UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


(Mark
One)


T
            QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURTIES EXCHANGE ACT OF
      1934





For the
quarterly period ended June 30, 2010





o
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE EXCHANGE
ACT





For the
transition period from _____________________ to
__________________________





Commission
File Number: 000-30515





Weststar
Financial Services Corporation


(Exact
name of registrant as specified in its charter)





North
      Carolina
            56-2181423(State
      or other jurisdiction of incorporation or organization)
            (IRS
      Employer Identification No.)





79
Woodfin Place, Asheville NC 28801


(Address
of principal executive offices)





828.252.1735


(Registrant’s
telephone number)


______________________________________________________________________________


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





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





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




Indicate
by checkmark whether the registrant is a large accelerated filer, an accelerated
filer, a non-accelerated filer or a smaller reporting company. See the
definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act: (Check one): Large
accelerated filer   o Accelerated
filer  o
Non-accelerated filer   o   (Do
not check if a smaller company) Smaller reporting company   T






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




APPLICABLE
ONLY TO CORPORATE ISSUERS:





State the
number of shares outstanding of each of the issuer’s classes of common equity,
as of the latest practicable date: Common stock, $1.00 par value – 2,167,517
shares outstanding as of August 23, 2010.













INDEX
            
            PagePart I – FINANCIAL INFORMATIONFinancial
      Statements:Consolidated Balance SheetsJune 30, 2010 and December 31, 2009
            
            2Consolidated Statements of OperationsThree and Six Months Ended June 30, 2010 and
      2009
            
            3Consolidated Statements of Comprehensive Income
      (Loss)Three and Six Months Ended June 30, 2010 and
      2009
            
            4Consolidated Statements of Changes in Shareholders’
      EquitySix Months Ended June 30, 2010 and 2009
            
            5Consolidated Statements of Cash FlowsSix Months Ended June 30, 2010 and 2009
            
            6Notes to Consolidated Financial
Statements
            
            7Item
      2 - Management’s Discussion and AnalysisFinancial Condition and Results of
Operations
            
            16Item 4T – Controls and Procedures
            
            31Part II – OTHER INFORMATIONItem 1. – Legal Proceedings
            
            33Item
      4 – {Reserved}
            
            33Item 5 – Other Information
            
            33Item 6 –Exhibits
            
            33Signatures
            
            33





Index





PartI.         
FINANCIAL INFORMATION





ItemI.         Financial
Statements





WeststarFinancial Services Corporation &
      SubsidiaryConsolidated
      Balance Sheets
            
            (unaudited)June
      30,
            
            
            December
      31,2010
            
            
            2009*ASSETS:Cash
      and cash equivalents:Cash
      and due from banks
            
            $
            4,253,292
            
            
            $
            6,785,293Interest-bearing
      deposits
            
            
            8,994,928
            
            
            
            1,550,240Total
      cash and cash equivalents
            
            
            13,248,220
            
            
            
            8,335,533Investment
      securities – available for sale, at fair value(amortized
      cost of $23,729,664 and $24,613,580, atJune
      30, 2010 and December 31, 2009, respectively)
            
            
            24,456,879
            
            
            
            25,046,500Loans
            
            
            170,438,295
            
            
            
            185,474,873Allowance
      for loan losses
            
            
            (4,185,422
            )
            
            
            (3,512,263
            )Net
      loans
            
            
            166,252,873
            
            
            
            181,962,610Premises
      and equipment, net
            
            
            2,765,853
            
            
            
            2,415,933Accrued
      interest receivable
            
            
            937,046
            
            
            
            886,471Federal
      Home Loan Bank stock, at cost
            
            
            592,300
            
            
            
            592,300Deferred
      income taxes
            
            
            -
            
            
            
            985,802Foreclosed
      properties
            
            
            2,910,381
            
            
            
            511,112Other
      assets
            
            
            3,074,451
            
            
            
            3,019,479TOTAL
            
            $
            214,238,003
            
            
            $
            223,755,740LIABILITIES
      AND SHAREHOLDERS' EQUITY:Liabilities:Deposits:Demand
            
            $
            25,235,372
            
            
            $
            23,569,001NOW
      accounts
            
            
            42,115,842
            
            
            
            43,591,452Money
      market accounts
            
            
            29,746,632
            
            
            
            26,442,360Savings
            
            
            3,727,603
            
            
            
            2,890,582Time
      deposits of $100,000 or more
            
            
            23,824,480
            
            
            
            27,166,487Other
      time deposits
            
            
            76,246,680
            
            
            
            73,462,859Total
      deposits
            
            
            200,896,609
            
            
            
            197,122,741Short-term
      borrowings
            
            
            840,310
            
            
            
            4,374,673Accrued
      interest payable
            
            
            366,550
            
            
            
            372,356Other
      liabilities
            
            
            985,004
            
            
            
            917,762Long-term
      debt
            
            
            8,124,000
            
            
            
            4,124,000Total
      liabilities
            
            
            211,212,473
            
            
            
            206,911,532COMMITMENTS
      AND CONTIGENCIES (Note 3)SHAREHOLDERS'
      EQUITY:Preferred
      stock; authorized 1,000,000 shares;no
      shares issued and outstanding
            
            
            -
            
            
            
            -Common
      stock, $1 par value, authorized – 9,000,000 shares;outstanding
      shares– 2,167,517 and 2,167,517 at June 30, 2010and
      December 31, 2009, respectively
            
            
            2,167,517
            
            
            
            2,167,517Additional
      paid-in capital
            
            
            6,269,404
            
            
            
            6,269,404Retained
      earnings(accumulated deficit)
            
            
            (5,858,264
            )
            
            
            8,141,258Accumulated
      other comprehensive income
            
            
            446,873
            
            
            
            266,029Total
      shareholders' equity (Note 7)
            
            
            3,025,530
            
            
            
            16,844,208TOTAL
            
            $
            214,238,003
            
            
            $
            223,755,740





*Derived from audited
consolidated financial statements.


See notes
to consolidated financial statements.





2
 Index





WeststarFinancial Services Corporation &
      SubsidiaryConsolidated Statements of
      Operations(unaudited)
            
            Three
      Months
              Ended
      June 30,
            
            
            Six
      Months
              Ended
      June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009INTEREST
      INCOME:Interest
      and fees on loans
            
            $
            2,262,780
            
            
            $
            2,968,095
            
            
            $
            4,755,880
            
            
            $
            5,759,201Federal
      funds sold
            
            
            -
            
            
            
            160
            
            
            
            -
            
            
            
            1,132Interest-bearing
      deposits
            
            
            5,887
            
            
            
            3,939
            
            
            
            8,365
            
            
            
            4,005Investments:Taxable
      interest income
            
            
            149,669
            
            
            
            169,191
            
            
            
            308,002
            
            
            
            349,073Nontaxable
      interest income
            
            
            107,914
            
            
            
            95,221
            
            
            
            213,523
            
            
            
            186,857Corporate
      dividends
            
            
            380
            
            
            
            -
            
            
            
            783
            
            
            
            -Total
      interest income
            
            
            2,526,630
            
            
            
            3,236,606
            
            
            
            5,286,553
            
            
            
            6,300,268INTEREST
      EXPENSE:Time
      deposits of $100,000 or more
            
            
            116,155
            
            
            
            220,283
            
            
            
            244,636
            
            
            
            448,812Other
      time and savings deposits
            
            
            629,858
            
            
            
            837,982
            
            
            
            1,260,451
            
            
            
            1,701,763Short-term
      borrowings
            
            
            475
            
            
            
            50,388
            
            
            
            45,468
            
            
            
            60,114Long-term
      debt
            
            
            54,202
            
            
            
            44,601
            
            
            
            90,900
            
            
            
            135,638Total
      interest expense
            
            
            800,690
            
            
            
            1,153,254
            
            
            
            1,641,455
            
            
            
            2,346,327NET
      INTEREST INCOME
            
            
            1,725,940
            
            
            
            2,083,352
            
            
            
            3,645,098
            
            
            
            3,953,941PROVISION
      FOR LOAN LOSSES
            
            
            14,069,355
            
            
            
            221,310
            
            
            
            14,507,390
            
            
            
            475,890NET
      INTEREST INCOME (EXPENSE) AFTER PROVISIONFOR
      LOAN LOSSES
            
            
            (12,343,415
            )
            
            
            1,862,042
            
            
            
            (10,862,292
            )
            
            
            3,478,051OTHER
      INCOME:Services
      charges on deposit accounts
            
            
            261,621
            
            
            
            287,680
            
            
            
            505,846
            
            
            
            552,335Other
      service fees and commissions
            
            
            154,181
            
            
            
            166,932
            
            
            
            295,481
            
            
            
            300,612Other
            
            
            9,106
            
            
            
            9,979
            
            
            
            16,553
            
            
            
            19,851Total
      other income
            
            
            424,908
            
            
            
            464,591
            
            
            
            817,880
            
            
            
            872,798OTHER
      EXPENSES:Salaries
      and wages
            
            
            668,706
            
            
            
            709,874
            
            
            
            1,361,609
            
            
            
            1,391,271Employee
      benefits
            
            
            192,444
            
            
            
            82,860
            
            
            
            314,908
            
            
            
            214,135Occupancy
      expense, net
            
            
            110,234
            
            
            
            122,076
            
            
            
            211,875
            
            
            
            307,129Equipment
      rentals, depreciation andmaintenance
            
            
            106,848
            
            
            
            102,653
            
            
            
            202,517
            
            
            
            201,375Supplies
            
            
            72,648
            
            
            
            67,585
            
            
            
            139,320
            
            
            
            131,858Professional
      fees
            
            
            90,001
            
            
            
            65,551
            
            
            
            168,322
            
            
            
            135,988Data
      processing fees
            
            
            186,728
            
            
            
            156,960
            
            
            
            369,475
            
            
            
            310,948FDIC
      insurance premiums
            
            
            86,516
            
            
            
            173,808
            
            
            
            171,310
            
            
            
            246,212Audit,
      tax and accounting
            
            
            32,551
            
            
            
            24,458
            
            
            
            118,935
            
            
            
            79,622Consultant
      fees
            
            
            63,383
            
            
            
            8,584
            
            
            
            117,169
            
            
            
            15,405Marketing
            
            
            87,932
            
            
            
            80,435
            
            
            
            151,606
            
            
            
            173,122Credit
      expenses, net of deferred fees/costs
            
            
            209,038
            
            
            
            (15,401
            )
            
            
            275,733
            
            
            
            (24,365
            )Expenses
      from foreclosed properties
            
            
            27,129
            
            
            
            70
            
            
            
            42,717
            
            
            
            70Other
            
            
            131,754
            
            
            
            109,363
            
            
            
            226,854
            
            
            
            201,994Total
      other expenses
            
            
            2,065,912
            
            
            
            1,688,876
            
            
            
            3,872,350
            
            
            
            3,384,764INCOME
      (LOSS) BEFORE INCOME TAXES
            
            
            (13,984,419
            )
            
            
            637,757
            
            
            
            (13,916,762
            )
            
            
            966,085INCOME
      TAX PROVISION
            
            
            96,351
            
            
            
            203,888
            
            
            
            82,760
            
            
            
            308,273NET
      INCOME (LOSS)
            
            $
            (14,080,770
            )
            
            $
            433,869
            
            
            
            (13,999,522
            )
            
            
            657,812EARNINGS
      / (LOSS) PER SHARE:Basic
            
            $
            (6.50
            )
            
            $
            .20
            
            
            $
            (6.46
            )
            
            $
            .31Diluted
            
            $
            (6.50
            )
            
            $
            .19
            
            
            $
            (6.46
            )
            
            $
            .29








See notes
to consolidated financial statements.





3
 Index





WeststarFinancial Services Corporation &
Subsidiary


Consolidated Statements of
Comprehensive Income (Loss)(unaudited)





Three
      Months
              Ended
      June 30,
            
            
            Six
      Months
              Ended
      June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009NET
      INCOME (LOSS)
            
            $
            (14,080,770
            )
            
            $
            433,869
            
            
            $
            (13,999,522
            )
            
            $
            657,812OTHER
      COMPREHENSIVE INCOMEUnrealized
      holding income (losses) on securitiesavailable
      for sale
            
            
            272,308
            
            
            
            (6,986
            )
            
            
            294,295
            
            
            
            243,677Tax
      effect
            
            
            (104,975
            )
            
            
            2,693
            
            
            
            (113,451
            )
            
            
            (93,937
            )Unrealized
      holding gains (losses) on securitiesavailable
      for sale, net of tax
            
            
            167,333
            
            
            
            (4,293
            )
            
            
            180,844
            
            
            
            149,740OTHER
      COMPREHENSIVE INCOME (LOSS), NET OF TAX
            
            
            167,333
            
            
            
            (4,293
            )
            
            
            180,844
            
            
            
            149,740COMPREHENSIVE
      INCOME (LOSS)
            
            $
            (13,913,437
            )
            
            $
            429,576
            
            
            $
            (13,818,678
            )
            
            $
            807,552








See notes to consolidated financial
statements.





4
 Index





WeststarFinancial Services Corporation &
Subsidiary


Consolidated
Statements of Changes in Shareholders’ Equity(unaudited)


For
the Six Months Ended June 30, 2010 and 2009




Common Stock
            
            
            Additional
              Paid-In
            
            
            Retained
              Earnings
              (Accumulated
            
            
            Accumulated
              Other
              Comprehensive
            
            
            Total
              Shareholders’Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit)
            
            
            Income (Loss)
            
            
            EquityBalance
      December 31, 2008
            
            
            2,125,747
            
            
            $
            2,125,747
            
            
            $
            6,152,868
            
            
            $
            8,214,480
            
            
            $
            17,476
            
            
            $
            16,510,571Net
      change in unrealizedgains
      on securities held for sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            149,740
            
            
            
            149,740Issuance
      of common stock pursuantto
      the exercise of stock options
            
            
            20,385
            
            
            
            20,385
            
            
            
            46,070
            
            
            
            
            
            
            
            
            
            
            
            66,455Tax
      benefit on exercise of non-qualified
      stock options
            
            
            
            
            
            
            
            
            
            
            16,581
            
            
            
            
            
            
            
            
            
            
            
            16,581Net
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            657,812
            
            
            
            
            
            
            
            657,812Balance
      June 30, 2009
            
            
            2,146,132
            
            
            $
            2,146,132
            
            
            $
            6,215,519
            
            
            $
            8,872,292
            
            
            $
            167,216
            
            
            $
            17,401,159Balance
      December 31, 2009
            
            
            2,167,517
            
            
            $
            2,167,517
            
            
            $
            6,269,404
            
            
            $
            8,141,258
            
            
            $
            266,029
            
            
            $
            16,844,208Net
      change in unrealizedgains
      on securities held for sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            180,844
            
            
            
            180,844Net
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (13,999,522
            )
            
            
            
            
            
            
            (13,999,522
            )Balance
      June 30, 2010
            
            
            2,167,517
            
            
            $
            2,167,517
            
            
            $
            6,269,404
            
            
            $
            (5,858,264
            )
            
            $
            446,873
            
            
            $
            3,025,530








See notes
to consolidated financial statements.





5
 Index





WeststarFinancial Services Corporation &
      SubsidiaryConsolidated
      Statements of Cash Flows (unaudited)For
      the Six Months Ended June 30,
            
            2010
            
            
            2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      Income (loss)
            
            $
            (13,999,522
            )
            
            $
            657,812Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Depreciation
            
            
            163,794
            
            
            
            175,464Provision
      for loan losses
            
            
            14,507,390
            
            
            
            475,890Premium
      amortization and discount accretion, net
            
            
            6,474
            
            
            
            (15,834
            )Deferred
      income tax provision
            
            
            872,351
            
            
            
            (202,424
            )Net
      (gains) losses from foreclosed properties
            
            
            15,534
            
            
            
            -Increase
      in accrued interest receivable
            
            
            (50,575
            )
            
            
            (6,643
            )Increase
      in other assets
            
            
            (41,647
            )
            
            
            (50,910
            )Decrease
      in accrued interest payable
            
            
            (5,806
            )
            
            
            (652
            )Increase
      in other liabilities
            
            
            67,242
            
            
            
            243,024Net
      cash provided by operating activities
            
            
            1,535,235
            
            
            
            1,275,727CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of securities available for sale
            
            
            (1,132,875
            )
            
            
            (1,499,005
            )Maturities
      of securities available for sale
            
            
            2,010,317
            
            
            
            2,538,623Net
      increase in loans
            
            
            (2,406,804
            )
            
            
            (9,570,746
            )Proceeds
      from sales of foreclosed properties
            
            
            1,181,023
            
            
            
            -FHLB
      stock purchase
            
            
            -
            
            
            
            (54,200
            )FHLB
      stock redemption
            
            
            -
            
            
            
            47,500Additions
      to premises and equipment
            
            
            (513,714
            )
            
            
            (61,973
            )Net
      cash used in investing activities
            
            
            (862,053
            )
            
            
            (8,599,801
            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      increase in demand deposits, NOW Accounts, MMDAand
      savings accounts
            
            
            4,332,054
            
            
            
            16,975,858Net
      increase (decrease) in time deposits
            
            
            (558,186
            )
            
            
            7,659,382Issuance
      of common stock
            
            
            -
            
            
            
            66,455Proceeds
      of FHLB advances
            
            
            4,000,000
            
            
            
            1,110,000Repayment
      of FHLB advances
            
            
            (4,000,000
            )
            
            
            (2,110,000
            )Tax
      benefit from exercise of non-qualified stock options
            
            
            -
            
            
            
            16,581Net
      increase (decrease) in short-term borrowing
            
            
            465,637
            
            
            
            (4,103,053
            )Net
      cash provided by financing activities
            
            
            4,239,505
            
            
            
            19,615,223NET
      INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            4,912,687
            
            
            
            12,291,149CASH
      AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
            
            
            8,335,533
            
            
            
            4,419,778CASH
      AND CASH EQUIVALENTS AT END OF PERIOD
            
            $
            13,248,220
            
            
            $
            16,710,927








See notes
to consolidated financial statements.





6
 Index





WESTSTARFINANCIAL SERVICES CORPORTION &
SUBSIDIARY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS







1.
            Weststar
      Financial Services Corporation (the “Company”) is the holding company for
      The Bank of Asheville (the “Bank”).  The Bank is a state
      chartered commercial bank, which was incorporated in North Carolina on
      October 29, 1997.  The Bank provides consumer and commercial
      banking services in Buncombe County and surrounding
      areas.  Common shares of The Bank of Asheville were exchanged
      for common shares of Weststar Financial Services Corporation on April 29,
      2000.  Weststar Financial Services Corporation formed Weststar
      Financial Services Corporation I (the “Trust”) during October 2003 in
      order to facilitate the issuance of trust preferred
      securities.  The Trust is a statutory business trust formed
      under the laws of the state of Delaware, of which all common securities
      are owned by Weststar Financial Services
  Corporation.





In the
opinion of management, the accompanying consolidated financial statements
contain all adjustments necessary to present fairly the consolidated financial
position of the Company as of June 30, 2010 and December 31, 2009, and the
consolidated results of their operations for the three and six-month periods
ended June 30, 2010 and 2009 and their cash flows for the six-month periods
ended June 30, 2010 and 2009.  Operating results for the three and
six-month periods ended June 30, 2010 are not necessarily indicative of the
results that may be expected for the fiscal year ending December 31,
2010.





The
accounting policies followed are set forth in Note 1 to the 2009 Annual Report
to Shareholders (Form 10-K) on file with the Securities and Exchange
Commission.







2.
            “Accounting
      for Transfers of Financial Assets”.  The Company adopted the new
      accounting standard governing the recognition and presentation of
      transfers of financial assets. This standard eliminates the concept of a
      qualifying special purpose entity (QSPE), changes the requirements for
      de-recognizing financial assets, and requires additional disclosures,
      including information about continuing exposure to risks related to
      transferred financial assets.  The effective date is for
      financial asset transfers occurring after the beginning of fiscal years
      beginning after November 15, 2009.  The disclosure requirements
      must be applied to transfers that occurred before and after the effective
      date. The adoption of this standard did not have a material effect on the
      Company’s financial position and results of
  operations.





”Consolidation
of Variable Interest Entities”.  The Company adopted the new
accounting standard governing the recognition and presentation of consolidation
of variable interest entities (VIE), which amended the VIE guidance in U.S. GAAP
to include new criteria for determining the primary beneficiary, eliminates the
exception to consolidating QSPEs, requires continual reconsideration of
conclusions reached in determining the primary beneficiary, and requires
additional disclosures.  This requirement is effective as of the
beginning of fiscal years beginning after November 15, 2009 and is applied using
a cumulative effect adjustment to retained earnings for any carrying amount
adjustments (e.g., for newly-consolidated VIEs). The adoption of this standard
did not have an effect on the Company.





“Fair
Value Measurements and Disclosures”.  The Company adopted the new
accounting standard governing the recognition and presentation of fair value
measurements and disclosures. This standard requires additional fair value
measurement disclosures including the amount of and reasons for transfers in and
out of Level 1 and Level 2 fair value measurements and changes the requirement
to disclose purchases, sales, issuances and settlements in the reconciliation of
Level 3 fair value measurements to a gross basis rather than a net basis. In
addition, the standard clarifies that the level of disaggregation required for
existing fair value disclosures should be provided for each class of assets and
liabilities. Disclosures about inputs and valuation techniques should be
disclosed for Level 2 and Level 3 fair value measurements. The requirements of
this standard are effective for interim and annual periods beginning after
December 15, 2009, except for the disclosures about measurements, which are
effective for fiscal years beginning after December 15, 2010 and interim periods
within those fiscal years. The adoption of this standard did not have a material
impact on our financial statements.





7
 Index





“Disclosures about the Credit Quality
of Financing Receivables and the Allowance for Loan Losses”.  In July
the Bank adopted the new standard governing the disclosures associated with
credit quality and the allowance for loan losses.  This standard
requires additional disclosures related to the allowance for loan loss with the
objective of providing financial statement users with greater transparency about
an entity’s loan loss reserves and overall credit quality.  Additional
disclosures include showing on a disaggregated basis the aging of receivables,
credit quality indicators, and troubled debt restructures with its effect on the
allowance for loan loss.  The provisions of this standard are
effective for interim and annual periods ending on or after December 15,
2010.  The adoption of this standard will not have a material impact
on the Bank’s financial position and results of operations however it will
increase the amount of disclosures in the notes to the financial
statements.








3.
            In
      the normal course of business there are various commitments and contingent
      liabilities such as commitments to extend credit, which are not reflected
      on the financial statements.  The unused portions of commitments
      to extend credit were $19,776,975 and $26,179,686 at June 30, 2010 and
      December 31, 2009, respectively.





On June
18, 2010, Queens Gap Holding Company, LLC and D.F. McCarthy Investments XVIII,
LLC filed suit against the Bank in the United States District
Court for the Western District of North Carolina.  In summary, the
Plaintiffs, who were the sellers in a real estate development
transaction, allege that the Bank improperly allowed the buyer
to divert, for personal use, funds from an account set up at the
Bank to fund infrastructure improvements in the development.  The
Plaintiffs' claims are based on alleged oral and email representations and
promises from the Bank to them.  The Plaintiffs seek $4,250,000 in
compensatory damages plus treble damages and attorney's fees.  The Bank
intends to defend this case vigorously. Bank’s management and its counsel are
still in the early phase of discovery and have concluded as of June 30, 2010
that it is not probable that the Bank will incur a loss as a result of this
suit.  As more information becomes available and as the suit
progresses, the conclusion may change.








4.
            Basic
      and diluted net income per share have been computed by dividing net income
      for each period by the weighted average number of shares of common stock
      outstanding during each period.





Basic
earnings per common share represents income available to common stockholders
divided by the weighted average number of common shares outstanding during the
period.  Diluted earnings per common share reflect additional common
shares that would have been outstanding if dilutive potential common shares had
been issued, as well as any adjustments to income that would result from the
assumed issuance.  Potential common shares that may be issued by the
Company relate solely to outstanding stock options and are determined using the
treasury stock method.  There were 211,615 options excluded during the
three and six month periods ended June 30, 2010 due to
antidilution.  During the periods ended June 30, 2009, no options were
excluded due to antidilution.




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




8
 Index





Three
      MonthsEnded
      June 30,
            
            
            Six
      MonthsEnded
      June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009Weighted
      average number ofcommon
      shares used incomputing
      basic net incomeper
      share
            
            
            2,167,517
            
            
            
            2,146,132
            
            
            
            2,167,517
            
            
            
            2,140,937Effect
      of dilutive stock options
            
            
            -
            
            
            
            111,231
            
            
            
            -
            
            
            
            100,807Weighted
      average number ofcommon
      shares and dilutivepotential
      common sharesused
      in computing diluted netincome
      per common share
            
            
            2,167,517
            
            
            
            2,257,363
            
            
            
            2,167,517
            
            
            
            2,241,744





5.
            The
      fair value estimates presented herein are based on pertinent information
      available to management as of June 30, 2010 and December 31,
      2009.  These fair value estimates are based on relevant market
      information and information about the financial
      instruments.  Fair value estimates are intended to represent the
      price an asset could be sold at or the price for which a liability could
      be settled.  However, given that there is no active market or
      observable market transaction for many of the Company’s financial
      instruments, the Company has made estimates of many of these fair values,
      which are subjective in nature, involve uncertainties and matters of
      significant judgment and therefore cannot be determined with
      precision.  Changes in assumptions could significantly affect
      the estimated values.








June 30, 2010
            
            
            December 31, 2009Carrying
              amount
            
            
            Estimated
              fair value
            
            
            Carrying
              amount
            
            
            Estimated
              fair value(In
      thousands)Assets:Cash
      and cash equivalents
            
            $
            13,248
            
            
            $
            13,248
            
            
            $
            8,336
            
            
            $
            8,336Investment
      securities
            
            
            24,457
            
            
            
            24,457
            
            
            
            25,047
            
            
            
            25,047Federal
      Home Loan Bank stock
            
            
            592
            
            
            
            592
            
            
            
            592
            
            
            
            592Loans,
      net
            
            
            166,253
            
            
            
            167,112
            
            
            
            181,963
            
            
            
            183,328Interest
      receivable
            
            
            937
            
            
            
            937
            
            
            
            886
            
            
            
            886Bank
      owned life insurance
            
            
            329
            
            
            
            329
            
            
            
            361
            
            
            
            361Liabilities:Demand
      deposits, NOW accounts,money
      market accounts, savings
            
            
            100,825
            
            
            
            100,825
            
            
            
            96,493
            
            
            
            96,493Time
      deposits
            
            
            100,071
            
            
            
            100,437
            
            
            
            100,629
            
            
            
            100,799Short-term
      borrowings
            
            
            840
            
            
            
            840
            
            
            
            4,375
            
            
            
            4,417Interest
      payable
            
            
            335
            
            
            
            335
            
            
            
            372
            
            
            
            372Long-term
      debt
            
            
            8,124
            
            
            
            8,085
            
            
            
            4,124
            
            
            
            4,039








Cash and
Cash Equivalents and Accrued Interest - The carrying amounts approximate their
fair value because of the short maturity of these financial
instruments.





Investment
Securities - The fair value of securities, excluding the Federal Home Loan Bank
stock, is based on quoted market prices. The carrying value of Federal Home Loan
Bank stock approximates fair value based on the redemption provisions of the
Federal Home Loan Bank.





9
 Index





Loans -
Fair value of loans are estimated based on discounted expected cash
flows.  These cash flows include assumptions for prepayment estimates
over the loan’s remaining life, considerations for the current interest rate
environment compared to the weighted average rate of each portfolio credit, a
credit risk component based on historical and expected performance of each
portfolio.  The fair value calculation did not include a liquidity
adjustment, which in the current environment could possibly reflect a
significant discount.





Deposits
- The fair value of deposits with no stated maturity, such as
non-interest-bearing demand deposits, savings, NOW, and money market accounts,
is equal to the amount payable on demand as of the valuation date. The fair
value of certificates of deposit is based on the discounted value of contractual
cash flows. The discount rate is estimated using the rates currently offered for
deposits of similar remaining maturities.





Short-term borrowings and long-term
debt – The fair values are based on discounting expected cash flows at the
interest rate for debt with same or similar remaining maturities and collateral
requirements.





The
Company groups assets and liabilities at fair value in three levels, based on
the markets in which the assets and liabilities are traded and the reliability
of the assumptions used to determine fair values.  These levels
are:





Level
1  Valuation is based upon quoted prices for identical instruments traded
in active markets.





Level
2  Valuation is based upon quoted prices for similar instruments in active
markets, quoted prices for identical or similar instruments in markets that are
not active, and model-based valuation techniques for which all significant
assumptions are observable in the market.





Level
3  Valuation is generated from model-based techniques that use at least one
significant assumption not observable in the market.  These
unobservable assumptions reflect estimates of assumptions that market
participants would use in pricing the asset or liability.  Valuation
techniques included use of option pricing models, discounted cash flow models
and similar techniques.





Following
is a description of valuation methodologies used for assets and liabilities
recorded at fair value.





Investment
Securities Available-for-Sale


Investment
securities available-for-sale are recorded at fair value on a recurring
basis.  Fair value measurement is based upon quoted prices, if
available.  If quoted prices are not available, fair values are
measured using independent pricing models or other model-based valuation
techniques such as present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumptions.  Level 1 securities included those traded on
an active exchange, such as the New York Stock Exchange, U.S. Treasury
securities that are traded by dealers or brokers in active over-the-counter
markets and money market funds.  Level 2 securities included
mortgage-backed securities issued by government sponsored entities, municipal
bonds and corporate debt securities.  Securities classified as Level 3
include asset-backed securities in less liquid markets.





Loans


The
Company does not record loans at fair value on a recurring
basis.  However, from time to time a loan is considered impaired and a
specific reserve is established.  Loans for which it is probable that
payment of interest and principal will not be made in accordance with the
contractual terms of the loan agreement are considered impaired.  The
fair value of impaired loans is estimated using one of several methods,
including collateral value, market value of similar debt, enterprise value,
liquidation value and discounted cash flow.  Those impaired loans not
requiring an allowance represent loans for which the fair value of the expected
repayments or collateral exceed the recorded investment in such
loans.  At June 30, 2010 and December 31, 2009, substantially all of
the total impaired loans were evaluated based on the fair





10
 Index





value of
the collateral.  In accordance with FASB ASC 820, impaired loans where
an allowance is established based on the fair value of collateral require
classification in the fair value hierarchy.  When the fair value of
the collateral is based on an observable market price or a current appraised
value, the Company records the impaired loan as nonrecurring Level
2.  When an appraised value is not available or management determines
the fair value of the collateral is further impaired below the appraised value
and there is no observable market price, the Company records the impaired loan
as nonrecurring Level 3.





Foreclosed
Properties


Foreclosed
assets are adjusted to fair value less estimated selling costs upon transfer of
the loans to foreclosed assets.  Subsequently, foreclosed assets are
carried at the lower of carrying value or fair value.  Fair value is
based upon independent market prices, appraised value of the collateral or
management’s estimation of the value of the collateral.  When the fair
value of the collateral is based on an observable market price or a current
appraised value, the Company records the foreclosed asset as nonrecurring Level
2.  When an appraised value is not available or management determines
the fair value of the collateral is further impaired below the appraised value
and there is no observable market price, the Company records the foreclosed
asset as nonrecurring Level 3.





Assets
measured at fair value on a recurring basis are summarized below:





Fair Value Measurements at June 30,
      2010Quoted
      Prices in Active Markets for Identical Assets
            
            
            Significant
      Other Observable Inputs
            
            
            Significant
      Unobservable Inputs
            
            
            Assets/LiabilitiesDescription
            
            (Level 1)
            
            
            (Level 2)
            
            
            (Level 3)
            
            
            at Fair ValueU.S.
      Governmentagencies
            
            
            -
            
            
            $
            2,218,212
            
            
            
            -
            
            
            $
            2,218,212Mortgage-backedSecurities
            
            
            -
            
            
            $
            10,697,788
            
            
            
            -
            
            
            $
            10,697,788Municipal
      bonds
            
            
            -
            
            
            $
            11,540,879
            
            
            
            -
            
            
            $
            11,540,879Fair Value Measurements at December 31,
      2009U.S.
      Governmentagencies
            
            
            -
            
            
            $
            2,449,886
            
            
            
            -
            
            
            $
            2,449,886Mortgage-backedSecurities
            
            
            -
            
            
            $
            11,764,887
            
            
            
            -
            
            
            $
            11,764,887Municipal
      bonds
            
            
            -
            
            
            $
            10,831,727
            
            
            
            -
            
            
            $
            10,831,727





Assets
measured at fair value on a non-recurring basis are summarized
below:





Fair Value Measurements at June 30,
      2010Quoted
      Prices in Active Markets for Identical Assets
            
            
            Significant
      Other Observable Inputs
            
            
            Significant
      Unobservable Inputs
            
            
            Assets/LiabilitiesDescription
            
            (Level 1)
            
            
            (Level 2)
            
            
            (Level 3)
            
            
            at Fair ValueImpaired
      Loans
            
            
            -
            
            
            $
            13,046,972
            
            
            $
            1,970,457
            
            
            $
            15,017,429Foreclosed
      properties
            
            
            -
            
            
            
            1,426,649
            
            
            
            1,483,732
            
            
            
            2,910,381





11
 Index





Fair Value Measurements at December 31,
      2009Quoted
      Prices in Active Markets for Identical Assets
            
            
            Significant
      Other Observable Inputs
            
            
            Significant
      Unobservable Inputs
            
            
            Assets/LiabilitiesDescription
            
            (Level 1)
            
            
            (Level 2)
            
            
            (Level 3)
            
            
            at Fair ValueImpaired
      Loans
            
            
            -
            
            
            $
            5,820,701
            
            
            $
            313,776
            
            
            $
            6,134,477Foreclosed
      properties
            
            
            -
            
            
            
            -
            
            
            
            511,112
            
            
            
            511,112








6.
            INVESTMENT
      PORTFOLIO





The
amortized cost, gross unrealized gains and losses and fair values of
available-for-sale securities at June 30, 2010 are as follows:





Available-for-sale
securities consist of the following at June 30, 2010:





Gross
            
            
            GrossAmortized
            
            
            unrealized
            
            
            unrealized
            
            
            Faircost
            
            
            gains
            
            
            losses
            
            
            valueType
      and Maturity GroupMortgage-backed
      securities due -Within
      1 year
            
            
            142,375
            
            
            
            1,594
            
            
            
            -
            
            
            
            143,969Municipal
      bonds due –Within
      1 year
            
            
            555,296
            
            
            
            11,242
            
            
            
            -
            
            
            
            566,538Total
      due within 1 year
            
            
            697,671
            
            
            
            12,836
            
            
            
            -
            
            
            
            710,507U.S.
      Government agencies due -Within
      1 to 5 years
            
            
            2,038,323
            
            
            
            179,889
            
            
            
            -
            
            
            
            2,218,212Residential
      mortgage-backedsecurities
      due -Within
      1 to 5 years
            
            
            781,453
            
            
            
            27,484
            
            
            
            -
            
            
            
            808,937Municipal
      bonds due –Within
      1 to 5 years
            
            
            988,831
            
            
            
            39,041
            
            
            
            -
            
            
            
            1,027,872Total
      due within 1 to 5 years
            
            
            3,808,607
            
            
            
            246,414
            
            
            
            -
            
            
            
            4,055,021Residential
      mortgage-backedsecurities
      due -Within
      5 to 10 years
            
            
            1,014,122
            
            
            
            72,082
            
            
            
            -
            
            
            
            1,086,204Municipal
      bonds due –Within
      5 to 10 years
            
            
            1,635,180
            
            
            
            22,062
            
            
            
            -
            
            
            
            1,657,242Total
      due within 5 to 10 years
            
            
            2,649,302
            
            
            
            94,144
            
            
            
            -
            
            
            
            2,743,446Residential
      mortgage-backedsecurities
      due -After
      10 years
            
            
            8,262,959
            
            
            
            395,719
            
            
            
            -
            
            
            
            8,658,678




12
 Index




Municipal
      bonds due –after
      10 years
            
            
            8,311,125
            
            
            
            104,844
            
            
            
            (126,742
            )
            
            
            8,289,227Total
      due after years
            
            
            16,574,084
            
            
            
            500,563
            
            
            
            (126,742
            )
            
            
            16,947,905Total
      at June 30, 2010
            
            $
            23,729,664
            
            
            $
            853,957
            
            
            $
            (126,742
            )
            
            $
            24,456,879





Available-for-sale
securities consist of the following at December 31, 2009:




Amortizedcost
            
            
            Grossunrealizedgains
            
            
            Grossunrealizedlosses
            
            
            FairvalueType
      and Maturity GroupResidential
      mortgage-backed securities -Within
      1 year
            
            $
            501,935
            
            
            $
            -
            
            
            $
            (176
            )
            
            $
            501,759U.S.
      Government agencies due –Within
      1 to 5 years
            
            
            1,019,655
            
            
            
            63,885
            
            
            
            -
            
            
            
            1,083,540Residential
      mortgage-backed U.S.Government
      agencies securities due -Within
      1 to 5 years
            
            
            999,939
            
            
            
            20,929
            
            
            
            -
            
            
            
            1,020,868Municipal
      bonds due –Within
      1 to 5 years
            
            
            1,549,329
            
            
            
            60,297
            
            
            
            -
            
            
            
            1,609,626Total
      due within 1 to 5 years
            
            
            3,568,923
            
            
            
            145,111
            
            
            
            -
            
            
            
            3,714,034U.S.
      Government agencies due -Within
      5 to 10 years
            
            
            1,265,259
            
            
            
            101,087
            
            
            
            -
            
            
            
            1,366,346Residential
      mortgage-backed U.S.Government
      agencies securities due -Within
      5 to 10 years
            
            
            722,932
            
            
            
            32,432
            
            
            
            -
            
            
            
            755,364Municipal
      bonds due –Within
      5 to 10 years
            
            
            1,642,396
            
            
            
            5,684
            
            
            
            (9,887
            )
            
            
            1,638,193Total
      due within 5 to 10 years
            
            
            3,630,587
            
            
            
            139,203
            
            
            
            (9,887
            )
            
            
            3,759,903Residential
      mortgage-backed U.S.Government
      agencies securities due -after
      10 years
            
            
            9,227,386
            
            
            
            308,305
            
            
            
            (48,795
            )
            
            
            9,486,896Municipal
      bonds due –after
      10 years
            
            
            7,684,749
            
            
            
            50,973
            
            
            
            (151,814
            )
            
            
            7,583,908Total
      due after years
            
            
            16,912,135
            
            
            
            359,278
            
            
            
            (200,609
            )
            
            
            17,070,804Total
      at December 31, 2009
            
            $
            24,613,580
            
            
            $
            643,592
            
            
            $
            (210,672
            )
            
            $
            25,046,500








The
following tables show investments’ gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at June 30,
2010.  These investments represent securities that the Company has the
positive intent and ability to hold to maturity.  The unrealized
losses on investment securities as of June 30, 2010 are a result of volatility
in the market during 2010 and relate to eight municipal bonds.  All
unrealized losses on investment securities resulted from changes in interest
rates and are considered by management to be





13
 Index





temporary
given the credit ratings on these investment securities, the duration of the
unrealized loss, and our intent and ability to retain our investment in a
security for a period of time sufficient to allow for any anticipated recovery
in market value.  Since the Company intends to hold all of its
investment securities until maturity, and it is more likely than not that the
Company will not have to sell any of its investment securities before unrealized
losses have been recovered, and because the Company expects to recover the
entire amount of the amortized cost basis of all its securities, none of the
securities are deemed other than temporarily impaired.







June 30, 2010Less Than 12 Months
            
            
            12 Months or
      More
            
            
            TotalFair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealizedvalue
            
            
            losses
            
            
            value
            
            
            losses
            
            
            value
            
            
            lossesSecurities
      available for sale:Municipal
      bonds
            
            $
            1,934,421
            
            
            $
            41,908
            
            
            $
            1,399,073
            
            
            $
            84,834
            
            
            $
            3,333,494
            
            
            $
            126,742Total
      temporarily impairedsecurities
            
            $
            1,934,421
            
            
            $
            41,908
            
            
            $
            1,399,073
            
            
            $
            84,834
            
            
            $
            3,333,494
            
            
            $
            126,742December
      31, 2009:Less Than 12 Months
            
            
            12 Months or More
            
            
            TotalFair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealizedvalue
            
            
            losses
            
            
            value
            
            
            losses
            
            
            value
            
            
            lossesSecurities
      available for sale:Residential
      mortgage-backed
      U.S. Governmentagencies
      securities
            
            $
            2,912,885
            
            
            $
            (48,971
            )
            
            $
            -
            
            
            $
            -
            
            
            $
            2,912,885
            
            
            $
            (48,971
            )Municipal
      bonds
            
            
            3,998,244
            
            
            
            (53,226
            )
            
            
            1,377,766
            
            
            
            (108,475
            )
            
            
            5,376,010
            
            
            
            (161,701
            )Total
      temporarily impairedsecurities
            
            $
            6,911,129
            
            
            $
            (102,197
            )
            
            $
            1,377,766
            
            
            $
            (108,475
            )
            
            $
            8,288,895
            
            
            $
            (210,672
            )




The
aggregate cost of the Company’s cost method investment, Federal Home Loan Bank
stock, totaled $592,300 at June 30, 2010.  The Company estimated that
the fair value equaled the cost of the investment (that is, the investment was
not impaired).  The investment in Federal Home Loan Bank stock is not
reflected in investment securities; the investment is carried as a separate line
item in the financial statements.




7.
              Capital and Regulatory
      Matters





Due to
the signifcant decline in capital, it is anticipated that the Bank will be
required to enter into a formal consent order with the North Carolina
Commissioner of Banks and the FDIC.  An enforcement action of this
nature would most likely require higher regulatory capital requirements than
would otherwise be required. A consent order could also result in requiring the
Bank to raise additional capital within a specified timeframe, limit access to
the brokered CD market, restrict rates it can offer on customer deposits and
necessitate a corrective plan for the reduction of non-performing assets, among
other matters. Furthermore, because such consent orders are public, there could
be an adverse customer or market reaction to such announcement. These matters
potentially raise substantial doubt about the Bank’s ability to continue as a
going concern.  If the Bank is unable to comply with the terms of any
such consent order, further regulatory actions could be taken.





As a
result of the loan losses, our capital accounts have changed significantly since
year and are as follows as of June 30, 2010:





14
 Index




REGULATORY
CAPITAL




Actual
            
            
            For
      Capital Adequacy Purposes
            
            
            To
      Be Well Capitalized Under Prompt Corrective Action
    ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio(Dollars
      in Thousands)As
      of June 30, 2010Total
      Capital (to Risk WeightedAssets)Consolidated
            
            $
            6,878
            
            
            
            3.85
            %
            
            $
            14,278
            
            
            
            8.00
            %
            
            $
            17,847
            
            
            
            10.00
            %Bank
            
            $
            8,249
            
            
            
            4.63
            %
            
            $
            14,258
            
            
            
            8.00
            %
            
            $
            17,823
            
            
            
            10.00
            %Tier
      1 Capital (to Risk WeightedAssets)Consolidated
            
            $
            3,439
            
            
            
            1.93
            %
            
            $
            7,139
            
            
            
            4.00
            %
            
            $
            10,708
            
            
            
            6.00
            %Bank
            
            $
            5,997
            
            
            
            3.36
            %
            
            $
            7,129
            
            
            
            4.00
            %
            
            $
            10,694
            
            
            
            6.00
            %Tier
      1 Capital (to Average Assets)Consolidated
            
            $
            3,439
            
            
            
            1.51
            %
            
            $
            9,122
            
            
            
            4.00
            %
            
            $
            11,403
            
            
            
            5.00
            %Bank
            
            $
            5,997
            
            
            
            2.63
            %
            
            $
            9,113
            
            
            
            4.00
            %
            
            $
            11,392
            
            
            
            5.00
            %





The Bank
is considered significantly undercapitalized under the prompt corrective action
provisions of the FDIC.





15
 Index





Item2.    Management’s Discussion and
Analysis


Financial
Condition and Results of Operations





Weststar
Financial Services Corporation & Subsidiaries


Management’s
Discussion and Analysis





Management’s
Discussion and Analysis is provided to assist in understanding and evaluating
the Company’s results of operations and financial condition. The following
discussion should be read in conjunction with the consolidated financial
statements and related notes included elsewhere in this report. Weststar
Financial Services Corporation is the holding company for The Bank of Asheville
(the “Bank”).  The Bank is a state-chartered commercial bank which was
incorporated in North Carolina on October 29, 1997. The Bank provides consumer
and commercial banking services in Buncombe County and surrounding areas. Common
shares of The Bank of Asheville were exchanged for common shares of Weststar
Financial Services Corporation on April 28, 2000. Weststar Financial Services
Corporation formed Weststar Financial Services Corporation I (the “Trust”)
during October 2003 in order to facilitate the issuance of trust preferred
securities.  The Trust is a statutory business trust formed under the
laws of the state of Delaware, of which all common securities are owned by
Weststar Financial Services Corporation.  Because Weststar Financial
Services Corporation has no material operations and conducts no business on its
own other than owning the Bank, the discussion contained in Management’s
Discussion and Analysis concerns primarily the business of the
Bank.  However, for ease of reading and because the financial
statements are presented on a consolidated basis, Weststar Financial Services
Corporation and the Bank are collectively referred to herein as the
Company.







EXECUTIVE
OVERVIEW





Net
charge-offs during the three and six month periods ended June 30, 2010 totaled
$13,398,016 and $13,834,231, respectively, compared to $51,667 and $158,363
during the three and six month periods ended June 30, 2009,
respectively.  Second quarter 2010 charge-offs were primarily related
to declines in real estate values of impaired collateral dependent loans and
changes in the types of appraisals obtained to support valuations on properties
that are expected to be resolved via foreclosure.  The sluggish real
estate market continues to significantly affect real estate collateral values
which directly impacts the level of specific reserves required on impaired
loans.





Non-performing
assets totaled $27,780,216 and $25,973,097 at June 30, 2010 and December 31,
2009, respectively.  Loans outstanding decreased 8.11% to
$170,438,295, when compared to December 31, 2009 primarily as a result of loan
charge-offs and write-downs. The investment portfolio remained relatively flat
at $24,456,879, when compared to $25,046,500 at December 31, 2009.





As a
reaction to the continued trends in nonperforming loans, the Bank has brought in
third party loan review assistance to review significant portions of the
portfolio for potential problem loans.  During the quarter, this
function has identified additional classified or impaired loans.  The
Bank will continue to have the portfolio reviewed by the outside consultant for
additional problem loans.





Net
interest income decreased by 17.16% during the three-month period due to a
decrease in net earning assets and net interest margin.  Primarily as
a result of net charge-offs, the Company added $14,069,355 to the allowance for
loan losses compared to $221,310 during the comparable period in
2009.  Other non-interest income for the June 30, 2010 and 2009
quarters totaled $424,908 and $464,591, respectively.  The decrease in
other income primarily reflects decreased fees from the origination of mortgage
loans and decreased overdraft fees.  Non-interest expenses increased
from $1,688,876 to $2,065,912 or 22.32%.  The increase was primarily
attributable to credit related expenses such as appraisals and collections, and
expenses incurred to support loan and deposit servicing.





Net
income (loss) totaled $(14,080,770) and $433,869 for the quarters ended June 30,
2010 and 2009, respectively.





16
 Index





The
Company’s net interest income decreased by 7.81% during the six-month period due
to a decrease in earning assets.  Primarily as a result of net
charge-offs, the Company added $14,507,390 to the loan loss reserve compared to
$475,890 during the comparable period in 2009.  Other non-interest
income for the June 30, 2010 and 2009 periods totaled $817,880 and $872,798
respectively.  The decrease in other income primarily reflects
decreased fees from the origination of mortgage loans and decreased overdraft
fees.  Non-interest expenses increased from $3,384,764 to $3,872,350
or 14.41%.  The increase was primarily attributable to credit related
expenses such as appraisals and collections, and expenses incurred to support
loan and deposit servicing.





Net
income (loss) totaled $(13,999,522) and $657,812 for the six month periods ended
June 30, 2010 and 2009, respectively.





CHANGES
IN FINANCIAL CONDITION


JUNE 30,
2010 COMPARED TO DECEMBER 31, 2009





During
the period from December 31, 2009 to June 30, 2010, total assets decreased
$9,517,737 or 4.25%.  This decrease, reflected primarily in loans,
resulted from net charge-offs and/or write-downs. This trend was driven by the
sluggish real estate market’s affect on real estate collateral which had a
significant impact on the level of specific reserves required on impaired
loans.





Securities
and interest-bearing balances with other financial institutions at June 30, 2010
totaled $33,451,807 compared to $26,596,740 at December 31,
2009.  Through an investment in the Federal Home Loan Bank, the
Company gained access to the Federal Home Loan Bank system.  This
access grants the Company sources of funds for lending and
liquidity.  Investments in Federal Home Loan Bank stock to date total
$592,300.





At June
30, 2010, the loan portfolio constituted 79.56% of the Company’s total
assets.  Loans decreased $15,036,578, or 8.11%, from December 31, 2009
to June 30, 2010 as a result of net charge-offs and/or write-downs
..





The
recorded investment in impaired loans was $28,461,384, $3,007,369 and
$33,329,137, which includes nonperforming and restructured loans, at June 30,
2010 and 2009 and December 31, 2009, respectively.  Impaired loans of
$28,461,384, $2.193,220 and $33,329,137 had no related allowances for loan
losses.  The Company compares the net realizable value of impaired
loans against the recorded investment in such loans and generally charges-off
any deficit to the allowance for loan losses in accordance with FDIC
guidance.  The average recorded balance of impaired loans for the six
months ended June 30, 2010 and 2009 totaled $33,731,623 and $1,861,357,
respectively and $7,356,699 for the year ended December 31, 2009.  For
the six-month periods ended June 30, 2010 and 2009, the Company recognized
interest income from impaired loans of approximately $191,530 and $20,115,
respectively.  See “Asset Quality” for discussion and analysis of loan
loss reserves.





During
2010, the Company focused significant attention on working with loan customers,
who were experiencing financial difficulties.  The economic downturn
impacted many businesses in our market ranging from real estate development to
retail sales, which in turn negatively impacted land sales in the region and
retail sales of our commercial customers.  The Company attempted to
take proactive measures to restructure notes for businesses and individuals,
where restructuring indicated an improvement in loan
collectibility.





The
following table presents the recorded investments in troubled debt restructure
loans by category that are performing:




17
 Index




June
      30,
              
              
              December
      31,2010
              
              
              2009Commercial
      real estate:Residential
      ADC
              
              $
              56,723
              
              
              $
              5,527,742Other
      commercial real estate
              
              
              -
              
              
              
              464,270


Total
      non-owner occupiedcommercial  real
      estate
            
            
            56,723
            
            
            
            5,992,012Commercial
      owner occupiedreal
      estate
            
            
            3,015,186
            
            
            
            1,172,095Commercial
      and industrial
            
            
            150,224
            
            
            
            167,341Residential
      mortgage:First
      lien, closed end
            
            
            267,588
            
            
            
            274,151Home
      equity lines of credit
            
            
            80,804
            
            
            
            198,602Consumer
            
            
            13,202
            
            
            
            8,987Total
            
            $
            3,583,727
            
            
            $
            7,813,188





The
reduction in troubled debt restructured loans was primarily due to loan
charge-offs.  Potential problem loans consist of loans that are
performing in accordance with contractual terms, but for which management has
concerns about the ability of an obligor to continue to comply with repayment
terms, because of the obligor’s potential operating or financial
difficulties.  Management monitors these loans closely and reviews
their performance on a regular basis.  These loans do not meet the
standards for, and are therefore not included in, nonperforming
assets.  At June 30, 2010, the Company identified nine potential
problem loans totaling $3,058,281 as compared to one potential problem loan
totaling $2,756 at December 31, 2009.





Deposits
increased $3,773,868 during the six months ended June 30, 2010.  The
increase in deposits was primarily attributable to growth in demand, money
market and savings accounts.  The Company experienced a $1,475,610
decrease in NOW accounts during the quarter.  The decrease primarily
resulted from fluctuations in Interest On Lawyers Trust Accounts, commonly
called IOLTAs, which is an escrow account primarily used for real estate
transactions.  These accounts are subject to wide fluctuations
representing real estate closing activities.  During the second
quarter, the Company reduced the rate paid on eZchecking, a NOW account product,
from 4.01% to 3.65% and reduced the maximum base upon which the rate could be
paid from $25,000 to $15,000.  Changes in the product reflect trends
in the market area and adjustments needed to increase product
profitability.  eZchecking remains one of the Company’s most popular
accounts.  Qualifiers for the account included a minimum of 10 debit
card transactions, one direct deposit and receipt of an electronic statement
each month.  The Company earns interchange revenue from debit card
usage and can deliver electronic statements more efficiently than through
standard U.S. mail; these two factors effectively minimize the cost of funds on
the product.  At June 30, 2010, the Company had 2,151 eZchecking
accounts totaling $31,287,410 compared to 1,818 accounts totaling $29,777,082 at
December 31, 2009.  Savings accounts increased from $2,890,582 to
$3,727,603 or 28.96%.  The increase in savings most likely reflects
the national trends of increased savings and reduced spending as consumers
remain pessimistic about the economy.  Time deposits decreased
$558,186 from December 31, 2009 to June 30, 2010.  The decrease
appears to have stemmed from a shift in funds from certificates of deposit to
the equities sector as the stock market demonstrated gains during the majority
of the period.  Demand deposit account growth primarily reflects
increased deposits in commercial accounts rather than retail consumer
accounts.





Short-term
borrowings consisted of securities sold under agreements to repurchase in the
amount of $840,310.  Securities sold under agreements to repurchase
bear a variable rate of interest and mature daily.  At June 30, 2010,
the rate on these borrowings was .25%.





Long-term
borrowings consisted of trust preferred securities totaling $4,124,000 and one
advance from the Federal Home Loan Bank of Atlanta.  The trust
preferred securities bear a rate of LIBOR plus 315 basis points (3.45% at June
30, 2010) and pay dividends quarterly.  The rate is subject to
quarterly resets.  The trust preferred securities mature October 7,
2033, and became callable on or after October 7, 2008.  $860,000 of
the trust preferred securities were eligible for inclusion as Tier I capital and
$1,184,000 as Tier 2 capital.  Trust preferred securities are limited
25% of Tier 1 capital.  Amounts in excess of this limit generally may
be included in Tier 2 capital.  Advances from the FHLB are secured by
a blanket lien on 1-4 family real estate loans and certain commercial real
estate loans.  The interest rate on the advance was 1.83% and matures
on March 15, 2013.





18
 Index





The
Company’s total capital to risk weighted assets totaled 3.85% at June 30,
2010.  Current regulations require a minimum ratio of total capital to
risk weighted assets of 8%, with at least 4% being in the form of Tier 1
capital, as defined in the regulation.  As of June 30, 2010, the
Company’s capital was considered to be significantly undercapitalized under the
prompt corrective action provisions.   If the Company does not
improve its capital, regulators may issue a warning to the Company and may also
be required to take certain actions with respect to the Bank under federal bank
regulatory “prompt corrective action” standards, including changing management
and forcing the Bank to take other corrective actions. In addition, the Bank
would lose the ability to renew, rollover or originate brokered deposits and to
offer certain deposit products priced at above market
rates.  Additionally, the Company’s access to borrowing from the
Federal Home Loan Bank – Atlanta and Federal Reserve Bank may also be subject to
reduced levels and terms.  See discussions under “Capital Resources”
and “Liquidity”





RESULTS
OF OPERATIONS


FOR THE
THREE-MONTH AND SIX-MONTH PERIODS ENDED JUNE 30, 2010 AND
2009





Net
interest income, the principal source of the Company’s earnings, is the amount
of income generated by earning assets (primarily loans and investment
securities) less the total interest cost of the funds obtained to carry them
(primarily deposits and other borrowings).  The volume, rate and mix
of both earning assets and related funding sources determine net interest
income.





COMPARATIVE
THREE MONTHS





Net
interest income for the quarter ended June 30, 2010 totaled $1,725,940 compared
to $2,083,352 in 2009.  The decrease was attributable to decreases in
net earning assets and net interest margin.  The Company’s net
interest margin was approximately 3.13% and 3.93% for the quarters ended June
30, 2010 and 2009, respectively.





Primarily
as a result of changes in nonperforming loans and charge-offs, partially offset
by some stabilization in the national and local economies, the Company recorded
a provision for loan losses of $14,069,355 for the three months ended June 30,
2010 compared to $221,310 for the same period in 2009.  The increased
provision was necessary in order to bring the allowance for loan losses to a
level deemed appropriate in light of the risk inherent in the Bank’s loan
portfolio indicated by recent loss experience, management’s analysis of
applicable credit quality metrics and updated appraisals that resulted in
charge-offs based upon their analysis of loan repayment probabilities of
projected borrower cash flows or underlying collateral values, as
applicable.Charge-offs, net of
recoveries, totaled $13,398,016 for the three months ended June 30, 2010
compared to $51,667 for the same period in 2009.  Impaired loans,
which include both nonaccrual and nonperforming restructured loans, are measured
at net realizable value (the value of supporting collateral less costs to sell)
or present value of cash flows, if not collateral-
dependent.   If the net realizable value or present value of cash
flows is less than the carrying value of the loan, the deficit is charged
against the loan loss reserve.  During 2009, real estate values and
real estate sales continued to decline on the heels of the depressed national,
regional and local economies.  Real estate loans that formerly
reflected low loan-to-value levels now reflect higher loan-to-value
levels.  Management has taken these factors among others such as a a
short time horizon of historic charge-off rates,  concentrations of
credit, delinquency trend, economic and business conditions, external factors,
lending management/staff, lending policies/procedures, loss and recovery trends,
nature and volume of portfolio, nonaccrual trends, and other adjustments,
problem loan trend and quality of loan review system by loan sector, into
account when estimating the allowance for loans losses for both performing and
nonperforming loans, which resulted in an increased provision for loan
losses.  Loan charge-offs during second quarter resulted primarily
from the decline in real estate values of impaired collateral dependent loans
and changes in the types of appraisals obtained to support valuations on
collateral of impaired loans.  Management continues to be concerned
about the economy and related job growth.  Sustained growth in
unemployment may necessitate additional increases to the provision for loan
losses.  See “ASSET QUALITY” for more discussion.





Other
non-interest income for the June 30, 2010 and 2009 quarters totaled $424,908 and
$464,591, respectively.  The decrease in other income primarily
reflects decreased fees from overdraft activities and fees from the origination
of mortgage loans; decreases were partially offset by an increase in interchange
revenue.  Fees earned





19
 Index





on
overdrafts decreased from $228,301 to $205,014.  Fees from this
service are activity based.  Mortgage fee income dropped by $39,074 as
fewer customers qualified for mortgage loans.  Qualifications are
primarily based upon customer credit scores and cash flows to meet borrowing
obligations.  The Company continues to explore alternate financing
options in an effort to provide a wide array of products to meet borrower
needs.  Interchange revenue increased from $87,152 to $111,723 for the
periods ended June 30, 2009 and 2010, respectively.  The Company earns
interchange revenue from customer ATM, debit and credit card
activities.  Other income remained relatively flat at
$9,106.





Other
non-interest expense totaled $2,065,912 compared to $1,688,876 in
2009.  The increase was primarily attributable to credit expenses and
consultant fees.  During the period, the Bank ordered numerous
appraisals on problem loans secured by real estate in order to determine the
underlying value of the collateral.  Depending on the size and
complexity of the collateral, appraisal costs ranged from $500 to
$6,000.  Additionally, the Bank incurred loan collection and
repossession expenses of $135,972 compared to $5,765 during 2009.  The
majority of the loan collection expenses were attributable to legal
fees.  The Bank further employed consultants to review lending
activities and processes for quality control purposes.  Consultant
fees totaled $63,383 during 2010 compared to $8,584 during 2009.





Salaries
and benefits increased 8.63% to $861,150.  The increase was largely
due to the changes in cash surrender value of an insurance contract and the
increased participation in the Company’s 401(k) retirement
plan.  Occupancy expense decreased from $122,076 to
$110,234.  The decrease in expense reflects the change from lease to
purchase of one of the Bank’s properties.  In January, the Bank
purchased the building that houses the Reynolds office, which had originally
been established as a leased property.  Equipment expenses remained
relatively flat at $106,848.  Professional fees increased from $65,551
to $90,001 primarily due to various legal fees.  Data processing fees
increased by 18.96% to $186,728 as a result of growth in the number of loans and
deposits and increased internet banking and remote deposit capture
activities.  FDIC insurance premiums decreased from $173,808 to
$86,516 in 2010.  During the second quarter of 2009, the FDIC imposed
a 5 basis point special assessment, which totaled approximately $101,000, to
help replenish the FDIC’s deposit insurance fund.  No such assessment
was imposed during 2010.  Marketing expenses increased from $80,435 to
$87,932, which reflects increased marketing efforts for products and
services.  Expenses from the foreclosures of properties increased from
$70 during 2009 to $27,129 during 2010.  The increase reflects the
levels of foreclosure related activities.  Other expenses totaled
$131,754 in 2010 compared to $109,363 in 2009.  Income (loss) before
income tax provision totaled $(13,984,419) and $637,757 for the quarters ended
June 30, 2010 and 2009, respectively.  Income tax provision totaled
$96,351 and $203,888 for the quarters ended June 30, 2010 and 2009,
respectively, which equated to an effective tax rate of (.69)% and 31.97%,
respectively.  The decrease in 2010’s tax rate reflects the creation
of a deferred tax valuation allowance account, which offset the Company’s
deferred tax assets.   No such valuation existed during the
comparable 2009 period.  Net income (loss) totaled $(14,080,770) and
$433,869 for the quarters ended June 30, 2010 and 2009,
respectively.





Other
comprehensive income (loss) totaled $167,333 and $(4,293) for the three months
ended June 30, 2010 and 2009, respectively.  Comprehensive income
(loss), which is the change in shareholders’ equity excluding transactions with
shareholders, totaled $(13,913,437) and $429,576 for the quarters ended June 30,
2010 and 2009, respectively.





COMPARATIVE
SIX MONTHS





Net
interest income for the six-month period ended June 30, 2010 totaled $3,645,098
compared to $3,953,941 for the same period in 2009.  The decrease was
attributable to a decrease in net earning assets and net interest
margin.  The Company’s net interest margin was approximately 3.35% and
3.85% for the six months ended June 30, 2010 and 2009,
respectively.





The
Company recorded a provision for loan losses of $14,507,390 and $475,890 for the
six months ended June 30, 2010 and 2009, respectively.  The provision
for loan losses is charged to operations to bring the allowance to a level
deemed appropriate by management based on the factors discussed under “Asset
Quality.”





20
 Index





Other
non-interest income for the six months ended June 30, 2010 and 2009 totaled
$817,880 and $872,798, respectively.  The decrease in other income
primarily reflects decreased fees from overdraft activities and fees from the
origination of mortgage loans; decreases were partially offset by an increase in
interchange revenue.  Fees earned on overdrafts decreased from
$436,734 to $393,256.  Fees from this service are activity
based.  Effective July 1, 2010, changes in federal regulations that
govern the Company’s ability to charge overdraft fees will likely further reduce
the Company’s revenue from this service.  The Company will be
prohibited from charging overdraft fees for ATM and one-time debit card
transactions under the new Federal Reserve rules.  The new rules
require the Company to ask consumers whether they want to opt in for overdraft
protection. Additionally, the Company’s customers will be allowed only one
overdraft fee per month, or six annually.  Mortgage fee income dropped
by $55,269 as fewer customers qualified for mortgage
loans.  Qualifications are primarily based upon customer credit scores
and cash flows to meet borrowing obligations.  The Company continues
to explore alternate financing options in an effort to provide a wide array of
products to meet borrower needs.  Interchange revenue increased from
$160,628 to $207,622 for the periods ended June 30, 2009 and 2010,
respectively.  The Company earns interchange revenue from customer
ATM, debit and credit card activities.  Other income remained
relatively flat at $16,553.





Other
non-interest expense totaled $3,872,350 compared to $3,384,764 in
2009.  The increase was primarily attributable to credit expenses and
consultant fees.  During the period, the Bank ordered numerous
appraisals on problem loans secured by real estate in order to determine the
underlying value of the collateral.  Depending on the size and
complexity of the collateral, appraisal costs ranged from $500 to
$6,000.  Additionally, the Bank incurred loan collection and
repossession expenses of $205,814 compared to $12,895 during
2009.  The majority of the loan collection expenses were attributable
to legal fees.  The Bank further employed consultants to review
lending activities and processes for quality control
purposes.  Consultant fees totaled $117,169 during 2010 compared to
$15,405 during 2009.





Salaries
and benefits increased 4.43% to $1,676,517.  The increase was largely
due to the changes in cash surrender value of an insurance contract and the
increased participation in the Company’s 401(k) retirement
plan.  Occupancy expense decreased from $307,129 to
$211,875.  The decrease in expense reflects the change from lease to
purchase of one of the Bank’s properties.  In January, the Bank
purchased the building that houses the Reynolds office, which had originally
been established as a leased property.  Equipment expenses remained
relatively flat at $202,517.  Professional fees increased from
$135,988 to $168,322 primarily due to various legal fees.  Data
processing fees increased by 18.82% to $369,475 as a result of growth in the
number of loans and deposits and increased internet banking and remote deposit
capture activities.  FDIC insurance premiums decreased from $246,212
to $171,310 in 2010.  During the second quarter of 2009, the FDIC
imposed a 5 basis point special assessment, which totaled approximately
$101,000, to help replenish the FDIC’s deposit insurance fund.  No
such assessment was imposed during 2010.  Marketing expenses decreased
from $173,122 to $151,606, which reflects decreased marketing efforts for
products and services during the first quarter of 2010.  Expenses from
the foreclosures of properties increased from $70 during 2009 to $42,717 during
2010.  The increase reflects the levels of foreclosure related
activities.  Other expenses totaled $226,854 in 2010 compared to
$201,994 in 2009.  Income (loss) before income tax provision totaled
$(13,916,762) and $966,085 for the periods ended June 30, 2010 and 2009,
respectively.  Income tax provision totaled $82,760 and $308,273 for
the periods ended June 30, 2010 and 2009, respectively, which equated to an
effective tax rate of (.59)% and 31.91%, respectively.  The decrease
in 2010’s tax rate reflects the creation of a deferred tax valuation allowance
account, which offset the Company’s deferred tax assets.   No
such valuation existed during the comparable 2009 period.  Net income
(loss) totaled $(13,999,522) and $657,812 for the periods ended June 30, 2010
and 2009, respectively.





Other
comprehensive income totaled $180,844 and $149,740 for the six months ended June
30, 2010 and 2009, respectively.  Comprehensive income (loss), which
is the change in shareholders’ equity excluding transactions with shareholders,
totaled $(13,818,678) and $807,552 for the six months ended June 30, 2010 and
2009, respectively.





21
 Index





ASSET/LIABILITY
MANAGEMENT





The
Company’s asset/liability management, or interest rate risk management, program
is focused primarily on evaluating and managing the composition of its assets
and liabilities in view of various interest rate scenarios. Factors beyond the
Company’s control, such as market interest rates and competition, may also have
an impact on the Company’s interest income and interest expense.





Interest Rate Gap Analysis.As
a part of its interest rate risk management policy, the Company calculates an
interest rate “gap.” Interest rate “gap” analysis is a common, though imperfect,
measure of interest rate risk, which measures the relative dollar amounts of
interest-earning assets and interest-bearing liabilities which reprice within a
specific time period, either through maturity or rate adjustment. The “gap” is
the difference between the amounts of such assets and liabilities that are
subject to repricing. A “positive” gap for a given period means that the amount
of interest-earning assets maturing or otherwise repricing within that period
exceeds the amount of interest-bearing liabilities maturing or otherwise
repricing within the same period. Accordingly, in a declining interest rate
environment, an institution with a positive gap would generally be expected,
absent the effects of other factors, to experience a decrease in the yield on
its assets greater than the decrease in the cost of its liabilities and its
income should be negatively affected. Conversely, the cost of funds for an
institution with a positive gap would generally be expected to increase more
slowly than the yield on its assets in a rising interest rate environment, and
such institution’s net interest income generally would be expected to be
positively affected by rising interest rates. Changes in interest rates
generally have the opposite effect on an institution with a “negative
gap.”





The
majority of the Company’s deposits are rate-sensitive instruments with rates
that tend to fluctuate with market rates. These deposits, coupled with the
Company’s short-term certificates of deposit, have increased the opportunities
for deposit repricing. The Company places great significance on monitoring and
managing the Company’s asset/liability position. The Company’s policy of
managing its interest margin (or net yield on interest-earning assets) is to
maximize net interest income while maintaining a stable deposit base. The
Company’s deposit base is not generally subject to the level of volatility
experienced in national financial markets in recent years; however, the Company
does realize the importance of minimizing such volatility while at the same time
maintaining and improving earnings. Therefore, management prepares on a regular
basis earnings projections based on a range of interest rate scenarios of
rising, flat and declining rates in order to more accurately measure interest
rate risk.





Interest-bearing
liabilities and variable rate loans are generally repriced to current market
rates. Based on its analysis, the Company believes that its balance sheet is
liability-sensitive; meaning that in a given period there will be more
liabilities than assets subject to immediate repricing as the market rates
change. Because a significant portion of the Company’s deposits are either
variable rate or have short-term maturities, they reprice more rapidly than rate
sensitive interest-earnings assets. During periods of rising rates, this results
in decreased net interest income, assuming similar growth rates and stable
product mixes in loans and deposits. The opposite occurs during periods of
declining rates.





The
Company uses interest sensitivity analysis to measure the sensitivity of
projected earnings to changes in interest rates. The sensitivity analysis takes
into account the current contractual agreements that the Company has on
deposits, borrowings, loans, investments and any commitments to enter into those
transactions. The Company monitors interest sensitivity by means of computer
models that incorporate the current volumes, average rates, scheduled maturities
and payments and repricing opportunities of asset and liability portfolios.
Using this information, the model estimates earnings based on projected
portfolio balances under multiple interest rate scenarios. In an effort to
estimate the effects of pure interest-rate risk, the Company assumes no growth
in its balance sheet, because to do so could have the effect of distorting the
balance sheet’s sensitivity to changing interest rates. The Company simulates
the effects of interest rate changes on its earnings by assuming no change in
interest rates as its base case scenario and either (1) gradually increasing or
decreasing interest rates by over a twelve-month period or (2) immediately
increasing or decreasing interest rates by .25%, .50%, 1% and 2%. Although these
methods are subject to the accuracy of the assumptions that underlie the process
and do not take into account the pricing strategies that management would
undertake in response to sudden interest rate changes,





22
 Index





the
Company believes that these methods provide a better indication of the
sensitivity of earnings to changes in interest rates than other
analyses.





Income
simulation through modeling is one tool that the Company uses in the
asset/liability management process. The Company also considers a number of other
factors in determining its asset/liability and interest rate sensitivity
management strategies. Management strives to determine the most likely outlook
for the economy and interest rates by analyzing external factors, including
published economic projections and data, the effects of likely monetary and
fiscal policies as well as any enacted or prospective regulatory changes. The
Company’s current and prospective liquidity position, current balance sheet
volumes and projected growth, accessibility of funds for short-term needs and
capital maintenance are also considered. This data is combined with various
interest rate scenarios to provide management with information necessary to
analyze interest sensitivity and to aid in the development of strategies to
manage the Company’s balance sheet.





The
following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at June 30, 2010, which are projected
to reprice or mature in each of the future time periods shown. Except as stated
below, the amounts of assets and liabilities shown which reprice or mature
within a particular period were determined in accordance with the contractual
terms of the assets or liabilities. Loans with adjustable rates are shown as
being due at the end of the next upcoming adjustment period.  The
interest rate sensitivity of the Company’s assets and liabilities illustrated in
the following table would vary substantially if different assumptions were used
or if actual experience differs from that indicated by such
assumptions.





TERMS
      TO REPRICING AT JUNE 30, 20101-90
      Days
            
            
            91-180
      Days
            
            
            181-365
      Days
            
            
            Total
      One
            
            
            Non-
            
            
            TotalYear
            
            
            SensitiveInterest-earning
      assets:Interest
      bearing deposits
            
            $
            8,994,928
            
            
            $
            8,994,928
            
            
            $
            8,994,928Investment
      securities
            
            
            263,646
            
            
            $
            236,087
            
            
            $
            919,075
            
            
            
            1,418,808
            
            
            $
            22,310,856
            
            
            
            23,729,664Federal
      Home Loan Bankstock
            
            
            592,300
            
            
            
            -
            
            
            
            -
            
            
            
            592,300
            
            
            
            -
            
            
            
            592,300Loans
            
            
            96,370,259
            
            
            
            7,150,267
            
            
            
            7,825,507
            
            
            
            111,346,033
            
            
            
            59,092,262
            
            
            
            170,438,295Total
      Interest-earning assets
            
            
            106,221,133
            
            
            
            7,386,354
            
            
            
            8,744,582
            
            
            
            122,352,069
            
            
            
            81,403,118
            
            
            
            203,755,187Interest-bearing
      liabilities:Time
      deposits
            
            
            37,801,847
            
            
            
            19,184,488
            
            
            
            31,827,771
            
            
            
            88,814,106
            
            
            
            11,257,055
            
            
            
            100,071,161All
      other deposits
            
            
            75,590,076
            
            
            
            -
            
            
            
            -
            
            
            
            75,590,076
            
            
            
            -
            
            
            
            75,590,076Short-term
      debt
            
            
            840,310
            
            
            
            -
            
            
            
            -
            
            
            
            840,310
            
            
            
            -
            
            
            
            840,310Long-term
      debt
            
            
            4,124,000
            
            
            
            -
            
            
            
            -
            
            
            
            4,124,000
            
            
            
            4,000,000
            
            
            
            8,124,000Total
      interest-bearing liabilities
            
            
            118,356,233
            
            
            
            19,184,488
            
            
            
            31,827,771
            
            
            
            169,368,492
            
            
            
            15,257,055
            
            
            
            184,625,547Interest
      sensitivity gap
            
            $
            (12,135,100
            )
            
            $
            (11,798,134
            )
            
            $
            (23,083,189
            )
            
            $
            (47,016,423
            )
            
            $
            66,146,063Cumulative
      interest sensitivityGap
            
            $
            (12,135,100
            )
            
            $
            23,933,234
            
            
            $
            (47,016,423
            )Interest-earning
      assets asPercent
      of interest sensitiveliabilities*
            
            
            89.7
            %
            
            
            38.5
            %
            
            
            27.5
            %
            
            
            72.2
            %





*Percentages
shown are not cumulative.





The
Company has established an acceptable range of 80% to 120% for interest-earning
assets as a percent of interest sensitive liabilities for the total one year
horizon.  The increase in nonaccrual loans and the popularity of
eZchecking caused the Company’s static gap to fall outside of
policy.  Efforts are being undertaken to decrease nonaccrual
loans.  As mentioned elsewhere, the Company has augmented selected
components of its eZchecking product, which should minimize the gap between
actual ratios and policy.





23
 Index





ASSET
QUALITY








Total
loans outstanding at June 30, 2010 and December 31, 2009 were $170,438,295 and
$185,474,873, respectively.  Historically, the Bank has made loans
within its primary market area.  The Bank generally considers its
primary market to be Buncombe County in North Carolina.  Emphasis is
placed on commercial loans to small- and medium-sized business and
consumers.  The amounts and types of loans outstanding are shown the
following table.





June
      30,
            
            
            December
      31,2010
            
            
            2009LOANS:Real
      Estate -Construction
            
            $
            62,993,477
            
            
            $
            68,712,886Mortgage
            
            
            85,363,394
            
            
            
            88,843,525Commercial,
      financial and agricultural
            
            
            20,323,689
            
            
            
            25,833,920Consumer
            
            
            1,892,894
            
            
            
            2,254,665Subtotal
            
            
            170,573,454
            
            
            
            185,644,996Deferred
      origination fees, net
            
            
            (135,159
            )
            
            
            (170,123
            )Total
            
            $
            170,438,295
            
            
            $
            185,474,873





Real
estate loans represented 87% and 85% of the portfolio at June 30, 2010 and
December 31, 2009, respectively.  Commercial loans represented 12% of
the portfolio in 2010 compared to 14% at December 31, 2009, while consumer loans
represented 1% of the portfolio at June 30, 2010 and December 31, 2009,
respectively.  Commercial loans of $20,323,689 and $25,833,920,
consumer loans of $1,892,894 and $2,254,665 and real estate mortgage loans of
$85,363,394 and $88,843,525 at June 30, 2010 and December 31, 2009,
respectively, are loans for which the principal source of repayment is derived
from the ongoing cash flow of the business and other generally recurring sources
of income.  Real estate construction loans of $62,993,477 and
$68,712,886 are loans for which the principal source of repayment comes from the
sale of real estate or from obtaining permanent financing.





Total
non-owner occupied loans decreased from $93,004,204 to
$85,230,079.  The decrease was primarily attributable to loan
charge-offs and write-downs as a result of decreased asset
values.  These loans primarily represent residential acquisition and
development (“ADC”) real estate loans, which totaled $56,764,647 and $66,364,620
and commercial real estate, which totaled $28,388,363 and $26,560,538 at June
30, 2010 and December 31, 2009, respectively.  Residential ADC loans
consist of short-term construction facilities with the majority having takeouts
for permanent financing.  Commercial real estate owner-occupied loans
decreased modestly from $34,988,710 to $33,992,112.  Commercial and
industrial loans decreased from $25,833,920 to $20,323,689.  The
majority of the decrease was attributable to charge-offs and
write-downs.  Residential mortgage loans remained relatively flat at
$17,470,989.  Home equity lines of credit increased slightly from
$11,329,544 to $11,663,690 primarily as a result of increased draws on available
lines of credit, while consumer loans dropped slightly to
$1,892,894.





The Bank
has a diversified loan portfolio with two notable
concentrations.  While management believes there is no concentration
to any one borrower, a concentration does exist among a group of interrelated
parties.  The Bank had funded a total of 14 commercial notes totaling
in excess of $13,000,000 to individuals, who appear to have interrelated
business connections; a portion of which is secured by residential lots in a
real estate development project that has filed for protection under Chapter 11
bankruptcy.  The individual borrowers, however, have not filed
bankruptcy.  As of June 30, 2010 these loans had been charged-off
and/or written-down to approximately $6,600,000. Write downs were attributed to
the receipt of updated appraisals during the period which reflect lower values
due to the continued slow real estate sales environment.  All notes to
this group of related parties continue to be classified as nonaccrual, and are
carried at the lower of cost or net





24
 Index





realizable
values.  Management monitors these loans closely, meets with the
borrowers on a frequent basis and is pursuing collection efforts against debtors
and guarantors.





The
Bank’s loan portfolio also reflects a concentration in real estate lending;
however, that lending while geographically concentrated, is spread across a
diverse group of businesses and industries.  The Bank further attempts
to mitigate its exposure to real estate construction lending by limiting the
number of unsold houses to four per developer.  Currently, home
developer loans have an average balance of approximately $300,000 per
unit.  The Bank uses third party building inspectors to evaluate
construction progress.  Based upon reports provided by the inspectors,
the Bank believes it is better equipped to monitor and distribute loan draws
according to percent of project completed.  Approximately 20% of
commercial real estate mortgage loans are owner-occupied.  In general,
owner-occupied loans pose lower risks than non-owner-occupied loans as there is
lower risk of the borrower-tenant leaving the building for a better
lease.  Additionally, in the normal owner-occupied loan situation,
personal guarantees for the loan are present. Lastly, the Bank also contracts
with a third party loan reviewer to evaluate a selection of loans on a quarterly
basis.  The reviewer provides feedback on quality of loan
underwriting, timeliness of customer financial statements, independent global
cash flow analysis, concentrations of credit risk and loan risk grading, among
others.  Management believes this third party review to be an integral
part of its internal controls and risk monitoring systems.





At June
30, 2010, restructured loans, including both nonaccrual and performing, were
largely concentrated in the residential ADC sector of commercial real estate
notes followed by owner-occupied commercial real estate notes as shown
below.





Loan
Type


RestructuredLoansOutstanding
            
            
            RestructuredLoans
            
            
            Loans
      to LoansOutstandingCommercial
      real estate:Residential
      ADC
            
            $
            56,764,647
            
            
            $
            3,136,228
            
            
            
            5.52
            %Other
      Commercial
            
            
            28,388,363
            
            
            
            436,502
            
            
            
            1.54
            %Agricultural
            
            
            77,069
            
            
            
            -
            
            
            
            -Total
      non-owner occupied
            
            
            85,230,079
            
            
            
            3,572,730
            
            
            
            4.19
            %Commercial
      real estateowner-occupied
            
            
            33,992,112
            
            
            
            3,249,705
            
            
            
            9.56
            %Commercial:Construction
      and industrial
            
            
            20,323,689
            
            
            
            227,806
            
            
            
            1.12
            %Residential
      mortgage:1st
      lien; closed end
            
            
            15,334,436
            
            
            
            628,325
            
            
            
            4.10
            %Junior
      lien; closed end
            
            
            2,136,554
            
            
            
            -
            
            
            
            -
            %Total
      residential mortgage
            
            
            17,470,990
            
            
            
            628,325
            
            
            
            3.60
            %Home
      equity lines
            
            
            11,663,690
            
            
            
            343,403
            
            
            
            2.94
            %Consumer
      - other
            
            
            1,892,894
            
            
            
            13,041
            
            
            
            .69
            %Deferred
      fees/costs
            
            
            (135,159
            )
            
            
            -
            
            
            
            -
            %Total
            
            $
            170,438,295
            
            
            $
            8,035,010
            
            
            
            4.71
            %





Restructured
owner-occupied commercial real estate included four commercial customers with
combined balances of approximately $3.2 million.  Four of the five
loans totaling approximately $3.0 million were in compliance with modified
terms.  Restructured non-owner occupied commercial real estate of
approximately $3.6 million includes of 10 customers with a total of 13
notes.





25
 Index





NONPERFORMING
ASSETS





June
      30,
            
            
            December
      31,2010
            
            
            2009NONPERFORMING
      ASSETSNonaccrual
            
            $
            20,386,235
            
            
            $
            22,870,696Restructured
      loans
            
            
            4,470,275
            
            
            
            2,591,289Nonperforming
      loans
            
            
            24,856,510
            
            
            
            25,461,985Other
      real estate owned
            
            
            2,910,381
            
            
            
            511,112Repossessions
            
            
            13,325
            
            
            
            -Total
            
            $
            27,780,216
            
            
            $
            25,973,097Restructured
      loans not included incategories
      above
            
            $
            3,564,735
            
            
            $
            7,748,562








Approximately
$3.7 million of loans classified as nonperforming loans receive regular payments
from the borrowers.  The Company, however, requires the borrowers to
continue payments for a minimum of six months and provide financial projections
that indicate an ability to continue to make payments before the loan is
returned to performing status.  As of June 30, 2010, $3.6 million of
loans categorized as restructured loans not included in categories above
continue to make regular payments in accordance with their restructured
terms.





We
maintain an allowance for loan losses to absorb probable losses inherent in the
loan portfolio. The loan portfolio is analyzed monthly in an effort to identify
potential problems before they actually occur.  The allowance for loan
losses is established as losses are estimated to have occurred through a
provision for loan losses charged to earnings. The provision for loan losses is
based upon management’s best estimate of the amount needed to maintain the
allowance for loan losses at an adequate level. Loan losses are charged against
the allowance when management believes the uncollectibility of a loan balance is
confirmed. Subsequent recoveries, if any, are credited to the
allowance.





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





This
evaluation is inherently subjective, as it requires estimates that are
susceptible to significant revision as more information becomes available.
Therefore, while management uses the best information available to make
evaluations, future adjustments to the allowance may be necessary if conditions
differ substantially from the assumptions used in making the evaluations. In
addition, regulatory examiners may require the Company to recognize changes to
the allowance for loan losses based on their judgments about information
available to them at the time of their examination.





A loan is
considered impaired when, based on current information and events, it is
probable that the Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value, and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls generally are not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower,
including the length of the delay, the reasons for the delay, the borrower’s
prior payment record, and the amount of the





26
 Index





shortfall
in relation to the principal and interest owed.  Impairment is
measured on a loan by loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loan’s
effective interest rate, the loan’s obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.  Large groups
of smaller balance homogeneous loans are collectively evaluated for
impairment.  Accordingly, the Company does not separately identify
individual consumer and residential loans for impairment
disclosures.





The
provision for loan losses represents a charge against income in an amount
necessary to maintain the allowance at an appropriate level.  The
quarterly provision for loan losses may fluctuate based on the results of this
analysis.  The allowance for loan losses at June 30, 2010 and 2009,
and December 31, 2009 was $4,185,422, $2,847,508 and $3,512,263 or 2.46%, 1.58%
and 1.89%, respectively, of gross loans outstanding.   The ratio
of annualized net charge-offs to average loans outstanding was 15.09%, .18% and
1.24% at June 30, 2010 and 2009, and December 2009, respectively.





The
following table contains an analysis for the allowance for loan losses,
including the amount of charge-offs and recoveries by loan type, for the
six-months ended June 30, 2010 and 2009, and for the year ended December 31,
2009.








Summary
of Allowance for Loan Losses





For
      the six months
            
            
            For
      the year endedended
      June 30,
            
            
            December
      31,2010
            
            
            2009
            
            
            2009Balance,
      beginning of period
            
            $
            3,512,263
            
            
            $
            2,529,981
            
            
            $
            2,529,981Charge-offs:Commercial,
      financial and agricultural
            
            
            (4,026,985
            )
            
            
            (117,754
            )
            
            
            (994,756
            )Real
      estate:Construction
            
            
            (8,899,115
            )
            
            
            -
            
            
            
            (693,002
            )Mortgage
            
            
            (634,925
            )
            
            
            (30,000
            )
            
            
            (493,467
            )Consumer
            
            
            (344,747
            )
            
            
            (31,242
            )
            
            
            (85,257
            )Total
      charge-offs
            
            
            (13,905,772
            )
            
            
            (178,996
            )
            
            
            (2,266,482
            )RecoveriesCommercial,
      financial and agricultural
            
            
            -
            
            
            
            -
            
            
            
            28Real
      estate:Construction
            
            
            -
            
            
            
            -
            
            
            
            -Mortgage
            
            
            -
            
            
            
            -
            
            
            
            -Consumer
            
            
            71,541
            
            
            
            20,633
            
            
            
            30,336Total
      recoveries
            
            
            71,541
            
            
            
            20,633
            
            
            
            30,364Net
      charge-offs
            
            
            (13,834,231
            )
            
            
            (158,363
            )
            
            
            (2,236,118
            )Provision
      charged to operations
            
            
            14,507,390
            
            
            
            475,890
            
            
            
            3,218,400Balance,
      end of period
            
            $
            4,185,422
            
            
            $
            2,847,508
            
            
            $
            3,512,263Percentage
      of annualized net charge-offs toaverage
      loans
            
            
            15.09
            %
            
            
            .18
            %
            
            
            1.24
            %Percentage
      of allowance toperiod-end
      loans
            
            
            2.46
            %
            
            
            1.58
            %
            
            
            1.89
            %





The Bank
operates in a well diversified market.  Major economic drivers include
tourism, medical industry and light manufacturing in addition to state and
federal government agencies.  The majority of the commercial loan
chargeoffs were related to a loan whose proceeds were used for an ADC project
that was collateralized by a note





27
 Index





receivable
that was deemed worthless in the current quarter.  This is considered
a nonrecurring type of charge-off and not reflective of our commercial portfolio
as a whole.  The Bank’s primary market area has experienced increased
unemployment levels, but they are lower than the North Carolina
average.  However, the ADC market has experienced significant
disruption in volumes and market value due to the reduced level of purchasers
providing liquidity to this market segment.  Continued low volumes of
sales could have a negative impact on the Bank in the form of increased
nonperforming loans and real estate owned.





The Bank
attempts to mitigate its exposure to real estate construction lending by
limiting the number of unsold houses to four per
developer.  Currently, home developer loans have an average balance of
approximately $300,000 per unit.  The Bank uses third party building
inspectors to evaluate construction progress.  Based upon reports
provided by the inspectors the Bank believes it is better equipped to monitor
and distribute loan draws according to percent of project
completed.  Approximately 20% of commercial real estate mortgage loans
are owner-occupied.  In general, owner-occupied loans pose lower risks
than non-owner-occupied loans as there is lower risk of the borrower-tenant
leaving the building for a better lease and generally there are business-related
cash flows which provide debt service capacity.  Additionally, in the
normal owner-occupied loan situation, personal guarantees for the loan are
present.





Nonaccrual
and restructured loans decreased slightly from $25,461,985 at December 31, 2009
to $24,856,510 at June 30, 2010 due primarily to significant charge-offs
previously discussed offset by impaired loans migrating to nonaccrual
status.  Although some of the customers have resumed payments,
management has continued to classify the relationships until such time as the
borrowers demonstrate a consistent and consecutive payment
history.  Management has reviewed each non-performing loan, supporting
collateral, financial stability of each borrower and the relevant loan loss
allowance.  During the first quarter of 2010, management reorganized
its credit administration department to improve its underwriting analysis,
training and loan monitoring.  Management continued its engagement of
third party loan review services to supplement and validate overall loan review
analytics and portfolio risk assessments.  Based upon this analysis,
management believes the allowance is appropriate in light of the risk associated
with current loans outstanding.





The Bank
utilizes a loan migration model to assist in its determination of the proper
level of reserves for loan losses. During second quarter, the loss horizon time
frame in the migration analysis was reduced for the construction and commercial
secured loan pool groupings as a result of a significant short-term increase in
substandard loans and losses on those loans related to a group of loans totaling
approximately $13, million related through interrelated business
connections.  Management believes that the losses of these loans are
isolated and not indicative of the risks currently in the remaining construction
and commercial loan portfolio.  Therefore, the changes made to the
loss horizon better represent the management’s current judgment about the credit
quality of the loan portfolio as a whole.





The
following table allocates the allowance for loan losses by loan category at the
dates indicated.  The allocation of the allowance to each category is
not necessarily indicative of future losses and does not restrict the use of the
allowance to absorb losses in any category.








June
      30, 2010
            
            
            December
      31, 2009Amount
      of Allowance
            
            
            Percent
      of Total Loans
            
            
            Amount
      of Allowance
            
            
            Percent
      of Total LoansTYPE
      OF LOAN:Real
      Estate
            
            $
            3,340,312
            
            
            
            87
            %
            
            $
            2,481,578
            
            
            
            85
            %Commercial
      and industrialloans
            
            
            751,127
            
            
            
            12
            %
            
            
            878,086
            
            
            
            14
            %Consumer
            
            
            93,983
            
            
            
            1
            %
            
            
            152,599
            
            
            
            1
            %Unallocated
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
      Allowance
            
            $
            4,185,422
            
            
            
            100
            %
            
            $
            3,512,263
            
            
            
            100
            %





28
 Index





CAPITAL
RESOURCES





Banks and
bank holding companies, as regulated institutions, must meet required levels of
capital. The Federal Deposit Insurance Corporation (“FDIC”) and the Federal
Reserve, the primary federal regulators of The Bank of Asheville and Weststar,
respectively, have adopted minimum capital regulations or guidelines that
categorize components and the level of risk associated with various types of
assets. Financial institutions are expected to maintain a level of capital
commensurate with the risk profile assigned to its assets in accordance with
these guidelines. As shown in the following table, Weststar and the Bank of
Asheville both are no longer considered adequately capitalized in accordance
with these guidelines.  The Bank is considered significantly
undercapitalized under the prompt corrective action
provisions.  Currently, the Company is actively pursuing strategic
plans to enhance its capital ratios.  As part of these efforts, the
Company has retained the services of investment bankers to review all strategic
opportunities available to the Company and Bank.





REGULATORY
CAPITAL





Actual
            
            
            For
      Capital Adequacy Purposes
            
            
            To
      Be Well Capitalized Under Prompt Corrective Action
    ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio(Dollars
      in Thousands)As
      of June 30, 2010Total
      Capital (to Risk WeightedAssets)Consolidated
            
            $
            6,878
            
            
            
            3.85
            %
            
            $
            14,278
            
            
            
            8.00
            %
            
            $
            17,847
            
            
            
            10.00
            %Bank
            
            $
            8,249
            
            
            
            4.63
            %
            
            $
            14,258
            
            
            
            8.00
            %
            
            $
            17,823
            
            
            
            10.00
            %Tier
      1 Capital (to Risk WeightedAssets)Consolidated
            
            $
            3,439
            
            
            
            1.93
            %
            
            $
            7,139
            
            
            
            4.00
            %
            
            $
            10,708
            
            
            
            6.00
            %Bank
            
            $
            5,997
            
            
            
            3.36
            %
            
            $
            7,129
            
            
            
            4.00
            %
            
            $
            10,694
            
            
            
            6.00
            %Tier
      1 Capital (to Average Assets)Consolidated
            
            $
            3,439
            
            
            
            1.51
            %
            
            $
            9,122
            
            
            
            4.00
            %
            
            $
            11,403
            
            
            
            5.00
            %Bank
            
            $
            5,997
            
            
            
            2.63
            %
            
            $
            9,113
            
            
            
            4.00
            %
            
            $
            11,392
            
            
            
            5.00
            %








LIQUIDITY





Maintaining
adequate liquidity while managing interest rate risk is the primary goal of our
asset and liability management strategy. Liquidity is the ability to fund the
needs of the Company’s borrowers and depositors, pay operating expenses, and
meet regulatory liquidity requirements. Loan repayments, deposit growth, federal
funds purchased and borrowings from the Federal Home Loan Bank are presently the
main sources of the Company’s liquidity. The Company’s primary uses of liquidity
are to fund loans, deposit maturities and to make investments.





As of
June 30, 2010 liquid assets (cash and due from banks and interest-earning bank
deposits) were approximately $13.2 million, which represents 6.18% of total
assets and 6.59% of total deposits. Supplementing this liquidity, Weststar has
available lines of credit from correspondent banks of approximately $18.9
million; and unpledged investment securities of $18.3 million. At June 30, 2010,
outstanding commitments to extend credit and available lines of credit
were $19.8 million.





Certificates
of deposit represented approximately 49.81% of Weststar’s total deposits at June
30, 2010. Certificates of deposit of $100,000 or more represented 11.86% of the
Company’s total deposits at June 30, 2010.  These deposits are
generally considered rate sensitive, but management believes most of them are
relationship-





29
 Index





oriented.
While the Company will need to pay competitive rates to retain these deposits at
maturity, there are other subjective factors that will determine the Company’s
continued retention of these deposits.





The
anticipated order from our primary regulators and the current level of capital
may restrict the Bank’s ability to use brokered CD’s as a source of liquidity
and may also reduce access to other lines of credit that were previously
mentioned without posting additional collateral.  The anticipated
order may also restrict our ability to offer interest rates on deposit products
above the market rates.





30
 Index





IMPACT
OF INFLATION AND CHANGING PRICES





A
financial institution has assets and liabilities that are distinctly different
from those of a company with substantial investments in plant and inventory
because the major portion of its assets is monetary in nature. As a result, a
bank’s performance may be significantly influenced by changes in interest rates.
Although the banking industry is more affected by changes in interest rates than
by inflation in the prices of goods and services, inflation is a factor, which
may influence interest rates. However, the frequency and magnitude of interest
rate fluctuations do not necessarily coincide with changes in the general
inflation rate. Inflation does affect operating expenses in that personnel
expenses, cost of supplies and outside services tend to increase more during
periods of high inflation.





Item4T.    Controls and Procedures





At the
end of the period covered by this report, the Company carried out an evaluation,
under the supervision and with the participation of the Company’s management,
including the Company’s Chief Executive Officer and Chief Financial Officer, of
the effectiveness of the design and operation of the Company’s disclosure
controls and procedures pursuant to Securities Exchange Act Rule
13a-14.








Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company’s disclosure controls and procedures were not
effective (1) to provide reasonable assurance that information required to be
disclosed by the Company in the reports filed or submitted by it under the
Securities Exchange Act was recorded, processed, summarized and reported within
the time periods specified in the SEC’s rules and forms, and (2) to provide
reasonable assurance that information required to be disclosed by the Company in
such reports is accumulated and communicated to the Company’s management,
including its Chief Executive Officer and Chief Financial Officer, as
appropriate to allow for timely decisions regarding required
disclosure.








As
discussed in Item 2 of this report, we experienced substantial deterioration in
the quality of our loan portfolio. We have identified material weaknesses in our
disclosure controls and procedures and internal controls relating to segregation
of duties, underwriting practices, overdraft policy overrides and problem asset
management.  We have engaged an independent third party to assist us
with an in-depth loan portfolio review and review our loan policies, internal
controls and governance practices.  This third party reviewer’s
recommendations included improving loan polices, practices and procedures;
utilizing appropriate measures to identify current credit losses; and enhancing
our monitoring and workout strategies for problem assets.





Remediation
Plan





In
response to the material weaknesses stated above, we have developed the
following remediation plan to address these weaknesses and are diligently
proceeding with the following measures to enhance our disclosure controls and
procedures and internal controls.





·
            We
      have revised loan officer lending authority and reassigned portfolio
      responsibilities.





·
            We
      have restructured the Chief Credit Officer role to be independent of
      lending and to report to the Loan Committee of the Board of
      Directors.





·
            We
      have provided additional resources to our Credit Administrative staff with
      the addition an interim Chief Credit Officer and Credit Analyst. We have
      also implemented additional monitoring procedures that have helped improve
      underwriting practices.





·
            We
      have increased the frequency of loan committee meetings from monthly to
      weekly or as needed.





31
 Index





·
            We
      are in the process of developing a disciplined approach for problem
      assets.  We have strengthened our appraisal policies and
      obtaining updated appraisals on all troubled
  loans.





·
            We
      are assessing current lending policies and credit administration
      procedures in order to determine what changes are necessary to strengthen
      our internal controls.





Our Board
of Directors is actively monitoring our remediation accomplishments and will
oversee additional measures if deemed necessary.  We cannot be certain
of the length of time for implementation of this remediation plan, whether it
will be effective to maintain adequate controls over our financial processes and
reporting in the future, or whether the remediation plan will be sufficient to
address and eliminate the material weaknesses that have been
identified.





Changes
in Internal Control Over Financial Reporting


Except
for the matters discussed above, there were no changes in the Company’s internal
control over financial reporting during the period covered by this report that
have materially affected, or are reasonably likely to materially affect, the
Company’s internal control over financial reporting. The Company reviews its
disclosure controls and procedures, which may include its internal control over
financial reporting, on an ongoing basis, and may from time to time make changes
aimed at enhancing their effectiveness and to ensure that the Company’s systems
evolve with its business.





32
 Index





PartII.    OTHER INFORMATION





Item1.    Legal Proceedings





In the
Matter of Queens Gap Holding Company, LLC, et al.:  On June 18, 2010,
Queens Gap Holding Company, LLC and D.F. McCarthy Investments XVIII, LLC filed
suit against the Bank in the United States District Court for the
Western District of North Carolina..   In summary, the Plaintiffs, who
were the sellers in a real estate development transaction, allege that the
Bank improperly allowed the buyer to divert, for personal use, funds from
an account set up at the Bank to fund infrastructure improvements in
the development.  The Plaintiffs' claims are based on alleged oral and
email representations and promises from the Bank to them.  The Plaintiffs
seek $4,250,000 in compensatory damages plus treble damages and attorney's
fees.  The Bank intends to defend this case vigorously. Bank’s management
and its counsel sre still in the early phase of discovery and has concluded as
of June 30, 2010 that it is not probable that the Bank will incur a loss as a
result of this suit.  As more information becomes available and as the
suit progresses, the conclusion may change.








Item5.    Other Information


(a)
            None.


(b)
            None.





Item6.    Exhibits





(a)
            Exhibits.





31.1 –
            Certification
      of the Chief Executive Officer  and Chief Financial Officer
      pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002




32.1 –
            Certification
      by the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002





33
 Index





SIGNATURES








Under the
requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.








WESTSTAR
      FINANCIAL SERVICES CORPORATIONDate:
      August 23, 2010
            
            By:
            /s/   Randall C.
      HallRandall
      C. HallInterim
      President and Chief Executive OfficerChief
      Financial and Principal Accounting
Officer







34