**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **(MARK  ONE)**                                            |
|------------------------------------------------------------|
|                                                       |   |
| **x**                                                      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                       |   |
| **For the Quarterly Period ended September 30, 2009** |
| ** **                                                 |
| **OR**                                                     |
| ** **                                                 |
| **o**                                                      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For the Transition Period from                  to                  **

 

**Commission File No. ****000-51896**

 

**COMMUNITYSOUTH FINANCIAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

| **South  Carolina**          | ** ** | **20-0934786**      |
|------------------------------|------------|---------------------|
| (State or other jurisdiction |       | (I.R.S. Employer    |
| of incorporation)            |       | Identification No.) |

 

**6602 Calhoun Memorial Highway**

**Easley,South Carolina 29640**

(Address of principal executive offices)

 

**(864) 306-2540**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes  x   No  o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  o  Yes   o  No

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).

 

| Large accelerated filer o                                      |   | Accelerated filer o         |
|----------------------------------------------------------------|--------|-----------------------------|
|                                                           |   |                        |
| Non-accelerated o

(do not check if smaller reporting company) |   | Smaller reporting company x |

 

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

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: 

4,698,697 shares of commonstock, $0.01 par value pershare, were issued and outstanding as of October 22, 2009.

 

 

 

----

 

**CommunitySouth FinancialCorporation**

 

**Part I- Financial Information**

 

## **Item 1. FinancialStatements**.

## ** **

**CONSOLIDATED BALANCE SHEETS**

(dollars in thousands)

** **
| ** **                                                                                                                                                                                 | ** ** | **September 30, 2009** | ** **    | **December 31, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|---------------|----------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **(Unaudited)**             | ** **    | **(Audited)**              | ** ** |
| **Assets**                                                                                                                                                                                 |       |                        | ** **    | ** **                 | ** ** |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| Cash and cash  equivalents                                                                                                                                                                 |       |                        |          |                       |       |
| Cash and due from bank                                                                                                                                                                     |       | $                           |  6,618   |                       | $          |  5,251 |   |
| Federal funds sold                                                                                                                                                                         |       | 14,918                      |          | 4,625                      |       |
| Total cash and cash  equivalents                                                                                                                                                           |       | 21,536                      |          | 9,876                      |       |
| Investment securities,  available for sale                                                                                                                                                 |       | 113,964                     |          | 47,602                     |       |
| Other investments, at  cost                                                                                                                                                                |       | 1,599                       |          | 1,805                      |       |
| Loans, net                                                                                                                                                                                 |       | 282,634                     |          | 312,819                    |       |
| Accrued interest  receivable                                                                                                                                                               |       | 1,536                       |          | 1,628                      |       |
| Property and equipment,  net                                                                                                                                                               |       | 4,051                       |          | 4,618                      |       |
| Bank-owned life  insurance                                                                                                                                                                 |       | —                      |          | 5,437                      |       |
| Other real estate owned                                                                                                                                                                    |       | 7,011                       |          | 415                        |       |
| Repossessed collateral                                                                                                                                                                     |       | 1,407                       |          | —                     |       |
| Other assets                                                                                                                                                                               |       | 5,820                       |          | 3,616                      |       |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| Total assets                                                                                                                                                                               |       | $                           |  439,558 |                       | $          |  387,816 |   |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                              |       |                        |          |                       |       |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| **Liabilities**                                                                                                                                                                            |       |                        |          |                       |       |
| Deposits                                                                                                                                                                                   |       |                        |          |                       |       |
| Non-interest bearing                                                                                                                                                                       |       | $                           |  22,142  |                       | $          |  22,162 |   |
| Interest bearing                                                                                                                                                                           |       | 355,672                     |          | 274,481                    |       |
| Total deposits                                                                                                                                                                             |       | 377,814                     |          | 296,643                    |       |
| Repurchase agreements                                                                                                                                                                      |       | 30,000                      |          | 30,000                     |       |
| Federal Home Loan Bank  advances                                                                                                                                                           |       | —                      |          | 25,000                     |       |
| Note payable                                                                                                                                                                               |       | —                      |          | 1,570                      |       |
| Subordinated debt                                                                                                                                                                          |       | 4,325                       |          | 4,325                      |       |
| Accrued interest payable                                                                                                                                                                   |       | 1,450                       |          | 1,406                      |       |
| Accrued expenses                                                                                                                                                                           |       | 368                         |          | 193                        |       |
| Other liabilities                                                                                                                                                                          |       | 3                           |          | 151                        |       |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| Total liabilities                                                                                                                                                                          |       | 413,960                     |          | 359,288                    |       |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| **Shareholders’ Equity**                                                                                                                                                              |       |                        |          |                       |       |
| Preferred stock, par  value $.01 per share 10,000,000 shares authorized, no shares issued                                                                                                  |       | —                      |          | —                     |       |
| Common stock, par value  $.01 per share 10,000,000 shares authorized, 4,698,697 and 4,698,697 issued and  outstanding at September 30, 2009 and December 31, 2008,  respectively |       | 47                          |          | 47                         |       |
| Additional paid-in  capital                                                                                                                                                                |       | 29,812                      |          | 29,760                     |       |
| Accumulated other  comprehensive income                                                                                                                                                    |       | 484                         |          | 491                        |       |
| Retained earnings                                                                                                                                                                          |       | (4,745                      | )             | (1,770                     | )          |
| Total shareholders’  equity                                                                                                                                                           |       | 25,598                      |          | 28,528                     |       |
|                                                                                                                                                                                       |       |                        |          |                       |       |
| Total liabilities and  shareholders’ equity                                                                                                                                           |       | $                           |  439,558 |                       | $          |  387,816 |   |

 

2

----

 

**CONSOLIDATED STATEMENTS OF INCOME**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                  | ** ** | **Three months ended**      | ** **   | **Three months ended**      | ** ** |
|-------------------------------------------------------------|------------|-----------------------------|--------------|-----------------------------|------------|
| ** **                                                  | ** ** | **September 30, 2009** | ** **   | **September 30, 2008** | ** ** |
| **Interest income**                                         |       |                        |         |                        |       |
| Interest and fees on  loans                                 |       | $                           |  4,270  |                        | $          |  5,030 |   |
| Interest and dividends  on investments                      |       | 561                         |         | 604                         |       |
| Total interest income                                       |       | 4,831                       |         | 5,634                       |       |
|                                                        |       |                        |         |                        |       |
| **Interest expense – deposits and  other borrowings**  |       | 2,145                       |         | 2,995                       |       |
| ** **                                                  |       |                        |         |                        |       |
| Net interest income                                         |       | 2,686                       |         | 2,639                       |       |
|                                                        |       |                        |         |                        |       |
| **Provision for loan losses**                               |       | 3,500                       |         | 160                         |       |
| ** **                                                  |       |                        |         |                        |       |
| Net interest income  (loss) after provision for loan losses |       | (814                        | )            | 2,479                       |       |
|                                                        |       |                        |         |                        |       |
| **Non-interest income**                                     |       |                        |         |                        |       |
| Mortgage origination  fees                                  |       | 197                         |         | 96                          |       |
| Other                                                       |       | 213                         |         | 208                         |       |
| Total non-interest  income                                  |       | 410                         |         | 304                         |       |
|                                                        |       |                        |         |                        |       |
| **Non-interest expense**                                    |       |                        |         |                        |       |
| Salaries and benefits                                       |       | 1,344                       |         | 1,223                       |       |
| Data processing                                             |       | 225                         |         | 194                         |       |
| Occupancy                                                   |       | 170                         |         | 156                         |       |
| Depreciation                                                |       | 190                         |         | 178                         |       |
| Equipment maintenance  and rental                           |       | 55                          |         | 57                          |       |
| Advertising                                                 |       | 64                          |         | 107                         |       |
| Professional fees                                           |       | 73                          |         | 226                         |       |
| Office supplies                                             |       | 20                          |         | 26                          |       |
| Telephone                                                   |       | 35                          |         | 42                          |       |
| FDIC assessment                                             |       | 135                         |         | 56                          |       |
| Other                                                       |       | 514                         |         | 359                         |       |
| Total non-interest  expense                                 |       | 2,825                       |         | 2,624                       |       |
|                                                        |       |                        |         |                        |       |
| **Income (loss) before income  taxes**                      |       | (3,229                      | )            | 159                         |       |
|                                                        |       |                        |         |                        |       |
| **Income tax expense (benefit)**                            |       | (1,095                      | )            | 74                          |       |
| ** **                                                  |       |                        |         |                        |       |
| **Net income (loss)**                                       |       | $                           |  (2,134 | )                           | $          |  85 |   |
| ** **                                                  |       |                        |         |                        |       |
| **Earnings (losses) per share**                             |       |                        |         |                        |       |
| Basic                                                       |       | $                           |  (0.45  | )                           | $          |  0.02 |   |
| Diluted                                                     |       | $                           |  (0.45  | )                           | $          |  0.02 |   |
|                                                        |       |                        |         |                        |       |
| **Weighted average shares  outstanding**                    |       |                        |         |                        |       |
| Basic                                                       |       | 4,698,697                   |         | 4,698,697                   |       |
| Diluted                                                     |       | 4,698,697                   |         | 4,698,697                   |       |

 

3

----

 

**CONSOLIDATED STATEMENTS OF INCOME**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                 | ** ** | **Nine months ended**       | ** **   | **Nine months ended**       | ** ** |
|------------------------------------------------------------|------------|-----------------------------|--------------|-----------------------------|------------|
| ** **                                                 | ** ** | **September 30, 2009** | ** **   | **September 30, 2008** | ** ** |
| **Interest income**                                        |       |                        |         |                        |       |
| Interest and fees on  loans                                |       | $                           |  12,931 |                        | $          |  15,581 |   |
| Interest and dividends  on investments                     |       | 1,460                       |         | 2,007                       |       |
| Total interest income                                      |       | 14,391                      |         | 17,588                      |       |
|                                                       |       |                        |         |                        |       |
| **Interest expense – deposits and  other borrowings** |       | 6,176                       |         | 9,985                       |       |
| ** **                                                 |       |                        |         |                        |       |
| Net interest income                                        |       | 8,215                       |         | 7,603                       |       |
|                                                       |       |                        |         |                        |       |
| **Provision for loan losses**                              |       | 6,305                       |         | 2,864                       |       |
| ** **                                                 |       |                        |         |                        |       |
| Net interest income  after provision for loan losses       |       | 1,910                       |         | 4,739                       |       |
|                                                       |       |                        |         |                        |       |
| **Non-interest income**                                    |       |                        |         |                        |       |
| Mortgage origination  fees                                 |       | 502                         |         | 431                         |       |
| Other                                                      |       | 1,163                       |         | 590                         |       |
| Total non-interest  income                                 |       | 1,665                       |         | 1,021                       |       |
|                                                       |       |                        |         |                        |       |
| **Non-interest expense**                                   |       |                        |         |                        |       |
| Salaries and benefits                                      |       | 3,946                       |         | 3,686                       |       |
| Data processing                                            |       | 696                         |         | 561                         |       |
| Occupancy                                                  |       | 509                         |         | 476                         |       |
| Depreciation                                               |       | 552                         |         | 539                         |       |
| Equipment maintenance  and rental                          |       | 133                         |         | 143                         |       |
| Advertising                                                |       | 161                         |         | 146                         |       |
| Professional fees                                          |       | 239                         |         | 358                         |       |
| Office supplies                                            |       | 62                          |         | 73                          |       |
| Telephone                                                  |       | 110                         |         | 112                         |       |
| FDIC assessment                                            |       | 502                         |         | 163                         |       |
| Other                                                      |       | 1,168                       |         | 916                         |       |
| Total non-interest  expense                                |       | 8,078                       |         | 7,173                       |       |
|                                                       |       |                        |         |                        |       |
| **Loss before income taxes**                               |       | (4,503                      | )            | (1,413                      | )          |
|                                                       |       |                        |         |                        |       |
| **Income tax benefit**                                     |       | (1,528                      | )            | (449                        | )          |
| ** **                                                 |       |                        |         |                        |       |
| **Net loss**                                               |       | $                           |  (2,975 | )                           | $          |  (964 | ) |
| ** **                                                 |       |                        |         |                        |       |
| **Losses per share**                                       |       |                        |         |                        |       |
| Basic                                                      |       | $                           |  (0.63  | )                           | $          |  (0.21 | ) |
| Diluted                                                    |       | $                           |  (0.63  | )                           | $          |  (0.21 | ) |
|                                                       |       |                        |         |                        |       |
| **Weighted average shares  outstanding**                   |       |                        |         |                        |       |
| Basic                                                      |       | 4,698,697                   |         | 4,698,697                   |       |
| Diluted                                                    |       | 4,698,697                   |         | 4,698,697                   |       |

 

4

----

 

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

**For the six month periods ended September 30,2009 and September 30, 2008**

**(UNAUDITED)**

(dollars in thousands, except share amounts)

** **
| ** **                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total********Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** **                                                  | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income**   | ** ** | **Earnings**                        | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance  at December 31, 2008                          |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,760       |       | $                                   | 491        |                     | $          | (1,770 | ) | $ | 28,528 |   |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Net  loss                                                   |       | —           |       | —                  |       | —                                |       | —       |       | (2,975                              | )          | (2,975                   | )          | $ | (2,975 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Other  comprehensive income:                                |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Unrealized  gains (losses) on securities, net of income tax |       | —           |       | —                  |       | —                                |       | (7           | )          | —                              |       | (7                       | )          | (7 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Total  comprehensive income (loss)                          |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       | $ | (2,982 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Stock  option compensation                                  |       | —           |       | —                  |       | 52                                    |       | —       |       | —                              |       | 52                       |       |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Balance  at September 30, 2009                         |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,812       |       | $                                   | 484        |                     | $          | (4,745 | ) | $ | 25,598 |   |   |   |

 
| ** **                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total********Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** **                                                  | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income**   | ** ** | **Earnings**                        | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance  at December 31, 2007                          |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,691       |       | $                                   | 152        |                     | $          | 1,581 |   | $ | 31,471 |   |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Net  loss                                                   |       | —           |       | —                  |       | —                                |       | —       |       | (964                                | )          | (964                     | )          | $ | (964 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Other  comprehensive income:                                |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Unrealized  gains (losses) on securities, net of income tax |       | —           |       | —                  |       | —                                |       | (198         | )          | —                              |       | (198                     | )          | (198 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Total  comprehensive income(loss)                           |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       | $ | (1,162 | ) |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Stock  option compensation                                  |       | —           |       | —                  |       | 51                                    |       | —       |       | —                              |       | 51                       |       |   |   |
|                                                        |       |             |       |                    |       |                                  |       |         |       |                                |       |                     |       |   |   |
| Balance  at September 30, 2008                         |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,742       |       | $                                   | (46        | )                        | $          | 617 |   | $ | 30,360 |   |   |   |

 

5

----

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                                       | ** ** | **Nine months  ended** | ** ** | **Nine Months  ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                       | ** ** | **2009**               | ** ** | **2008**               | ** ** |
| **Operating activities**                                                         |       |                   |       |                   |       |
| Net  income loss                                                                 |       | $                      | (2,975     | )                      | $          | (964 | ) |
| Adjustments  to reconcile net loss to net cash provided by operating activities: |       |                   |       |                   |       |
| Provision  for loan losses                                                       |       | 6,305                  |       | 2,864                  |       |
| Stock  option compensation                                                       |       | 52                     |       | 51                     |       |
| Sale  (appreciation) of bank-owned life insurance                                |       | 5,437                  |       | (156                   | )          |
| Depreciation                                                                     |       | 552                    |       | 539                    |       |
| Deferred  income tax benefit                                                     |       | (1,948                 | )          | (827                   | )          |
| Decrease  in accrued interest receivable                                         |       | 92                     |       | 610                    |       |
| Increase  (decrease) in accrued interest payable                                 |       | 44                     |       | (1,804                 | )          |
| Increase  (decrease) in accrued expenses                                         |       | 175                    |       | (154                   | )          |
| Increase  in other assets                                                        |       | (264                   | )          | (58                    | )          |
| Increase  (decrease) in other liabilities                                        |       | (148                   | )          | 13                     |       |
| Loss  on sale of fixed assets                                                    |       | 1                      |       | —                 |       |
|                                                                             |       |                   |       |                   |       |
| Net  cash provided by operating activities                                       |       | 7,323                  |       | 114                    |       |
|                                                                             |       |                   |       |                   |       |
| **Investing activities**                                                         |       |                   |       |                   |       |
| Net  (increase) decrease in loans outstanding                                    |       | 15,877                 |       | (18,402                | )          |
| Purchases  of investment securities                                              |       | (66,362                | )          | (24,178                | )          |
| Maturities  of investment securities                                             |       | —                 |       | 4,880                  |       |
| Sale  (purchases) of FHLB stock                                                  |       | 206                    |       | (684                   | )          |
| Disposal  (purchase) of property and equipment                                   |       | 15                     |       | (202                   | )          |
|                                                                             |       |                   |       |                   |       |
| Net  cash used in investing activities                                           |       | (50,264                | )          | (38,586                | )          |
|                                                                             |       |                   |       |                   |       |
| **Financing activities**                                                         |       |                   |       |                   |       |
| Net  increase (decrease) in deposit accounts                                     |       | 81,171                 |       | (32,696                | )          |
| Advances  (repayments) from FHLB                                                 |       | (25,000                | )          | 10,000                 |       |
| Increase  in repurchase agreements                                               |       | —                 |       | 15,000                 |       |
| Increase  in line of credit                                                      |       | —                 |       | 1,570                  |       |
| Increase  in subordinated debt                                                   |       | —                 |       | 3,545                  |       |
| Increase  in federal funds purchased                                             |       | —                 |       | 9,491                  |       |
| Repayment  of note payable                                                       |       | (1,570                 | )          | —                 |       |
|                                                                             |       |                   |       |                   |       |
| Net  cash provided by financing activities                                       |       | 54,601                 |       | 6,910                  |       |
|                                                                             |       |                   |       |                   |       |
| Net  increase (decrease) in cash and cash equivalents                            |       | 11,660                 |       | (31,562                | )          |
|                                                                             |       |                   |       |                   |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                              |       | 9,876                  |       | 40,152                 |       |
|                                                                             |       |                   |       |                   |       |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                    |       | $                      | 21,536     |                   | $          | 8,590 |   |
|                                                                             |       |                   |       |                   |       |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                             |       |                   |       |                   |       |
| Cash  paid for:                                                                  |       |                   |       |                   |       |
| Interest                                                                         |       | $                      | 6,132      |                   | $          | 11,789 |   |
| Income  taxes                                                                    |       | $                      | 419        |                   | $          | 483 |   |
|                                                                             |       |                   |       |                   |       |
| **Schedule of non-cash transactions**                                            |       |                   |       |                   |       |
| Unrealized  gains / (losses) on investment securities, net of income taxes       |       | $                      | (7         | )                      | $          | (198 | ) |
| Transfers  to other real estate owned                                            |       | $                      | 6,596      |                   | $          | — |   |
| Transfers  to repossessed collateral                                             |       | $                      | 1,407      |                   | $          | — |   |

 

6

----

 

**Notes toUnaudited Consolidated Financial Statements**

 

**NOTE 1 — NATURE OF BUSINESS ANDBASIS OF PRESENTATION**

 

**Business Activity andOrganization —**CommunitySouthFinancial Corporation (the “Company”) is a South Carolina corporation organizedfor the purpose of owning and controlling all of the capital stock ofCommunitySouth Bank and Trust (the “Bank”). The Bank is a state chartered bank organized under the laws of SouthCarolina.  From inception on March 20,2004 through January 18, 2005, the Company engaged in organizational andpre-opening activities necessary to obtain regulatory approvals and to prepareits subsidiary, the Bank, to commence business as a financial institution.  The Company received approval from theFederal Deposit Insurance Corporation (“FDIC”), the Federal Reserve Board (“FRB”)and the State Board of Financial Institutions in January 2005.

 

The Bank began operationson January 18, 2005.  The Bankprimarily is engaged in the business of accepting deposits insured by the FDIC,and providing commercial, consumer and mortgage loans to the general public.

 

The Company sold4,681,069 shares of common stock at $6.40 per share in an initial publicoffering that was completed on February 15, 2005 (as adjusted for allstock splits).  The offering raised$29,430,810, net of offering costs.  Thedirectors and officers of the Company purchased 659,531 shares at $6.40 pershare for a total of $4,221,000.

 

**Basis of Presentation —**The accompanying financial statementshave been prepared in accordance with generally accepted accounting principlesin the United States of America and to general practices in the bankingindustry for interim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the three and ninemonth periods ended September 30, 2009 are not necessarily indicative ofthe results that may be expected for the year ending December 31,2009.  For further information, refer tothe audited consolidated financial statements and footnotes dated December 31,2008 included in the Company’s Form 10-K for the year ended December 31,2008 as filed with the Securities and Exchange Commission (the “SEC”).

 

**NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Principles of Consolidation —**The consolidated financial statements include the accounts of CommunitySouth Financial Corporation, the parent company, and CommunitySouth Bank and Trust, its wholly owned subsidiary. All significant intercompany items have been eliminated in the consolidated financial statements.

 

**Management’sEstimates** — Thepreparation of consolidated financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of income and expenses during the reportingperiod.  Actual results could differ fromthose estimates.

 

**Disclosure Regarding Segments** — The Company reports as one operatingsegment, as management reviews the results of operations of the Company as asingle enterprise.

 

**Cash and Cash Equivalents**— For purposes of reporting cash flows,cash and cash equivalents include cash on hand, amounts due from banks,short-term interest bearing deposits and federal funds sold.  Cash and cash equivalents have an originalmaturity of three months or less.

 

**Concentrationsof Credit Risk** —Financial instruments, which potentially subject the Company to concentrationsof credit risk, consist principally of loans receivable, investment securities,federal funds sold and amounts due from banks.

 

The Company makes loansto individuals and small businesses for various personal and commercialpurposes primarily in the upstate region of South Carolina.  The Company’s loan portfolio is notconcentrated in loans to any single borrower or to a relatively small number ofborrowers.  The Bank does have aconcentration of loans classified as commercial real estate. These loans areespecially susceptible to being adversely effected by the current economicdownturn. The current downturn in the real estate market has resulted in anincrease in loan delinquencies, defaults and foreclosures, and we believe thesetrends are likely to continue.  In somecases, this downturn has resulted in a significant impairment to the value ofour collateral and our ability to sell the collateral upon foreclosure, and thereis a risk that this trend will continue. The commercial real estate collateral in each case provides an alternatesource of repayment in the event of default by the borrower and may deterioratein value during the time the credit is extended.  If real estate values continue to decline, itis also more likely that we would be required to increase our allowance forloan losses.

 

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In addition to monitoringpotential concentrations of loans to particular borrowers or groups ofborrowers, industries and geographic regions, management monitors exposure tocredit risk that could arise from potential concentrations of lending productsand practices such as loans that subject borrowers to substantial paymentincreases (e.g. principal deferral periods, loans with initial interest-onlyperiods, etc), and loans with high loan-to-value ratios.  Additionally, there are industry practicesthat could subject the Company to increased credit risk should economicconditions change over the course of a loan’s life.  For example, the Company makes variable rateloans and fixed rate principal-amortizing loans with maturities prior to theloan being fully paid (i.e. balloon payment loans).  These loans are underwritten and monitored tomanage the associated risks.  Managementhas determined that there is no concentration of credit risk associated withits lending policies.

 

The Company’s investmentportfolio consists of both marketable and non-marketable equitysecurities.  Management believes creditrisk associated with the equity securities is not significant. The Companyplaces its deposits and correspondent accounts with and sells its federal fundsto high quality institutions.  Managementbelieves credit risk associated with correspondent accounts is not significant.

 

**Investment Securities** — The Company accounts for investment securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” (FASB ASC 32-10-05, 15, 25, 35, 45, 50, 55) (“SFAS 115”).  The statement requires investments in equity and debt securities to be classified into three categories:

 

| 1. | * * | *Available  for sale securities*: These are securities that are not classified as either held to  maturity or as trading securities.  These securities are reported at  fair market value.  Unrealized gains and losses are reported, net of  income taxes, as separate components of shareholders’ equity (accumulated  other comprehensive income). |
|----|----------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2. | * * | *Held  to maturity securities*: These are investment securities that the Company has the ability  and intent to hold until maturity.  These securities are stated at cost,  adjusted for amortization of premiums and the accretion of discounts.                                                                                                               |
| 3. | * * | *Trading  securities*:  These are securities that are bought and held principally for the purpose of  selling in the near future.  Trading securities are reported at fair  market value, and related unrealized gains and losses are recognized in the  income statement.  The Company has no trading securities.                                         |

 

Gains or losses ondispositions of investment securities are based on the differences between thenet proceeds and the adjusted carrying amount of the securities sold, using thespecific identification method.  Premiums and discounts are amortizedor accreted into interest income by a method that approximates a level yield.

 

**Other Investments —**CommunitySouth Bank and Trust, as a memberinstitution, is required to own stock investments in the Federal HomeLoan Bank of Atlanta(“FHLB”).  Investment in the FHLB is acondition of borrowing from the FHLB, and the stock is pledged to collateralizesuch borrowings.  No ready market existsfor the stock and it has no quoted market value.  However, redemption of these stocks hashistorically been at par value.  The dividendreceived on this stock is included in interest and dividends on investments.

 

**LoansReceivable** —Loans are stated at their unpaid principal balance less an allowance for loanlosses and net deferred loan origination fees. Interest income is computed using the simple interest method and isrecorded in the period earned. Loan origination fees collected and certain loanorigination costs are deferred and the net amount is accreted as income using amethod that approximates the level yield method over the life of the relatedloans.

 

In accordance with SFAS No. 114,“Accounting by Creditors for Impairment of a Loan,” (FASB ASC 310-10-35) (“SFAS114”), loans are considered to be impaired when, in management’s judgment andbased on current information, the full collection of principal and interestbecomes doubtful.  A loan is alsoconsidered impaired if its terms are modified in a troubled debtrestructuring.  Impaired loans are placedin non-performing status, and future payments are applied to principal untilsuch time as collection of the obligation is no longer doubtful. Interestaccrual resumes only when loans return to performing status.  To return to performing status, loans must befully current, and continued timely payments must be a reasonable expectation.  Loans are generally placed on non-accrualstatus when principal or interest becomes ninety days past due, or when paymentin full is not anticipated.  When a loan is placed on non-accrual status,interest accrued but not received is generally reversed against interestincome.  Cash receipts on non-accrual loans are not recorded as interestincome, but are used to reduce principal.

 

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The Company identifiesimpaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loanlist are considered potentially impaired loans. These loans are evaluated in determining whether all outstandingprincipal and interest are expected to be collected.  Loans are not considered impaired if aminimal payment delay occurs and all amounts due, including accrued interest atthe contractual interest rate for the period of delay, are expected to becollected.  Management has determinedthat the Company had $34,769,000 and $13,172,000 in impaired loans at September 30,2009 and December 31, 2008, respectively.

 

**Allowance for Loan Losses** — The allowance for loan losses isestablished as losses are estimated to have occurred through a provision forloan losses charged to earnings.  Loanlosses are charged against the allowance when management believes theuncollectability of a loan balance is confirmed.  Subsequent recoveries, if any, are creditedto the allowance.

 

The allowance for loanlosses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectability of the loans in light ofhistorical experiences, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

The allowance consists ofspecific, general and unallocated components. The specific component relates to loans that are classified as eitherdoubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of theloan. The general component covers non-classified loans and is based onhistorical loss experience adjusted for qualitative factors.  An unallocated component is maintained tocover uncertainties that could affect management’s estimate of probablelosses.  The unallocated component of theallowance reflects the margin of imprecision inherent in the underlyingassumptions used in the methodologies for estimating specific and generallosses in the portfolio.

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentsdue.  Loans that experience insignificantpayment delays and payment shortfalls generally are not classified asimpaired.  Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record and the amount of the shortfall in relation tothe principal and interest owed. Impairment is measured on a loan by loan basis for commercial andconstruction loans by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Company does not separatelyidentify individual consumer and residential loans for impairment disclosures,unless such loans are the subject of a restructuring agreement.

 

**Bank-OwnedLife Insurance** — The Company made the decision to sell these policiesin order to help reduce assets, thereby improving the Bank’s risk based capitalratio. During the first quarter of 2009, the Company began the process ofdivesting of its key employee life insurance policies by selling policies at nogain or loss.  Income from these policiesand changes in the net cash surrender value are currently recorded in non-interestincome. The final policy was sold in April 2009.

 

**Advertising —** Advertising, promotional, and other businessdevelopment costs generally are expensed as incurred.  External costs incurred in producing mediaadvertising are expensed the first time the advertising takes place.  External costs relating to direct mailingcosts are expensed in the period in which the direct mailings are sent.

 

**Propertyand Equipment** —Premises, furniture and equipment are stated at cost, less accumulateddepreciation.  Depreciation expense iscomputed using the straight-line method, based on the estimated useful livesfor furniture and equipment of 5 to 10 years. Leasehold improvements are amortized over the life of the lease.  Maintenance and repairs are charged tocurrent expense.  The costs of majorrenewals and improvements are capitalized.

 

**ResidentialLoan Origination Fees** — The Company offers residential loanorigination services to its customers in its immediate market area.  The loans are offered on terms and pricesoffered by the Company’s correspondents and are closed in the name of thecorrespondents.  The Company receivesfees for services it provides in conjunction with the origination services itprovides.  The fees are recognized at thetime the loans are closed by the Company’s correspondent.

 

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**Income Taxes** — The consolidated financial statements have been prepared on the accrual basis.  When income and expenses are recognized in different periods for financial reporting purposes versus for the purposes of computing income taxes currently payable, deferred taxes are provided on such temporary differences.  The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” (FASB ASC 740) (“SFAS 109”).

 

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (FASB ASC 740) (“FIN 48”) to clarify the accounting and disclosure for uncertainty in tax positions, as defined.  FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes.  The Company implemented the provisions of FIN 48 as of January 1, 2007, and has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions.  The Company believes that its income tax filing positions taken or expected to be taken in its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow.  Therefore, no reserves for uncertain income tax positions have been recorded pursuant to FIN 48.  In addition, the Company did not record a cumulative effect adjustment related to the adoption of FIN 48.

 

Under SFAS 109 and FIN 48, deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns.  Income taxes are the sum of amounts currently payable to taxing authorities and the net changes in income taxes payable or refundable in future years.  Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled.  Income taxes deferred to future years are determined utilizing an asset and liability approach.  This method gives consideration to the future tax consequences associated with differences between financial accounting and tax bases of certain assets and liabilities which are principally the allowance for loan losses, depreciable premises and equipment, and net operating loss carry-forwards.

 

**Earnings (loss) Per Share** — Basic earnings (loss) per sharerepresents the net income (loss) allocated to shareholders divided by theweighted-average number of common shares outstanding during the period.  Diluted earnings per share reflect the impactof additional common shares that would have been outstanding if dilutivepotential common shares had been issued. Potential common shares that may be issued by the Company relate to bothoutstanding warrants and stock options, and are determined using the treasurystock method.

 

**Stock—based Compensation** — The Company has adopted the fair valuerecognition provisions of the SFAS No. 123(R), “Share-Based Payment” (FASBASC 718), which is a revision of SFAS No. 123, “Accounting for Stock-BasedCompensation”, to account for compensation costs under its stock optionplans.  The Company previously utilizedthe intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees (as amended)” (“APB 25”).  Under the intrinsic value method prescribedby APB 25, no compensation costs were recognized for the Company’s stockoptions because the option exercise price in its plans equaled the market priceon the date of grant.

 

# **Inadopting SFAS No. 123(R), the Company elected to use the modifiedprospective method to account for the transition from the intrinsic valuemethod to the fair value recognition method. Under the modified prospective method, compensation cost is recognizedfrom the adoption date forward for all new stock options granted and for anyoutstanding unvested awards as if the fair value method had been applied tothose awards as of the date of grant.**

# ** **

**Off-BalanceSheet Financial Instruments** — In the ordinary course of business, the Companyenters into off-balance sheet financial instruments consisting of commitmentsto extend credit and letters of credit. These financial instruments are recorded in the financial statementswhen they become payable by the customer.

 

**Recently Issued AccountingStandards —**Thefollowing is a summary of recent authoritative pronouncements that could impactthe accounting, reporting, and / or disclosure of financial information by theCompany.

 

InJune 2009, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 168, “The *FASB Accounting Standards Codification*TM and the Hierarchy of Generally AcceptedAccounting Principles — a replacement of FASB Statement No. 162,” (“SFAS168”).  SFAS 168 establishes the *FASB Accounting Standards Codification*TM (“Codification”) as the source ofauthoritative generally accepted accounting principles (“GAAP”) fornongovernmental entities.  TheCodification does not change GAAP. Instead, it takes the thousands ofindividual pronouncements that currently comprise GAAP and reorganizes theminto approximately 90 accounting Topics, and displays all Topics using aconsistent structure.  Contents in eachTopic are further organized first by Subtopic, then Section and finallyParagraph. The Paragraph level is the only level that contains substantivecontent. Citing particular content in the 

 

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Codificationinvolves specifying the unique numeric path to the content through the Topic,Subtopic, Section and Paragraph structure. FASB suggests that allcitations begin with “FASB ASC,” where ASC stands for *AccountingStandards Codification*. Changes to the ASC subsequent to June 30,2009 are referred to as Accounting Standards Updates (“ASU”).

 

Inconjunction with the issuance of SFAS 168, the FASB also issued its firstAccounting Standards Update No. 2009-1, “Topic 105 —Generally AcceptedAccounting Principles” (“ASU 2009-1”) which includes SFAS 168 in its entiretyas a transition to the ASC.    ASU 2009-1is effective for interim and annual periods ending after September 15,2009 and will not have an impact on the Company’s financial position or resultsof operations but will change the referencing system for accountingstandards.  Certain of the followingpronouncements were issued prior to the issuance of the ASC and adoption of theASUs. For such pronouncements, citations to the applicable Codification byTopic, Subtopic and Section are provided where applicable in addition tothe original standard type and number.

 

The FASB issued ASU 2009—05,“Fair Value Measurements and Disclosures (Topic 820) — Measuring Liabilities atFair Value” in August, 2009 to provide guidance when estimating the fair valueof a liability.  When a quoted price inan active market for the identical liability is not available, fair valueshould be measured using (a) the quoted price of an identical liabilitywhen traded as an asset; (b) quoted prices for similar liabilities orsimilar liabilities when traded as assets; or (c) another valuationtechnique consistent with the principles of Topic 820 such as an incomeapproach or a market approach.  If arestriction exists that prevents the transfer of the liability, a separateadjustment related to the restriction is not required when estimating fairvalue.  The ASU was effective October 1,2009 for the Company and will have no impact on financial position oroperations.

 

ASU 2009-12, “Fair ValueMeasurements and Disclosures (Topic 820) - Investments in Certain Entities ThatCalculate Net Asset Value per Share (or Its Equivalent),” issued in September,2009, allows a company to measure the fair value of an investment that has noreadily determinable fair market value on the basis of the investee’s net assetvalue per share as provided by the investee. This allowance assumes that theinvestee has calculated net asset value in accordance with the GAAP measurementprinciples of Topic 946 as of the reporting entity’s measurement date.   Examples of such investments includeinvestments in hedge funds, private equity funds, real estate funds and venturecapital funds. The update also provides guidance on how the investment should beclassified within the fair value hierarchy based on the value for which theinvestment can be redeemed.  Theamendment is effective for interim and annual periods ending after December 15,2009 with early adoption permitted.  TheCompany does not have investments in such entities and, therefore, there willbe no impact to our financial statements.

 

IssuedOctober, 2009, ASU 2009-15, “Accounting for Own-Share Lending Arrangements inContemplation of Convertible Debt Issuance or Other Financing” amends ASC Topic470 and provides guidance for accounting and reporting for own-share lendingarrangements issued in contemplation of a convertible debt issuance.  At the date of issuance, a share-lendingarrangement entered into on an entity’s own shares should be measured at fairvalue in accordance with Topic 820 and recognized as an issuance cost, with anoffset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per shareunless default of the share-lending arrangement occurs.  The amendments also require severaldisclosures including a description and the terms of the arrangement and thereason for entering into the arrangement. The effective dates of the amendments are dependent upon the date theshare-lending arrangement was entered into and include retrospectiveapplication for arrangements outstanding as of the beginning of fiscal yearsbeginning on or after December 15, 2009.  The Company has no plans to issue convertible debt and, therefore, doesnot expect the update to have an impact on its financial statements.

 

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

 

**Risks and Uncertainties** — In the normal course of its business,the Company encounters two significant types of risk: economic andregulatory.  There are three maincomponents of economic risk:  interestrate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that itsinterest-bearing liabilities mature or reprice at different speeds, or ondifferent bases, than its interest-earning assets.  Credit risk is the risk of default on theCompany’s loan portfolio that results from the borrower’s inability orunwillingness to make contractually required payments.  Market risk reflects changes in the value ofcollateral underlying loans receivable and the valuation of real estate held bythe Company.

 

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The Company is subject tothe regulations of various governmental agencies.  These regulations can and do changesignificantly from period to period.  TheCompany also undergoes periodic examinations by the regulatory agencies, whichmay subject it to further changes with respect to asset valuations, amounts ofrequired loss allowances and operating restrictions from the regulators’judgments based on information available to them at the time of theirexamination.  As discussed in more detailin Note 9, on June 29, 2009, the Bank entered into a Memorandum ofUnderstanding (the “MOU”) with the Commissioner of Banking of the SouthCarolina State Board of Financial Institutions and the Regional Director of theFDIC’s Atlanta Regional Office.

 

The Bank is subject toFDIC insurance premiums. Legislation has recently passed that imposed a onetime FDIC insurance premium that equated to a $178,000 one time charge to theBank in 2009. This was expensed in June 2009 and was paid September 30,2009.

 

**Reclassifications** - Certain captions and amounts in theprior financial statements were reclassified to conform with the 2009presentation.  Such reclassifications hadno effect on previously reported net income or shareholders’ equity.

 

**NOTE 3 — INVESTMENT SECURITIES**

 

# **The amortized costs and fair values of investment securities are asfollows (in thousands):**

 
| ** **                        | ** ** | **Amortized** | ** **  | **Gross Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------------|------------|---------------|-------------|----------------------|------------|------------|------------|
| **As of September 30, 2009** | ** ** | **Cost**      | ** **  | **Gains**            | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **Available for sale**            |       |          |        |                 |       |       |       |   |   |
| Government  sponsored enterprises |       | $             | —      |                 | $          | —     |       | $ | — |   | $ | — |   |
| Mortgage-backed                   |       | 113,132       |        | 787                  |       | 55         |       | 113,864 |   |
| Marketable  securities            |       | 100           |        | —               |       | —     |       | 100 |   |
| Total  available for sale         | ** ** | **$**         | **113,232** | ** **           | **$**      | **787**    | ** ** | **$** | **55** | ** ** | **$** | **113,964** | ** ** |

 

The table belowsummarizes gross unrealized losses on investment securities and the fair marketvalue of the related securities, aggregated by investment category and lengthof time that individual securities have been in a continuous unrealized lossposition, at September 30, 2009.

 
| ** **                        | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                        | ** ** | **Fair**                | ** ** | **Unrealized**          | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **As of September 30, 2009** | ** ** | **Value**               | ** ** | **Loss**                | ** ** | **Value** | ** ** | **Gain/(Loss)** | ** ** | **Value** | ** ** | **Gain/(Loss)** | ** ** |
| **Available for sale**            |       |                    |       |                    |       |      |       |   |   |   |   |   |   |
| (dollars  in thousands)           |       |                    |       |                    |       |      |       |   |   |   |   |   |   |
| Mortgage-backed                   |       | $                       | 35,958     |                    | $          | 55        |       | $ | — |   | $ | — |   | $ | 35,958 |   | $ | 55 |   |
| Total  Available for sale         | ** ** | **$**                   | **35,958** | ** **              | **$**      | **55**    | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **35,958** | ** ** | **$** | **55** | ** ** |

 

**NOTE 4 — LEASES**

 

The Company leases branchlocations in Spartanburg, Mauldin, Anderson, Greer and Greenville as well asthe loan operations center in Easley. The initial lease terms range from threeto ten years with various renewal options. The minimum future rental paymentsunder non-cancelable operating leases having remaining terms in excess of oneyear, for each of the next five years and in the aggregate are (in thousands):

 
| 2009                                  |       | $     | 80        |       |
|---------------------------------------|------------|-------|-----------|------------|
| 2010                                  |       | 320   |      |
| 2011                                  |       | 332   |      |
| 2012                                  |       | 345   |      |
| 2013                                  |       | 351   |      |
| Thereafter                            |       | 938   |      |
| Total  minimum future rental payments | ** ** | **$** | **2,366** | ** ** |

 

The loan operations center in Easley is leased from apartnership in which a Company director has a partnership interest.

 

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**NOTE 5 — RELATED PARTYTRANSACTIONS**

 

Certain parties(principally certain directors and executive officers of the Company, theirimmediate families and business interests) (“affiliates”) are loan customers inthe normal course of business with the Bank. These loans are made on substantially the same terms, including interestrates and collateral, as those prevailing at the time for comparabletransactions with unrelated persons and do not involve more than the normalrisk of collectability.

 

### **NOTE 6 — COMMITMENTS ANDCONTINGENCIES**

### ** **

The Company is subject toclaims and lawsuits which arise primarily in the ordinary course ofbusiness.  Management is not aware of anylegal proceedings which would have a material adverse effect on the financialposition or operating results of the Company.

 

**NOTE 7 — STOCK-BASED COMPENSATION**

 

Upon completion of itsinitial public offering in 2005, the Company agreed to issue warrants to theorganizing directors for the purchase of one share of common stock at $6.40 pershare for every two shares purchased in the stock offering, up to a maximum of15,625 warrants per director. The warrants were fully vested 120 days after January 18,2005 and will expire on January 18, 2015. Warrants held by directors of the Company will expire 90 days after thedirector ceases to be a director or officer of the Company (365 days if due todeath or disability). The Company issued a total of 171,404 warrants.  In addition, the Company has adopted a stockoption plan.  As of September 30,2009 the Company has 754,320 outstanding options to employees and directors. OnJanuary 16, 2006 the Company adopted a resolution that terminated the “evergreen”provision of the Company 2005 Stock Incentive Plan. As a result, the number ofshares of common stock issuable under the plan shall not be further increasedin connection with any future share issuances by the Company. The exerciseprice of each option is equal to the market price of the Company’s stock on thedate of grant. The maximum term is ten years, and they typically vest in nogreater than five years. When necessary, the Company may purchase shares on theopen market to satisfy share option exercises. During the ensuing year, theCompany is expected to acquire no shares.

 

The table set forth belowsummarizes stock option activity for the Company’s stock compensation plans forthe period ended September 30, 2009 as adjusted for all stock splits.

 
| ** **                                  | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|---------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                  | ** ** | ** **        | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **        | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | ** **        | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                  | ** ** | **Number**        | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2008**  |       | 764,113           |       | $             | 7.08       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                     |       | 16,100            |       | 2.64          |       | — |   | — |   |
| Forfeited                                   |       | 25,893            |       | 6.44          |       | — |   | — |   |
| Exercised                                   |       | —            |       | —        |       | — |   | — |   |
| **Outstanding  at September 30, 2009** | ** ** | **754,320**       | ** ** | **7.01**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
|                                             |            |                   |            |               |            |  |  |  |  |  |  |

 

The table set forth belowsummarizes non-vested stock options as of September 30, 2009.

 
| ** **                                  | ** ** | ** ** | ** ** | **Fair**  | ** ** |   |   |   |   |
|---------------------------------------------|------------|------------|------------|-----------|------------|--------|--------|--------|--------|
| ** **                                  | ** ** | **Number** | ** ** | **Value** | ** ** |   |   |   |   |
| **Outstanding  at December 31, 2008**  |       | 51,810     |       | $         | 5.34       |   |   |   |   |   |
| Granted                                     |       | 16,100     |       | 1.51      |       |   |   |   |   |
| Vested                                      |       | 10,392     |       | 5.96      |       |   |   |   |   |
| Forfeited                                   |       | 10,930     |       | 2.68      |       |   |   |   |   |
| **Outstanding  at September 30, 2009** | ** ** | **46,588** | ** ** | **4.50**  | ** ** |   |   |   |   |
|                                             |            |            |            |           |            |        |        |        |        |  |

 

As of September 30,2009, there was $189,445 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 34 months. As of December 31,2008, there was $223,689 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which was expected to berecognized over a weighted average period of 42 months.

 

13

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The fair value of eachoption granted is estimated on the grant date using the Black-Scholesoption-pricing model with the following assumptions for 2009:  dividend yield of 0%, expected term of 10years, risk-free interest rate equal to the 10-year treasury rate on therespective grant date, and expected life of 10 years.  Expected volatility is derived from the mostrecent actual historical volatility of South Carolina institutions available atthe time of the grant.  The followingassumptions were used for the 2008 estimates: dividend yield of 0%, expected term of 10 years, risk-free interest rateof 5.0%, expected life of 10 years, and expected volatility of 20%.

 

The following tablesummarizes information about stock options outstanding under the Company’splans at September 30, 2009 and December 31, 2008.

 
| **September 30, 2009**      | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number  of options               |       | 754,320         |       | 707,732         |       |
| Weighted  average remaining life |       | 5.71 years      |       | 5.57 years      |       |
| Weighted  average exercise price |       | $               | 7.00       |            | $          | 6.83 |   |
| High  exercise price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low  exercise price              |       | $               | 2.00       |            | $          | 7.00 |   |

 
| **December 31, 2008**       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number  of options               |       | 764,113         |       | 712,303         |       |
| Weighted  average remaining life |       | 6.42 years      |       | 6.26 years      |       |
| Weighted  average exercise price |       | $               | 7.08       |            | $          | 6.74 |   |
| High  exercise price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low  exercise price              |       | $               | 6.40       |            | $          | 6.40 |   |

 

There were no optionsexercised during the quarter and thus no cash was received related to this typeof transaction. There was no intrinsic value of options exercised during 2009and 2008.

 

At September 30,2009, all of the 171,404 warrants were exercisable and had an average remaininglife of 5.30 years. At December 31, 2008, all of the 171,404 warrants wereexercisable and had an average remaining life of 6.05 years.

 

**NOTE 8 — FAIR VALUE OF FINANCIALINSTRUMENTS**

 

SFAS No. 107, “Disclosuresabout Fair Value of Financial Instruments” (FASB ASC 825-10-50) (“SFAS 107”),requires disclosure of fair value information, whether or not recognized in theconsolidated balance sheets, when it is practical to estimate the fairvalue.  SFAS 107 defines a financialinstrument as cash, evidence of an ownership interest in an entity or contractualobligations, which require the exchange of cash, or other financialinstruments.  Certain items arespecifically excluded from the disclosure requirements, including the Company’scommon stock, premises and equipment, accrued interest receivable and payable,and other assets and liabilities.

 

The fair value of afinancial instrument is the amount at which the asset or obligation could beexchanged in a current transaction between willing parties, other than in aforced or liquidation sale.  Fair valueestimates are made at a specific point in time based on relevant marketinformation and information about the financial instruments.  Because no market value exists for asignificant portion of the financial instruments, fair value estimates arebased on judgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments, and otherfactors.

 

The Company has usedmanagement’s best estimate of fair value based on the above assumptions.  Thus, the fair values presented may not bethe amounts, which could be realized, in an immediate sale or settlement of theinstrument. In addition, any income taxes or other expenses, which would beincurred in an actual sale or settlement, are not taken into consideration inthe fair values presented.

 

# **TheCompany adopted SFAS No. 157 at the beginning of our 2008 fiscalyear.  SFAS No. 157 applies to allassets and liabilities that are being measured and reported on a fair valuebasis.  SFAS No. 157 requires newdisclosure that establishes a framework for measuring fair value in GAAP, andexpands disclosure about fair value measurements.  This statement enables the reader of thefinancial statements to assess the inputs used to develop those measurements byestablishing a hierarchy for ranking the quality and reliability of theinformation used to determine fair values. The statement requires that assets and liabilities carried at fair valuewill be classified and disclosed in one of the following three categories:**

# ** **

·                  Level 1:  Quotedmarket prices in active markets for identical assets or liabilities.

 

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·                  Level 2: Observable market based inputs or unobservable inputs that arecorroborated by market data.

 

·                  Level 3: Unobservable inputs that are not corroborated by market data.

 

In determiningappropriate levels, the Company performs a detailed analysis of the assets andliabilities that are subject to SFAS No. 157.  At each reporting period, all assets and liabilitiesfor which the fair value measurement is based on significant unobservableinputs are classified as Level 3.

 

The following methods andassumptions were used to estimate the fair value of significant financialinstruments:

 

***Cash and Duefrom Banks*** -The carrying amount is a reasonable estimate of fair value.

 

***Federal FundsSold*** -Federal funds sold are for a term of one day, and the carrying amountapproximates the fair value.

 

***SecuritiesAvailable for Sale*** — Investment securities available-for-sale are recorded at fair valueon a recurring basis.  Fair valuemeasurement is based upon quoted prices, if available.  If quoted prices are not available, fairvalues are measured using independent pricing models or other model-basedvaluation techniques such as the present value of future cash flows, adjustedfor the security’s credit rating, prepayment assumptions and other factors suchas credit loss assumptions.  Level 1securities include those traded on an active exchange, such as the New YorkStock Exchange, U.S. Treasury securities that are traded by dealers or brokersin active over-the-counter markets and money market funds.  Level 2 securities include mortgage-backedsecurities issued by government sponsored entities, municipal bonds and corporatedebt securities.  Securities classifiedas Level 3 include asset-backed securities in less liquid markets.

 

***OtherInvestments*** -The carrying value of non-marketable equity securities approximates the fairvalue since no ready market exists for the stocks.

 

# ***Loansreceivable***- For certain categories of loans, such as variable rate loans which arerepriced frequently and have no significant change in credit risk, fair valuesare based on the carrying amounts.  Thefair value of other types of loans is estimated by discounting the future cashflows using the current rates at which similar loans would be made to borrowerswith similar credit ratings and for the same remaining maturities.  However, from time to time, a loan isconsidered impaired and an allowance for loan losses is established.  Loans for which it is probable that paymentof interest and principal will not be made in accordance with the contractualterms of the loan agreement are considered impaired.  The fair value of impaired loans is estimatedusing one of several methods, including collateral value, market value ofsimilar debt, enterprise value, liquidation value and discounted cashflows.  Those impaired loans notrequiring an allowance represent loans for which the fair value of the expectedrepayments or collateral exceed the recorded investments in such loans.

# ** **

***Foreclosedassets*** —Foreclosed assets are adjusted to fair value upon transfer of the loans toforeclosed assets.  Subsequently,foreclosed assets are carried at the lower of carrying value or fairvalue.  Fair value is based uponindependent market prices, appraised values of the collateral or management’sestimation of the value of the collateral.

 

***Deposits*****- The fair value of demand deposits,savings, and money market accounts is the amount payable on demand at thereporting date.  The fair values ofcertificates of deposit are estimated using a discounted cash flow calculationthat applies current interest rates to a schedule of aggregated expectedmaturities.

 

***RepurchaseAgreements*** -The carrying value of these instruments is a reasonable estimate of fair value.

 

***SubordinatedDebt -***Thecarrying value of these instruments is a reasonable estimate of fair value.

 

15

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The carrying values and estimated fair values of theCompany’s financial instruments at September 30, 2009 are shown in thefollowing table.

 
| *** ***                                                        | ** ** | **Carrying** | ** ** | **Estimated**   | ** ** |
|---------------------------------------------------------------------|------------|--------------|------------|-----------------|------------|
| **(Dollars in thousands)**                                          | ** ** | **Amount**   | ** ** | **Fair  Value** | ** ** |
| **September 30,  2009**                                        |       |         |       |            |       |
| **Financial  Assets**                                               |       |         |       |            |       |
| Cash and due  from banks                                            |       | $            | 6,618      |            | $          | 6,618 |   |
| Federal funds  sold                                                 |       | 14,918       |       | 14,918          |       |
| Investment  securities, available for sale                          |       | 113,964      |       | 113,964         |       |
| Other  investments                                                  |       | 1,599        |       | 1,599           |       |
| Loans, gross                                                        |       | 292,958      |       | 304,286         |       |
| Other real  estate owned                                            |       | 7,011        |       | 7,011           |       |
| Repossessed  collateral                                             |       | 1,407        |       | 1,407           |       |
|                                                                |       |         |       |            |       |
| **Financial  Liabilities**                                          |       |         |       |            |       |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $            | 56,106     |            | $          | 56,106 |   |
| Certificates of  deposit and other time deposits                    |       | 321,708      |       | 323,687         |       |
| Repurchase  agreements                                              |       | 30,000       |       | 30,000          |       |
| Subordinated  debt                                                  |       | 4,325        |       | 5,471           |       |

 
| ** **                                   | ** ** | **September 30, 2009** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**                   | ** ** | **Notional  Amount**        | ** ** | **Estimated  Fair Value** | ** ** |
| **Off-Balance Sheet Financial Instruments:** |       |                        |       |   |   |
|                                         |       |                        |       |   |   |
| Commitments  to extend credit                |       | $                           | 18,159     |   | $ | — |   |
| Standby  Letters of Credit                   |       | 1,255                       |       | $ | — |   |
|                                              |            |                             |            |  |  |  |  |

# ** **

The table below presentsthe balances of assets and liabilities measured at fair value on a recurringbasis by level within the SFAS No. 157 valuation hierarchy (as describedabove) as of September 30, 2009.

 
| ** **                                 | ** ** | **September 30, 2009** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **Total**                   | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment  securities, available for sale |       | $                           | 113,964    |   | $ | — |   | $ | 113,964 |   | $ | — |   |
|                                            |            |                             |            |  |  |  |  |  |  |  |  |  |  |

 

Certain assets andliabilities are measured at fair value on a nonrecurring basis; that is, theinstruments are not measured at fair value on an ongoing basis but are subjectto fair value adjustments in certain circumstances (for example, when there isevidence of impairment).  The followingtable presents the assets and liabilities carried on the balance sheet bycaption and by level within the SFAS No. 157 valuation hierarchy (asdescribed above) as of September 30, 2009 for which a nonrecurring changein fair value has been recorded during the year ended September 30, 2009.

 
| ** **                 | ** ** | **Sepetember 30, 2009** | ** ** |
|----------------------------|------------|-------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**               | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired  loans            |       | $                       | 34,769     |   | $ | — |   | $ | 34,769 |   | $ | — |   |
| Other  real estate owned   |       | 7,011                   |       | — |   | 7,011 |   | — |   |
| Repossessed  collateral    |       | 1,407                   |       | — |   | 1,407 |   | — |   |
|                            |            |                         |            |  |  |  |  |  |  |  |  |  |  |

 

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**NOTE 9 — RECENT REGULATORY DEVELOPMENTS**

 

On June 29, 2009, the Bank entered into the MOUwith the Commissioner of Banking of the South Carolina State Board of FinancialInstitutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  The MOU requires the Bank to,among other things, (1) submit a capital plan to the supervisoryauthorities for maintaining a “well-capitalized” designation; (2) developspecific plans and proposals for the reduction and improvement of assets whichare subject to adverse classification and past due loans; (3) implement aplan to decrease the concentration of commercial real estate loans; (4) developand implement an adequate loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improving liquidityand reducing reliance on volatile liabilities to fund longer-term assets.  In addition, the Bank may not pay dividendswithout the prior written consent of each supervisory authority.

 

Since entering into the MOU, the Bank has beenactively pursuing the corrective actions required by the MOU in an effort toensure that the requirements of the MOU are met in a timely manner.  The MOU is characterized by the supervisoryauthorities as an informal action that is neither published nor made publiclyavailable by the supervisory authorities and is used when circumstances warranta milder form of action rather than a formal supervisory action such as aformal agreement or a cease and desist order. For additional information regarding the Bank’s compliance with the MOU,see discussion under the heading “Recent Regulatory Developments” in Item 2.

 

**NOTE 10 — SUBSEQUENT EVENTS**

 

The Bank has evaluated events and transactions throughour filing date for potential recognition or disclosure in the consolidated financialstatements and has determined there are no subsequent events to disclose.

 

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**Item 2.  Management’sDiscussion and Analysis or Plan of Operation.**

 

*The following discussion reviews our results ofoperations and assesses our financial condition.  You should read the following discussion andanalysis in conjunction with the accompanying consolidated financialstatements.  The commentary should beread in conjunction with the discussion of forward-looking statements, thefinancial statements, and the related notes and the other statisticalinformation included in this report.*

 

**DISCUSSION OF FORWARD-LOOKINGSTATEMENTS**

 

This report containsstatements which constitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934.  Forward-looking statementsrelate to the financial condition, results of operations, plans, objectives,future performance, and business of our Company.  Forward-looking statements are based on manyassumptions and estimates and are not guarantees of future performance. Ouractual results may differ materially from those anticipated in anyforward-looking statements, as they will depend on many factors about which weare unsure, including many factors which are beyond our control. The words “may,”“would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,”“potential,” “continue,” “assume,” “believe,” “intend,” “plan,” “forecast,” “goal,”and “estimate,” as well as similar expressions, are meant to identify suchforward-looking statements.  Potentialrisks and uncertainties that could cause our actual results to differmaterially from those anticipated in our forward-looking statements include,without limitation, those described under the heading “Risk Factors” in ourAnnual Report on Form 10-K for the year ended December 31, 2008 asfiled with the Securities and Exchange Commission (the “SEC”) and thefollowing:

 

·       ourrapid growth to date and short operating history;

·       reducedearnings due to higher credit losses generally and specifically because lossesin the sectors of our loan portfolio secured by real estate are greater thanexpected due to economic factors, including declining real estate values,increasing interest rates, increasing unemployment, or changes in paymentbehavior or other factors;

·       reducedearnings due to higher credit losses because our loans are concentrated by loantype, industry segment, borrower type, or location of the borrower orcollateral;

·       ourreliance on available secondary funding sources such as Federal Home Loan Bankadvances, Federal Reserve Bank discount window borrowings, sales of securitiesand loans, federal funds lines of credit from correspondent banks, andout-of-market time deposits, including in particular brokered deposits, to meetour liquidity needs;

·       ourability to raise capital or otherwise improve our capital ratios;

·       ourability to comply with the terms of the MOU between the Bank and itssupervisory authorities within the timeframes specified;

·       theopening of additional full-service branches and the resulting pressure thiscould cause on our management team;

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

·       changesin the interest rate environment which could reduce anticipated or actualmargins;

·       changesin political conditions or the legislative or regulatory environment;

·       generaleconomic conditions, either nationally or regionally and especially in ourprimary service area, becoming less favorable than expected resulting in, amongother things, a deterioration in credit quality;

·       changesoccurring in business conditions and inflation;

·       changesin technology;

·       changesin deposits flows;

·       changesin monetary and tax policies;

·       thelack of seasoning of our loan portfolio, especially given our rapid loangrowth;

·       theamount of our real estate based loans, and the weakness in the commercial realestate market;

·       adequacyof the level of our allowance for loan losses;

·       therate of delinquencies and amounts of loans charged-off;

·       ourefforts to raise capital or otherwise increase our regulatory capital ratios;

·       theeffects of our efforts to raise capital on our balance sheet, liquidity,capital, and profitability;

·       increasedfunding costs due to market illiquidity, increased competition for funding,and/or regulatory requirements;

·       ourability to retain our existing customers, including our deposit relationships;

·       adversechanges in asset quality and resulting credit risk-related losses and expenses,including the risk of further impairment to the value of our collateral onloans for which we have already taken specific reserves;

·       lossof consumer confidence and economic disruptions resulting from terroristactivities or other military actions;

·       changesin the securities markets; and

·       otherrisks and uncertainties detailed from time to time in our filings with the SEC.

 

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We have based ourforward-looking statements on our current expectations about future events.Although we believe that the expectations reflected in our forward-lookingstatements are reasonable, we cannot guarantee you that these expectations willbe achieved. We undertake no obligation to publicly update or otherwise reviseany forward-looking statements, whether as a result of new information, futureevents, or otherwise.

 

These risks areexacerbated by the recent developments in national and international financialmarkets, and we are unable to predict what effect these uncertain marketconditions will have on us.  During 2008and 2009, the capital and credit markets have experienced extended volatilityand disruption.  There can be no assurancethat these unprecedented recent developments will not continue to materiallyand adversely affect our business, financial condition and results ofoperations, as well as our ability to raise capital or other funding forliquidity and business purposes.

 

# **Overview**

# ** **

CommunitySouth Financial Corporation, (the “Company”), is a bankholding company headquartered in Easley, South Carolina.  Our subsidiary, CommunitySouth Bank andTrust, (the “Bank”), opened for business on January 18, 2005.  In addition to the main office in Easley, theBank has five branch locations in the upstate region of South Carolina.  We opened our Mauldin branch in the fourthquarter of 2005, our Spartanburg branch in the first quarter of 2006, ourAnderson branch in the third quarter of 2006, our Greer branch in the fourthquarter of 2006 and our Greenville branch in the third quarter of 2007.  The Bank provides banking services todomestic markets, principally in the Upstate of South Carolina.  The deposits of the Bank are insured by theFDIC.

 

Like most communitybanks, we derive most of our income from interest we receive on our loans andinvestments.  Our primary source of fundsfor making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of oursuccess is our amount of net interest income, or the difference between theincome on our interest-earning assets, such as loans and investments, and theexpense on our interest-bearing liabilities, such as deposits.  Another key measure is the spread between theyield we earn on these interest-earning assets and the rate we pay on ourinterest-bearing liabilities.

 

A significant portion ofour loan portfolio is secured by real estate. As of September 30, 2009, approximately 90.1% of our loans had realestate as a primary or secondary component of collateral.  The real estate collateral in each caseprovides an alternate source of repayment in the event of default by theborrower and may deteriorate in value during the time the credit isextended.  When we are required toliquidate the collateral securing a loan to satisfy the debt during a period ofreduced real estate values such as this, our earnings and capital are adverselyaffected.

 

The current economicenvironment in our market area has resulted in a downturn in the real estatemarket, which has placed greater pressure on our borrowers’ repaymentcapabilities.  We are experiencing higherlevels of loan delinquencies, defaults and foreclosures.  Further, the downturn in the real estatemarket has adversely impacted the value of the underlying real estate securingthe loans.

 

Included in our loanssecured by real estate, we have approximately $40.3 million of acquisition anddevelopment (A&D) loans as of September 30, 2009, most of which are onproperties located in the Upstate of South Carolina and Western NorthCarolina.  A&D loans are typicallycomprised of loans to borrowers for real estate to be developed (intoproperties such as sub-divisions or spec houses).  Normally, these loans are repaid with theproceeds from the sale of the developed property.  The greater degree of strain on these typesof loans and the significance to our overall loan portfolio has caused us toapply a greater degree of scrutiny in analyzing the ultimate collectability ofamounts due.  The majority of theseborrowers are having financial difficulties. Our analysis has resulted in a significant provision expense in order tomeet the estimated allowance for loan loss reserve requirement.

 

Included in our loanssecured by real estate, we have approximately $42.7 million of acreage andfinished or buildable lot loans as of September 30, 2009.  These loans are comprised of loans toborrowers for raw land and lots in subdivisions that have utilities and areready to be built on individually but not as part of an entire developmentproject.  These loans are generallyrepaid with the proceeds from the sale of the property.  As with our A&D loans, many of theseborrowers are also experiencing financial difficulties and the greater degreeof strain on these types of loans and the significance to our overall loanportfolio has caused us to apply a greater degree of scrutiny in analyzing theultimate collectability of amounts due. Our analysis has resulted in a significant provision expense in order tomeet the estimated allowance for loan loss reserve requirement.

 

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Of course, thereare risks inherent in all loans, not just those secured by real estate, so wemaintain an allowance for loan losses to absorb probable losses on existingloans that may become uncollectible.   Asstated above, we establish and maintain this allowance by charging a provisionfor loan losses against our operating earnings. In the following section we have included a detailed discussion of thisprocess.

 

In addition toearning interest on our loans and investments, we earn income through fees andother expenses we charge to our customers. We describe the various components of this non-interest income, as wellas our non-interest expense, in the following discussion.

 

The Bank is currentlyrestructuring its balance sheet to reduce its risk weighted assets and improvecapital ratios.  Since December 31,2008, the Bank has converted all of its 20% risk weighted securities into 0%risk weighted securities. It has sold its 100% risk weighted BOLI policies. Ithas implemented a loan reduction policy with regards to the loan portfolio. TheBank is strictly limiting new lending. This combined with normal payoffs,principal amortization and charge-offs, has resulted in a decrease in the loanportfolio of $27.9 million from December 31, 2008 to September 30,2009. The effect of all of these actions has been to reduce risk weightedassets by $52.3 million from December 31, 2008 to September 30, 2009.Because the Bank is required to keep a minimum of 10% capital to risk weightedassets to remain well capitalized, this equates to $5.2 million in capitalimprovement.

 

**RecentLegislative and Regulatory Initiatives to Address Financial and Economic Crises**

 

Marketsin the United States and elsewhere have experienced extreme volatility anddisruption for more than 12 months. These circumstances have exerted significant downward pressure on pricesof equity securities and virtually all other asset classes, and have resultedin substantially increased market volatility, severely constrained credit andcapital markets, particularly for financial institutions, and an overall lossof investor confidence.  Loan portfolioperformances have deteriorated at many institutions resulting from, among otherfactors, a weak economy and a decline in the value of the collateral supportingtheir loans.  Dramatic slowdowns in thehousing industry, due in part to falling home prices and increasingforeclosures and unemployment, have created strains on financialinstitutions.  Many borrowers are nowunable to repay their loans, and the collateral securing these loans has, insome cases, declined below the loan balance.  In response to the challenges facing the financial services sector,several regulatory and governmental actions have recently been announcedincluding:

 

·                  TheEmergency Economic Stabilization Act of 2008 (“EESA”), approved by Congress andsigned by President Bush on October 3, 2008, which, among otherprovisions, allowed the U.S. Treasury to purchase up to $700 billion ofmortgages, mortgage-backed securities and certain other financial instrumentsfrom financial institutions for the purpose of stabilizing and providingliquidity to the U.S. financial markets. EESA also temporarily raised the basic limit of FDIC deposit insurancefrom $100,000 to $250,000 through December 31, 2013;

 

·                  OnOctober 7, 2008, the FDIC approved a plan to increase the rates banks payfor deposit insurance;

 

·                  OnOctober 14, 2008, the U.S. Treasury announced the creation of a newprogram, the Troubled Asset Relief Program (the “TARP”) Capital PurchaseProgram (the “CPP”) that encourages and allows financial institutions to buildcapital through the sale of senior preferred shares to the U.S. Treasury onterms that are non-negotiable;

 

·                  OnOctober 14, 2008, the FDIC announced the creation of the TemporaryLiquidity Guarantee Program (the “TLGP”), which seeks to strengthen confidenceand encourage liquidity in the banking system.  The TLGP has two primarycomponents that are available on a voluntary basis to financial institutions:

 

·                  TheTransaction Account Guarantee Program (“TAGP”), which provides unlimiteddeposit insurance coverage through December 31, 2009 fornoninterest-bearing transaction accounts (typically business checking accounts)and certain funds swept into noninterest-bearing savings accounts.  Institutions participating in the TLGP pay a10 basis points fee (annualized) on the balance of each covered account inexcess of $250,000, while the extra deposit insurance is in place;

 

·                  TheDebt Guarantee Program (“DGP”), under which the FDIC guarantees certain seniorunsecured debt of FDIC-insured institutions and their holding companies.  The unsecured debt must be issued on or afterOctober 14, 2008 and not later than June 30, 2009, and the guaranteeis effective through the earlier of the maturity date or June 30,2012.  The DGP coverage limit isgenerally 125% of the eligible entity’s eligible debt outstanding on September 30,2008 and scheduled to mature on or before June 30, 2009 or, for certain 

 

20

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insuredinstitutions, 2% of their liabilities as of September 30, 2008.  Depending on the term of the debt maturity,the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) forcovered debt outstanding until the earlier of maturity or June 30,2012.  The TAGP and DGP are in effect forall eligible entities, unless the entity opted out on or before December 5,2008.

 

·                  On February 17, 2009 President Obamasigned into law The American Recovery and Reinvestment Act of 2009 (“ARRA”),more commonly known as the economic stimulus or economic recovery package. ARRAincludes a wide variety of programs intended to stimulate the economy andprovide for extensive infrastructure, energy, health, and education needs.  In addition, ARRA imposes certain newexecutive compensation and corporate expenditure limits on all current andfuture TARP recipients that are in addition to those previously announced bythe U.S. Treasury. These new limits are in place until the institution hasrepaid the Treasury, which is now permitted under ARRA without penalty andwithout the need to raise new capital, subject to the Treasury’s consultationwith the recipient institution’s appropriate regulatory agency.

 

·                  On March 23, 2009, the U.S.Treasury, in conjunction with the FDIC and the Federal Reserve, announced thePublic-Private Partnership Investment Program for Legacy Assets which consistsof two separate plans, addressing two distinct asset groups:

 

·                  The Legacy Loan Program, in which theprimary purpose will be to facilitate the sale of troubled mortgage loans byeligible institutions, which include FDIC-insured federal or state banks andsavings associations. Eligible assets may not be strictly limited to loans;however, what constitutes an eligible asset will be determined by participatingbanks, their primary regulators, the FDIC and the Treasury. Additionally, theLoan Program’s requirements and structure will be subject to notice and commentrulemaking, which may take some time to complete.

 

·                  The Securities Program, which will beadministered by the Treasury, involves the creation of public-privateinvestment funds to target investments in eligible residential mortgage-backedsecurities and commercial mortgage-backed securities issued before 2009 thatoriginally were rated AAA or the equivalent by two or more nationallyrecognized statistical rating organizations, without regard to ratingenhancements (collectively, “Legacy Securities”). Legacy Securities must bedirectly secured by actual mortgage loans, leases or other assets, and may bepurchased only from financial institutions that meet TARP eligibilityrequirements.

 

Itis likely that further regulatory actions may arise as the Federal governmentcontinues to attempt to address the economic situation.

 

Weare participating in the TAGP component of the TLGP.  As a result of the enhancements to depositinsurance protection and the expectation that there will be demands on the FDIC’sdeposit insurance fund, our deposit insurance costs have increased and willcontinue to increase significantly through the remainder of 2009 and throughout2010.  We have elected not to participatein the CPP.  Regardless of our lack ofparticipation, governmental intervention and new regulations under theseprograms could materially and adversely affect our business, financialcondition and results of operations.  Thefollowing discussion and analysis describes our performance in this challengingeconomic environment.

 

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** **

**Results of Operations**

 

*Three Months ended September 30, 2009 and 2008*

 

*Overview*

 

Our net loss was $2,134,000 for the three months ended September 30,2009 as compared to net income of $85,000 for the three months ended September 30,2008.  Our net loss for the quarter isprimarily due to a $3.5 million provision for loan losses.  For the three months ended September 30,2009, we realized $4,831,000 in interest income, of which $561,000 was frominvestment activities and $4,270,000 was from loan activities.  For the three months ended September 30,2008, we realized $5,634,000 in interest income, of which $604,000 was frominvestment activities and $5,030,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired both locally and via the nationalbrokered certificate market.  We incurredinterest expense of $2,145,000 and $2,995,000 for the three months ended September 30,2009 and September 30, 2008, respectively. This decrease in our interest expense was a result of a decreasedinterest rate environment.  We haveexperienced a decrease in our net interest margin to 2.79% from 2.85% for thequarters ended September 30, 2009 and 2008, respectively.  While net interest income increased onlyslightly, average earning assets increased by $18 million and deposits costsdid not decrease enough to compensate for the decline in loan yields.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the three months ended September 30, 2009 was $3,500,000compared to $160,000 for the comparable prior year period.  The loan loss provision has increased due tocontinued deterioration in the overall quality of the loan portfolio, which isprimarily a result of the downturn in the economy.

 

*Non-interest Income*

 

We had non-interest income of $410,000 and $304,000 for the threemonths ended September 30, 2009 and 2008, respectively.  Mortgage origination fee income for the threemonths ended September 30, 2009 was $197,000.  We had $96,000 in mortgage origination feeincome in the third quarter of 2008.

 

*Non-interest Expense*

 

We incurred non-interest expense of $2,825,000 during the three monthsended September 30, 2009.  Includedin the expense was $1,344,000 of salaries and employee benefits, $225,000 ofdata processing expense, $73,000 of professional fees expense, $64,000 ofadvertising expense, $20,000 of expense related to office supplies, $35,000 oftelephone expense and $135,000 of assessments related to FDIC.  The non-interest expense incurred in thethree months ended September 30, 2008 was $2,624,000.  Included in the expense was $1,223,000 ofsalaries and employee benefits, $194,000 of data processing expense, $226,000of professional fee expense, $107,000 of advertising expense, $26,000 ofexpense related to office supplies, $42,000 of telephone expense and $56,000 ofassessments related to FDIC.

 

For the three months ended September 30, 2009, we incurred otherfixed asset expenses of $190,000 in depreciation and $55,000 in equipmentmaintenance and rental.  For the threemonths ended September 30, 2008, we incurred other fixed asset expenses of$178,000 in depreciation and $57,000 in equipment maintenance and rental.  We incurred $170,000 and $156,000 inoccupancy expense related to all of our office locations for the three monthsended September 30, 2009 and 2008, respectively.

 

The increase in non-interest expense is the result of the increasedadministrative expenses, including, without limitation, FDIC assessments,advertising, professional fees, and data processing, resulting from an increasein customer volume.  The increase in FDICassessment includes increased annual premiums by the FDIC due to the increasein our deposit base and our current financial condition.

 

22

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*Nine Months ended September 30, 2009 and 2008*

 

*Overview*

 

Our net loss was $2,975,000 for the nine months ended September 30,2009 as compared to net loss of $964,000 for the nine months ended September 30,2008.  Our net loss for the nine monthsended September 30, 2009 is primarily due to a $6.3 million provision forloan losses.  For the nine months ended September 30,2009, we realized $14,391,000 in interest income, of which $1,460,000 was frominvestment activities and $12,931,000 was from loan activities.  For the nine months ended September 30,2008, we realized $17,588,000 in interest income, of which $2,007,000 was frominvestment activities and $15,581,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired both locally and via the nationalbrokered certificate market.  We incurredinterest expense of $6,176,000 and $9,985,000 for the nine months ended September 30,2009 and September 30, 2008, respectively. This decrease in our interest expense was a result of a decreasedinterest rate environment.  We haveexperienced an increase in our net interest margin to 2.89% from 2.75% for thenine months ended September 30, 2009 and 2008, respectively.  This increase is due a decline in depositcosts at a faster rate than our decline in loan yields.

 

*Rate/Volume Analysis*

 

Net interest income can be analyzed in terms of the impact of changinginterest rates and changing volumes.  Thefollowing tables set forth the effect which the varying levels ofinterest-earning assets and interest-bearing liabilities and the applicablerates have had on changes in the net interest income for the periods presented.

 
| ** **                  | ** ** | **Nine Months Ended  September  30,  2009 vs. 2008** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **Increase (decrease) Due to**                            | ** ** |
| ** **                  | ** ** | ** **                                                | ** ** | ** ** | ** ** | **Rate /** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)** | ** ** | **Volume**                                                | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| Interest Income             |       |                                                      |       |   |   |   |   |   |   |
| Loans                       |       | $                                                         | (52        | ) | $ | (2,607 | ) | $ | 9 |   | $ | (2,650 | ) |
| Investment securities  (1)  |       | 211                                                       |       | (677 | ) | (80 | ) | (547 | ) |
| Federal funds               |       | 133                                                       |       | (85 | ) | (49 | ) | — |   |
| Total Interest Income       | ** ** | **$**                                                     | **292**    | ** ** | **$** | **(3,369** | **)** | **$** | **(120** | **)** | **$** | **(3,197** | **)** |
|                        |       |                                                      |       |   |   |   |   |   |   |
| Interest Expense            |       |                                                      |       |   |   |   |   |   |   |
| Deposits                    |       | $                                                         | 298        |   | $ | (4,508 | ) | $ | (144 | ) | $ | (4,354 | ) |
| Other borrowings            |       | 119                                                       |       | 359 |   | 67 |   | 545 |   |
| Total Interest Expense      | ** ** | **$**                                                     | **417**    | ** ** | **$** | **(4,149** | **)** | **$** | **(77** | **)** | **$** | **(3,809** | **)** |
|                        |       |                                                      |       |   |   |   |   |   |   |
| Net Interest Income         | ** ** | **$**                                                     | **(125**   | **)** | **$** | **780** | ** ** | **$** | **(43** | **)** | **$** | **612** | ** ** |

 

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(1)          For the purpose of thistable, the investment securities include marketable and non-marketablesecurities.

 

23

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*AverageBalances, Income and Expenses and Rate*

 

The following table sets forth, for the nine monthsended September 30, 2009 and 2008, information related to the Company’saverage balance sheet and its average yields on earning assets and averagecosts of interest-bearing liabilities. Such yields are derived by dividing income or expense by the averagebalance of the corresponding earning assets or interest-bearingliabilities.  Average balances have beenderived from the daily balances throughout the periods indicated.

 
| ** **                                      | ** ** | **Nine  Months Ended  September 30, 2009** | ** **  | **Nine  Months Ended  September 30, 2008** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|-------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **Average**                                     | ** **  | **Income  /**                                   | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income  /** | ** ** | **Yield  /** | ** ** |
| **(Dollars in thousands)**                      | ** ** | **Balance**                                     | ** **  | **Expense**                                     | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                      |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| Earning assets:                                 |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| Loans (1)                                       |       | $                                               | 311,250     |                                            | $          | 12,931 |   | 5.55 | % | $ | 312,291 |   | $ | 15,581 |   | 6.66 | % |
| Investment securities (2)                       |       | 53,552                                          |        | 1,228                                           |       | 3.07 | % | 47,785 |   | 1,775 |   | 4.96 | % |
| Federal funds sold and other                    |       | 14,621                                          |        | 232                                             |       | 2.12 | % | 9,287 |   | 232 |   | 3.34 | % |
| Total earning assets                            |       | 379,423                                         |        | 14,391                                          |       | 5.07 | % | 369,363 |   | 17,588 |   | 6.36 | % |
| Cash and due from banks                         |       | 7,409                                           |        |                                            |       |   |   | 5,406 |   |   |   |   |   |
| Premises and equipment                          |       | 4,512                                           |        |                                            |       |   |   | 4,931 |   |   |   |   |   |
| Other assets                                    |       | 12,597                                          |        |                                            |       |   |   | 8,970 |   |   |   |   |   |
| Allowance for loan losses                       |       | (8,400                                          | )           |                                            |       |   |   | (5,096 | ) |   |   |   |   |
| Total assets                                    | ** ** | **$**                                           | **395,541** |                                            |       |   |   | ** ** | **$** | **383,574** |   |   |   |   |   |
| ** **                                      |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| **Liabilities**                                 |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                   |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| Repurchase agreements                           |       | $                                               | 30,000      |                                            | 729        |   | 3.25 | % | $ | 28,029 |   | 478 |   | 2.28 | % |
| Federal funds purchased                         |       | 208                                             |        | 1                                               |       | 0.64 | % | 699 |   | 10 |   | 1.91 | % |
| Federal reserve discount window                 |       | 84                                              |        | —                                          |       | — | % | — |   | — |   | — | % |
| Federal Home Loan Bankadvances                  |       | 7,198                                           |        | 72                                              |       | 1.34 | % | 5,912 |   | 108 |   | 2.44 | % |
| Note Payable                                    |       | 329                                             |        | 7                                               |       | 2.84 | % | 592 |   | 15 |   | 3.38 | % |
| Subordinated Debt                               |       | 4,325                                           |        | 372                                             |       | 11.50 | % | 290 |   | 25 |   | 11.50 | % |
| Interest-bearing transaction accounts           |       | 18,511                                          |        | 163                                             |       | 1.18 | % | 15,651 |   | 156 |   | 1.33 | % |
| Savings deposits                                |       | 22,860                                          |        | 323                                             |       | 1.89 | % | 20,449 |   | 282 |   | 1.84 | % |
| Time deposits                                   |       | 256,331                                         |        | 4,509                                           |       | 2.35 | % | 252,408 |   | 8,911 |   | 4.72 | % |
| Total interest-bearing liabilities              |       | 339,846                                         |        | 6,176                                           |       | 2.24 | % | 324,030 |   | 9,985 |   | 4.33 | % |
| Demand deposits                                 |       | 22,450                                          |        |                                            |       |   |   | 23,850 |   |   |   |   |   |
| Accrued interest and other liabilities          |       | 1,473                                           |        |                                            |       |   |   | 4,570 |   |   |   |   |   |
| Total liabilities                               |       | 363,769                                         |        |                                            |       |   |   | 352,450 |   |   |   |   |   |
| Shareholders’ equity                       |       | 31,772                                          |        |                                            |       |   |   | 31,124 |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | **$**                                           | **395,541** |                                            |       |   |   |   | **$** | **383,574** |   |   |   |   |   |
| ** **                                      |       |                                            |        |                                            |       |   |   |   |   |   |   |   |   |
| Net interest income                             | ** ** |                                            | ** **  | **$**                                           | **8,215**  |   |   |   |   |   | **$** | **7,603** |   |   |   |
| Net interest spread                             | ** ** | ** **                                      | ** **  | ** **                                      | ** ** | **2.64** | **%** | ** ** | ** ** | ** ** | ** ** | **2.24** | **%** |
| Net interest margin                             | ** ** | ** **                                      | ** **  | ** **                                      | ** ** | **2.89** | **%** | ** ** | ** ** | ** ** | ** ** | **2.75** | **%** |

 

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(1)          There were $16.2 million and$8.7 million of loans in non-accrual status as of September 30, 2009 and2008, respectively.  The effect of feescollected on loans for the nine months ended September 30, 2009 and 2008totaled $137,000 and $220,000, respectively, and increased the annualized yieldon loans by 5 basis points from 5.50% for September 30, 2009 and by 9basis points from 6.57% for September 30, 2008.  The effect of such fees on the annualizedyield on earning assets was an increase of 5 basis points from 5.02% for September 30,2009 and an increase of 8 basis points from 6.28% for September 30,2008.  The effects of such fees on netinterest spread were an increase of 5 basis points from 2.59% for September 30,2009 and an increase of 8 basis points from 2.16% for September 30,2008.  The effects of such fees on netinterest margin were an increase of 4 basis points from 2.85% for September 30,2009 and an increase of 8 basis points from 2.67% for September 30, 2008.

 

24

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(2)          For the purpose of thistable, the investment securities include marketable and non-marketablesecurities.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the nine months ended September 30, 2009 was $6,305,000compared to $2,864,000 for the comparable prior year period. The loan lossprovision has increased due to continued deterioration in the overall qualityof the loan portfolio, which is primarily a result of the downturn in theeconomy.

 

*Non-interest Income*

 

We had non-interest income of $1,665,000 and $1,021,000 for the ninemonths ended September 30, 2009 and 2008, respectively.  Mortgage origination fee income for the ninemonths ended September 30, 2009 was $502,000.  We had $431,000 in mortgage origination feeincome in the first three quarters of 2008. We also had a gain on sale of available for sale securities of $520,000for the nine months ended September 30, 2009.

 

*Non-interest Expense*

 

We incurred non-interest expense of $8,078,000 during the nine monthsended September 30, 2009.  Includedin the expense was $3,946,000 of salaries and employee benefits, $696,000 ofdata processing expense, $239,000 of professional fees expense, $161,000 ofadvertising expense, $62,000 of expense related to office supplies, $110,000 oftelephone expense and $502,000 of assessments related to FDIC.  The non-interest expense incurred in the ninemonths ended September 30, 2008 was $7,173,000.  Included in the expense was $3,686,000 ofsalaries and employee benefits, $561,000 of data processing expense, $358,000of professional fee expense, $146,000 of advertising expense, $73,000 ofexpense related to office supplies, $112,000 of telephone expense and $163,000of assessments related to FDIC.

 

For the nine months ended September 30, 2009, we incurred otherfixed asset expenses of $552,000 in depreciation and $133,000 in equipmentmaintenance and rental.  For the ninemonths ended September 30, 2008, we incurred other fixed asset expenses of$539,000 in depreciation and $143,000 in equipment maintenance and rental.  We incurred $509,000 and $476,000 inoccupancy expense related to all of our office locations for the nine monthsended September 30, 2009 and 2008, respectively.

 

The increase in non-interest expense is the result of the increasedadministrative expenses including FDIC assessments, advertising, professionalfees, and data processing, resulting from an increase in customer volume.   The increase in FDIC assessment includesincreased annual premiums by the FDIC due to the increase in our deposit baseand our current financial condition and a one-time FDIC insurance premium thatequated to a $178,000 one time charge to the Bank in 2009.

 

**Assets and Liabilities**

 

*General*

 

At September 30, 2009, total assets increased13.3% to $439.6 million as compared to $387.8 million at December 31,2008.  Gross loans decreased $27.9million, or 8.7%, during the first nine months of 2009.  As described below, federal funds soldincreased to $14.9 million at September 30, 2009 compared to $4.6 millionat December 31, 2008.  Cash and cashequivalents increased $11.7 million, or 118.1%, since December 31,2008.  As described below, depositsincreased $81.2 million, or 27.4%, during the first nine months of 2009.  At September 30, 2009, shareholders’equity was $25.6 million.

 

*Investment Securities*

 

Investments available for sale increased by $66.4 million, or 139.4%,since December 31, 2008 due to increased liquidity from deposit growth.

 

*Other Investments*

 

Other investments decreased by $206,000 since December 31, 2008due to the sale of FHLB stock.  All ofthe FHLB stock is used to collateralize advances from the FHLB. The FHLB stockwas sold because the FHLB advances which were collateralized by this stock havebeen replaced by brokered CDs with longer maturity dates.  See discussion below under “Advances fromFederal Home Loan Bank.”

 

25

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*Loans*

 

Since loans typically provide higher interest yields than other typesof interest earning assets, we allocate the majority of our earning assets toour loan portfolio.  Gross loansdecreased by $27.9 million, or 8.7%, during the first nine months of 2009.  Loan demand has slowed during the first threequarters of 2009 due to general economic conditions and the real estate market,along with management’s decision to shrink the size of the Bank’s loanportfolio, to help improve the Bank’s risk based capital ratios.****We expect this trend to continue during the next quarter.

 

Balances within major loan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2009** | ** **  | **December 31, 2008** | ** ** |
|-----------------------------------|------------|-----------------------------|-------------|----------------------------|------------|
| Real estate -  construction       |       | $                           | 91,360      |                       | $          | 129,777 |   |
| Real estate - mortgage            |       | 172,515                     |        | 154,838                    |       |
| Commercial and  industrial        |       | 26,996                      |        | 33,303                     |       |
| Consumer and other                |       | 2,088                       |        | 2,989                      |       |
| Total loans, gross                |       | 292,959                     |        | 320,907                    |       |
| Less allowance for loan  losses   |       | (10,325                     | )           | (8,088                     | )          |
| Total loans, net                  | ** ** | **$**                       | **282,634** | ** **                 | **$**      | **312,819** | ** ** |

 

We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect principal and/or interest from the borrower.  We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income.  We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain.  At September 30, 2009, there were $16.2 million in loans that were non-accruing and $2.8 million in loans that were 30 days past due, excluding non-accrual loans.  At December 31, 2008, there were $9.9 million in loans that were non-accruing and $2.4 million in loans that were 30 days past due, excluding non-accrual loans.

 

The increase of $6.7 million in non-performing loans from December 31,2008 to September 30, 2009 is related primarily to continued deteriorationin the Bank’s overall Commercial Real Estate loan portfolio. The number ofloans on non-accrual have increased from 30 to 44 since December 31, 2008.The average non-accrual loan balance is $330,000 and $368,000 as of December 31,2008 and September 30, 2009, respectively. At September 30, 2009, 99% of the non-accrual loans were secured byreal estate. This increase in non-performing loans is a direct result of thepoor economic environment, as noted below, taking a toll on numerous borrowers’ability to pay as scheduled. At this time, management is unable to determinethe length of the economic downturn and therefore unable to determine theultimate impact on the Bank’s Commercial Real Estate portfolio.

 

We have approximately$40.3 million of A&D loans as of September 30, 2009, most of which areon properties located in the Upstate of South Carolina and Western NorthCarolina.  A&D loans are typicallycomprised of loans to borrowers for real estate to be developed (into propertiessuch as sub-divisions or spec houses). Normally, these loans are repaid with the proceeds from the sale of thedeveloped property.  The greater degreeof strain on these types of loans and the significance to our overall loanportfolio has caused us to apply a greater degree of scrutiny in analyzing theultimate collectability of amounts due. The majority of these borrowers are having financial difficulties.  Our analysis has resulted in a significantprovision expense in order to meet the estimated allowance for loan lossreserve requirement.

 

Included in our loanssecured by real estate, we have approximately $42.7 million of acreage andfinished or buildable lot loans as of September 30, 2009.  These loans are comprised of loans toborrowers for raw land and lots in subdivisions that have utilities and areready to be built on individually but not as part of an entire developmentproject.  These loans are generallyrepaid with the proceeds from the sale of the property.  Many of these borrowers are also experiencingfinancial difficulties.

 

The current economicenvironment in our market area has resulted in a downturn in the real estatemarket, which has placed greater pressure on our borrowers’ repaymentcapabilities.  We are experiencing higherlevels of loan delinquencies, defaults and foreclosures.  Further, the downturn in the real estatemarket has adversely impacted the value of the underlying real estate securingthe loans.  The greater degree of strainon these types of loans and the significance to our overall loan portfolio hascaused us to apply a greater degree of scrutiny in analyzing the ultimatecollectability of amounts due.  Ouranalysis has resulted in a significant provision expense in order to meet theestimated allowance for loan loss reserve requirement.  

 

26

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Nevertheless, given thecurrent economic environment, there is a risk of further impairment to thevalue of our collateral on these loans, which would require even furtherincreases to our allowance for loan losses and in the corresponding expensecharged to our provision for loan losses.

 

*Impaired Loans*

 

The Company identifies impaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loan list are considered potentially impaired loans.  These loans are evaluated in determining whether all outstanding principal and interest are expected to be collected.  Loans are not considered impaired if a minimal payment delay occurs and all amounts due, including accrued interest at the contractual interest rate for the period of delay, are expected to be collected.  Management has determined that the Company had $34.8 million and $13.2 million in impaired loans at September 30, 2009 and December 31, 2008, respectively.  $4 million of the allowance for loan loss has been specifically allocated to these relationships.

 

*Potential ProblemLoans*

 

Potential problem loans are loans that are not included in impaired loans (non-accrual loans or loans past due 90 days or more and still accruing), but about which management has become aware of information about possible credit problems of the borrowers that causes concern about their ability to comply with current repayment terms.  At September 30, 2009 and December 31, 2008, the Company had identified $12.7 million and $4.4 million, respectively, of potential problem loans through its internal review procedures.  The results of this internal review process are considered in determining management’s assessment of the adequacy of the allowance for loan losses.

 

*Provision andAllowance for Loan Losses*

 

The Company has developed policies and procedures for evaluating theoverall quality of its credit portfolio and the timely identification ofpotential problem loans.  On a quarterlybasis, the Company’s Board of Directors reviews and approves the appropriatelevel for the Company’s allowance for loan losses based upon management’srecommendations, the results of the internal monitoring and reporting system,and an analysis of economic conditions in its market.  Recently, the Company has developed and beganto implement an improved loan review program, which includes the hiring of anew internal loan review officer and the engagement of a new external loan reviewfirm and the establishment of a new system for tracking borrower financialstatements and the structure of our watch reports.

 

Additions to the allowance for loan losses, which are expensed throughthe provision for loan losses on the Company’s income statement, are madeperiodically to maintain the allowance at an appropriate level based onmanagement’s analysis of the estimated losses inherent in the loanportfolio.  Loan losses and recoveriesare charged or credited directly to the allowance.  The amount of the provision is a function ofthe level of loans outstanding, the level of non-performing loans, historicalloan loss experience, the amount of loan losses actually charged against thereserve during a given period, and current and anticipated economic conditions.

 

The Company’s allowance for loan losses is based upon judgments andassumptions about risk elements in the portfolio, future economic conditions,and other factors affecting borrowers. The process includes identification and analysis of loss potential invarious portfolio segments utilizing a credit risk grading process and specificreviews and evaluations of significant problem credits.  However, there is no precise method ofestimating credit losses, since any estimate of loan losses is necessarilysubjective and the accuracy depends on the outcome of future events.  In addition, due to our rapid growth over thepast several years and our limited operating history, a large portion of theloans in our loan portfolio was originated recently.  In general, loans do not begin to show signsof credit deterioration or default until they have been outstanding for someperiod of time, a process referred to as seasoning.  As a result, a portfolio of more mature loanswill usually behave more predictably than a newer portfolio.  Because our loan portfolio is relatively new,the current level of delinquencies and defaults may not be representative ofthe level that will prevail when the portfolio becomes more seasoned, which maybe higher than current levels.  Ifcharge-offs in future periods increase, we may be required to increase ourprovision for loan losses, which would decrease our net income and possibly ourcapital.

 

In addition, the currentdownturn in the real estate market has resulted in an increase in loandelinquencies, defaults and foreclosures, and we believe these trends arelikely to continue.  In some cases, thisdownturn has resulted in a significant impairment to the value of ourcollateral and our ability to sell the collateral upon foreclosure, and thereis a risk that this trend will continue. The real estate collateral in each case provides an alternate source ofrepayment in the event of default by the borrower and may deteriorate in valueduring the time the credit is extended. If real estate values continue to decline, it is 

 

27

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also more likely that wewould be required to increase our allowance for loan losses.  We determine the value of real estatecollateral by using a current appraisal. Contrary to any other relevantinformation an appraisal is considered current if it is less than 12 months old except when economic or market changes have caused values to rise or fallsignificantly. If a current appraisal is not maintained the bank willgenerally order a new appraisal priorto accepting the property as a result of a deed in lieu of foreclosure orcompletion of a foreclosure action. Commercial appraisals generally takeless than 4 weeks to complete.  A specific impairment is made as soon as possible upon receipt ofthe appraisal.  Based on presentinformation and an ongoing evaluation, management considers the allowance forloan losses to be adequate to meet presently known and inherent losses in theloan portfolio.  Management’s judgmentabout the adequacy of the allowance is based upon a number of assumptions aboutfuture events which it believes to be reasonable but which may or may not beaccurate.  Thus, there can be noassurance that charge-offs in future periods will not exceed the allowance forloan losses or that additional increases in the allowance for loan losses willnot be required, especially considering the overall weakness in the commercialreal estate market in our market areas. The Company does not allocate the allowance for loan losses to specificcategories of loans but evaluates the adequacy on an overall portfolio basisutilizing a risk grading system.

 

*Deposits*

 

Our primary source of funds for loans and investments is ourdeposits.  We have chosen to obtain aportion of our certificates of deposit from areas outside of our market, whichare brokered deposits. The deposits obtained outside of our market areagenerally have been below those being offered for comparable certificates ofdeposit in our local market. Because of this, even though brokered deposits areinterest sensitive, they have been considered a desirable source of funds. Wecannot be assured that we will continue to have access to such funds. Seefurther discussion in the “Liquidity” section. As of September 30, 2009,total deposits had increased by $81.2 million, or 27.4%, from December 31,2008.  The largest percentage increasewas in Savings, which increased $68.0 million, or 470.5%, from December 31,2008 to September 30, 2009, primarily due to a local Savings campaign inthe third quarter of 2009, which raised approximately $68 million in Savingsdeposits.

 

Balances within the major deposit categories are asfollows:

 
| **(dollar  amounts in thousands)** | ** ** | **September 30,  2009** | ** **  | **December 31,  2008** | ** ** |
|------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
| Non-interest  bearing demand       |       | $                            | 22,142      |                        | $          | 22,162 |   |
| Interest bearing  demand           |       | 19,302                       |        | 16,449                      |       |
| Savings                            |       | 82,500                       |        | 14,461                      |       |
| Time deposits  less than $100,000  |       | 29,078                       |        | 32,111                      |       |
| Time deposits of  $100,000 or over |       | 22,001                       |        | 25,162                      |       |
| Brokered  deposits                 |       | 202,791                      |        | 186,298                     |       |
| Total deposits                     | ** ** | **$**                        | **377,814** | ** **                  | **$**      | **296,643** | ** ** |

 

During the period between December 31,2008 and September 30, 2009, as brokered deposits matured, the Bank movedall brokered deposits from 3 month maturities into 15 to 18 month maturities inorder to lock in funding sources. This extension of maturities removed thepossibility of funding issues related to brokered deposits until mid-2010.Given the current economic environment, management considered this prudentliquidity management. At the time, due to downward market rate changes, thisfunding design resulted in a slight decrease in interest expense related tobrokered deposits. The average cost of brokered funds in the quarter ending September 30,2009 was 2.18%.

 

28

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Maturities of Certificatesof Deposit of $100,000 or More (Including Brokered Deposits)

 
| ** **                                         | ** ** | ** ** | ** ** | **After**   | ** ** | **After**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|------------|------------|------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Three**   | ** ** | **Six**     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **Within** | ** ** | **Through** | ** ** | **Through** | ** ** | **After**  | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **Three**  | ** ** | **Six**     | ** ** | **Twelve**  | ** ** | **Twelve** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**                         | ** ** | **Months** | ** ** | **Months**  | ** ** | **Months**  | ** ** | **Months** | ** ** | **Total**  | ** ** |
| **September 30,  2009**                       |       |       | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | —     |        | $          | 6,800       |       | $          | 101,041    |       | $          | 94,950 |   | $ | 202,791 |   |
| Other  certificates of deposit of $100,000 or more |       | 11,437     |       | 4,827       |       | 5,200       |       | 537        |       | 22,001     |       |
| Total                                              |       | $          | 11,437     |        | $          | 11,627      |       | $          | 106,241    |       | $          | 95,487 |   | $ | 224,792 |   |
|                                               |       |       |       |        |       |        |       |       |       |       |       |
| **December 31,  2008**                        |       |       | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | 186,298    |        | $          | —      |       | $          | —     |       | $          | — |   | $ | 186,298 |   |
| Other  certificates of deposit of $100,000 or more |       | 1,782      |       | 11,231      |       | 10,494      |       | 1,655      |       | 25,162     |       |
| Total                                              |       | $          | 188,080    |        | $          | 11,231      |       | $          | 10,494     |       | $          | 1,655 |   | $ | 211,460 |   |

 

Of the Company’s time deposits of $100,000 or over as of September 30,2009 and December 31, 2008, 5.09% and 88.94% are scheduled maturitieswithin three months, respectively. As of September 30, 2009 and December 31,2008, 57.52% and 99.22%, respectively, of the Company’s time deposits of $100,000or over had maturities within twelve months.

 

*Advances from Federal Home Loan Bank (“FHLB”)*

 

Advances from FHLB are a source of funding that theBank uses depending on the current level of deposits and the availability ofcollateral to secure FHLB borrowings.  AtSeptember 30, 2009, the Bank had no outstanding advances from FHLB. TheBank replaced $25 million of outstanding FHLB advances with an average maturityof two months and average cost of 1.49% as of December 31, 2008 withbrokered certificates of deposit with an average maturity of 14 months and costof 2.25% as of inception in order to extend maturities and remove the risk ofthe borrowings being called.

 

*Repurchase Agreements*

 

At September 30, 2009, the Bank had sold $30.0million of securities under agreements to repurchase with brokers with aweighted average rate of 3.24% and an average maturity of 81 months.  The maximum amount outstanding at anymonth-end was $30.0 million.  Theseagreements were secured with approximately $35.6 million of investmentsecurities.

 

*Subordinated Debt*

 

At September 30, 2009, the Company had subordinated debt totaling$4.3 million.  The subordinated noteswere sold during the third quarter of 2008 to a limited number of purchasers ina private offering, bear an interest rate of 11.5%, are callable after September 30,2011, at a premium, and mature in 2018. The subordinated debt has beenstructured to fully count as Tier 2 regulatory capital on a consolidated basis.

 

*Deferred Tax Asset*

 

At this time, management believes that it is more likely than not thatthe company will be able to realize the full value of the company’s deferredtax asset through the use of loss carry-backs and its projected taxable incomeover the next five years.

 

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**Liquidity**

 

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash, federal funds and investments available for sale are our primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans.  Historically, individual and commercial deposits have been our primary source of funds for credit activities. These include brokered deposits, which comprised 53.7% of our deposit base as of September 30, 2009. Brokered deposits have proven to be a reliable source of funds. However, access to the brokered deposit market could be curtailed if the Bank were to fall to a “less than well capitalized” status unless we are able to obtain FDIC approval to renew the brokered deposits, which is unlikely given the current regulatory environment. This would not have any liquidity impact in the short term due to the extended maturities of the brokered deposits, but it would cause long-term funding issues. If access to the brokered deposit market were to become unavailable, the Bank would be required to replace those funds with the combination of FHLB advances, Federal Reserve Discount Window borrowings and local deposits. The Federal Reserve and FHLB borrowings would require pledging additional collateral. At this time, we believe these are viable alternatives. The Bank is currently reducing the loan portfolio which is helping to increase liquidity. Loans have decreased by $27.9 million from December 31, 2008 to September 30, 2009 primarily due to payoffs, amortization and charge-offs. We expect this trend to continue through the remainder of 2009 and during 2010.  See the “Overview” section for more information on the risk weighted asset restructuring policy. Deposit balances, net of brokered deposits, have increased $64.7 million from December 31, 2008 to September 30, 2009 due to a recent Savings campaign we have conducted in our local market.  We anticipate that our funding cost and funding mix will remain stable.

 

The level of liquidity is measured by the cash, cash equivalents and securities available for sale less pledged securities-to-total adjusted assets ratio, which was at 21% at September 30, 2009. We anticipate that this will increase with the combination of deposit growth and shrinkage of assets.

 

In addition to our on balance sheet sources of funds, we also rely on off-balance sheet lines of credit. At September 30, 2009, we had lines of credit with unrelated banks totaling $5 million.  These lines, all of which are secured, are available on a one-to-seven day basis for general corporate purposes.  These lines may be terminated at any time based on our financial condition, although we believe that not to be the case. As members of the FHLB, we have credit availability of up to 15% of the Bank’s total assets. Advances under this credit facility are subject to qualifying collateral**.**Advances may be terminated and called at any time by the FHLB, although we believe that not to be the case. We also have credit availability through the Federal Reserve Discount Window.  As of September 30, 2009, $22 million was available, based on qualifying collateral. Availability of the Federal Reserve Discount Window may be terminated at any time by the Federal Reserve, although we believe that not to be the case.

 

We believe our liquidity sources are adequate to meet our short and long term operating needs.

 

**Impactof Off-Balance Sheet Instruments**

 

Through the operations of our Bank, we have made contractualcommitments to extend credit in the ordinary course of our businessactivities.  These commitments arelegally binding agreements to lend money to our customers at predeterminedinterest rates for a specified period of time. At September 30, 2009, we had issued commitments to extend creditof $19.4 million through various types of lending arrangements.  We evaluate each customer’s credit worthinesson a case-by-case basis.  The amount ofcollateral obtained, if deemed necessary by us upon extension of credit, isbased on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory,property, plant and equipment, commercial and residential real estate.  We manage the credit risk on thesecommitments by subjecting them to normal underwriting and risk managementprocesses.  The following tablesummarizes our off-balance-sheet financial instruments whose contract amountsrepresent credit risk:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------|------------|
|                              |       |                        |       |                       |       |
| Commitments to extend  credit     |       | $                           | 18,159     |                       | $          | 36,260 |   |
|                              |       |                        |       |                       |       |
| Letters of credit                 |       | $                           | 1,255      |                       | $          | 3,488 |   |

 

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**Capital Resources**

 

Total shareholders’ equity decreased from $28.5 million at December 31,2008 to $25.6 million at September 30, 2009.  The decrease is principally due to the netloss for the nine months ended September 30, 2009 of $2,975,000.

 

The FRB and bankregulatory agencies require bank holding companies and financial institutionsto maintain capital at adequate levels based on a percentage of assets andoff-balance sheet exposures, adjusted for risk weights ranging from 0% to100%.  FRB guidelines contain anexemption from the capital requirements for “small bank holding companies,”which in 2006 were amended to cover most bank holding companies with less than$500 million in total assets that do not have a material amount of debt orequity securities outstanding registered with the SEC.  Although our class of common stock isregistered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the Federal Reserve Board will interpret its new guidelines to meanthat we qualify as a small bank holding company.  Nevertheless, our Bank remains subject tothese capital requirements.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classifications are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.  Regardless, our Bank is “well capitalized”under these minimum capital requirements as set per bank regulatoryagencies.  However, due to the currenteconomic environment, the Company considers it prudent to increase its capitallevels, given that additional losses of any significance would most likelycause the bank to fall to a less than “well capitalized” capital level.  The Company is currently analyzing multiplecapital issuance alternatives.

 

Under the capitaladequacy guidelines, regulatory capital is classified into two tiers.  These guidelines require an institution tomaintain a certain level of Tier 1 and Tier 2 capital to risk-weightedassets.  Tier 1 capital consists ofcommon shareholders’ equity, excluding the unrealized gain or loss onsecurities available for sale, minus certain intangible assets.  In determining the amount of risk-weightedassets, all assets, including certain off-balance sheet assets, are multipliedby a risk-weight factor of 0% to 100% based on the risks believed to beinherent in the type of asset.  Tier 2capital consists of Tier 1 capital plus the general reserve for loan losses,subject to certain limitations.  We arealso required to maintain capital at a minimum level based on total averageassets, which is known as the Tier 1 leverage ratio.

 

The Bank is also required to maintain capital at a minimum level basedon quarterly average assets, which is known as the leverage ratio.  Only the strongest banks are allowed tomaintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratiosat least 1% to 2% above the minimum.

 

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The Bank exceeded the regulatory capital requirements at September 30,2009 and December 31, 2008 as set forth in the following table (dollars inthousands).

 
| ** **                                | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                | ** ** | **Amount**                   | ** ** | **Ratio**                   | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                         |       |                        |       |   |   |   |   |
| Tier 1 capital  (to risk-weighted assets) |       | $                            | 26,071     |                        | 8.88       | % | $ | 30,836 |   | 8.92 | % |
| Total capital  (to risk-weighted assets)  |       | 29,823                       |       | 10.16                       |       | 35,205 |   | 10.18 |   |
| Tier 1 capital  (to average assets)       |       | 26,071                       |       | 6.50                        |       | 30,836 |   | 7.98 |   |
|                                           |            |                              |            |                             |            |  |  |  |  |  |  |

 

The Bank’s capital ratioshave remained stable despite its current year losses due to its balance sheetrestructuring as noted in the “Overview” section.

 

The Company did apply forTARP as outlined above in the Recent Legislative and Regulatory Initiatives toAddress Financial and Economic Crises section. However, after consideration ofrequirements, the Company withdrew its application. The Bank is seeking tocontinue to improve its capital ratios through the restructuring of its balancesheet, reduction of classified assets and investigation of external capitalsources.

 

**RecentRegulatory Developments**

 

On June 29, 2009, the Bank entered into a MOUwith the Commissioner of Banking of the South Carolina State Board of FinancialInstitutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  The MOU requires the Bank to,among other things, (1) submit a capital plan to the supervisoryauthorities for maintaining a “well-capitalized” designation; (2) developspecific plans and proposals for the reduction and improvement of assets whichare subject to adverse classification and past due loans; (3) implement aplan to decrease the concentration of commercial real estate loans; (4) developand implement an adequate loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisory authority.

 

Since entering into theMOU, the Bank has been actively pursuing the corrective actions required by theMOU in an effort to ensure that the requirements of the MOU are met in a timelymanner.  The MOU is characterized by thesupervisory authorities as an informal action that is neither published normade publicly available by the supervisory authorities and is used whencircumstances warrant a milder form of action than a formal supervisory action,such as a formal agreement or a cease and desist order.

 

Since entering into theMOU, the Bank has taken a number of steps to improve its financialposition.  For example:

 

·                                          We have developed a capital plan formaintaining our “well-capitalized” designation, and we submitted this plan tothe FDIC and the South Carolina State Board of Financial Institutions in July 2009.  Our capital plan outlines how we intend tomaintain our bank’s risk-based capital ratio level over 10% by (i) reducingour overall amount of assets and, in particular, our amount of risk-basedassets and (ii) raising additional capital.  To reduce our amount of assets, we have soldassets such as our bank-owned life insurance and some of our available-for-salesecurities.  As a result of these steps, duringthe first nine months of 2009 we have decreased our amount of risk-based assetsby $52.3 million.  We are currentlyanalyzing multiple capital issuance alternatives.

 

·                                          We have developed and implemented a planto reduce our amount of classified loans by establishing an IMPAC committee(Improving Problem Asset Committee) to focus on the development of work-outplans for our other real estate owned (OREO) and classified loans and toexplore approaches to provide additional capital to support our classifiedloans or to reduce the level of such loans, such as through the sale of loansto third parties. As a result, we have created a more risk-based loan reviewprogram, which we believe has enhanced the underwriting and monitoring of ourloan portfolio.

 

·                                          We have implemented a plan to decreasethe concentration of our commercial real estate loans.  Since January 2009 we have effectivelyceased making any new commercial real estate loans and we are decreasing theexisting level of these loans through the normal sale of real estate byborrowers and by encouraging borrowers who are not full relationship clients ofthe bank to seek other financing when their loans mature.  We are also actively seeking secondary marketpermanent financing for recently completed residential constructionprojects.  As a result of these efforts,in the first nine months of 2009  ouramount of commercial real estate loans has decreased from $251.3 million of ourtotal loan portfolio, at December 31, 2008 to $237.4 million of our totalloan portfolio, at September 30, 2009.

 

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·                                          We have developed and begun to implementan improved loan review program, which includes the hiring of a new internalloan review officer and the engagement of a new external loan review firm andthe establishment of a new system for tracking borrower financial statementsand the structure of our watch reports.

 

·                                          On September 10, 2009, we submittedto the FDIC and the South Carolina State Board of Financial Institutions arevised Funds Management Policy to reflect our plan to continue to improveliquidity levels and reduce our reliance on brokered deposits and othernon-core funding sources over the next 18 months.  During the first nine months of 2009, we haveimproved the bank’s liquidity position by 17%, due in large part to our localSavings campaign, through which we have raised approximately $68 million in newlocal deposits.

 

**Critical Accounting Policies**

 

We have adopted various accounting policies thatgovern the application of accounting principles generally accepted in theUnited States of America and with general practices within the banking industryin the preparation of our financial statements. Our significant accounting policies are described in Note 1 to thefinancial statements in Item 1.

 

Certain accounting policies involve significant judgments andassumptions by us that have a material impact on the carrying value of certainassets and liabilities.  We considerthese accounting policies to be critical accounting policies.  The judgment and assumptions we use are basedon historical experience and other factors, which we believe to be reasonableunder the circumstances.  Because of thenature of the judgments and assumptions we make, actual results could differfrom these judgments and estimates that could have a material impact on thecarrying values of our assets and liabilities and our results of operations.

 

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flows, the determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 

Some of the more criticaljudgments supporting the amount of our allowance for loan losses includejudgments about the creditworthiness of borrowers, the estimated value of theunderlying collateral, cash flow assumptions, the determination of loss factorsfor estimating credit losses, the impact of current events, and other factorsimpacting the level of probable inherent losses.  Under differentconditions or using different assumptions, the actual amount of credit lossesincurred by us may be different from management’s estimates provided in ourconsolidated financial statements.  Please see “Allowance for LoanLosses” for a more complete discussion of our processes and methodology fordetermining our allowance for loan losses.

 

*Allowancefor Loan Losses*

 

The allowance for loanlosses represents an amount that we believe will be adequate to absorb probablelosses on existing loans that may become uncollectible. Assessing theadequacy of the allowance for loan losses is a process that requiresconsiderable judgment. Our judgment in determining the adequacy of theallowance is based on evaluations of the collectability of loans, includingconsideration of factors such as the balance of impaired loans; the quality,mix and size of our overall loan portfolio; economic conditions that may affectthe borrower’s ability to repay; the amount and quality of collateral securingthe loans; our historical loan loss experience; and a review of specificproblem loans. We adjust the amount of the allowance periodically based onchanging circumstances as a component of the provision for loan losses. Wecharge recognized losses against the allowance and add subsequent recoveriesback to the allowance.

 

We calculate theallowance for loan losses for specific types of loans (excluding mortgage loansheld for sale) and evaluate the adequacy on an overall portfolio basisutilizing our credit grading system which we apply to each loan.  Wecombine our estimates of the reserves needed for each component of theportfolio, including loans analyzed on a pool basis and loans analyzedindividually.  The allowance is divided into two portions: (1) anamount for specific allocations on significant individual credits and (2) ageneral reserve amount.

 

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*SpecificReserve*

 

We analyze individualloans within the portfolio and make allocations to the allowance based on eachindividual loan’s specific factors and other circumstances that affect thecollectability of the credit in accordance with SFAS No. 114, “Accountingby Creditors for Impairment of a Loan.” Significant individual creditsclassified as doubtful or substandard/special mention within our credit gradingsystem require both individual analysis and specific allocation.

 

Loans in the substandardcategory are characterized by deterioration in quality exhibited by any numberof well-defined weaknesses requiring corrective action such as declining ornegative earnings trends and declining or inadequate liquidity.  Loans inthe doubtful category exhibit the same weaknesses found in the substandardloan; however, the weaknesses are more pronounced.  These loans,however, are not yet rated as loss because certain events may occur which couldsalvage the debt such as injection of capital, alternative financing, orliquidation of assets.

 

In these situations wherea loan is determined to be impaired (primarily because it is probable that allprincipal and interest due according to the terms of the loan agreement willnot be collected as scheduled), the loan is excluded from the general reservecalculations described below and is assigned a specific reserve.  Wecalculate specific reserves on those impaired loans exceeding$250,000.  These reserves are based on a thorough analysis of themost probable source of repayment which is usually the liquidation of theunderlying collateral, but may also include discounted future cash flows or, inrare cases, the market value of the loan itself.

 

Generally, for largercollateral dependent loans, current market appraisals are ordered to estimatethe current fair value of the collateral.  However, in situationswhere a current market appraisal is not available, management uses the bestavailable information (including recent appraisals for similar properties,communications with qualified real estate professionals, information containedin reputable trade publications and other observable market data) to estimatethe current fair value.  The estimated costs to sell the subjectproperty are then deducted from the estimated fair value to arrive at the “netrealizable value” of the loan and to determine the specific reserve on eachimpaired loan reviewed.  The credit risk management groupperiodically reviews the fair value assigned to each impaired loan and adjuststhe specific reserve accordingly.

 

*GeneralReserve*

 

We calculate our generalreserve based on a percentage allocation for each of the categories of thefollowing unclassified loan types such as:  real estate, commercial,consumer, A&D/construction and mortgage.  We apply our historicaltrend loss factors to each category and adjust these percentages forqualitative or environmental factors, as discussed below.  Thegeneral estimate is then added to the specific allocations made to determinethe amount of the total allowance for loan losses.

 

We also maintain ageneral reserve in accordance with December 2006 regulatory interagencyguidance in our assessment of the loan loss allowance.  This generalreserve considers qualitative or environmental factors that are likely to causeestimated credit losses including, but not limited to:  changes indelinquent loan trends, trends in risk grades and net chargeoffs,concentrations of credit, trends in the nature and volume of the loanportfolio, general and local economic trends, collateral valuations, theexperience and depth of lending management and staff, lending policies andprocedures, the quality of loan review systems, and other external factors.

 

The current economicenvironment has adversely affected our general reserve requirement.  Historical data, environmental factors andloan trends have all deteriorated over the past year.  This has resulted in a larger calculatedgeneral reserve requirement than compared to a year ago.

 

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

Not applicable.

 

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

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure 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 30,2009.  There have been no significantchanges in our internal controls over financial reporting

 

34

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during the fiscal quarterended September 30, 2009 that have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

 

The design of any systemof controls and procedures is based in part upon certain assumptions about thelikelihood of future events.  There canbe no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions, regardless of how remote.

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings.**

 

Not Applicable.

 

**Item 2. Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

Not applicable.

 

**Item 3. Defaults Upon SeniorSecurities.**

 

Not applicable.

 

**Item 4. Other Information.**

 

Not applicable.

 

**Item 5. Exhibits.**

 

31.1                        Rule 13a-14(a) Certification ofthe Principal Executive Officer.

 

31.2                        Rule 13a-14(a) Certification ofthe Principal Financial Officer.

 

32                                  Section 1350 Certifications.

 

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# **SIGNATURES**

# ** **

In accordance with the requirements of the Securities Exchange Act of1934, the Registrant caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
| Date: October 26,  2009 | By:                                          | /s/ C. Allan Ducker, III |
|------------------------------|----------------------------------------------|-------------------------------|
|                         | C. Allan Ducker, III                    |
|                         | Chief Executive Officer                      |
|                         | (Principal Executive Officer)                |
|                         |                                         |
| Date: October 26,  2009 | By:                                          | /s/ John W. Hobbs             |
|                         | John W. Hobbs                                |
|                         | Chief Financial Officer                      |
|                         | (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                  |
|-------------|------------|-----------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                             |
|        |       |                                                                        |
| 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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