** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **x**  | ** ** | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                 |
|--------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |       | **For the quarterly period ended: September 30, 2008**                                                                                                                                                                                                                                                                                                                                                      |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                             |
| o      |       | **TRANSITION REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |       | **For the transition period from                                  to                              ** |

 

**Commission file number: 000-22503**

 

**BEACH FIRST NATIONAL BANCSHARES,INC.**

(Exact name ofregistrant as specified in its charter)

 

| **South Carolina**       | ** ** | **57-1030117**                       |
|--------------------------|------------|--------------------------------------|
| (State of Incorporation) |       | (I.R.S. Employer Identification No.) |

 

**3751 Robert M. Grissom Parkway, Suite 100, Myrtle Beach, SouthCarolina 29577**

(Address ofprincipal executive offices)

 

**(843)626-2265**

(Registrant’stelephone number)

 

**Not Applicable**

(Former name,former address and former fiscal year, if changed since last report)

 

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

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

 

Largeaccelerated filer o           Accelerated filer x           Smaller reporting company x            Non-accelerated filer o

 

Indicate by check markwhether the registrant is shell company (as defined in Rule 12b-2 of theExchange Act). Yes  o    No  x

 

State the number of shares outstanding of each of the issuer’s classesof common equity, as of the latest practicable date:  On November 3, 2008, 4,845,018 shares ofthe issuer’s common stock, par value $1.00 per share, were issued andoutstanding.

 

 

 

----

 

**PART I**

**FINANCIALINFORMATION**

**Item1.  Financial Statements.**

 

**Beach First National Bancshares, Inc. and Subsidiaries**

**ConsolidatedCondensed Balance Sheets**

 
| ** **                                                                                                                                                                                         | ** ** | **September 30,** | ** **  | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                         | ** ** | **2008**               | ** **  | **2007**              | ** ** | **2007**               | ** ** |
| ** **                                                                                                                                                                                         | ** ** | **(unaudited)**        | ** **  | **(audited)**         | ** ** | **(unaudited)**        | ** ** |
| **Assets**                                                                                                                                                                                         |       |                   |        |                  |       |                   |       |
| Cash and due from banks                                                                                                                                                                            |       | $                      | 6,716,033   |                  | $          | 4,992,634              |       | $ | 4,691,640 |   |
| Federal funds sold and short-term  investments                                                                                                                                                     |       | 9,813,955              |        | 566,044               |       | 735,387                |       |
| Total cash and cash equivalents                                                                                                                                                                    |       | 16,529,988             |        | 5,558,678             |       | 5,427,027              |       |
| Investment securities                                                                                                                                                                              |       | 70,501,563             |        | 65,677,993            |       | 69,093,920             |       |
|                                                                                                                                                                                               |       |                   |        |                  |       |                   |       |
| Portfolio loans                                                                                                                                                                                    |       | 553,485,128            |        | 503,432,516           |       | 465,394,875            |       |
| Allowance for loan losses (ALL)                                                                                                                                                                    |       | (7,663,434             | )           | (6,935,616            | )          | (6,397,012             | )          |
| Portfolio loans, net of ALL                                                                                                                                                                        |       | 545,821,694            |        | 496,496,900           |       | 458,997,863            |       |
|                                                                                                                                                                                               |       |                   |        |                  |       |                   |       |
| Mortgage loans held for sale                                                                                                                                                                       |       | 5,328,679              |        | 6,475,619             |       | 6,392,792              |       |
| Federal Reserve Bank stock                                                                                                                                                                         |       | 1,014,000              |        | 984,000               |       | 984,000                |       |
| Federal Home Loan Bank stock                                                                                                                                                                       |       | 3,545,100              |        | 3,395,300             |       | 3,395,300              |       |
| Premises and equipment, net                                                                                                                                                                        |       | 15,908,455             |        | 15,746,143            |       | 15,458,744             |       |
| Cash value of life insurance                                                                                                                                                                       |       | 3,641,485              |        | 3,554,807             |       | 3,522,501              |       |
| Investment in BFNB Trusts                                                                                                                                                                          |       | 310,000                |        | 310,000               |       | 310,000                |       |
| Other assets                                                                                                                                                                                       |       | 10,297,383             |        | 7,788,978             |       | 7,803,341              |       |
| Total assets                                                                                                                                                                                       |       | $                      | 672,898,347 |                  | $          | 605,988,418            |       | $ | 571,385,488 |   |
|                                                                                                                                                                                               |       |                   |        |                  |       |                   |       |
| **Liabilities  and shareholders’ equity**                                                                                                                                                     |       |                   |        |                  |       |                   |       |
| **Liabilities**                                                                                                                                                                                    |       |                   |        |                  |       |                   |       |
| Deposits                                                                                                                                                                                           |       |                   |        |                  |       |                   |       |
| Noninterest bearing deposits                                                                                                                                                                       |       | $                      | 33,358,001  |                  | $          | 33,138,936             |       | $ | 40,317,614 |   |
| Interest bearing deposits                                                                                                                                                                          |       | 503,350,295            |        | 431,059,409           |       | 399,947,404            |       |
| Total deposits                                                                                                                                                                                     |       | 536,708,296            |        | 464,198,345           |       | 440,265,018            |       |
| Advances from Federal Home Loan Bank                                                                                                                                                               |       | 55,000,000             |        | 55,000,000            |       | 37,500,000             |       |
| Federal funds purchased and other  borrowings                                                                                                                                                      |       | 11,537,176             |        | 18,288,148            |       | 26,781,626             |       |
| Junior subordinated debentures                                                                                                                                                                     |       | 10,310,000             |        | 10,310,000            |       | 10,310,000             |       |
| Other liabilities                                                                                                                                                                                  |       | 5,341,014              |        | 5,613,875             |       | 5,202,383              |       |
| Total liabilities                                                                                                                                                                                  |       | $                      | 618,896,486 |                  | $          | 553,410,368            |       | $ | 520,059,027 |   |
|                                                                                                                                                                                               |       |                   |        |                  |       |                   |       |
| **Shareholders’  equity**                                                                                                                                                                     |       |                   |        |                  |       |                   |       |
| Common stock, $1 par value; 10,000,000  shares authorized; 4,845,018 issued and outstanding at September 30,  2008, 4,845,018 at December 31, 2007, and 4,842,766 at September 30,  2007 |       | 4,845,018              |        | 4,845,018             |       | 4,842,766              |       |
| Paid-in capital                                                                                                                                                                                    |       | 29,508,457             |        | 29,494,912            |       | 29,110,906             |       |
| Retained earnings                                                                                                                                                                                  |       | 20,005,060             |        | 18,583,425            |       | 17,839,719             |       |
| Accumulated other comprehensive loss                                                                                                                                                               |       | (356,674               | )           | (345,305              | )          | (466,930               | )          |
| Total shareholders’ equity                                                                                                                                                                    |       | 54,001,861             |        | 52,578,050            |       | 51,326,461             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                    |       | $                      | 672,898,347 |                  | $          | 605,988,418            |       | $ | 571,385,488 |   |

 

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

 

2

----

 

**Beach First National Bancshares, Inc, and Subsidiaries**

**Consolidated Condensed Statements of Income**

(Unaudited)

 
| ** **                                                            | ** ** | **Nine Months Ended** | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **September 30,**          | ** ** | **September 30,**           | ** ** |
| ** **                                                            | ** ** | **2008**                        | ** ** | **2007**                         | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Interest  income**                                                  |       |                            |       |                             |       |   |   |   |   |
| Interest and fees on loans                                            |       | $                               | 28,972,905 |                             | $          | 30,594,681 |   | $ | 9,508,908 |   | $ | 10,570,132 |   |
| Investment securities                                                 |       | 2,757,353                       |       | 2,783,588                        |       | 851,011 |   | 934,016 |   |
| Fed funds sold and short term investments                             |       | 111,185                         |       | 289,167                          |       | 24,300 |   | 144,597 |   |
| Other                                                                 |       | 13,486                          |       | 17,905                           |       | 4,041 |   | 6,045 |   |
| Total interest income                                                 |       | 31,854,929                      |       | 33,685,341                       |       | 10,388,260 |   | 11,654,790 |   |
|                                                                  |       |                            |       |                             |       |   |   |   |   |
| **Interest  expense**                                                 |       |                            |       |                             |       |   |   |   |   |
| Deposits                                                              |       | 14,154,313                      |       | 13,980,166                       |       | 4,522,376 |   | 4,780,404 |   |
| Advances from the FHLB, federal funds  purchased and other borrowings |       | 2,215,458                       |       | 2,033,175                        |       | 735,416 |   | 844,873 |   |
| Junior subordinated debentures                                        |       | 446,256                         |       | 599,407                          |       | 134,530 |   | 202,424 |   |
| Total interest expense                                                |       | 16,816,027                      |       | 16,612,748                       |       | 5,392,322 |   | 5,827,701 |   |
| Net interest income                                                   |       | 15,038,902                      |       | 17,072,593                       |       | 4,995,938 |   | 5,827,089 |   |
|                                                                  |       |                            |       |                             |       |   |   |   |   |
| **Provision  for loan losses**                                        |       | 2,291,000                       |       | 950,800                          |       | 977,000 |   | 278,800 |   |
| Net interest income after provision for  possible loan losses         |       | 12,747,902                      |       | 16,121,793                       |       | 4,018,938 |   | 5,548,289 |   |
|                                                                  |       |                            |       |                             |       |   |   |   |   |
| **Noninterest  income**                                               |       |                            |       |                             |       |   |   |   |   |
| Service fees on deposit accounts                                      |       | 261,606                         |       | 426,979                          |       | 52,129 |   | 148,956 |   |
| Mortgage production related income                                    |       | 2,707,666                       |       | 4,207,879                        |       | 1,043,967 |   | 920,076 |   |
| Merchant income                                                       |       | 737,825                         |       | 517,111                          |       | 352,996 |   | 257,885 |   |
| Income from cash value life insurance                                 |       | 102,537                         |       | 114,150                          |       | 29,954 |   | 39,734 |   |
| Gain on sale of investment securities                                 |       | 21,034                          |       | —                           |       | 21,034 |   | — |   |
| Gain on sale of fixed assets                                          |       | 220                             |       | 5,499                            |       | — |   | 719 |   |
| Other income                                                          |       | 771,246                         |       | 1,019,837                        |       | 255,193 |   | 436,823 |   |
| Total noninterest income                                              |       | 4,602,134                       |       | 6,291,455                        |       | 1,755,273 |   | 1,804,193 |   |
|                                                                  |       |                            |       |                             |       |   |   |   |   |
| **Noninterest  expense**                                              |       |                            |       |                             |       |   |   |   |   |
| Salaries and wages                                                    |       | 5,665,648                       |       | 5,984,093                        |       | 1,991,960 |   | 1,636,798 |   |
| Employee benefits                                                     |       | 1,245,430                       |       | 1,230,203                        |       | 445,577 |   | 422,781 |   |
| Supplies and printing                                                 |       | 152,897                         |       | 150,074                          |       | 47,981 |   | 56,988 |   |
| Advertising and public relations                                      |       | 426,432                         |       | 495,967                          |       | 107,490 |   | 178,915 |   |
| Professional fees                                                     |       | 525,943                         |       | 455,203                          |       | 186,783 |   | 182,379 |   |
| Depreciation and amortization                                         |       | 842,634                         |       | 792,982                          |       | 292,428 |   | 270,021 |   |
| Occupancy                                                             |       | 1,190,710                       |       | 1,331,457                        |       | 384,468 |   | 465,912 |   |
| Data processing fees                                                  |       | 844,434                         |       | 528,118                          |       | 207,909 |   | 175,056 |   |
| Mortgage production related expenses                                  |       | 596,794                         |       | 1,016,369                        |       | 217,776 |   | 199,991 |   |
| Merchant Processing                                                   |       | 685,406                         |       | 489,920                          |       | 279,224 |   | 209,894 |   |
| Other operating expenses                                              |       | 2,960,699                       |       | 1,965,481                        |       | 1,299,078 |   | 722,341 |   |
| Total noninterest expenses                                            |       | 15,137,027                      |       | 14,439,867                       |       | 5,460,674 |   | 4,521,076 |   |
| Income before income taxes                                            |       | 2,213,009                       |       | 7,973,381                        |       | 313,537 |   | 2,831,406 |   |
| **Income  tax expense**                                               |       | 791,374                         |       | 2,840,459                        |       | 112,122 |   | 1,009,300 |   |
| Net income                                                            |       | $                               | 1,421,635  |                             | $          | 5,132,922 |   | $ | 201,415 |   | $ | 1,822,106 |   |
|                                                                  |       |                            |       |                             |       |   |   |   |   |
| **Basic  net income per common share**                                |       | $                               | 0.29       |                             | $          | 1.07 |   | $ | 0.04 |   | $ | 0.38 |   |
| **Diluted  net income per common share**                              |       | $                               | 0.29       |                             | $          | 1.04 |   | $ | 0.04 |   | $ | 0.37 |   |
| Weighted average common shares outstanding                            |       |                            |       |                             |       |   |   |   |   |
| Basic                                                                 |       | 4,845,018                       |       | 4,809,546                        |       | 4,845,018 |   | 4,840,145 |   |
| Diluted                                                               |       | 4,904,259                       |       | 4,942,553                        |       | 4,877,147 |   | 4,939,253 |   |

 

Theaccompanying notes are an integral part of these consolidated condensedfinancial statements.

 

3

----

 

**BeachFirst National Bancshares, Inc. and Subsidiaries**

**ConsolidatedCondensed Statements of Changes in Shareholders’ Equity and ComprehensiveIncome**

(Unaudited)

 
| ** **                                | ** ** | ** **            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                | ** ** | ** **            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                | ** ** | **Common stock** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**  | ** ** | **Earnings**      | ** ** | **Income  (Loss)**     | ** ** | **Equity** | ** ** |
|                                      |       |                  |       |        |       |         |       |              |       |                   |       |       |       |
| Balance, January 1, 2007             |       | 4,768,413             |       | $           | 4,768,413  |         | $          | 28,657,576        |       | $                      | 12,706,797 |       | $          | (673,205 | ) | $ | 45,459,581 |   |
| Net income                                |       | —                |       | —      |       | —       |       | 5,132,922         |       | —                 |       | 5,132,922  |       |
| Other comprehensive income, net of taxes: |       |                  |       |        |       |         |       |              |       |                   |       |       |       |
| Unrealized loss on investment securities  |       | —                |       | —      |       | —       |       | —            |       | 35,655                 |       | 35,655     |       |
| Unrealized gain on interest rate swap     |       | —                |       | —      |       | —       |       | —            |       | 170,620                |       | 170,620    |       |
| Comprehensive income                      |       | —                |       | —      |       | —       |       | —            |       | —                 |       | 5,339,197  |       |
| Stock based compensation expense          |       | —                |       | —      |       | 6,955        |       | —            |       | —                 |       | 6,955      |       |
| Exercise of stock options                 |       | 74,353                |       | 74,353      |       | 446,375      |       | —            |       | —                 |       | 520,728    |       |
| Balance, September 30, 2007          |       | 4,842,766             |       | $           | 4,842,766  |         | $          | 29,110,906        |       | $                      | 17,839,719 |       | $          | (466,930 | ) | $ | 51,326,461 |   |

 
| ** **                                | ** ** | ** **            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                | ** ** | ** **            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                | ** ** | **Common stock** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**  | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Equity** | ** ** |
|                                      |       |                  |       |        |       |         |       |              |       |                   |       |       |       |
| Balance, January 1, 2008             |       | 4,845,018             |       | $           | 4,845,018  |         | $          | 29,494,912        |       | $                      | 18,583,425 |       | $          | (345,305 | ) | $ | 52,578,050 |   |
| Net income                                |       | —                |       | —      |       | —       |       | 1,421,635         |       | —                 |       | 1,421,635  |       |
| Other comprehensive income, net of taxes: |       |                  |       |        |       |         |       |              |       | —                 |       | —     |       |
| Unrealized loss on investment securities  |       | —                |       | —      |       | —       |       | —            |       | 19,731                 |       | 19,731     |       |
| Unrealized loss on interest rate swap     |       | —                |       | —      |       | —       |       | —            |       | (31,100                | )          | (31,100    | )          |
| Comprehensive income                      |       | —                |       | —      |       | —       |       | —            |       | —                 |       | 1,410,266  |       |
| Stock based compensation expense          |       | —                |       | —      |       | 13,545       |       | —            |       | —                 |       | 13,545     |       |
| Exercise of stock options                 |       | —                |       | —      |       | —       |       | —            |       | —                 |       | —     |       |
| Balance, September 30, 2008          |       | 4,845,018             |       | $           | 4,845,018  |         | $          | 29,508,457        |       | $                      | 20,005,060 |       | $          | (356,674 | ) | $ | 54,001,861 |   |

 

Theaccompanying notes are an integral part of these consolidated condensedfinancial statements.

 

4

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**Beach First National Bancshares, Inc.and Subsidiaries**

**Consolidated Condensed Statementsof Cash Flows**

 
| ** **                                                 | ** ** | **Nine Months Ended** | ** ** | **For the Year  Ended** | ** ** |
|------------------------------------------------------------|------------|---------------------------------|------------|-----------------------------------|------------|
| ** **                                                 | ** ** | **September 30,**          | ** ** | **December 31,**             | ** ** |
| ** **                                                 | ** ** | **2008**                        | ** ** | **2007**                          | ** ** | **2007** | ** ** |
| ** **                                                 | ** ** | **(unaudited)**                 | ** ** | **(unaudited)**                   | ** ** | **(audited)** | ** ** |
| **Operating  activities**                                  |       |                            |       |                              |       |   |   |
| Net income                                                 |       | $                               | 1,421,635  |                              | $          | 5,132,922 |   | $ | 5,876,630 |   |
| Adjustments to reconcile net income to net                 |       |                            |       |                              |       |   |   |
| cash provided by (used in) operating  activities:          |       |                            |       |                              |       |   |   |
| Depreciation and amortization                              |       | 842,634                         |       | 792,982                           |       | 1,060,255 |   |
| Write-down on real estate acquired in  settlement of loans |       | 370,000                         |       | —                            |       | — |   |
| Proceeds from sale of mortgages held for  sale             |       | 95,481,358                      |       | 206,707,644                       |       | 231,970,200 |   |
| Disbursements for mortgages held for sale                  |       | (94,334,417                     | )          | (200,956,390                      | )          | (225,967,597 | ) |
| Discount accretion and premium amortization                |       | (210,306                        | )          | (103,077                          | )          | (153,431 | ) |
| Deferred income taxes                                      |       | —                          |       | (250,144                          | )          | (673,024 | ) |
| Provisions for loan losses                                 |       | 2,291,000                       |       | 950,800                           |       | 2,045,600 |   |
| Recourse reserve provision                                 |       | 10,000                          |       | —                            |       | 205,000 |   |
| Loss (gain) on sale of fixed assets                        |       | (220                            | )          | (5,499                            | )          | (6,324 | ) |
| (Gain) on sale of investment securities                    |       | (21,034                         | )          | —                            |       | (7,904 | ) |
| (Gain) on sale of other real estate owned                  |       | 39,439                          |       | —                            |       | (99,267 | ) |
| Stock based compensation expense                           |       | 13,545                          |       | 6,955                             |       | 7,643 |   |
| (Increase) decrease in other assets                        |       | (183,454                        | )          | (1,901,321                        | )          | (1,713,779 | ) |
| Increase (decrease) in other liabilities                   |       | (282,861                        | )          | 1,939,824                         |       | 1,994,064 |   |
| Net cash provided by (used in) operating  activities       |       | 5,437,319                       |       | 12,314,696                        |       | 14,538,066 |   |
| **Investing  activities**                                  |       |                            |       |                              |       |   |   |
| Proceeds from paydowns of investment  securities           |       | 5,817,012                       |       | 3,864,926                         |       | 4,988,852 |   |
| Proceeds from sale of investment securities                |       | 25,204,000                      |       | 1,000,000                         |       | 8,623,625 |   |
| Purchase of investment securities                          |       | (35,583,346                     | )          | (5,327,218                        | )          | (10,077,003 | ) |
| Purchase of FHLB stock                                     |       | (149,800                        | )          | (919,700                          | )          | (919,700 | ) |
| Purchase of Federal Reserve Stock                          |       | (30,000                         | )          | —                            |       | — |   |
| Increase in loans, net                                     |       | (56,472,657                     | )          | (66,715,900                       | )          | (107,223,880 | ) |
| Purchase of life insurance contracts                       |       | (86,678                         | )          | (97,915                           | )          | (130,221 | ) |
| Purchase of property and equipment                         |       | (1,004,947                      | )          | (1,907,827                        | )          | (2,462,068 | ) |
| Proceeds from sale of property and  equipment              |       | 220                             |       | 5,930                             |       | 6,324 |   |
| Proceeds from sale of other real estate  owned             |       | 2,081,208                       |       | —                            |       | 1,679,229 |   |
| Net cash used in investing activities                      |       | (60,224,988                     | )          | (70,097,704                       | )          | (105,514,842 | ) |
| **Financing  activities**                                  |       |                            |       |                              |       |   |   |
| Repayment of advances from Federal Home  Loan Bank         |       | —                          |       | —                            |       | (5,000,000 | ) |
| Advances from Federal Home Loan Bank                       |       | —                          |       | 17,500,000                        |       | 22,500,000 |   |
| Increase (decrease) in Federal funds  purchased            |       | (6,508,005                      | )          | 2,297,000                         |       | 11,382,100 |   |
| Net increase in deposits                                   |       | 72,509,951                      |       | 23,907,889                        |       | 47,841,216 |   |
| Proceeds from exercise of stock options                    |       | —                          |       | 520,728                           |       | 520,733 |   |
| Tax benefit of stock options                               |       | —                          |       | —                            |       | 385,565 |   |
| Repayments of other borrowings                             |       | (242,967                        | )          | (225,194                          | )          | (303,772 | ) |
| Net cash provided by financing activities                  |       | 65,758,979                      |       | 44,000,423                        |       | 77,325,842 |   |
|                                                       |       |                            |       |                              |       |   |   |
| Net increase (decrease) in cash and cash  equivalents      |       | 10,971,310                      |       | (13,782,585                       | )          | (13,650,934 | ) |
|                                                       |       |                            |       |                              |       |   |   |
| **Cash and  cash equivalents beginning of period**         |       | $                               | 5,558,678  |                              | $          | 19,209,612 |   | $ | 19,209,612 |   |
| **Cash and  cash equivalents end of period**               |       | $                               | 16,529,988 |                              | $          | 5,427,027 |   | $ | 5,558,678 |   |
| **Cash  paid for**                                         |       |                            |       |                              |       |   |   |
| Income taxes                                               |       | $                               | 1,631,780  |                              | $          | 3,195,252 |   | $ | 3,851,653 |   |
| Interest                                                   |       | $                               | 17,093,065 |                              | $          | 16,577,634 |   | $ | 22,042,809 |   |

 

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

 

5

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**Beach First National Bancshares, Inc.**

**Notes to Consolidated Condensed FinancialStatements (Unaudited)**

 

**1.****                   Basis ofPresentation**

 

Theaccompanying consolidated condensed financial statements for Beach FirstNational Bancshares, Inc. (“Company”) were prepared in accordance withinstructions for Form 10-Q and, therefore, do not include all disclosuresnecessary for a complete presentation of financial condition, results ofoperations, and cash flows in conformity with generally accepted accountingprinciples.  All adjustments, consistingonly of normal recurring accruals, which are, in the opinion of management,necessary for fair presentation of the interim consolidated financialstatements have been included.  Theresults of operations for the nine month period ended September 30, 2008are not necessarily indicative of the results that may be expected for theentire year.  These consolidatedfinancial statements do not include all disclosures required by generallyaccepted accounting principles and should be read in conjunction with the Company’saudited consolidated financial statements and related notes for the year ended December 31,2007.

 

Certain previously reported amounts have been reclassified to conformto the current year’s presentations. Such changes had no effect on previously reported net income orshareholders’ equity.

 

**2.****                   Principlesof Consolidation**

 

The accompanying consolidated condensedfinancial statements include the accounts of the Company and its subsidiaries,Beach First National Bank and BFNM Building, LLC (“LLC”) (See No. 4  “Investment in LLC” below).  The Company also owns two grantor trusts,Beach First National Trust and Beach First National Trust II.  All significant inter-company items andtransactions have been eliminated in consolidation.  In accordance with current accountingguidance, the financial statements of the trusts have not been included in theCompany’s financial statements.

 

**3.****              Earnings PerShare**

 

The Companycalculates earnings per share in accordance with Statement of FinancialAccounting Standard No. 128, “Earnings per Share” (“SFAS 128”).  SFAS 128 specifies the computation,presentation, and disclosure requirements for earnings per share (EPS) forentities with publicly held common stock or potential common stock such asoptions, warrants, convertible securities, or contingent stock agreements ifthose securities trade in a public market.

 

This standard specifies computation andpresentation requirements for both basic EPS and, for entities with complexcapital structures, diluted EPS.  Basicearnings per share are computed by dividing net income by the weighted averagecommon shares outstanding.  Dilutedearnings per share is similar to the computation of basic earnings per shareexcept that the denominator is increased to include the number of additionalcommon shares that would have been outstanding if the dilutive potential commonshares had been issued.  The dilutiveeffect of options outstanding under the Company’s stock option plan isreflected in diluted earnings per share by application of the treasury stockmethod.

 

**RECONCILIATION OF THE NUMERATORS AND DENOMINATORS OF THE BASIC ANDDILUTED EPS COMPUTATIONS:**

 
| ** **                                                   | ** ** | **For the Nine Months Ended** | ** **    | **For the Year Ended** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------------|---------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**                            | ** **    | **December 31,**                 | ** ** |
| ** **                                                   | ** ** | **2008**                                          | ** **    | **2007**                              | ** ** | **2007** | ** ** |
| **Basic earnings per share:**                                |       |                                              |          |                                  |       |   |   |
| Net income available to common shareholders                  | ** ** | **$**                                             | **1,421,635** | ** **                            | **$**      | **5,132,922** | ** ** | **$** | **5,876,630** | ** ** |
| Average common shares outstanding – basic               |       | 4,845,018                                         |          | 4,809,546                             |       | 4,817,911 |   |
| Basic earnings per share                                     | ** ** | **$**                                             | **0.29**      | ** **                            | **$**      | **1.07** | ** ** | **$** | **1.22** | ** ** |
| **Diluted earnings per share:**                              |       |                                              |          |                                  |       |   |   |
| Net income available to common shareholders                  | ** ** | **$**                                             | **1,421,635** | ** **                            | **$**      | **5,132,922** | ** ** | **$** | **5,876,630** | ** ** |
| Average common shares outstanding – basic               |       | 4,845,018                                         |          | 4,809,546                             |       | 4,817,911 |   |
| Incremental shares from assumed conversion of  stock options |       | 59,241                                            |          | 133,007                               |       | 159,156 |   |
| Average common shares outstanding – diluted             |       | 4,904,259                                         |          | 4,942,553                             |       | 4,977,067 |   |
| Diluted earnings per share                                   | ** ** | **$**                                             | **0.29**      | ** **                            | **$**      | **1.04** | ** ** | **$** | **1.18** | ** ** |

 

6

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**4.  Investmentin LLC**

 

The LLC is a partnership with our legalcounsel, Nelson Mullins Riley & Scarborough LLP (NMRS), for purposesof acquiring a parcel of land and constructing an office building on theproperty.  The Company owns two-thirds ofthe LLC and NMRS owns the remaining one-third. The building is a three-story, 46,066 square foot office buildinglocated on 3.5 acres at the southwest corner of Robert M. Grissom Parkway and38th Avenue North in Myrtle Beach, South Carolina.  The Company leases two-thirds of the building(approximately 30,000 square feet) from the LLC.  Because the Company occupies approximately12,500 square feet of space, it intends to lease the other 17,500 square feetof its portion to outside tenants.  NMRSalso leases one-third of the building from the LLC.  As of September 30, 2008, 4,700 squarefeet is available for lease.

 

Uponcompletion of construction, the construction financing note from thethird-party lender was converted to a term loan payable by the LLC to thethird-party bank and is secured by the building. The loan requires 107installments of principal and interest based on a fifteen year amortization,with all remaining principal and interest due on June 15, 2015. Theinterest rate is variable based on one-month LIBOR plus 1.40%. The outstandingbalance on the loan at September 30, 2008 is $6,663,081 and is shown asother borrowings in the accompanying balance sheet.

 

**5.** **Derivative Financial Instruments – Interest RateSWAP**

 

The Company has two types of derivative instruments. One is an interestrate swap on the LLC building loan, which is discussed below, and the other iscreated as part of residential mortgage lending activities when the Companyenters into a rate-locked loan commitment with a prospective borrower and, atthe same time, arranges to sell the loan to an investor. The Company has determinedthat this latter derivative activity is not material.

 

In June 2005, the LLC obtained a $7,235,000 loan from a bank forthe construction of the building that serves as the Company’s corporate office.The interest on this loan floats based on LIBOR plus 1.40%. At the same time,the LLC entered into an interest rate swap agreement in the same notionalamount as a risk management tool to lock the interest cash outflows on thefloating-rate debt. Under the terms of the swap (which expires upon maturity ofthe building loan in June 15, 2015), the Company pays monthly a fixedinterest rate of 4.62% and receives interest payments equal to LIBOR. As thereare no differences between the critical terms of the interest rate swap and thehedged debt obligation, the Company assumes no ineffectiveness in the hedgingrelationship.

 

The estimated fair value of this agreement at September 30, 2008was a liability of approximately $190,904, which is included in the Company’sbalance sheet. Changes in the fair value are recorded as a separate componentin other comprehensive income.   Thefixed rate of 4.62% paid under the swap agreement, when added to the loan’smargin above LIBOR of 1.40%, converts the building loan’s interest (and cashflows) from a variable rate to a fixed rate of 6.02%, resulting in interestexpense of $311,982 and $243,002 for the nine months ended September 30,2008 and 2007, respectively.

 

The Company formally documents all relationships between hedginginstruments and hedged items, as well as its risk-management objective andstrategy for undertaking various hedged transactions. This process includeslinking all derivatives that are designated as fair value or cash flow hedgesto specific assets and liabilities on the balance sheet or to specific firmcommitments or forecasted transactions. The Company also formally assesses,both at the hedge’s inception and on an ongoing basis, whether the derivativesthat are used in hedging transactions are highly effective in offsettingchanges in fair values or cash flows of hedged items. When it is determinedthat a derivative is not highly effective as a hedge or that it has ceased tobe a highly effective hedge, the Company discontinues hedge accountingprospectively, as discussed below.

 

The Company discontinues hedge accounting prospectively when (1) itis determined that the derivative is no longer effective in offsetting changesin cash flows of a hedged item (including forecasted transactions); (2) thederivative expires or is sold, terminated, or exercised; (3) thederivative is no longer designated as a hedge instrument because is it unlikelythat a forecasted transaction will occur; or (4) management determinesthat designation of the derivative as a hedge instrument is no longerappropriate.

 

When hedge accounting is discontinued because it is probable that aforecasted transaction will not occur, the derivative will continue to becarried on the balance sheet at its fair value, and gains and losses that wereaccumulated in other comprehensive income will be recognized immediately inearnings. In all other situations in which hedge accounting

 

7

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is discontinued, the derivative will be carried at its fair value onthe balance sheet, with subsequent changes in its fair value recognized incurrent earnings.

 

8

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**6.** **Fair Value Measurements**

 

Effective January 1, 2008, the Company adopted SFAS No. 157,“Fair Value Measurements” (“SFAS 157”) which provides a framework for measuringand disclosing fair value under generally accepted accounting principles. SFAS157 requires disclosures about the fair value of assets and liabilitiesrecognized in the balance sheet in periods subsequent to initial recognition,whether the measurements are made on a recurring basis (for example,available-for-sale investment securities) or on a nonrecurring basis (forexample, impaired loans).

 

SFAS 157 defines fair value as the exchange price that would bereceived for an asset or paid to transfer a liability (an exit price) in theprincipal or most advantageous market for the asset or liability in an orderlytransaction between market participants on the measurement date. SFAS 157 alsoestablishes a fair value hierarchy which requires an entity to maximize the useof observable inputs and minimize the use of unobservable inputs when measuringfair value. The standard describes three levels of inputs that may be used tomeasure fair value:

 

**Level 1:**Quoted prices in active markets foridentical assets or liabilities. Level 1 assets and liabilities include debtand equity securities and derivative contracts that are traded in an activeexchange market, as well as U.S. Treasury Securities.

 

**Level 2:**Observable inputs other than Level 1prices such as quoted prices for similar assets or liabilities; quoted pricesin markets that are not active; or other inputs that are observable or can becorroborated by observable market data. Level 2 assets and liabilities includedebt securities with quoted prices that are traded less frequently thanexchange-traded instruments, mortgage-backed securities, municipal bonds,corporate debt securities and derivative contracts whose value is determinedusing a pricing model with inputs that are observable in the market or can bederived principally from or corroborated by observable market data.  This category generally includes certainderivative contracts and impaired loans.

 

**Level 3:**Unobservable inputs that aresupported by little or no market activity and that are significant to the fairvalue of the assets or liabilities. Level 3 assets and liabilities includefinancial instruments whose value is determined using pricing models,discounted cash flow methodologies, or similar techniques, as well as instrumentsfor which the determination of fair value requires significant managementjudgment or estimation. For example, this category generally includes certainprivate equity investments, retained residual interests in securitizations,residential mortgage servicing rights, and highly-structured or long-termderivative contracts.

 

Assets and liabilities measured at fair value on a recurring basis areas follows as of September 30, 2008:

 
| ** **                               | ** ** | **Quoted Market  Price in Active  Markets** | ** ** | **Significant Other  Observable  Inputs** | ** ** | **Significant  Unobservable  Inputs** | ** ** |
|------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **(Level 1)**                                         | ** ** | **(Level 2)**                             | ** ** | **(Level 3)**                    | ** ** |
| Available-for-sale investment securities |       | —                                                     |       | $                                              | 70,501,563 |                                  | —     |   |
|                                     |       |                                                       |       |                                           |       |                                  |       |
| Mortgage loans held for sale             |       | —                                                     |       | $                                              | 5,328,679  |                                  | —     |   |
|                                     |       |                                                       |       |                                           |       |                                  |       |
| Interest rate swap agreement (liability) |       | —                                                     |       | (190,904                                       | )          | —                                |       |
| Total                                    |       | $                                                          | —     |                                           | $          | 75,639,338                            |       | $ | — |   |
|                                          |            |                                                            |            |                                                |            |                                       |            |  |  |  |

 

The Company is predominantly an asset based lender with real estateserving as collateral on a substantial majority of loans. Loans which aredeemed to be impaired are primarily valued at the fair values of the underlyingreal estate collateral. Such fair values are obtained using independentappraisals on a nonrecurring basis, which the Company considers to be level 2inputs. The aggregate carrying amount of impaired loans at September 30,2008 was $17,887,473.  The Company has noassets or liabilities whose fair values are measured using level 3 inputs.   The company has no assets or liabilitieswhose fair values we measured using level 3 inputs.

 

FASB Staff Position No. FAS 157-2 delays the implementation ofSFAS 157 until the first quarter of 2009 with respect to goodwill, otherintangible assets, real estate and other assets acquired through foreclosureand other non-financial assets measured at fair value on a nonrecurring basis.

 

9

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

Thefollowing is our discussion and analysis of certain significant factors thathave affected our financial position and operating results and those of our subsidiary,Beach First National Bank, during the periods included in the accompanyingfinancial statements.  This commentaryshould be read in conjunction with the financial statements and the relatednotes and the other statistical information included in this report.

 

Thisreport contains “forward-looking statements” relating to, without limitation,future economic performance, plans and objectives of management for futureoperations, and projections of revenues and other financial items that arebased on the beliefs of management, as well as assumptions made by andinformation currently available to management. The words “may,” “will,” “anticipate,” “should,” “would,” “believe,”“contemplate,” “expect,” “estimate,” “continue,” and “intend,” as well as othersimilar words and expressions of the future, are intended to identifyforward-looking statements.  Our actualresults may differ materially from the results discussed in the forward-lookingstatements, and our operating performance each quarter is subject to variousrisks and uncertainties that are discussed in detail in our filings with theSecurities and Exchange Commission (the “SEC”), including, without limitation:

 

·                  significantincreases in competitive pressure in the banking and financial servicesindustries;

·                  changes in the interest rateenvironment which could reduce anticipated or actual margins;

·                  changes inpolitical conditions or the legislative or regulatory environment;

·                  general economicconditions, either nationally or regionally and especially in our primaryservice area, continuing to be weak resulting in, among other things, adeterioration in credit quality;

·                  changesoccurring in business conditions and inflation;

·                  changes inmanagement;

·                  changes intechnology;

·                  changes indeposit flows;

·                  the level ofallowance for loan loss;

·                  the rate ofdelinquencies and amounts of charge-offs;

·                  the rates ofloan growth;

·                  adverse changesin asset quality and resulting credit risk-related losses and expenses;

·                  slower growth, adecrease in reliance upon brokered deposits, increased capital requirements, andother changes in our business that may be required or necessary in order for usto comply with the agreement we have with the OCC;

·                  higher thananticipated levels of defaults on loans;

·                  the amount ofour real estate-based loans and the weakness in the commercial real estatemarket:

·                  misperceptionsby depositors about the safety of their deposits;

·                  changes inmonetary and tax policies;

·                  loss of consumerconfidence and economic disruptions resulting from terrorist activities;

·                  changes in thesecurities markets;

·                  other risks anduncertainties detailed from time to time in our filings with the SEC; and

·                  naturaldisasters, such as a hurricane or flooding in our primary service area.

 

These risks are exacerbated by the recent developments in national andinternational financial markets, and we are unable to predict what effect theseuncertain market conditions will have on our company.  During 2008, the capital and credit marketshave experienced extended volatility and disruption. In the last 90 days, thevolatility and disruption have reached unprecedented levels.  There can be no assurance that theseunprecedented recent developments will not materially and adversely affect ourbusiness, financial condition and results of operations.

 

**Critical Accounting Policies**

 

We have adopted various accounting policies that govern the applicationof accounting principles generally accepted in the United States and withgeneral practices within the banking industry in the preparation of ourconsolidated financial statements.  Oursignificant accounting policies are described in the footnotes to our auditedconsolidated financial statements as of December 31, 2007 as filed on ourForm 10-K.

 

Certain accounting policies involve significant judgments andassumptions by management which has a material impact on the carrying value ofcertain assets and liabilities.  Weconsider such accounting policies to be critical accounting policies.  The judgments and assumptions we use arebased on historical experience and other factors, which are believed to bereasonable under the circumstances. Because of the nature of the judgments and assumptions we

 

10

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make, actual results could differ from these judgments andestimates.  These differences could havea material impact on our carrying values of assets and liabilities and ourresults of operations.

 

We believe the allowance for loan losses is the critical accountingpolicy that requires the most significant judgment and estimates used inpreparation of our consolidated financial statements.  Some of the more critical judgmentssupporting the amount of our allowance for loan losses include judgments aboutthe credit worthiness of borrowers, the estimated value of the underlyingcollateral, the assumptions about cash flow, determination of loss factors forestimating credit losses, the impact of current events, and conditions, andother factors impacting the level of probable inherent losses.  Under different conditions or using differentassumptions, the actual amount of credit losses incurred by us may be differentfrom management’s estimates provided in our consolidated financialstatements.  Refer to the subsection entitled“Allowance for Loan Losses” below for a more complete discussion of ourprocesses and methodology for determining our allowance for loan losses.

 

**Overview**

 

The following discussion describes our results of operations for thequarter ended September 30, 2008 as compared to the quarter endedSeptember 30, 2007, as well as results for the nine months endedSeptember 30, 2008 and 2007, along with our financial condition as ofSeptember 30, 2008 as compared to December 31, 2007.  Like most community banks, we derive most ofour income from interest we receive on our portfolio loans andinvestments.  Our primary source of fundsfor making these loans and investments is our deposits, on which we payinterest.  Consequently, one of the keymeasures of our success is our amount of net interest income, or the differencebetween the income on our interest-earning assets, such as loans andinvestments, and the expense on our interest-bearing liabilities, such asdeposits.  Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

Of course, there are risks inherent in all loans, so we maintain anallowance for loan losses to absorb probable losses on existing loans that maybecome uncollectible.  We establish andmaintain this allowance by charging a provision for loan losses against ouroperating earnings.  In the followingsection, we have included a detailed discussion of this process.

 

In addition to earning interest on our loans and investments, we earnincome through fees and other expenses we charge to our customers.  We describe the various components of thisnoninterest income, as well as our noninterest expense, in the followingdiscussion.

 

In response to financial conditions affecting the banking system andfinancial markets and the potential threats to the solvency of investment banksand other financial institutions, the United States government has takenunprecedented actions.  OnOctober 3, 2008, President Bush signed into law the Emergency EconomicStabilization Act of 2008 (the “EESA”). Pursuant to the EESA, the U.S. Treasury will have the authority to,among other things, purchase mortgages, mortgage-backed securities, and otherfinancial instruments from financial institutions for the purpose ofstabilizing and providing liquidity to the U.S. financial markets. OnOctober 14, 2008, the U.S. Department of Treasury announced the CapitalPurchase Program under the EESA, pursuant to which the Treasury intends to makesenior preferred stock investments in participating financialinstitutions.  We are evaluating whetherto participate in the Capital Purchase Program. Governmental intervention and new regulations under these programs couldmaterially affect our business, financial condition, and results of operations.

 

The followingdiscussion and analysis also identifies significant factors that have affectedour financial position and operating results during the periods included in theaccompanying financial statements.  Weencourage you to read this discussion and analysis in conjunction with thefinancial statements and the related notes and the other statisticalinformation also included in this report.

** **

**Results ofOperations**

** **

***Earnings Review***

 

Our net income was $1,421,635 or $0.29 diluted net income per commonshare, for the nine months ended September 30, 2008 as compared to$5,132,922, or $1.04 diluted net income per common share, for the same periodin 2007.  Our net income was $201,415 or$0.04 per diluted common share, for the three months ended September 30,2008 as compared to net income of $1,822,106 or $0.37 per diluted common sharefor the same period in 2007.  Thedecrease in net income reflects the effect of the challenging financialenvironment that is facing all banks. The net interest margin declined to 3.21% at September 30, 2008,due in part to rate reductions since September 2007 of 3.25%

 

11

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in the prime lending rate. We expect continued pressure on the netinterest margin throughout 2008.  Thereturn on average assets for the nine month period ended September 30,2008 was 0.29% as compared to 1.24% for the same period in 2007.  The return on average equity was 3.56% forthe nine month period ended September 30, 2008 versus 14.34% for the sameperiod in 2007.

 

Over the past 27 months, real estate values have fallen and the rate ofdefault on mortgage loans has risen. There has been a resulting disruption in secondary markets formortgages, especially in non-conforming loan products.  The Federal Reserve Bank has reducedshort-term rates to stimulate the economy. As a result of pressures coming from oil, food and certain othersectors, the long end of the yield curve has not dropped as fast as the shortend, resulting in a steepening of the yield curve.  The Company has been affected by these eventsin areas such as mortgage banking; land acquisition, development andconstruction lending; and consumer lending. The Company has seen an increase in delinquencies and non-performingloans during 2007 and in 2008, and it continues to monitor its portfolio ofreal estate loans closely.  The reductionin short-term rates has adversely impacted the Company’s net interestmargin.  In the current economic, marketand credit environment, there can be no assurance that the Company’s portfoliowill continue to perform at current levels.

 

*Net Interest Income*

 

Our primary source of revenue is net interest income, which representsthe difference between the income on interest-earning assets and expense oninterest-bearing liabilities.  During thefirst nine months of 2008, net interest income decreased 11.91% to $15,038,902from $17,072,593 for the same period of 2007. For the three months endedSeptember 30, 2008, net interest income decreased 14.26% to $4,995,938from $5,827,089 during the comparable period of 2007.  The decline in net interest income for thefirst nine months of 2008 resulted from a decrease of $1,830,412 in interestincome and an increase in interest expense of $203,279.  Our level of net interest income isdetermined by the level of our earning assets and our net interest margin.  The impact on net interest income from thecontinued growth of our loan portfolio was offset by the decrease in the primelending rate which reduced our net interest margin.  Average total loans increased from $448.4million in the first nine months of 2007 to $546.5 million in the same periodin 2008.  Average total loans increased$87.8 million from $458.7 million for the year ended December 31, 2007 ascompared to $546.5 million for the nine months ended September 30,2008.  In addition, average securitiesdecreased to $73.2 million in the first nine months of 2008 compared to $73.8million for the first nine months of 2007, and decreased $0.2 million from$73.4 million for the year ended December 31, 2007.  Net interest spread, the difference betweenthe rate we earn on interest-earning assets and the rate we pay on interest-bearingliabilities, was 3.74% in the first nine months of 2007 compared to 2.79%during the same period of 2008, and 3.63% for the year ended December 31,2007.  The net interest margin was 3.21%for the nine month period ended September 30, 2008 compared to 4.31% forthe same period of 2007, and 4.20% for the year ended December 31,2007.  The decline in the net interestspread and the net interest margin can be attributed to the challengingfinancial environment facing banks including the reduction in the prime lendingrate and an increase in nonaccrual loans. Because we are asset-sensitive over a one year period, the rate cutsimmediately impact approximately 60% of our portfolio loans. Since our depositrates have not declined as quickly, this has put pressure on our net interestmargin.  We anticipate that some of thispressure may be eased as we are able to reprice our deposits to current marketrates.   However, there is risk we maynot be able to replace these deposits with lower rate deposits, or replacethese deposits at all, especially given our intent to reduce our reliance onbrokered deposits in the near future.

 

The following table sets forth, for the periods indicated, informationrelated to our average balance sheet and average yields on assets and averagerates paid on liabilities.  The yield orrates were derived by dividing annualized income or expense by the averagebalance of the corresponding assets or liabilities.  The average balances are calculated from thedaily balances from the periods indicated.

 

12

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| ** **                                                                 | ** ** | **Average  Balances, Income and Expenses, and Rates** | ** **  |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------|-------------|
| ** **                                                                 | ** ** | **For  the nine months ended September 30,**     | ** **  |
| ** **                                                                 | ** ** | **2008**                                              | ** **  | **2007** | ** ** |
| ** **                                                                 | ** ** | **Average**                                           | ** **  | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                                 | ** ** | **Balance**                                           | ** **  | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold, short term investments  and trust preferred securities |       | $                                                     | 5,671,960   |   | $ | 111,185 |   | 2.62 | % | $ | 7,431,080 |   | $ | 301,157 |   | 5.42 | % |
| Investment securities plus FHLB and FRB  Stock                             |       | 73,195,278                                            |        | 2,770,839 |   | 5.06 | % | 73,491,043 |   | 2,783,588 |   | 5.06 | % |
| Loans                                                                      |       | 546,539,465                                           |        | 28,972,905 |   | 7.08 | % | 448,406,531 |   | 30,594,681 |   | 9.12 | % |
| Total earning assets                                                       |       | $                                                     | 625,406,703 |   | $ | 31,854,929 |   | 6.80 | % | $ | 529,328,654 |   | $ | 33,679,426 |   | 8.51 | % |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Cash & Due from Banks                                             |       | 6,298,178                                             |        |   |   |   |   | 6,503,070 |   |   |   |   |   |
| Other Assets                                                               |       | 22,051,983                                            |        |   |   |   |   | 19,850,535 |   |   |   |   |   |
| Total Assets                                                               |       | $                                                     | 653,756,864 |   |   |   |   |   | $ | 555,682,259 |   |   |   |   |   |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing deposits                                            |       | $                                                     | 479,531,765 |   | $ | 14,154,314 |   | 3.94 | % | $ | 399,903,909 |   | $ | 13,980,166 |   | 4.67 | % |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Other borrowings                                                           |       | 80,672,564                                            |        | 2,661,713 |   | 4.41 | % | 66,053,022 |   | 2,672,793 |   | 5.41 | % |
| Total interest-bearing liabilities                                         |       | $                                                     | 560,204,329 |   | $ | 16,816,027 |   | 4.01 | % | $ | 465,956,931 |   | $ | 16,652,959 |   | 4.78 | % |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                                                            |       | 34,889,247                                            |        |   |   |   |   | 36,126,247 |   |   |   |   |   |
| Other Liabilities                                                          |       | 5,287,129                                             |        |   |   |   |   | 5,732,232 |   |   |   |   |   |
| Total Liabilities                                                          |       | $                                                     | 600,380,705 |   |   |   |   |   | $ | 507,815,410 |   |   |   |   |   |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Equity Capital                                                             |       | 53,376,159                                            |        |   |   |   |   | 47,866,849 |   |   |   |   |   |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Total Liabilities and Equity                                               |       | $                                                     | 653,756,864 |   |   |   |   |   | $ | 555,682,259 |   |   |   |   |   |
|                                                                       |       |                                                  |        |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                                                        |       |                                                  |        |   |   | 2.79 | % |   |   |   |   | 3.74 | % |
| Net interest income/margin                                                 |       |                                                  |        | $ | 15,038,902 |   | 3.21 | % |   |   | $ | 17,026,467 |   | 4.30 | % |

 

The following table sets forth the impact of the varying levels ofearning assets and interest-bearing liabilities and the applicable rates havehad on changes in net interest income for the periods presented.

 
| ** **                                                                    | ** ** | **Analysis  of Changes in Net Interest Income**   | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                    | ** ** | **For the  nine months ended September 30,** | ** ** |
| ** **                                                                    | ** ** | **2008 versus 2007**                    | ** ** |
| ** **                                                                    | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **Net change** | ** ** |
| Federal funds sold and short term  investments and trust preferred securities |       | $                                                 | (34,164    | ) | $ | (201,934 | ) | $ | (236,098 | ) |
| Investment securities                                                         |       | (8,633                                            | )          | (4,118 | ) | (12,751 | ) |
| Loans                                                                         |       | 5,230,349                                         |       | (6,852,127 | ) | (1,621,778 | ) |
| Total earning assets                                                          |       | 5,187,552                                         |       | (7,058,179 | ) | (1,870,627 | ) |
|                                                                          |       |                                              |       |   |   |   |   |
| Interest-bearing deposits                                                     |       | 2,363,243                                         |       | (2,189,096 | ) | 174,147 |   |
| Other borrowings                                                              |       | 378,517                                           |       | (389,597 | ) | (11,080 | ) |
| Total interest-bearing liabilities                                            |       | 2,741,760                                         |       | (2,578,693 | ) | 163,067 |   |
|                                                                          |       |                                              |       |   |   |   |   |
| Net interest income                                                           |       | $                                                 | 2,445,792  |   | $ | (4,479,486 | ) | $ | (2,033,694 | ) |

 

13

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*Provision for Loan Losses*

 

We haveestablished an allowance for loan losses through a provision for loan lossescharged as an expense on our statement of income.  We review our loan portfolio periodically toevaluate our outstanding loans and to measure both the performance of theportfolio and the adequacy of the allowance for loan losses.  The provision for loan losses was $2,291,000for the first nine months of 2008 as compared to $950,800 for the same periodof 2007.  The provision for loan losseswas $977,000 for the three months ended September 30, 2008 and $278,800for the same period in 2007.  Theincrease in the provision was the result of management’s assessment of theadequacy of the reserve for possible loan losses given the size, mix, andquality of the current loan portfolio, the increases in nonperforming loans,and the current economic environment.  Pleasesee the discussion below under “Allowance for Loan Losses” for a description ofthe factors we consider in determining the amount of the provision we expenseeach period to maintain this allowance.

 

*Noninterest Income*

 

Noninterest income decreasedto $4,602,134 for the nine months ended September 30, 2008, down 26.9%from $6,291,455 for the same period in 2007.  This decrease in noninterest income is primarily attributable to thedecrease in income from our mortgage operation, which fell from $4,207,879 forthe first nine months of 2007 to $2,707,666 for the first nine months of2008.  For the three months endedSeptember 30, 2008, noninterest income decreased to $1,755,273 as comparedto $1,804,193 in 2007.  The reduction innoninterest income from our mortgage operation is a reflection of the downturnin the economy in general and the real estate and mortgage markets inparticular.

 

*Noninterest Expense*

 

Total noninterest expense increased 4.83% to $15,137,027 for the ninemonth period ended September 30, 2008 from $14,439,867 for the same periodin 2007, and increased 20.8% to $5,460,674 for the three months endedSeptember 30, 2008 from $4,521,076 in the same period of 2007.  Salaries and wages and employee benefitsexpense decreased $303,218 to $6,911,078 during the nine month period endedSeptember 30, 2008 compared to the same period in 2007.  The reduction in salaries and benefitsrelates to the decline in mortgage production related income as well as reducedstaffing in the mortgage operation.

 

We had 156 and 163 full-time equivalent employees (“FTE”) atSeptember 30, 2008 and 2007, respectively. The mortgage operation FTE declined from 75 FTE to 58 FTE during thisperiod. Excluding our mortgage operation staff, FTE increased from 88 atSeptember 30, 2007 to 98 FTE at September 30, 2008.  Staffing increases were primarily due tooverall growth and the addition of our 73rd Avenue branch thatopened in the first quarter of 2008.

 

For the nine months ended September 30, 2008, advertising andpublic relations costs decreased $69,535 to $426,432 as compared to the sameperiod in 2007, and decreased $71,425 to $107,490 for the three months endedSeptember 30, 2008 compared to the same period in 2007.  Professional fees increased $70,740 to$525,943 for the nine month period ended September 30, 2008 compared tothe same period in 2007.  These feescontinue to increase due to our growth, the regulatory fees associated withsuch growth, and the escalating cost of accounting, auditing, and legalservices for a public company.

 

Occupancy expenses decreased $140,747 to $1,190,710 during the ninemonths ended September 30, 2008 compared to the same period in 2007, andby $81,444 for the three months ended September 30, 2008 compared to thesame period in 2007.

 

Data processing fees increased during the nine months endedSeptember 30, 2008 to $844,434 from $528,118 during the same period in2007.  For the three months endedSeptember 30, 2008, data processing costs totaled $207,909 compared to$175,056 for September 30, 2007. Data processing costs are primarily related to the volume of loan anddeposit accounts and transaction activity. During April 2008, we converted to a new core operating system. Theone time conversion cost of $225,760 was expensed in the second quarter of2008.

 

Other operating expenses increased 50.63% to $2,960,699 during the ninemonths ended September 30, 2008 compared to $1,965,481 during the sameperiod in 2007.  Other operating expensesincreased 79.8%, to $1,299,078 for the three months ended September 30,2008 compared to the same period in 2007. These increases are primarily the result of increased operating expensesrelated to the growth of the Company, including our new branch, along withother expenses associated with the expansion of loans and deposits.

 

The increase in other operating expenses was primarily due to increasesin FDIC fees, director and advisory fees, credit and collection expenses, otherreal estate owned write downs, and software maintenance.  Specifically,

 

14

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FDIC fees increased $151,101, director and board advisory feesincreased $149,176, credit and collections expense increased $224,094 and otherreal estate owned write downs increased $370,000 collectively totaling anincrease of $894,371.  The total increasein other operating expenses was $995,218 during the nine months endedSeptember 30, 2008 as compared to the same period in 2007.

 

The following table presents a comparison of other operating expenses:

** **
| ** **                                        | ** ** | **Other Operating Expenses**            | ** **    |
|---------------------------------------------------|------------|---------------------------------------------------|---------------|
| ** **                                        | ** ** | **For the nine months ended** | ** **    | **For the three months ended** | ** ** |
| ** **                                        | ** ** | **September 30,**                            | ** **    | **September 30,** | ** ** |
| ** **                                        | ** ** | **2008**                                          | ** **    | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| Telephone                                         |       | $                                                 | 128,058       |   | $ | 97,076 |   | $ | 39,629 |   | $ | 33,431 |   |
| Postage and freight                               |       | 92,543                                            |          | 73,728 |   | 31,516 |   | 26,410 |   |
| Armored Car                                       |       | 52,692                                            |          | 67,305 |   | 9,403 |   | 24,755 |   |
| Credit and collection-bank                        |       | 334,184                                           |          | 110,090 |   | 155,112 |   | 23,129 |   |
| Dues and subscriptions                            |       | 122,589                                           |          | 103,173 |   | 43,137 |   | 36,929 |   |
| Employee travel, conferences, meals, and  lodging |       | 141,247                                           |          | 217,622 |   | 51,603 |   | 88,218 |   |
| Business development and donations                |       | 277,100                                           |          | 226,511 |   | 90,239 |   | 38,558 |   |
| FDIC insurance                                    |       | 245,356                                           |          | 94,255 |   | 95,111 |   | 69,877 |   |
| Other insurance                                   |       | 40,596                                            |          | 57,801 |   | 15,176 |   | 12,570 |   |
| Debit/ATM                                         |       | 89,769                                            |          | 70,623 |   | 34,493 |   | 24,599 |   |
| Credit card processing fees                       |       | 43,802                                            |          | 33,720 |   | 16,241 |   | 12,968 |   |
| Federal Reserve charges                           |       | 30,967                                            |          | 32,531 |   | 10,420 |   | 11,850 |   |
| Software maintenance                              |       | 208,683                                           |          | 92,244 |   | 73,881 |   | 35,263 |   |
| Director and advisory board fees                  |       | 220,676                                           |          | 71,500 |   | 76,002 |   | 70,800 |   |
| NASDAQ                                            |       | 21,818                                            |          | 37,758 |   | 8,182 |   | 8,182 |   |
| Furniture and equipment                           |       | 240,936                                           |          | 226,972 |   | 98,335 |   | 64,973 |   |
| Other real estate owned write downs               |       | 370,000                                           |          | 0 |   | 370,000 |   | 0 |   |
| Other operating expenses                          |       | 299,683                                           |          | 352,572 |   | 80,598 |   | 139,829 |   |
| **Total**                                         | ** ** | **$**                                             | **2,960,699** | ** ** | **$** | **1,965,481** | ** ** | **$** | **1,299,078** | ** ** | **$** | **722,341** | ** ** |

 

**Balance Sheet Review**

 

*General*

 

We had total assets of $672.9 million at September 30, 2008, anincrease of 17.8% from $571.4 million at September 30, 2007, and anincrease of 11.0% from $606.0 million at December 31, 2007.  Total assets at September 30, 2008consisted primarily of $558.8 million in loans including mortgage loans heldfor sale, $70.5 million in investments, Fed Funds sold and other short terminvestments of $9.8 million, and $6.7 million in cash and due from banks.  Our liabilities at September 30, 2008totaled $618.9 million, consisting primarily of $536.7 million in deposits,$55.0 million in Federal Home Loan Bank (“FHLB”) advances, and $10.3 million ofjunior subordinated debentures.  Ourtotal deposits increased to $536.7 million at September 30, 2008, up 21.9%from $440.3 million at September 30, 2007, and up 15.6% from $464.2million at December 31, 2007. Shareholders’ equity increased $1.4 million to $54.0 million atSeptember 30, 2008 from $52.6 million at December 31, 2007, andincreased $2.7 million from $51.3 million at September 30, 2007.

 

**InvestmentSecurities**

** **

Total investment securitiesaveraged $68.4 million during the first nine months of 2008 and totaled $70.5million at September 30, 2008. Total investment securities averaged $69.5 million during the first ninemonths of 2007 and totaled $69.1 million at September 30, 2007.   Total investment securities averaged $69.0million for the year ended December 31, 2007 and totaled $65.7 million atDecember 31, 2007.  AtSeptember 30, 2008, our total investment securities portfolio had a bookvalue of $70.9 million and a fair market value of $70.5 million, for anunrealized net loss of $0.4 million.  Weprimarily invest in short term U.S. Government Sponsored Enterprises andFederal Agency securities.

 

15

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At September 30, 2008, federal funds sold and short-terminvestments totaled $9.8 million, compared to $735,387 at September 30,2007 and $566,404 at December 31, 2007. These funds are one source of our bank’s liquidity and are generallyinvested in an earning capacity on an overnight or short-term basis. Thisincrease in short-term investments is due to a larger growth in deposits thanin the portfolio loans and investments during the first nine months of 2008 andalso reflects our decision to increase liquidity in the third quarter of 2008because of the uncertainty in the financial market.

 

*Loans*

 

Since loans typically provide higher yields than other types of earningassets, a substantial percentage of our earning assets are invested in our loanportfolio.  As of September 30,2008, loans represented 87.4% of average earning assets as compared to 84.7% atSeptember 30, 2007, and 85.2% at December 31, 2007.  At September 30, 2008, net portfolioloans (portfolio loans less the allowance for loan losses and deferred loanfees) totaled $545.8 million, an increase of $86.8 million, or 18.9%, from September 30,2007 and an increase of $49.3 million, or 9.9% from December 31,2007.  Average gross loans increased to$546.5 million with a yield of 7.08% during the first nine months of 2008 from$448.4 million with a yield of 9.12% during the same period in 2007.  Average gross loans were $458.7 million witha yield of 8.95% for the year ended December 31, 2007.  The decrease in yield on loans during theseperiods is caused by the interest rate declines in 2007 and 2008.  The interest rates charged on loans vary withthe degree of risk, the maturity, the guarantees, and the collateral on eachloan.  Competitive pressures, moneymarket rates, availability of funds, and government regulations also influenceinterest rates.

 

                The followingtable shows the composition of the loan portfolio and mortgage loans held forsale by category at September 30, 2008, December 31, 2007, andSeptember 30, 2007.

 
| ** **                         | ** ** | **Composition of Loan Portfolio** | ** **  |
|------------------------------------|------------|--------------------------------------------------|-------------|
| ** **                         | ** ** | **September 30, 2008**                 | ** **  | **December 31, 2007** | ** ** | **September 30, 2007** | ** ** |
| ** **                         | ** ** | ** **                                       | ** **  | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** |
| ** **                         | ** ** | **Amount**                                       | ** **  | **of Total** | ** ** | **Amount** | ** ** | **of Total** | ** ** | **Amount** | ** ** | **of Total** | ** ** |
| Commercial                         |       | $                                                | 57,369,241  |   | 10.4 | % | $ | 60,376,105 |   | 12.0 | % | $ | 52,213,925 |   | 11.2 | % |
| Real estate – construction    |       | 48,597,643                                       |        | 8.8 | % | 63,988,173 |   | 12.7 | % | 51,724,912 |   | 11.1 | % |
| Real estate – mortgage        |       | 438,913,742                                      |        | 79.2 | % | 370,989,308 |   | 73.6 | % | 353,061,859 |   | 75.8 | % |
| Consumer                           |       | 8,956,047                                        |        | 1.6 | % | 8,504,685 |   | 1.7 | % | 8,768,942 |   | 1.9 | % |
| Portfolio loans, gross             |       | 553,836,673                                      |        | 100.0 | % | 503,858,271 |   | 100.0 | % | 465,769,638 |   | 100.0 | % |
| Unearned loan fees and costs, net  |       | (351,545                                         | )           |   |   | (425,755 | ) |   |   | (374,763 | ) |   |   |
| Allowance for possible loan losses |       | (7,663,434                                       | )           |   |   | (6,935,616 | ) |   |   | (6,397,012 | ) |   |   |
| Portfolio loans, net               |       | 545,821,694                                      |        |   |   | 496,496,900 |   |   |   | 458,997,863 |   |   |   |
| Mortgage loans held for sale       |       | 5,328,679                                        |        |   |   | 6,475,619 |   |   |   | 6,392,792 |   |   |   |
| Loans, net                         |       | $                                                | 551,150,373 |   |   |   | $ | 502,972,519 |   |   |   | $ | 465,390,655 |   |   |   |

 

The principal component of our portfolio loans at September 30,2008, December 31, 2007, and September 30, 2007, was mortgage loans,which represented 79.2%, 73.6%, and 75.8%, respectively.  In the context of this discussion, a “realestate mortgage loan” is defined as any loan, other than loans for constructionpurposes, secured by real estate, regardless of the purpose of the loan.  We follow the common practice of financialinstitutions in our market area of obtaining a security interest in real estatewhenever possible, in addition to any other available collateral.  The collateral is taken to reinforce thelikelihood of the ultimate repayment of the loan and tends to increase themagnitude of the real estate loan portfolio component.  Generally, we limit the loan-to-value ratioto 80%.  We attempt to maintain arelatively diversified loan portfolio to help reduce the risk inherent inconcentrations of collateral.  Loans heldfor sale are consumer real estate loans that are pending sale to investors.

 

**Allowancefor Loan Losses**

 

We haveestablished an allowance for loan losses through a provision for loan lossescharged to expense on our statement of income. The allowance for loan losses represents an amount which we believe willbe adequate to absorb probable losses on existing loans that may becomeuncollectible.  Our judgment as to theadequacy of the allowance for loan losses is based on a number of assumptionsabout future events, which we believe to be reasonable, but which may

 

16

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or may not prove to beaccurate.  The evaluation of theallowance is segregated into general allocations and specific allocations.  For general allocations, the portfolio issegregated into risk-similar segments for which historical loss ratios arecalculated and adjusted for identified trends or changes in current portfoliocharacteristics.  Historical loss ratiosare calculated by product type for consumer loans (installment and revolving),mortgage loans, and commercial loans and may be adjusted for other riskfactors. To allow for modeling error, a range of probable loss ratios is thenderived for each segment.  The resultingpercentages are then applied to the dollar amounts of the loans in each segmentto arrive at each segment’s range of probable loss levels.  Certain nonperforming loans are individuallyassessed for impairment under SFAS No. 114 and assigned specificallocations.  Other identified high-riskloans or credit relationships based on internal risk ratings are alsoindividually assessed and assigned specific allocations.  The provision for loan losses generally, andthe loans impaired under the criteria defined in FAS 114 specifically, reflectthe impact of the continued deterioration in the real estate market,specifically in our markets, and the economy in general.

 

The general allocation also includes a component for probable lossesinherent in the portfolio, based on management’s analysis that is not fullycaptured elsewhere in the allowance. This component serves to address the inherent estimation and imprecisionrisk in the methodology as well as address management’s evaluation of variousfactors or conditions not otherwise directly measured in the evaluation of thegeneral and specific allocations.  Suchfactors include the current general economic and business conditions;geographic, collateral, or other concentrations of credit; system, procedural,policy, or underwriting changes; experience of the lending staff; entry intonew markets or new product offerings; and results from internal and externalportfolio examinations.

 

Periodically, we adjust the amount of the allowance based on changingcircumstances.  We charge recognizedlosses to the allowance and add subsequent recoveries back to the allowance forloan losses.  There can be no assurancethat charge-offs of loans in future periods will not exceed the allowance forloan losses as estimated at any point in time or that provisions for loanlosses will not be significant to a particular accounting period.

 

The allocation of the allowance to the respective loan segments is anapproximation and not necessarily indicative of future losses or futureallocations.  The entire allowance isavailable to absorb losses occurring in the overall loan portfolio.  In addition, the allowance is subject toexamination and adequacy testing by regulatory agencies, which may considersuch factors as the methodology used to determine adequacy and the size of theallowance relative to that of peer institutions, and other adequacy tests.  Such regulatory agencies could require us toadjust the allowance based on information available to them at the time oftheir examination.

 

At September 30, 2008, the allowance for loan losses was $7.7million, or 1.37% of total outstanding loans, compared to an allowance for loanlosses of $6.4 million, or 1.36% of total outstanding loans, atSeptember 30, 2007, and $6.9 million, or 1.36% of total outstanding loans,at December 31, 2007.  During thefirst nine months of 2008, we had net charge-offs totaling $1,563,182. Duringthe same period in 2007, we had net charge-offs totaling $391,840.  We had non-performing loans totaling $17.9million, $549,714 and $2.9 million at September 30, 2008, September 30,2007, and December 31, 2007, respectively. This difficult economic environment has caused several of our customersto reach a point where payment sources have been exhausted.   While there can be no assurances, we do notexpect significant losses relating to these nonperforming loans because webelieve that the collateral supporting these loans is sufficient to cover theoutstanding loan balance.  Nevertheless, the downturn in the real estatemarket has resulted in an increase in loan delinquencies, defaults andforeclosures, and we believe these trends are likely to continue.  In some cases, this downturn has resulted ina significant impairment to the value of our collateral and our ability to sellthe collateral upon foreclosure, and there is a risk that this trend willcontinue.  The real estate collateral ineach case provides an alternate source of repayment in the event of default bythe borrower and may deteriorate in value during the time the credit isextended.  If real estate values continueto decline, it is also more likely that we would be required to increase ourallowance for loan losses.

 

The following table sets forth certain information with respect to ourallowance for loan losses and the composition of charge-offs and recoveries forthe nine months ended September 30, 2008, September 30, 2007, and thefull year ended December 31, 2007.

 

17

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| ** **                                           | ** ** | **Allowance for Loan Losses**    | ** **  |
|------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                           | ** ** | **Nine months  ended  September 30,** | ** **  | **Year ended  December 31,** | ** ** | **Nine months  ended  September 30,** | ** ** |
| ** **                                           | ** ** | **2008**                                        | ** **  | **2007** | ** ** | **2007** | ** ** |
|                                                 |       |                                            |        |   |   |   |   |
| Average total loans outstanding                      |       | $                                               | 546,539,465 |   | $ | 458,703,105 |   | $ | 448,406,531 |   |
| Total loans outstanding at period end                |       | 558,813,807                                     |        | 509,908,135 |   | 471,787,667 |   |
| Total nonperforming loans                            |       | 17,887,473                                      |        | 2,902,888 |   | 549,714 |   |
|                                                 |       |                                            |        |   |   |   |   |
| Beginning balance of allowance                       |       | 6,935,616                                       |        | 5,888,052 |   | 5,888,052 |   |
|                                                 |       |                                            |        |   |   |   |   |
| Loans charged off                                    |       | (1,582,032                                      | )           | (984,430 | ) | (410,175 | ) |
| Total recoveries                                     |       | 18,850                                          |        | 36,394 |   | 18,334 |   |
| Net loans charged off                                |       | (1,563,182                                      | )           | (948,036 | ) | (391,841 | ) |
| Transfer to mortgage recourse                        |       | —                                          |        | (50,000 | ) | (50,000 | ) |
| Provision for loan losses                            |       | 2,291,000                                       |        | 2,045,600 |   | 900,800 |   |
| Balance at period end                                |       | $                                               | 7,663,434   |   | $ | 6,935,616 |   | $ | 6,347,011 |   |
|                                                 |       |                                            |        |   |   |   |   |
| Net charge-offs to average total loans  (annualized) |       | 0.38                                            | %           | 0.21 | % | 0.12 | % |
| Allowance as a percent of total loans                |       | 1.37                                            | %           | 1.36 | % | 1.36 | % |
| Allowance as a percentage of nonperforming  loans    |       | 42.84                                           | %           | 238.90 | % | 1163.70 | % |

 

The followingtable sets forth the breakdown of the allowance for loan losses by loancategory and the percentage of loans in each category to gross loans as ofSeptember 30, 2008.  We believe thatthe allowance can be allocated by category only on an approximate basis.  The allocation of the allowance to eachcategory is not necessarily indicative of further losses and does not restrictthe use of the allowance to absorb losses in any category.

 

**Allocation of the Allowance for Loan Losses**

 
| ** **                      | ** ** | **As of September 30, 2008** | ** **  |
|---------------------------------|------------|--------------------------------------------------|-------------|
| Commercial                      |       | $                                                | 57,369,241  |   | 10.3 | % |
| Real estate – construction |       | 48,597,643                                       |        | 8.7 | % |
| Real estate – mortgage     |       | 444,242,421                                      |        | 79.4 | % |
| Consumer                        |       | 8,956,047                                        |        | 1.6 | % |
| Unallocated                     |       | —                                           |        | — |   |
| Total allowance for loan losses |       | $                                                | 559,165,352 |   | 100.0 | % |

 

*Nonperforming Assets/Other Real Estate Owned and Repossessed Assets*

 

We discontinueaccrual of interest on a loan when we conclude it is doubtful that we will beable to collect interest from the borrower. We reach this conclusion by taking into account factors such as theborrower’s financial condition, economic and business conditions, and theresults of our previous collection efforts. Generally, we will place a delinquent loan in nonaccrual status when theloan becomes 90 days or more past due. When we place a loan in nonaccrual status, we reverse all interest whichhas been accrued on the loan but remains unpaid and we deduct this interestfrom earnings as a reduction of reported interest income.  We do not accrue any additional interest onthe loan balance until we conclude the collection of both principal andinterest is reasonably certain.  AtSeptember 30, 2008, there were no loans accruing interest which were 90days or more past due and we had no restructured loans.

 

Impaired loanstotaled $21,501,308, $1,881,551 and $6,435,683 at September 30, 2008,September 30, 2007, and December 31, 2007 respectively, which had theeffect of reducing net income $1,316,565, $88,501, and $259,958 for the ninemonths ended September 30, 2008, September 30, 2007 and the yearended 2007.  Included in the allowancefor loan losses related to impaired loans at September 30, 2008,September 30, 2007, and December 31, 2007 was $3,273,459,   $778,701, and $1,378,306 respectively.  Impaired loans with a specific allocation ofthe allowance for loan losses totaled $12,073,909, $1,881,551 and $5,526,724 atSeptember 30, 2008, September 30, 2007, and December 31, 2007respectively.    The average recordedinvestment in total impaired loans for the nine months ended September 30,2008, September 30, 2007 and the year ended December 31, 2007 was $15,362,667,$1,961,531, and

 

18

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$3,080,069, respectively.  Interest income recognized on impaired loansfor the nine months ended September 30, 2008, September 30, 2007 andthe year ended December 31, 2007 was $668,045, $243,420, and $324,556,respectively.

 

Nonaccrualloans were $17,887,473, $549,714, and $2,902,888 as of September 30, 2008,September 30, 2007, and December 31, 2007, respectively.  As the economy continues to weaken, some ofour borrowers find that they do not have sufficient cash flow to make paymentson time, and we place their loans on nonaccrual status.  There are currently 32 borrowers that are onnonaccrual at September 30, 2008. Six of those borrowers amount to 62% of the total nonaccrual loans.

 

If the banktakes properties from a loan work-out, it places it in the other real estateowned asset account (“OREO”), if it is real estate, or in a repossessed assetaccount, if it is not real estate.  Theproperties that are received are recorded at the lower of cost or the currentvalue of the collateral.  Any write-downin value, before being placed into OREO or repossessed asset account, isincluded as a charge-off in the allowance for loan loss.  Any subsequent gain or loss, including expensesrelated to the sale, is recorded through the income statement.

 

AtSeptember 30, 2008 we had $2,265,215 in OREO, compared to $328,775 atSeptember 30, 2007, and $15,000 at December 31, 2007.  At September 30, 2008 we had $116,000 inrepossessed property compared to $0 at September 30, 2007 andDecember 31, 2007. As of September 30, 2008, there are six propertiesin OREO, one of which is under contract. The properties in OREO at September 30, 2008 include two parcels ofundeveloped land, two developed residential lots, one office building, and onerestaurant. During the third quarter of 2008, we wrote down the value of OREOby $370,000, based on a decline in value of the underlying properties.

 

**Deposits**

** **

Average totaldeposits were $514.4 million for the nine months ended September 30, 2008,up 17.9% from $436.0 million during the same period in 2007 and up 16.9% from$440.2 million at December 31, 2007. Average interest-bearing deposits were $479.5 million for nine monthsended September 30, 2008, up 19.9% from $399.9 million during the sameperiod of 2007 and up 18.7% from $404.1 million at December 31, 2007.

 

The followingtable sets forth our deposits by category as of September 30, 2008,September 30, 2007, and December 31, 2007.

 
| ** **                         | ** ** | **Deposits**                     | ** **  |
|------------------------------------|------------|----------------------------------|-------------|
| ** **                         | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** | **September 30, 2007** | ** ** |
| ** **                         | ** ** | **Amount**                       | ** **  | **Percent  of  Deposits** | ** ** | **Amount** | ** ** | **Percent  of  Deposits** | ** ** | **Amount** | ** ** | **Percent of  Deposits** | ** ** |
|                               |       |                             |        |   |   |   |   |   |   |   |   |   |   |
| Demand deposit accounts            |       | $                                | 33,358,001  |   | 6.2 | % | $ | 33,138,936 |   | 7.1 | % | $ | 40,317,614 |   | 9.2 | % |
| Interest bearing checking accounts |       | 21,826,376                       |        | 4.1 | % | 20,377,754 |   | 4.4 | % | 23,650,334 |   | 5.4 | % |
| Money market accounts              |       | 128,220,053                      |        | 23.9 | % | 103,821,154 |   | 22.4 | % | 107,480,890 |   | 24.4 | % |
| Savings accounts                   |       | 3,329,978                        |        | 0.6 | % | 2,988,881 |   | 0.6 | % | 3,265,956 |   | 0.7 | % |
| Time deposits less than $100,000   |       | 218,927,856                      |        | 40.8 | % | 161,038,254 |   | 34.7 | % | 150,064,341 |   | 34.1 | % |
| Time deposits of $100,000 or more  |       | 131,046,032                      |        | 24.4 | % | 142,833,366 |   | 30.8 | % | 115,485,883 |   | 26.2 | % |
| Total deposits                     |       | $                                | 536,708,296 |   | 100.0 | % | $ | 464,198,345 |   | 100.00 | % | $ | 440,265,018 |   | 100.00 | % |

 

Deposit growthwas attributable to a new deposit product that maximizes FDIC insurance(CDARS), brokered funds, internal growth, and the generation of new depositsdue primarily to special promotions and increased advertising.

 

Core deposits,which exclude certificates of deposit of $100,000 or more, provide a relativelystable funding source for our loan portfolio and other earning assets.  Our core deposits were $405.7 million atSeptember 30, 2008, compared to $324.8 million at September 30, 2007,and $321.4 million at December 31, 2007. Our brokered deposits were $91.7 million as of September 30, 2008,$37.1 million as of September 30, 2007, and $46.1 million as ofDecember 31, 2007. Our level of brokered deposits increased due to theimplementation of the CDARS program and to improve our net interestmargin.  We expect a stable base ofdeposits to be our primary source of funding to meet both our short-term andlong-term liquidity needs.  Core depositsas a percentage of total deposits were 75.6% at September 30, 2008, 73.8%at September 30, 2007, and 69.2% at December 31, 2007. Ourloan-to-deposit ratio was 104.1% at

 

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September 30, 2008 versus 107.2% atSeptember 30, 2007 and 109.8% at December 31, 2007.  The average loan-to-deposit ratio was 106.2%during the first nine months of 2008, 102.8% during the same period of 2007,and 104.2% at December 31, 2007.

 

Another aspectof EESA (in addition to the other components described above) which becameeffective on October 3, 2008 is a temporary increase of the basic limit onfederal deposit insurance coverage from $100,000 to $250,000 perdepositor.  The basic deposit insurancelimit will return to $100,000 after December 31, 2009.  At September 30, 2008 the Bank had timedeposits of $100,000 or more of $131.1 million. Approximately $82.9 million or 63% of these deposits would be coveredunder the new FDIC insurance coverage. An additional $32 million, or 24% of these deposits, are to local publicentities that are required to have securities as collateral.

 

In addition,our subsidiary Beach First National Bank anticipates participating in theFDIC’s Temporary Liquidity Guarantee Program which was announcedOctober 14, 2008 as part of EESA. This guarantee applies to the following transactions:

 

·Allnewly issued senior unsecured debt (up to $1.5 trillion) issued on or beforeJune 30, 2009, including promissory notes, commercial paper, inter-bankfunding, and any unsecured portion of secured debt. For eligible debt issued onor before June 30, 2009, coverage would only be provided for three yearsbeyond that date, even if the liability has not matured; and

 

·Fundsin non-interest-bearing transaction deposit accounts (up to $500 billion) heldby FDIC-insured banks until December 31, 2009.

 

All FDICinstitutions are covered until December 5, 2008 at no cost.  After this initial period expires, theinstitution must opt out if it no longer wishes to participate in the program;otherwise, it will be assessed for future participation. There will be a75-basis point fee to protect new debt issues and an additional 10-basis pointfee to fully cover non-interest bearing deposit transaction accounts.

 

The companywill see an increase in FDIC premiums in future periods based on the increasein insured deposits and proposed changes to FDIC premiums.

 

**Advances from Federal Home Loan Bank**

 

In addition to deposits, we obtained fundsfrom the FHLB to help fund our loan growth. Average borrowings from the FHLB were $55.0 million and $46.6 millionduring the third quarter of 2008 and 2007 respectively and $48.7 million forthe year ended December 31, 2007. The following table reflects the current borrowing terms.

 
| **FHLB Description**    | ** ** | **Balance** | ** ** | **Current  Rate** | ** ** | **Maturity  Date** | ** ** | **Option  Date** | ** ** |
|------------------------------|------------|-------------|------------|-------------------|------------|--------------------|------------|------------------|------------|
| **Fixed  rate advances:**    |       |        |       |              |       |               |       |             |       |
| Fixed rate                   |       | $           | 10,000,000 |              | 5.36       | %                  | 06/04/2010 |             | —     |   |
| Fixed Rate Hybrid            |       | 5,000,000   |       | 4.76              | %          | 10/21/2010         |       | —           |       |
| Convertible                  |       | 7,500,000   |       | 4.51              | %          | 11/23/2010         |       | 11/24/08         |       |
| Convertible                  |       | 5,000,000   |       | 3.68              | %          | 07/13/2015         |       | 10/14/08         |       |
| Convertible                  |       | 5,000,000   |       | 4.06              | %          | 09/29/2015         |       | 9/29/09          |       |
| Convertible                  |       | 5,000,000   |       | 4.16              | %          | 03/13/2017         |       | 3/13/09          |       |
| Convertible                  |       | 7,500,000   |       | 4.39              | %          | 04/13/2017         |       | 4/13/09          |       |
| **Variable  rate advances:** |       |        |       |              |       |               |       |             |       |
| Prime Based Advance          |       | 10,000,000  |       | 2.16              | %          | 09/19/2011         |       | —           |       |
|                         |       | $           | 55,000,000 |              |       |               |       |             |       |   |

 

**Junior Subordinated Debentures**

 

The averageand period end balances of the floating rate trust preferred securities throughBFNB Trust and BFNB Trust II (the “Trusts”) totaled $10.3 million for allperiods reported.  These trust preferredsecurities are reported on our consolidated balance sheet as juniorsubordinated debentures. The trust preferred securities accrue and paydistributions annually at a rate per annum equal to the six month LIBOR plus270 on $5.15 million and LIBOR plus 190 basis points on the remaining $5.15million, respectively, which was 5.50% and 4.72% at September 30,2008.  The

 

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distribution rate payable on these securitiesis cumulative and payable quarterly in arrears. The Company has the right, subject to events of default, to deferpayments of interest on the trust preferred securities for a period not toexceed 20 consecutive quarterly periods, provided that no extension period mayextend beyond the maturity dates of May 27, 2034 and March 30, 2035,respectively.  The Company has no currentintention to exercise its right to defer payments of interest on the trustpreferred securities.  The Company hasthe right to redeem the trust preferred securities, in whole or in part, on orafter May 27, 2009 and March 30, 2010, respectively.  The trust preferred securities can beredeemed prior to such dates upon occurrence of specified conditions and thepayment of a redemption premium.

 

**Capital Resources**

 

At both theholding company and bank level, we are subject to various regulatory capitalrequirements administered by the federal banking agencies.  To be considered “well-capitalized,”generally a bank must maintain total risk-based capital of at least 10%, Tier 1capital of at least 6%, and a leverage ratio of at least 5%.

 

AtSeptember 30, 2008, our total shareholders’ equity was $54.0 million($56.9 million at the bank level).  AtSeptember 30, 2008, our Tier 1 capital ratio was 12.16% (10.98% at thebank level), our total risk-based capital ratio was 13.41% (12.23% at the banklevel), and our Tier 1 leverage ratio was 9.63% (8.67% at the bank level).  At September 30, 2008 the bank wasconsidered “well capitalized”, per the OCC, and the holding company met orexceeded its applicable regulatory capital requirements.

 

**Liquidity Management**

 

Liquidityrepresents the ability of a company to convert assets into cash or cashequivalents without significant loss, and the ability to raise additional fundsby increasing liabilities.  Liquiditymanagement involves monitoring our sources and uses of funds in order to meetour day-to-day cash flow requirements while maximizing profits.  Liquidity management is made more complicatedbecause different balance sheet components are subject to varying degrees ofmanagement control.  For example, thetiming of maturities of our investment portfolio is fairly predictable andsubject to a high degree of control at the time investment decisions aremade.  However, net deposit inflows andoutflows are far less predictable and are not subject to the same degree ofcontrol.  As noted above, because of thecurrent uncertain economic conditions, we have increased our level ofliquidity.

 

Our primarysources of liquidity are deposits, scheduled repayments on our loans, andinterest on and maturities of our investments. We plan to meet our future cash needs through the liquidation oftemporary investments and the generation of deposits.  In addition, we are evaluating whether toparticipate in the Treasury’s capital purchase plan and exploring otheralternatives for raising additional capital. All of our securities have been classified as available for sale.  Occasionally, we might sell investmentsecurities in connection with the management of our interest sensitivity gap orto manage cash availability.  We may alsoutilize our cash and due from banks, security repurchase agreements, andfederal funds sold to meet liquidity requirements as needed.  In addition, we have the ability, on ashort-term basis, to purchase federal funds from other financialinstitutions.  Presently, we havearrangements with commercial banks for short-term unsecured advances of up to$31.8 million.  We maintain a securedline of credit in the amount of $10.0 million with our primarycorrespondent.  A $4.5 million unsecuredarrangement will expire on November 3, 2008 and we have added a $20million secured line with the Federal Reserve Bank of Richmond.  We also have a line of credit with the FHLBto borrow based on our 1 to 4 family loans and investment securities pledged,resulting in an availability of up to $65.0 million at September 30,2008.  The FHLB has approved borrowingsup to 15% of the bank’s total assets less advances outstanding.  The borrowings are available by pledgingadditional collateral and purchasing FHLB stock.  At September 30, 2008, we had borrowed$55.0 million on this line of credit.  Webelieve that our existing stable base of core deposits, our bond portfolio,borrowings from the FHLB, short-term federal funds lines, and the potential newcapital we may raise will enable us to successfully meet our liquidity.

 

**Interest Rate Sensitivity**

 

A significant portion of our assets and liabilities are monetary innature, and consequently they are very sensitive to changes in interestrates.  This interest rate risk is ourprimary market risk exposure, and it can have a significant effect on our netinterest income and cash flows.  Wereview our exposure to market risk on a regular basis, and we manage thepricing and maturity of our assets and liabilities to diminish the potentialadverse impact that changes in interest rates could have on our net interestincome.

 

We activelymonitor and manage our interest rate risk exposure principally by measuring ourinterest sensitivity “gap,” which is the positive or negative dollar differencebetween assets and liabilities that are subject to interest rate

 

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repricing within a given period of time.  A gap is considered positive when the amountof interest-rate sensitive assets exceeds the amount of interest-rate sensitiveliabilities, and it is considered negative when the amount of interest-ratesensitive liabilities exceeds the amount of interest-rate sensitiveassets.  We generally would benefit fromincreasing market interest rates when we have an asset-sensitive, or apositive, interest rate gap and we would generally benefit from decreasingmarket interest rates when we have liability-sensitive, or a negative, interestrate gap.  When measured on a “gap”basis, we are liability-sensitive over the cumulative one-year time frame andasset-sensitive after one year as of September 30, 2008.  However, our gap analysis is not a preciseindicator of our interest sensitivity position. The analysis presents only a static view of the timing of maturities andrepricing opportunities, without taking into consideration that changes ininterest rates do not affect all assets and liabilities equally.  For example, rates paid on a substantialportion of core deposits may change contractually within a relatively shorttime frame, but we believe those rates are significantly less interest-sensitivethan market-based rates such as those paid on noncore deposits.

 

Net interestincome is also affected by other significant factors, including changes in thevolume and mix of interest-earning assets and interest-bearingliabilities.  We perform asset/liabilitymodeling to assess the impact of varying interest rates and the impact thatbalance sheet mix assumptions will have on net interest income.  We attempt to manage interest ratesensitivity by repricing assets or liabilities, selling securities available-for-sale,replacing an asset or liability at maturity, or adjusting the interest rateduring the life of an asset or liability. Managing the amount of assets and liabilities that reprice in the sametime interval helps us to hedge risks and minimize the impact on net interestincome of rising or falling interest rates. We evaluate interest sensitivity risk and then formulate guidelinesregarding asset generation and repricing, funding sources and pricing, andoff-balance sheet commitments in order to decrease interest rate sensitivityrisk.

 

**Off Balance Sheet Risk**

 

Through theoperations of our bank, we have made contractual commitments to extend creditin the ordinary course of our business activities.  These commitments are legally bindingagreements to lend money to our customers at predetermined interest rates for aspecified period of time.  We evaluateeach customer’s credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemednecessary by us upon extension of credit, is based on our credit evaluation ofthe borrower.  Collateral varies but mayinclude accounts receivable, inventory, property, plant and equipment,commercial and residential real estate. We manage the credit risk on these commitments by subjecting them tonormal underwriting and risk management processes.

 

At September 30, 2008, the bank had issued unused commitments toextend credit of $43.6 million through various types of lendingarrangements.  Past experience indicatesthat many of these commitments to extend credit will expire unused.  We believe that we have adequate sources ofliquidity to fund commitments that are drawn upon by the borrowers.

 

In addition to commitments to extend credit, we also issue standbyletters of credit which are assurances to a third party that if our customer failsto meet its contractual obligation to the third party the bank will honor thosecommitments up to the letter of credit issued. Standby letters of credit totaled $8.8 million at September 30,2008.  Past experience indicates thatmany of these standby letters of credit will expire unused.  However, through our various sources ofliquidity, we believe that we will have the necessary resources to meet theseobligations should the need arise.

 

Except asdisclosed in this report, we are not involved in off-balance sheet contractualrelationships, unconsolidated related entities that have off-balance sheetarrangements or transactions that could result in liquidity needs or othercommitments or significantly impact earnings.

 

**Impact of Inflation**

 

Theeffect of relative purchasing power over time due to inflation has not beentaken into account in our consolidated financial statements.  Rather, our financial statements have beengenerally prepared on an historical cost basis in accordance with generallyaccepted accounting principles.

 

Unlike most industrial companies, our assets and liabilities areprimarily monetary in nature.  Therefore,the effect of changes in interest rates will have a more significant impact onour performance than will the effect of changing prices and inflation ingeneral.  In addition, interest rates maygenerally increase as the rate of inflation increases, although not necessarilyin the same magnitude.  As discussedpreviously, we seek to manage the relationships between interest sensitiveassets and liabilities in order to protect against wide rate fluctuations,including those resulting from inflation.

 

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**Recently Issued AccountingStandards**

 

The following is asummary of recent authoritative pronouncements that could impact theaccounting, reporting, and/or disclosure of financial information by us.

 

In December 2007,the FASB issued SFAS No. 141(R), “Business Combinations,” (“SFAS 141(R)”)which replaces SFAS 141. SFAS 141(R) establishes principles andrequirements for how an acquirer in a business combination recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any controlling interest; recognizes and measuresgoodwill acquired in the business combination or a gain from a bargainpurchase; and determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusiness combination. FAS 141(R) is effective for acquisitions by theCompany taking place on or after January 1, 2009. Early adoption isprohibited. Accordingly, a calendar year-end company is required to record anddisclose business combinations following existing accounting guidance until January 1,2009. The Company will assess the impact of SFAS 141(R) if and when afuture acquisition occurs.

 

In December 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements – an amendment of ARB No. 51” (“SFAS 160”). SFAS 160establishes new accounting and reporting standards for the noncontrollinginterest in a subsidiary and for the deconsolidation of a subsidiary. Beforethis statement, limited guidance existed for reporting noncontrolling interests(minority interest). As a result, diversity in practice exists. In some casesminority interest is reported as a liability and in others it is reported inthe mezzanine section between liabilities and equity. Specifically, SFAS 160requires the recognition of a noncontrolling interest (minority interest) asequity in the consolidated financials statements and separate from the parent’sequity. The amount of net income attributable to the noncontrolling interestwill be included in consolidated net income on the face of the incomestatement. SFAS 160 clarifies that changes in a parent’s ownership interest ina subsidiary that do not result in deconsolidation are equity transactions ifthe parent retains its controlling financial interest. In addition, thisstatement requires that a parent recognize gain or loss in net income when asubsidiary is deconsolidated. Such gain or loss will be measured using the fairvalue of the noncontrolling equity investment on the deconsolidation date. SFAS160 also includes expanded disclosure requirements regarding the interests ofthe parent and its noncontrolling interests. SFAS 160 is effective for theCompany on January 1, 2009.  Earlier adoption is prohibited. At this time, the Company believes thatupon adoption, SFAS 160 will not materially impact on its financial position,results of operations or cash flows.

 

In March 2008, theFASB issued SFAS No. 161, “Disclosures about Derivative Instruments andHedging Activities” (“SFAS 161”).  SFAS161 requires enhanced disclosures about an entity’s derivative and hedgingactivities and thereby improving the transparency of financial reporting.  It is intended to enhance the currentdisclosure framework in SFAS 133 by requiring that objectives for usingderivative instruments be disclosed in terms of underlying risk and accountingdesignation. This disclosure better conveys the purpose of derivative use interms of the risks that the entity is intending to manage. SFAS 161 iseffective for the Company on January 1, 2009. This pronouncement does notimpact accounting measurements but will result in additional disclosures if theCompany is involved in material derivative and hedging activities at that time.

 

In February 2008, the FASB issued FASB StaffPosition No. 140-3, “Accounting for Transfers of Financial Assets andRepurchase Financing Transactions” (“FSP 140-3”).  This FSP providesguidance on accounting for a transfer of a financial asset and the transferor’srepurchase financing of the asset.  This FSP presumes that an initialtransfer of a financial asset and a repurchase financing are considered part ofthe same arrangement (linked transaction) under SFAS No. 140. However, ifcertain criteria are met, the initial transfer and repurchase financing are notevaluated as a linked transaction and are evaluated separately under Statement140.  FSP 140-3 will be effective for financial statements issued forfiscal years beginning after November 15, 2008, and interim periods withinthose fiscal years and earlier application is not permitted. Accordingly, thisFSP is effective for the Company on January 1, 2009.  The Company iscurrently evaluating the impact, if any, the adoption of FSP 140-3 will have onits financial position, results of operations and cash flows.

 

InApril 2008, the FASB issued FASB Staff Position No. 142-3,“Determination of the Useful Life of Intangible Assets” (“FSP 142-3”).  This FSP amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets”.  The intent of this FSP is to improve theconsistency between the useful life of a recognized intangible asset under SFASNo. 142 and the period of expected cash flows used to measure the fairvalue of the asset under SFAS No. 141(R), “Business Combinations,”**andother U.S. generally accepted accounting principles.  This FSP is effective for financial statementsissued for fiscal years beginning after December 15, 2008, and interimperiods within those fiscal years and early adoption is prohibited.  Accordingly, this FSP is effective for theCompany on January 1, 2009.  TheCompany does not believe the adoption of FSP 142-3 will have a material impacton its financial position, results of operations, or cash flows.

 

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In May, 2008, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard (“SFAS”) No. 162, “The Hierarchy of Generally AcceptedAccounting Principles,” (“SFAS No. 162”). SFAS No. 162 identifies the sources of accounting principles andthe framework for selecting the principles used in the preparation of financialstatements of nongovernmental entities that are presented in conformity withgenerally accepted accounting principles (GAAP) in the United States (the GAAPhierarchy).  SFAS No. 162 will beeffective November 15, 2008.  TheFASB has stated that it does not expect SFAS No. 162 will result in achange in current practice. The application of SFAS No. 162 will have noeffect on the Company’s financial position, results of operations or cashflows.

 

FSP SFAS 133-1 and FIN45-4, “Disclosures about Credit Derivatives and Certain Guarantees: AnAmendment of FASB Statement No. 133 and FASB Interpretation No. 45;and Clarification of the Effective Date of FASB Statement No. 161,” (“FSPSFAS 133-1 and FIN 45-4”) was issued September 2008, effective for reportingperiods (annual or interim) ending after November 15, 2008.  FSP SFAS 133-1 and FIN 45-4 amends SFAS 133to require the seller of creditderivatives to disclose the nature of the credit derivative, the maximumpotential amount of future payments, fair value of the derivative, and thenature of any recourse provisions. Disclosures must be made for entire hybrid instruments that haveembedded credit derivatives.

 

Thestaff position also amends FIN 45 to require disclosure of the current statusof the payment/performance risk of the credit derivative guarantee.  If an entity utilizes internal groupings as abasis for the risk, how the groupings are determined must be disclosed as wellas how the risk is managed.  The staffposition encourages that the amendments be applied in periods earlier than theeffective date to facilitate comparisons at initial adoption.  After initial adoption, comparativedisclosures are required only for subsequent periods.

 

FSPSFAS 133-1 and FIN 45-4 clarifies the effective date of SFAS 161 such thatrequired disclosures should be provided for any reporting period (annual orquarterly interim) beginning after November 15, 2008.  The adoption of this Staff Position will have nomaterial effect on the Company’s financial position, results of operations orcash flows.

 

The SEC’s Office of theChief Accountant and the staff of the FASB issued press release 2008-234 on September 30,2008 (“Press Release”) to provide clarifications on fair value accounting.  The press release includes guidance on theuse of management’s internal assumptions and the use of “market” quotes.  It also reiterates the factors in SEC StaffAccounting Bulletin (“SAB”) Topic 5M which should be considered whendetermining other-than-temporary impairment: the length of time and extent towhich the market value has been less than cost; financial condition andnear-term prospects of the issuer; and the intent and ability of the holder toretain its investment for a period of time sufficient to allow for any anticipatedrecovery in market value.

 

On October 10, 2008,the FASB issued FSP SFAS 157-3, “Determining the Fair Value of a FinancialAsset When the Market for That Asset Is Not Active” (“FSP SFAS 157-3”). ThisFSP clarifies the application of SFAS No. 157, “Fair Value Measurements”(see Note 6) in a market that is not active and provides an example toillustrate key considerations in determining the fair value of a financialasset when the market for that asset is not active.  The FSP is effective upon issuance, includingprior periods for which financial statements have not been issued. For theCompany, this FSP is effective for the quarter ended September 30, 2008.

 

The Company consideredthe guidance in the Press Release and in FSP SFAS 157-3 when conducting its reviewfor other-than-temporary impairment as of September 30, 2008 anddetermined that it did not result in a change to its impairment estimationtechniques.

 

Other accountingstandards that have been issued or proposed by the FASB or other standards-settingbodies are not expected to have a material impact on the Company’s financialposition, results of operations or cash flows.

 

**Other Developments**

 

As previously disclosedin our SEC filings, Beach First National Bank, the bank subsidiary of theCompany, entered into an agreement with the OCC on September 30,2008.  We believe we have made progressin complying with all components and will be able to meet the timelines andrequirements of the agreement.

 

**Item 3.  Quantitative and Qualitative Disclosures aboutMarket Risk****.**

 

Market risk is the risk of loss fromadverse changes in market prices and rates. Our market risk arises principally from interest rate risk inherent inour lending, deposit, and borrowing activities. Management actively monitors and manages its interest rate riskexposure.  In addition to other risksthat we manage in the normal course of business, such as credit quality andliquidity, management considers interest rate risk to be a significant marketrisk that 

 

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couldpotentially have a material effect on our financial condition and results ofoperations.  The information contained inItem 2 in the section captioned “Interest Rate Sensitivity” is incorporatedherein by reference.  Other types ofmarket risks, such as foreign currency risk and commodity price risk, do notarise in the normal course of our business activities.

 

The primary objective of asset andliability management is to manage interest rate risk and achieve reasonable stabilityin net interest income throughout interest rate cycles.  This is achieved by maintaining the properbalance of rate-sensitive earning assets and rate-sensitive interest-bearingliabilities.  The relationship ofrate-sensitive earning assets to rate-sensitive interest-bearing liabilities isthe principal factor in projecting the effect that fluctuating interest rateswill have on future net interest income. Rate-sensitive assets and liabilities are those that can be repriced tocurrent market rates within a relatively short time period. Management monitorsthe rate sensitivity of earning assets and interest-bearing liabilities overthe entire life of these instruments, but places particular emphasis on thenext twelve months.  At September 30,2008, on a cumulative basis through 12 months, rate-sensitive liabilitiesexceeded rate-sensitive assets by $48.5 million.  This liability-sensitive position is largelyattributable to short-term certificates of deposit, money market accounts andinterest bearing checking accounts, which totaled $460.3 million at September 30,2008.

 

**Item 4. Controls and Procedures****.**

 

Asof the end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our currentdisclosure controls and procedures are effective as of September 30,2008.  There have been no significantchanges in our internal controls over financial reporting during the fiscalquarter ended September 30, 2008 that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

Thedesign of any system of controls and procedures is based in part upon certainassumptions about the likelihood of future events.  There can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

 

**PART II**

 

**OTHERINFORMATION**

 

**Item1.  Legal Proceedings.**

 

There are no material legal proceedingsto which the company or any of our subsidiaries is a party or of which any ofour property is the subject.

 

**Item 1A. Risk Factors.**

 

Other than as described elsewhere in thisForm 10-Q, there wereno material changes from the risk factors presented in our annualreport on Form 10-K for the year ended December 31, 2007.

 

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds.**

 

Not applicable.

 

**Item3.  Defaults Upon Senior Securities.**

 

Not applicable.

 

**Item4.   Submission of Matters to a Vote of Security Holders**

 

Notapplicable

 

**Item5.  Other Information.**

 

Notapplicable

 

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**Item6.  Exhibits.**

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                                                                        |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                   |
| 10.1        |       | Agreement by and  between Beach First National Bank and The Office of the Comptroller of the  Currency dated September 30, 2008 (incorporated by reference to  Exhibit 99.1 of the Company’s Form 8-K filed October 6, 2008). |
|        |       |                                                                                                                                                                                                                                                   |
| 31.1        |       | Rule 13a-14(a) Certification  of the Principal Executive Officer                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                                                   |
| 31.2        |       | Rule 13a-14(a) Certification of the  Principal Financial Officer                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                                                   |
| 32          |       | Section 1350  Certifications                                                                                                                                                                                                                      |

 

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SIGNATURES

 

In accordance withthe requirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|   | BEACH FIRST  NATIONAL BANCSHARES, INC. |
|--------|----------------------------------------|
|   |                                   |   |
|   |                                   |   |
| Date:  |  November 7, 2008            |   | By: |     /s/  Walter E. Standish, III |
|   |                                   |     Walter  E. Standish, III |
|   |                                   |     President  and Chief Executive Officer |
|   |                                   |
|   |                                   |
| Date:  |  November 7, 2008            |   | By: |     /s/  Gary S. Austin |
|   |                                   |     Gary  S. Austin |
|   |                                   |     Chief  Financial and Principal Accounting Officer |

 

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INDEX TO EXHIBITS

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                        |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                   |
| 10.1                |       | Agreement by and  between Beach First National Bank and The Office of the Comptroller of the  Currency dated September 30, 2008 (incorporated by reference to Exhibit 99.1  of the Company’s Form 8-K filed October 6, 2008). |
|                |       |                                                                                                                                                                                                                                                   |
| 31.1                |       | Rule 13a-14(a) Certification  of the Principal Executive Officer                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                   |
| 31.2                |       | Rule 13a-14(a) Certification of the  Principal Financial Officer                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                   |
| 32                  |       | Section 1350  Certifications                                                                                                                                                                                                                      |

 

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