                
                
                13Total
      interest income
                
                
                20,066
                
                
                19,668Interest
      expense:Deposits
                
                
                6,151
                
                
                7,769Borrowings
      and repurchase agreements
                
                
                1,365
                
                
                1,718Total
      interest expense
                
                
                7,516
                
                
                9,487Net
      interest income
                
                
                12,550
                
                
                10,181Provision
      for loan losses
                
                
                11,734
                
                
                5,986Net
      interest income after provision for loan losses
                
                
                816
                
                
                4,195Noninterest
      income:Service
      charges and other fees
                
                
                868
                
                
                952Bank
      card services
                
                
                415
                
                
                339Mortgage
      origination and other loan fees
                
                
                327
                
                
                527Brokerage
      fees
                
                
                187
                
                
                163Bank-owned
      life insurance
                
                
                239
                
                
                258Net
      gain (loss) on investment securities
                
                
                328
                
                
                (320
                )Net
      loss on other real estate
                
                
                (876
                )
                
                (7
                )Other
                
                
                167
                
                
                187Total
      noninterest income
                
                
                1,655
                
                
                2,099Noninterest
      expense:Salaries
      and employee benefits
                
                
                5,400
                
                
                5,961Occupancy
                
                
                1,502
                
                
                1,373Furniture
      and equipment
                
                
                745
                
                
                830Data
      processing and telecommunications
                
                
                517
                
                
                631Advertising
      and public relations
                
                
                430
                
                
                323Office
      expenses
                
                
                332
                
                
                335Professional
      fees
                
                
                475
                
                
                379Business
      development and travel
                
                
                267
                
                
                328Amortization
      of deposit premiums
                
                
                235
                
                
                288Miscellaneous
      loan handling costs
                
                
                441
                
                
                163Directors
      fees
                
                
                298
                
                
                359FDIC
      deposit insurance
                
                
                665
                
                
                229Other
                
                
                407
                
                
                358Total
      noninterest expense
                
                
                11,714
                
                
                11,557Net
      loss before tax benefit
                
                
                (9,243
                )
                
                (5,263
                )Income
      tax benefit
                
                
                (3,909
                )
                
                (800
                )Net
      loss
                
                $
                (5,334
                )
                $
                (4,463
                )Dividends
      and accretion on preferred stock
                
                
                589
                
                
                587Net
      loss attributable to common shareholders
                
                $
                (5,923
                )
                $
                (5,050
                )Net
      loss per common share – basic
                
                $
                (0.49
                )
                $
                (0.45
                )Net
      loss per common share – diluted
                
                $
                (0.49
                )
                $
                (0.45
                )
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  Index
 - 4
-
 CAPITAL
BANK CORPORATION
 CONDENSED
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE
INCOME (LOSS)
 For
the Three Months Ended March 31, 2010 and 2009 (Unaudited)
 Preferred
      Stock
              
              Common
      Stock
              
              Other
      Comprehensive
              
              AccumulatedShares
              
              Amount
              
              Shares
              
              Amount
              
              Income
              
              Deficit
              
              Total(Dollars
      in thousands except share data)Balance
      at January 1, 2009
              
              41,279
              
              $
              39,839
              
              
              11,238,085
              
              $
              139,209
              
              $
              886
              
              $
              (31,420
              )
              $
              148,514Comprehensive
      loss:Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (4,463
              )
              
              (4,463
              )Net
      unrealized gain on securities, net of tax of $196
              
              
              
              
              
              
              
              
              
              
              
              
              
              312
              
              
              
              
              
              312Net
      unrealized loss on cash flow hedge, net of tax benefit of
    $315
              
              
              
              
              
              
              
              
              
              
              
              
              
              (502
              )
              
              
              
              
              (502
              )Prior
      service cost recognized on SERP
              
              
              
              
              
              
              
              
              
              
              
              
              
              (54
              )
              
              
              
              
              (54
              )Total
      comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (4,707
              )Accretion
      of preferred stock discount
              
              
              
              
              71
              
              
              
              
              
              
              
              
              
              
              
              (71
              )
              
              –Restricted
      stock awards
              
              
              
              
              
              
              
              20,000
              
              
              120
              
              
              
              
              
              
              
              
              120Stock
      option expense
              
              
              
              
              
              
              
              
              
              
              13
              
              
              
              
              
              
              
              
              13Directors’
      deferred compensation
              
              
              
              
              
              
              
              42,284
              
              
              153
              
              
              
              
              
              
              
              
              153Dividends
      on preferred stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (516
              )
              
              (516
              )Dividends
      on common stock ($0.08 per share)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (903
              )
              
              (903
              )Balance
      at March 31, 2009
              
              41,279
              
              $
              39,910
              
              
              11,300,369
              
              $
              139,495
              
              $
              642
              
              $
              (37,373
              )
              $
              142,674Balance
      at January 1, 2010
              
              41,279
              
              $
              40,127
              
              
              11,348,117
              
              $
              139,909
              
              $
              3,955
              
              $
              (44,206
              )
              $
              139,785Comprehensive
      loss:Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (5,334
              )
              
              (5,334
              )Net
      unrealized loss on securities, net of tax benefit of $234
              
              
              
              
              
              
              
              
              
              
              
              
              
              (372
              )
              
              
              
              
              (372
              )Amortization
      of prior service cost on SERP
              
              
              
              
              
              
              
              
              
              
              
              
              
              2
              
              
              
              
              
              2Total
      comprehensive loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (5,704
              )Accretion
      of preferred stock discount
              
              
              
              
              73
              
              
              
              
              
              
              
              
              
              
              
              (73
              )
              
              –Issuance
      of common stock
              
              
              
              
              
              
              
              1,468,770
              
              
              5,065
              
              
              
              
              
              
              
              
              5,065Stock
      option expense
              
              
              
              
              
              
              
              
              
              
              12
              
              
              
              
              
              
              
              
              12Directors’
      deferred compensation
              
              
              
              
              
              
              
              64,467
              
              
              150
              
              
              
              
              
              
              
              
              150Dividends
      on preferred stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (516
              )
              
              (516
              )Balance
      at March 31, 2010
              
              41,279
              
              $
              40,200
              
              
              12,881,354
              
              $
              145,136
              
              $
              3,585
              
              $
              (50,129
              )
              $
              138,792
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  Index
 - 5
-
 CAPITAL
BANK CORPORATION
 CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
 For
the Three Months Ended March 31, 2010 and 2009 (Unaudited)
 March
      31, 2010
              
              March
      31, 2009(Dollars
      in thousands)Cash
      flows from operating activities:Net
      loss
              
              $
              (5,334
              )
              $
              (4,463
              )Adjustments
      to reconcile net loss to net cash provided by operating
      activities:Provision
      for loan losses
              
              
              11,734
              
              
              5,986Amortization
      of deposit premium
              
              
              236
              
              
              288Depreciation
              
              
              635
              
              
              759Stock-based
      compensation
              
              
              192
              
              
              196Net
      (gain) loss on investment securities
              
              
              (328
              )
              
              320Net
      amortization of premium/discount on investment securities
              
              
              34
              
              
              20Loss
      on disposal of premises, equipment and other real estate
              
              
              225
              
              
              8Loss
      on write-down of other real estate
              
              
              646
              
              
              –Deferred
      income tax (benefit) expense
              
              
              640
              
              
              (18
              )Increase
      in cash surrender value of bank-owned life insurance
              
              
              (251
              )
              
              (278
              )Net
      decrease (increase) in accrued interest receivable and other
      assets
              
              
              (6,063
              )
              
              3,105Net
      decrease in accrued interest payable and other liabilities
              
              
              (559
              )
              
              (286
              )Net
      cash provided by operating activities
              
              
              1,807
              
              
              5,637Cash
      flows from investing activities:Loan
      originations, net of principal repayments
              
              
              (3,743
              )
              
              (27,321
              )Additions
      to premises and equipment
              
              
              (1,469
              )
              
              (961
              )Proceeds
      from sales of premises, equipment and real estate owned
              
              
              3,541
              
              
              79Net
      purchases of FHLB stock
              
              
              (2,025
              )
              
              (20
              )Purchase
      of securities – available for sale
              
              
              (18,013
              )
              
              (16,958
              )Proceeds
      from principal repayments/calls/maturities of securities – available for
      sale
              
              
              32,108
              
              
              8,590Proceeds
      from principal repayments/calls/maturities of securities – held to
      maturity
              
              
              330
              
              
              384Net
      cash provided by (used in) investing activities
              
              
              10,729
              
              
              (36,207
              )Cash
      flows from financing activities:Net
      increase in deposits
              
              
              2,574
              
              
              25,660Net
      decrease in repurchase agreements
              
              
              (3,316
              )
              
              (3,360
              )Proceeds
      from borrowings
              
              
              141,000
              
              
              30,000Principal
      repayments of borrowings
              
              
              (136,000
              )
              
              (35,000
              )Proceeds
      from issuance of subordinated debentures
              
              
              3,393
              
              
              –Proceeds
      from issuance of common stock
              
              
              5,065
              
              
              –Dividends
      paid
              
              
              (1,424
              )
              
              (1,268
              )Net
      cash provided by financing activities
              
              
              11,292
              
              
              16,032Net
      change in cash and cash equivalents
              
              
              23,828
              
              
              (14,538
              )Cash
      and cash equivalents at beginning of period
              
              
              29,513
              
              
              54,455Cash
      and cash equivalents at end of period
              
              $
              53,341
              
              $
              39,917Supplemental
      Disclosure of Cash Flow InformationTransfer
      of loans and premises to other real estate owned
              
              $
              9,305
              
              $
              2,324Cash
      paid (received) for:Income
      taxes
              
              $
              –
              
              $
              (4,297
              )Interest
              
              $
              7,368
              
              $
              9,375
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
  Index
 - 6
-
 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
Company.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,
2009.
 
 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 on
total assets, net income or shareholders’ equity as previously reported. The
results of operations for the three months ended March 31, 2010 are not
necessarily indicative of the results of operations that may be expected for the
year ended December 31, 2010.
 
 The
condensed consolidated balance sheet at December 31, 2009 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, 2009.
 
 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, 2009.
 
 Current
Accounting Developments
 
 In
January 2010, the Financial Accounting Standards Board (“FASB”) issued
Accounting Standards Update (“ASU”) 2010-06, Improving Disclosures about Fair
Value Measurements, to amend FASB Accounting Standards Codification
(“ASC”) Topic 820, Fair Value
Measurements and Disclosures. The amendments in this update require more
robust disclosures about (1) the different classes of assets and liabilities
measured at fair value, (2) the valuation techniques and inputs used, (3) the
activity in Level 3 fair value measurements, and (4) the transfers between
Levels 1, 2, and 3. The new disclosures and clarifications of existing
disclosures are effective for interim and annual reporting periods beginning
December 15, 2009, except for the disclosures about purchases, sales, issuances,
and settlements in the roll forward of activity in Level 3 fair value
measurements. Those disclosures are effective for fiscal years beginning after
December 15, 2010, and for interim periods within those fiscal years. Management
does not expect the adoption of the amendments in this update to have an impact
on the Company’s financial position or results of operations.
 
 In
December 2009, the FASB issued ASU 2009-16, Accounting for Transfers of
Financial Assets, to amend ASC Topic 860, Transfers and Servicing, for
the issuance of FASB Statement No. 166, Accounting for Transfers of
Financial Assets—an amendment of FASB Statement No. 140. The amendments
in this update eliminate the exceptions for qualifying special-purpose entities
from the consolidation guidance and the exception that permitted sale accounting
for certain mortgage securitizations when a transferor has not surrendered
control over the transferred financial assets. In addition, the amendments
require enhanced disclosures about the risks that a transferor continues to be
exposed to because of its continuing involvement in transferred financial
assets. The amendments in this update are the result of FASB Statement No. 166
and are effective for annual reporting periods beginning after November 15, 2009
and interim and annual reporting periods thereafter. Adoption of the amendments
in this update did not have a material impact on the Company’s financial
position or results of operation.
 
 Index
 - 7
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
 In August
2009, the FASB issued ASU 2009-05, Measuring Liabilities at Fair
Value, to amend ASC Topic 820 to clarify how entities should estimate the
fair value of liabilities. The amendments to this update include clarifying
guidance for circumstances in which a quoted price in an active market is not
available, the effect of the existence of liability transfer restrictions, and
the effect of quoted prices for the identical liability, including when the
identical liability is traded as an asset. The amended guidance on measuring
liabilities at fair value is effective for the first interim or annual reporting
period beginning after August 28, 2009. Adoption of the amendments in this
update had no impact on the Company’s financial position or results of
operations.
 
 2.Earnings Per
Share
 
 Basic
earnings per share (“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 and
warrants, unless the effect is to reduce a loss or increase earnings. Basic EPS
is adjusted for outstanding stock options and warrants using the treasury stock
method in order to compute diluted EPS. The weighted average number of shares
outstanding for the three month periods ended March 31, 2010 and 2009 were as
follows:
 
 March
      31, 2010
                
                March
      31, 2009(Dollars
      in thousands)Net
      loss attributable to common shareholders
                
                $
                (5,923
                )
                $
                (5,050
                )Shares
      used in the computation of earnings per share:Weighted
      average number of shares outstanding – basic
                
                
                12,014,430
                
                
                11,293,480Incremental
      shares from assumed exercise of stock options and warrants
                
                
                –
                
                
                –Weighted
      average number of shares outstanding – diluted
                
                
                12,014,430
                
                
                11,293,480Net
      loss per common share – basic
                
                $
                (0.49
                )
                $
                (0.45
                )Net
      loss per common share – diluted
                
                $
                (0.49
                )
                $
                (0.45
                )
 
 Due to
the net loss attributable to common shareholders for the quarters ended March
31, 2010 and 2009, the Company excluded potential shares, if any, from its EPS
calculations since the effect of including those potential shares would have
been antidilutive to the per share amounts.
 
 3.Comprehensive Income
(Loss)
 
 Comprehensive
income (loss) represents the change in the Company’s equity during the period
from transactions and other events and circumstances from non-owner sources.
Total comprehensive income (loss) consists of net income (loss) and other
comprehensive income (loss). The Company’s other comprehensive income (loss) and
accumulated other comprehensive income (loss) 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 (loss) for the
three month periods ended March 31, 2010 and 2009 is as follows:
 
 March
      31, 2010
                
                March
      31, 2009(Dollars
      in thousands)Unrealized
      gain (loss) on available-for-sale investment securities
                
                $
                (606
                )
                $
                508Unrealized
      loss on change in fair value of cash flow hedge
                
                
                –
                
                
                (817
                )Prior
      service cost recognized on SERP, net of amortization
                
                
                2
                
                
                (54
                )Income
      tax benefit
                
                
                234
                
                
                119Other
      comprehensive loss
                
                $
                (370
                )
                $
                (244
                )
 
 Index
 - 8
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
 4.  Investment
Securities
 
 Investment
securities as of March 31, 2010 and December 31, 2009 are summarized as
follows:
 
 Amortized
      Cost
                
                Unrealized
                  Gains
                
                Unrealized
                  Losses
                
                Fair
      Value(Dollars
      in thousands)March
      31, 2010Available
      for sale:U.S.
      agency obligations
                
                $
                19,013
                
                $
                17
                
                $
                22
                
                $
                19,008Municipal
      bonds
                
                
                54,387
                
                
                522
                
                
                725
                
                
                54,184Mortgage-backed
      securities issued by GSEs
                
                
                131,722
                
                
                6,839
                
                
                –
                
                
                138,561Non-agency
      mortgage-backed securities
                
                
                7,676
                
                
                12
                
                
                536
                
                
                7,152Other
      securities
                
                
                2,252
                
                
                –
                
                
                202
                
                
                2,050215,050
                
                
                7,390
                
                
                1,485
                
                
                220,955Held
      to maturity:Municipal
      bonds
                
                
                300
                
                
                6
                
                
                –
                
                
                306Mortgage-backed
      securities issued by GSEs
                
                
                1,415
                
                
                81
                
                
                –
                
                
                1,496Non-agency
      mortgage-backed securities
                
                
                1,629
                
                
                –
                
                
                134
                
                
                1,4953,344
                
                
                87
                
                
                134
                
                
                3,297Other
      investments
                
                
                8,481
                
                
                –
                
                
                –
                
                
                8,481Total
                
                $
                226,875
                
                $
                7,477
                
                $
                1,619
                
                $
                232,733December
      31, 2009Available
      for sale:U.S.
      agency obligations
                
                $
                1,000
                
                $
                29
                
                $
                –
                
                $
                1,029Municipal
      bonds
                
                
                72,556
                
                
                1,006
                
                
                668
                
                
                72,894Mortgage-backed
      securities issued by GSEs
                
                
                144,762
                
                
                6,896
                
                
                –
                
                
                151,658Non-agency
      mortgage-backed securities
                
                
                8,345
                
                
                19
                
                
                567
                
                
                7,797Other
      securities
                
                
                2,252
                
                
                –
                
                
                204
                
                
                2,048228,915
                
                
                7,950
                
                
                1,439
                
                
                235,426Held
      to maturity:Municipal
      bonds
                
                
                300
                
                
                7
                
                
                –
                
                
                307Mortgage-backed
      securities issued by GSEs
                
                
                1,576
                
                
                84
                
                
                –
                
                
                1,660Non-agency
      mortgage-backed securities
                
                
                1,800
                
                
                –
                
                
                145
                
                
                1,6553,676
                
                
                91
                
                
                145
                
                
                3,622Other
      investments
                
                
                6,390
                
                
                –
                
                
                –
                
                
                6,390Total
                
                $
                238,981
                
                $
                8,041
                
                $
                1,584
                
                $
                245,438
 
 The
following table summarizes the gross unrealized losses and fair value of the
Company’s investments in an unrealized loss position for which
other-than-temporary impairments have not been recognized in earnings,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, as of March 31, 2010 and
December 31, 2009:
 
 Less
      than 12 Months
                
                12
      Months or Greater
                
                Total(Dollars in
      thousands)
                
                Fair
      Value
                
                Unrealized
                  Losses
                
                Fair
      Value
                
                Unrealized
                  Losses
                
                Fair
      Value
                
                Unrealized
                  LossesMarch
      31, 2010Available
      for sale:U.S.
      agency obligations
                
                $
                12,991
                
                $
                22
                
                $
                –
                
                $
                –
                
                $
                12,991
                
                $
                22Municipal
      bonds
                
                
                19,026
                
                
                502
                
                
                2,379
                
                
                223
                
                
                21,405
                
                
                725Non-agency
      mortgage-backed securities
                
                
                –
                
                
                –
                
                
                5,998
                
                
                536
                
                
                5,998
                
                
                536Other
      securities
                
                
                –
                
                
                –
                
                
                798
                
                
                202
                
                
                798
                
                
                20232,017
                
                
                524
                
                
                9,175
                
                
                961
                
                
                41,192
                
                
                1,485
 Index
 - 9
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
  Less
      than 12 Months
                
                12
      Months or Greater
                
                Total(Dollars in
      thousands)
                
                Fair
      Value
                
                Unrealized
                  Losses
                
                Fair
      Value
                
                Unrealized
                  Losses
                
                Fair
      Value
                
                Unrealized
                  LossesMarch
      31, 2010Held
      to maturity:Non-agency
      mortgage-backed securities
                
                
                –
                
                
                –
                
                
                1,495
                
                
                134
                
                
                1,495
                
                
                134Total
                
                $
                32,017
                
                $
                524
                
                $
                10,670
                
                $
                1,095
                
                $
                42,687
                
                $
                1,619December
      31, 2009Available
      for sale:Municipal
      bonds
                
                $
                21,194
                
                $
                448
                
                $
                2,382
                
                $
                220
                
                $
                23,576
                
                $
                668Non-agency
      mortgage-backed securities
                
                
                3,711
                
                
                93
                
                
                2,791
                
                
                474
                
                
                6,502
                
                
                567Other
      securities
                
                
                –
                
                
                –
                
                
                1,546
                
                
                204
                
                
                1,546
                
                
                20424,905
                
                
                541
                
                
                6,719
                
                
                898
                
                
                31,624
                
                
                1,439Held
      to maturity:Non-agency
      mortgage-backed securities
                
                
                –
                
                
                –
                
                
                1,655
                
                
                145
                
                
                1,655
                
                
                145Total
                
                $
                24,905
                
                $
                541
                
                $
                8,374
                
                $
                1,043
                
                $
                33,279
                
                $
                1,584
 
 Each
quarter, the Company makes an assessment to determine whether there have been
any events or economic circumstances to indicate that a marketable security on
which there is an unrealized loss is impaired on an other-than-temporary basis.
The Company considers many factors, including the severity and duration of the
impairment and recent events specific to the issuer or industry, including any
changes in credit ratings.
 
 Unrealized
losses on the Company’s investments in non-agency mortgage-backed securities, or
private label mortgage securities, are related to eight different securities.
These losses are due to a combination of changes in credit spreads and other
market factors. These mortgage securities are not issued and guaranteed by an
agency of the federal government but are instead issued by corporate entities,
primarily financial institutions, and therefore carry an element of credit risk.
Management closely monitors the performance of these securities and the
underlying mortgages, which includes a detailed review of credit ratings,
prepayment speeds, delinquency rates, default rates, current loan-to-values,
regional allocation of collateral, remaining terms, interest rates, loan types,
etc. The Company has engaged a third party expert to provide a “stress test” of
each private label security through a model using assumptions to simulate
certain credit events and recessionary conditions and their impact on the
performance of each mortgage security.
 
 Unrealized
losses on the Company’s investments in municipal bonds are related to 32
different securities. These losses are primarily related to concerns in the
marketplace regarding credit quality of certain municipalities in light of the
recent economic recession and high unemployment rates as well as expectations of
future market interest rates. Management monitors the underlying credit of these
bonds by reviewing the financial strength of the issuers and the sources of
taxes and other revenues available to service the debt. Unrealized losses on
other securities relate to an investment in subordinated debt of one corporate
financial institution. Management monitors the financial strength of this
institution by reviewing its quarterly financial reports and considers its
capital, liquidity and earnings in this review.
 
 As of
March 31, 2010, two investment securities remained in an other-than-temporarily
impaired position. The first of these investments was a private label mortgage
security with a book value and unrealized loss of $777,000 and $363,000,
respectively, as of March 31, 2010. This impairment determination was based on
the extent and duration of the unrealized loss as well as recent credit rating
downgrades from two rating agencies to below investment grade. Based on its
analysis of expected cash flows, management expects to receive all contractual
principal and interest from this security and therefore did not consider any of
the unrealized loss to represent credit impairment. The second of these
investments was subordinated debt of a corporate financial institution with a
book value and unrealized loss of $1.0 million and $203,000, respectively, as of
March 31, 2010. This impairment determination was based on the extent of the
unrealized loss as well as adverse economic and market conditions for community
banks in general. Based on its review of capital, liquidity and earnings of this
institution, management expects to receive all contractual principal and
interest from this security and therefore did not consider any of the unrealized
loss to represent credit impairment. Unrealized losses from these two
investments were related to factors other than credit and were recorded to other
comprehensive income.
 Index
 - 10
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 The
securities in an unrealized loss position as of March 31, 2010 not determined to
be other-than-temporarily impaired are all still performing and are expected to
perform through maturity, and the issuers have not experienced significant
adverse events that would call into question their ability to repay these debt
obligations according to contractual terms. Further, because the Company does
not intend to sell these investments and it is not more likely than not that the
Company will be required to sell the investments before recovery of their
amortized cost bases, which may be maturity, the Company does not consider such
securities to be other-than-temporarily impaired as of March 31,
2010.
 
 Other
investment securities primarily include an investment in Federal Home Loan Bank
(“FHLB”) stock, which has no readily determinable market value and is recorded
at cost. As of March 31, 2010 and December 31, 2009, the Company’s
investment in FHLB stock totaled $8.0 million and $6.0 million, respectively.
Based on its quarterly evaluation, management has concluded that the Company’s
investment in FHLB stock was not impaired as of March 31, 2010 and that ultimate
recoverability of the par value of this investment is probable. During the three
months ended March 31, 2009, the Company recorded an investment loss of $320,000
related to an equity investment in Silverton Bank, a correspondent financial
institution that was closed by the Office of the Comptroller of the Currency in
2009. The loss represented the full amount of the Company’s investment in
Silverton Bank and was recorded as a reduction to noninterest income on the
Condensed Consolidated Statements of Operations.
 
 The
amortized cost and estimated market values of debt securities as of March 31,
2010 by final contractual maturities are summarized in the table below. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.
 
 Available
      for Sale
                
                Held
      to Maturity(Dollars
      in thousands)
                
                Amortized
      Cost
                
                Fair
      Value
                
                Amortized
      Cost
                
                Fair
      ValueDebt
      securities:Due
      within one year
                
                $
                –
                
                $
                –
                
                $
                300
                
                $
                306Due
      after one year through five years
                
                
                14,562
                
                
                14,613
                
                
                –
                
                
                –Due
      after five years through ten years
                
                
                14,612
                
                
                14,617
                
                
                1,004
                
                
                1,066Due
      after ten years
                
                
                185,126
                
                
                190,975
                
                
                2,040
                
                
                1,925Total
      debt securities
                
                
                214,300
                
                
                220,205
                
                
                3,344
                
                
                3,297Total
      equity securities
                
                
                750
                
                
                750
                
                
                –
                
                
                –Total
      investment securities
                
                $
                215,050
                
                $
                220,955
                
                $
                3,344
                
                $
                3,297
 
 5.Loans and Allowance for Loan
Losses
 
 The
composition of the loan portfolio by loan classification as of March 31, 2010
and December 31, 2009 was as follows:
 
 March
      31,2010
                
                December
      31, 2009(Dollars
      in thousands)Commercial
      real estate:Construction
      and land development
                
                $
                456,448
                
                $
                452,120Commercial
      non-owner occupied
                
                
                240,177
                
                
                245,674Total
      commercial real estate
                
                
                696,625
                
                
                697,794Consumer
      real estate:Residential
      mortgage
                
                
                165,362
                
                
                165,374Home
      equity lines
                
                
                96,556
                
                
                97,129Total
      consumer real estate
                
                
                261,918
                
                
                262,503Commercial
      owner occupied
                
                
                186,067
                
                
                194,359Commercial
      and industrial
                
                
                181,111
                
                
                183,733Consumer
                
                
                7,617
                
                
                9,692Other
      loans
                
                
                42,002
                
                
                41,8511,375,340
                
                
                1,389,932Deferred
      loan fees and origination costs, net
                
                
                745
                
                
                370$
                1,376,085
                
                $
                1,390,302
 Index
 - 11
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 A summary
of activity in the allowance for loan losses for the three month periods ended
March 31, 2010 and 2009 is as follows:
 
 March
      31,2010
                
                March
      31,2009(Dollars
      in thousands)Balance
      at beginning of period
                
                $
                26,081
                
                $
                14,795Provision
      for loan losses
                
                
                11,734
                
                
                5,986Loans
      charged off, net of recoveries
                
                
                (8,655
                )
                
                (2,301
                )Balance
      at end of period
                
                $
                29,160
                
                $
                18,480
 
 The
allowance for credit losses includes the allowance for loan losses, detailed
above, and the reserve for unfunded lending commitments, which is included in
other liabilities on the Condensed Consolidated Balance Sheets. As of March 31,
2010 and December 31, 2009, the reserve for unfunded lending commitments totaled
$447,000 and $351,000, respectively.
 
 The
following is a summary of information related to nonperforming assets as of
March 31, 2010 and December 31, 2009:
 
 March
      31,2010
                
                December
      31,2009(Dollars
      in thousands)Nonperforming
      assets:Nonaccrual
      loans
                
                $
                58,205
                
                $
                39,512Accruing
      loans greater than 90 days past due
                
                
                –
                
                
                –Total
      nonperforming loans
                
                
                58,205
                
                
                39,512Other
      real estate
                
                
                15,635
                
                
                10,732Total
      nonperforming assets
                
                $
                73,840
                
                $
                50,244
 
 For the
three month periods ended March 31, 2010 and 2009, no interest income was
recognized on loans while in nonaccrual status. Cumulative interest payments
collected on nonaccrual loans and applied as a reduction to the principal
balance of the respective loans totaled $402,000 and $366,000 as of March 31,
2010 and December 31, 2009, respectively.
 
 6.Stock-Based
Compensation
 
 The
Company uses the following forms of stock-based compensation as an incentive for
certain employees and non-employee directors: stock options, restricted stock,
and stock issued through a deferred compensation plan for non-employee
directors.
 
 Stock
Options
 
 Pursuant
to the Capital Bank Corporation Equity Incentive Plan (“Equity Incentive Plan”),
the Company has a stock option plan providing for the issuance of options for
the purchase of up to 1,150,000 shares of the Company’s common stock to officers
and directors. As of March 31, 2010, options for 286,350 shares of common stock
were outstanding and options for 605,709 shares of common stock remained
available for future issuance. In addition, options for 566,071 shares were
assumed under various plans from previously acquired financial institutions, of
which options for 49,911 shares remain outstanding. Grants of options are made
by the Board of Directors or the Compensation/Human Resources Committee of the
Board. All grants must be made with an exercise price at no less than fair
market value on the date of grant, must be exercised no later than 10 years from
the date of grant, and may be subject to certain vesting
provisions.
 
 A summary
of the activity during the three month periods ended March 31, 2010 and 2009 of
the Company’s stock option plans, including the weighted average exercise price
(“WAEP”) is presented below:
 Index
 - 12
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 March
      31, 2010
                
                March
      31, 2009Shares
                
                WAEP
                
                Shares
                
                WAEPOutstanding
      at beginning of period
                
                
                366,583
                
                $
                11.76
                
                
                377,083
                
                $
                11.71Granted
                
                
                –
                
                
                –
                
                
                –
                
                
                –Exercised
                
                
                –
                
                
                –
                
                
                –
                
                
                –Forfeited
      and expired
                
                
                (30,322
                )
                
                8.08
                
                
                –
                
                
                –Outstanding
      at end of period
                
                
                336,261
                
                $
                12.09
                
                
                377,083
                
                $
                11.71Options
      exercisable at end of period
                
                
                256,161
                
                $
                12.83
                
                
                274,283
                
                $
                12.40
 
 The
following table summarizes information about the Company’s stock options as of
March 31, 2010:
 
 Exercise
      Price
                
                Number
                  Outstanding
                
                Weighted
      Average
                  Remaining
      Contractual
                  Life
      in Years
                
                Number
                  Exercisable
                
                Intrinsic
                  Value$6.00
      – $9.00
                
                
                100,131
                
                
                5.38
                
                
                52,131
                
                $
                –$9.01
      – $12.00
                
                
                78,880
                
                
                1.86
                
                
                77,380
                
                
                –$12.01
      – $15.00
                
                
                20,000
                
                
                6.38
                
                
                10,400
                
                
                –$15.01
      – $18.00
                
                
                83,000
                
                
                5.30
                
                
                62,000
                
                
                –$18.01
      – $18.37
                
                
                54,250
                
                
                4.74
                
                
                54,250
                
                
                –336,261
                
                
                4.49
                
                
                256,161
                
                $
                –
 
 The fair values of options granted are estimated on the
date of the grants using the Black-Scholes option pricing model. Option pricing
models require the use of highly subjective assumptions, including expected
stock volatility, which when changed can materially affect fair value estimates.
The expected life of the options used in this calculation is the period the
options are expected to be outstanding. Expected stock price volatility is based
on the historical volatility of the Company’s common stock for a period
approximating the expected life; the expected dividend yield is based on the
Company’s historical annual dividend payout; and the risk-free rate is based on
the implied yield available on U.S. Treasury issues.There were no
options granted in the three month periods ended March 31, 2010 and
2009.
 
 As of
March 31, 2010, the Company had unamortized compensation expense related to
unvested stock options of $128,000, which is expected to be fully amortized over
the next four years. For the three months ended March 31, 2010 and 2009, the
Company recorded compensation expense of $12,000 and $13,000, respectively,
related to stock options.
 
 Restricted
Stock
 
 Pursuant
to the Equity Incentive Plan, the Board of Directors may grant restricted stock
to certain employees and Board members at its discretion. There have been no
restricted stock grants since 2008. Unvested shares are subject to forfeiture if
employment terminates prior to the vesting dates. The Company expenses the cost
of the stock awards, determined to be the fair value of the shares at the date
of grant, ratably over the period of the vesting. As of March 31, 2010, the
Company had 23,600 shares of unvested restricted stock grants, which represents
unrecognized compensation expense of $155,000 to be recognized over the
remaining vesting period of the respective grants. Total compensation expense
related to these restricted stock awards for the three month periods ended March
31, 2010 and 2009 was $30,000 in each period.
 
 Deferred
Compensation for Non-employee Directors
 
 The
Company administers the Capital Bank Corporation Deferred Compensation Plan for
Outside Directors (“Deferred Compensation Plan”). Eligible directors may elect
to participate in the Deferred Compensation Plan by deferring all or part of
their directors’ fees for at least one calendar year, in exchange for common
stock of the Company. If a director does not elect to defer all or part of his
fees, then he is not considered a participant in the Deferred Compensation Plan.
The amount deferred is equal to 125% of total director fees. Each participant is
fully vested in his account balance. The Deferred Compensation Plan provides for
payment of share units in shares of common stock of the Company after the
participant ceases to serve as a director for any reason. For the three month
periods ended March 31, 2010 and 2009, the Company recognized compensation
expense of $150,000 and $153,000, respectively, related to the Deferred
Compensation Plan.
 
 Index
 - 13
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
 7.Commitments and
Contingencies
 
 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 March 31, 2010 and
December 31, 2009 is as follows:
  March
      31,2010
                
                December
      31, 2009(Dollars
      in thousands)
                
                (Unaudited)Unused
      lines of credit and overdraft lines
                
                $
                213,894
                
                $
                231,691Standby
      letters of credit
                
                
                10,118
                
                
                9,144Total
      commitments
                
                $
                224,012
                
                $
                240,835
 
 The
Company has limited partnership investments in two related private investment
funds which totaled $1.8 million as of both March 31, 2010 and December 31,
2009. These investments are recorded on the cost basis and were included in
other assets on the Condensed Consolidated Balance Sheets. Remaining capital
commitments to these investment funds totaled $1.6 million as of March 31,
2010.
 
 In 2009,
the Company discovered that the 1st State Bancorp, Inc. Employee Stock Ownership
Plan (“ESOP”), which was to be terminated immediately prior to the Company’s
merger with 1st State Bank in 2006, was not correctly terminated. Among other
things, management discovered that certain required filings with the Internal
Revenue Service (“IRS”) related to the termination of the ESOP were never made,
insufficient withholding taxes were submitted to the IRS, and incorrect
distributions were made from the ESOP, resulting in an overpayment of certain
accounts and underpayment of others. The Company engaged outside counsel and an
independent third party record keeper and has corrected the errors and submitted
necessary filings to the IRS and U.S. Department of Labor (“DOL”). The Company
paid penalties and interest to the IRS due to the delinquent filings and
insufficient payment of taxes and has fully funded participant accounts in the
ESOP. Currently, the Company is awaiting plan termination approval from the
IRS.
 
 The
Company recorded total expense of $244,000 related to this ESOP matter in the
fourth quarter of 2009 and an additional $8,000 in the first quarter of 2010.
These amounts represent penalties and interest paid to the IRS, corrective
amounts that the Company contributed to the ESOP, and professional fees
incurred. Such expense was recorded in other noninterest expense on the
Condensed Consolidated Statements of Operation. The Company may be required to
record expense related to this matter as additional facts become known or as
additional assessments are levied by either the IRS or DOL.
 
 8.Fair Value
Measurement
 
 The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and liabilities and to determine fair value disclosures.
Investment securities, available for sale, and derivatives are recorded at fair
value on a recurring basis. Additionally, the Company may be required to record
at fair value other assets on a nonrecurring basis, such as loans held for sale,
impaired loans 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. The following is a description of valuation
methodologies used for assets and liabilities recorded at fair
value.
 Index
 - 14
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 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 and
corporate entities as well as municipal bonds. Securities classified as Level 3
include corporate debt instruments that are not actively traded.
 
 Loans are
not recorded at fair value on a recurring basis. However, from time to time, a
loan is considered impaired, and a valuation allowance is established based on
the estimated value of the 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. 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 classifies
the impaired loan as nonrecurring Level 3.
 
 Other
real estate, which includes foreclosed assets, is adjusted to fair value upon
transfer of loans and premises to other real estate. Subsequently, other real
estate is 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 other real estate 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 classifies other real estate as
nonrecurring Level 3.
 
 Assets
and liabilities measured at fair value on a recurring basis as of March 31, 2010
and December 31, 2009 are summarized below:
 
 Quoted
      Prices inActive
      Markets forIdentical
      Assets(Level
      1)
                
                Significant
      OtherObservableInputs(Level
      2)
                
                SignificantUnobservableInputs(Level
      3)
                
                Total(Dollars
      in thousands)March
      31, 2010Investment
      securities, available for sale
                
                $
                750
                
                $
                218,905
                
                $
                1,300
                
                $
                220,955December
      31, 2009Investment
      securities, available for sale
                
                $
                748
                
                $
                233,378
                
                $
                1,300
                
                $
                235,426
 
 The table
below presents a reconciliation and income statement classification of gains and
losses for all assets measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) for the three month period ended March
31, 2010:
 
 Level
      3InvestmentSecurities(Dollars
      in thousands)Balance
      at December 31, 2009
                
                $
                1,300Total
      unrealized losses included in:Net
      income
                
                
                –Other
      comprehensive income
                
                
                –Purchases,
      sales and issuances, net
                
                
                –Transfers
      in and (out) of Level 3
                
                
                –Balance
      at March 31, 2010
                
                $
                1,300
 
 Index
 - 15
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
 Assets
and liabilities measured at fair value on a nonrecurring basis as of March 31,
2010 and December 31, 2009 are summarized below:
 
 Quoted
      Prices inActive
      Markets forIdentical Assets(Level
      1)
                
                Significant
      OtherObservableInputs(Level
      2)
                
                SignificantUnobservableInputs(Level
      3)
                
                Total(Dollars
      in thousands)March
      31, 2010Impaired
      loans
                
                $
                –
                
                $
                73,287
                
                $
                6,045
                
                $
                79,332Other
      real estate
                
                
                –
                
                
                15,635
                
                
                –
                
                
                15,635December
      31, 2009Impaired
      loans
                
                $
                –
                
                $
                36,972
                
                $
                34,181
                
                $
                71,153Other
      real estate
                
                
                –
                
                
                10,732
                
                
                –
                
                
                10,732
 9. 
Fair Value of Financial Instruments
 
 Due to
the nature of the Company’s business, a significant portion of its assets and
liabilities consist of financial instruments. Accordingly, the estimated fair
values of these financial instruments are disclosed. Quoted market prices, if
available, are utilized as an estimate of the fair value of financial
instruments. Because no quoted market prices exist for a significant part of the
Company’s financial instruments, the fair value of such instruments has been
derived based on management’s assumptions with respect to future economic
conditions, the amount and timing of future cash flows and estimated discount
rates. Different assumptions could significantly affect these estimates.
Accordingly, the net amounts ultimately collected could be materially different
from the estimates presented below. In addition, these estimates are only
indicative of the values of individual financial instruments and should not be
considered an indication of the fair value of the Company taken as a
whole.
 
 Fair
values of cash and due from banks and federal funds sold are equal to the
carrying value due to the nature of the financial instruments. Estimated fair
values of investment securities are based on quoted market prices, if available,
or model-based values from pricing sources for mortgage-backed securities and
municipal bonds. Fair value of the net loan portfolio has been estimated using
the present value of future cash flows, discounted at an interest rate giving
consideration to estimated prepayment risk. The credit risk component of the
loan portfolio has been set at the recorded allowance for loan losses balance
for purposes of estimating fair value. Thus, there is no difference between the
carrying amount and estimated fair value attributed to credit risk in the
portfolio. Carrying amounts for accrued interest approximate fair value given
the short-term nature of interest receivable and payable.
 
 Fair
values of time deposits and borrowings are estimated by discounting the future
cash flows using the current rates offered for similar deposits and borrowings
with the same remaining maturities. Fair value of subordinated debt is estimated
based on current market prices for similar trust preferred issues of financial
institutions with equivalent credit risk. The estimated fair value for the
Company’s subordinated debt is significantly lower than carrying value since
credit spreads (i.e., spread to LIBOR) on similar trust preferred issues are
currently much wider than when these securities were originally issued.
Interest-bearing deposit liabilities and repurchase agreements with no stated
maturities are predominately at variable rates and, accordingly, the fair values
have been estimated to equal the carrying amounts (the amount payable on
demand).
 
 The
carrying values and estimated fair values of the Company’s financial instruments
as of March 31, 2010 and December 31, 2009 are as follows:
 
 March
      31, 2010
                  
                  December
      31, 2009(Dollars
      in thousands)
                  
                  Carrying
                    Amount
                  
                  Estimated
                    Fair
      Value
                  
                  Carrying
                    Amount
                  
                  Estimated
                    Fair
      ValueFinancial
      Assets:Cash
      and cash equivalents
                  
                  $
                  53,341
                  
                  $
                  53,341
                  
                  $
                  29,513
                  
                  $
                  29,513Investment
      securities
                  
                  
                  232,780
                  
                  
                  232,733
                  
                  
                  245,492
                  
                  
                  245,438Loans
                  
                  
                  1,346,925
                  
                  
                  1,343,353
                  
                  
                  1,364,221
                  
                  
                  1,368,233Accrued
      interest receivable
                  
                  
                  6,479
                  
                  
                  6,479
                  
                  
                  6,590
                  
                  
                  6,590
  Index
 - 16
-
 Capital
Bank Corporation – Notes to Condensed Consolidated Financial Statements
(Unaudited)
  March
      31, 2010
                  
                  December
      31, 2009(Dollars
      in thousands)
                  
                  Carrying
                    Amount
                  
                  Estimated
                    Fair
      Value
                  
                  Carrying
                    Amount
                  
                  Estimated
                    Fair
      ValueFinancial
      Liabilities:Non-maturity
      deposits
                  
                  $
                  496,856
                  
                  $
                  496,856
                  
                  $
                  529,257
                  
                  $
                  529,257Time
      deposits
                  
                  
                  883,683
                  
                  
                  896,808
                  
                  
                  848,708
                  
                  
                  861,378Repurchase
      agreements
                  
                  
                  3,227
                  
                  
                  3,227
                  
                  
                  6,543
                  
                  
                  6,543Borrowings
                  
                  
                  172,000
                  
                  
                  177,395
                  
                  
                  167,000
                  
                  
                  171,278Subordinated
      debentures
                  
                  
                  34,323
                  
                  
                  15,593
                  
                  
                  30,930
                  
                  
                  12,200Accrued
      interest payable
                  
                  
                  1,972
                  
                  
                  1,972
                  
                  
                  1,824
                  
                  
                  1,824
 
 There is
no material difference between the carrying amount and estimated fair value of
off-balance-sheet commitments totaling $224.0 million and $240.8 million as of
March 31, 2010 and December 31, 2009, respectively, which are primarily
comprised of unfunded loan commitments and standby letters of credit. The
Company’s remaining assets and liabilities are not considered financial
instruments.
 
 10. 
Private Placement Offering
 
 On March
18, 2010, the Company sold 849 investment units (“Units”) for gross proceeds of
$8.5 million. Each Unit was priced at $10,000 and consisted of a $3,996.90
subordinated promissory note and a number of shares of the Company’s common
stock valued at $6,003.10. The offering and sale of the Units was limited to
accredited investors. As a result of the sale of the Units, the Company sold
$3.4 million in aggregate principal amount of subordinated promissory notes due
March 18, 2020 (the “Notes”) and 1,468,770 shares of the Company’s common stock
valued at $5.1 million. The Notes were recorded in subordinated debentures on
the Condensed Consolidated Balance Sheets. Under certain circumstances, the
Company may elect to sell additional Units in one or more subsequent closings on
or prior to June 16, 2010, unless the Company elects to extend the offering,
provided that the aggregate amount of all Units sold does not exceed
1,500.
 
 The
Company is obligated to pay interest on the Notes at 10% per annum payable in
quarterly installments commencing on the third month anniversary of the date of
issuance of the Notes. The Company may prepay the Notes at any time after March
18, 2015 subject to approval by the Federal Reserve and compliance with
applicable law.
 
 The
Company’s obligation to repay the Notes is subordinate to all indebtedness owed
by the Company to its current and future secured creditors and general
creditors, including the Federal Reserve and the Federal Deposit Insurance
Corporation, and certain other financial obligations of the
Company.
  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 months ended March 31, 2010 and 2009 for Capital Bank Corporation,
or the Company, and its wholly owned subsidiary, Capital Bank, or 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”).
 Index
 - 17
-
 Overview
 
 Capital
Bank Corporation is a financial holding company incorporated under the laws of
North Carolina on August 10, 1998. The Company’s primary wholly-owned subsidiary
is Capital Bank (the “Bank”), a state-chartered banking corporation. The Bank
was incorporated under the laws of the State of North Carolina on May 30, 1997
and commenced operations on June 20, 1997. As of March 31, 2010, the Company
conducted no business other than holding stock in the Bank and in three trusts,
Capital Bank Statutory Trust I, II, and III.
 
 Capital
Bank is a community bank engaged in the general commercial banking business and
operates through four North Carolina regions: Triangle, Sandhills, Triad and
Western. As of March 31, 2010, the Bank had assets of approximately $1.7
billion, with gross loans and deposits outstanding of approximately $1.4 billion
each. The Bank operates 32 branch offices in North Carolina: five in Raleigh,
four in Asheville, four in Fayetteville; three in Burlington, three in Sanford,
two in Cary, and one each in Clayton, Graham, Hickory, Holly Springs, Mebane,
Morrisville, Oxford, Pittsboro, Siler City, Wake Forest and
Zebulon.
 
 The Bank
offers a full range of banking services, including the following: checking
accounts; savings accounts; NOW accounts; money market accounts; certificates of
deposit; individual retirement accounts; loans for real estate, construction,
businesses, agriculture, personal use, home improvement and automobiles; equity
lines of credit; mortgage loans; credit loans; consumer loans; credit cards;
safe deposit boxes; bank money orders; internet banking; electronic funds
transfer services including wire transfers and remote deposit capture;
traveler’s checks; and free notary services to all Bank customers. In addition,
the Bank provides automated teller machine access to its customers for cash
withdrawals through nationwide ATM networks. Through a partnership between the
Bank’s financial services division and Capital Investment Companies, an
unaffiliated Raleigh, North Carolina-based broker-dealer, the Bank also makes
available a complete line of uninsured investment products and services. The
securities involved in these services are not deposits or other obligations of
the Bank and are not insured by the Federal Deposit Insurance Corporation, or
the FDIC.
 
 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 and ATM fees, fees
generated from originating mortgage loans, commission income generated from
brokerage activity, and the increase in cash surrender value of bank-owned life
insurance. Operating expenses primarily consist of compensation and benefits,
occupancy related expenses, advertising and public relations, data processing
and telecommunications, professional fees, FDIC deposit insurance and other
noninterest 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 our 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.
 
 As a
financial holding company, the Company is subject to the supervision of the
Board of Governors of the Federal Reserve System, or Federal Reserve. The
Company is required to file with the Federal Reserve reports and other
information regarding its business operations and the business operations of its
subsidiaries. As a North Carolina chartered bank, the Bank is subject to primary
supervision, periodic examination and regulation by the North Carolina
Commissioner of Banks, or NC Commissioner, and by the FDIC, as its primary
federal regulator.
 Index
 - 18
-
 Critical
Accounting Policies and Estimates
 
 The
following discussion and analysis of the Company’s financial condition and
results of operations are based on the Company’s condensed consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States, or U.S. GAAP. The
preparation of these financial statements requires the Company to make estimates
and judgments regarding uncertainties that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. 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. However, because future events and their effects cannot be
determined with certainty, actual results may differ from these estimates under
different assumptions or conditions, and the Company may be exposed to gains or
losses that could be material.
 
 The
Company has identified the following accounting policies as being critical in
terms of significant judgments and the extent to which estimates are used:
allowance for loan losses, other-than-temporary impairment on investment
securities, income taxes, and impairment of long-lived assets. These policies
are important in understanding management’s discussion and analysis. For more
information on the Company’s critical accounting policies, refer to Part II,
Item 7 of the Company’s Annual Report on Form 10-K for the year ended December
31, 2009.
 
 Executive
Summary
 
 The
following is a summary of our significant results of operations and changes in
financial position for the three months ended March 31, 2010:
 
 •
                    The
      Company increased total regulatory capital during the quarter ended March
      31, 2010 through an $8.5 million private placement offering to qualified
      investors. The offering was structured in the form of investment units
      consisting of a subordinated promissory note and shares of the Company’s
      common stock. As a result of the offering, the Company sold subordinated
      promissory notes with an aggregate principal amount of $3.4 million and
      shares of the Company’s common stock valued at approximately $5.1
      million.•
                    Net
      loss attributable to common shareholders was $5.9 million, or $0.49 per
      diluted share, in the first quarter of 2010 compared with net loss
      attributable to common shareholders of $5.1 million, or $0.45 per diluted
      share, in the first quarter of 2009. Results of operations in the first
      quarter of 2010 compared with the same quarter last year primarily reflect
      a significant increase in provision for loan losses, partially offset by
      improved net interest income and a higher tax benefit.•
                    Net interest income increased by $2.4 million,
      rising from $10.2 million in the first quarter of 2009 to $12.6 million in
      the first quarter of 2010.This improvement was due to an increase
      in net interest margin from 2.72% in the first quarter of 2009 to 3.22% in
      the first quarter of 2010, coupled with 4.1% growth in average earning
      assets over the same period. Net interest margin benefited from a
      significant decline in funding costs, partially offset by a small decrease
      in loan yields as the Company’s interest rate swap on prime-indexed
      commercial loans expired late in 2009.•
                    Provision
      for loan losses for the quarter ended March 31, 2010 totaled $11.7
      million, an increase from $6.0 million for the quarter ended March 31,
      2009. The increase in the loan loss provision was driven by continued
      difficult economic conditions and weakness in local real estate markets
      which resulted in significantly higher levels of nonperforming assets and
      impaired loans as well as downgrades to the credit ratings of certain
      loans in the portfolio. Further, a significant decline in commercial real
      estate values contributed to higher levels of specific reserves or
      charge-offs on impaired loans.•
                    Noninterest
      income decreased by $444 thousand, or 21%, declining from $2.1 million in
      the first quarter of 2009 to $1.7 million in the first quarter of 2010.
      This decrease was primarily related to write-downs to the values of real
      estate owned totaling $646 thousand in the quarter ended March 31, 2010.
      Other noninterest income was further reduced by $230 thousand in losses on
      the sale of certain real estate owned during the first quarter of 2010.
      Mortgage origination and other loan fees also declined by $200 thousand in
      the quarter ended March 31, 2010 compared with the quarter ended March 31,
      2009. The lower noninterest income was partially offset by gains of $263
      thousand on the sale of certain debt securities and recognized
      appreciation of $65 thousand in the market value of an equity security in
      the quarter ended March 31, 2010 compared with a $320 thousand loss on an
      investment in Silverton Bank stock in the quarter ended March 31,
      2009.
  Index
 - 19
-
 •
                    Noninterest
      expense increased $157 thousand, or 1%, rising from $11.6 million in the
      first quarter of 2009 to $11.7 million in the first quarter of 2010. This
      increase was primarily due to higher FDIC deposit insurance expense, which
      rose by $436 thousand during the first quarter of 2010. Additionally,
      miscellaneous loan handling costs increased $278 thousand as higher loan
      workout, appraisal and foreclosure costs were incurred in the quarter
      ended March 31, 2010. Partially offsetting the increase in noninterest
      expense, salaries and employee benefits expense fell by $561 thousand due
      to the suspension of the Company’s 401(k) employer matching contributions
      in 2009 and higher deferred loan costs which reduced
    expense.
 Results
of Operations
 
 Quarter
ended March 31, 2010 compared to quarter ended March 31, 2009
 
 Net loss
attributable to common shareholders was $5.9 million, or $0.49 per diluted
share, in the first quarter of 2010 compared with net loss attributable to
common shareholders of $5.1 million, or $0.45 per diluted share, in the first
quarter of 2009. Results of operations in the first quarter of 2010 compared
with the same quarter last year primarily reflect a significant increase in
provision for loan losses, partially offset by improved net interest income and
a higher tax benefit.
 
 Net Interest Income.Net
interest income increased from $10.2 million for the quarter ended March 31,
2009 to $12.6 million for the quarter ended March 31, 2010. Average
interest-earning assets were $1.64 billion for the quarter ended March 31, 2010
compared to $1.57 billion for the quarter ended March 31, 2009, an increase of
4.1%. Average interest-bearing liabilities were $1.45 billion for the quarter
ended March 31, 2010 compared to $1.37 billion for the quarter ended March 31,
2009, an increase of 5.5%. On a fully tax equivalent basis, net interest spread
was 2.98% and 2.37% for the quarters ended March 31, 2010 and 2009,
respectively. Net interest margin on a tax equivalent basis increased by 50
basis points to 3.22% for the quarter ended March 31, 2010 from 2.72% for the
quarter ended March 31, 2009. The yield on average interest-earning assets was
5.08% and 5.17% for the quarters ended March 31, 2010 and 2009, respectively,
while the interest rate paid on average interest-bearing liabilities for those
periods was 2.10% and 2.80%, respectively.
 
 The increase in the net interest margin was primarily
due to the significant decline in funding costs through disciplined pricing
controls and a more favorable competitive pricing landscape.Partially
offsetting declining funding costs was a significant increase in nonperforming
loans over the past year and the expiration of an interest rate swap on
prime-indexed commercial loans.
 
 The
following two tables set forth certain information regarding the Company’s yield
on interest-earning assets and cost of interest-bearing liabilities and the
component changes in net interest income. The first table, Average Balances,
Interest Earned or Paid, and Interest Yields/Rates, reflects 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. Changes in net interest income from year to
year can be explained in terms of fluctuations in volume and rate. The second
table, Rate and Volume Variance Analysis, presents further information on those
changes. For each category of interest-earning asset and interest-bearing
liability, we have provided information on changes attributable to:
 
 •
                    changes
      in volume, which are changes in average volume multiplied by the average
      rate for the previous period;•
                    changes
      in rates, which are changes in average rate multiplied by the average
      volume for the previous period;•
                    changes
      in rate/volume, which are changes in average rate multiplied by the
      changes in average volume; and•
                    total
      change, which is the sum of the previous
  columns.
  Index
 - 20
-
 CAPITAL
BANK CORPORATION
 Average
Balances, Interest Earned or Paid, and Interest Yields/Rates
 For
the Three Months Ended March 31, 2010, December 31, 2009 and March 31,
2009
 Tax Equivalent Basis1
 
 March
      31, 2010
                    
                    December
      31, 2009
                    
                    March
      31, 2009(Dollars
      in thousands)
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      Rate
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      Rate
                    
                    Average
      Balance
                    
                    Amount
      Earned
                    
                    Average
      RateAssetsLoans:
      2Commercial
                    
                    $
                    1,187,760
                    
                    $
                    15,089
                    
                    
                    5.15
                    %
                    $
                    1,190,645
                    
                    $
                    15,668
                    
                    
                    5.22
                    %
                    $
                    1,095,804
                    
                    $
                    13,942
                    
                    
                    5.16
                    %Consumer
                    
                    
                    205,409
                    
                    
                    2,473
                    
                    
                    4.88
                    
                    
                    193,640
                    
                    
                    2,431
                    
                    
                    4.98
                    
                    
                    169,634
                    
                    
                    2,150
                    
                    
                    5.14Total
      loans
                    
                    
                    1,393,169
                    
                    
                    17,562
                    
                    
                    5.11
                    
                    
                    1,384,285
                    
                    
                    18,099
                    
                    
                    5.19
                    
                    
                    1,265,438
                    
                    
                    16,092
                    
                    
                    5.16Investment
      securities 3
                    
                    
                    225,819
                    
                    
                    2,956
                    
                    
                    5.24
                    
                    
                    247,253
                    
                    
                    3,283
                    
                    
                    5.31
                    
                    
                    288,679
                    
                    
                    3,957
                    
                    
                    5.48Federal
      funds sold and interest-earning cash
                    
                    
                    20,226
                    
                    
                    10
                    
                    
                    0.20
                    
                    
                    17,334
                    
                    
                    8
                    
                    
                    0.18
                    
                    
                    19,900
                    
                    
                    13
                    
                    
                    0.26Total
      interest-earning assets
                    
                    
                    1,639,214
                    
                    $
                    20,528
                    
                    
                    5.08
                    %
                    
                    1,648,872
                    
                    $
                    21,390
                    
                    
                    5.15
                    %
                    
                    1,574,017
                    
                    $
                    20,062
                    
                    
                    5.17
                    %Cash
      and due from banks
                    
                    
                    19,450
                    
                    
                    
                    
                    
                    
                    
                    
                    18,169
                    
                    
                    
                    
                    
                    
                    
                    
                    22,116Other
      assets
                    
                    
                    102,321
                    
                    
                    
                    
                    
                    
                    
                    
                    90,303
                    
                    
                    
                    
                    
                    
                    
                    
                    78,814Allowance
      for loan losses
                    
                    
                    (28,045
                    )
                    
                    
                    
                    
                    
                    
                    
                    (20,923
                    )
                    
                    
                    
                    
                    
                    
                    
                    (15,180
                    )Total
      assets
                    
                    $
                    1,732,940
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,736,421
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,659,767Liabilities
      and Shareholders’ EquitySavings
      deposits
                    
                    $
                    28,992
                    
                    $
                    10
                    
                    
                    0.14
                    %
                    $
                    29,012
                    
                    $
                    11
                    
                    
                    0.15
                    %
                    $
                    28,793
                    
                    $
                    13
                    
                    
                    0.18
                    %Interest-bearing
      demand deposits
                    
                    
                    342,048
                    
                    
                    886
                    
                    
                    1.05
                    
                    
                    365,889
                    
                    
                    1,078
                    
                    
                    1.17
                    
                    
                    353,262
                    
                    
                    1,205
                    
                    
                    1.38Time
      deposits
                    
                    
                    871,507
                    
                    
                    5,255
                    
                    
                    2.45
                    
                    
                    844,776
                    
                    
                    5,352
                    
                    
                    2.51
                    
                    
                    800,879
                    
                    
                    6,551
                    
                    
                    3.32Total
      interest-bearing deposits
                    
                    
                    1,242,547
                    
                    
                    6,151
                    
                    
                    2.01
                    
                    
                    1,239,677
                    
                    
                    6,441
                    
                    
                    2.06
                    
                    
                    1,182,934
                    
                    
                    7,769
                    
                    
                    2.66Borrowed
      funds
                    
                    
                    170,956
                    
                    
                    1,145
                    
                    
                    2.72
                    
                    
                    155,989
                    
                    
                    1,224
                    
                    
                    3.11
                    
                    
                    146,233
                    
                    
                    1,389
                    
                    
                    3.85Subordinated
      debt
                    
                    
                    31,232
                    
                    
                    218
                    
                    
                    2.83
                    
                    
                    30,930
                    
                    
                    216
                    
                    
                    2.77
                    
                    
                    30,930
                    
                    
                    322
                    
                    
                    4.22Repurchase
      agreements and federal funds purchased
                    
                    
                    4,667
                    
                    
                    2
                    
                    
                    0.17
                    
                    
                    7,246
                    
                    
                    4
                    
                    
                    0.22
                    
                    
                    13,849
                    
                    
                    7
                    
                    
                    0.20Total
      interest-bearing liabilities
                    
                    
                    1,449,402
                    
                    $
                    7,516
                    
                    
                    2.10
                    %
                    
                    1,433,842
                    
                    $
                    7,885
                    
                    
                    2.18
                    %
                    
                    1,373,946
                    
                    $
                    9,487
                    
                    
                    2.80
                    %Noninterest-bearing
      deposits
                    
                    
                    131,973
                    
                    
                    
                    
                    
                    
                    
                    
                    139,877
                    
                    
                    
                    
                    
                    
                    
                    
                    124,893Other
      liabilities
                    
                    
                    10,658
                    
                    
                    
                    
                    
                    
                    
                    
                    12,695
                    
                    
                    
                    
                    
                    
                    
                    
                    11,643Total
      liabilities
                    
                    
                    1,592,033
                    
                    
                    
                    
                    
                    
                    
                    
                    1,586,414
                    
                    
                    
                    
                    
                    
                    
                    
                    1,510,482Shareholders’
      equity
                    
                    
                    140,907
                    
                    
                    
                    
                    
                    
                    
                    
                    150,007
                    
                    
                    
                    
                    
                    
                    
                    
                    149,285Total
      liabilities and shareholders’ equity
                    
                    $
                    1,732,940
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,736,421
                    
                    
                    
                    
                    
                    
                    
                    $
                    1,659,767Net
      interest spread 4
                    
                    
                    
                    
                    
                    
                    
                    
                    2.98
                    %
                    
                    
                    
                    
                    
                    
                    
                    2.96
                    %
                    
                    
                    
                    
                    
                    
                    
                    2.37
                    %Tax
      equivalent adjustment
                    
                    
                    
                    
                    $
                    462
                    
                    
                    
                    
                    
                    
                    
                    $
                    527
                    
                    
                    
                    
                    
                    
                    
                    $
                    394Net
      interest income and net interest margin 5
                    
                    
                    
                    
                    $
                    13,012
                    
                    
                    3.22
                    %
                    
                    
                    
                    $
                    13,505
                    
                    
                    3.25
                    %
                    
                    
                    
                    $
                    10,575
                    
                    
                    2.72
                    %
 
 1
                    The
      tax equivalent basis is computed using a federal tax rate of
      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-earning assets and the average cost of interest-bearing
      liabilities.5
                    Net
      interest margin represents net interest income divided by average
      interest-earning assets.
 Index
 - 21
-
 Rate
and Volume Variance Analysis
 Tax
Equivalent Basis 1
 Three
      Months Ended
                      March
      31, 2010 vs. 2009(Dollars
      in thousands)
                    
                    Rate
                      Variance
                    
                    Volume
                      Variance
                    
                    Total
                      VarianceInterest
      income:Loans
                    
                    $
                    (129
                    )
                    $
                    1,599
                    
                    $
                    1,470Investment
      securities
                    
                    
                    (178
                    )
                    
                    (823
                    )
                    
                    (1,001
                    )Federal
      funds sold
                    
                    
                    (3
                    )
                    
                    –
                    
                    
                    (3
                    )Total
      interest income
                    
                    
                    (310
                    )
                    
                    776
                    
                    
                    466Interest
      expense:Savings
      and interest-bearing demand deposits and other
                    
                    
                    (293
                    )
                    
                    (29
                    )
                    
                    (322
                    )Time
      deposits
                    
                    
                    (1,722
                    )
                    
                    426
                    
                    
                    (1,296
                    )Borrowed
      funds
                    
                    
                    (410
                    )
                    
                    166
                    
                    
                    (244
                    )Subordinated
      debt
                    
                    
                    (106
                    )
                    
                    2
                    
                    
                    (104
                    )Repurchase
      agreements and federal funds purchased
                    
                    
                    (1
                    )
                    
                    (4
                    )
                    
                    (5
                    )Total
      interest expense
                    
                    
                    (2,532
                    )
                    
                    561
                    
                    
                    (1,971
                    )Increase
      in net interest income
                    
                    $
                    2,222
                    
                    $
                    215
                    
                    $
                    2,437
 
 1
                    The
      tax equivalent basis is computed using a federal tax rate of
      34%.
 Interest income on loans rose from $16.1 million for the
quarter ended March 31, 2009 to $17.4 million for the quarter ended March 31,
2010, an increase of 8.2%. This increase was primarily due to growth in the loan
portfolio, partially offset by slightly lower loan yields. Average loan
balances, which yielded 5.11% and 5.16% for the quarters ended March 31, 2010
and 2009, respectively, increased from $1.27 billion in the first quarter of
2009 to $1.39 billion in the first quarter of 2010.The Company’s
interest rate swap on prime-indexed commercial loans, which expired in October
2009, increased loan interest income by $1.1 million in the first quarter of
2009, representing a benefit to net interest margin of 29 basis points in that
quarter. Since the swap expired in 2009, the Company received no benefit in the
first quarter of 2010. A significant increase in loans placed on nonaccrual
status during the first quarter of 2010 also negatively affected loan interest
income during the quarter when compared with the same quarter one year ago. When
loans are placed on nonaccrual status, any accrued but unpaid interest is
immediately reversed and has a direct impact on net interest income and net
interest margin.
 
 Interest
income on investment securities decreased from $3.6 million for the quarter
ended March 31, 2009 to $2.6 million for the quarter ended March 31, 2010, a
decline of 25.8%. This decrease was due to a decline in the size of the
investment portfolio coupled with lower fixed income investment yields. Average
investment balances, at cost, decreased from $288.7 million for the quarter
ended March 31, 2009 to $225.8 million for the quarter ended March 31, 2010, and
the tax equivalent yield on investment securities decreased from 5.48% to 5.24%
over the same period. The decrease in average investment balances reflects
management’s efforts to effectively execute its asset-liability management
strategy and to reduce the duration of the portfolio with the prospect of a
rising interest rate environment. Additionally, yields have fallen as
prepayments on higher yielding mortgage-backed securities and sales of certain
long-dated municipal bonds have been re-invested at lower rates in shorter-dated
U.S. government agency debt.
 
 Interest
expense on deposits decreased from $7.8 million for the quarter ended March 31,
2009 to $6.2 million for the quarter ended March 31, 2010, a decline of 20.8%.
The decline is primarily due to falling interest-bearing deposit rates from
2.66% for the quarter ended March 31, 2009 to 2.01% for the quarter ended March
31, 2010. For time deposits, which represented 70.1% and 67.7% of total average
interest-bearing deposits for the quarters ended March 31, 2010 and 2009,
respectively, the average rate decreased from 3.32% for the quarter ended March
31, 2009 to 2.45% for the quarter ended March 31, 2010, reflecting disciplined
pricing controls and a more favorable competitive pricing landscape for customer
deposits. Interest expense on borrowings decreased from $1.7 million for the
quarter ended March 31, 2009 to $1.4 million for the quarter ended March 31,
2010, a decline of 20.5%. The average rate paid on average borrowings, including
subordinated debt and repurchase agreements, decreased from 3.65% for the
quarter ended March 31, 2009 to 2.68% for the quarter ended March 31,
2010.
  Index
 - 22
-
 Provision for Loan Losses.Provision for loan losses for the quarter ended March 31, 2010 totaled
$11.7 million, an increase from $6.0 million for the quarter ended March 31,
2009. The increase in the loan loss provision was driven by continued difficult
economic conditions and weakness in local real
estate markets which resulted in significantly higher levels of nonperforming
assets and impaired loans as well as downgrades to the credit ratings of certain
loans in the portfolio. Further, a significant decline in commercial real estate
values contributed to higher levels of specific reserves or charge-offs on
impaired loans.
 
 Net charge-offs increased from $2.3 million, or 0.73%
(annualized) of average loans, in the first quarter of 2009 to $8.7 million, or
2.48% (annualized) of average loans, in the first quarter of 2010.Nonperforming assets, which include loans on nonaccrual and other real
estate, increased to 4.24% of total assets as of March 31, 2010 compared to
2.90% as of December 31, 2009 and 1.24% as of March 31, 2009. Further,
nonperforming loans increased to 4.23% of total loans as of March 31, 2010
compared to 2.84% as of December 31, 2009 and 1.33% as of March 31, 2009. The elevated provision for loan losses, net charge-offs
and nonperforming loans reflect the economic climate in the Company’s primary
markets and consistent application of the Company’s policy to recognize losses
as they occur. Given significant volatility and rapid changes in current market
conditions, management cannot predict its provision or nonperforming loan levels
into the future but anticipates that credit losses and problem loans may remain
elevated, or even increase, throughout 2010 as the Company continues working to
resolve problem loans in these challenging market
conditions.
 
 Noninterest Income.Noninterest income decreased from $2.1 million for the
quarter ended March 31, 2009 to $1.7 million for the quarter ended March 31,
2010, a decline of 21.2%.Management continues to focus on noninterest
income improvement strategies, which are based on core deposit growth, fee
collection efforts, restructured pricing and innovative product enhancements.
The following table presents the detail of noninterest income and related
changes for the quarters ended March 31, 2010 and 2009:
 
 March
      31,2010
                      
                      
                      March
      31,2009
                      
                      
                      $
      Change
                      
                      
                      %
      Change(Dollars
      in thousands)Noninterest
      income:Service
      charges and other fees
                      
                      $
                      868
                      
                      $
                      952
                      
                      $
                      (84
                      )
                      
                      (8.8
                      )%Bank
      card services
                      
                      
                      415
                      
                      
                      339
                      
                      
                      76
                      
                      
                      22.4Mortgage
      origination and other loan fees
                      
                      
                      327
                      
                      
                      527
                      
                      
                      (200
                      )
                      
                      (38.0
                      )Brokerage
      fees
                      
                      
                      187
                      
                      
                      163
                      
                      
                      24
                      
                      
                      14.7Bank-owned
      life insurance
                      
                      
                      239
                      
                      
                      258
                      
                      
                      (19
                      )
                      
                      (7.4
                      )Net
      gain (loss) on investment securities
                      
                      
                      328
                      
                      
                      (320
                      )
                      
                      648
                      
                      
                      202.5Loss
      on other real estate
                      
                      
                      (876
                      )
                      
                      (7
                      )
                      
                      (869
                      )
                      
                      NMOther
                      
                      
                      167
                      
                      
                      187
                      
                      
                      (20
                      )
                      
                      (10.7
                      )Total
      noninterest income
                      
                      $
                      1,655
                      
                      $
                      2,099
                      
                      $
                      (444
                      )
                      
                      (21.2
                      )%
 
 Noninterest
income decreased primarily due to write-downs to the values of real estate owned
totaling $646 thousand in the quarter ended March 31, 2010. Management continues
to proactively monitor the market values of its real estate owned by obtaining
updated appraisals, and reduces other noninterest income by any decline in
valuations during the period. Loss on other real estate also includes $230
thousand in losses on the sale of certain foreclosed properties during the first
quarter of 2010. The lower noninterest income was partially offset by gains of
$263 thousand on the sale of certain debt securities and recognized appreciation
of $65 thousand in the market value of an equity security in the quarter ended
March 31, 2010 compared with a $320 thousand loss on an investment in Silverton
Bank stock in the quarter ended March 31, 2009.
 
 Service
charges and other fees, which includes overdraft and non-sufficient funds, or
NSF, charges, decreased primarily from continued reduction in the frequency of
overdrawn accounts and NSF checks as consumers have closely monitored their
accounts during the recent economic recession. Bank card services, which
includes income received from debit card transactions, increased primarily due
to checking account growth. Mortgage origination and other loan fees declined as
fewer prepayment penalties were recognized on commercial loans. Brokerage fees,
bank-owned life insurance income, and other noninterest income remained
relatively consistent over the period under comparison.
 
 Noninterest Expense.Noninterest expense increased from $11.6 million for the
quarter ended March 31, 2009 to $11.7 million for the quarter ended March 31,
2010, an increase of 1.4%. Management regularly monitors all categories of
noninterest expense in an effort to improve productivity and operating
performance.The following table presents the detail of noninterest
expense and related changes for the quarters ended March 31, 2010 and
2009:
  Index
 - 23
-
 March
      31,2010
                      
                      
                      March
      31,2009
                      
                      
                      $
      Change
                      
                      
                      %
      Change(Dollars
      in thousands)Noninterest
      expense:Salaries
      and employee benefits
                      
                      $
                      5,400
                      
                      $
                      5,961
                      
                      $
                      (561
                      )
                      
                      (9.4
                      )%Occupancy
                      
                      
                      1,502
                      
                      
                      1,373
                      
                      
                      129
                      
                      
                      9.4Furniture
      and equipment
                      
                      
                      745
                      
                      
                      830
                      
                      
                      (85
                      )
                      
                      (10.2
                      )Data
      processing and telecommunications
                      
                      
                      517
                      
                      
                      631
                      
                      
                      (114
                      )
                      
                      (18.1
                      )Advertising
      and public relations
                      
                      
                      430
                      
                      
                      323
                      
                      
                      107
                      
                      
                      33.1Office
      expenses
                      
                      
                      332
                      
                      
                      335
                      
                      
                      (3
                      )
                      
                      (0.9
                      )Professional
      fees
                      
                      
                      475
                      
                      
                      379
                      
                      
                      96
                      
                      
                      25.3Business
      development and travel
                      
                      
                      267
                      
                      
                      328
                      
                      
                      (61
                      )
                      
                      (18.6
                      )Amortization
      of deposit premiums
                      
                      
                      235
                      
                      
                      288
                      
                      
                      (53
                      )
                      
                      (18.4
                      )Miscellaneous
      loan handling costs
                      
                      
                      441
                      
                      
                      163
                      
                      
                      278
                      
                      
                      170.6Directors
      fees
                      
                      
                      298
                      
                      
                      359
                      
                      
                      (61
                      )
                      
                      (17.0
                      )FDIC
      deposit insurance
                      
                      
                      665
                      
                      
                      229
                      
                      
                      436
                      
                      
                      190.4Other
                      
                      
                      407
                      
                      
                      358
                      
                      
                      49
                      
                      
                      13.7Total
      noninterest expense
                      
                      $
                      11,714
                      
                      $
                      11,557
                      
                      $
                      157
                      
                      
                      1.4
                      %
 
 Salaries
and employee benefits expense decreased partially due to suspension of the
Company’s 401(k) employer matching contributions in 2009 and partially due to
higher levels of deferred loan costs, which reduce expense. Occupancy costs
increased primarily due to additional costs incurred as new branches were opened
during the past year in the Triangle region. Furniture and equipment expense
declined from lower depreciation charges. Data processing and telecommunications
costs dropped as the Company realized cost savings through renegotiation of
certain vendor contracts. Management continues to monitor and update the
Company’s technology infrastructure in an efficient and cost controlled manner
that provides for future growth opportunities. Advertising and public relations
expense increased as television commercials were aired and other advertising was
conducted to promote the Company’s special financing programs for home buyers.
Office expenses remained constant over the period under comparison. Professional
fees increased as the Company has recently outsourced its internal audit
function to a professional services firm. Business development and travel costs
declined as management continues to closely monitor and control
spending.
 
 Amortization
of deposit premiums decreased as intangible assets acquired in previous
acquisitions are amortized on an accelerated method over the expected benefit of
the core deposit premium. Amortization expense is greater in earlier periods
after a business combination occurs and the intangible asset is created.
Miscellaneous loan handling costs increased as higher loan workout, appraisal
and foreclosure costs were incurred. Directors’ fees decreased as the Company
reduced the size of its board in the fourth quarter of 2009. FDIC deposit
insurance expense rose with higher deposit insurance assessment rates and growth
in insured deposit accounts.
 
 Income Taxes.The Company’s income tax benefit increased from
$800 thousand in the first quarter of 2009 to $3.9 million in the first quarter
of 2010. This increase was primarily due to a larger net loss before taxes in
the first quarter of 2010 as compared to the same period in 2009.
 
 Analysis
of Financial Condition
 
 Overview
 
 The
Company’s financial condition is measured in terms of its asset and liability
composition as well as asset quality. The fluctuation and composition of the
balance sheet during the quarter ended March 31, 2010 reflects a small decline
in the loan portfolio as the Company focuses on resolving problem loans and
capital preservation.
 
 Total
assets as of March 31, 2010 were $1.74 billion, a small increase of $5.2 million
from $1.73 billion as of December 31, 2009. Earning assets, which represented
94.3% and 94.6% of total assets as of March 31, 2010 and December 31, 2009,
respectively, remained relatively unchanged at $1.64 billion at each period end.
Loans declined from $1.39 billion as of December 31, 2009 to $1.38 billion as of
March 31, 2010, a decrease of 1.0%. This decline primarily occurred in the
commercial owner occupied real estate portfolio and to a lesser extent in the
consumer non-real estate portfolio. Allowance for loan losses was $29.2 million
as of March 31, 2010 compared to $26.1 million as of December 31, 2009,
representing approximately 2.12% and 1.88%, respectively, of total loans. As of
March 31, 2010, investment securities totaled $232.8 million compared to $245.5
million as of December 31, 2009. The decrease in investments was primarily due
to increased prepayments on mortgage-backed securities and sales of certain
municipal bonds. These proceeds were partially re-invested in shorter duration
U.S. agency debentures. Management is currently re-positioning its investment
portfolio to provide for greater liquidity and to mitigate the risk of a rising
interest rate environment and its impact on a fixed income
portfolio.
 Index
 - 24
-
 Total
deposits as of March 31, 2010 were $1.38 billion, an increase of $2.6 million,
or 0.2%, from December 31, 2009. The increase was primarily due to a $35.0
million increase in time deposits, partially offset by a $24.1 million decrease
in money market accounts and a $8.3 million decrease in demand deposit accounts.
The decline in demand deposit accounts reflects a decline in average account
balances as consumer spending has risen with a stabilizing economy. Time
deposits represented 64.0% of total deposits at March 31, 2010 compared to 61.6%
at December 31, 2009. Subordinated debt increased from $30.9 million as of
December 31, 2009 to $34.3 million as of March 31, 2010 from the private
placement offering in the first quarter of 2010.
 
 Total
shareholders’ equity decreased from $139.8 million as of December 31, 2009 to
$138.8 million as of March 31, 2010. The Company’s accumulated deficit increased
by $5.9 million in the first quarter of 2010, reflecting a $5.3 million net loss
and dividends and accretion on preferred stock of $589 thousand. Common stock
increased due to $5.1 million of proceeds from the issuance of shares of the
Company’s common stock as part of the private placement offering. Accumulated
other comprehensive income, which includes unrealized gains and losses on
available-for-sale investment securities, net of tax, decreased from $4.0
million as of December 31, 2009 to $3.6 million as of March 31,
2010.
 
 Nonperforming
Assets and Impaired Loans
 
 Loans are
generally classified as nonaccrual if they are past due as to maturity or
payment of principal or interest for a period of more than 90 days, unless such
loans are well secured and in the process of collection. If a loan or a portion
of a loan is classified as doubtful or as partially charged off, the loan is
generally classified as nonaccrual. Loans that are on a current payment status
or past due less than 90 days may also be classified as nonaccrual if
repayment in full of principal and/or interest is in doubt. Loans may be
returned to accrual status when all principal and interest amounts contractually
due (including arrearages) are reasonably assured of repayment within an
acceptable period of time, and there is a sustained period of repayment
performance of interest and principal by the borrower in accordance with the
contractual terms.
 
 The
following table presents an analysis of nonperforming assets as of March 31,
2010 and December 31, 2009:
 
 March
      31,2010
                      
                      December
      31, 2009(Dollars
      in thousands)
                      
                      (Unaudited)Nonperforming
      loans:Commercial
      real estate
                      
                      $
                      44,086
                      
                      $
                      25,593Consumer
      real estate
                      
                      
                      3,809
                      
                      
                      3,330Commercial
      owner occupied
                      
                      
                      6,085
                      
                      
                      6,607Commercial
      and industrial
                      
                      
                      4,217
                      
                      
                      3,974Consumer
                      
                      
                      8
                      
                      
                      8Total
      nonperforming loans
                      
                      
                      58,205
                      
                      
                      39,512Other
      real estate:Construction,
      land development, and other land
                      
                      
                      7,411
                      
                      
                      2,8631-4
      family residential properties
                      
                      
                      783
                      
                      
                      2,0601-4
      family residential properties sold with 100% financing
                      
                      
                      4,376
                      
                      
                      3,314Commercial
      properties
                      
                      
                      1,769
                      
                      
                      1,199Closed
      branch office
                      
                      
                      1,296
                      
                      
                      1,296Total
      other real estate
                      
                      
                      15,635
                      
                      
                      10,732Total
      nonperforming assets
                      
                      $
                      73,840
                      
                      $
                      50,244Nonperforming
      loans to total loans
                      
                      
                      4.23
                      %
                      
                      2.84
                      %Nonperforming
      assets to total assets
                      
                      
                      4.24
                      %
                      
                      2.90
                      %
 Index
 - 25
-
 Other
real estate, which includes foreclosed assets and other real property held for
sale, increased to $15.6 million as of March 31, 2010 from $10.7 million as of
December 31, 2009. As of  March 31, 2010, other real estate included
$1.3 million of real estate from a closed branch office held for sale and
included $4.4 million of residential properties sold to individuals prior to
March 31, 2010 where the Company financed 100% of the purchase price of the home
at closing. These financed properties will remain in other real estate until
regular payments are made by the borrowers that total at least 5% of the
original purchase price, which is expected to occur late in 2010, at which time
the property will be moved out of other real estate and into the performing
mortgage loan portfolio.
 
 The increase in other real estate was primarily due to
the repossession of commercial and residential construction and land development
properties in the first quarter of 2010. The Company is actively marketing all
of its foreclosed properties. Such properties are adjusted to fair value upon
transfer of the loans or premises to other real estate. Subsequently, these
properties are carried at the lower of carrying value or updated fair value. The
Company obtains updated appraisals and/or internal evaluations for all other
real estate. The Company considers all other real estate to be classified
as Level 2 fair value estimates since values are established based on recent
independent appraisals.
 
 Impaired
loans primarily consist of nonperforming loans and troubled debt restructurings,
or TDRs, but can include other loans identified by management as being impaired.
Impaired loans totaled $86.2 million and $77.3 million as of March 31, 2010 and
December 31, 2009, respectively. The increase in impaired loans is primarily due
to weakness experienced in the local economy and real estate markets from the
recent economic recession.
 
 The
following table summarizes the Company’s impaired loans and TDRs as of March 31,
2010 and December 31, 2009:
 
 March
      31,
                        2010
                      
                      December
      31, 2009(Dollars
      in thousands)Impaired
      loans:Impaired
      loans with related allowance for loan losses
                      
                      $
                      50,100
                      
                      $
                      60,490Impaired
      loans for which the full loss has been charged off
                      
                      
                      36,146
                      
                      
                      16,775Total
      impaired loans
                      
                      
                      86,246
                      
                      
                      77,265Allowance
      for loan losses related to impaired loans
                      
                      
                      (6,914
                      )
                      
                      (6,112
                      )Net
      carrying value of impaired loans
                      
                      $
                      79,332
                      
                      $
                      71,153Performing
      TDRs:Commercial
      real estate
                      
                      $
                      19,086
                      
                      $
                      27,532Consumer
      real estate
                      
                      
                      166
                      
                      
                      598Commercial
      owner occupied
                      
                      
                      4,621
                      
                      
                      4,633Commercial
      and industrial
                      
                      
                      816
                      
                      
                      1,288Consumer
                      
                      
                      125
                      
                      
                      126Total
      performing TDRs
                      
                      $
                      24,814
                      
                      $
                      34,177
 
 Loans are
classified as TDRs by the Company when certain modifications are made to the
loan terms and concessions are granted to the borrowers due to financial
difficulty experienced by those borrowers. The Company only restructures loans
for borrowers in financial difficulty that have designed a viable business plan
to fully pay off all obligations, including outstanding debt, interest, and
fees, either by generating additional income from the business or through
liquidation of assets. Generally, these loans are restructured to provide the
borrower additional time to execute upon their plans. With respect to
restructured loans, the Company grants concessions by (1) reduction of the
stated interest rate for the remaining original life of the debt or (2)
extension of the maturity date at a stated interest rate lower than the current
market rate for new debt with similar risk. The Company does not generally grant
concessions through forgiveness of principal or accrued interest. Restructured
loans where a concession has been granted through extension of the maturity date
generally include extension of payments in an interest only period, extension of
payments with capitalized interest and extension of payments through a
forbearance agreement. These extended payment terms are also combined with a
reduction of the stated interest rate in certain cases. Success in restructuring
loan terms has been mixed but it has proven to be a useful tool in certain
situations to protect collateral values and allow certain borrowers additional
time to execute upon defined business plans. In situations where a TDR is
unsuccessful and the borrower is unable to follow through with terms of the
restructured agreement, the loan is placed on nonaccrual status and continues to
be written down to the underlying collateral value.
  Index
 - 26
-
 The
Company’s policy with respect to accrual of interest on loans restructured in a
TDR follows relevant supervisory guidance. That is, if a borrower has
demonstrated performance under the previous loan terms and shows capacity to
perform under the restructured loan terms, continued accrual of interest at the
restructured interest rate is likely. If a borrower was materially delinquent on
payments prior to the restructuring but shows the capacity to meet the
restructured loan terms, the loan will likely continue as nonaccrual going
forward. Lastly, if the borrower does not perform under the restructured terms,
the loan is placed on nonaccrual status. The Company will continue to closely
monitor these loans and will cease accruing interest on them if management
believes that the borrowers may not continue performing based on the
restructured note terms. If a loan is restructured a second time, after
previously being classified as a TDR, that loan is automatically placed on
nonaccrual status. The Company’s policy with respect to nonperforming loans
requires the borrower to make a minimum of six consecutive payments in
accordance with the loan terms before that loan can be placed back on accrual
status. Further, the borrower must show capacity to continue performing into the
future prior to restoration of accrual status. To date, the Company has not
restored any nonaccrual loan classified as a TDR to accrual status.
 
 All TDRs
are considered to be impaired and are evaluated as such in the quarterly
allowance calculation. As of March 31, 2010, allowance for loan losses allocated
to performing TDRs totaled $2.0 million. Outstanding nonperforming TDRs and
their related allowance for loan losses totaled $16.8 million and $2.5 million,
respectively, as of March 31, 2010.
 
 Allowance
for Loan Losses
 
 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 Officer reports directly to the Chief Credit
Officer and the Audit Committee of the Company’s Board of
Directors.
 
 The
allowance for loan losses represents management’s best estimate of probable
credit losses that are inherent in the loan portfolio at the balance sheet date
and is determined by management through quarterly evaluations of the loan
portfolio. The allowance calculation consists of specific and general reserves.
Specific reserves are applied to individually impaired loans. 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.
Specific reserves on impaired loans that are collateral dependent are based on
the fair value of the underlying collateral while specific reserves on loans
that are not collateral dependent are based on either an observable market
price, if available, or the present value of expected future cash flows
discounted at the historical effective interest rate. Management evaluates loans
that are classified as doubtful, substandard or special mention to determine
whether or not they are impaired. This evaluation includes several factors,
including review of the loan payment status and the borrower’s financial
condition and operating results such as cash flows, operating income or loss,
etc. General reserves are determined by applying loss percentages to pools of
loans that are grouped according to loan type and internal risk ratings. Loss
percentages are based on the Company’s historical default and charge-off
experience in each pool and management’s consideration of environmental factors
such as changes in economic conditions, credit quality trends, collateral
values, concentrations of credit risk, and loan review as well as regulatory
exam findings.
 
 Impaired
loans on borrower relationships over $750 thousand totaled $74.3 million and
$69.4 million as of March 31, 2010 and December 31, 2009, respectively, with
specific reserves of $6.2 million and $5.7 million, respectively. Specific
reserves represented 8.3% and 8.2% of impaired loan balances as of March 31,
2010 and December 31, 2009, respectively. Specific reserves represented 14.5%
and 10.6% of impaired loan balances, net of impaired loans charged down to
estimated market value, as of March 31, 2010 and December 31, 2009,
respectively. These loans were evaluated for impairment and valued individually.
Given the Company’s concentration in real estate lending, the vast majority of
impaired loans are collateral dependent and are therefore valued based on
underlying collateral values. In the case of unsecured loans that become
impaired, principal balances are fully charged off. For impaired loans where
legal action has been taken to foreclose, the loan is charged down to estimated
fair value, and a specific reserve is not established.
 
 For
impaired loans on borrower relationships less than $750 thousand where legal
action has been taken to foreclose, impairment is evaluated on an individual
basis and the loan is charged down to estimated fair value. Impaired loans on
relationships less than $750 thousand charged down to estimated fair value
totaled $5.4 million and $3.1 million as of March 31, 2010 and December 31,
2009, respectively.
  Index
 - 27
-
 For most
impaired loans evaluated individually, the fair value of underlying collateral
is generally estimated based on a current independent appraised value, adjusted
for estimated holding and selling costs. These are considered Level 2 fair value
estimates. For certain impaired loans where appraisals are aged or where market
conditions have significantly changed since the appraisal date, a further
reduction is made to appraised value to arrive at the fair value of collateral.
These are considered Level 3 fair value estimates. In other situations,
management will use broker price opinions, internal valuations or other
valuation sources. These are also considered Level 3 fair value estimates. Of
the $73.6 million in estimated fair value of impaired loans evaluated and valued
on an individual basis as of March 31, 2010, $73.3 million were valued based on
current independent appraisals and $300 thousand were valued based on a
combination of broker price opinions and internal valuations. Internal
valuations are used primarily for equipment valuations or for certain real
estate valuations where recent home sales data was used to estimate value for
similar fully or partially built houses. For any impaired loan where a specific
reserve has previously been established, or where a partial charge-off has been
recorded, an updated appraisal that reflects a further decline in value will
result in an additional reserve or partial charge-off during the current period.
Currently, all partially charged-off loans are on nonaccrual
status.
 
 Impaired
loans on borrower relationships less than $750 thousand not evaluated
individually for impairment totaled $6.5 million and $4.8 million as of March
31, 2010 and December 31, 2009, respectively, with associated reserves of $0.7
million and $0.4 million, respectively. Reserves on these loans were based on
loss percentages applied to pools of loans stratified by common risk rating and
loan type.
 
 General
reserves are determined by applying loss percentages to pools of loans that are
grouped according to loan type and internal risk ratings. Loss percentages are
based on the Company’s historical default and charge-off experience in each pool
and management’s consideration of environmental factors. As of March 31, 2010,
the Company used two years of charge-off history for purposes of calculating
general reserve rates. Nonperforming loans and net charge-offs have
significantly increased over recent quarters, particularly in the commercial
real estate portfolio. Such increases have directly impacted loss percentages
and the resulting allowance for loan losses for each loan pool.
 
 The
allowance 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 collectability of the principal is unlikely. The following table
presents an analysis of changes in the allowance for loan losses for the three
month periods ended March 31, 2010 and 2009:
 
 Three
      Months Ended March 31,2010
                      
                      2009(Dollars
      in thousands)Allowance
      for loan losses, beginning of period
                      
                      $
                      26,081
                      
                      $
                      14,795Net
      charge-offs:Loans
      charged off:Commercial
      real estate
                      
                      
                      6,880
                      
                      
                      1,593Consumer
      real estate
                      
                      
                      715
                      
                      
                      385Commercial
      owner occupied
                      
                      
                      637
                      
                      
                      173Commercial
      and industrial
                      
                      
                      467
                      
                      
                      183Consumer
                      
                      
                      48
                      
                      
                      39Other
      loans
                      
                      
                      11
                      
                      
                      –Total
      charge-offs
                      
                      
                      8,758
                      
                      
                      2,373Recoveries
      of loans previously charged off:Commercial
      real estate
                      
                      
                      57
                      
                      
                      –Consumer
      real estate
                      
                      
                      24
                      
                      
                      1Commercial
      and industrial
                      
                      
                      16
                      
                      
                      61Consumer
                      
                      
                      6
                      
                      
                      10Total
      recoveries
                      
                      
                      103
                      
                      
                      72Total
      net charge-offs
                      
                      
                      8,655
                      
                      
                      2,301Provision
      for loan losses
                      
                      
                      11,734
                      
                      
                      5,986Allowance
      for loan losses, end of period
                      
                      $
                      29,160
                      
                      $
                      18,480
 Index
 - 28
-
 Three
      Months Ended March 31,2010
                      
                      2009(Dollars
      in thousands)Key
      Allowance-Related Ratios:Net
      charge-offs to average loans (annualized)
                      
                      
                      2.48
                      %
                      
                      0.73
                      %Allowance
      for loan losses to total loans
                      
                      
                      2.12
                      
                      
                      1.45Allowance
      to nonperforming loans
                      
                      
                      50
                      
                      
                      109Allowance
      to nonperforming loans, net of loans
                        charged
      down to market value
                      
                      
                      132
                      
                      
                      155
 
 The
evaluation of the allowance for loan losses is inherently subjective, and
management uses the best information available to establish this estimate.
However, if factors such as economic conditions differ substantially from
assumptions, or if amounts and timing of future cash flows expected to be
received on impaired loans vary substantially from the estimates, future
adjustments to the allowance for loan losses may be necessary. In addition,
various regulatory agencies, as an integral part of their examination process,
periodically review the Company’s allowance for loan losses. Such agencies may
require the Company to recognize additions to the allowance for loan losses
based on their judgments about all relevant information available to them at the
time of their examination. Any adjustments to original estimates are made in the
period in which the factors and other considerations indicate that adjustments
to the allowance for loan losses are necessary.
  Supplemental
Commercial Real Estate Analysis
 
 Residential
Acquisition, Development and Construction Loan Analysis by
Type:
 Residential
      Land /
                        Development
                      
                      Residential
                        Construction
                      
                      Total(Dollars
      in thousands)March
      31, 2010Loans
      outstanding
                      
                      $
                      146,163
                      
                      $
                      101,313
                      
                      $
                      247,476Nonaccrual
      loans
                      
                      
                      32,287
                      
                      
                      7,265
                      
                      
                      39,552Allowance
      for loan losses
                      
                      
                      6,968
                      
                      
                      2,686
                      
                      
                      9,654YTD
      net charge-offs
                      
                      
                      5,120
                      
                      
                      1,489
                      
                      
                      6,609Loans
      outstanding to total loans
                      
                      
                      10.62
                      %
                      
                      7.36
                      %
                      
                      17.98
                      %Nonaccrual
      loans to loans in category
                      
                      
                      22.09
                      
                      
                      7.17
                      
                      
                      15.98Allowance
      to loans in category
                      
                      
                      4.77
                      
                      
                      2.65
                      
                      
                      3.90YTD
      net charge-offs to average loans in category (annualized)
                      
                      
                      13.26
                      
                      
                      5.90
                      
                      
                      10.35December
      31, 2009Loans
      outstanding
                      
                      $
                      162,733
                      
                      $
                      100,724
                      
                      $
                      263,457Nonaccrual
      loans
                      
                      
                      16,935
                      
                      
                      7,102
                      
                      
                      24,037Allowance
      for loan losses
                      
                      
                      7,569
                      
                      
                      1,707
                      
                      
                      9,276Loans
      outstanding to total loans
                      
                      
                      11.70
                      %
                      
                      7.24
                      %
                      
                      18.95
                      %Nonaccrual
      loans to loans in category
                      
                      
                      10.41
                      
                      
                      7.05
                      
                      
                      9.12Allowance
      to loans in category
                      
                      
                      4.65
                      
                      
                      1.69
                      
                      
                      3.52
 Index
 - 29
-
 Residential
Acquisition, Development and Construction Loan Analysis by Region:
 Loans
                        Outstanding
                      
                      Percent
      of
                        Total
      Loans
                        Outstanding
                      
                      Nonaccrual
                        Loans
                      
                      Nonaccrual
                        Loans
                        to
      Loans
                        Outstanding
                      
                      Allowance
      for
                        Loan
      Losses
                      
                      Allowance
                        to
      Loans
                        Outstanding(Dollars
      in thousands)March
      31, 2010Triangle
                      
                      $
                      171,255
                      
                      
                      69.20
                      %
                      $
                      31,872
                      
                      
                      18.61
                      %
                      $
                      7,274
                      
                      
                      4.25
                      %Sandhills
                      
                      
                      34,167
                      
                      
                      13.81
                      
                      
                      885
                      
                      
                      2.59
                      
                      
                      908
                      
                      
                      2.66Triad
                      
                      
                      5,372
                      
                      
                      2.17
                      
                      
                      –
                      
                      
                      –
                      
                      
                      121
                      
                      
                      2.25Western
                      
                      
                      36,682
                      
                      
                      14.82
                      
                      
                      6,795
                      
                      
                      18.52
                      
                      
                      1,351
                      
                      
                      3.68Total
                      
                      $
                      247,476
                      
                      
                      100.00
                      %
                      $
                      39,552
                      
                      
                      15.98
                      %
                      $
                      9,654
                      
                      
                      3.90
                      %December
      31, 2009Triangle
                      
                      $
                      185,319
                      
                      
                      70.34
                      %
                      $
                      14,349
                      
                      
                      7.74
                      %
                      $
                      7,325
                      
                      
                      3.95
                      %Sandhills
                      
                      
                      31,257
                      
                      
                      11.86
                      
                      
                      –
                      
                      
                      –
                      
                      
                      412
                      
                      
                      1.32Triad
                      
                      
                      5,509
                      
                      
                      2.09
                      
                      
                      106
                      
                      
                      1.92
                      
                      
                      86
                      
                      
                      1.56Western
                      
                      
                      41,372
                      
                      
                      15.71
                      
                      
                      9,582
                      
                      
                      23.16
                      
                      
                      1,453
                      
                      
                      3.51Total
                      
                      $
                      263,457
                      
                      
                      100.00
                      %
                      $
                      24,037
                      
                      
                      9.12
                      %
                      $
                      9,276
                      
                      
                      3.52
                      %
   Other
Commercial Real Estate Loan Analysis by Type:
 Commercial
      Land /
                        Development
                      
                      Commercial
                        Construction
                      
                      Multifamily
                      
                      Other
      Non-
                        Residential
      CRE
                      
                      Total(Dollars
      in thousands)March
      31, 2010Loans
      outstanding
                      
                      $
                      130,298
                      
                      $
                      78,674
                      
                      $
                      43,631
                      
                      $
                      196,546
                      
                      $
                      449,149Nonaccrual
      loans
                      
                      
                      466
                      
                      
                      –
                      
                      
                      314
                      
                      
                      3,754
                      
                      
                      4,534Allowance
      for loan losses
                      
                      
                      2,473
                      
                      
                      1,067
                      
                      
                      561
                      
                      
                      3,287
                      
                      
                      7,388YTD
      net charge-offs
                      
                      
                      2
                      
                      
                      –
                      
                      
                      11
                      
                      
                      211
                      
                      
                      224Loans
      outstanding to total loans
                      
                      
                      9.47
                      %
                      
                      5.72
                      %
                      
                      3.17
                      %
                      
                      14.28
                      %
                      
                      32.64
                      %Nonaccrual
      loans to loans in category
                      
                      
                      0.36
                      
                      
                      –
                      
                      
                      0.72
                      
                      
                      1.91
                      
                      
                      1.01Allowance
      to loans in category
                      
                      
                      1.90
                      
                      
                      1.36
                      
                      
                      1.29
                      
                      
                      1.67
                      
                      
                      1.64YTD
      net charge-offs to average loans in category (annualized)
                      
                      
                      0.01
                      
                      
                      –
                      
                      
                      0.10
                      
                      
                      0.42
                      
                      
                      0.20December
      31, 2009Loans
      outstanding
                      
                      $
                      128,745
                      
                      $
                      59,918
                      
                      $
                      43,379
                      
                      $
                      202,295
                      
                      $
                      434,337Nonaccrual
      loans
                      
                      
                      529
                      
                      
                      –
                      
                      
                      325
                      
                      
                      702
                      
                      
                      1,556Allowance
      for loan losses
                      
                      
                      1,732
                      
                      
                      462
                      
                      
                      474
                      
                      
                      3,043
                      
                      
                      5,711Loans
      outstanding to total loans
                      
                      
                      9.26
                      %
                      
                      4.31
                      %
                      
                      3.12
                      %
                      
                      14.55
                      %
                      
                      31.24
                      %Nonaccrual
      loans to loans in category
                      
                      
                      0.41
                      
                      
                      –
                      
                      
                      0.75
                      
                      
                      0.35
                      
                      
                      0.36Allowance
      to loans in category
                      
                      
                      1.35
                      
                      
                      0.77
                      
                      
                      1.09
                      
                      
                      1.50
                      
                      
                      1.31
 Index
 - 30
-
 Other
Commercial Real Estate Loan Analysis by Region:
 Loans
                        Outstanding
                      
                      Percent
      of
                        Total
      Loans
                        Outstanding
                      
                      Nonaccrual
                        Loans
                      
                      Nonaccrual
                        Loans
                        to
      Loans
                        Outstanding
                      
                      Allowance
      for
                        Loan
      Losses
                      
                      Allowance
                        to
      Loans
                        Outstanding(Dollars
      in thousands)March
      31, 2010Triangle
                      
                      $
                      294,987
                      
                      
                      65.68
                      %
                      $
                      3,404
                      
                      
                      1.15
                      %
                      $
                      4,954
                      
                      
                      1.68
                      %Sandhills
                      
                      
                      61,894
                      
                      
                      13.78
                      
                      
                      604
                      
                      
                      0.98
                      
                      
                      1,188
                      
                      
                      1.92Triad
                      
                      
                      37,147
                      
                      
                      8.27
                      
                      
                      41
                      
                      
                      0.11
                      
                      
                      581
                      
                      
                      1.56Western
                      
                      
                      55,121
                      
                      
                      12.27
                      
                      
                      485
                      
                      
                      0.88
                      
                      
                      665
                      
                      
                      1.21Total
                      
                      $
                      449,149
                      
                      
                      100.00
                      %
                      $
                      4,534
                      
                      
                      1.01
                      %
                      $
                      7,388
                      
                      
                      1.64
                      %December
      31, 2009Triangle
                      
                      $
                      281,664
                      
                      
                      64.85
                      %
                      $
                      361
                      
                      
                      0.13
                      %
                      $
                      3,653
                      
                      
                      1.30
                      %Sandhills
                      
                      
                      60,593
                      
                      
                      13.95
                      
                      
                      605
                      
                      
                      1.00
                      
                      
                      937
                      
                      
                      1.55Triad
                      
                      
                      35,987
                      
                      
                      8.29
                      
                      
                      41
                      
                      
                      0.11
                      
                      
                      576
                      
                      
                      1.60Western
                      
                      
                      56,093
                      
                      
                      12.91
                      
                      
                      549
                      
                      
                      0.98
                      
                      
                      545
                      
                      
                      0.97Total
                      
                      $
                      434,337
                      
                      
                      100.00
                      %
                      $
                      1,556
                      
                      
                      0.36
                      %
                      $
                      5,711
                      
                      
                      1.31
                      %
 
 The
Company utilizes interest reserves on certain commercial real estate loans to
fund the interest payments which are funded from loan proceeds. The decision to
establish a loan-funded interest reserve upon origination of a loan is based on
the feasibility of the project, the creditworthiness of the borrower and
guarantors and the protection provided by the real estate and other collateral.
For the lender, an interest reserve may provide an effective means for
addressing the cash flow characteristics of a properly underwritten acquisition,
development and construction loan. Similarly, for the borrower, interest
reserves may provide the funds to service the debt until the property is
developed, and cash flow is generated from the sale or lease of the developed
property.
 
 Although
potentially beneficial to the lender and the borrower, the use of interest
reserves carries certain risks. Of particular concern is the possibility that an
interest reserve may not accurately reflect problems with a borrower’s
willingness or ability to repay the debt consistent with the terms and
conditions of the loan obligation. For example, a project that is not completed
in a timely manner or falters once completed may appear to perform if the
interest reserve keeps the loan current. In some cases, a lender may extend,
renew or restructure the term of certain loans, providing additional interest
reserves to keep the loan current. As a result, the financial condition of the
project may not be apparent and developing problems may not be addressed in a
timely manner. Consequently, a lender may end up with a matured loan where the
interest reserve has been fully advanced, and the borrower’s financial condition
has deteriorated. In addition, the project may not be complete, its sale or
lease-up may not be sufficient to ensure timely repayment of the debt or the
value of the collateral may have declined, exposing the lender to increasing
credit losses.
 
 To
mitigate risks related to the use of interest reserves, the Company follows an
interest reserve policy approved by its Board of Directors which sets
underwriting standards for loans with interest reserves. These policies include
loan-to-value, or LTV, limits as well as guarantor strength and equity
requirements. Additionally, strict monitoring requirements are followed. LTV
limits have been established based on regulatory guidelines for each loan type,
and any loan with an LTV (using an updated independent appraisal) exceeding
those limits are immediately placed on nonaccrual status.
 
 As of
March 31, 2010, the Company had a total of 39 loans funded by an interest
reserve with total outstanding balances of $97.1 million, representing
approximately 7% of total outstanding loans. Total commitments on these loans
equaled $127.0 million with total remaining interest reserves of $3.9 million,
representing a weighted average term of approximately 10 months of remaining
interest coverage. The following table summarizes the Company’s residential and
commercial acquisition, development and construction, or ADC, loans with active
interest reserves as of March 31, 2010:
  Index
 - 31
-
 OutstandingBalance
                      
                      CommittedBalance
                      
                      Numberof
      Loans
                      
                      RemainingReserves(Dollars
      in thousands)Residential
                      
                      $
                      38,229
                      
                      $
                      43,921
                      
                      
                      21
                      
                      $
                      1,238Commercial
                      
                      
                      58,917
                      
                      
                      83,066
                      
                      
                      18
                      
                      
                      2,618Total
      ADC loans with interest reserves 1
                      
                      $
                      97,146
                      
                      $
                      126,987
                      
                      
                      39
                      
                      $
                      3,856
 
 1
                      Excludes
      loans where interest reserves have previously been depleted and the
      borrower is paying from other
sources.
 
 Capital
Resources
 
 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.
 
 To be categorized as well capitalized, the Company and
the Bank each must maintain minimum capital amounts and ratios. The Company’s
and the Bank’s actual capital amounts and ratios as ofMarch 31,
2010and the minimum requirements to be well
capitalized are presented in the following table:
 
 Actual
                        
                        Minimum
      Requirements
                          To
      Be Well Capitalized(Dollars
      in thousands)
                        
                        Amount
                        
                        
                        Ratio
                        
                        Amount
                        
                        
                        RatioCapital
      Bank Corporation:Total
      capital (to risk-weighted assets)
                        
                        $
                        173,809
                        
                        
                        11.73
                        %
                        $
                        148,209
                        
                        
                        10.00
                        %Tier
      I capital (to risk-weighted assets)
                        
                        
                        151,753
                        
                        
                        10.24
                        
                        
                        88,926
                        
                        
                        6.00Tier
      I capital (to average assets)
                        
                        
                        151,753
                        
                        
                        8.80
                        
                        
                        86,227
                        
                        
                        5.00Capital
      Bank:Total
      capital (to risk-weighted assets)
                        
                        $
                        171,550
                        
                        
                        11.60
                        %
                        $
                        147,931
                        
                        
                        10.00
                        %Tier
      I capital (to risk-weighted assets)
                        
                        
                        149,528
                        
                        
                        10.11
                        
                        
                        88,759
                        
                        
                        6.00Tier
      I capital (to average assets)
                        
                        
                        149,528
                        
                        
                        8.71
                        
                        
                        86,527
                        
                        
                        5.00
 
 Total
shareholders’ equity decreased from $139.8 million as of December 31, 2009 to
$138.8 million as of March 31, 2010. The Company’s accumulated deficit increased
by $5.9 million in the first quarter of 2010, reflecting a $5.3 million net loss
and dividends and accretion on preferred stock of $589 thousand. Common stock
increased due to $5.1 million of proceeds from the issuance of shares of the
Company’s common stock as part of the private placement offering. Accumulated
other comprehensive income, which includes unrealized gains and losses on
available-for-sale investment securities, net of tax, decreased from $4.0
million as of December 31, 2009 to $3.6 million as of March 31,
2010.
 
 As of
March 31, 2010, the Company had a leverage ratio of 8.80%, a Tier 1 capital
ratio of 10.24%, and a total risk-based capital ratio of 11.73%. These ratios
exceed the federal regulatory minimum requirements for a “well capitalized”
bank. The Company’s tangible equity to tangible assets ratio decreased from
7.91% as of December 31, 2009 to 7.85% as of March 31, 2010, and its tangible
common equity to tangible assets ratio declined from 5.53% as of December 31,
2009 to 5.47% as of March 31, 2010.
 On
December 12, 2008, the Company entered into a Securities Purchase Agreement with
the U.S. Treasury Department pursuant to which, among other things, the Company
sold to the Treasury for an aggregate purchase price of $41.3 million, 41,279
shares of Series A Fixed Rate Cumulative Perpetual Preferred Stock of the
Company, or Series A Preferred Stock, and warrants to purchase up to 749,619
shares of common stock of the Company. The Series A Preferred Stock ranks senior
to the Company’s common shares and pays a compounding cumulative dividend, in
cash, at a rate of 5% per annum for the first five years, and 9% per annum
thereafter on the liquidation preference of $1,000 per share. The Company is
prohibited from paying any dividend with respect to shares of common stock or
repurchasing or redeeming any shares of the Company’s common shares unless all
accrued and unpaid dividends are paid on the Series A Preferred Stock for all
past dividend periods (including the latest completed dividend period). The
Series A Preferred Stock is non-voting, other than class voting rights on
matters that could adversely affect the Series A Preferred Stock. The
Series A Preferred Stock is callable at par after three years. The Treasury
may also transfer the Series A Preferred Stock to a third party at any
time.
 Index
 - 32
-
 On
February 1, 2010, the Company announced that its Board of Directors voted to
suspend payment of the Company’s quarterly cash dividend to its common
shareholders.
 
 On March
18, 2010, the Company sold 849 investment units, or the Units, for gross
proceeds of $8.5 million. Each Unit was priced at $10,000 and consisted of a
$3,996.90 subordinated promissory note and a number of shares of the Company’s
common stock valued at $6,003.10. The offering and sale of the Units was limited
to accredited investors. As a result of the sale of the Units, the Company sold
$3.4 million in aggregate principal amount of subordinated promissory notes due
March 18, 2020, or the Notes, and 1,468,770 shares of the Company’s common stock
valued at $5.1 million. Under certain circumstances, the Company may elect to
sell additional Units in one or more subsequent closings on or prior to June 16,
2010, unless the Company elects to extend the offering, provided that the
aggregate amount of all Units sold does not exceed 1,500. The Company is
obligated to pay interest on the Notes at 10% per annum payable in quarterly
installments commencing on the third month anniversary of the date of issuance
of the Notes. The Company may prepay the Notes at any time after March 18, 2015
subject to approval by the Federal Reserve and compliance with applicable
law.
 
 Liquidity
Management
 
 Liquidity
management involves the ability to meet the cash flow requirements of depositors
desiring to withdraw funds or borrowers needing assurance that sufficient funds
will be available to meet their credit needs. To ensure the Company is
positioned to meet immediate and future cash demands, management relies on
internal analysis of its liquidity, knowledge of current economic and market
trends and forecasts of future conditions. Regulatory agencies set certain
minimum liquidity standards, including the setting of a reserve requirement by
the Federal Reserve. The Company must submit weekly reports to the Federal
Reserve to ensure compliance with those requirements. As of March 31, 2010, the
Company met all of its regulatory liquidity requirements.
 
 The
Company had $53.3 million in its most liquid assets, cash and cash equivalents,
as of March 31, 2010. The Company’s principal sources of funds are loan
repayments, deposits, short-term 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 funded $1.17 billion, or 67.1%, of
total assets as of March 31, 2010 compared to $1.18 billion, or 67.8%, of total
assets as of December 31, 2009.
 
 Additional
sources of liquidity are available to the Company through the Federal Reserve
Bank, or FRB, and through membership in the Federal Home Loan Bank, or FHLB,
system. As of March 31, 2010, the Company had a maximum and available borrowing
capacity of $117.0 million and $5.0 million, respectively, through the FHLB.
These funds can be made available with various maturities and interest rate
structures. Borrowings with the FHLB are collateralized by a blanket lien on
certain qualifying assets. The Company also maintains a credit line at the FRB’s
discount window that is used for short-term funding needs and as an additional
source of available liquidity. As of March 31, 2010, the Company had a maximum
and available borrowing capacity of $79.6 million and $69.6 million,
respectively, at the discount window. Available credit at the discount window is
collateralized by eligible commercial construction and commercial and industrial
loans. The Company also maintains off-balance sheet liquidity from other sources
such as federal funds lines, repurchase agreement lines and through brokered
deposit sources.
  Item 3.Quantitative and Qualitative
Disclosures about Market Risk
 
 As described in more detail in Part II, Item 7A of our
Annual Report on Form 10-K for the year ended December 31, 2009, 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, 2009 to March 31,
2010.
 
 Item 4.Controls and
Procedures
 
 Not
applicable.
  Index
 - 33
-
 Item 4T.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 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, or CEO, and Chief Financial Officer, or
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 end 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.
  
 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
 
 The
following discussion addresses some of the risks and uncertainties that could
cause, or contribute to causing, actual results to differ materially from
expectations. In evaluating our business, you should pay particular attention to
the descriptions of risks and uncertainties described below. 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.
 
 Risks
Related to Our Business
 
 U.S.
and international credit markets and economic conditions could adversely affect
our liquidity, financial condition and profitability.
 
 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 we remain well capitalized and have not suffered any significant
liquidity problems 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 also adversely
affect our liquidity, financial condition and profitability.
  Index
 - 34
-
 Legislative
and regulatory actions taken now or in the future to address the current
liquidity and credit crisis in the financial industry may significantly affect
our liquidity or financial condition.
 
 The
Federal Reserve, U.S. Congress, the Treasury, the FDIC and others have taken
numerous actions to address the current liquidity and credit situation in the
financial markets. These measures include actions to encourage loan
restructuring and modification for homeowners; the establishment of significant
liquidity and credit facilities for financial institutions and investment banks;
and coordinated efforts to address liquidity and other weaknesses in the banking
sector. The Economic Emergency Stabilization Act, or EESA, which established the
Troubled Asset Relief Program, or TARP, was enacted on October 3, 2008. As part
of the TARP, the Treasury created the Capital Purchase Program, or CPP, under
which the Treasury will invest up to $250 billion in senior preferred stock of
U.S. banks and savings associations or their holding companies for the purpose
of stabilizing and providing liquidity to the U.S. financial
markets.
 On
February 17, 2009, the American Recovery and Reinvestment Act, or ARRA, was
enacted as a sweeping economic recovery package intended to stimulate the
economy and provide for extensive infrastructure, energy, health and education
needs. We participated in the CPP and sold $41.3 million of our Series A
Preferred Stock, and a warrant to purchase 749,619 shares of our common stock to
the Treasury. Future participation in this or similar programs may subject us to
additional restrictions and regulation. There can be no assurance as to the
actual impact that EESA or its programs, including the CPP, and ARRA or its
programs, will have on the national economy or financial markets. The failure of
these significant legislative measures to help stabilize the financial markets
and a continuation or worsening of current financial market conditions could
materially and adversely affect our financial condition, results of operations,
liquidity or stock price.
 
 Further,
the U.S. Congress and state legislatures and federal and state regulatory
authorities continually review banking laws, regulations and policies for
possible changes. Changes to statutes, regulations or regulatory policies,
including interpretation and implementation of statutes, regulation or policies,
including EESA, ARRA, and TARP and recently proposed executive compensation
guidance by the Federal Reserve and FDIC, could affect us in substantial and
unpredictable ways, including limiting the types of financial services and
products we may offer or increasing the ability of non-banks to offer competing
financial services and products. While we cannot predict the regulatory changes
that may be borne out of the current economic crisis, and we cannot predict
whether we will become subject to increased regulatory scrutiny by any of these
regulatory agencies, any regulatory changes or scrutiny could increase or
decrease the cost of doing business, limit or expand our permissible activities,
or affect the competitive balance among banks, credit unions, savings and loan
associations and other institutions. We cannot predict whether new legislation
will be enacted and, if enacted, the effect that it, or any regulations, would
have on our business, financial condition or results of operations.
 
 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.
 
 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.
 
 Because
the majority of our borrowers are individuals and businesses located and doing
business in Wake, Granville, Lee, Cumberland, Johnston, 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 or a continued increase in
unemployment rates 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.
  Index
 - 35
-
 We
are 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 accordance with 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 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.
 
 A
significant portion of our loan portfolio is secured by real estate, and events
that negatively impact the real estate market could hurt our
business.
 
 A
significant portion of our loan portfolio is secured by real estate. As of March
31, 2010, approximately 83% of our loans had real estate as a primary or
secondary component of collateral. The real estate collateral in each case
provides an alternate source of repayment in the event of default by the
borrower and may deteriorate in value during the time the credit is extended. A
continued weakening of the real estate market in our primary market areas could
continue to result in an increase in the number of borrowers who default on
their loans and a reduction in the value of the collateral securing their loans,
which in turn could have an adverse effect on our profitability and asset
quality. If we are required to liquidate the collateral securing a loan to
satisfy the debt during a period of reduced real estate values, our earnings and
shareholders’ equity could be adversely affected. 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 a deepened economic recession and continued
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 on 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. 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 could adversely affect our financial condition or
results of operations.
 
 Our
real estate and land acquisition and development loans are based upon estimates
of costs and the value of the complete project.
 
 We extend
real estate land loans, construction loans, and acquisition and development
loans to builders and developers, primarily for the construction/development of
properties. We originate these loans on a presold and speculative basis and they
include loans for both residential and commercial purposes. As of March 31,
2010, these loans totaled $456.4 million, or 33% of our total loan portfolio.
Approximately $101.3 million of this amount was for construction of residential
properties and $78.7 million was for construction of commercial properties.
Additionally, approximately $203.4 million was for acquisition and development
loans for both residential and commercial properties. Land loans, which are
loans made with raw land as security, totaled $73.1 million, or 5% of our
portfolio, as of March 31, 2010.
 
 In
general, construction and land lending involves additional risks because of the
inherent difficulty in estimating a property’s value both before and at
completion of the project. Construction costs may exceed original estimates as a
result of increased materials, labor or other costs. In addition, because of
current uncertainties in the residential and commercial real estate markets,
property values have become more difficult to determine than they have been
historically. Construction and land acquisition and development loans often
involve the repayment dependent, in part, on the ability of the borrower to sell
or lease the property. These loans also require ongoing monitoring. In addition,
speculative construction loans to a residential builder are often associated
with homes that are not presold, and thus pose a greater potential risk than
construction loans to individuals on their personal residences. As of March 31,
2010, $83.0 million of our residential construction loans were for speculative
construction loans. Slowing housing sales have been a contributing factor to an
increase in nonperforming loans as well as an increase in delinquencies.
Residential construction loans and commercial construction loans represented 12%
and 0%, respectively, of our nonperforming loans as of March 31,
2010.
  Index
 - 36
-
 Our
non-owner occupied commercial real estate loans may be dependent on factors
outside the control of our borrowers.
 
 We
originate non-owner occupied commercial real estate loans for individuals and
businesses for various purposes, which are secured by commercial properties.
These loans typically involve repayment dependent upon income generated, or
expected to be generated, by the property securing the loan in amounts
sufficient to cover operating expenses and debt service. This may be adversely
affected by changes in the economy or local market conditions. Non-owner
occupied commercial real estate loans expose a lender to greater credit risk
than loans secured by residential real estate because the collateral securing
these loans typically cannot be liquidated as easily as residential real estate.
If we foreclose on a non-owner occupied commercial real estate loan, our holding
period for the collateral typically is longer than a 1-4 family residential
property because there are fewer potential purchasers of the collateral.
Additionally, non-owner occupied commercial real estate loans generally have
relatively large balances to single borrowers or related groups of borrowers.
Accordingly, charge-offs on non-owner occupied commercial real estate loans may
be larger on a per loan basis than those incurred with our residential or
consumer loan portfolios.
 
 As of
March 31, 2010, our non-owner occupied commercial real estate loans totaled
$240.2 million, or 17% of our total loan portfolio.
 
 Repayment
of our commercial business loans is dependent on the cash flows of the borrower,
which may be unpredictable, and the collateral securing these loans may
fluctuate in value.
 
 We offer
different types of commercial loans to a variety of small to medium-sized
businesses. The types of commercial loans offered are owner-occupied term real
estate loans, business lines of credit and term equipment financing. Commercial
business lending involves risks that are different from those associated with
non-owner occupied commercial real estate lending. Our commercial business loans
are primarily underwritten based on the cash flow of the borrower and
secondarily on the underlying collateral, including real estate. The borrowers’
cash flow may be unpredictable, and collateral securing these loans may
fluctuate in value. Some of our commercial business loans are collateralized by
equipment, inventory, accounts receivable or other business assets, and the
liquidation of collateral in the event of default is often an insufficient
source of repayment because accounts receivable may be uncollectible and
inventories may be obsolete or of limited use.
 
 As of
March 31, 2010, our commercial business loans totaled $367.2 million, or 27% of
our total loan portfolio. Of this amount, $186.1 million was secured by
owner-occupied real estate and $181.1 million was secured by business
assets.
 
 A
portion of our commercial real estate loan portfolio utilizes interest reserves
which may not accurately portray the financial condition of the project and the
borrower’s ability to repay the loan.
 
 Some of
our commercial real estate loans utilize interest reserves to fund the interest
payments and are funded from loan proceeds. Our decision to establish a
loan-funded interest reserve upon origination of a loan is based on the
feasibility of the project, the creditworthiness of the borrower and guarantors
and the protection provided by the real estate and other collateral. When
applied appropriately, an interest reserve can benefit both the lender and the
borrower. For the lender, an interest reserve provides an effective means for
addressing the cash flow characteristics of a properly underwritten acquisition,
development and construction loan. Similarly, for the borrower, interest
reserves provide the funds to service the debt until the property is developed,
and cash flow is generated from the sale or lease of the developed
property.
 
 Although
potentially beneficial to the lender and the borrower, our use of interest
reserves carries certain risks. Of particular concern is the possibility that an
interest reserve may not accurately reflect problems with a borrower’s
willingness or ability to repay the debt consistent with the terms and
conditions of the loan obligation. For example, a project that is not completed
in a timely manner or falters once completed may appear to perform if the
interest reserve keeps the loan current. In some cases, we may extend, renew or
restructure the term of certain loans, providing additional interest reserves to
keep the loan current. As a result, the financial condition of the project may
not be apparent and developing problems may not be addressed in a timely manner.
Consequently, we may end up with a matured loan where the interest reserve has
been fully advanced, and the borrower’s financial condition has deteriorated. In
addition, the project may not be complete, its sale or lease-up may not be
sufficient to ensure timely repayment of the debt or the value of the collateral
may have declined, exposing us to increasing credit losses.
 
 Index
 - 37
-
 As of
March 31, 2010, we had a total of 39 loans funded by an interest reserve with a
total outstanding balance of $97.1 million, representing approximately 7% of our
total outstanding loans. Total commitments on these loans equaled $127.0 million
with total remaining interest reserves of $3.9 million, representing a weighted
average term of approximately ten months of remaining interest
coverage.
 
 Our
allowance for loan losses may prove to be insufficient to absorb losses in our
loan portfolio.
 
 Lending
money is a substantial part of our business, and each loan carries a certain
risk that it will not be repaid in accordance with its terms or that any
underlying collateral will not be sufficient to assure repayment. This risk is
affected by, among other things:
 
 •
                      cash
      flow of the borrower and/or the project being financed;•
                      the
      changes and uncertainties as to the future value of the collateral, in the
      case of a collateralized loan;•
                      the
      duration of the loan;•
                      the
      credit history of a particular borrower; and•
                      changes
      in economic and industry
conditions.
 
 We
maintain an allowance for loan losses, which is a reserve established through a
provision for loan losses charged to expense, which we believe is appropriate to
provide for probable losses in our loan portfolio. The amount of this allowance
is determined by our management through periodic reviews and consideration of
several factors, including, but not limited to:
 
 •
                      our
      general reserve, based on our historical default and loss experience and
      certain macroeconomic factors based on management’s expectations of future
      events; and•
                      our
      specific reserve, based on our evaluation of nonperforming loans and their
      underlying collateral.
 
 The
determination of the appropriate level of the allowance for loan losses
inherently involves a high degree of subjectivity and requires us to make
significant estimates of current credit risks and future trends, all of which
may undergo material changes. Continuing deterioration in economic conditions
affecting borrowers, new information regarding existing loans, identification of
additional problem loans and other factors, both within and outside of our
control, may require an increase in the allowance for loan losses. In addition,
bank regulatory agencies periodically review our allowance for loan losses and
may require an increase in the provision for probable loan losses or the
recognition of further loan charge-offs, based on judgments different than those
of management. In addition, if charge-offs in future periods exceed the
allowance for loan losses, we will need additional provisions to increase the
allowance for loan losses. Any increases in the allowance for loan losses will
result in a decrease in net income and, possibly, capital, and may have a
material adverse effect on our financial condition and results of
operations.
 
 If
our allowance for loan losses is not adequate, we may be required to make
further increases in our provisions for loan losses and to charge off additional
loans, which could adversely affect our results of operations.
 
 For the
quarter ended March 31, 2010, we recorded a provision for loan losses of $11.7
million compared to $6.0 million for the quarter ended March 31, 2009, an
increase of $5.7 million. We also recorded net loan charge-offs of $8.7 million
for the quarter ended March 31, 2010 compared to $2.3 million for the quarter
ended March 31, 2009. Generally, our nonperforming loans and assets reflect
operating difficulties of individual borrowers resulting from weakness in the
local economy; however, more recently the deterioration in the general economy
has become a significant contributing factor to the increased levels of
delinquencies and nonperforming loans. Slower sales and excess inventory in the
housing market has been the primary cause of the increase in delinquencies and
foreclosures for residential construction loans, which represented 12% of our
nonperforming loans as of March 31, 2010. In addition, slowing housing sales
have been a contributing factor to the increase in nonperforming loans as well
as the increase in delinquencies. As of March 31, 2010, our total nonperforming
loans increased to $58.2 million, or 4.23% of total loans, compared to $17.0
million, or 1.33% of total loans, as of March 31, 2009.
  Index
 - 38
-
 If
current trends in the housing and real estate markets continue, we expect that
we will continue to experience higher than normal delinquencies and credit
losses. Moreover, until general economic conditions improve, we may continue to
experience increased delinquencies and credit losses. As a result, we may be
required to make additional provisions for loan losses and to charge off
additional loans in the future, which could materially adversely affect our
financial condition and results of operations.
 
 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 to address unknown liabilities 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.
 
 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. Approximately 62% of
our loans were variable rate loans as of March 31, 2010, which means that our
interest income will generally decrease in lower interest rate environments and
rise in higher interest rate environments. Our net interest income will be
adversely affected if market interest rates change such that the interest we
earn on loans and investments decreases faster than the interest we pay on
deposits and borrowings. 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 Board of Governors of
the Federal Reserve, 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 earnings and financial condition.
 
 The
fair value of our investments could decline.
 
 The
majority of our investment portfolio as of March 31, 2010 has been designated as
available-for-sale. Unrealized gains and losses in the estimated value of the
available-for-sale portfolio must be “marked to market” and reflected as a
separate item in shareholders’ equity (net of tax) as accumulated other
comprehensive income. As of March 31, 2010, we maintained $221.0 million, or
95%, of our total investment securities as available-for-sale. Shareholders’
equity will continue to reflect the unrealized gains and losses (net of tax) of
these investments. The fair value of our investment portfolio may decline,
causing a corresponding decline in shareholders’ equity.
 
 As of
March 31, 2010, our available-for-sale securities portfolio contained $7.7
million in book value of non-agency mortgage-backed securities with gross
unrealized losses of $524 thousand. We may continue to observe declines in the
fair market value of these securities. We evaluate the securities portfolio for
any other-than-temporary impairment each reporting period, and as of March 31,
2010, one of our non-agency mortgage-backed securities with an unrealized loss
of $363 thousand was other-than-temporarily impaired due to factors other than
credit. There can be no assurance that future evaluations of this security or
other similar securities will not result in other-than-temporary impairment
related to credit which will negatively impact future earnings.
 
 Further,
we own two corporate bonds in the available-for-sale investment portfolio, both
of which were issued by community banks. One of the bonds exhibited credit
impairment in a previous period, and the loss was charged to earnings in that
period. As of March 31, 2010, the other bond had an unrealized loss of $202
thousand which was determined not to be a credit impairment. This unrealized
loss is recorded in accumulated other comprehensive income. There may be future
declines in the fair value of these corporate bond investments which would
negatively impact shareholders’ equity and may impact future
earnings.
  Index
 - 39
-
 Management
believes that several factors affect the fair values of our investment
portfolio. These include, but are not limited to, changes in interest rates or
expectations of changes, changes to the credit ratings and financial condition
of security issuers, the degree of volatility in the securities markets,
inflation rates or expectations of inflation, and the slope of the interest rate
yield curve. The yield curve refers to the differences between shorter-term and
longer-term interest rates; a positively sloped yield curve means shorter-term
rates are lower than longer-term rates. These and other factors may impact
specific categories of the portfolio differently, and we cannot predict the
effect these factors may have on any specific category.
 
 Government
regulations 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 FDIC and the NC Commissioner. Banking
regulations, designed primarily for the protection of depositors, may limit our
growth and the return to our current and/or potential investors by restricting
certain of our activities, such as:
 
 •
                      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. Many of these regulations are intended to protect depositors, the
public and the FDIC, not shareholders. The cost of compliance with regulatory
requirements including those imposed by the SEC may adversely affect our ability
to operate profitably.
 
 Specifically,
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.
 
 The
terms governing the issuance of the Series A Preferred Stock to the Treasury may
be changed, the effect of which may have an adverse effect on our
operations.
 
 The terms
of the Securities Purchase Agreement, which we entered into with the Treasury,
provides that the Treasury may unilaterally amend any provision of the
Securities Purchase Agreement to the extent required to comply with any changes
in applicable federal law that may occur in the future. We have no control over
any change in the terms of the transaction that may occur in the future. Such
changes may place restrictions on our business or results of operations, which
may adversely affect the market price of our common stock.
  Index
 - 40
-
 There
are 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
and other markets in North Carolina, South Carolina and Virginia, at this time
particularly through FDIC-assisted transactions. 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 in integrating 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 our
target markets. In attempting to make such acquisitions, we anticipate competing
with other financial institutions, many of which have greater financial and
operational resources. The process of identifying acquisition opportunities,
negotiating potential acquisitions, obtaining the required regulatory approvals,
and integrating new operations and personnel requires a significant amount of
time and expense and may divert management’s attention from our existing
business. 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 such acquisitions. Any given acquisition, if and
when consummated, may adversely affect our results of operations or 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.
 
 Our
ability to raise additional capital could be limited, could affect our liquidity
and could be dilutive to existing shareholders.
 
 We may be
required or choose to raise additional capital, including for strategic,
regulatory or other reasons. Current conditions in the capital markets are such
that traditional sources of capital may not be available to us on reasonable
terms if we need to raise additional capital, and the inability to access the
capital markets could impair our liquidity, which is important to our business.
In such case, there is no guarantee that we will be able to successfully raise
additional capital at all or on terms that are favorable or otherwise not
dilutive to existing shareholders.
 
 We
are dependent on our key personnel, including our senior management and
directors, and our inability to hire and retain key personnel may adversely
affect our operations and financial performance.
 
 We are,
and for the foreseeable future will be, dependent on the services of our senior
management and directors. Members of our senior management have extensive and
long-standing ties within our market area and substantial experience with our
operations, which have contributed significantly to our growth. Should the
services of a member of our senior management team become unavailable, our
operations and growth may be disrupted, and there can be no assurance that a
suitable successor could be retained upon the terms and conditions that we would
offer. In December 2008, we entered into the Securities Purchase Agreement in
connection with the CPP pursuant to which we sold the Treasury 41,279 shares of
our Series A Preferred Stock and a warrant to purchase up to 749,619 shares of
our common stock for an aggregate purchase price of $41.3 million. Our
participation in the CPP restricts our ability to provide certain types of
compensation to certain senior executive officers and employees. The inability
to make certain types of compensation available to certain senior executive
officers and employees may reduce our ability to retain key
personnel.
 
 Further,
as we continue to grow our operations both in our current markets and other
markets that we may target, we expect to continue to be dependent on our senior
management and their relationships in such markets. Our inability to attract or
retain additional personnel could materially adversely affect our business or
growth prospects in one or more markets.
 
 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.
  Index
 - 41
-
 We may
not be able to compete effectively in our markets, and our results of operations
could be adversely affected by the nature or pace of 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.
 
 The
failure of other financial institutions could adversely affect us.
 
 Our
ability to engage in routine transactions, including, for example, funding
transactions, could be adversely affected by the actions and potential failures
of other financial institutions. We have exposure to many different industries
and counterparties, and we routinely execute transactions with a variety of
counterparties in the financial services industry. As a result, defaults by, or
even rumors or concerns about, one or more financial institutions with which we
do business, or the financial services industry generally, have led to
market-wide liquidity problems and could lead to losses or defaults by us or by
others. In addition, our credit risk may be exacerbated when the collateral we
hold cannot be sold at prices that are sufficient for us to recover the full
amount of our exposure. Any such losses could materially and adversely affect
our financial condition or results of operations.
 
 Consumers
may decide not to use banks to complete their financial transactions, which
could limit our revenue.
 
 Technology
and other changes are allowing parties to complete financial transactions
through alternative methods that historically have involved banks. 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 through the use of various electronic payment systems. 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.
 
 Technological
advances impact our business.
 
 The
banking industry is undergoing rapid 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 financial institutions 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 invest in 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.
 
 Our
information systems, or those of our third party contractors, may experience an
interruption or breach in security.
 
 We rely
heavily on our communications and information systems, and those of third party
contractors, 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 of our information systems, or those of our
third party contractors, or, if they do occur, that they will be adequately
addressed. The occurrence of any failures, interruptions or security breaches of
such 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.
 
 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.
  Index
 - 42
-
 Issues
discovered related to the administration and termination of the 1st State
Bancorp, Inc. Employee Stock Ownership Plan may subject us to liability and
adversely impact our financial condition and results of operations.
 
 In 2009,
we discovered that the 1st State Bancorp, Inc. Employee Stock Ownership Plan, or
ESOP, which was to be terminated immediately prior to the Bank’s merger with 1st
State Bank in 2006, was not correctly terminated. Among other things, management
discovered that certain required filings with the Internal Revenue Service, or
IRS, related to the termination of the ESOP were never made, insufficient
withholding taxes were submitted to the IRS, and incorrect distributions were
made from the ESOP, resulting in an overpayment of certain accounts and
underpayment of others. We engaged outside counsel and an independent third
party record keeper and have corrected the errors and submitted necessary
filings to the IRS and U.S. Department of Labor, or DOL. The Company paid
penalties and interest to the IRS due to the delinquent filings and insufficient
payment of taxes and has fully funded participant accounts in the ESOP.
Currently, the Company is awaiting plan termination approval from the
IRS.
 
 The
Company recorded total expense of $244 thousand related to this ESOP matter in
the fourth quarter of 2009 and an additional $8 thousand in the first quarter of
2010. These amounts represent penalties and interest paid to the IRS, corrective
amounts that the Company contributed to the ESOP, and professional fees
incurred. The Company may be required to record expense related to this matter
as additional facts become known or as additional assessments are levied by
either the IRS or DOL.
 
 Risks
Related to Ownership of Our Common Stock
 
 The
trading volume in our common stock has been low, which could make it difficult
to sell shares of our common stock.
 
 Our
common stock is currently traded on the NASDAQ Global Select Market. Our common
stock is thinly traded and has substantially less liquidity than the average
trading market for many other publicly traded companies. Thinly traded stocks
can be more volatile than stock trading in an active public market. Our stock
price has been volatile in the past and several factors could cause the price to
fluctuate substantially in the future. These factors include but are not limited
to changes in analysts’ recommendations or projections, our announcement of
developments related to our business, operations and stock performance of other
companies deemed to be peers, news reports of trends, concerns, irrational
exuberance on the part of investors and other issues related to the financial
services industry. Recently, the stock market has experienced a high level of
price and volume volatility, and market prices for the stock of many companies,
including those in the financial services sector, have experienced wide price
fluctuations that have not necessarily been related to operating performance.
Our stock price may fluctuate significantly in the future, and these
fluctuations may be unrelated to our performance. General market declines or
market volatility in the future, especially in the financial institutions sector
of the economy, could adversely affect the price of our common stock, and the
current market price may not be indicative of future market prices. Therefore,
our shareholders may not be able to sell their shares at the volume, prices or
times that they desire.
 
 We
may issue additional shares of common stock or convertible securities that will
dilute the percentage ownership interest of existing shareholders and may dilute
the book value per share of our common stock and adversely affect the terms on
which we may obtain additional capital.
 
 Our
authorized capital includes 50,000,000 shares of common stock. As of March 31,
2010, we had 12,881,354 shares of common stock outstanding and had reserved for
issuance 336,261 shares underlying options that are or may become exercisable at
an average price of $12.09 per share. In addition, as of March 31, 2010, we had
the ability to issue 605,059 shares of common stock pursuant to options and
restricted stock that may be granted in the future under our existing equity
compensation plans. Subject to applicable NASDAQ Listing Rules, our Board of
Directors generally has the authority, without action by or vote of the
shareholders, to issue all or part of any authorized but unissued shares of
common stock for any corporate purpose, including issuance of equity-based
incentives under or outside of our equity compensation plans. We may seek
additional equity capital in the future as we develop our business and expand
our operations. Any issuance of additional shares of common stock or convertible
securities will dilute the percentage ownership interest of our shareholders and
may dilute the book value per share of our common stock.
  Index
 - 43
-
 The
Bank’s ability to pay dividends is subject to regulatory limitations, which may
affect our ability to pay our obligations and dividends.
 
 We are a
separate legal entity from the Bank and our other subsidiaries, and we do not
have significant operations of our own. We have historically depended on the
Bank’s cash and liquidity as well as dividends to pay our operating expenses.
Various federal and state statutory provisions limit the amount of dividends
that subsidiary banks can pay to their holding companies without regulatory
approval. The Bank is also subject to limitations under state law regarding the
payment of dividends, including the requirement that dividends may be paid only
out of undivided profits and only if the Bank has surplus of a specified level.
In addition to these explicit limitations, it is possible, depending upon the
financial condition of the Bank and other factors, that the federal and state
regulatory agencies could take the position that payment of dividends by the
Bank would constitute an unsafe or unsound banking practice. In the event the
Bank is unable to pay dividends sufficient to satisfy our obligations or is
otherwise unable to pay dividends to us, we may not be able to service our
obligations as they become due or to pay dividends on our common stock or Series
A Preferred Stock. Consequently, the inability to receive dividends from the
Bank could adversely affect our financial condition, results of operations, cash
flows and prospects.
 
 In
addition, holders of our common stock are only entitled to receive such
dividends as our Board of Directors may declare out of funds legally available
for such payments. Although we have historically paid cash dividends on our
common stock, we are not required to do so and our Board of Directors has
recently announced that it has suspended the payment of our quarterly cash
dividend. This could adversely affect the market price of our common stock.
Also, we are a financial holding company and our ability to declare and pay
dividends depends on certain federal regulatory considerations, including the
guidelines of the Federal Reserve regarding capital adequacy and
dividends.
 
 The
Treasury’s investment in us imposes restrictions and obligations limiting our
ability to pay dividends and repurchase common stock.
 
 Under the
Securities Purchase Agreement and the rights of the Series A Preferred Stock set
forth in our Articles of Incorporation, our ability to declare or pay dividends
on any of our shares is restricted. Specifically, we may not declare dividend
payments on common, junior preferred or pari passu preferred shares
if we are in arrears on the dividends on the Series A Preferred Stock.
Furthermore, prior to December 12, 2011, unless we have redeemed all of the
Series A Preferred Stock, or the Treasury has transferred all of the Series A
Preferred Stock to a third party, the consent of the Treasury will be required
for us to, among other things, increase common stock dividends or effect
repurchases of common stock (with certain exceptions, including the repurchase
of our common stock to offset share dilution from equity-based employee
compensation awards).
 
 Holders
of Series A Preferred Stock have certain voting rights that may adversely affect
our common shareholders, and the holders of Series A Preferred Stock may have
different interests from, and vote their shares in a manner deemed adverse to,
our common shareholders.
 
 In the
event that we fail to pay dividends on shares of Series A Preferred Stock for an
aggregate of at least six quarterly dividend periods (whether or not
consecutive), the Treasury will have the right to appoint two directors to our
Board of Directors until all accrued but unpaid dividends have been paid;
otherwise, except as required by law, holders of Series A Preferred Stock have
limited voting rights. So long as shares of Series A Preferred Stock are
outstanding, in addition to any other vote or consent of shareholders required
by law or our Articles of Incorporation, the vote or consent of holders owning
at least 66 2/3% of the shares of Series A Preferred Stock outstanding is
required for:
 
 •
                      any
      amendment or alteration of our Articles of Incorporation to authorize or
      create or increase the authorized amount of, or any issuance of, any
      shares of, or any securities convertible into or exchangeable or
      exercisable for shares of, any class or series of capital stock ranking
      senior to the Series A Preferred Stock with respect to payment of
      dividends and/or distribution of assets on our liquidation, dissolution or
      winding up;•
                      any
      amendment, alteration or repeal of any provision of our Articles of
      Incorporation so as to adversely affect the rights, preferences,
      privileges or voting powers of the Series A Preferred Stock;
      or
  Index
 - 44
-
 •
                      any
      consummation of a binding share exchange or reclassification involving the
      Series A Preferred Stock or of a merger or consolidation of us with
      another entity, unless (i) the shares of Series A Preferred Stock remain
      outstanding following any such transaction or, if we are not the surviving
      or resulting entity, such shares are converted into or exchanged for
      preference securities of the surviving or resulting entity or its ultimate
      parent, and (ii) such remaining outstanding shares of Series A Preferred
      Stock or preference securities, as the case may be, have rights,
      preferences, privileges and voting powers, and limitations and
      restrictions thereof, that are not materially less favorable than the
      rights, preferences, privileges and voting powers, and limitations and
      restrictions thereof, of the Series A Preferred Stock prior to such
      consummation, taken as a whole. Holders of Series A Preferred Stock could
      block such a transaction, even where considered desirable by, or in the
      best interests of, holders of our common
stock.
 
 In
addition, the shares of common stock that are issuable upon the exercise of the
warrant held by the Treasury will enjoy voting rights identical to those of our
other outstanding shares of common stock. Although the Treasury has agreed not
to vote the shares of common stock it would receive upon any exercise of the
warrant, a transferee of any portion of the warrant or any of the shares of
common stock it acquires upon exercise of the warrant is not bound by this
limitation.
 
 There
can be no assurance when the Series A Preferred Stock may be redeemed and the
warrant held by the Treasury may be repurchased.
 
 There can
be no assurance when the Series A Preferred Stock may be redeemed and the
warrant may be repurchased. In addition, the Series A Preferred Stock may only
be redeemed upon the express approval of the Federal Reserve. Until such time as
the Series A Preferred Stock is redeemed and the warrant is repurchased, we will
remain subject to the terms and conditions set forth in the Securities Purchase
Agreement, the warrant and the rights of the Series A Preferred Stock as set
forth in the Articles of Incorporation.
 
 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, Capital Bank Statutory Trust
I, II and III. We conditionally guarantee all payments of the principal and
interest on these 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.
 
 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, our shareholders may lose some or all of their investment
in our common stock.
 
 Item 2.Unregistered Sales of Equity
Securities and Use of Proceeds
 
 There
were no repurchases (both open market and private transactions) during the three
months ended March 31, 2010 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.
 
 Other
than as disclosed in our Current Report on Form 8-K, filed with the SEC on March
22, 2010, we have not completed any unregistered sales of equity securities
during the period ended March 31, 2010.
 
 Item 3.Defaults upon Senior
Securities
 
 None
 
 Item 4.(Removed and
Reserved)
 
 Item 5.Other
Information
 
 None
  Index
 - 45
-
 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
      4.2
                        
                        Agreement
      to furnish instruments and agreements defining rights of holders of
      long-term debt*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 2002Exhibit
      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
 
 *  Filed
herewith
  Index
 - 46
-
 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 10th day of May
2010.
 
 CAPITAL
      BANK CORPORATIONBy:
                        /s/
      Michael R. MooreMichael
      R. MooreChief
      Financial Officer(Authorized
      Officer and Principal Financial Officer)
 Index
 - 47
-
 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
      4.2
                        
                        Agreement
      to furnish instruments and agreements defining rights of holders of
      long-term debt*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 2002Exhibit
      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
 
 *  Filed
herewith
  Index
 - 48
-